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The most overlooked factor in selecting stocks

Jan 12, 2015

In this issue:
» FY13 sees a contraction in industrial employment
» Companies see credit upgrades at fastest pace in 5 years
» Chinese markets see first time investors flock to penny stocks
» ...and more!

There are two ways a company's management can keep its shareholders away from the profits of the company.

The first way of course is fraud. The management gets tempted and cooks up ways in which it can steal the money from the company without anyone coming to know. Think Satyam. But because this route is outright illegal, very few choose this route. And that is why, of the two routes, this is the less dangerous one as far as minority shareholders are concerned.

The second way on the other hand is not illegal. Yet ever so often ends up keeping shareholders away from the company's profits. Profits that rightfully belong in their pockets. And because this route is not illegal in the letter of the law, it is a favorite among company managements. In fact, it is rampantly used by even some of the biggest names in corporate India.

What is this route?

It is that of taking the profits made by a company, and instead of paying them out to the shareholders, utilizing these accumulated profits in the most unproductive of ways.

This malaise can take various forms - making expensive acquisitions, investing in unrelated businesses where management has no expertise, investing in low return businesses for the sake of making the company bigger, hoarding cash without any specific end use in mind, racking up large surplus investment portfolios, the list can go on...

And even though not illegal, in substance it often ends up having the same wealth destructive effect as that of the first route. That is, it robs the minority shareholder of the profits made by the core business of which he is a co-owner.

For us at Equitymaster, the propensity of a management to allocate the company's capital in an efficient manner has always been a very important criterion while selecting stocks for investment. Warren Buffett, while giving complete independence to his managers, has always insisted on efficient capital allocation so as to return healthy profits to shareholders. Hence, stocks selected for the ValuePro portfolios have to strictly pass the capital allocation test.

One instance that we can recollect is when the team stuck its neck out to reject a big tobacco company that is popularly considered a 'blue chip' by many. Purely because its management has been doing a very poor job indeed when it comes to capital allocation. It has been taking the profits from its extremely profitable core business, and using them not only for diversifying in a myriad list of unrelated businesses, but also very low return businesses at that. Businesses whose profitability is highly circumspect even after injecting very large chunks of money into them.

Indeed, the wealth that the company could have created for its shareholders would have been multiples of what it currently is, if only the management had simply paid out as dividends all the profits it saw no fruitful way of employing. No points for guessing which is the company we're talking about...

Do you carefully consider how a management is allocating the company's capital before you invest in its stock? Let us know your comments or share your views in the Equitymaster Club.

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  Chart of the day
A recent Live Mint report makes an interesting observation. That is, for the first time in almost a decade, there has been a drop in the number of organized sector industrial workers in FY13. Importantly, this comes on the back of nearly ten years of rapid growth in industrial employment. For example, the growth in industrial employment during the year FY03 to FY07 was on average 6.3% per year, and that during FY07 to FY12 was 5.7% per year. However, this figure during FY13 stood at a negative 3.7%. That's right, there was actually a contraction in industrial employment during the year.

Further, as today's chart shows, some of the biggest industries to see job losses in FY13 were the paper, mining, auto and textile industries. No wonder then that the consumer demand sentiment in the economy has been so anemic and the economic recovery has been woefully reluctant so far.

Reason for suppressed consumer demand in the economy?

2008 was the year when the too big to fail banks were exposed for their poor risk assessment. They did get bailed out by governments and investors. However, the fact that the banks had ignored systemic risks led to huge regulatory repercussions. Many were even penalized for misreporting or under reporting risks. However, the gatekeepers of the risk profile of banks, the credit rating agencies, almost went unhurt. Even in 2008 we wrote about how the rating agencies were amongst the biggest culprits of the crisis. And we have maintained this view ever since! Hence the fact that rating agencies are once again playing a big role in creating the 'sentiment' about India's economic recovery does not leave us elated. As per an article in Mint, companies in India are being upgraded at the fastest pace in five years. All in the anticipation of economic revival promised by the new government.

Now, do not get us wrong. We are not trying to be the naysayers and projecting GDP growth to languish in the coming years. But the rating agencies at least are expected to take hard facts into account before changing their views. That corporate capex cycle has yet to pick up and projects worth US$ 200 bn are still awaiting approvals cannot go unnoticed. Further the asset quality of loan books of PSU banks clearly shows that there is a problem. Hence we believe that the rating agencies are going overboard in their drive to 'please clients' rather than focusing on giving an independent view. Their eagerness to upgrade debt seems a little too premature.

Stock markets world over have had a great run in the past year, and in the process made retail investors with no exposure to the asset class, feel left out. Just the other day we wrote about how some small cap stocks are trading at obscene valuations and are at a premium to safe bluechips. Same is the case with penny stocks that are attracting first time investors to stock markets. In most of these cases, it is speculation rather than underlying fundamentals that are driving the stock prices. And it is not the retail investors in India alone that are falling prey to the penny stock mania. As per Bloomberg, most of the rally in Chinese penny stocks over the past few months has been driven by amateur investors. The country has seen trading accounts open at the fastest pace since 2007 and 80% of the new traders are individuals with no trading experience. The lure of investing in low price stocks to make quick riches is attracting even housewives. Thus the Chinese government has now started educating investors about the risk of investing in penny stocks. Looks like be it China or India, gambling instincts are gambling instincts after all!

The Indian stock markets were trading on a volatile note today with the indices crisscrossing the dotted line through the day. Nonetheless, the benchmark BSE-Sensex managed to end the day in the green, closing higher by 127 points today. Gains were largely seen in capital goods and FMCG stocks.

 Today's investing mantra
"The root of my success is acting rationally about capital allocation"- Warren Buffett

This edition of The 5 Minute WrapUp is authored by Taha Merchant and Tanushree Banerjee.

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6 Responses to "The most overlooked factor in selecting stocks"


Jan 18, 2015

Asset allocation is the most important factor in the management of finances for a person or a company. Diversification is an attempt to mitigate risk by not putting all eggs in one basket. It is well known that a company focused on one or two core products earns money more efficiently if demand for its products or services is perpetual and it's management is honest. If such a company can maintain its USP - in the face of imitating competitors - it will be a great investment. I believe this is the core of Warren Buffet's teachings. Coca-cola, Colgate, P&GHH (makes only Vicks and Whisper) are examples that come to mind. It is also well known that diversification in unrelated fields almost always results in slower rate of growth and profits. It often results in loss of capital.

Like (2)


Jan 14, 2015

Yes companies which had diversified into sectors other than its core strength is finding it difficult to cope up with the and showing lesser growth. RIL is a good example. Internationally companies are selling of the diversified
units and coming back to core strength. Working on your core strength and introducing innovation in that field will be more appropriate

Like (2)

yogendra pal singh

Jan 13, 2015

I have never scrutinized the detail of resource allocation by company management. I can not do it in future as well
For this, corporate affairs have to more transparent.

Like (2)


Jan 13, 2015

The points I want to highlight have been done by Harit Shah and Kundu.ITC is one of the most investor friendly companies and has good corporate governance and healthy return on capital employed and excellent pricing power.(some impt. prerequisites for investment). In coming years,Tobacco can face problems from govt as well as consumers and they are diversifying into other activities but results not too great.HUL too passed thro' stagnant periods, mindless diversification etc but now darling of investors.
Reliance Industries used to give superb returns but now subdued. Their diversification into Retail and telecom can be good or can turn out to be disastrous.
HCL TECH is one of the most investor friendly co. I have come across
As suggested by Harit, just have review of scrips which gave excellent returns but escaped attention/recommendation of EM. You can modify your approach accordingly.

Like (2)

Harit Shah

Jan 13, 2015

While the point is taken regards inefficient capital allocation of ITC (its obvious that the company being referred to is ITC), the fact remains that ITC's stock has returned an excellent 25% CAGR over the past 10 years, rising from around Rs 30,000 crore market cap to nearly Rs 2,90,000 crore! That is quite a solid performance from any angle, I would think, and for a large cap stock to return so much over a 10-year time frame is, I think, an excellent performance. This return is more than what Infosys has returned over the same time frame, which is around 17% CAGR and Infosys has traditionally been a favoured stock for Equitymaster. TCS has also returned slightly less over 10 years, at 23% CAGR, compared with ITC. Interestingly enough, HCL Tech, which has never been favoured at EQTM, has returned 27% CAGR over 10 years! Maybe you should question whether your decision to stay negative on HCL Tech was the right one. A 10-year time frame can be called long term and for a stock to return this much over such a time frame means it is doing something right :) Something for you to reflect upon :) Cheers.

Like (3)

S. Kundu

Jan 12, 2015

Well, Yogi baba is in a tight spot. With all kinds of bans being placed in tobacco consumption the company has to has to diversify into other sectors. With their very successful e-choupal initiative it made sense to foray into FMCG. As of now setting up the supply chain is taking time/effort/money.. but I am hopeful. Lets see how the dairy initiative goes about.

Like (2)
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