The Upcoming Storm May Destroy Your Portfolio. Here's How to Avoid It... - The 5 Minute WrapUp by Equitymaster
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The Upcoming Storm May Destroy Your Portfolio. Here's How to Avoid It...

May 24, 2016
In this issue:
» Corporate India's market cap falls in Modi Sarkar!
» More distress among Indian start-ups
» Today's market...
» ...and more!
0:00
Devanshu Sampat, Research analyst

14 January 2008. The day the Sensex hit its peak in the bull-run which ended in early 2008.

Post this, the index fell more than 60% over the next thirteen months.

But as all good things come to an end, so too do the dull times. Since its March 2009 lows, the Sensex is up 2.1x, a performance of 17% per annum.

But this is hindsight bias as we are tracking performance from the lowest levels. But investors who put in money at the peak and have averaged just 2.5% per annum. A pathetic result for sure. Fixed deposits would have fetched far better results.

But while it's easy to say this in hindsight, I thought of inverting the process. I looked at the performance of the BSE 500 stocks and sorted them by their returns since January 2008.

Let me remind you that this was when Sensex valuations were at their highest - about 28x their trailing twelve month profits. Much higher than the current figure of 18.5x.

If one had invested Rs 100 in each stocks forming part of the BSE 500 index in January 2008, the investment would be worth Rs 118 today. That's again a dismal performance over an eight-and-a-quarter-year period.

But...

If one were to break it down - putting the stocks in various buckets in terms of returns - you'd see a pattern. And you'd know why the stocks that actually did well outperformed the rest by such wide margins.

Of the 417 stocks that were part of the index then and still are now, turns out that 35% of them have still not recaptured their peaks. That's a big chunk. Let's term them the 'underperformers'.

Another 15% of the 417 stocks have underperformed FDs (assumed to be 8%) since then. No good again...

That knocks out half the list.

Now, 18% of the balance gave returns of less than 15% but more than 8%, which is okay...beating FDs...but just average in absolute terms.

However, the bucket that warrants further study is the balance 31%. These stocks returned more than 15% per annum since the market peak of 2008. Let's term them the 'outperformers'.

What did these outperformers have in common? Turns out the majority of them were value enhancers, not value destroyers.

Enter Economic Value Addition (EVA)...

According to Investopedia, EVA is 'a measure of a company's financial performance based on the residual wealth calculated by deducting cost of capital from its operating profit (adjusted for taxes on a cash basis)'.

Here's the formula:

  • EVA= Net Operating Profit After Taxes (NOPAT) - (Capital * Cost of Capital)

This metric aims to estimate the value a company creates in excess of the required rate of return expected by its shareholders.

Below I've plotted the average eight-year return on capital employed (RoCE) of the 'outperformers'.

RoCE data for the 'Outperformers'

RoCE data for the 'Outperformers'


The average of this lot was about 30%, and the median was 24.3%.

Moving on to the underperformers...

RoCE data for the 'Underperformers'

RoCE data for the 'Underperformers'


The average of the underperforming lot was 12.5%, and the median was 11.6%.

As you can see in the charts, not every EVA-positive company has outperformed over this period. So this is not a foolproof plan. But...the odds are better when investing in companies with high a high EVA.

Whether the markets skyrocket from here...or see the biggest collapse in history, this basic strategy will hold you in good stead.

Do you think value-enhancing businesses will bolster your portfolio over the long term? Let us know your comments or share your opinions in the Equitymaster Club.

3:10 Chart of the Day

On May 26th, two days from today, the Modi government will complete two years in power. A lot has been said about the promises of acche din remaining unfulfilled. But what about corporate India? Have they benefited?

Today's chart shows the market cap gains of various corporate houses since the Modi government came to power. We are aware that changes in market cap may not be the best way to evaluate performance. However, at times such data can be very illuminating.

While Sunil Mittal and the Tatas seem to have escaped unscathed, the other top business groups have seen their valuations fall sharply. Of course, their problems cannot be traced back entirely to the government. As an article in the Economic Times points out, the global commodity price fall has played its part.

However, we believe investor's expectations from these business houses went through the roof two years ago. The high expectations were based on the prospects of a turnaround in performance due to the change in government. Clearly, those hopes have been belied.

No Acche Din for Corporates

No Acche Din for Corporates


3:55

Yesterday, we shared with you the disturbing story of a well-known startup. The management is clearly untrustworthy. Today, we read an article in Livemint about the tough times that Indian startups are going through.

Food delivery startup, TinyOwl has discontinued operations in all locations other than Mumbai. This does not surprise us. The company's business model was flawed right from the beginning. It was acquired by Bangalore based Roadrunner a few weeks back.

We see this as a healthy trend among Indian startups. If the best have to survive then mergers and acquisitions are critical. The harsh reality is that many of India's startups have unsustainable business models. It is imperative that the stronger ones take over the weak. We will closely follow these trends and keep readers up to date.

4:40

After a flat opening, the Indian indices were unable to find direction and were trading near the dotted line at the time of writing. Most sectoral indices were trading in the red with stocks from the energy and engineering sectors leading the losers. The BSE Sensex was trading up by 7 points and the NSE Nifty was trading up by 6 points. Both - the BSE Mid Cap index and the BSE Small Cap index - are trading down by 0.8% each.

4:50 Today's Investing Mantra

"I have owned one stock since 1969, two since 1988 and one I started buying in 1986 or so. That's my portfolio. Six stocks. I once owned 17, but that was way too much." - Philip Fisher

This edition of The 5 Minute WrapUp is authored by Devanshu Sampat (Research Analyst).

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5 Responses to "The Upcoming Storm May Destroy Your Portfolio. Here's How to Avoid It..."

Megha

May 25, 2016

Interesting read.find 10 companies with good Eva.

Like 

Rajesh

May 25, 2016

Is it possible to provide list of companies out BSE 500 that are classified as performer?

Like 

SJ

May 25, 2016

You keep getting better by the day. Your work is really helpful. Keep up the good work.

Like 

R Tayal

May 25, 2016

Your 'Chart of the Day' column in this edition twists data to suit your argument. So in a way you are guilty of the same tendency which you (in another article) have blamed NITI Aayog chief of. You must know that the base date of 26-May-14 chosen by you is faulty in that the markets had started going up several months prior to that with research predicting a Modi victory. This is not a defence of Modi Govt's performance but a comment on your jumping to a conclusion with the mind already made up. As they say "if you torture data long enough, it will admit to whatever you want it to".

Like 

Shoibal Chatterji

May 24, 2016

Great but how does one calculate the EVA for a company i.e. How do you obtain Net Operating Profit After Taxes (NOPAT) and how to obtain Capital and Cost of Capital???? an example will help....

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