What causes Wealth Destruction over Long term? Lack of Growth and ROE below 15% or High Valuations?

Note: This is still a work-in-progress and am no way suggesting below finding are conclusive. Any how presenting my findings, with a view to receive some feedback.

Acknowledgement: In no way I would like to take any claim for the below finding. The below finding stuck me while re-reading all the interviews of Mr. Bharat Shah, who along with Prof. Sanjay Bakshi has influenced my thinking and investment philosophy to a great extent. But if there are any errors in below finding of-course its only my fault.

Mr. Bharat Shah says “Equity is all about growth. When the growth goes way, equity becomes a bond and bond is clearly not equity. Idea of growth is to get a compounding power, to get a value much higher than the net worth or what suggest and essentially since the equity markets thrive on growth, the idea is to hunt for virtuous market cycles where largely you will see growth sustaining”

[You can read the related post on Mr. Bharat Shah here ]

Below are my finding after studying data for 2000-16, Mar 2007 to Jan-2016 and for Dec-2007 to Jan-2016:

  1. For majority of the non-financial companies [with very few exceptions] common cause of wealth destruction is when Sales/PAT CAGR or ROCE or ROE average is lower than 15%. If all the four conditions are satisfied it’s highly unlikely [though there are few exceptions especially in metals & others] that wealth will be destroyed. Am nowhere suggesting that if one has a Long Term view then one can buy at any price. What I am suggesting is IF ONE’S AIM IS NOT TO LOOSE MONEY, one should invest ONLY AND ONLY if one feels that company can sustain Sales/PAT/ROCE and ROE above 15% over long term basis. To put it in another way, it’s highly unlikely that over Long Term one can make any real material wealth if above four conditions are not satisfied, even if one buys business very cheap. [ofcourse one can make money if one is good at Short Term trading. I am definitely very bad in Short Term trading]. In absence of profit growth above 15% even high dividend payout ratio may not help much. As Bharat Shah says “Without growth, equities are worst than bonds”
  2. Why all the above four conditions need to be satisfied simultaneously is that one cannot expect PAT to grow at 15% CAGR if sales are not expanding, it can happen for 2-3 years but not permanently. Higher ROCE is required, else it means company is maintaining higher ROE only by increasing leverage even when profit margins are declining. [Of course I am making it simple. There will be lot of other factors but my guess is that it will mostly get capture in these numbers]
  3. High valuation will result in destruction of wealth over 8-9 years only if subsequently there is collapse in profit growth /ROE. Else worse case one may single digit return but no destruction of wealth. Destruction of wealth will happen only if one pays ATROCIOUS VALUATION at the beginning…

What will cause business to sustain above four critical parameters above 15%? I have attempted to explore that in the above post on Mr. Bharat Shah and in the post on Sustainable Moat: Five force analysis is NOT Enough , Ralph Wanger- Identify LT trends, Buy Small Cap & Aim only Multi-Baggers.

This post is aimed at quantifying numerically what destroys value. I have tried to capture qualitative factors which causes wealth destruction in my earlier post on WHAT LONG TERM INVESTORS CAN AND SHOULD LERAN FROM SHORT SELLERS and in COMMON MISTAKES BY INVESTORS

Let me know if you disagree. 

Find below data for

You can go through few examples here [Still work in progress]

 

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5 Responses to What causes Wealth Destruction over Long term? Lack of Growth and ROE below 15% or High Valuations?

  1. Very good Anil. My 2 cents:
    The %growth in PAT/Sales/ROCE & Mar cap should be taken on rolling basis. You really don’ t want market sentiment on particular starting/end date influence your analysis.
    Few adjustments are required. I suppose you have not take dividend income. I kind of disagree partially that PAT growth is absolutely necessary. If you see companies like NTPC, Power Grid, they have compounded money at x% with regular dividends (regulated equity). Also, IDFC has returned 14% CAGR from listing price, but point to point basis it’s showing negative.
    I didn’t check nos of other cos, but I’m sure we will get most of the bugs fixed if we pen down numbers on rolling basis.
    I found your blog interesting. Will dig further to understand ‘correlation factor’ of these inputs in my investee companies. Happy Investing & sharing

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    • 1) On your first point agree. We can try with rolling basis. But doing it for all companies is too much of a data mining exercise and time commitment required. I have seen one study which was done on rolling basis and the results were not very different. Of course when you start with abnormally high or low valuations results will vary. Unfortunately I have no permission to share that study publicly. What I am trying is solve this issue fundamentally rather than through data mining. Will post on finding in next post.
      2) Regarding your point on dividends. I disagree. I suggest you one exercise. Try to put numbers for any company on excel sheet for 10 year basis. Assume PE multiple remains constant. Try with any number of assumptions like ROE > 50% , dividend payout ratio > 80% but keep PAT growth only at 10%.. also assume liberally that you can re-invest dividend at 20% CAGR. Still dividend income won’t account for more than 2-3% CAGR return to your stock. As long as PAT growth < ROE, it’s the PAT growth which will drive growth in intrinsic value. Look at the Navneet education example here. I have done the same exercise for LMW, Castrol too.. Results are same. Wait for next post for more details…

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  2. Pingback: Good Business Vs Bad Business for Investors? No its Just NOT dependent on HIGH ROE. | ContrarianValue Edge

  3. Manoj Dua says:

    ppl would say it would be challenge to find stock whoseSales/PAT CAGR or ROCE or ROE average is greater than 15% at good price , i would say its challenge also to find stock who in future will me maintaining Sales/PAT CAGR or ROCE or ROE average greater than 15% for next few year. past growth is not promising future growth ..

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    • Yes…very very few …..that’s why one get rewarded disproportionate ly if one can find and buy at right price and more difficult could hold that for long long term bearing occasional underperformance for 2-3 years

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