Companies with high ROCE such as FMCGs have the margin of safety to generate positive ROCE, over and above high interest rates and inflation.
People usually think of gold as a hedge against inflation; a high ROCE business may prove to be an equal, if not better, hedge during inflationary times.
Last week, this column discussed about how companies (within the BSE 100) that deliver better Return on Capital Employed (ROCE) — a comprehensive profitability metric — experienced higher valuation measured in terms of price/book (P/B) multiple at which their shares trade.
Taking our analysis further this week, I’d like to talk about the stock returns generated by these companies during the last five-year period, with a particular focus on the FMCG sector.
What’s exceptional about the last five years is that:
The market (Sensex) peaked five years back in January 2008 and is yet to scale its previous high
India experienced a period of extraordinary inflation c) the world has undergone a mighty recession, which it is yet to fully recover from.
These factors have caused a flight to safety in terms of investments — into gold — as a hedge during uncertain times, leading to a run up in its demand and consequently its price.
However, an analysis of BSE 100 companies bucketed, based on ROCE levels, indicates that companies in the highest ROCE bucket have on average delivered stock returns of 104 per cent during the last five years compared to 73 per cent returns posted by gold (in dollar rates) during the same period (Gold has run up more in rupee terms, but let’s exclude the currency effect).
The chart reveals that the two higher ROCE buckets of BSE 100 firms posted positive returns vis-a-vis the market during this period, while the two lower ROCE buckets posted significantly negative returns vis-a-vis the market.
I would argue that during high inflationary period, firms whose ROCE doesn’t even compensate for risk-adjusted equivalent of fixed deposit returns, are in essence losing money in real terms.
Think about NHPC as an example from the lower ROCE bucket.
The company clocks a ROCE of about 8 per cent, which is significantly less than bank FD return of approximately 10 per cent; NBFC return of approximately 13 per cent and inflation of close to 10 per cent.
When the company is consistently not making ROCE in excess of what safer alternatives provide and is, in fact, net negative, post inflation, technically speaking, the capital employed by the firm is better off getting re-deployed elsewhere.
So suddenly a business that seemed viable during days of low interest rates and inflation can become unviable (economically speaking) during periods of high inflation and interest rates.
The market penalises such firms with negative stock returns and rewards those which continue to add economic value (high ROCE firms) with positive returns.
High ROCE as a hedge
High ROCE companies have the required margin of safety to continue generating positive ROCE over and above high interest rates and inflation during difficult times.
Nestle is one such company from the high ROCE bucket that clocks average ROCE in excess of 100 per cent. Nestle would continue to be an economically attractive business, despite interest rates or inflation moving to double-digits, because the difference between the safer FD returns and what the business generates is considerably large.
The difference is largely attributable to the FMCG sector to which Nestle belongs.
It is really hard for a company to be in the FMCG business and generate less than 20 per cent ROCE.
No wonder, the FMCG index has recorded 132 per cent returns during the last five years compared to 6 per cent for the Sensex.
The FMCG sector is broadly characterised by strong consumer brands and small-to-medium ticket size of products — making them affordable by many.
So you have many people who seek out the brands and do not mind paying a little extra for the same (thanks to the ticket size), for example, Maggi, Kit Kat and Nescafe.
This provides for what is considered to be the most powerful weapon in the world of business — pricing power.
Customers are willing to pay significantly more than what the products cost to make, due to intangible value of the brand that they perceive in their mind.
This translates to healthy operating margins, a key component of ROCE. Secondly, since customers are primarily concerned about the brand, the company can outsource many of its business processes such as manufacturing, distribution, and so on, without worrying about warranty claims and focus on R&D and marketing.
Such flexibility, along with the fact there is neither hefty licence fee nor any need to hire rocket scientists, translates to low fixed costs and less capital tied up in bulky fixed assets.
Thirdly, FMCG companies sell for cash and pay their vendors in credit, making way for near zero or even negative working capital.
These boost asset turns — another key component of ROCE. Lastly, the combination of pricing power and small ticket size, allows these companies to protect ROCE by passing on any increase in raw material costs to customers during inflationary times.
What’s a couple of more rupees on a regular packet of Maggi or Horlicks? After all, you could always pick up a smaller packet so that you don’t feel the pinch.
(The author is a business consultant. Feedback can be sent to firstname.lastname@example.org)