The Art Of Identifying Market Winners

When it comes to choosing the right stocks, Dr. Ruzbeh Bodhanwala and Dr. Shernaz Bodhanwala, faculty at FLAME University, Pune suggest that no single metric or ratio should be used to make an investment decision. There is no substitute for thorough fundamental analysis and one should understand the companies’ risk profile before investing 

The Nifty is trading at a PE multiple of 22, which makes it reasonably valued considering the historical PE multiples at which it has traded earlier. Whenever the market is reasonably valued, it gives investors a good investment opportunity. In this article, we discuss some of the characteristics of companies that have generated great wealth for shareholders as compared to other companies that have either been de-rated or not appreciated as much. We use the past 10 years of data to study the performances of the top 500 publicly listed companies.

For wealth creation, investors should look out for three metrics: return on capital, growth in sales and earnings, and reasonable valuation. The earning potential can be influenced by many factors such as changes in sales, changes in cost structure, tax efficiency, better capital allocation, etc. For an investor, the most important parameter which captures many business efficiency factors is the return on equity (ROE) or return on net worth (RONW), which is provided by many database providers. This is a standardised ratio that is calculated as net profit divided by the total shareholders’ fund.

This ratio indicates the return generated by the company over the capital obtained from the shareholders and is one of the good indicators to quantify business performance. The shareholders’ fund is defined as equity capital invested plus all reserves and surpluses of the company generated through its years of operations. The ROE can be used in comparing companies across various sectors. A change in ROE can be caused by a combination of any of the factors such as a change in the profit margins, capital turnover, financial cost ratio, financial structure ratio and change in tax structure.

If we were to look at this ratio from an investor’s perspective, generally speaking, investors expect the ROE to grow or at the least be consistent over the years, and it should be higher than the cost of capital. With this expectation in mind, investors would search for companies with higher reported RONW or ROE.

In the present context, we would assume that a company generating an ROE of 15 per cent or more should be considered a good investment opportunity. Earnings growth is another closely watched parameter by investors.

Earnings visibility along with high capital efficiency and a strong management team is a perfect recipe for finding a multibagger company if we pay the right price. In this study, we compute growth in earnings and sales by calculating the compounded annual growth rate (CAGR) at which the sales and earnings have changed between 2014 and 2023 using the consolidated reported numbers. We sorted companies based on market capitalisation on February 16, 2024, and selected 500 companies that had a trading history over the past 10 years. We then obtained the CAGR of price growth, sales growth and earnings growth.

We separated the companies into four buckets based on the stock price CAGR over 2014-2024 – companies with stock price CAGR greater than 20 per cent, CAGR of 10-20 per cent, CAGR of 0-10 per cent, and less than 0 per cent. Up to 275 companies have given stock price CAGR of over 20 per cent over the last 10 years and we call them ‘super wealth creators’. Up to 157 companies have generated stock price CAGR between 10-20 per cent and we call them ‘wealth creators’ while 67 companies that have generated returns less than 10 per cent have been termed ‘capital preservers’.

The last bucket that generated a stock price CAGR of less than 0 per cent has been called ‘wealth destructors’. After calculating the sales and earnings growth for each company, we obtained the median sales and earnings growth in each bucket. For the valuation metrics, we obtained the median PE ratio in 2014 and 2024, and for measuring the return to shareholders, we calculated the median ROE in each bucket. The results in Table 1 indicate that our super wealth creators were trading at a lower median PE ratio of 11.6 as compared to the Nifty PE ratio of 16 in 2014.

In the year 2024, the median PE ratio for these super wealth creators grew to 36.2, which is much higher as compared to the median Nifty PE ratio at 22.7. Let’s see the ROE generated by these super wealth creator companies. The median ROE of super wealth creators’ bucket was 11.3 per cent in 2014 which has now increased to 16.6 per cent. This can largely be attributed to the median sales growth of 11 per cent and median earnings growth of 18 per cent recorded by these companies from 2014-2023. As a student of the markets, we should also study the attributes of companies falling into the wealth destructors and wealth preservers bucket.

As American investor and philanthropist Charlie Munger said, “All I want to know is where I am going to die so that I will never go there.” The wealth preservers were found to be companies that had a median ROE in 2014 at a similar level to that of the wealth creators’ bucket. However, they recorded lower sales and earnings growth when compared to the wealth creators and super wealth creators. The wealth destructor bucket companies had much lower median ROEs in 2014, and these companies’ median ROEs further deteriorated over 10 years. This can largely be attributed to the poor sales and earnings growth exhibited by them.

Table 2 indicates the median values of promoter holding, leverage position and the quality of earnings for each of the buckets. The promoter’s holding is a parameter that shows the ‘skin in the game’ of the promoter shareholders. We observe that across all the top three buckets, the median promoter shareholding has decreased over 2014-2023. However, in the wealth destructor bucket, the median promoter shareholding has increased by 6.7 per cent over 2014-2023. Companies across buckets have reduced the level of debt in the capital structure over this period.

This can be attributed to lower interest rates and the easy availability of funds during the coronavirus-led pandemic along with the companies’ efforts to deleverage. Another vital parameter that the analyst community admires is the quality of earnings (QE), which is defined as cash flow from operations (CFO) divided by the net income. The companies’ cash flow from operations should ideally move in line with the net profit generated by the business. The CFO number talks about the company’s ability to generate cash from its business operations which in turn can support its expansion capex and operational expenditures. For the wealth destructor bucket, we observe a sharp decline in the QE ratio over 2014-2023.

This indicates the weakness of the business model and may sometimes be a financial misrepresentation of the income statement. The learning for investors is to stick to companies that have the potential for higher sales and earnings growth, which would ultimately lead to higher price appreciation over time as the PE multiples expand. Investing is a long-term game, so investors should not switch in and out of the company based on quarterly or annual results if the long-term growth trajectory is visible.

Further, it is important to remember that wealth creation is only possible if we invest at reasonable valuations. Since the annual earning season is yet to start for the year ending FY 2024, investors who can track results should always watch out for companies with high governance standards, brighter growth prospects, and high capital efficiency to maximise returns. All said, we suggest that no single metric or ratio should be used to make an investment decision. There is no substitute for thorough fundamental analysis and one should understand their risk profile before investing.