Warren Buffett is not just one of the greatest investors ever. He is also someone who can qualify as a prolific writer. Anyone who has gone through the great man`s writings over the years can testify this. Of course, there is a wealth of investment wisdom in his works. But there is perhaps hardly anyone who has more clarity of expression and simplicity in his writing than the Oracle of Omaha.
A good illustration of the simplicity of thought could be found in his idea of a good investment candidate. A stock is a good investment candidate according to Buffett if every dollar invested in the business generates at least one dollar throughout the business` lifetime. In other words, Buffett says that our job is to select a business with economic characteristics allowing each dollar of retained earnings to be translated eventually into at least a dollar of market value.
Clearly, there cannot be a simpler and more precise definition of a good investment than the one mentioned above. Simply put, it means that a stock is a good stock if the underlying business generates higher return on equity (ROE) than the cost of capital for a sustained period of time. Thus, if the business reinvests most of its earnings, those earnings should also generate return on equity than the higher cost of capital. If that is not the case, the total return on equity will eventually come down and the stock will stop being a good investment.
Say for e.g. a business has a net worth of Rs 100 and an ROE of 20%. Also assume the opportunity cost of capital to be 15%. Thus, if this business keeps on generating ROE of 20% forever and does not invest a single rupee back into the business but rather pays out as dividends to shareholders then the intrinsic value of this business is said to be Rs 133.3 (20 divided by 15% which is the cost of capital). Therefore, as can be seen, every rupee in the business is worth Rs 1.33. Naturally, this is a good investment as per Buffett because one rupee has created a market value of Rs 1.33.
Now, assume that the same business does not choose to pay back all its profits but wants to invest some money back into the business. It should be noted that as long as the profits which are invested back into the business generate an ROE of at least 15%, they should be allowed to be reinvested. But if the ROE on this incremental capital is less than 15% then a sustained reinvestment of such sort can eventually take down the total ROE to less than 15%. Thus, in this case, in the long run, one rupee of money invested as equity back into the business may not eventually translate into at least one rupee of market value.
The above explanation can have profound implications for the way we invest. Investors most often are lured into believing that companies that witness the highest earnings growth are considered to be good investments. But if the profit growth takes the overall return on equity of the business down to less than the cost of capital, then that business has destroyed market value and not created it.
Also, doubling of share price is no proof that the investment is good business. What needs to be found out is the fact that how much money has been added to company`s net worth to bring about the doubling of share price. If net worth has increased by Rs 150 and market value by Rs 100 then it is no use.
Thus, the most important factor while analysing the company is the `one rupee` test as highlighted above and not the growth in earnings per share. Only if the business has generated more than one rupee of market value for every rupee invested over a long period of time, it should be considered as a potential investment candidate.
Now, let us try and perform this so called `one rupee test` on the BSE Mid cap universe. In other words, we will have a look at those Midcaps that have provided the maximum bang for the buck in the last five years. This is to say that for every one rupee increase in the net worth of these stocks, what is the market value that the investors have assigned to them. It is important to add here that we have considered only those stocks where the average Debt to equity ratio (D/E) in the last five years has been less than 0.5 times. This is because increasing debt could be the best way to increase ROE but increase beyond a certain debt to equity ratio makes the stock a speculation rather than an investment and we are only concerned with the latter.
Out of the more than 250 stocks that we have considered from the BSE Midcap index for our study, only about 75 managed to pass the `one rupee test` i.e. not only did these stocks generate more than one rupee of market value for every rupee increase in net worth but they managed to do it by keeping the average D/E ratio less than 0.5 times. The list below presents the top 20 such stocks.
||Increase in net
worth in Rs m (A)
|Increase in market
value in Rs m (B)
|Value created for
every Re. 1 invested (B/A)
|P&G Hygiene and Healthcare
|Gujarat Gas Company
|Kansai Nerolac Paints
|Info Edge (India)
Please be informed that the top few numbers look improbable in the future as they seem to be the result of some one time equity restructuring or other such one off effects. In fact, we believe that the numbers towards the end and in single digits are more likely to be maintained in the near future. Even if they do come down, the value created in these cases is expected to remain more than one for every rupee invested in the long run. Investors should keep an eye on such companies.
First Published: 9/14/2011 12:04:25 PM