How consistent growth can fuel high returns
3 min read 18 May 2023, 12:55 AM ISTOnly a few companies can deliver high profit growth consistently over the years
PremiumCompanies that are able to deliver high profit growth, consistently every year, have the potential to generate large stock price returns for investors. That higher profit growth has a favourable effect on stock prices is relatively well understood. However, the meaningful effect that the regularity of such growth can have on stock prices is often under-appreciated. We try to illustrate this through a simple exercise.
Towards this end, we assume that a person remains invested in stocks for seven years. While investors might have different time horizons, this period illustrates the overall point. The exercise delivers similar results when carried out for five years or a longer period of 10 years. From the current composition of BSE 500 companies, we selected stocks that have a listed history of seven years or more. There are 366 such names, or about 70% of the constituents of the BSE 500 index.
We expect a minimum 10% growth in profit annually from these firms: 10% is the minimum nominal GDP growth that India has achieved every year, during the 7-year period from fiscal 2016 to fiscal 2022 (excluding the Covid19-impacted fiscal years of 2020 and 2021). It is fair to expect a company to grow its earnings at least near the growth rate of the economy. For profit growth, we have considered company financials only up to fiscal 2022, as full year fiscal 2023 results have not yet been declared for all companies. Some volatility in profits of a business are inevitable. Hence, we expect this minimum threshold of 10% profit growth to be delivered in a majority of the years during this evaluation period- so in at least four of these seven years. There are 212 such firms that fulfil the previous criteria, or about 60% of the 366 companies.
While the stock prices of the entire basket of 366 stocks increased on an average by 15% per year during the 7-year period from 2016 March-end to 2023 March-end, the stock prices of the pool of these 212 names increased at a significantly higher 19%.
If we expect that the threshold of 10% profit growth be achieved in five of seven years, instead of four years taken previously, the above pool further reduces by half to just 102 names or less than 30% of the original selection of 366 stocks. The average increase in stock prices per year for this pool is noticeably higher at 23% versus 19% for the previous one. If we further expect that the threshold 10% profit growth be achieved in 6 of 7 years, the above pool now shrinks to only 25 names. For this pool, the average increase in stock prices per year is a dramatic 28%, almost double that of the entire original selection of 366 stocks.
While the exercise has shortcomings like a hindsight bias, all money to be invested equally in the corresponding stocks, on Day 1, at a specific point of time, and without any portfolio changes whatosever, the key points brought forth are highly potent and simple:
First, only a few companies can deliver high profit growth regularly. The ability of being consistent is relatively rare. As we saw, with each additional year of minimum profit growth requirement, there is a marked reduction in the number of qualifying firms.
Second, the pool of these few companies are better rewarded by the markets over a long-time horizon than the overall basket. As we saw, the returns increase substantially for each subsequent pool with an additional year of minimum profit growth requirement.
Also, this exercise is more relevant for investors who invest in equities directly post their own research or take assistance from advisors. Mutual funds are likely to have other parameters for investments rather than only the criteria used above.
Sandip Bansal is an associate director at ASK Investment Managers Ltd.
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