Over the past years we have studied various businesses. What we found out is that we can broadly categorize them into two buckets based on how they achieve Growth.
The first category are businesses which do not need much capital to grow. They have in-built levers to grow upto a certain level without using much capital. However, there is a catch, these businesses cannot scale aggressively after a certain level. Lets understand this business with the help of an example.
Assume a street vendor selling your favourite snack. He will have fixed assets of Rs. 50,000. Inventory of Rs. 2000. Let’s assume he makes a profit Rs. 1000 everyday. Now here comes the interesting part. His businesses RoCE at the end of the year comes out to be a staggering 700% (3,65,000/52,000). This is almost 8 times higher than HUL. If we assign a PE of 20x the value of the business would be Rs. 73 Lakhs & Price/Book would turn out to be 140 times . This is insane because he just invested Rs. 52,000. Does that mean our street vendor is better at Capital Allocation than Mr. Sanjiv Mehta? The short answer is No. The problem here is that RoCE here is only optically high. It does not make sense to an investor as the incremental RoCE is pretty low. Same is the case with HUL, they have a great business but very few opportunities to Re-Invest & grow their business.
There are a few exceptions though. Certain businesses are able to consistently grow without re-investing. Take for instance an AMC business (Mutual Fund Company). For them AUM growth translates to profit growth. There are two in-built levers which translate to AUM growth- SIP’s & Market growth.
For HDFC AMC, the inflows through systematic transactions in Dec 2020 was Rs 910 cr. Annualising this number we get ~ Rs. 11,000 cr. The Avg Equity AUM as of Dec 20 was Rs. 1,45,300 Cr. The share of SIP’s in the Equity book comes out to around 7% (We have ignored ETF’s,Liquid & Debt AUM as major profitability is driven by Equity AUM). Assuming the market growth of around 10% per annum we can forecast the Equity AUM of HDFC AMC to grow at 7% + 10% = 17% in the long term. Of course there are going to be redemptions, closure of SIP’s, under-performance of funds, liquidity crisis in debt funds, gradual shift towards ETF etc. However, this magical growth should sustain in the long run given the under-penetration of equities as an asset class in our country. This business has a mouth-watering core business EBITDA of 76% & RoCE of 46%. Even a modest 17% long term growth with such high margins has the potential to create tremendous shareholder wealth. Both HDFC AMC and HUL have sky high RoCE & low Re-investment Rates, but only the former business can Grow sustainably without Re-Investing.
The second category is where most of the business lie. They need to Reinvest profits back into their business to fund growth. In this category what matters is the incremental RoCE & the longevity of growth.
Longevity of growth
Just growing at lower double digits for 3-5 years doesn’t create a lot of shareholder value. However, if a company can sustain that same growth for 20-25 years, tremendous shareholder wealth is created, this is where the magic of compounding happens. However, to sustain this growth on higher bases is not every management’s cup of tea. Only a few like HDFC Bank, Bajaj Finance etc. can sustain such growth.
Incremental RoCE
When a company is ploughing back profits & reinvesting the same, what matters more is that what is the incremental RoCE they are going to earn? And How much capital can the Reinvest?
Generally businesses can reinvest maximum 100% of their profits.
Some outliers like Bajaj Finance could reinvest more than 100%. They could do this by raising additional equity to fund their high growth prospects. In the past they have raised capital between 8-11 times book which ensured low equity dilution for existing investors.
Now let us understand why these businesses always trade at premium even though they are actually cheap.
Below is a chart which shows that the higher the reinvestment rate of a company, the higher entry PE multiple can be assigned to it. At this entry PE an investor can still make 11% (Cost of Equity) over the next 20 years.
For example,if a company can reinvest 80% profits at 30% incremental RoCE for the next 20 years (Blue Line), an investor can buy this business at 153 PE & still make 11% p.a for the next 20 years.
Compare this with a company that can only reinvest 30% of its profits at a 35% incremental RoCE for the next 20 years (Grey Line), an investor should not ideally pay more than 15 times earnings.
This is the reason why 100 times earnings for a wonderful business can be cheap & 20 times earnings for a mediocre business would be ridiculously expensive. Now imagine how expensive some PSU companies with 10-12% RoCE’s with low reinvestment rates trade at.
To conclude, while identifying companies if we find great managements that can deliver- High Reinvestment Rates at High Incremental RoCE’s (RoE’s for financials) for a long time (say more than 10 yrs). The valuations might look optically high, but the Sustainable Growth is what justifies the “rich” valuations
Proinvest Nirmiti Research Desk
Disclaimer– Proinvest Nirmiti is a SEBI Registered Investment Advisor INA000013305. We may have positions in the above mentioned companies in our own & in our clients holdings. This newsletter is for educational purposes & should not be construed as investment advice. Please consult your financial advisor before making any investment decisions
