I did a post in March 2019 on one of the best theories I have read on the importance of high ROCE and good earnings growth, which make a great combination for long-term wealth creation.
This theory came from Bharat Shah of ASK Group, who wrote a book (sad, it’s not available publicly) titled “Of Long Term Value and Wealth Creation from Equity Investing.”
In the chapter titled “Quality of Business: Capital Intensity and Capital Efficiency,” he suggested a matrix, which I have illustrated below –
(Click on the image to open a larger version)
Mr. Shah categorized businesses into six buckets –
1. Winner: High ROCE (>20%) + High earnings growth (>15%) – Will create the highest value as these show superb capital efficiency and outstanding earnings growth; fertile territory for finding multi-year compounding machines and yet offering great safety during tough market conditions.
2. Aspirer: High ROCE (>20%) + Moderate earnings growth (5-15%) – Provide safety with reasonable value creation due to superior capital efficiency but moderate earnings growth rate; should compound at a rate closer to earnings growth; largely a recipe for capital preservation with reasonable appreciation, though unlikely to be rewarded substantially due to moderate growth.
3. Gentry: High ROCE (>20%) + Low earnings growth (<5%) - At best a recipe for capital preservation; high business quality should ensure that value is preserved but lack of earnings growth would not enable these businesses to create long-term value; in fact, a challenging phase could result in value fading away.
4. Treadmill: Moderate ROCE (10-20%) + High earnings growth (>15%) – Value creation is difficult and unpredictable for these businesses; value creation generally tracks higher of ROCE and growth in good market conditions and lower of the two in bad times; buying at cheap prices could help create returns higher than earnings growth for some time, but that may be unsustainable.
5. Struggler: Moderate ROCE (10-20%) + Moderate to low earnings growth (5-15%) – It’s never easy for the business or shareholders in them; value creation is low and irregular; not ideal candidates in a portfolio from a value creation perspective; buying at cheap prices could help create returns higher than earnings growth for some time, but that may be unsustainable.
6. Value Obliterator/ Sweatshop: Low ROCE (<10%) + Any growth – Value is destroyed in the long run as any kind of growth is bad when ROCE is lower than even cost of capital; cheap initial valuation may cause accidental investment returns, but it’s not sustainable.
Based on these six buckets, I compiled six lists of companies (using data from Screener.in) that meet the respective criteria as described above.
Apart from the ROCE and earnings growth parameters as suggested under each of these buckets, for the purpose of creating my screens, I restricted the lists to companies with market capitalization greater than Rs 1,000 crore, and debt/equity lower than 1.
Now, one year is too less a time to check back on the performance of stocks under each bucket, but I have done that today given that we are going through one of the worst crisis since 2008, which provides a good testing ground for stocks, largely in terms of the ones that are able to handle the crisis less badly than others.
And here are some observations on each bucket’s performance over the last one year –
Note: Data is sourced from Google. Expect some discrepancies.
- The Sweatshop (Low ROCE + Any Growth) bucket has been the worst performer of the lot with stocks, on an average, falling by 49% from their 52-week high levels. Median decline is almost 50%. What is more, of the 47 stocks in this list, 16 have fallen more than 60%. The worst declines range from 80% to 95%, all in a span of almost one year!
- The Treadmill (Moderate ROCE + High Growth) bucket has been the second worst performer of the lot with stocks, on an average, falling by 47% from their 52-week high levels. Median decline is almost 50%. As per the description, for this category of businesses, value creation is difficult and unpredictable, and it generally tracks higher of ROCE and growth in good market conditions and lower of the two in bad times. In the current conditions, these stocks have been hit the highest maybe because of expectations of poor growth or degrowth in earnings given the crisis and the way it is playing out. Also, given the high growth nature of these businesses, and that markets pays higher P/E multiples in general for growth, a P/E contraction has also seemingly played out in this segment, contribution to the overall decline in stock prices.
- The Struggler (Moderate ROCE + Moderate to Low Growth) bucket is the third worst performer with stocks, on an average, falling by 44% from their 52-week high levels. Median decline here is 42%. As the market was earlier paying for growth, the expectations of which have evaporated now, these stocks were anyways not highly paid for as the Treadmill category. And thus, seemingly, despite their poorer quality as compared to Treadmill, these have fallen less in the crisis. Anyways, it is never easy for the business or shareholders in this category to create value, and these are not ideal candidates in a portfolio from a value creation perspective. Buying at cheap prices could help create returns higher than earnings growth for some time, but that may be unsustainable. As a matter of fact, the average P/E of this bucket of stocks as of now is around 11 times. Not much, but then both earnings and earnings quality are doubtful. So, buyer beware!
- The Winner (High ROCE + High Growth) bucket presents the biggest surprise here, in being the fourth worst performer. Stocks in this category have, on an average, fallen by 38% from their 52-week high levels. Median decline here is also 38%. These are described as companies with the potential to create the highest value, given their superb capital efficiency and outstanding earnings growth. These businesses are considered as offering great safety during tough market conditions. Their high valuations before the start of this crisis, which remains reasonably high (average P/E of 30x), seems to have done them in. Markets seems to have focused more on the decline in their prospective earnings growth, than their inherent quality as suggested by high ROCE, and has thus punished them. However, considering any improvement in the business and consumption environment, once the crisis fades away, this category would continue to hold the potential to create the highest value, assuming their capital efficiency remains as good as in the past and earnings growth returns to their normalized levels. However, these are just assumptions in a world that has been brought to task by high levels of uncertainty, and thus paying high prices for even such high-quality businesses is fraught with risks.
- The Gentry (High ROCE + Low Growth) and Aspirer (High ROCE + Moderate Growth) buckets have been the best performers. Stocks here have fallen, on an average by around 31-33% from their 52-week high levels. These categories, given their strong capital efficiency but moderate to low earnings growth, are seen as buckets of capital preservation over the long run, with reasonable value creation. While these have also destroyed capital in the crisis, along with all other buckets of stocks, the fact that these have destroyed less somewhat proves their capital preservation attribute. The focus with these buckets should be how fast they revert to their normalised levels of earnings growth, because if they are not able to do that, their ROCE may start suffering, and so would their value creation potential.
Words of Warning
Before you look at these lists, here are some words of warning.
What you see there is just data. Numbers speak out loudly in most cases, but sometimes they don’t. Like you may never know from past numbers how the future might look, even though a long-term past is a good indicator of what may happen in the future. Also, you may never be able to locate a turnaround based on a poor track record in the past (though as Buffett says, turnarounds rarely turn around).
Another warning is that a great past may lead you to be greedy and imagine with certainty a great future and thus pay up or overpay for the stock. So, be careful of what you observe and how you act.
Just treat these lists and the theory around them (ROCE + Earnings Growth) as a mental model to think about how to pick the right kind of businesses and avoid the wrong ones.
And please remember Warren Buffett’s adage that investing –
- Is simple – We know that sustainably high ROCE and earnings growth is a great combination for long-term wealth creation
- But not easy – Practicing what we know and paying appropriate prices even for the best of businesses and avoiding the bad ones when others may be making some money on them in good times.
Keep this in mind, keep it simple, work hard, and stay safe.
Statutory Warning: This is NOT an investment advice to buy or sell shares. Please make your own decision, as blindly acting on anyone else’s research and opinions can be injurious to your wealth. My analysis may be biased, and wrong. I have been wrong many times in the past. I am a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014 (Registration No. INH000000578).