India's Third Giant Leap

This Leap Could Potentially Generate Gains
Far Bigger than Anything We Have Seen in Our Lifetimes

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How to Pick Growth Stocks

Oct 28, 2022

How to Pick Growth Stocks

I recently came across a very interesting quote from Charlie Munger. Understanding it could make a huge difference to your investment journey.

But before I share it with you, I would like you to participate in a simple stock picking exercise.

Consider two companies - A and B.

A is a clear market leader in the lubricant space, a mature industry. B is a growing company in textile space, a highly competitive industry.

This is what the financial profiles and valuations of these two companies look like.

  Castrol Page Industries
  A (Lubricant ) B (Textile)
Sales (Rs m) 31,208 8,763
5 Year Average EBITDA Margin (%) 21% 21%
5 Year Average Return on Capital Employed (ROCE ,%) 77% 52%
5 Year Average Dividend Payout (%) 84% 52%
Debt/Equity - 0.47
TTM PE (Trailing 12 months Price to Earnings) 31 38
Source: Ace Equity, Equitymaster

From a fundamental point of view - return ratios, margins, dividend payouts and balance sheet strength - company A seems to be better than company B.

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Now assume both stocks can maintain these their respective dividend policies and high returns. If I ask you to consider a period of about ten years, which stock would you choose?

It's obvious that despite healthy financials - be it their profit margins or return ratios, neither looks cheap.

You can choose to not pick any. Or make a choice. And we will see how your selection has performed in next few minutes.

Well, if you are already feeling you have enough data to make a choice, I'm afraid you have a lot to learn about investing in share markets in India.

At this stage, a diligent investor would want to know the competitive intensity, the management's track record in terms of execution, and the potential growth rates of the businesses.

Let me share some more data with you.

As lubricants is a mature industry, let's assume the earnings of company A, which is the market leader, will grow at a CAGR of 6% in next 9 years.

For the textile company, the earnings CAGR over same duration is 19%.

Does this info make any difference to the choice you made? You can still switch your selection.

This is how you have fared in the real world.

If you picked company A, i.e. the market leader in lubricant space, you would have ended up with a loss of 21% over 9 years.

If you picked company B, i.e. a growing textile firm in a highly competitive industry, your return would be 1,084% over nine years. That's a CAGR of 32% over 9 years.

If you picked none of these considering a PE of 38 times was expensive for stock B despite its decent fundamentals, then a 32% CAGR over 9 years would have been your opportunity loss.

In case you have not guessed yet, the stock A is Castrol. The stock B is Page Industries.

In the table, the base year is 2012 - December 2012 for Castrol and March 2013 for Page Industries, as per their financial reporting for annual results.

The earnings growth of 6% and 19% are the actual growth numbers for these two companies since the base year until FY22.

The PE for Castrol has fallen from 31 to 15 times, while Page Industries' PE has expanded from 38 to 81 times.

The reason Page has done so well is it had a runway in an underpenetrated organised segment in India, and a management team with strong execution capabilities.

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Castrol, on the other hand, despite being a decent business, was severely limited by lack of growth opportunities in a mature market.

The example of Castrol underscores the importance of margin of safety in businesses with strong balance sheets and returns.

Page Industries, on the other hand, is classic example that is proof of wisdom shared by Charlie Munger...

    That if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result.

It's also a case study that makes us see the moats in a new light. Moats are seen as some kind of competitive advantage that helps a business march ahead of its peers and allow high return on equity over the long term.

Investors think these are the best stocks to buy. However, that's not all there is to it.

While speaking of moats, most investors only consider the legacy moat. The concept of legacy moats applies to companies that enjoy leading market shares and earn strong returns on capital.

But they are unable to find opportunities to deploy their incremental capital at similar high rates.

Often, it is due to a mature or saturated market. As such, these companies tend to redistribute most of the profits earned in the form of dividend or buybacks.

Castrol that enjoys 20% market share in a mature lubricant market, a market that is hardly growing at 2% CAGR, is a classic example.

You could expect to earn dividends from such stocks but forget about getting a multibagger stock by relying on just legacy moats and a stock screener.

What you ideally need to assess in a business is the reinvestment moat. It's something at which Page Industries has fared better.

Reinvestment moat applies to companies that find opportunities to deploy incremental capital at high rates. Hence their stocks are likely to compound at a higher rate.

The renowned value investor Chuck Akre uses a unique construct to identify potential compounding stocks - the three legged stool.

It evaluates business on three important aspects:

  1. Business model
  2. Management quality
  3. Reinvestment prospects

This is his explanation of the approach....

    The first leg has to do with the quality of the business enterprise, look for businesses that earn high returns on the owner's capital.

    Spend time to understand what's causing that better-than-average return on capital to occur and is it getting better or worse.

    The second leg of the stool goes to the issue of the people who manage the business.

    They need to be not just competent managers, but are they honest and do they have high integrity? Do they see that what's happening at the company level is happening identically at the per share level?

    And then lastly, the third leg is the issue of reinvestment. This is the glue that holds everything together.

    There is an opportunity that exists because of the skill of the manager and the nature of the business to reinvest what we presume is excess cash, in a way to continue to earn these above-average rates of return.

    And then to that, we apply our valuation overlay, which is our quantitative way of saying we're just not willing to pay very much for it.

    Once you have found a great business run by an ethical management with the potential to reinvest its own capital, compounding takes over.

Coming to practical aspects of it, here is a video for you that will further help you in picking growth stocks.

Warm regards,

Richa Agarwal
Richa Agarwal
Editor and Research Analyst, Hidden Treasure

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