5 Beaten Down Names to Watch Closely 

Hello everyone, Rahul Shah here, trying to make investing accessible and profitable for the average investor.

Check out the following quote:

• A good company is one which creates value for its shareholders by making a high return on capital - significantly above its cost of capital - across the business and economic cycle.

In case you are thinking that this quote is straight out of the Warren Buffett playbook, you are certainly correct.

This quote comes from Terry Smith, a famous investor in the Warren Buffett mould and someone who's made a name for himself in identifying and holding on to quality stocks for the long term.

In fact, Terry Smith is also affectionately called as the Warren Buffett of the United Kingdom.

At its core, his point is simple. If a company 's cost of capital is 10% then the company should at least earn a few percentage points more in terms of its return on capital.

In other words, a company consistently earning 15% or more on the capital employed in the business and across a business and an economic cycle, is the company that one should consider for investment.

If a company is consistently earning a few percentage points more than its cost of capital, then it has something unique that is allowing it to either charge a higher price on its products or incur a lower cost or both.

It is these companies that create shareholder wealth in the long term.

This is nothing but the idea of investing in companies with strong moats, a concept made famous by Warren Buffett.

However, this is not the approach that I follow. You will seldom see me extol the virtues of moat based invested or harping too much on return on capital.

You see, moat-based investing is about identifying the right stocks and then holding on to them for the long term.

It is not a move in and move out fast kind of investing.

First off, you need to zero in on stocks that have the ability to consistently earn return on capital higher than their cost of capital. A lot of the companies are able to do this for few years and then wither away. Therefore, a lot of research should go into finding those handful of companies that have a unique competitive advantage that allows them to earn high return on capital on a consistent basis.

Well, this alone is not enough. Once you zero in on these companies, your next goal is to buy them at attractive valuations. These stocks are very rarely available at attractive valuations and hence, waiting for that rare moment is likely to be a test of your patience as well as character.

In fact, even after you've ensured that you tick both these boxes, there's no guarantee that you've landed yourself a winner. A disruption or any other adverse development can come from anywhere and take away the unique advantage that your company possesses.

This is the reason putting together a portfolio of companies with unique competitive advantages or moats, is not for the faint hearted. A market beating outperformance can disappear just as fast as it came.

I therefore recommend keeping it simple. Investing is not just about identifying stocks with strong moats and then holding on to them for the long term.

It is also about investing in companies that earn close to their cost of capital or slightly higher, but face challenges every now and then such that their return on capital slides below their cost of capital for a couple of years and comes back up again.

If I were to give you an example, I will happily recommend a stock where return on capital has fallen to say 8% provided, we are convinced that in 1-2 years, the return on capital will go back to 12%-13%.

Mr Market frequently goes too far in punishing companies where performance dips for a couple of years.

We, as value investors, take advantage of this excessive punishment by recommending such stocks and then waiting patiently for Mr Market to rectify its mistakes.

And more often than not, such mistakes are rectified, and we are rewarded for sticking our necks out and also for our patience.

Hence, I am not about following Warren Buffett or Terry Smith but vintage Ben Graham, who believed in buying a Rs 100 note for Rs 70 or lower and selling when the market pays the full price i.e. Rs 100, for the note.

Both the approaches are legit and have rewarded their adherents quite well over the long term.

In fact, here's the performance comparison of two portfolios side by side. Portfolio 1 is the Warren Buffett approach of identifying companies with strong moats i.e. high return on capital and portfolio 2 is about companies where the market has gone too far in punishing them but they have the potential to bounce back and earn a respectable ROCE.

Here are the rules for the Warren Buffett portfolio.

This portfolio was created on 31st Dec 2014 and was held for the next 10 years i.e. till 31st Dec 2024.

It was an equal weighted 20 stock portfolio. Each stock had a minimum ROCE or return on capital employed of at least 15% for each year. There was no year where the ROCE dropped below 15%.

Since more than 20 stocks qualified based on this parameter, the stocks with the lowest debt to equity ratio were chosen.

Other parameters like minimum revenue and liquidity were also considered.

Here are the rules for the second portfolio or the 'Anti-Warren Buffett' portfolio as I like to call it.

Equal weighted 20 stock portfolio.

This portfolio was also started in Dec 2014 and ended in Dec 2024 i.e. a 10-year period.

All the stocks had an average ROCE of between 10% and 15% for the last 10 years.

We picked those 20 stocks where the ROCE had fallen below 10% and where the price had also gone below book value.

We rebalance the portfolio after every 12 months i.e. we hold for one year and then buy a new set of 20 stocks at the start of each year and then hold for another 1 year and so on.

Other parameters like minimum revenue of Rs 2 bn and liquidity were also considered.

Well, these rules are important but what is even more important is the bigger strategy I believe.

And the big strategy is that buying quality businesses and holding them for the long term is good. However, buying extremely beaten down stocks which are currently going through a low ROCE phase is not a bad strategy either.

So, if you are considering implementing this 'ROCE turnaround' strategy, these are the 5 stocks you can have on your watchlist.

• The Andhra Sugars Ltd
• Century Enka
• Amarjothi Spinning Mills
• Indo-National Ltd
• Vindhya Telelinks

These are not the type of stocks that you can buy and forget for the next 10 years.

These are not your quality stocks with multibagger potential.

By the way, these are also not speculative companies where investing in them is similar to rolling a dice.

These are decent companies with decent ROCE, which are available at dirt cheap valuations because the business has run into some issues which seem to be temporary in nature.

As our study just showed, a portfolio of 20 such companies had beaten a Warren Buffett 'buy and hold' portfolio by a significant margin.

There is a sound logic to following such a strategy and if the track record is anything to go by, there's no reason why it can't outperform in the next 10 years the way it has done in the last 10 years.

Let me know what you think.

This brings me to the end of this session. I will see you again in the next. Good bye and happy investing.