Quality investing for wealth creation

Equity markets are going through great uncertainty amidst unprecedented volatility. While governments across the world are battling issues of high debt and deficits, Indian policy makers have their own share of problems such as high fiscal deficit, spiralling inflation and high interest rates.

In such unsettling times, the time-tested strategy that can lead to long-term wealth creation and protection of underlying investments is of “quality investing” according to a study conducted by ASK Investment Managers (ASKIM). The research shows that a portfolio constructed with a core holding of high quality businesses has the potential to deliver healthy long-term compounded returns with minimal volatility.

ASKIM using a filter of a minimum Rs 500-crore market cap arrived at a shortlist of such high quality businesses that have consistently generated an ROCE (Return on Capital Employed) of over 25 per cent during the past five years with an added filter of minimum ROCE (return on capital employed) of 15 per cent in each of those five years.

Some of the findings that emerged from the back-testing of the “high quality” universe were:

Consistent operating history: These firms enjoy consistent operating history with their business models typically being self-replicating, sustainable and consistent. This means that these businesses are not cyclical in nature and deliver strong performance on a consistent basis year after year.

For instance, Nestle has a business model which is easily understood and self-replicating in nature as a new or existing customer of a product such as Kit-Kat and/or Maggi is likely to be a repetitive lifetime user of the same. In essence, some of these are annuity businesses and are not order-book driven, and hence they have been able to clock consistent operating profits on a yearly basis.

Consumption oriented themes: It has emerged that leading domestic consumption-oriented businesses have largely been the ones that have been able to maintain a consistent operating history. These include businesses from sectors including FMCG, banking and pharma backed by the strong Indian consumption story driven by a consistent shift in demographic changes towards life-style consumption as in the west, and are largely unaffected by the ongoing global upheavals.

Low capital intensity and leverage: These businesses are typically low on leverage with no major need for capex requirements being in a mature life-cycle stage of existence and have a conservative approach to capital raising. Since, most of these companies are cash rich and enjoy high ROCE, they are not dilutive of their equity and have the ability to plough back their profits into the business without having the need to rely on debt. Companies such as Castrol, Nestle and ITC have hardly ever raised capital after their inception and have grown on their own steam without having to approach the markets repeatedly for capital to fund their growth.

High dividend payouts: Due to the low capital intensity, these businesses have been paying a large part of profits consistently over long periods of time. This is also evident from the fact that managements are quite investor friendly and are willing to part with available cash in the form of dividends rather than hoard large cash reserves.

The resultant dividend yields from these companies are also higher as compared to market averages. The dividend yield of the universe in subject stood at around 1.50 per cent as compared to the dividend yield of around one per cent for BSE-200 index companies.

Cushions during tough times and outperformers during recovery: It is a proven fact that markets stick to “quality” during times of crisis. As the markets crashed through 2008 and early 2009, many if not most stocks from this high quality universe, exhibited lower down-side volatility as investors preferred to hold onto such businesses.

During this period while the broad market indices fell close to 60 per cent, these high-quality businesses witnessed a significantly lower stock-price fall of around 40 per cent, thereby significantly outperforming the indices.

It is also evident that markets preferred “quality” during recovery too. As the markets started to recover during the middle of 2009, these were the stocks that were lapped up first by the investors as is evident from the analysis. Post crisis, the broad market indices climbed about 150 per cent from the bottom, while the “quality universe” showed a jump of nearly 250 per cent.

This defensive-offensive combination can be attributed largely to clean unlevered balance-sheets, visible annuity of profits and cash-flows and high pedigree of managements running the show that didn't get entangled in any corporate governance mess.

Long Track Record: Over the long term, markets have regarded these as superior businesses as they have added to their market capitalisation at a faster rate than earnings growth. In terms of the performance track record seen since 2001, these companies collectively did not exhibit any negative returns on any rolling five-year periods during the last decade. In contrast, the broad market index BSE-200 showed returns in the negative territory on various occasions.

To summarise, exceptionally high returns on capital employed, consistent surplus cash flows, minimum or no dilution of capital, high dividend payouts, predictability of earnings, excellent management pedigree and long-term non-destruction of investors' wealth are all attributes of high quality companies.

Such companies need to be at the core of any investor's equity portfolio construct. Investors holding a portfolio of such high quality businesses can expect healthy long-term wealth creation, reduced volatility risks and consistency of returns.

In other words, the strategy of investing into “quality” can put investors on a stronger footing with more peace of mind and without losing sleep over one's investments especially during times of great volatility or crisis.

Most of these companies are cash rich and enjoy high ROCE, they are not dilutive of their equity and have the ability to plough back their profits. — Mr Sameer Kamdar, CEO and Managing Director, ASK Investment Managers

(The author is CEO and Managing Director, ASK Investment Managers. The views are personal)

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