Growth is vanity, profit is sanity: 10 fast growing companies with high ROCE

Investors and analysts use ratio analysis to evaluate the health of companies. (Photo: Reuters)
Investors and analysts use ratio analysis to evaluate the health of companies. (Photo: Reuters)

Summary

  • As savvy investors know that growth should not come at the cost of profit. Here are the top 10 fast growing companies with high ROCE.

Whether, a human being, a small business or a multinational conglomerate, Growth is crucial for survival in the long term.

But while a lot of companies which attain a certain level of success are content to stay at this plateau, this is a risky stance for any firm.

Growth isn’t just important for a company – it’s absolutely essential.

However, too much growth over a short period can be dangerous. If a business continues to scale without adequate resources to handle it, it won’t be able to sustain itself in the long run.

In recent times, the phrase “fast growth" conjures up a picture of a group like Adani, serving markets with seemingly inexhaustible appetites for its products and services.

Gasping investors and rising stock prices are generally part of the image.

But as we have seen time and again, some companies became so obsessed with aggressively scaling up and growing revenue, they end up destroying substantial value in their businesses. Simply put, they fail at smart growth.

For investors, it is a daunting task having to choose among such high growth companies. After all, last year’s top performer might be a laggard in the current year.

This is why investors and analysts use ratio analysis to evaluate the health of companies. They do this by scrutinising past and current financial statements.

For this article, we looked through hundreds of companies to find out which ones were able to grow consistently over the years.

As most large-cap stocks tend to be companies with massive size and scale. These are primarily “mature firms."

While these companies will continue to grow and expand their operations, they may not experience significant growth year on year.

Hence, the companies we selected are primarily from the universe of midcaps, barring a few largecaps. We avoided smallcaps so as to steer clear of any dubious companies.

To avoid any one hit wonders, we looked at a longer duration, so as to even out the field.

To identify our high growth companies, we used 5 characteristics:- 


Consistently strong revenue growth

Having a large market for its products & services

Among the leaders in its industry

High quality management team

Industries with significant growth potential


But growth in itself is not enough in the long term…

In recent months, a handful of high-profile, high-growth companies have announced job cuts.

Then, we have the infamous Adani scandal that has rocked markets in recent time. Again, the group was on a path of quick expansion supported by a huge debt load.

If you look carefully, in most cases, these firms experienced high growth in revenues, but none of them were making a profit!

Why does any firm, big or small, do business?

A lot of companies, in the rush to succeed, forget why they went into business in the first place, and that’s to make money.

While growth is essential, what is the point for a business to keep growing if it doesn’t make adequate profits.

And then again, if a company is making a profit, is it enough to justify the capital it employs to make it?

Hence, we also used a very important financial ratio, the Return on Capital Employed (ROCE) to filter out only the ten best companies that meet all of these criteria.

Before we get on to our list of ten fast growing companies with high ROCE, let us take a moment to understand the crucial difference between high growth and profit and what the ROCE is and why it is important for investors and our study.

Growth or Profit, what are you betting on?

Back when I was a kid, in one of our summer holidays, my sister and I decided to set up food & drink stalls in our society to make some money. Our father lent us ₹200 each to start our so called “business."

While my sister chose to sell sandwiches for ₹5, I set up a stall right next to hers selling lemon juice for ₹2 per glass.

Over the first week, my sister sold 50 sandwiches, pocketing a revenue of ₹250 of which profits were approximately ₹100 ( ₹2 per sandwich).

On the other hand, I sold over 100 glasses of lime juice, earning a revenue of ₹200 and profit of ₹100 (Re 1 per glass).

Buoyed by her success, in the next week, my sister borrowed an additional ₹200 from my dad and also roped in a friend to help her make sandwiches to keep up with the demand. She agreed to pay her friend ₹0.5 per sandwich sold.

At the end of the second week, my sister had sold 100 sandwiches, earning a revenue of ₹500 and after paying her friend and covering costs, she earned a profit of ₹150.

For me, the sales were slightly higher as I sold 110 glasses of lime juice, earning a revenue of ₹220 and profit of ₹110.

My sister and her friend teased me for not growing my sales and admonished me for not being aggressive enough to make more profit.

But when we went back to dad, surprisingly, he said that I had done better business than my sister, confusing us all at the time…

Here’s how…

In the first week, we both used ₹200 to generate a profit of ₹100 each. 
That’s a return of 50% on investment (100/200).

But in the second week, in her pursuit to grow sales, my sister had used ₹400 to make a profit of ₹150. I had used the same 200 bucks to make a profit of ₹110.

In effect, this meant that the return generated by my sister was 37.5% (150/400), whereas for me it was 55% (110/200).

As an investor, for my father, my business was far more attractive - with lesser money, I was earning a significantly higher return.

On the other hand, my sister used twice the amount of money and an additional resource (her friend) and even yet, had earned a lower return on investment.

At the time, we didn’t understand this in terms of financial ratios, but it was an important lesson that I carried forward through my career.

One must not get blindsided by growth alone if it doesn’t add more money to your pocket. Maybe, that is the reason why I have never invested in any of these cash burning high growth companies and their IPOs.

It’s akin to going to a restaurant and ordering all the dishes on the menu and then just looking at all the food on the table without eating anything. You go to a restaurant to eat, similarly, you run a business to make profit!

Of course, there is another important aspect here as well.

While my stall required very limited resources (free water, free ice, lime, and sugar), my sisters stall in a way was more resource intensive. It required bread, vegetables, sauces, pepper, salt, and ultimately an extra hand.

I wasn’t wise enough to know this at the time. It was probably just an easier idea to execute for me and I got lucky.

But if you look at it from a business point of view, then it does make a significant difference which industry a company operates in.

Certain industries such as airlines for instance are by nature poor compounders of capital over the long term. This is due to certain intrinsic characteristics such as, their capital-intensive nature, wafer-thin margins, and inability to pass on cost increases to customers.

But, if you look at IT services or the FMCG sector, it is clear that these firms record higher returns on their capital very comfortably.

Hence, as an investor, it is important to choose an industry first, which by default tends to have a high ROCE.

Return on Capital Employed (ROCE)


Many investors think that growth is the ‘end-all’ of value. Yet, time and again, the markets have proven that in the long term, profitability is critical, and growth for growth’s sake can destroy value.

A study of listed companies that constitute the BSE 100 index indicates that, on average, companies that deliver better ROCE, experience a higher valuation measured in terms of the price to book (P/B) multiple.

Thus a company that can expand its ROCE, expands its valuation multiple too. But what does this mean?

Return on Equity (ROE) and return on capital employed (ROCE)are ratios used for understanding the efficiency of a company's operations relative to the amount of capital employed.


ROE is calculated by dividing the net income by total equity. ROCE is calculated by dividing the operating profit before taxes by the capital employed.

But as ROE is purely focused on equity shareholders, it tends to gloss over the very important aspect of return on assets. On the other hand, ROCE considers the return to all stakeholders in the company including equity and debt.


Hence, for our discussion, we have chosen the ROCE as a criteria for our list of companies.

Return on capital employed (ROCE)is a profitability metricthat indicates a company’s efficiency in earningprofits from itscapitalemployed with respect to its operating profit.

It is the return that a company generates for its two principal capital providers, equity and debt. ROCE can be expressed as…

ROCE = Earnings before Interest and Tax (EBIT) / (Total Equity + Long Term Debt)

In simple terms, the market rewards companies that can compound the capital they employ in their business at high rates of return, by valuing them at a higher premium as compared to peers that don’t.

The corollary to this is that companies with low ROCE end up leveraging to boost return on equity (ROE) which in the long run might burden them with high debt.

When a company consistently fails to get a ROCE in excess of returns from safer alternatives such as a fixed deposit, the capital employed by the firm is better off getting re-deployed elsewhere.

The market penalises such companies with negative stock returns and rewards high ROCE companies with positive returns.

Another reason why one must invest in companies with high ROCE is that these companies tend to outperform their peers even in difficult times.

This again is simply because a high ROCE company has the necessary ‘margin of safety’ to continue generating positive ROCE even in times of inflation and higher interest rates.

Such companies are attractive for investors despite interest rates or inflation moving higher, because the difference between what their businesses generate and safer returns like a fixed deposit is considerably large.

Unfortunately, due to cheaper availability of capital, a lot of companies lose sight of profitability, enticed with the hope of expanding their business empires.

This leads to investments in below average projects and non-core expansions which are sadly justified in the name of growth.

And ultimately, this leads to erosion of ROCE and subsequently, valuation, and stock prices of these companies.

All in all, as the quote goes, “Revenue is Vanity, Profit is Sanity".

Now that we understand, just how important ROCE truly is, let us look at some of the stocks that almost made it to our list but fell short of meeting all the desired parameters.

(Equitymaster)
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(Equitymaster)

While Nestle boasts of an excellent ROCE, if you notice, the sales growth has been quite dismal over the 3 year and 5-year period. Profit growth has also been negative for all three periods, i.e., over 3 years, 5 years, and 10 years. This ticks the stock off our chosen list.


(Equitymaster)
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(Equitymaster)

Then we have One97 Communications, the parent company of Paytm which has had a high growth rate of revenue over the years but consistent losses and a negative ROCE. This stock definitely doesn’t make the cut for our list.


(Equitymaster)
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(Equitymaster)

Finally, in case of Bata India, while the company has a reasonably healthy ROCE and profit growth has also been consistent, if we look at sales, the growth is unimpressive.

Looking at the above examples, you might have understood that while some companies have a strong ROCE, others may have healthy revenue growth or perhaps higher profit growth. But it is difficult to identify companies that make the cut based on all the criteria.

Fortunately, we have been able to separate the wheat from the chaff in our list of companies just for you!

Here are the top 10 companies that meet our standards based on a healthy ROCE, strong sales growth, and solid profits.

The Growth Chasers: 10 Fast Growing Companies with High ROCE 
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The Growth Chasers: 10 Fast Growing Companies with High ROCE 

While our list of ten companies might not be the fastest growing companies in the market, they have a brilliant track record of consistent high growth along with a high ROCE over the last decade.

These companies have a large market for their products & services, good quality management teams and operate in industries with significant growth potential.

It is important to note that ROCE is just one of many factors that investors should consider when evaluating a stock. Other factors such as the company's growth prospects, financial stability, and competitive position should also be considered.

Look at trends for all return ratios over a number of years and analyse each of its components. It will not only help you understand the company's profit and loss statement better, but also balance it against the overlooked left and right sides of the balance sheet.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.

This article is syndicated from Equitymaster.com

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