I did a post in March 2019 on one of the best theories I have read on the importance of high ROCE and good earnings growth, which make a great combination for long-term wealth creation.
This theory came from Bharat Shah of ASK Group, who wrote a book (sad, it’s not available publicly) titled “Of Long Term Value and Wealth Creation from Equity Investing.”
In the chapter titled “Quality of Business: Capital Intensity and Capital Efficiency,” he suggested a matrix, which I have illustrated below –
Mr. Shah categorized businesses into six buckets –
1. Winner: High ROCE (>20%) + High earnings growth (>15%) – Will create the highest value as these show superb capital efficiency and outstanding earnings growth; fertile territory for finding multi-year compounding machines and yet offering great safety during tough market conditions.
2. Aspirer: High ROCE (>20%) + Moderate earnings growth (5-15%) – Provide safety with reasonable value creation due to superior capital efficiency but moderate earnings growth rate; should compound at a rate closer to earnings growth; largely a recipe for capital preservation with reasonable appreciation, though unlikely to be rewarded substantially due to moderate growth.
3. Gentry: High ROCE (>20%) + Low earnings growth (<5%) - At best a recipe for capital preservation; high business quality should ensure that value is preserved but lack of earnings growth would not enable these businesses to create long-term value; in fact, a challenging phase could result in value fading away.
4. Treadmill: Moderate ROCE (10-20%) + High earnings growth (>15%) – Value creation is difficult and unpredictable for these businesses; value creation generally tracks higher of ROCE and growth in good market conditions and lower of the two in bad times; buying at cheap prices could help create returns higher than earnings growth for some time, but that may be unsustainable.
5. Struggler: Moderate ROCE (10-20%) + Moderate to low earnings growth (5-15%) – It’s never easy for the business or shareholders in them; value creation is low and irregular; not ideal candidates in a portfolio from a value creation perspective; buying at cheap prices could help create returns higher than earnings growth for some time, but that may be unsustainable.
6. Value Obliterator/ Sweatshop: Low ROCE (<10%) + Any growth – Value is destroyed in the long run as any kind of growth is bad when ROCE is lower than even cost of capital; cheap initial valuation may cause accidental investment returns, but it’s not sustainable.
Based on these six buckets, I compiled six lists of companies (using data from Screener.in) that meet the respective criteria as described above.
Click here to download the list of companies.
Apart from the ROCE and earnings growth parameters as suggested under each of these buckets, for the purpose of creating my screens, I restricted the lists to companies with market capitalization greater than Rs 1,000 crore, and debt/equity lower than 1.
Now, one year is too less a time to check back on the performance of stocks under each bucket, but I have done that today given that we are going through one of the worst crisis since 2008, which provides a good testing ground for stocks, largely in terms of the ones that are able to handle the crisis less badly than others.
And here are some observations on each bucket’s performance over the last one year –
Click here to download the list of companies.
Words of Warning
Before you look at these lists, here are some words of warning.
What you see there is just data. Numbers speak out loudly in most cases, but sometimes they don’t. Like you may never know from past numbers how the future might look, even though a long-term past is a good indicator of what may happen in the future. Also, you may never be able to locate a turnaround based on a poor track record in the past (though as Buffett says, turnarounds rarely turn around).
Another warning is that a great past may lead you to be greedy and imagine with certainty a great future and thus pay up or overpay for the stock. So, be careful of what you observe and how you act.
Just treat these lists and the theory around them (ROCE + Earnings Growth) as a mental model to think about how to pick the right kind of businesses and avoid the wrong ones.
And please remember Warren Buffett’s adage that investing –
Keep this in mind, keep it simple, work hard, and stay safe.
https://www.safalniveshak.com/roce-growth-matrix-update/
Created by Tan KW | Apr 17, 2024
Created by Tan KW | Jan 30, 2024