- Wealth PMS
This is a guest post by Vikas Kasturi (@VikasKasturi). He is a value investor based out of Bengaluru. All views expressed are solely those of the author. The author has no direct or indirect holding in any of the businesses mentioned. This post is part of our “Writers Block” series where we invite guest contributors with a flair for writing to get published on capitalmind. Interested in getting published? Write in to writersblock [at] capitalmind [dot] in.
Some of us might recall from high school Physics, the efficiency of a machine is calculated as the ratio of its output to its input.
You can apply this idea of efficiency to businesses as well. In this case, the input is the capital that you supply in the form of equity and debt. The output, the profits the business generates.
The efficiency of the business at deploying capital is the ratio of profits to the input capital.
What physicists call Efficiency, finance professionals call Return on Capital.
Companies that have competitive advantages can more efficiently convert input capital into profitable output.
Take the case of Colgate. The name is synonymous with oral care and oral care is synonymous with Colgate. It has over 50% market share in the oral care segment and is present in every nook and corner of India. It achieved all of that through investments in branding and marketing, educating the market, building associations with dentists and schools, distribution and much more. All of those investments in the past have yielded it the efficiency of converting input capital to profits at the rate of 72% as of today!
Wait. What? Here’s how.
As per the Balance Sheet of FY 2019, Colgate had Equity + Debt of ₹ 1,524 Crs. It generated a Profit Before Interest and Taxes (PBIT) of ₹ 1,114 Crs, giving it an efficiency of 72%.
From Physics, let’s now switch to high school Mathematics.
We know that Compound Interest far outperforms Simple Interest simply because it can re-invest the interest every year.
Likewise, businesses with high Return on Capital that can reinvest profits far outperform businesses that can’t reinvest.
Now, Colgate which has a high Return On Capital can reinvest only 29% of its profits back, averaged over 4 years, into the business.
Contrast that with Dr Lal Pathlabs, an emerging pathological and diagnostics brand in India. It has a Return on Capital of 35%, but reinvests 78% back into its business in building regional reference labs and acquiring smaller competitors etc. And since the unorganized market is 85%, it has a long runway ahead of it.
The concepts of Return on Capital and Reinvestment Ratio can be illustrated with a 2X2 matrix as below.
The data in tabular form with the current Price-Earnings and EV/EBITDA of these stocks
Some of the simplest and best ideas can come from this quadrant. These are companies that have high Return on Capital and the ability to reinvest, kind of like have your cake and eat it too.
Businesses in this quadrant usually return cash to shareholders in the form of dividends or buybacks. Therefore these businesses, like Colgate, can be compared to a high quality bond with some growth on the upside and minimal downside. They can offer very high dividend yields when purchased at low prices.
Only investors that have painstakingly studied the nuances of the industry and its cycles have an edge here. The small investor with limited understanding can give this quadrant a pass.
Companies that usually have very low Return on Capital and high Reinvestment tend to be wealth destroyers. Examples, Coffee Day Enterprises, despite having a great brand like Cafe Coffee Day, has lost over 85% of it’s market cap since listing on the exchange! It’s best to avoid these as long term investments.
For the most part, companies in Quadrant 1 and Quadrant 2 are expensive. But once in a while, the Markets panic and irrationally beat down the prices of these companies (e.g. Nestle during the Maggi crisis, Infosys when Dr. Sikka resigned and Bajaj Finance during demonetization). Investors should turn bargain hunters at such times.
There are over 6,000 companies listed in India. But amongst them, very few companies have Return on Capital > 20%. Even fewer companies have the runway to reinvest at least 50% of their profits over sustained periods of time. Therefore, it pays to narrow down the field to a smaller investable universe where one can gain an edge by focussing on the nuts and bolts of the businesses.