Searching For Greatness
Saurabh Mukherjea has started the chapter with an interesting story of how he found one the best stock picks of his life, “Asian Paints” during a train journey. Unexpectedly, this story did not leave him with a specific answer, but a very important question, “What defines a great company.”
According to Mukherjea, Asian Paints was not making an exceptional product that was irreplaceable. Many companies were making high quality paints and some even at a cheaper price than Asian Paints, but still, the project consultants and painters still recommended the brand. So, what made this a great company? According to his research, a great company is one, which:
- Attracts best talent
- Commands respect in the business community
- Generally, trades at a premium valuation in the stock market
To him, stock prices are an “Effect” and not “a cause” of a company’s greatness. Investors reward the strategies that businesses have created to win their rivals. This was the reason why Asian Paints is called a "Great Company”. The massive dealer and distributor network, the company has created over years, pose a huge entry barrier for the competitors, apart from the premium quality product.
With this he moves his analysis to quantify the characteristics of quality companies so that investors can easily look for the important variables in the fundamentals of the company and identify the “Great company.” Therefore, with this section, he is helping us develop a stock screener.
Define Companies: Out of all the stocks listed in the Indian stock market, Mukherjea has excluded companies with mcap lower than 100 crores which leaves him with about 1500 listed companies. From this universe he selects the stocks which possess quality factors.
Define Long Periods: He has taken a time horizon of 10 years for his study. The logic behind this is that a decade usually covers a full business cycle.
Define Superior Financial Performance: According to him, two major factors investors look for is a profitable company that is able to grow by reinvesting these profits. Therefore, his screen includes companies that have been able to deliver a 10% revenue growth and a 15% ROCE every year for the past ten years. Let's understand why this 10% revenue growth and 15% ROCE are important.
- India’s nominal GDP growth, which is the real GDP growth plus inflation, has been about 14.5% over the past ten years. And since India on average is growing by 14.5% annually, a company should at least grow at this rate if operating in India. However, to be conservative, he has considered 10% growth rate as a threshold.
- Now, why is 15% ROCE an important factor? According to Mukherjea’s study, the weighted average cost of capital, which is an average of cost of equity and cost of debt, for the Indian companies is about 15%. This means that for a company to actually create value, for both the equity and debt holders, it has to earn a rate of return higher than 15%. Companies with high ROCE have been able to beat the market index (BSE200) by an impressive margin.
The author has clarified that he is not looking for companies with just the highest revenue growth or the highest ROCE. He likes consistency and hence has based the rule that his selection companies must be generating at least 10% sales growth along with at least 15% ROCE for the past ten years. This shows their capabilities through both good and bad times.
As simple as the screen looks, as difficult it is to achieve this. In fact, for the ten-year period spanning FY06 to FY15, out of 36 companies growing revenue at a rate higher than 10% and 102 companies generating ROCE above the threshold of 15%, just 18 companies were able to satisfy both criteria over the decade.
For financial services firms such as banks, NBFCs, etc. Mukherjea has taken separate factors that include a 15% ROE and loan growth rate of at least 15% over the ten-year period. The logic for these numbers were quite similar to the ones used in the initial screen.