Earnings growth is one of the important determinant of wealth creation. Broadly there can be 4 situations that favor occurrence of high earnings growth.
- Value migration – Value migrates from outdated business model to new ones. For eg: Value migration in IT and Pharma sectors from western world to low-cost countries; value migration from public sector to private sector banks
- Sustained industry tailwind – Sectors catering to the growing, aspiring population in India – like FMCG, consumer durables, quick-service restaurants, autos, housing finance, construction related materials like sanitary ware, tiles, electrical goods etc. Here wealth is created by companies that are dominant/market leader (top 3) in the segment or by niche companies with unique business model that created the market segment.
- Turnaround due to operating leverage – Disproportionate increase in earnings due to one/combination of the following conditions: new large investment getting commissioned, change in business mix, improvement in under-performing business vertical, change in management.
- Turnaround due to financial leverage – Disproportionate increase in earnings due to one/combination of the following conditions: Sale of non-core assets, Sale of loss-making subsidiary, raising fresh equity to reduce interest cost.
Over the years, Motilal Oswal wealth creation studies have shown that there is higher probability of wealth creation in secular growth themes such as value migration and sustained industry tailwind in Indian context. But most of the time, we investors are more enamored with the turnaround themes than the secular growth stories. Warren Buffett famously quipped in 1979 letter that “Both our operating and investment experience cause us to conclude that turnarounds seldom turn”. Following is edited excerpts from the annual report of Crompton Greaves (one of the company i followed closely in recent years), which is undergoing business re-structuring.
Excerpts from FY 2013 annual report:
“The restructuring exercise started in FY 2012 continues and is part of an on-going process of globalization of CG. Full fledged restructuring for creating a greater and more efficient global footprint takes time. There is no reason why your company’s global management team cannot effect the turnaround in FY 2015, and deliver better results for the shareholders”. “Results include Includes Exceptional items of one time Belgium operations restructuring costs of Rs. 229 crores“.
Excerpts from FY 2014 annual report:
“I am happy to state that your company’s restructuring has started delivering better results. Sales grown by 11.5% and PAT have more than trebled to Rs. 258 crores”. “CG has done better than last year. But it is the beginning of the climb back to the top. We will get there – perhaps faster than we think”.
Excerpts from FY 2015 annual report:
“In my last year’s letter to you, I wrote “that your Company has started delivering better results” and expected “better days ahead”. Regrettably, this has not happened in FY2015. On consolidated basis, Net sales grew by 2.8% and PAT was 20.2% lower”.
“Unfortunately, the overseas business has affected your Company. Revenue from overseas operations decreased by 0.6% to US$ 1,023 million in FY2015. Operating EBIDTA posted a loss of US$ 6 million. And because of some significant one-time charges (170 crores) and additional provisions, losses at the PAT level deteriorated from US$ 40 million last year to US$ 83 million in FY2015″.
Even the management tend to underestimate the time taken to restructure and turnaround business operations. Note the one-time exceptional charges which are recurring :). Over the years i realized that for the turnaround theme to work, lot of moving parts have to align perfectly (except in the case of new large investment getting commissioned) making it a low-medium probability event.
Recently, I came across 13 top picks of analysts for the CY 2016 in Outlook Business magazine. 10 out of 13 analysts (77%) picked turnaround themes. Only 3 out of 13 (23%) chose franchise business which can compound steadily. I classified their investment thesis based on the earnings growth category mentioned above. (Note: Average 3 year ROE > 15% is classified as well-run business and Average 3 year ROE < 15% is classified as poor business. In an ideal scenario, i would have preferred ROCE when compared to ROE to eliminate the impact of debt. Data Source: Moneyworks4me.com).
Average 3 year ROE < 15%:
3 Year average ROE: 1.4%; FY 15 ROE: -1.12%; Debt to Equity: 2.74
Investment case: Turnaround due to operating leverage (better realization due to consolidation of competition, volume growth, cost efficiency).
3 Year average ROE: 2.25%; FY 15 ROE: -2.75%; Debt to Equity: 0.44
Investment case: Turnaround due to operating leverage (New large investment getting commissioned at Daman) and financial leverage (non-core asset sale expected).
3 Year average ROE: 4.7%; FY 15 ROE: 4.94%; Debt to Equity: 1.98
Investment case: Turnaround due to Operating (better business performance expected in recently diversified business verticals) & Financial leverage (raised equity and better working capital management is targeted).
3 Year average ROE: Negative (loss making in FY 13 and FY 14); FY 15 ROE: 6.78%; Debt to Equity: 40.67
Investment case: Turnaround due to Operating leverage (higher contribution from enterprise telecom vertical) and financial leverage (debt reduction due to sale of SA subsidiary).
3 Year average ROE: 5.22%; FY 15 ROE: 7.25%; Debt to Equity: 0.02
Investment case: Turnaround due to change in business mix going forward (Higher contribution of component business expected).
3 Year average ROE: 0.58% (loss making in FY 13 and FY 14); FY 15 ROE: 8.6%; Debt to Equity: 0.08
Investment case: Turnaround due to operating leverage (better performance expected from women’s clothing brands like westside and JV with Zara, closure of struggling Landmark and stabilization of JV with TESCO in hypermarkets).
Astec Life Sciences:
3 Year average ROE: 8.54%; FY 15 ROE: 11.88%; Debt to Equity: 0.73
Investment case: Turnaround due to operating leverage (Change in management – takeover by Godrej group).
FY 15 ROE: 12.49% (Believe no point in looking at 3 year average ROE due to US-FDA ban on plants); Debt to Equity: 0.55
Investment case: Turnaround due to operating leverage (Better performance from high-margin US export business vertical due to the expected removal of US-FDA ban)
VA Tech Wabag:
3 Year average ROE: 14.02%; FY 15 ROE: 12.69%; Debt to Equity: 0.06
Investment case: Turnaround due to operating leverage (Higher order off-take expected from domestic water treatment vertical and turnaround of low-margin International business vertical which faced significant headwinds)
3 Year average ROE: 14.23%; FY 15 ROE: 17.37%; Debt to Equity:0.00
Investment case: Turnaround due to operating leverage (Higher demand for ACs expected due to impending 7th pay commission and OROP and turnaround in electro-mechanical vertical performance)
Average 3 year ROE > 15%:
FY 15 ROE: 24.36% (listed recently); Debt to Equity: 1.76
Investment case: Sustained industry tailwind (in inner ware and lounge ware + Valentine brand)
3 Year average ROE: 25.18%; FY 15 ROE: 22.57%; Debt to Equity: 0.00
Investment case: Sustained industry tailwind (in footwear market + Good brands)
3 Year average ROE: 26%; ROE: 18.57%; Debt to Equity: 0.00
Investment case: Sustained industry tailwind (in QSR segment + Dominos & Dunkin Donuts brand tie-ups)
Following are the reasons i believe investors tend to choose turnaround themes over steady compounding machine. Consider following scenarios mentioned in most investment thesis in the magazine:
Scenario 1: This turnaround candidate will double in 3 years
Scenario 2: This franchise business will compound steadily over time
- Framing effect: Scenario 1 is far more exciting than the scenario 2
- Illusory of control: People tend to choose ‘certainty’ in the CAGR returns of turnaround candidates (mostly people say that it will double in a specific time frame) over ‘uncertainty’ in the returns of steady compounders (mostly people will refrain from giving number)
- Most investors including experts fail to see steady compounders as small incremental changes tend to go unnoticed (Charlie Munger called this phenomenon as “boiling frog syndrome“).
I am not advocating that we should abandon turnaround stories and load up on steady-growth themes. Both of them has a place in the investor’s portfolio. Well-judged turnaround story even in a commodity business will work wonders.
My learning: We need to be aware of the base rate of success in the category and tilt our portfolio towards higher probability events. Because hope is not a strategy 🙂
Looking forward to your comments.