Widely read:
A healthy earnings growth is not enough to guarantee good returns. The business should also have a track record of using its resources efficiently.
No, you don't have to take our word for it. The above forms the crux of the 2013 book 'Of Long-Term Value & Wealth Creation from Equity Investing: Observations, Ideas & Reflections' by Bharat Shah, Executive Director at ASK Group and one of the most renowned Indian investors.
Why earnings growth is not enough
In the book, Shah explains how a business's earnings growth does not accurately represent its growth potential.
Why?
Suppose you and your friend both run a dairy business. Business is booming, and you decide to invest Rs 10 lakh and expand. Everything works out, and your earnings shoot up by 5 per cent.
Your friend is impressed and decides to follow suit. He invests Rs 20 lakh to expand, and his earnings increases by 5 per cent too.
On paper, both you and your friend achieved an earnings growth of five per cent. However, it is clear you were far more efficient with your capital as you achieved the five per cent growth using only Rs 10 lakh.
Thus, it is more likely that you will be able to sustain this earnings growth as you can achieve growth at a lesser cost.
Thus, Bharat Shah advises investors that earnings growth and RoCE (return on capital employed - a metric that gauges how efficiently a business uses its capital) should work in tandem. It is always a positive when a business' earnings shoot up. But if the management is wasteful with its resources, it will not be able to sustain the growth. So, investors should always look at both earnings growth and RoCE when gauging a company's growth potential.
A matrix to make things easier
To help investors, Bharat shah introduced a novel matrix to assess a business' growth potential. In simpler terms, one can use the matrix to guess how likely a business is to give good returns.
- Winners (earnings growth > 15 per cent & RoCE > 20 per cent): High probability of high and sustained value creation. These businesses are perfect for long-term investment.
- Aspirers (earnings growth between five and 15 per cent & RoCE > 20 per cent): These businesses will provide moderate growth but are still safe bets thanks to their high efficiency.
- Gentry (earnings growth < 5 per cent & RoCE > 20 per cent): While these businesses are safe investments, you should look elsewhere if aggressive growth is a priority.
- Treadmill (earnings growth > 20 per cent & RoCE between 10 to 20 per cent): While these businesses exhibit high earnings growth, they might suffer when the economy suffers and credit is not cheap. You can look into these bets if you have a moderate to high risk appetite.
- Strugglers (earnings growth < 15 per cent & RoCE between 10 to 20 per cent): These businesses are often limping, and most of their rallies are short-lived. Not ideal candidates if you have wealth creation on your mind.
- Value Obliterator/ Sweatshop (earnings growth < 15 per cent & RoCE < 10 per cent): Your portfolio is better off without these businesses. Investors would be wise to stay away.
We at Value Research have always advocated for long-term wealth creation. As you can see from the matrix, Winners and Aspirers are the ideal candidates for investors who share our investing philosophy.
We ran the screen for Winners in our Stock Screener by using the following filters:
(i) Market capitalisation > Rs 500 crores,
(ii) five-year average ROCE > 20 per cent; and
(iii) five-year growth in EPS > 15 per cent
For the list of companies, click here.
This article was originally published on January 12, 2023.
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