In cricket, it is important for the batsman to watch the ball before stroking it. Likewise, it is equally important for equity investors to check return on equity (ROE) of a company before buying its share. ROE depicts the shareholder's value created by the business. No doubt, investors always yearn for companies that deliver high ROEs for a sustained period of time, which is quite challenging to find. But the question is - even if you find such a company, is it enough to buy a business just because it delivers high ROE? Probably, not always. Apart from high ROE, investors need to take growth and barriers to entry aspects into consideration as well.
Growth provides a business with the opportunity to achieve high ROE year on year. After all, higher sales growth ultimately translates into higher earnings while keeping costs in check, thereby leading to an increase in ROE. On the other hand, barriers to entry reduce the threat from newer players (competition), thus providing existing companies with better pricing power. Hence, businesses having high ROEs, operating in sectors with a long runway for growth and enjoying high barriers to entry can be a treat for investors.
To test this hypothesis, we have taken companies from the BSE 500 (excluding Banking & Financial firms) reporting an average ROE and ROCE of more than 20 per cent in the last five years till March 2020. Next, we have checked their five-year sales and profit growth till March 2020 and filtered those that have delivered less than 7 per cent (around the GDP growth rate) sales and profit growth YoY. We have finally come up with a list of 14 companies. The median five-year stock price return for these 14 companies was just -2.2 per cent YoY.
To further strengthen this hypothesis, we have identified three companies that have low growth and barriers to entry but enjoy high ROEs.
Bajaj Consumer Care
The size of the Indian hair-oil industry is roughly Rs 13,600 crore (source: the company's annual report). Marico, Dabur and Bajaj Consumer with their brands, Parachute, Dabur Amla Hair Oil and bajaj Almond Drops Hair Oil, respectively, occupy roughly 60-62 per cent of the industry. The rest 38 per cent of the industry is dominated by around 1,300 mom-and-pop brands from the unorganised sector. Such a huge presence of brands from the unorganised sector signifies that barriers to entry in the hair-oil industry remain low. Mobile internet penetration is further giving an advantage to regional players to market their products through e-commerce and social media platforms, thereby enabling them to save on ad and marketing expenses and distribution costs.
Bajaj Consumer Care has been able to maintain a market share of around 10 per cent in the hair-oil market over the years. However, slow demand in the segment has led to revenue growth of just 0.6 per cent YoY in the last five years till March 2020. On the other hand, the absence of any meaningful pricing power has led to profit growth of just 1.4 per cent YoY in the last five years till March 2020. In 2019, the company hired Bain Consulting to develop growth strategies and is implementing them in a second state now. Although FMCG stocks are now performing well, Bajaj Consumer has given a return of -9 per cent in the last one year, with its P/E today trading at 17.5 as compared to a five-year median of 24.8.
TVS Srichakra
The Indian tyre industry was a roughly Rs 59,500 crore industry (source: Alpha Invesco) in 2017-18. Out of this, the two- and three-wheeler tyre industry accounted for roughly 13 per cent in value and 56 per cent in volume terms (annual report). Part of TVS group, TVS Srichakra is a dominant player in the two- and three-wheeler tyre industry, with a market share of 29 per cent, as per a Nirmal Bang Equities report. Although the top three players are occupying 85-90 per cent of the two-wheeler industry, competition is immense among these companies.
Although factors like the relationship with OEMs, the distribution network and brand recognition play a big role in the tyre business, stiff competition among leading players leads to the absence of any meaningful pricing power. Moreover, barriers to entry in the business aren't high, as is evident from the import of cheaper Chinese tyres and the entrance of new players like Maxxis Tyres. Moreover, the volume of tyre sales has shrunk over the years, owing to regulatory changes and slowing consumption, thereby resulting in a deterioration of margin profiles of tyre companies. Experiencing a sales decline of -0.7 per cent in five years till March 2020, TVS Srichakra recorded a profit decline of -3.7 per cent during the same period. A low share in the replacement market and its presence only in the two-wheeler segment added to its dismal performance. In the last one year, the stock has given a return of 14 per cent and currently trades at a P/E of 18 (based on FY20 earnings) as compared to a five-year median of 14.8.
Blue Dart Express
Apparently, the logistics sector looks like a sunshine sector with immense opportunities for growth. After all, only 10-15 per cent of the $215-billion Indian logistics market is owned by organised players (Source: Annual report). To make the economy competitive, logistics costs need to come down and both the government and industry have taken measures to achieve this goal. Despite the industry's growth potential, Blue Dart Express has faced its share of turbulence.
Hit by digitisation and a slowing economy, the company's flagship business of couriers and documents has slowed down. On the other hand, its e-commerce business segment - which was experiencing tremendous growth a few years ago - is facing business-model challenges. With a steady growth of e-commerce, companies have in recent years started cutting reliance on expensive air transportation and moved to multi-modal logistics services, comprising both air and ground transportation. Further, with Blue Dart's dedicated fleet being costlier and having fixed routes, customers started choosing other airlines. Adding to it, several startups, such as Delhivery, Ecom Express, Rivigo, backed by investors money, tech capabilities and business-model agility, quickly pitched in to offer services at a lower cost. These business developments have reflected in numbers. In the last five years till March 2020, the company's sales grew by 7 per cent, while the profit declined by -180 per cent YoY, albeit affected by one-time restructuring costs and a change in accounting treatment. Amid the sudden investors' interest in the logistics sector, the stock has given 83 per cent return in the last one year. However, the last five-year price return is dismal at -9 per cent YoY. Since TTM earning is negative, P/E isn't meaningful.
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