How to identify consistent compounders?
Updated: May 11
Before we understand how to identify consistent compounders, we need to know what consistent compounders are. These are those companies that have grown their earnings at a healthy level over a long period without equity dilution.
Stock price performance over the long-term mimics earnings growth. If a company has grown at a healthy growth rate, it is expected that over the long term (> 5 years) the share performance of this company will be similar to its earnings growth rate.
In this article, I will explain how to identify these consistent compounders. There are a few criteria that we need to follow:
For simplicity, market capitalization > Rs 50,000 crores.
Average 5-years Return on capital employed (ROCE) > 15% per year.
Average 5-years Sales growth > 7% per year.
When we apply the first condition, we get a list of hundred companies. Out of those hundred companies, we exclude companies that do not meet our criteria numbers two and three. The list reduces to under 30 companies. Out of those, we remove cyclical companies including commodities and financials.
Please note that these companies are tracked not only by Indian institutional investors but also by foreign institutional investors. Therefore, it is extremely hard to outsmart these investors. However, you can understand the mood of the market. Once you know the mood, you can develop your investment thesis.
We all know it is impossible to predict the future, yet we focus our energies on this useless activity. Thousands of economists publish forecasts every day. If they can exactly predict the future, they would be millionaires by now, but we see them peacefully employed. This indicates that even the most trained lot cannot predict. We spend our valuable time reading what these PhDs have to offer. There is no harm in reading these reports, the problem is when we start acting based on these opinions.
To avoid this trap, I prefer using a tool to understand the mood of the market. To understand the mood, I assume the current price is fair price. Then I estimate what the market is expecting from a ‘growth’ point of view.
People use discounted cash flow model to estimate the fair value of a company. I prefer using the same model but in reverse form. This helps in understanding what the market expects from the company and if the current price is assumed to be fair, what is the growth baked into the current price.
The first step is to understand what the free cash flow of the company is. Simply speaking operating cash flow minus purchases of plant property and equipment is an indication of free cash flow. You can also arrive at free cash flow through a profit and loss account. Operating profit (Net operating profit after tax NOPAT) add non-cash charges less working capital investment less Capex will be free cash flow.
Assuming a certain discount rate, also called the weighted average cost of capital (WACC) and a terminal growth rate of 7%, I calculate implied growth. For a set of robust companies with predictable cash flows a low WACC is justified. A 10-year government bond yield is 7.3% if you add 1.5% to 2% so approximately a 9% discount rate is fair for these ‘great’ companies.
I prefer using a terminal growth rate of 7%, a 3% real growth rate plus inflation of 4%. Additionally, I assess over 10 years. A company that is operational and growing for the last 30-40 years, is expected to survive for the next 10 years.
Initial cash flow along with terminal growth rate and WACC helps in arriving at the value of the company. I model ‘implied growth” i.e., the expected growth over the next 10 years.
At this stage, it is only a plug-and-play analysis. We find out that 15% is the implied growth rate of Nestlé India. We compare this implied growth rate with the last five-year average NOPAT growth rate of 19%. The market expects the company to grow a little less than what it has grown in the past five years. If there is a big disparity between what the market expects and what it has delivered in the past, the analyst must spend time analyzing it further.
So, when we apply the same analysis across our chosen companies, we see a trend.
HAL and BEL are both government-owned defence companies and have delivered well in the last five years. The market still expects negative growth. Is it because these are government owned?
Similarly, we see all the IT companies have a big difference between what they have delivered and implied growth. Is it due to negative global sentiment?
In the last two years due to China +1 strategy, a lot of chemical companies have seen traction. As you can see the chemical companies have extremely high implied growth, indicating that the market is euphoric about the sector. It is time to apply caution for this sector.
When you do this kind of assessment you understand what the market expects. When the market expects extremely high growth or low growth, it is indicative of some opportunity.
This assessment should not be treated as a complete analysis. It is just a better screening tool. Over the last few years, there are a few investment professionals who have promoted consistent compounders at any price, it is not a good idea.
The analyst must spend time understanding the industry dynamics, business potential, management quality, and future growth prospects more deeply.
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Advisor: Ankur Kapur
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