Significance Of High Return on Equity (ROE) in Indian Context

Legendary Warren Buffet opined in annual report of Berkshire Hathaway in 1979 that 

" the primary test of economic and managerial performance of an enterprise is the achievement of high earning rate on equity capital employed (ROE) (without undue leverage and accounting gimmickry) and not the achievement of consistent gains in earnings per share. In our view many businesses would be better understood by their shareholder owners as well as the general public, if management and financial analysts modified the primary emphasis they place upon earning per share."

This unequivocal affirmation my Mr. Buffet that ROE is one of the most critical parameters to identify the quality of business is supported by many other great investors.

So let me first start with the definition of Return on Equity.

ROE = Net Income/ Shareholder's average equity during the period.

In other words, ROE signifies the returns earned on shareholder's money, a very important metrics to keep tab of a company indeed!

This led me to dig deeper in the context of Indian market to identify companies having high ROE (>25%) and reasonable market capitalization ( > INR 1000 Crores). I consciously decided to ignore smaller companies, but more on that later! The objective of the exercises was to understand whether there exists any common thread that binds all these companies leading to higher ROE.

Based on the edelweiss database, i found that there are 112 such companies that have market capitalization of 1000 crores and higher and ROE in excess of 25%. Surprisingly, there is a discernible pattern in the list. Around 80% these companies have enjoyed some "moat" or "sustainable competitive advantage" leading to higher ROE and hence premium valuations in most of the cases. 

Companies having Strong Brand Recognition:

Almost 33% of companies belonged to this universe. These companies themselves are formidable brands ( like Consumer side:Dabur, Emami, Titan, VIP, Bata, Industrial side: Exide, Crompton, Alfa laval) or have products that have immense brand recognition (i.e Nestle- Maggie, Nescafe; Pidilite: Fevicol, M-seal' Zydus wellness: Sugar free, Nutralite;)

- Most of the companies are market leaders by a big margin in respective

  segments

- These companies have established channels for pushing the product/brand

- They enjoy high net profit margin

- Many of these companies enjoy substantially higher ROE than that of their competitors (e.g. Asian paints has ROE of 42 % while that of the nearest rival is 23%, Exide ROE -31% as compared to 24% of nearest competitor)

Companies Operating in Natural Monopolies/Oligopolies:

This universe consists of mainly government owned/promoted companies that are involved in businesses which are either regulated natural monopolies or government controlled businesses. Companies like Coal India, NMDC, Gujarat State Petronet Limited, Indraprashta Gas Limited, BHEL, Enginners India Limited belong to this list. Some of these companies have very strong barriers to entry such as GSPL and Indraprastha Gas because these businesses are natural monopolies. Others such as NMDC and Coal India operate in areas where private sector enterprises are not allowed to do business.

- Most of the companies in this business are regulated and hence prone to whims/fancies of government and regulators

- Many companies have very inefficient operations however they are able to pass on the cost to the users because of lack of alternative for the user/customer

- Such companies have very strong balance sheets with many having huge cash reserves

Companies Having Niche Business:

This group comprised of companies that have carved out their own niche and hence are less prone to competitive intensity. The group consists of companies like 

Balkrishna Industries- One of the world's largest manufacturer of Off -Highway tyres.

Shriram Transport Finance: Company has pioneered commercial vehicle finance in India and is India's largest commercial vehicle finance company.

Muthoot Finance: India's largest gold loan company.

DB Corp: India's largest print media conglomerate. It is the only print media company focusing on vernacular language newspapers.

Most of niche businesses operate in unorganised manner at small scale, however above companies have bucked the trend and have established themselves as clear market leader in their respective businesses.

Companies having Asset-light business models:

Last group consists of companies that have asset light business models. It is noteworthy that, in most of these companies, value creation happens through intellectual inputs. Companies that belong to this group are Infosys, Wipro, Tech Mahindra, CRISIL and pharmaceutical companies like Astrazeneca, GSK pharma, Cadial Health care, Torrent pharmaceuticals etc.

Some of the characteristics of these companies are

- They derive competitive advantage through intellectual capital i.e. quality of 

  human resources, patents, path breaking business models etc.

- Most of these businesses are asset-light and does not require substantial 

  tangible capital. Hence these businesses, by nature, are high ROCE 

  businesses.

Takeaways from Analysis:

Here are some important takeaways on my analysis of high ROE companies

• If the company has grown to a reasonable size in terms of revenues over a period of time, and has consistently maintained high ROE, without resorting to excessive debt, chances are that company has "moat" and hence represents a strong business
• However the same can not be said for smaller companies, as many small companies start with high ROE but as they grow in scale, competitive intensity increases and scalability of business and business model is tested. Many companies lose their way at this stage and they become "survivors" instead of "market leaders"
• Typically, market puts a substantial discount to companies that enjoy monopoly due to government controls even though such companies have high ROE and strong balance sheet.
• There is no "silver bullet" in investing and the same is true for ROE is as well. ROE is a critical differentiator between a great business and a mediocre business, however it shall be analyzed in sync with other ratios such as debt/equity, sales/profit growth rate and free cash flow generation.
• If you come across a company where differential between ROCE and ROE is high, most likely reasons is "leveraging"
• One shall avoid looking at average ROE for last 5 years, instead one should look for trend in ROE as it may provide insight into the improvement/deterioration in quality of business.