The lesser known secret to earning great returns - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

The lesser known secret to earning great returns 

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In this issue:
» RBI to stock up on US dollars in the coming months
» Indian IT sector finding it difficult to deal with local government
» American food and restaurant companies lose pricing power
» Over 800 Indian brokers shut shop in FY14
» and more....

When trying to arrive at a justified valuation multiple for companies, three key inputs need to be considered. These are the long term sustainable return on capital, sustainable growth rate and the desired returns on the investment.

It is the first one that we will briefly be focusing on in this write up.

There are periods in time when companies do exceedingly well; thereby generating excess cash - amounts that are more than what is required to be deployed back in the business. What the managements of such companies essentially do with that cash is something that would determine the future profits, cash generation and essentially the return ratios. Buy backs, dividend payouts, acquisitions, hoarding the cash, deploying into unrelated areas, are amongst the many options that management of such companies would have. While some of these moves would be wealth creating in nature, others would be quite the opposite.

The trait of having good capital allocation skills is thus that is as important, if not more, as other traits that we look for in high quality companies; some of which include honest and able managements, competitive advantages, strong cash generation, and pricing power.

Some of the major examples of poor capital allocators would be the recent large scale acquisitions made by metal sector behemoths Tata Steel and Hindalco. Not only were these acquisitions done at the wrong time (and at high prices), but were also largely funded by taking on more debt. In all probability, had these companies continued to focus on Indian operations, their market values would have been higher.

An example in the midcap stocks would be of Bajaj Electricals facing the brunt of diversifying into the engineering & projects space, which has been a major drag on the company's profitability and return ratios for a few years now. This is especially considering that its age old consumer products division has been a flourishing one.

In contrast there have been companies that have been very profitably deploying the cash back into the businesses, or else paying out the not so required portions. An example of such a company would be cookware manufacturer Hawkins Cookers; it that has not ventured into unrelated businesses (yet), has been sticking to what it does best and has been increasing its payout ratio over the years. All of this while staying profitable and growing at a steady pace.

As long as companies - that are good capital allocators - continue to grow in a profitable manner year after another, the likelihood of investors making good money from such investments would be high; especially over longer periods!

Investing in such companies would also tend to provide a cushion to investors that would have bought into such stocks at valuations slightly higher than what they would have been comfortable paying.

As aptly explained in an article on - "By 1963, American Express has already been a successful business for more than a century. You could buy its stock in any single day during its history and do very well over the long run. The scandal in 1963 tanked the stock. It was an incredibly stupid mistake. American Express was perceived to be going for bankruptcy. We all know Buffett purchased as many American Express shares as possible and made a lot of money.

But here is an interesting question. What would happen, if you had purchased American Express' stock the day before the scandal broke out and therefore, paid a lot more than Mr. Buffett? You would think that you would not do very well. But If you have bought AMEX at a much higher price than Buffett, the return difference would have gotten closer and closer with each passing day. Today, you and Buffett would compound the American Express investment at nice double digit rates with almost negligible difference."

According to you, which companies are good and poor allocators of capital? Do state the rationale behind the same as well. Let us know in the Equitymaster Club or share your comments below.

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01:40  Chart of the day
The economic slowdown has taken its toll not only on the manufacturing and industrial sector but on the financial sector as well. Indeed, as far as the latter is concerned, brokerages in particular have been hit quite hard. This is evident from an article in Business Standard, which has highlighted how 819 stock brokers have been forced out of business in FY14. The reasons have been attributed to falling profitability and low trade volumes of options in the cash segment.

Poor market conditions led many brokers to shut shop in FY14

First of all, volumes of options overall have surged to around 77% of the overall market volumes in FY14, Now in this, trading of options is more profitable in the cash rather than the derivatives segment. However, in recent times, options volumes in the derivatives segment have significantly increased. Thus, brokerages have been reporting poor profits and many of them have had to close down. Regional brokers especially have been impacted because of the closure of several regional exchanges. Whether this trend is likely to improve in the coming years remains to be seen.

When the markets are over optimistic, trust the RBI to set expectations right. And the central bank has been doing a brilliant job of it. Indian stock markets may be moving into unchartered territories each day. But the election euphoria seems to have hardly impressed the monetary policy maker. It is in fact in preparation for the challenges ahead. Not just challenges from the domestic economy but also those from geo political risks. The QE tapering, turmoil in Ukraine and slowdown in FDI and foreign institutional investors (FIIs) inflows are on top o the RBI's mind. And the central bank is losing no time to keep its dollar reserves ready for unexpected volatility in the exchange rates. The RBI also expected current account deficit to widen in FY15. Not to mention the inflation risk, which has hardly subsided despite keeping interest rates high. Thus, as per Economic Times, the RBI may be buying more US dollars in the coming days. Hence, those predicting the rupee to move to 40 per dollar may well be disappointed. And companies that were looking forward to importing more with a cheaper rupee will have to keep their costs in leash.

Indian software sector is going through challenging times. The western world has not recovered quickly from the global financial crisis. This has meant that winning large deals and retaining clients has become increasingly difficult. Add to this, the problems in managing a large employee base and new disruptive digital technologies like cloud computing. We would think that they have more than enough on their hands right now but as per the Economic Times; another problem can be added to the list. This pertains to government contracts. Indian IT firms which are used to 20% profit margins have found it very tough to deal with the Indian government.

Delayed payments and the need for getting multiple approvals have lowered profit margins for such contracts. Infosys recently had faced a payment delay of over six months in the Rs 7 bn contract to modernize the Indian postal department. This has caused many IT firms to become more selective while dealing with the Indian government. Some firms have even decided to stop bidding for such contracts until the next government launches new schemes. Thankfully, software contracts from the Indian government contribute less than 3% of revenues for the Indian IT sector. Hopefully they would have learnt valuable lessons from such experiences and will be more careful while bidding for government software projects in the future.

Some economic recessions leave behind a bruise in the minds of the consumers. However, there are some others that leave behind not a bruise but a prominent scar. Hardly anyone would bet against the fact that the crisis that occurred in the US in 2008 evoked metaphors of the latter variety. And if there's further evidence needed, it has been provided by an article on It argues how food and restaurant companies that used to have no problems raising prices earlier, are now finding it extremely difficult to take the same step. And what happens if they do? Well, the article argues that the consumer literally goes on a strike. In other words, the firms raising prices can either kiss their businesses goodbye or be left staring at a much lower demand than before.

Now, this is exactly what've been highlighting all this while whenever we end up discussing measures like QE and artificially low interest rates. The Government bailout has only ended up making the top 1% richer. The vast majority of the US population is still struggling to make ends meet or is busy repairing its broken balance sheets. Therefore, unless the Government approach changes, lower standard of living in America is a stronger possibility than a return back to good old days we believe.

Even as uncertainty looms large over the hike in the price of domestic natural gas, here is one company that is applying its own terms and conditions to this critical national resource. As per an article in, Reliance Industries has told buyers that new rates for KG D6 gas will apply from April 2014 as and when a price hike is notified. One must note here that the Government had approved a gas price hike from the same month. However, the hike was put on hold in line with the election code of conduct.

In fact, the company has taken the matter of delay in implementation of gas price hike to the court. We agree that lack of clarity on prices will impact investments in the sector and decision making process for gas companies. However, it is quite amusing to see Reliance Industries being so vocal about the issue. This is the same company that has failed to meet gas supply commitment in the past when it had to supply gas at US$ 4.2 per unit. The reason cited for under supply was geological issues. However, the company has been blamed for hoarding gas and deliberately keeping the supplies low in the time of low gas prices. Hence, even if the gas prices are hiked, to allow Reliance to sell at new prices will be unfair, we believe.

The share markets in India were marred with volatility today. At the time of writing, the benchmark BSE-Sensex was up by 40 points (+0.2%). Most of the sectoral indices were trading in the green with power and consumer durables stocks leading the gainers. However, IT and capital goods stocks were trading in the red. Asian stock markets were trading mixed with Indonesia and Hong Kong being major gainers. But the Chinese and Japanese indices were trading lower. European markets opened the day on a mixed note.

04:55  Today's investing mantra
"The first question I ask is: "Does the owner love the business or does he/she love the money?" It's very easy to tell the difference." - Warren Buffet
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3 Responses to "The lesser known secret to earning great returns"


May 27, 2014

Steel and other hardware manufactureing companies, who are going to hit big?



May 16, 2014

Not at all justified. As you mentioned above, this fobia may remain for few days.
Our new PM have to do a good job.
1)He should find a way to drill for oil domestically and to reduce oil import.
2)He must try to start implementing a dedicated system of birth control through education(India is over populated).
3)As mentioned by you, implementation of projects, mining, corruption, etc etc....
Note:- Exports may not pick up until Europe mess is resolved.



May 16, 2014

I am looking for list of companies which has CAGR growth of 20% or more far last Five years consistently in EPS and topline.

Can Equitymaster help me on this?

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