Why have the stock prices of Bajaj Finance & Asian Paints been rising for decades?

Say you’d invested a Lakh each in the shares of Asian Paints, Bajaj Finance & HDFC Bank in 2009. Eyes shut, that’d have been close to ₹13 Cr. today! But how?

COMPOUNDING. Listen to any legendary investor you admire, and they’ll, more or less, attribute their success to this ‘eighth wonder of the world’. Because money makes money, and the money thus made... makes more money. That’s an invincible cycle.

If you were to extend this logic to the stock market, you’d realize that there are companies that have compounded the wealth of their shareholders year-after-year for decades now, called ‘Consistent Compounders’ in market parlance. Don’t believe us? See this-

As you can clearly notice, these stocks have significantly outperformed the NIFTY 50 index every year. Even one has given as high as 45% CAGR! That’s almost 4x the annualized returns of the index!!

Thrilled? Curious to know what actually makes these stocks compound the way they’ve done in the past? Wanna grab some of such consistent compounders and reap the benefits years down the line? Well, here’s help. Thank us later ;)

What makes Consistent Compounders?

If there is an investment strategy as simple as it could be, that has to be this. But often, simple tactics aren’t easy. It takes years of practice to master such a simple craft, to make the art look effortless. And that’s the trickiest part of all.

But if you’re willing to try complicated stuff like trading, a simple one like this is definitely not worth a miss. So, here’s how you can implement this technique:

Criteria 1: ROCE > CoE

For newbies:

Return On Capital Employed (ROCE) indicates how efficiently a company is using its capital to turn a profit. It’s of utmost importance for an investor because if a company hasn’t been able to efficiently utilize capital, staying put in the company would be like fighting a losing war.

ROCE = Earning Before Interest and Tax (EBIT) / Capital Employed

Cost of Equity Capital (CoE) is simply the cost of a company’s equity funds. It matters for investors because CoE is ultimately the cost that the company has to bear on the capital it has raised. Without complicating stuff, CoE is just how much is expected to be paid to equity investors (by dividend or otherwise).

CoE = Risk free rate of return + Volatility * (Market rate of return - Risk free rate)

Coming to the question, what makes a stock a consistent compounder?

Well, the ROCE should have been significantly higher than the CoE for a substantial period in the past. The excess of ROCE over CoE is simply how much more profits the firm is generating than was expected, i.e., the firm’s free cash flow (FCFF). So, you could say the firm must have generated FCFF for years now.

Standardizing it a bit, a thumb rule is to see which firms have generated more than 10-15% ROCE every year for decades now.

You will usually find this attribute in market leaders of respective industries. But you know there is something peculiar about these metrics globally. Whenever a market leader has its ROCE > CoE, it attracts competition, and thus the advantage doesn’t last long.

For instance, Walmart dominates US grocery retail, Toyota dominates Japan’s mid-segment car market, Hanes dominates Europe’s innerwear market, JPMC is the world’s fourth-largest bank. Still, their ROCEs have been falling & are now just marginally higher than the lower limit (10%).

The Indian scene, however, is unique. India’s market leaders in several segments have maintained their ROCE significantly higher than the CoE for decades in a row -

(Source: Marcellus.in)

As the stats speak, such Indian companies’ median ROCE (34%) is almost thrice that of companies globally (12%). So, now you know why in India you can have a number of consistent compounders. You just need to have an eye (& mind) for it.

Once you have filtered companies on the basis of ROCE, look out for their revenue growth.

Criteria 2: High Revenue Growth

Revenue growth is an essential consideration for long-term investment decision-making. The reason is simple. You are planning to stay invested in a company for years. You wouldn’t want to invest in a company that is at its saturation point. Instead, look out for companies that expand and grow their earnings. Because that’s what drives the share price ultimately, right?

So, a general thumb rule could be a revenue growth of more than 9-10% every year for the past decade or so.

Using this filter, you can narrow down your watchlist and many companies will be eliminated due to their slow growth. For instance -

As you can clearly see, HUL has exhibited a ROCE of a whopping 95% in the last five years. But its sales grew at a little over just 8%! So, that won’t fit our criteria of high revenue growth. These kinds of companies can be stricken-off from the consistent compounders watchlist, and then, you’ll be left with a select few companies.

The two filters that we discussed above can be used in a good screener to come up with a list of companies before proceeding further. The query could be:

 

Like we have done, you can browse the Screener section in Ticker, run that query, & boom.. you have the list:

Although you’ll have a universe of companies to start with, as we said earlier, this ain’t easy. It was never meant to be. Once you have used the quantitative metrics, you’ll have to apply qualitative filters (discussed below) to pick your consistent compounders with more conviction.

Criteria 3: Pricing Power

This, we feel, is the most crucial among all metrics. It’s simply an analysis of the company’s moat & the sustainability of such moat.

For instance, companies like Maruti Suzuki can marginally pass the quant filters discussed above. But what about their moat? Yes, it’s a clear winner in terms of market share with over 50% share in India’s passenger cars market (thanks to Swift). That’s because its vehicles are cheaper than its peers (despite no quality advantage).

But what if Hyundai decides to slash the price of its i20 tomorrow? What if Ford cuts down Figo’s price by 20%? Will you still buy Maruti’s Swift? Will Swift still continue to be the best-selling car? Do you still think Maruti Suzuki’s moat will be sustainable in the long run? Well, we doubt.

So, that’s what the lack of pricing power can do to a giant. Even if your returns & revenue growth are great, if you don’t have sustainable moats, the numbers won’t last long.

So, here’s what you need to ask yourself when analyzing companies -

“If its nearest peer cuts down the price of its product by 20%, will the company be affected?”

If the answer is 'Yes', the company may not be an ideal consistent compounder.

Criteria 4: Business Model

This, in fact, is the primary criteria to evaluate any business, for that matter. Consistent compounders should have a tech-savvy, expansionary, and consumer-centric business model.

Expansionary strategies prevent the saturation of growth. For instance, Page Industries (you would know as Jockey) initially began with mens’ innerwear, but now its other divisions (women, kids & leisurewear) are almost 4x the size of the menswear division!

Asian Paints has a quintessential consumer-centric business model. To ensure affordability, Asian Paints has refrained from hiking its product prices too often. For context, while India’s inflation rate is believed to be 5-7% p.a., Asian Paints hiked its product prices by a mere 2.5% p.a.!

Then, there is technology.

Dr. Lal Pathlabs uses tech to minimize the time gap between sample collection & report generation (as against peers like Thyrocare). Asian Paints uses tech to collect & analyze proprietary data to gauge the demand for every nook and corner of the country (and accordingly ensure adequate SKUs at all places). Bajaj Finance, too, collects proprietary data for credit assessment & faster loan disbursal than its peers.

As they say, if a business isn’t using tech, it’s soon to be out of business. So, there you are.

The Bottom Line

Read these factual statements about Asian Paints (quoted):

“Asian Paints has reported annualised earnings growth of 15% over the past 5 years, 20% over the past 10 years and 21% over the past 15 years. As a result, its annualised share price return has been 22% over the past five years, 34% over the past 10 years, and 30% over the past 15 years. [..] All that an investor had to do was hold on to Asian Paints in his portfolio and he would have compounded his wealth at a very healthy pace without much volatility.”

But this wasn’t smooth. If you microstudy Asian Paints’ journey, you’ll see that there were concerns regarding over-valuation, stepping down of promoters, competition from the world’s largest paint company Sherwin Williams, GST hike on paints, etc. Any rational human would have sold the stock following such events, ask yourself, wouldn’t you?

But despite all those headwinds, Asian Paints has compounded wealth for those shareholders who played the long game. Moral of the story?

“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” - Paul Samuelson

On a serious note -

If you can pick some consistent compounders, and can indeed get your asset allocation & holding period sorted, none'll stop you from amassing great wealth in the long run. Then, why not play the long game, eh?

So, what's gonna be your consistent compounder pick? Tell us in the comments.

(Disclaimer: This should not be construed as investment advice or stock recommendation. Invest only after thorough research.)