Tough times don’t last, High ROC Companies do

This post was first published on capitalmind

The Calm Investor | Quality Companies

Symphony Ltd., Avanti Feeds, Tasty Bite Eatables, Relaxo, PI Industries, Eicher Motors, Safari Industries, La Opala RG, Bharat Rasayan, Ajanta Pharma – These are well-known names. Some of the biggest wealth creators in India over the last ten years.

Imagine finding just one such company early in its lifetime. No doubt, you have seen the charts of how Rs 100 invested in ‘X awesome company’ in 1999 would be worth enough today to pay off the national debt of a small country

For the record, investing Rs 1.5L in Symphony in 2008 could technically get you an apartment on Altamount Road in Mumbai worth Rs 6 Cr (~$0.9M) today.

Isn’t hindsight a wonderful thing?

Expecting to find and hold “triple-digit-baggers” is unrealistic for three reasons:

  1. They are rarer than unicorns (the mythical horned creature, not the more common cash-guzzling internet startup). Roughly 1 in 350 public companies that survive grow market cap by 100X or more.
  2. They spend years, even decades going nowhere. Symphony listed in 2002 but its stock barely moved for five years before beginning its meteoric rise.
  3. They go through massive drawdowns. Avanti Feeds has gone from 950 in Nov 2017 to 415 in July 2018. How many current shareholders who held it back then will still hold it in 2025?

Ergo, any stock picking approach that looks for sure-fire ways to find 100-baggers is delusional or a ponzi scheme, often both. That does not stop our pattern-recognition instincts from asking the question:

What separates companies that go on to become multibaggers from the rest?

The answer typically is a combination of crazy good execution skills and being in the right place at the right time. One other thing is the ability to generate high profits relative to the capital they need forming a virtuous cycle of being able to fund profitable growth through internal accruals.

Sustainably high ROCE. The holy grail.

But there’s a logical flaw when we select past multibaggers and try to find what’s common between them as a way of identifying future multibaggers.

It is best captured by this tweet (and its reactions) about what makes successful people.

The Calm Investor | What makes successful companies

This tweet itself got traction but the reactions are illuminating. My personal favourite:

The Calm Investor | Survivorship Bias

Instead of cherry-picking success stories to find “patterns”, we need to look at how all companies, with low and high ROCE have done historically.

Objective: To test whether a relationship exists between ROCE and stock returns. Therefore, historically, have companies with higher ROCE delivered better returns than the rest?

Method: A cross-section of over 1500+ companies classified into deciles (ten groups formed based on their ROCE rankings). For each year from FY 2008, lowest 10% of ROCEs would form the bottom 1st decile, the next highest 10% the 2nd decile and so on until the top 10% ROCEs would form the 10th decile.

This ensures that we are looking at the entire cross-section of abysmally low, mediocre and high ROCE companies.


Chart shows annual median returns for companies in each ROCE decile.

The Calm Investor | High ROCE company returns
How to read this busy chart: Within each year, the left-most bar (lightest blue) represents returns from companies with the lowest ROCE in the previous year, the darkest blue bar represents returns from companies with the highest ROCE. Companies with ROCEs in the middle, make up the remaining bars.

Therefore, investing in companies with the lowest ROCE at the end of FY 2008 would mean a median return of -53% in FY 2009 compared to -36% for the highest ROCE companies.

It would have been nice to see every bar showing higher returns than the bar to it’s left thus confirming beyond doubt that higher ROCE means higher return. But that’s the problem with how real life data communicate. More like a grudging confession than a willing informant.

However, if you look closer, you observe two things:

In good times, all except the worst ROCE companies do just fine.

FY10, 15, 17 when markets did phenomenally well, the highest returns did not come from the highest ROCE decile. The lowest ROCE deciles underperformed by a distance.

In bad times, all except the best ROCE companies struggle

FY09, 11, 12, 13, 16, 18 when markets were indifferent, the high ROCE deciles had significantly lower damage and even did respectably.

So What?

If in good times, the best returns come irrespective of ROC and in bad times, high ROC only barely keeps its head above water, then does Return on Capital even matter in portfolio construction?

The Calm Investor | ROCE Analysis India

The high ROC decile outperforms all others by a margin. Almost all ROC deciles outperform lower deciles.

Not losing much during bad times ensures outperformance over the long term. We know this intellectually, just not intuitively.

Return on Capital matters. A portfolio of companies with sustainably high Returns on Capital will outperform the broader market over the long term.

So, which companies are in top ROCE decile as of 2018?

The Calm Investor | India Stocks to Invest in 2018
Note that none of the stocks mentioned are recommendations. ROC is just one of several important parameters to consider when picking stocks. (Vakrangee and 8k Miles have reported consistently excellent ROC, for instance. And they’re not exactly what you’d call invest-worthy).

The point of this exercise is to examine the power of one metric to help reduce the probability of making poor investment decisions. Return on Capital should be part of any stock selection framework.

8 thoughts on “Tough times don’t last, High ROC Companies do

  • August 11, 2018 at 4:54 am

    Really interesting post. I think the underpinning of this post is the fundamental difference between value investing and growth investing. I did a quick analysis of some of the names on the table of sample companies you have here to understand their balance sheet structure. Excellent ROCE, good capital turns, little to no debt, strong cash position (in some cases overly so), healthy operating margins and consistent dividend payers. Some of them are growing, many of these aren’t. However, I pulled open their stock price charts and several of these stocks have generated little to no returns to investors over the last 3 years. No wonder so because we are sitting at the back end of a bull market (or at least that is what I think). It must be really unnerving to hold on to a structurally superior business and still make little to no returns over an extended period of time.

    Here is where what WB said comes to mind. During the times of Buffett partnership Warren keeps repeating in his yearly letters that in a raging bull market he would be more than happy to match the index. However, in a bear market he considered his stock portfolio to be able to generate a return of 10 percentage points better than the index.

  • August 11, 2018 at 4:11 pm

    Thanks Vignesh. Lower downside beta is what stood out to me as well about high ROCE stocks. Now more than ever I think that’s an important factor in portfolio construction.

  • August 11, 2018 at 8:28 pm

    I was wondering what is your high decile roce cut off. I was trying to run a filter on i am surprised that some companies like abm knowledge ware and Abbott have sneaked in.
    Also i have a question would roe be a better filter with debt to equity being less than 1. I am just wondering just having high roce may not be enough because heavy leverage can be a dampner? What about high roce coupled with moderate growth say 15% over 5 years in profits. Wouldn’t that be a compounding mahinrm?

  • August 11, 2018 at 8:41 pm

    Vinod, if you read the post carefully, it is not about finding the perfect screen but to examine the impact one variable (ROCE). I even mention at the end that ROCE alone is not a great way to pick stocks but is one that part of any selection framework.

  • August 12, 2018 at 7:39 pm

    thank you for a great post. I learned a new thing. My reading time was well spent. I now get the confirmation that I only have to consider buying decent ROCE companies, and that there is no edge is focusing on the best ones only. Which seems appropriate, since a good business makes more than it needs to invest back, and thus earn itself a surplus on used capital, which is the logic of any business anyway. I would also like you to put in between brackets the USD figures of the mentioned crore or lacks sums, since I have no clue how much that sum means (I live in Europe), and I am too lazy to convert them myself.

  • August 13, 2018 at 10:08 am

    Thanks Al. Good input on adding USD numbers to make them universal.

  • August 14, 2018 at 3:28 pm

    Good one. thinking loud – Could it be more specific, say if the top bracket decile in 25-30-35% ROCE etc would it give a different conclusion?

  • November 24, 2020 at 1:46 pm

    Hi, Thank you for the article. It gives a very clear thought structure around the importance of ROCE and its correlation with long term returns. The literature is quite simple as well to help a non-finance person like me to understand the concept throughly.
    I would like you to address a few queries. I assume the ROCE deciles are created for each year (in the 1st graph), so a company X might be in 1st decile in the 1st year but would have dropped to 3rd /4th in the following years. Given that, isn’t it normal to find a company giving good returns in a good ROCE year as the earnings would be higher? Alternatively, we can say good earnings have a good correlation to better returns.
    Secondly, in the 2nd graph while plotting the line for each decile are the companies the same for the 10 years or is it different for different years? If it has the same companies, have you taken the ROCE average over 10 years?

Leave a Reply

Your email address will not be published. Required fields are marked *