Pricing power of businesses – holding power in the portfolio
by Naveen November 24, 2021
Ever since the opening bell of the very first stock exchange in Amsterdam, investors have been enamored by equities to find ways to consistently generate returns and stay invested in good companies. The difficulty has always been around defining good, and staying invested during times of uncertainty in the market.
In our recent article, we wrote on why investing in growth is not easy, we spoke about the valuations of growth companies being higher than ‘average’. In this article, we delve further into this and concluding why investing in cash growth, generates consistent outperformance over the index or any average portfolio. More importantly, the biggest takeaway that we get by looking at the data is to get comfortable paying up higher than average multiples to own these companies. While valuation frameworks are extremely important to decipher how expensive a business is, a blind focus on PE will continue to not paint the full picture an investor needs to understand a business.
Historically, the best growth companies (defined by cash flow growth) have been valued on the expensive side of the spectrum when compared to the ‘market’. A sole focus on PE multiples, towards investing and looking at exiting the ‘market’ when PE reaches a certain level is an inefficient way to be managing portfolios. In order to further explain the same, we broke down the top 250 companies in India by market cap and bucketed them by cash flow growth over the last 5 years. We did this analysis every year, over the last 6 years. The table below shows the PE of the Top 30 companies (defined by cash flow growth) against the PE of the best performing index over the last 6 years (shown based on PE). It’s interesting to realize that the PE multiple of cash flow growth companies has been anywhere between 1.4x to 2x the PE of the Nifty 50 Index.
Table 1: PE of the Top 30 companies in India defined by cashflow growth against Nifty 50
Assuming we bought the top 30 Cash flow growth companies without any further emphasis on understanding the business, we wanted to look at the performance (return) of this portfolio as against the various indices in India (Nifty 50, Nifty Midcap 100 and Nifty Small 100) over the last decade – to see if investing in high cash flow growth resulted in outperformance over the long run. The scenarios we ran to test our hypothesis extended over rebalancing portfolios every year, and in the latter case, was to rebalance portfolios once in 3 years.
Scenario 1 (For the short-term investor): Based on a 1-year cash flow (OCF) change, we construct an equal-weight portfolio of the top-30 OCF growth stocks. The portfolio is rebalanced every year for the next 10 years. We then compare the return of the Top 30 portfolio as against the various indices.
It’s important to note that since we construct the portfolio based on 1Y cash flow growth, the returns in Table 2 are from FY 2012-2021 (10 Year period)
Table 2 : CAGR Growth of the Top 30 Cash Flow Growth Portfolio relative to the various indices (portfolio rebalanced annually)
The Cash Flow growth portfolio consistently outperforms the indices by a margin of 9% on average and beats the best performing index in the last 10 years by a 4.5% IRR (per year)
Scenario 2 (For the medium-term investor): We assume here that an investor in this bucket will stay invested in the markets for a period of 3 years. Hence, we choose to rebalance our Cash flow growth portfolio once every 3 years (Based on a 3-year cash flow (OCF) change, we construct an equal-weight portfolio of the top-30 OCF growth stocks). We compare the CAGR growth of the Top 30 Cash Flow growth portfolio against the indices. It’s important to note that since we construct the portfolio based on 3Y cash flow growth, the returns in Table 3 are from FY 2015-2021 (6 Year period).
Table 3: CAGR Growth of the Top 30 Cash Flow Growth Portfolio relative to the various indices (portfolio rebalanced once in three years)
Over a 3-year timeframe (where the investor has the ability to stay invested over a 3-year horizon), the portfolio grew 24.6% CAGR, vs 9.6% for Nifty 50, generating a 15% excess alpha.
In both scenarios, it is evident that while the stocks might be relatively expensive, growth in cash flows drives shareholder returns over the long run. It’s important to realize as an investor that portfolios constructed on cash-flow growth in businesses will outperform over longer periods of time. This will become significantly higher (in terms of outperformance) due to the fundamentals of the business being in better shape and taking market share from companies in the sector they operate in.
It is important to spend some time on why portfolios constructed on cash-flow growth works and why it remains a rarely practiced art.
Stocks are businesses and behind each business, lies a core aspect of capital allocations. Studying businesses that have the ability to convert their PAT To Cash flow has led us to 2 findings:
It’s this core aspect of capital allocation (which is a rarely spoken about topic) that eventually drives shareholder returns over longer periods in the equity markets.
Growth investing will continue to be a less practiced art, as it goes against the human psychology of buying businesses cheaply. There is a price to pay for buying businesses cheap – which one would only know with the benefit of hindsight, that the business could very well be a wealth destroyer as a minority shareholder (unless the investor has the ability to time exits).
It is far more fruitful to question — whether about this or any other business — not why the price is so high but why the price is low. It’s this fundamental aspect of investing, why we believe growth investing when done right, will continue to be the best way to grow capital in the equity markets over long periods of time.