How the cookie crumbles

A sectoral break-up of the Profit 100 universe

• 16 Capital goods
• 15 Technology
• 14 FMCG
•   9 Auto & Ancillary
•   9 Metals
•   7 Logistics
•   7 Miscellaneous
•   5 Cement
•   5 Energy
•   5 Fertilizer

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Lists excite us for their voyeuristic value despite being based on statistics derived out of relative measurement points. That said; a stock market fortnightly like ours cannot really go out and attempt compiling a list of best dressed stockbrokers, fund-managers and promoters (or can we). Our list has to be confined to publicly traded companies. Then again we could not quite rank up companies according to their sales, asset size or market-capitalisation (all done and boring). We scratched our heads and a lot more else to come up with this royal idea (at least we would like to think so) to rank companies on a composite measure of stability and profitability.

The way the world economy and the stock markets have shaped up in the past couple of years have brought to fore the perils of pursuing growth without attention to sustainability

While these are hygiene factors that you would look at in order to identify desirable companies for your portfolio, it is now that they deserve greater attention. The way the world economy and the stock markets have shaped up in the past couple of years have brought to fore the perils of pursuing growth without attention to sustainability. Some of India’s fastest growing companies faced a near death situation after the domestic economy lost momentum, exacerbated by a global financial crisis. That is now history as the much needed but less deserved, liquidity intervention came via central banks of the world led by the Federal Reserve.

As things stand now, risk is back in favor, funds cheaply available and companies gearing up for higher growth. So have any lessons been learnt yet? Not sure. One thing you can be sure of though is that companies that have consistently managed their capital efficiently should be able to hold their own when the world gets accustomed to lower growth rates.

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Growth brigade

Toppers by PAT growth

	5-yr CAGR %	FY04	FY05	FY06	FY07	FY08	FY09
Oil Country Tubular	139.45	0.87	7.87	8.99	15.76	28.91	68.48
Geodesic	99.66	7.89	19.14	42.46	91.18	148.66	250.36
Venus Remedies	99.63	1.26	4.12	16.17	25.38	35.81	39.95
Amtek India	89.09	14.60	22.61	40.82	66.98	128.88	352.89
Allcargo Global Logistics	81.98	5.91	24.92	47.61	54.18	83.62	117.96
Ratnamani Metals & Tubes	77.43	4.09	13.31	33.57	66.47	88.11	71.93
Praj Industries	73.09	7.57	22.02	23.80	86.74	152.37	117.62
Time Technoplast	71.37	5.14	7.98	24.52	41.27	82.06	75.96
Ahmednagar Forgings	71.17	4.44	12.49	20.59	40.67	65.54	65.14
Bharat Heavy Electricals	68.17	168.07	645.34	1376	1946	2283.93	2260.9

Source: CMIE

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This is what Profit 100 brings you, a list of companies that have managed to maintain a return on capital of over 12 per cent every year for the past six years. Some may think this is hardly a hurdle rate – but this combined with a steady growth in net profit (after adjusting for exceptional items) of 12 per cent per annum over the past five years is what makes this list capture the dual edge of quality and growth. Lending credence to this profit growth is another criterion which sets a minimum sales growth of 10 per cent for the same period. So here we do not have companies that have relied solely on internal efficiencies to generate profits, but have had a steadily growing market for their goods or services. Out also went companies that were overleveraged for our comfort i.e. had a debt-equity of greater than 1.

But make no mistake: this is not a recommendation to buy. Nor are we claiming companies out here will be the best performers on the bourses in the coming months or years. But for many companies in the list, the probability of delivering above average performance remains higher, notwithstanding the fact that much of the measured past execution was during buoyant times.

Profit 100 - rationale

Before, we actually get into the details of what is in the list, here is a low down on our rationale for the approach.

Growth is a relatively simple metric that everyone recognises is a must, so we will not delve much on that criteria except that we thought a net profit growth rate of 12 per cent was fair enough if it was of good quality. To measure that quality we chose Return on Capital Employed, why? The toss-up was between ROCE and return on equity (ROE), which is net profit as a proportion of total shareholders’ funds (networth). If you are a shareholder, obviously ROE is the relevant number because that is indeed the return you make at the end of the day. But then, a company can perk up its ROE by piling on to additional debt as long as the cost of funds is cheaper than the return on capital. But the moment, cost of funds go up, the company will be in trouble as the additional debt can become burdensome. And this will eat into the ROE. So it will not be wrong to say that there is an element in ROE that is governed purely by market forces (cheap funds) and no credit is due to the management or the potential of the business.

“There are certain sectors like power in which leverage is mandatory”Manishi Raychaudhari, MD & head of research, BNP Paribas Sec. India

Those are the type of companies we have avoided in this list anyway by restricting the debt-equity to 1. Then again, was this overly stringent as a benchmark, especially as most of the fastest growth names – those in the infrastructure space got thrown out of the list – because of this criterion? Manishi Raychaudhari, managing director and head of research at BNP Paribas Securities (India) explains that there are certain sectors in which leverage is compulsory, say in the power business someone like Power Grid has to take leverage because it is mandated that every power project be 70:30 debt equity. “Apart from that if you are left to your own means of financing, every investor would like to look at a company that is not too highly leveraged, somewhere in the range of 1 – 1.2,” he says.

This is backed by Jitendra Sriram, head-equities, HSBC AMC when he points out that it is not a “one size fits all” kind of approach. He says “We could be relatively lenient with higher debt equity for supply starved stable businesses like power, ports, toll roads, etc. Usually the metrics for commodity businesses are more stringent given the volatility in the business.” Chetan Parikh, director, Jeetay Investments cautions that you don’t want a company that is aggressively leveraged. “Then you would have a return on equity number that looks good purely because of leverage and not because of something inherently improving within the company. This is okay when times are good but when times turn bad, it is enough to demolish the company.”

“A sector may look cheap but the best players may not be very cheap and the bottom players may not be worth investing in”Chetan Parikh, Director, Jeetay Investments

Our idea for Profit 100 was to judge the quality of the business itself which the ROCE number captures better. ROCE does not depend on capital structure. It is the return that capital, be it equity or debt, can generate in your business. This also means if your business is inherently strong, you do not have to rely on debt to shore up returns.

Overleveraged companies then, can only be looked at if growth is expected to be high and if there are avenues to lower the leverage. The latter could be a function of the capital market or strong promoter backing where capital is not an issue or maybe funding cost is coming down as overleveraged companies benefit the most from an easy capital environment.

In 2008, the market was very scared of companies that had high leverage and everybody wanted to get into companies that had sustainable cash flows and high ROE, the feeling here being that since they are generating sustained cash flow they should also be able to deliver stable ROE. But as confidence crept back, there was a rush back to growth at the expense of quality. Harsha Upadhyaya, fund manager, UTI MF, feels that one can look at growth phase companies, who despite using borrowed capital, can regain their original level of efficiency within two to three years after expansion. He says, “It means that on a higher capacity and expanded capital they are sustaining pre-expansion margins.” The takeaway here is that if you are looking at it from an investor’s perspective what you are buying into is efficiency of capital, it does not matter what industry you belong to. The trick then is to find companies that can do that on a sustainable basis.

What is there in Profit 100?

Companies in the Profit 100 list are those that offer the best of both worlds (growth and quality) from a whole host of sectors. So there are companies that delivered high growth rates over the past six years because of firm prices (commodities like cement and metals) and high investment spends (capital goods) and those that could hold on to high return ratios because they are in businesses that inherently have low capital intensity. Examples of the latter being fast moving consumer goods, pharmaceuticals and software services. And there was also a sprinkling of auto ancillary companies which again, for a good part of the past five years, were riding on the boom in domestic and export demand.

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Quality first

Toppers by ROCE in %

	Six-yr Avg	FY04	FY05	FY06	FY07	FY08	FY09
Nesstle India	135.31	123.34	115.96	135.76	120.76	141.74	174.30
Godrej Consumer Products	115.39	129.56	170.49	208.13	80.18	65.19	38.78
Colgate Palmolive	94.24	55.33	65.65	70.47	67.37	131.64	175
Page Industries	86.09	105.06	86.73	163.80	61.83	46.29	52.84
Sesa Goa	84.32	61.69	114.90	87.61	69.19	101.76	70.79
Hero Honda Motors	66.60	93.15	81.15	72.80	52.22	49.24	51.06
Praj Industries	66.27	35.97	76.95	66.49	111.03	69.98	37.19
Castrol India	65.62	59.99	52.74	56.27	54.08	79.73	90.93
NMDC	63.79	34.55	53.96	84.98	71.68	70.60	66.97
Tata Elxsi	59.14	41.35	61.61	66.98	60.02	48.49	59.14

Source: CMIE

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What propelled growth in the last boom was that companies had become fairly efficient in the lean years pre-2003. As operating leverage and capacities were already in place, companies were in a position to supply when demand picked up. So they could easily rake in all the growth. That benefited companies in the auto space, cement and steel and so on. For metals, prices were not just a function of domestic demand but strong global growth which resulted in a favorable pricing environment till things turned grim in 2008.

Now, dissect the list in two parts, one half being companies that made the cut chiefly on the back of growth in profits, and the other based on high return ratios, and you see each selection is still a mix of diverse businesses. You have a company like Bhel which continues to be a prime beneficiary of the power sector thrust in the country, an iron ore producer Sesa Goa which multiplied its operating profit 56 times over the past five years on the back of strong global metal prices, couple of pipe companies like Oil Country Tubular and Ratnamani Metals and auto ancillary companies like Amtek India and Ahmednagar Forging. All these made it to the list chiefly because of the spectacular growth in profits during the period.

Look at the other half, companies that made it to the list mainly because of high capital efficiency and you see a domination of consumer companies. Five out of top ten companies ranked on ROCE were from this space: Nestle, Godrej Consumer Products, Colgate Palmolive, Page Industries and Castrol. All these companies have seen consistently high return ratios as they boast of strong brands that give them the power to register decent topline growth in both good and not so good times.

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Divergence

Win some, lose some

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Others that ranked high on capital efficiency included the all time market favorite Hero Honda, Tata Elxsi along with a clutch of high flying software service players and Praj Industries.

The Profit 100 topper Praj Industries, a supplier of equipment and turnkey solutions for producing bio-ethanol and bio-diesel, ranked among the top ten on both parameters by riding the rush towards alternate fuels. The company had a great run over the past six years barring one bad year, which was the last fiscal when profits slumped and ROCE nearly halved to 37 per cent as falling crude prices lessened the appeal of alternate fuels.

Software stocks have reserved their seats, thanks to high operating margins that have helped them maintain high return ratios for a long time. The slip has been showing progressively for many of them, because of deteriorating business conditions and rising margin pressure, but their glorious past makes them stand out.

Will it continue to be there?

Any company which has a reasonable amount of debt is a financially stable one, but that does not mean it will thrive in the next uptrend. In a supportive economy there is a strong case for highly leveraged companies as they can deliver greater earnings growth. While you can be fairly certain that growth will be there in several pockets going ahead, the moot question is how profitable that growth will be? So while infrastructure would continue to gain especially in areas like roads and power, companies may find it difficult to hold up their margins in the face of intensifying competition. Gyration in input and financing costs is another element that could make returns look dull at the earnings per share level.

On the other hand there are sectors like passenger cars or two-wheelers where the extent of competition actually can’t change dramatically and there is still scope for growth. Take the case of two-wheelers wherein leader Hero Honda has been consistently clocking an ROE of 50-60 per cent. Rival Bajaj Auto has not been able to match those numbers but is not far behind either. The prime reason for their superior earnings capability is self propelling, underlying growth. The profits that ensue, fund further expansion without the companies having to resort to equity dilution. It will be difficult to dislodge such companies from the list unless there is a marked change in consumer preference.

“For a steel company if prices go up, it goes straight to the bottomline, so it has very little to do with efficiency.”Aditya Narain, Head – Citi Investment Research (India)

When you are looking at commodities, it needs a company by company approach. Of course, everybody in the sector has grown due to the commodity upcycle but if a company has put up capacities without diluting too much equity or loading up on debt capital obviously that will have higher return generation capacity. So to that extent they are better placed in a down-trend. They will have more sustaining power and competing power compared with a player who has put in more capital to generate same kind of products and revenues. Upadhyaya says, “The return difference might not be evident from a one-two year perspective but if you look at it over a period of ten years then the addition in market cap growth will stand out for commodity companies which have used capital efficiently.”

The commodity cycles are different for a cement company versus that for a metals company. ACC and Grasim are completely domestic driven; they have little or no connection with what is happening to global cement prices. And here, although demand is expected to be buoyant, additional capacities coming on stream this year is likely to keep prices under check. But over the years, cement manufacturers have become more capital efficient and with their cash pile they now look a lot better prepared to cope with a downturn. Says Raychaudhari, “If you go back to the mid-90s, ACC used to be extremely inefficient, but now most cement companies generate 25-30 per cent ROCE, some even higher.” Even if the cycle were to turn down in say the middle of 2010, leading cement companies could maintain their return on capital around the mid-teens, which given a commodity company is a healthy number, he adds.

“GlaxoSmithkline Pharma has sustained growth despite patent protection not being there”Raamdeo Agrawal, Managing director, Motilal Oswal Securities

That is only part of the story, not the complete story. Like it or not, the fortunes of commodity players are determined 90 per cent by prices and 10 per cent by efficiency. If you have very robust growth in a strong pricing environment then your internal efficiencies tend to be secondary. Agrees Aditya Narain, head – Citi Investment Research (India), “For a cement company if prices are growing significantly then the operating leverage at work is huge. Similarly, even for a steel company if prices go up it goes straight to the bottomline, so it has very little to do with efficiency.”

Parikh echoes the same opinion. If some player in the industry says that we will be the last player to go out of the game if prices come down, it only means that they have no power over profitability in the short term. “Over the long run, cost efficiencies may determine survival, in the short term it means depressed profitability or losses, and everyone gets hit,” he adds.

As far as BHEL or the other equipment companies are concerned, they have been a huge beneficiary of the investment rush into power. On the part of the government the over-run in the Eleventh Plan occurred because the ordering process was delayed. But for the Twelfth Plan, the ordering process would start very shortly, that is two years before the plan period starts. If that indeed happens, it will result in strong order flows for a Bhel, Crompton Greaves or Thermax.

“Over 10 years, market cap growth will stand out for capital-efficient commodity companies.”Harsha Upadhyaya, Fund manager. UTI MF

So going forward, whether commodity and infrastructure companies will continue to stay in the list or not will depend on how the economy pans out. And in the case of metals, it will be global factors, which are in a state of flux at the moment.

What can be said with a good degree of certainty is that companies from the consumer and pharmaceutical space will continue to dominate the list. As for growth, these two sectors have it in their favor and these businesses inherently have the potential to generate high returns on capital because of low asset-intensity.

Having said that, high return on capital is a direct function of entry barriers, which can either, be prolonged or temporary. So predicting what returns a company can generate effectively requires you to assess how valuable that barrier is and how long it could continue. If you get a concession from the government that your tax rate will be zero for five years, that benefit will only be available for five years. So if Hero Honda has a tax concession on its Haridwar plant resulting in margin expansion, but that expansion is not permanent. However, brand strength and extensive distribution network built over the years hold it in good stead.

“Usually the metrics for commodity businesses are more stringent given the volatility in the business,”Jitendra Sriram, Head-equities, HSBC AMC

By and large if your product is selling like hot cakes, you don’t need inventory, you don’t have debtors, and you don’t need working capital. For well established pharmaceutical companies that is pretty much the script. That seems set to change. The industry structure in which Indian pharmaceutical companies have operated over the past decade is transforming. So they can’t be expected to repeat their past performance without making significant alterations to their business model. It could mean selling out to global generic majors or investing heavily in research and development as well as brand building, both of which were given short shrift in the rush towards generics. Raychaudhari feels that despite their capital efficiency, the pressures that India-based pharmaceutical giants such as Sun Pharma and Ranbaxy are facing is from the regulatory side, which is the stringent US FDA.

On the contrary, with a traditionally strong research backbone, multinational players seem to be in a cozy corner. Says Parikh, “MNC pharma companies have outsourced nearly everything, meaning there is not much fixed capital investment. So decent margins coupled with high asset turnover means their ROCE numbers turn out to be fairly pretty.” And some of them have a truly spectacular record. Raamdeo Agrawal, managing director, Motilal Oswal Securities, points to his favorite, GlaxoSmithkline Pharma, which has sustained growth despite patent protection not being there. He believes with the onset of patent protection regime, growth will accelerate substantially in the next 5-7 years. “Right now if they are growing at 10 per cent, it could gradually start inching up and even double from here. After 10 years the company might be growing by 20 per cent, so back ended residual value will be very large,” explains Agrawal.

“People who bought Infosys during the tech boom had to wait close to a decade to just breakeven.”Abhishek Dalmia, Director, Renaissance Group

Another sector that has witnessed high growth coupled with high returns for more than a decade is software services. But tough business conditions have affected margins over the recent past. If there is a sustained recovery in the US and IT spends gain momentum, companies such as Infosys and TCS would be the first to benefit due to the breadth of their offerings. The stock prices in the sector have already run up on the back of this optimism. So unless business conditions deteriorate dramatically from hereon, which could give a blow to return ratios, this again is not a business that is going to be dislodged from the list anytime soon.

What about those left out?

So does it mean that companies that have not performed during corporate India’s best years are not worth looking at in the next five years? Parikh brings up an interesting analogy that highlights the unpredictability in investing cycles. Historically, agrochemicals have not delivered high profitability. But last year, agrochemical companies blew the profitability charts, so you ask why that one year was an exception because now again they are reverting to mean. Parikh’s explanation: China was hosting the Olympics and stopped production of all polluting industries, so they cut down production. Since the China supply was cutoff, agrochemical product prices went through the roof, so that was a temporary extraneous reprieve that the industry got. Now supply is back. And prices and profitability are down. So it may happen that for 4-5 years that you are watching the data, nothing comes up and then you have two good years because of some external event that delivers blowout returns. “Generally five years is a good enough time frame and if any business has not delivered in the boom years, then one would really have to examine the case for wanting to view it differently for the next five years.”

That apart, Raychaudhari says there are certain sectors in India which have not seen the best of times yet. In the Indian wallet about 50-55 per cent is spent on staples like food and clothing. He believes as the wallet expands “an increasing allocation will go to discretionary and services, so people will spend more on education, healthcare and leisure industries.”

Why this is not a buy list

The world is too complex to be explained by simple filters. How does one put a numeric value to Mukesh Ambani’s contribution in the market capitalisation of Reliance Industries? Shifting consumer preferences, industry structure transition; management quality and intent are all examples of discontinuous change, which cannot be encapsulated in numbers. Upadhyaya concurs “Investment is not a straitjacket profession where you go by set numbers or a set matrix, otherwise you could have used a excel sheet to determine in which companies to invest and where to stay away from.”

The pitfall in looking at past ratios and trying to use it as a roadmap for the future is that, since it has occurred in the past, it does not mean that same set of favorable variables that helped it come through are going to be around in the time to come.

And then, the pitfall in looking at past ratios and trying to use it as a roadmap for the future is that, since it has occurred in the past, it does not mean that same set of favorable variables that helped it come through are going to be around in the time to come. Further, a company may do great as a small company but may struggle to get to the next level. So while the recent past may have been very bright, a lot of changes need to be made in the way a business is managed to break away from being a small/mid-cap to becoming a large-cap.

Also, like UTI’s Upadhyaya points out, India is not yet a mature market where you say I am okay with three per cent growth but I need high return on capital. And then, this list may be under-appreciating growth itself for many companies because it is based on trailing earnings and not what is expected in the future. Sriram draws attention to the infrastructure space, “A greenfield power plant, refinery, port, airport etc could have a build out time of five years which could lead to our underestimating the value of the business based on set screens.” Stock prices tend to discount actual performance much earlier, so even if trailing earnings are poor and the stock runs up, it is safe to assume that a much better set of numbers are in the offing.

In the same breadth, it can be said that ROE is a measure of profitability but stock prices are a measure of how it is valuing that profitability. You could have a very low ROE company where the stock upside could be more than a high ROE company. In large measure the market is expecting the ROE to rise. It is saying that the ROE will rise and that is why you should buy the stock, although you always run the risk that the company may not achieve the numbers the markets are expecting.

No doubt there are several companies in this list which seem promising from the growth perspective. If the uncertainty continues, we might actually see a comeback to traditional consumer sectors compared to the investment economy led returns that drove us in the past 4-5 years driven by capital goods, banking and financial services. That is one business space that finds ample presence in Profit 100 list.

But then, what we have ignored and something you can’t ignore as an investor is the price factor. Abhishek Dalmia, director, Renaissance Group, says, if the price at which you bought the stock is very rich, then you can forget about making money on your investment, even over long periods of time, quality of business no bar. His classic case in point in the Indian context is Infosys. People who bought the stock during the tech boom had to wait close to a decade for their investments to just breakeven. Parikh favors bottom-up stock picking. “While screens throw up names, your focus should be on figuring what is cheap, because within the sector you may have things that are expensive. So the sector on an average may look very cheap but the best players may not be very cheap and the bottom players may not be worth investing in."

Profit 100 essentially is a shortlist of financially stable, capital efficient companies. Our belief is that notwithstanding growth, a lot depends on the capital structure of a company and on whether it is as sustainable through lean times a during the good times. The overleveraging in the previous cycle was largely seen in companies that expanded inorganically. The lesson, hopefully, from the last downturn for borrowers is that there is indeed such a reality called the debt service coverage ratio, and for lenders that, debt covenants are meaningless when there is a complete breakdown in the credit mechanism that they themselves steer.