All businesses are not equal, some are tremendously profitable and some businesses perpetually make low returns.
As you might have heard the famous quote from Mr. Charlie Munger in which he says “Fish Where the Fish are” which simply means Invest where the profits/Cash Flows are.
Now let's apply this Quote in Indian Market and understand what Mr. Munger is trying to tell. What are the characteristics of a good business?
Answer is Simple:
1) Which has generated good Returns on capital and
2) Which has long runway of growth
For both of the above conditions there has to be high odds of future being same or better than the present
Let's focus on the first characteristic "which has generated good Returns on capital".
So “What is Good return in India?”
A business is said to generate good returns (measured by ROE/ROCE) if it earns more than the ideal Cost of capital also termed as minimum return an investor should expect from a business in India.
Understanding Cost of Capital
As you would know, Money has a cost associated with it. If it’s borrowed money (debt) then you will incur Interest payments and if it’s your own money (equity) then it's the opportunity cost.
Cost of Capital is opportunity Cost of your money i.e. what is the minimum return you could have earned by taking an equivalent or lower risk and having same time horizon as running a business.
It is also defined as the return you lost/sacrificed because you had to break some existing investment in order to fund your business.
Hence, with above perspective a good business in India is one which generates ROE/ROCE greater or equal to 12.5%.
Logic Behind 12.5% as Cost of Capital
You must be thinking how did we arrive at 12.5%? Let us explain.
As the majority of Indians have money parked in an FD, should we choose Bank FD return as our opportunity cost? The answer is a straight hard “No”.
Running a business and FD does not have same equivalent risk although the time horizons may be similar. People generally run business or park money in a FD with long term horizons of 5-10-15 years.
To arrive at right Opportunity cost we need something which has same risk like running a business & it has to be the next best option in providing exposure to similar characteristics as running a business and finally we should have mediums to invest in that alternative easily. Also as an icing on the cake if we have return data of past year for this alternative just to analyze track record of how much returns has been generated by this alternative during good & bad periods of an economy.
The closest option we have matching above characteristics is taking 10 year Rolling return of the Nifty 50 which represents 50 well established businesses of India.
Investing in indexes is the simplest way any investor even with zero understanding of fundamentals of economics/company/industry can use and if holding period is appropriate (5/7/10 years - the same horizon a businessman has while running his own business) the probability of making a 11-12% CAGR is extremely high.
So if a promoter can earn 11-12% CAGR by calmly investing in indexes shouldn't they at least expect this much from their own business where in fact they also have to take the entire stress of managing & operating the business along with the risk of financial failure?
The answer seems straightforward - YES.
Calculating & Interpreting NIFTY Rolling Returns
Now let us shift our attention to what do we mean by rolling returns?
Rolling return is an average return that NIFTY has generated in various 10 year blocks. if someone who invested in 1996 in NIFTY and held the index till 2006 would have made 13.19 % return whereas someone who may have entered NIFTY in 1997 and held till 2007 would have 14.7 % returns.
Hence since 1996 (the earliest period of availability of NIFTY data) there are 16 such 10 year periods and every 10 year period has a different CAGR.
Now as an analyst when you are estimating what can be the coming decade returns from NIFTY the best possible solution is to look at the average or median returns of the Set of last 16 rolling period return available. (NOTE: nifty does not give rolling returns. It just gives yearly and daily closing value of Nifty and we need to calculate rolling returns ourselves. Please download our excel file for the same)
Nifty Rolling Return
Download XLSX • 17KB
Average/Median is taken to avoid volatility of the market.
The Average of various after tax 10 year rolling return of NIFTY 50 is coming out to be 12.5%. Below is the link of calculation & logic on how 12.5% is derived.
As ROCE is after tax return available for a firm and Index returns are before taxed so here also we have calculated Index after tax returns to neutralize the same.
So in order to calculate the after tax return we took the total return of the index which is Price returns + Dividend yield. Then we deducted tax from the total return which we broadly took at LTCG levels of 10%. That's how we came to 12.5%.
Logic for taking ROCE instead of ROE
Now the second thing coming to your mind would be why ROCE not ROE to measure the returns of the business?
ROE is Return to shareholders (Equity participant) and ROCE is Return for all the stakeholders of the company.
First thing first, taking ROE or ROCE depends on sector you are analyzing, if we take steel or banking which majorly are debt driven businesses you need to work on ROEs whereas in FMCG companies which technically should have been debt free due to cash generating nature of businesses you will check ROCE. This is while you are analyzing a business individually without comparing it to its competitors. In case someone is doing peer analysis of financials then it's advised to work majorly on ROCEs (except for banking) as ROE are impacted due to different debt structure of competitors.
ROCE is taken because all companies have different Capital structure and if a company has a low equity component in their capital structure then ROE boosts up due to more leverage. More the leverage with the company More the ROE of the company because in numerator we are taking PAT which we could earn due to usage of whole capital - Debt + equity i.e. PAT is there due to assets and assets are built from both debt & equity but in denominator we only take equity capital and avoid debt. This is why leverage amplifies ROE ratio. To cater to this limitation we are using ROCE in our filter.
The Cut off for Growth should be above 10%. Here is the explanation for it.
India as a country is growing around 6-7% despite being a 2.5 trillion dollar economy so we can (focus on the word we CAN it does not mean every industry will grow) find Industries which are growing more than that due to simple logic of Base Effect. So due to this we have kept a benchmark for growth as 10%.
Note: Growing (%wise) on large base is difficult compared to low base for example, Its comparatively easy to grow from 1,000 crore to 2,000 crores but it is difficult to grow from 2,000 crores base to 4,000 crore although %wise change is same i.e. 100%.
Please see historical growth rate of Indian Economy in the below image: Real and Nominal growth
Source: World Bank
In no way we mean that you should only invest in such kind of businesses. There are abundant ways of making money. For example let's take the opposite. Good investment candidates can also be shortlisted from businesses which have been performing very poor or where performance has become so bad that the business has hit decadal lows in terms of ROEs, Margins & growth.
Let's see the same thing happening with textile spinning companies around Q3FY20. They were quoting at decadal low margins. (Please note this was in Dec 19 quarter which was before impact of Covid even started in India). Please find below margin data of few spinning companies.
Also Look at the yearly margins to understand this were lowest margins seen in a decade
The important thing to note is that this was in spite the fact that both of these companies has moved into value added products from just spinning to selling Yarn to selling fabrics. basically moving up the value chain which has higher margins. Even high margins products the margins were at the worst level of when they only used to do low margin commodity spinning work. This shows how hard margins of these companies were hit during last 2 quarters of FY20 and first quarter of FY21.
Even look at margins of US focused Pharma names. Companies coming for IPOs which have both Us based and domestic businesses are de-merging US based businesses to get high valuations in IPO 😀.
Case in Point: Emcure Pharma.
Same phenomena happened in telecom. Look at how badly the sales growth & margins of Bharti Airtel was hit in FY 19 leading to decadal low growth and margins. Intentionally we have taken only standalone numbers to focus on domestic telecom business.
and than look at the turnaround in the business performance of Bharti Airtel. Below are the quarterly numbers since march 2019. A one way upward improvement in margins.