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Why Good Investing Goes Beyond Growth Stocks

Nov 26, 2015

In this issue:
» Sugar stocks see big rally
» Should the EPFO really reconsider investing in equities?
» ...and more!
00.00
Rahul Shah, Co-Head of Research

I bet you would be shocked if your restaurant bill read 15 paise. You would probably put it down to some technical glitch and ask for the error to be rectified.

This is exactly how regulars at Cafe Madras, an iconic Mumbai restaurant, reacted a couple of days back. Except it wasn't some technical glitch. It was the restaurant's unique way of celebrating its 75th birthday, which included breakfast at 1940s prices.

While this was a nice trip down memory lane for everyone, I couldn't help but let my investing instincts take over. I thought it would be interesting to see by how much the menu prices have appreciated in those 75 years...

Turns out, they have appreciated a good deal.

A cup of coffee that was 15 paise back in the 40s now goes for Rs 25 at the cafe.

That is a jump of 167 times, or an increase of 7% per year in CAGR terms. To retain pricing power - and increase prices at the rate the cafe has for over 75 long years - and still retain its popularity amongst patrons is no small feat.

Throw in volume growth of 2 odd percent (roughly in line with the population growth) and you have a business that has grown for about 10% year in and year out for as much as 75 years.

Would this be good enough if this business were a listed company? Not quite if one looks at the growth numbers in isolation. The way stocks have grown in recent decades, anything less than 15% may not go down well with investors. However, once you consider some other important attributes, I think a business of the kind run by successful restaurants like Cafe Madras become one of the most powerful recipes for long term investment success.

They are what Warren Buffett calls dream businesses. Their growth may not be exciting, but they have two other qualities that more than make up for below average growth: the ability to raise prices year after year without affecting volumes and an efficient operation generating high returns on invested capital year after year.

If these are both in place, low growth does not matter much. One can always use the strong cash flows these businesses generate to buy similar businesses elsewhere. After all, you don't necessarily have to invest money where you earned it. Imagine having eight or ten such businesses in your kitty...and the kind of cash you would be swimming in...

When Radhika Pandit, ValuePro editor, looks at businesses to recommend to subscribers, a high growth stock is not what matters. Of more importance to her is the company's pricing power and its ability to generate high returns on capital.

If these attributes are in place, and if the growth is not high, she ensures that the management does a good job of distributing the excess cash to shareholders in the form of dividends. The shareholders can then use this excess cash to buy other similar businesses so that they earn still higher returns.

The approach has worked wonders for Warren Buffett. And it's helping ValuePro subscribers beat the markets as well. Consider the same for your portfolio.

Do you think investing in low growth companies could also be profitable if these two qualities are in place? Let us know your comments or share your views in the Equitymaster Club.


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2.18 Chart of the day

In a time as short as two months, the fortunes of sugar stocks seem to have drastically changed in the stock market. As today's chart shows, many like Dalmia Bharat Sugar and Dhampur Sugar Mills are up more than two to two-and-a-half times. The traded volumes of sugar stocks too have gone through the roof.

What's the reason for this? The biggest reason is a surge in sugar prices. As per reports in business daily Business Standard, international sugar prices have gained 30% on the back of an expected decline in global output. Production in Brazil remains affected by drought conditions and increased ethanol usage. Citing JPMorgan data, the daily goes on to observe that sugar output in China is likely to fall 11% compared to that of the previous year, while the EU's production is also down 20%. In India production may decline 4.6% YoY as per ICRA. All this is expected to give a boost to realisations for sugar companies.

But do these developments justify the kind of spectacular rise seen in the stocks of sugar companies? We don't think so. Why is that? Because events such as these do not do much to change the fundamentals of sugar companies. Sugar prices will rise, and they will fall. That doesn't mean it is a good idea for investors to correspondingly go in-and-out of sugar stocks. In the Indian context, a reform like linking end-sugar pricing to cane prices paid to farmers would be a better reason for sugar stocks to see such a sharp re-rating.

Investors make a beeline for sugar stocks
3.18

When some time back the Employee Provident Fund Organisation (EPFO) decided to take baby steps towards the world of equity investing, we were nothing short of glad at their decision. Done right, equity investing can give a powerful boost to your overall investing returns.

However, recent reports suggest that the organisation is now reconsidering its decision to invest in equities. This because of the 'low' returns generated from its equity investments in the three months ended October 2015. Its return on investments from exchange-traded funds (ETFs) was 1.5% during this period. And reportedly the traded unions, not in favour of investing in equities, are pointing towards this number to justify their stance.

While there has been no decision taken on this front yet, it would indeed be sad if the EPFO were to make U-turn on its allocation to equities. The most fundamental reality of equity investing is the fact that by reinvesting a part of their earnings, companies grow over the years. And owning a stake in a diversified group of strong listed businesses is the best way there is to take advantage of this phenomenon.

4.48

The Indian stock markets were trading strong today on the back of sustained buying activity across most index heavyweights. At the time of writing, the BSE-Sensex was trading up by around 220 points. Gains were largely seen in auto and energy stocks.

4:56 Investment mantra of the day

"The future is never clear and you pay a very high price for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst).

Today's Premium Edition.

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This data point hints towards staying away from this category of stocks for the time being...
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