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Wednesday, November 20, 2013

Strong Fundamentals are Key to Multibagger Returns

Looking for a long-term winner — a multibagger? It is simple! Buy shares of a company with strong fundamentals and consistently high financial performance.

To evaluate a company’s efficiency and the quality of its management, the two key financial ratios to be keenly observed are return on net worth (RoNW) and return on capital employed (RoCE). Besides, price-to-earnings ratio could be used to determine the market price of a company’s stock and to compare it with peers’ in the same sector. Price to book value measures the value of shareholder's ownership in the company. 

While earnings yield — the quotient of earnings per share divided by the share price — needs to be seen to compare directly against the returns offered by alternative investments such as interest on a bond or savings account, debt-to-equity ratio could measure a company’s financial leverage. A high debt-to-equity ratio generally means that a company has been aggressive in financing its growth with debt. This could result in volatile earnings because of additional interest expenses. 

TTK Prestige, a leader in the Indian kitchenware market, tops the list of multibaggers, with compound annual returns of 71 per cent in 10 years. In other words, Rs 1,450 invested in 2003 was valued at Rs 2.94 lakh on March 31, 2013. The company has benefited from market growth, driven by rising consumer spend, evolving lifestyle preferences and broad demographic trends. 

TTK’s product range and distribution have complemented the strong brand, helping it clock a revenue CAGR of 24 per cent in 10 years. The profit has grown at an even higher CAGR of 66 per cent, backed by its premium products and a debt-free status, from a debt-to-equity ratio of two in 2004. The efficiency and the quality of its management measured from consistently high RoNW and RoCE helped it become the most valuable company in the past decade. 

Titan Industries, the second in the league has made its investors 89 times richer, with its profit growing at 47 per cent CAGR. However, the top-class performance in the decade may cool a little in the coming years, as demand is expected to slow down, given the tough environment. Among other most valuable companies of the decade are Motherson Sumi (ranked third), followed by Coromandel International, Godrej Consumer, GMDC, SKF India, IndusInd Bank, Bajaj Finance and HDFC Bank.

While constant good financial performance by some companies has fetched handsome returns for their shareholders, some weak performers have underperformed the market, despite quality management and lower debt-to-equity ratio. For example, Hindustan Unilever has given below-par seven per cent annualised returns in 10 years, due to poor single-digit sales and profit CAGRs. Slowdown in growth has also hurt the market performance of some pharmaceutical firms like Dr Reddy’s Labs, Novartis and Ranbaxy.

Stock market investment runs in sector-specific cycles. According to reports of Morgan Stanley India, the stocks in a particular sector get bigger and give better returns as that sector gets popular. For example, between 2002 and 2007, realty, metals and capital goods companies topped the gainers’ list. The demand for housing and strong investment in capital goods and infrastructure projects saw Unitech, JSW Steel, Pantaloon Retail, Sesa Goa, Alstom T&D, Jubilant Life, Crompton Greaves, Siemens and Thermax emerge as top companies on the multibagger list.

Business Standard Research Bureau has analysed these trends through a study of top 200 stocks by market capitalisation with trading history of more than 10 years. There are 158 stocks that have outperformed the benchmark index with 10-year CAGR of more than 17.4 per cent each. Of these, as many as 99 stocks have been multibaggers — giving their stakeholders gains of over 10 times on investment made 10 years earlier, or annual average returns between 26.6 and 71 per cent. Of these, 59 have been long-term winners — the companies that have given very good high returns in 10 years as well as during the economic slowdown seen in last two years.

Among these 59 stocks, 10 have been consistent performers, that is, 20 per cent CAGR in sales and profit over the past decade as well as in last two consecutive years. These companies have recorded very high financial ratios, both RoNW and RoCE, and given strong earnings yield — significantly higher than the other prevailing investment avenues.

The consistent performers are from the sectors like auto ancillaries, banks, consumer durables, pharmaceuticals, housing finance, fertilisers, FMCG and mining. The dropdown list of 59 companies, too, has similar sectoral compositions, with additions from automobiles and capital goods.