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Great Indian companies

Of some 1,500 companies in India that have a market cap of over Rs 100 crore, only 16 have reliable financial performance

Great Indian companiesI moved to India in 2008 to work in the Indian stock market. Whilst I have captured my journey to understand India in my book Gurus of Chaos: Modern India's Money Masters, my new book The Unusual Billionaires delves into the issue of why there are so few Indian companies which deliver reliable financial performance over meaningful periods of time. Let me begin by being precise about what I define as 'reliable financial performance over meaningful periods of time'.

Step 1: Define 'long periods': A decade in India usually accommodates both the up and down cycles in the economy. For example, the decade from FY06 (i.e., the financial year ending March 31, 2006) to FY15 (i.e., the financial year ending March 31, 2015) coincides with six years of strong economic growth (FY06 to FY11, where average nominal GDP growth was 15.7 per cent) and four years of weak economic growth (FY12 to FY15, where average nominal GDP growth was 12.8 per cent). Hence, measuring greatness over a decadal period should not unfairly penalise cyclical companies, nor unfairly advantage companies in more stable, steady sectors.

Step 2: Define superior financial performance: At the very basic level, a company doing well would mean that it is profitable and it is growing (by successfully reinvesting its profits). Over very long periods of time, the twin filters of growth and profitability, in my view, are sufficient to assess the success of a franchise. Thus, my stock-selection filters are companies that deliver revenue growth of 10 per cent and return on capital employed (RoCE) of 15 per cent every year for the past ten years.

Why revenue growth of 10 per cent every year? India's nominal GDP growth rate has averaged 14.5 per cent over the past ten years. However, very few listed companies have managed to achieve this! Therefore, I reduce this filter rate modestly to 10 per cent.

Why return on capital employed (RoCE)? A company uses capital to invest in assets, which in turn generate cash flows and earnings. This capital invested consists of equity and debt, and the sum of the cost of equity and the cost of debt (weighted in proportion to their share in total capital) is known more popularly as the weighted average cost of capital or WACC. A measure of a company's effectiveness in investing its capital is to compare its WACC with the quantum of cash flows or earnings generated by the investment. The latter is known as the return on capital employed. Companies with low RoCEs keep requiring external infusions of capital to fund their growth. Therefore, this excess of RoCE over WACC is a measure of the excess returns to an investor in the company. It follows, therefore, that if a company grows without excess returns, it creates no value for equity investors. In general, I have found RoCE is the single biggest factor affecting a company's stock price.

Why minimum RoCE of 15 per cent? The minimum return that one would rationally expect from equities is the risk-free return that you would earn if you invested in the safest investment in India, namely, government bonds. In early 2016, the Government of India's ten-year bonds were giving a return of around 8 per cent. Given that equities carry an element of risk that government bonds don't, an equity investor would want a premium return for this extra risk. This is the equity-risk premium - the extra return an investor expects over and above the risk-free rate for investing in equities. The equity-risk premium, in turn, is calculated as 4 per cent (the long-term US equity risk premium) plus 250 bps to account for India's rating (BBB- as per S&P). Hence, adding the risk-free rate (8 per cent) and an equity-risk premium of 6.5-7 per cent gives cost of capital of broadly 15 per cent. Note further that over the past 20 years and 30 years, the Sensex has delivered returns of around 15 per cent per annum, thus validating my point of view that 15 per cent is a sensible measure of the cost of capital for an Indian company. Therefore, if a company is to be deemed to be great, it has to deliver an ROCE in excess of 15 per cent per annum over long periods of time.

There are around 1,500 companies in India with a market cap of ₹1 billion (₹100 crore) or more. So, if we look at the period of FY06-15, how many of these companies passed the twin filters of over 10 per cent revenue growth and 15 per cent ROCE? The answer is 16 or 1 per cent of our population of the 1,500 largest listed companies in India.

You can read the full article in the September edition of Wealth Insight.

Saurabh Mukherjea is CEO - Institutional Equities at Ambit Capital and the author of The Unusual Billionaires. You can buy the book here.