Good Business Vs Bad Business for Investors? No its Just NOT dependent on HIGH ROE.

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.
• The concept of Good Business and Bad Business is inspired from the post by Abhinav/Niren on Manufactured Luck blog here .
• The concept of Change in Intrinsic Value is inspired from Prof Sanjay Bakshi blog post “The Final Relaxo Lecture” in which he advices us to focus on expected return rather than on intrinsic value.

In my earlier post on “What causes Wealth Destruction over Long term? Lack of Growth and ROE below 15% or High Valuations?” I indicated that

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 over a long period of time [5-8 yrs]. 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

In the current post I am presenting more evidence that its the lack of sustainable growth over 15% over long term which causes destruction of wealth and NOT High Valuations. High Valuations will only result in low single returns for extended period of time. I have tried to classify all business on the basis of CHANGE IN INTRINSIC VALUE rather than abstract terms like High Quality, Low Quality, Cigar Butts, Deep value, High PE, Low PE, High Dividend yield etc.

You can download my study note from here or alternatively from here

Below are the finding based on my above study:

If Long term Growth < ROE, then change in Intrinsic value is NOT equal to ROE. In this case Change in Intrinsic Value is equal to average of PAT and Book Value CAGR

For companies like Hindustan Unilever and Castrol where PAT Growth is less than ROE, Growth in Intrinsic Value depends on PAT CAGR and not High ROE [even if its more than 50%]

To avoid Permanent Loss of Capital or Risk of Earning less than 15% Price CAGR, avoid investing in Bad Businesses. A Bad Business is any Business where Long Term Change in Intrinsic Value is less than 15% CAGR

I am classifying business as good or bad purely from investors perspective. For the society as a whole a business classified here as bad might be a good business and vice-versa

Unless Intrinsic Value grows at > 15% CAGR, Buying companies with Single Digit PE will NOT result in Price CAGR more than 15%

What causes PERMANENT LOSS OF CAPITAL? High Valuations or Lack of Sustainable Growth > 15% CAGR. Look for which companies are NOT PRESENT in this list and think Why?

 

Companies which destroyed wealth between Dec 2007 and Jan 2016 [All companies with Market cap > 5K crs as on DEc 2007

Companies which destroyed wealth between March 2003 and Jan 2016 [All companies with market cap of > 100crs as on March 2003

Note: See disclaimer at the end of the study note