Sep 6, 2011|
Is there a 'Rahul Dravid' in your portfolio?
If one is a follower of cricket - a rather silly question to ask given the patronage that the sport enjoys in India- one would be saddened by the turn of events over the past few weeks. India was toppled off its perch by a resurgent English side. What made matters worse was the manner in which we surrendered our crown. The only positive we believe was the resistance put up by India's crisis man, Rahul Dravid. If there was any doubt over who India's most dependable batsman of the modern age is, the series helped dispel it completely. Indeed, The Wall, as he is rightly called is a man for all seasons.
Source: Ace Equity
The reason we are bringing up cricket on a platform dedicated to stocks is that we want to draw an analogy today. We want to find out whether there exists a Rahul Dravid in the Indian stock market. In other words, we are making an attempt to find out the most consistent company in India, businesses that have performed well over the long term and have navigated different business cycles with ease.
Obviously, a question springs to mind immediately. There are so many different ratios to describe the overall financial health of a company. How do we know which one to choose? Of course, the number of ratios is quite a handful. But we believe there is one ratio that is the most important of them all. Infact, all the other ratios can be considered similar to different rivers and water bodies that merge into one big sea. The sea being the ratio that we consider the most important.
Well, the ratio answers to the name of RONW (Return on net worth). Simply put, it signifies how efficiently the money put by shareholders is being utilised by the business. Higher the RONW, the better the fundamentals of the business we believe. Of course, growth in earnings is also important. But over the long term, it is the ability of a business to generate strong RONWs that will determine the value it will create for shareholders.
Thus, according to us, the most consistent companies or the 'Rahul Dravids' of the stock market are those that have generated above average RONWs for a sustained period of time. This could be as long as 10 years.
Certainly, a simple average of RONWs for the past 10 years can tell us which companies have the best track record of being consistently high RONW generators. But there is a hitch here. An average does not tell the complete story. For e.g. a company generating 5% RONW in one year and 35% in another will have the same average RONW as the one generating 20% in each of the two years. This despite the very clear fact that the second company is more consistent and has a more stable business model.
What do we do now? Well, enter the concept called as standard deviation. In layman's terms, standard deviation is nothing but a tool that helps determine the consistency of a set of numbers. For e.g. the closer the standard deviation to the mean of RONWs of a firm over the last 10 years, the more stable the RONW profile of the firm. In fact, there is a law which states that for any given set of numbers, 95% of the values lie within (average +2 times standard deviation) and (average -2 times standard deviation) of the same set of numbers.
The concept will become clearer with an example we believe. Assume a firm has achieved an RONW of 25% for each of the past 10 years. In this case, its average would be 25% and the standard deviation would be zero as the RONW has not deviated even once from the 25% mark. This can be called as the most stable performance one can ever get and the firm would perhaps be a dream firm for any investor based on past record. Now, consider another firm that where RONW increases by 5% each year for a period of 10 years. Thus, the RONW is 5% in the first year and 50% in the 10th year. In this case, the average would 27.5% and the standard deviation would certainly not be zero as the RONWs have deviated a lot. The actual standard deviation comes out to be 14.4%. What this signifies is there is variation in the data and 95% of the values lie within a range of -1.22% and 56.2% (average +2 times standard deviation) and (average -2 times standard deviation). Obviously, this may not be as good a company to invest as RONW can even go down to -1.22% as pointed out in the formula.
Therefore as seen, the concept of standard deviation can help us zero in on companies that generate RONWs above a certain limit 95% of the time. And what is this limit? Well, we have set the limit at 20% as we believe an RONW of 20% at all times is the sign of a firm that has distinct competitive advantages and a fundamentally strong business model. In other words, we are looking for firms that even in the worst of years have generated an RONW of atleast 20%. Please be noted that we are not concerned with companies that generate RONW of say 40% in one year and then go all the way down to RONW of say 8% in another. Such a company may not be called consistent according to us. It should also be noted that we are not concerned with the number (mean +2 times standard deviation). This is because we want a minimum return of 20%. If the same is much higher than 20%, all the more better we believe.
There is one last difficulty though. It is the fact that RONW can also be inflated by taking on debt. Thus, in order to avoid such a scenario, we have ruled out companies having a D/E ratio of more than 0.5 times.
Okay, we now have conditions using which we can uncover few of the most consistent companies in the stock market. The table below gives the names of 10 stocks that as per the criteria listed above are the most consistent companies amongst all the listed companies on the BSE. These are the firms that have earned a return of atleast 20% in each of the past 10 years as per the formula (mean - 2 times standard deviation). In other words, there has hardly been a year in the past 10 years where the RONW has gone below 20% and that too using hardly any debt.
One glance at the table and it will be clear that the list is an investor's dream come true, consisting names that have proven themselves over the years.
Of course, the test will be incomplete without finding out how a portfolio of above mentioned stocks has returned over the past 1 yr, 3 yr and five year periods.
As can be seen below, an equal weighted portfolio consisting of the most consistent stocks are per the criterion set by us, has handily beaten the benchmark over all the time periods. This goes on to show that these stocks truly are the 'Rahul Dravids' of the Indian stock markets.
Source: Ace Equity
||Returns from 'Rahul Dravid' portfolio
|Rs 100 invested one year back is now
|Rs 100 invested 3 yr back is now
|Rs 100 invested 5 yr back is now
|Rs 100 invested 10 yr back is now
While it is not necessary that all the stocks mentioned above would attractively priced simultaneously, the list is nevertheless a good starting period if one wants to create a market beating portfolio.
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