×

 

Competitive Strengths of Wealth Creators

Successful investment in equities calls for:

1. Identifying the right business,
2. Which is run by a competent management, and
3. Is acquired at a price, which is at a huge discount to its underlying value.

Highlights & Insights
  • The study period (Mar-93 to Mar-98) saw the emergence of IT as a wealth creating sector for the first time, accounting for 5% of the wealth created.
  • Way back in 1998 itself, the study made three significant predictions:
    1. The widespread usage of IT in the years to come and India’s competitive advantage in this sector would provide exciting growth opportunities.
    2. As Indian industries face up to global integration, some businesses, such as pharmaceuticals would benefit significantly from an improvement in their business economics.
    3. The age and income profile of the Indian population and its irreversible nature can trigger a huge revolution in the consumer goods sector. Businesses built upon strong consumer visibility could hence flourish.
  • Earnings power is the prime source of wealth creation. Arithmetically, Price/Book (Mkt Cap/NW) = RoE (PAT/ NW) x P/E (Mkt Cap/PAT). Thus, valuation multiples are clearly a function of RoE.

Walking The Talk — The Contemporary Context

Infosys

  • Back in 1998, Infosys clearly embodied the essence of “(1) Identifying the right business (2) Which is run by a competent management, and (3) Is acquired at a price, which is at a huge discount to its underlying value.”
  • Its PAT has grown handsomely, its P/E had climbed to over 200x, and the stock has delivered compounded annual returns of over 26% for the last 20 years v/s only 12% for the Sensex.

Substantial growth in Infosys’ PAT translated into a P/E which rose to over 200x and a stock price that delivered CAGR of over 26% for the last 20 years.

The Quality-Price math, the non-quality aftermath

  • Even as markets remain obsessed with G(rowth), Wealth Creation studies never failed to emphasise the importance of Q(uality).
  • The 1998 study argued, “Predictability and growth in earnings is insufficient in itself. A company must earn stable or consistently higher returns on shareholder capital (i.e. ROE).”
  • The Quality-Price math (Price/Book = RoE x P/E) makes it clear what investors need to look for – “What is therefore paramount for any investor is to visualise or forecast accurately a corporation’s future RoE stream. Businesses which offer greater certainty in projecting its emerging stream of RoE are inherently less riskier and more valuable.”
  • Even as investors focus on what to buy, they need to equally know what to avoid. Thus, “Wealth-destroying companies tend to be asset-intensive businesses with negligible focus on intellectual capital.” They are also typically “highly-fragmented, lowentry barrier businesses that provide undifferentiated products or services.” (Interestingly, the 2008 study had a term to describe such businesses – Gruesome – of the triad of Great, Good and Gruesome).