Get bigger, get better


Director, Banyan Tree Advisors

December 20, 2011

You’re keeping the right company if you stick with those that are on a growth path.

HOW DO you identify great companies to invest in?

To find an answer, let’s look at the factors that influence purchase decisions in other spheres. A farmer is more likely to buy a plot that yields 200 kg per acre than another that gives 100 kg: that way, his chances of doing well even during a drought are considerably better. Again, a cow that yields 20 litres of milk is a better buy than one that gives just 10 litres. Of course, the high-yield plot–and the high-yield cow–will also cost more, but right now we’re discussing great buys, not the best price. That’s a different story in itself.

Much the same logic applies to equity investments. As we saw in an earlier column (Keep an eye on the RoE), the higher the return on equity (RoE), the better the company’s earning power. The RoE is also a measure of how the company will fare during downturns, so look for consistency of RoE over a period of time–not just a year.

Now, there are many companies that post great RoE, yet don’t do very well in the stock market. Experienced investors look at the growth factor–a measure of whether the company has managed to grow in its business.

Here are some ways in which a company can grow.

Increasing market share. This is perhaps the quickest way to grow. Take the example of Hero Honda vs Bajaj Auto. Both are in the two-wheeler industry, but over the past 10 years, Hero Honda has consistently increased its market share at Bajaj Auto’s expense. This is a classic case of one player taking share away from the market leader. Not surprisingly, Hero Honda has rewarded investors with a compounded annual appreciation of 45 per cent over the past five years, while Bajaj Auto has dipped at a compounded 9 per cent over the same period.

Punjab Tractors’ story is different. Over the past decade, the company gained market share quite evenly, and was one of the best performing stocks (with returns in excess of 50 per cent a year for over 10 years). But when growth flattened, the stock plummeted 60 per cent from its peak.

Then there’s the case of Hindustan Lever. In recent years, it gave Colgate a run for its money: over the past five years, the market share of Colgate’s core toothpaste brand has fallen from about 60 per cent to about 42 per cent. Most of this was taken by Lever, which was also made gains in other areas of business. But over the past two years, Lever’s sales growth has slackened–and its stock has went down nearly 30 per cent from its peak.

This leads us to an inescapable conclusion: the market detests a slowdown in sales growth. As long as you stick with a company that’s gaining market share, and stay away from one that’s losing it, you’re on a good wicket. But you have to be careful in playing this game. That’s because the moment the market senses that a company is no longer gaining market share, and that sales growth (and, consequently, profitability) is dipping, valuations will take a beating and there’s likely to be a sharp correction in the share price.

Efficient businesses.

A company also records quick growth when it moves into more profitable and efficient businesses. Take the case of Container Corporation, which moved away from traditional means of transporting freight to more efficient means–using containers. (But in this case, I haven’t been able to figure out why the stock hasn’t performed in tandem. Any ideas from those of our readers with an analytical bent of mind? Do write in to me.) Reliance’s petro-based products have taken market share away from alternative materials such as steel and aluminium. These offer good growth opportunities as they normally last for a long period. And competition, when it does come, will be from a less-efficient business model, which will not be able to compete with the new models.

Market growth. Asian Paints is a good example of a market growth play. Its market share within the industry has remained more or less stable at about 44 per cent (and it has returned 10 per cent annually over the past five years). Growing with the market is a stable way to do business, and although only rarely will you find extraordinary growth here, there are many companies–particularly in FMCG, pharma and finance–that log 12-15 per cent growth rates for long periods. As long as you are ready to play the volatilities in such stocks, you can rake in regular returns.

When you have a stock that offers a decent RoE and the company is growing at a fair clip, you can be sure it will give you fairly good returns. There’s also a high chance of getting extraordinary returns. But, then, the story doesn’t end here. There are many stocks that have registered good growth and offer attractive RoE, yet have not performed–Marico, Balrampur Chini, Zodiac Clothing, to name a few. Where did they falter? We’ll explore that in my next column.