CM MAGAZINE

A Class Apart
Stocks with consistently high return on equity have a better probability to outperform the market
It is fashionable during a market downturnto announce that stocks are available at attractionvaluation. The various exhibits displayedto justify the proposition includeP/E, BV and dividend yield. Another oftquotedcurrency is return on equity (ROE).The belief is that the market favours companiesgeneration high ROE.
Take for instance, Cummins India. Thestock has consistently outperformed theoverall market in calendar years 2006, 2007,2008, 2009 and 2010. The maker of dieseland natural gas engines gained 392% comparedwith the BSE Sensex, the benchmarkequity index, which returned 118.2% between30 December 2005 and 31 December2010.
The clues to Cummin India’s marketperformance can be found in its financials.The stock has delivered superior ROE overthe last five years. Its ROE stood at 35.1%in 2010-11, 30% in 2009-10, 34.7% in2008-09, 27.6% in 2007-08 and 28.2% in2006-07%. Moreover, it is almost debt-free,with loan of mere Rs 18.2 crore againstshareholders’ fund of Rs 1806.2 crore.
Two other companies have outperformedthe Sensex in each of the last five years. Theseare Gruh Finance, which has delivered pointto-point return of 468.7%, and Pidilite Industries,with a return of 271.4% between2005 and 2010. In both these cases, ROE ison the higher side. Gruh Finance’s ROE is inthe range of 23.6% and 31.4% in the last fiveyears. Pidilite Industries has posted ROEbetween 21.3% and 34.6%.
Among the various financial ratios thatare considered important to evaluate stocksfor investment, ROE is one of the most important.
ROE is determined as net profit upon shareholders’ fund.
Net profit refersto profit after tax minus preference dividend,if any.
Similarly, preference share capital isdeducted from shareholders’ fund.
Shareholders’ fund basically has twocomponents: equity share capital and
reserves and surplus.
This is done to calculatereturns generated on funds invested bythe equity shareholders in a company.
Preferenceshare capital carries a predeterminedand fixed dividend.
It is not completely arisk capital. Preference shareholders get precedenceover equity shareholders in redemptionof their shares if a company goes intoliquidation.
A high RoE, expressed in percentageterms, reflects superior returns generatedby the company. This ratio is also known as return on net worth (RONW).
ROE of various players in an industrycan be compared to determine who is betterwithin the business.
Investors can have a lookat ROE of companies across industries toarrive at sectors that can generate better ROE.This even helps investors to churn their portfolio,and move to stocks with higher ROE.
A gradual or year on year gain in ROEis an indicator of improving efficiency inutilisation of equity capital.
It shows themanagement is making good use of moneyentrusted to it by equity shareholders.
Castrol India has reported increase in ROEin each of the last four years. The company’sROE stood at 93.5% in the year ended 31December 2010 compared with 78.5% in2009, 57.9% in 2008, 51.5% in 2007 and38.2% in 2006.However, such improvement is exceptional.Investors instead could focus onstocks with lower volatility in ROE and improvementin ROE over a shorter period.
Companies to have seen increase in ROEover the last two years include VST Industries,TTK Prestige, Ador Fontech, WendtIndia, Titan Industries, ITC, Gruh Finance,Grindwell Norton, GlaxoSmith ConsumerHealthcare, City Union Bank, and SuranaCorporation.
Capital Market checked around 2,800companies listed on the Bombay Stock Exchange(BSE) to pick companies with superiorROE. For this, companies with marketcapitalisation of over Rs 100 crore wereselected. Only those companies whose latestfinancial results were available weretaken into account.
The median ROE for all these companiesin each of the last five years was determined.
Only those companies that had generatedabove median ROE in each of the lastfive years were shortlisted.
This way, greatersignificance was attributed to companies withconsistent track record of profit and also generatinghigher ROE.
At the end there were 85 companies (see googledocs file CM High ROE Stocks v26i13
As only profit-making companies in eachyear were included, the median ROE for eachyear is on the higher side.
In that sense, these85 companies outperforming the medianROE in each of the last five years is commendable.
The median ROE for companiesstood at 18.3% in 2010-11, 19.4% in 2009-10, 18.2% in 2008-09, 21.7% in 2007-08 and20.9% in 2006-07.
Internationally, ROE of15% is considered as a benchmark.
All these85 companies are well above this threshold.
The chief drawback of the filter is thatturnaround stocks are left out.
Turnaroundstocks could deliver superior returns. Thisis because consistency in ROE varies.
Out of these 85 companies, 23 belongto the large-cap category (market cap Rs10000 crore and above),
44 are from themid-cap category (market cap between Rs500 crore to Rs 10000 crore), and
the remaining18 are from the small-cap category(market cap below Rs 500 crore).
Out of these 85 stocks, 63 stocks haveoutperformed the Sensex, which reported again of 118.2% on point-to-point return between2010 and 2005.
This means 74% ofthe companies with consistently high ROEover the last five years have managed to outperformthe overall market. The bottom lineis companies with consistently higher ROEhave the potential to deliver better returns.
In the current calendar year, 75%, or64 companies, of the 85 beat the marketbetween the BSE closing on 26 July 2011and 31 December 2010. The Sensex lost9.7% in this period.
The prominent gainers in 2011 so farinclude Elantas Beck (23.2%), VST Industries(99.1%), TTK Prestige (90.3%),Ador Fontech (82.7%), Wendt India(54.4%), Hawkins Cookers (50.2%),CRISIL (39%), Novartis India (37.9%)and Foseco India (36.5%).
The star performers in the large-cap categorybased on stock market performancebetween 2005 and 2010 comprised ExideIndustries (558.5%), Sesa Goa (548.8%),Lupin (526.5%), Hindustan Zinc (457.6%),Asian Paints (397.9%), Crompton Greaves(393.2%), and Cummins India (392.6%).The gain is based on the BSE closing as on31 December 2010 compared with closingas on 30 December 2005.
Among mid-cap companies, the biggestgainers were Hawkins Cookers (1756%),TTK Prestige (1171.8%), Coromandel International(790%), Amara Raja Batteries(643.1%), City Union Bank (537%), BajajElectrical (473.2%), GRUH Finance(468.7%), CMC (464%), Thermax(359.3%), and Areva T&D (357.8%).
Among small-cap companies Bliss GVSPharma (1706.3%), Muthoot Capital Services(1073.8%), Ashiana Housing(703.4%), VST Tillers Tractors (514%), andGujarat Reclaim (473%) emerged at the top.
The trends emerging from the ROE toppersreveal certain interesting facts. Out of these 85 companies, 26 are debt-free. Theprominent debt-free companies includeInfosys, Hindustan Unilever, GlaxoSmithConsumer Health, Crisil, Abbott India,Alfa Laval, Castrol India, Nestle India, andP&G Hygiene.
Further, 15 companies have negligibledebt (less than 2% of total shareholders’fund). Colgate Palmolive, Novartis India,Siemens, Hindustan Zinc, Exide Industries,Wyeth, Glaxosmit Pharma, CromptonGreaves, Cummins India, TCS and ITC areamong the companies with insignificant debt.
Companies from industries such as pharmaceuticals(11), personal care (6), chemicals(5), software (5), engineering (4), andfinance & investment (4) dominate the listof 85 companies with consistently high ROE.
Another trend is that many companies command rich valuations. For instance, 20companies’ P/E is in excess of 30. Another20 companies’ P/E is in the range between20 and 30. Astrazeneca Pharma (54.8),Elantas Beck (53.3), P&G Hygiene (50.2),Titan Industries (47.2), and Nestle India (47)are the most expensive stocks.
The recent market carnage offers goodopportunity to investors to pick stocks withconsistently higher ROE as several stockshave reported sharp correction. These includeCrompton Greaves (-43.6%), JyotiStructures (-35%), Voltas (-34.2%), BlueStar (-33.9%), and Thermax (-31.5%).
ROE has certain drawbacks. It providesno hint about debt levels. Equity could below, pushing the company to borrow to fundits business growth. Borrowing could begood way to finance growth when marketconditions are robust. But in difficult timeshigh debt could put companies in trouble ifprofitability dips. Interest cost is mostlyfixed and would not decline in case of slowdownin business.
For instance, Balaji Amines has a debt-to-equityratio of 1.4 times, with debt of Rs165.4 crore compared with shareholders’fund of Rs 112.4 crore on 31 March 2011.The stock has underperformed the marketin the current calendar year so far.
Anotherexample is Jyoti Structures, which hasunderperformed the market. Its debt-to-equityratio stood at 0.8, with debt of Rs 476.6crore as against equity of Rs 576.1 crore.So like all other parameters, ROEshould not be viewed in isolation but consideredas one of the checklists to shortlistor validate a stock’s selection for inclusionin the portfolio.

(source: CM mag Vol 26 Issue 13  Aug 22 - Sep 04 2011)