Can You Earn High Returns from Low Growth Stocks Like Bajaj Consumer and Castrol?

A well-respected and a widely followed investor posted the following message on his Twitter account the other day.

• High and consistent return on equity will not create value for shareholders if there is lack of earnings growth.
  
  In such companies Investors will get only dividend but not capital appreciation.
  
  Example: Castrol India/Bajaj consumer.

I think he is bang on when it comes to both these stocks.

While the Sensex has almost doubled over the last two years, investors in Castrol would have seen their investments barely move an inch. The stock price has remained flat.

Bajaj Consumer on the other hand has done better than Castrol. However, its 25% returns pale in comparison to what the index has delivered.

So, is this investor right in making a generalised statement on the basis of just two examples?

Should one never invest in companies where there are no visible signs of growth if we need solid capital appreciation?

I would like to think so. After all, share prices are slaves to growth in earnings. If there is no growth in earnings, there is not going to be any significant rise in share prices.

However, there is a small problem. The implicit assumption here is that one knows in advance whether the growth in earnings is going to be high or low.

This is not often the case though. If history is any indication, our track record of predicting earnings growth is mediocre at best.

Most of us seem to extrapolate the past into the future rather than conduct any meaningful analysis.

Therefore, if a company has had a history of good earnings growth, we assume the good times will continue to roll. We end up projecting the past growth well into the future.

Likewise, if a stock has had a run of poor earnings growth, we predict the same for the future as well.

However, this is not how it works in the real world.

Just as trees don't grow into the sky, a period of high earnings growth does not last forever. It's invariably followed by a period of low earning growth or even a negative growth for that matter.

Likewise, if the company has strong fundamentals, it eventually bounces back from a period of low earnings growth.

Therefore, the real skill or the real talent lies in identifying these important turning points. This is where most of the money is made or lost.

Here's the good news though. You can do well in the stock market without predicting earnings growth.

Yes, you read that right. You can achieve stock market success without trying to break your head over a company's past performance and wonder if it will continue or turn in a different direction.

Let's put together a portfolio of stocks with high ROEs and high dividend payouts. I did just that and here's how the results look like.

Period	No of stocks	Returns (%)	Sensex Returns (%)
2020-2022	106	169.8%	98.6%
2019-2022	103	57.3%	51.4%
2017-2022	94	95.7%	98.0%

Source: ACE Equity, Equitymaster

Back in March 2020, I found 106 stocks with a dividend payout of at least 25% every year over the last five years and minimum revenue of Rs 2 bn. Well, these 106 stocks as a group gave much better returns than the benchmark index.

To make sure this is not a fluke, I went back one more year and created another portfolio using the same conditions. Between 2019-2022, this portfolio of 103 stocks gave 57% returns, again outperforming the benchmark index.

Then I went back another two years. This time, a 94-stock portfolio, using the same criteria, underperformed the benchmark index only marginally.

However, once you assume the stocks in this portfolio would have paid more generous dividends, even this small underperformance gets wiped away.

Interesting, isn't it? In this portfolio we are not trying to figure what the future growth is going be. We have only considered dividends. This ends up doing so much better than the benchmark index.

This makes me wonder whether it really makes sense to obsess so much about growth prospects.

Since it's so much hard to predict, you are better off ignoring it entirely and focusing on high quality stocks with generous payouts.

Now I know what you are thinking. All the three portfolios above have very high number of stocks. A portfolio size of 100 stocks isn't ideal. It will be great if we can bring it down to say 30 stocks.

Besides, what if we throw in another criterion in the form of valuations? Well, again, this is exactly what did done next. Here's how the performance stacks up.

Period	No of stocks	Returns (%)	Sensex Returns (%)
2020-2022	30	190.7%	98.6%
2019-2022	30	66.7%	51.4%
2017-2022	30	110.7%	98.0%

Source: ACE Equity, Equitymaster

Well, across all the three time periods, these 30-stock portfolios gave higher returns than the larger portfolios.

Buying something at attractive valuations really works. These 30-stock portfolios consist of stocks trading at the biggest discount to their 5-year average PE ratios.

So, if a stock had a 5-year average PE of 30 and was available at a PE of 20, the discount would be 33%. It would form part of the 30-stock portfolio if there were very few stocks trading at an even bigger discount.

Once again, we are not considering the future growth at all. Only the underlying quality of the business and the attractive valuation of the stock.

I think one of the main reasons these portfolios have all outperformed is because they were being penalised for their recent poor performance more than required.

All the undervalued companies may have had a year or two of below par growth. Therefore, they may have fallen out of favour with investors.

But since these were good quality companies, most of them seemed to have made a comeback. This resulted in a huge jump in their share prices.

I know you would be eager to know the stocks in these 30 stock portfolios. To be honest though, these names don't matter. The underlying strategy does. If the strategy is sound, you will end up making good money over the long term.

To conclude, no one knows if Bajaj Consumer or Castrol will continue to record below par growth. They may or they may not.

However, as long as you buy such stocks at a significant discount to their long term valuation multiples and you buy them as a group i.e. invest in at least 30 such stocks, there's a strong chance of your portfolio doing well over the medium to long term.

In fact, you can even end up beating the benchmark index like we just saw in the examples above.

So, ignore growth and focus more on the past performance. If the past performance has been stellar and the company is of great quality with good dividend payouts and also trading at a discount to its long-term average, buy 25-30 such stocks.

With history as your guide, you may end up with much better results than most investors.

Warm regards,


Rahul Shah
Editor and Research Analyst, Profit Hunter