Four high return on equity stock ideas

Starting with this new Portfolio edition, we are offering the ‘Do-It-Yourself’ (DIY) investors among our readers a shortlist of stocks that we have screened, based on certain critical parameters.

We hope these screeners can be a starting point for you to undertake further research into the businesses we have highlighted to unearth hidden gems that can add to your wealth in the long run. We kick off the series with that holy grail of equity investors -- ROE or return on equity.

Why ROE

Return on equity is the net profit of a company after taxes, divided by its net worth or share capital plus reserves. It is a window into the amount of returns that a company is able to generate on all the shareholder profits that it has held on to over the years.

Companies that can sustain a high ROE year after year are strong earnings compounders because they are able to manage a high return on profits reinvested into the business.

A high ROE also offers justification for a company to hold on to surplus profits without distributing it.

When a company combines consistently high ROE with a moderate valuation, it merits attention as a possible addition to your portfolio. This screener attempts the simple exercise of identifying companies that meet these two parameters.

Other criteria

Using Capitaline database, we shortlisted companies (excluding banks and finance companies) with ROEs of at least 20 per cent for five years until March 2020. We considered only the S&P BSE 500 companies as a starting point to ensure adequate visibility and market interest. The five-year criterion was used to ensure that only companies that have sustained high ROEs consistently made the cut, and not those with flash-in-the-pan profit. High ROE in one year can simply be the result of a sudden upturn in a company’s commodity cycle, a one-off business opportunity or even unusual input cost savings in a year.

ROEs can vary substantially between sectors. For instance, companies that don’t require significant levels of incremental capital or fixed assets to generate earnings can have higher ROEs compared to more asset heavy or capital-intensive businesses.

Keeping this in mind, we further pruned this list of high ROE companies by picking out those that had the highest ROEs within their peer group in the sector. In this raging bull market, most high ROE businesses have already been bid up to equally high valuations. To identify those where high expectations are not factored into the price, we chose companies with relatively lower stock valuations within their respective sectors.

Who made the cut

Caplin Point Laboratories (Labs), a ₹3,650-market cap pharma company, having Latin American and African countries as its focus markets, is one such high ROE company. While Caplin Point Lab’s ROE has come down overtime, it was still high at 28 per cent in FY20 and 21 per cent for 12 months ended Sep-20. Caplin Point Labs multiplied its revenue and net profit 30 per cent and 39 per cent between FY15 and FY20 and is a debt-free company.

On the valuation front too, compared to several large pharma companies that are trading at high multiples, the stock of Caplin Point Labs is relatively inexpensive at a trailing twelve-month price to earnings multiple (TTM PE) of 17 times. This is a tad below its 3-year average TTM P/E ratio of 19 times. With Caplin Point’s injectables facility getting USFDA approval in 2017, the company has entered the lucrative and competitive US market.

Higher ROEs combined with low debt levels indicate that a company’s higher earnings are a result of efficient equity utilisation and are not being fuelled by higher levels of leverage.

Leading lubricant-maker Castrol India is yet another high ROE (upwards of 65 per cent) stock. For 12 months ended June 2020, Castrol India had an ROE of 53 per cent. At a trailing twelve month P/E of 19.4 times, the stock trades below its 3-year historical P/E average of 21 times. It also looks cheap compared to the stock of its peer, Gulf Oil Lubricants, which is trading at 23.4 times TTM P/E. Castrol India recorded revenue and profit growth of 4 per cent and 8 per cent, respectively, during 2015 to 2020 (calendar year).

However, dragged down by the sharp decline in the June quarter, Castrol India posted year-on-year 28 per cent and 29 per cent decline in sales and profit for the nine-months ended December 2020. With the gradual unlocking of the economy, the company’s revenue and profit recovered in the latest September quarter, both sequentially and from year-ago period. A pick-up in economic growth and auto demand; new launches in the personal mobility segment and the tie-up of its promoter BP with Reliance Industries should benefit Castrol India.

Bajaj Auto, one of the largest motorcycle and three-wheeler companies in the Indian market, has returned an ROE of 22-34 per cent in the last five years. Reflecting the imapct of sluggish demand, the company ROE fell to 18 per cent in September-20 (12 months ended). It has grown its revenue and profit at 6.7 per cent and 11.5 per cent (both CAGR), respectively, between FY15 and FY20. This was despite the dismal FY 2020 performance in line with the slowdown in the auto sector.

Valuation-wise, the stock looks relatively less expensive compared to some of its peers. Though at 22.4 times TTM P/E, the stock is trading above its 3-year P/E average of 18 times. A positive outlook for exports (largely to Africa) which account for 40 per cent of the company’s revenue should aid growth. The company’s strong position in premium bikes along with its presence in the lower end of the market too should hold it in good stead.

Mid-sized IT player Sonata Software has generated ROEs of 29-39 per cent between FY15 and FY20 and 30 per cent for the 12 months ended September-2020. During the 5-year period, the company posted revenue and profit growth of 17.3 per cent and 15.7 per cent (CAGR), respectively. At a TTM P/E of close to 14.6 times, the stock is only slightly above its 3-year average multiple of 14.4 times. While the company is exposed to client concentration risk, its partnership with Microsoft and higher IP-led revenues are some positives for future growth.

Bajaj Consumer Care, like many other FMCG companies, has had an ROE of far higher than 20 per cent the past few years. The stock of Bajaj Consumer Care is also trading relative cheap likely reflecting the company’s under 1.5 per cent (CAGR) net profit growth between FY15 and FY20. Likewise, the ROE for the State-owned Coal India too has been well over 20 per cent consistently the last five years. The stock is trading at only 6 times its TTM earnings. The contraction in the company’s profits in FY17 and FY18 have chipped away at its equity capital, thereby bumping up the ROE in recent years without commensurate earnings growth. For companies like these, concrete triggers to a pickup in profit growth may be the key to stock re-rating.