Strategy

STRATEGY INSIGHT April 13, 2017

Does market reward true value addition? Top 30 companies on RoCE – WACC
strategy (basis FY16 nos)
Valuation metrics like P/E and PEG can skew the actual picture of Ambit Mcap
Company Name
Stance ($ mn)
shareholder value creation and make it look rosier than it actually is.
Tata Consultancy Services Ltd. BUY 74,460
We highlight how instead of looking at such earnings-based metrics,
looking at the Return on Capital Employed (RoCE) versus Weighted Hindustan Unilever Ltd. BUY 31,129
Average Cost of Capital (WACC) makes more sense. An analysis of top Hero MotoCorp Ltd. SELL 9,989
500 firms (basis market cap) over last 15-year period (FY02-16) shows Britannia Industries Ltd. SELL 6,268
that a portfolio designed to invest in best 30 companies basis ‘net’ Interglobe Aviation Ltd. SELL 5,842
return on capital (RoCE-WACC) would not only do much better than the Oracle Financial Services
portfolio designed basis EPS or revenue growth, it does so at a much NR 5,073
Software Ltd.
lower portfolio churn. Such a portfolio also beats the BSE500 index and Colgate-Palmolive (India) Ltd. SELL 4,279
‘Magic Score’ portfolio convincingly both on average and median return Torrent Pharmaceuticals Ltd. BUY 3,831
basis. Procter & Gamble Hygiene &
NR 3,714
Health Care Ltd.
What’s wrong with the way market currently looks at ‘value’?
Castrol India Ltd. NR 3,257
Valuation metrics like P/E and PEG skew the actual picture of shareholder value
Page Industries Ltd. BUY 2,484
creation by companies and make it look rosier than it actually is. In this note we
highlight this fact by comparing two hypothetical companies with same revenue Ajanta Pharma Ltd. SELL 2,358
and earnings growth rate but different marginal rates of return on capital. While Alembic Pharmaceuticals Ltd. NR 1,821
the company with higher marginal rate of return on capital should make a Symphony Ltd. NR 1,645
better investment candidate, we highlight how metrics like P/E and PEG might
Dr. Lal Pathlabs Ltd. NR 1,242
skew the analysis incorrectly to favour the other, less worthy companies.
Bajaj Corp Ltd. NR 930
Is ‘net’ return on capital persistent?
Jet Airways (India) Ltd. NR 878
Using top 500 companies (basis market cap and ex-BFSI) over FY02-16, we
Spicejet Ltd. NR 864
highlight how the best companies basis ‘net’ return on capital (RoCE-WACC) are
able to sustain their performance on this metric much better (both 1-year and 5- eClerx Services Ltd. SELL 864
year perspective) than the best companies on metrics like EPS growth or Tata Elxsi Ltd. NR 744
revenue growth. To a large extent, such persistence in delivering high RoCE- Triveni Turbine Ltd. NR 718
WACC is a result of the differences in industry structures itself allowing certain VST Industries Ltd. NR 702
sectors like FMCG to enjoy a higher pricing power, lower costs and ability to run
Kushal Tradelink Ltd. NR 613
business with less capital. Such high persistence in generating high ‘net’ return
on capital combined with expected reduction in cost of capital in India makes an Indo Count Industries Ltd. NR 600
excellent case for investing in companies basis ‘net’ return on capital. Avanti Feeds Ltd. NR 573

Investment Implications Caplin Point Laboratories Ltd. NR 459

A portfolio comprising of top 30 companies basis ‘net’ return on capital not only TVS Srichakra Ltd. NR 433
delivers much better performance (both on average and median basis) than Accelya Kale Solutions Ltd. NR 339
similar portfolio basis EPS growth or revenue growth. Not only this, such a Hawkins Cookers Ltd. NR 250
portfolio also has much lower churn than the other two strategies (see chart).
Atul Auto Ltd. NR 161
From a portfolio point of view our analysis reveals that a portfolio of top 30
companies basis RoCE-WACC (rebalanced in June every year) outperforms both Source: Bloomberg, Ambit Capital Research
benchmark BSE500 index as well as ‘magic score’ strategy. The current list
(basis FY16 numbers) is given on the right-hand margin.
‘Net’ return on capital strategy delivers much better returns than EPS or revenue
growth

Research Analyst
Prashant Mittal, CFA
prashant.mittal@ambit.co
Source: Ambit Capital Research, Bloomberg Note: The returns have been computed basis annual median returns from 30
Tel: +91 22 3043 3218
June to 30 June every year under each strategy
Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital
may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.
 Strategy

CONTENTS
Section 1: What’s wrong with the way market currently looks at value ………3

Section 2: Is ‘net’ return on capital persistent …………………………………….6

Section 3: Investment Implications ………………………………………………..10

Appendix ………………………………………………………………………………14

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Section 1: What’s wrong with the way

market currently looks at ‘value’?
“Leaving the question of price aside, the best business to own is one that over an
extended period can employ large amounts of incremental capital at very high rates of
return. The worst business to own is one that must, or will, do the opposite - that is,
consistently employ ever-greater amounts of capital at very low rates of return.
Unfortunately, the first type of business is very hard to find.”
- Warren Buffet, 1992 letter to shareholders
A big proponent of investing in businesses with sustainable “moats”, that can produce
substantial return on capital for investors over a long period of time, Warren Buffet in
his 2007 letter to shareholders, defined three types of businesses.
Exhibit 1: Three categories of businesses basis Return on Capital
Category Business Characteristics
The first example refers to a business like See’s Candy that Mr. Buffet owns. These
businesses can’t, for any extended period, reinvest a large portion of their
earnings internally at high rates of return. However, in light of their pricing power,
High Return on their earnings keep growing without needing incremental capital, thus steadily
Capital businesses delivering a high return on (rather low) capital. Typically, for such companies two
with Low Capital factors help to minimize the funds required for operations. First, the product is
Requirements sold for cash which eliminates accounts receivable. Second, the production and
distribution cycle is short, which minimizes inventories. Such a business eventually
becomes likely a cash machine allowing investors to use that steady stream of
cash to buy other attractive businesses.
Warren says the businesses described above are extremely difficult to find and
Businesses that typically companies require additional capital to keep growing their earnings.
Require Capital to That’s because growing businesses have both working capital needs that increase
Grow and generate in proportion to sales growth and significant requirements for fixed asset
decent Returns on investments. Such businesses also form a decent investment option as long as they
that Capital enjoy durable competitive advantages that can lead to attractive return on
incremental capital.
Finally, he talks about the worst sort of businesses that grow rapidly, require
significant capital to engender the growth, and then earn little or no money. He
Businesses that
cites airlines as an example (his current investments in the sector notwithstanding)
Require Capital but
of such a business wherein a durable competitive advantage has proven elusive
generate Low
ever since the days of the Wright Brothers. Such businesses’ demand for capital is
Returns on Capital
insatiable and investors chasing growth of such companies end up throwing
money in a bottomless pit.
Source: Berkshire Hathaway

The risk of investors putting money in such ‘worst’ businesses (third category above)
in India is high given that the investment community has over the years looked at
ratios like P/E, P/B and PEG to assess the businesses that are likely to form great
investment candidates. In our note dated October 24, 2016, ‘Why does value
investing not work in India?’ we argued against this philosophy and presented three
key reasons for that:
 Declining return ratios: We showcased how both RoCE and RoE have been
declining for ‘value’ companies in India (i.e., the companies in the lowest P/B
quartile of BSE200 index) as compared to their US counterparts (lowest P/B
quartile of S&P500) which display a mean reverting profile for these return ratios.
Thus, while investors in the cheapest companies in the USA would have reaped
the benefits of a bounce-back in returns after periods of economic stress, such
investors in India would have been gravely disappointed by a similar investment
strategy in India.
 Excessive leverage: The issues faced by Indian value stocks are further visible
from the extent of leverage employed by these stocks. We highlighted how the
leverage for such stocks (i.e. stocks with lowest P/B multiple in BSE200 index) has
been rising consistently while their interest coverage ratio has been declining.
This raises concerns regarding the cash flows available for equity holders after
servicing debt. Hence, though such stocks might look cheap in terms of earnings
and dividend yields (mostly an outcome of over-optimistic earnings growth
expectations), the very ability of such companies to generate enough cash flow to
reward equity holders is questionable.

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 Poor accounting quality: Lastly, the companies that look the cheapest on P/B
multiples in India (i.e. the lowest quartile on P/B) are also the ones with the
lowest forensic accounting scores (please click here to access our December 2016
forensic accounting thematic which lays out our accounting framework). Our
accounting framework penalizes companies for shenanigans such as aggressive
revenue recognition, aggressive provisioning practices, and poor quality of
auditors. With poor accounting quality a recurrent theme in Indian corporate life,
any earnings growth might simply be a function of accounting shenanigans rather
than an underlying change in earnings prospects.
In the very same note we talked about how investing in businesses with consistent
past performance with respect to both Return on Capital Employed (RoCE) and
revenue growth as captured by our ‘Coffee Can’ series make for a much better
investment.
In this note, we present a simple example below of how ratios like P/E and PEG can
skew the actual picture of shareholder value creation and make it look rosier than it
actually is.
Take two hypothetical companies X & Y which earn `1mn of revenue in year 1 and
have the same projected revenue growth and profit margin at 5% and 10%
respectively till year 5. However, as shown in the table below, Company X needs to
reinvest 50% of its earnings each year in order to maintain its 5% growth in revenues
and earnings, while Company Y needs to reinvest 25% of its earnings. Thus, in year
1, Company X generates `50,000 in free cash flow while Company Y generates
`75,000 in free cash flow. Further, in both cases, those free cash flow figures then
grow at 5% per year, just like the earnings and revenue figures do. To value each
company then, would you look at the free cash flows or earnings?
Exhibit 2: Comparison of two firms with similar earnings but different cash flows
Company X (in `) Year 1 Year 2 Year 3 Year 4 Year 5
Revenue 1,000,000 1,050,000 1,102,500 1,157,625 1,215,506
Earnings 100,000 105,000 110,250 115,763 121,551
Investment -50,000 -52,500 -55,125 -57,881 -60,775
Free cash flow 50,000 52,500 55,125 57,881 60,775
Company Y (in `)
Revenue 1,000,000 1,050,000 1,102,500 1,157,625 1,215,506
Earnings 100,000 105,000 110,250 115,763 121,551
Investment -25,000 -26,250 -27,563 -28,941 -30,388
Free cash flow 75,000 78,750 82,688 86,822 91,163
Source: adapted by Ambit Capital from “Value: the four cornerstones of corporate finance”

The interesting thing about earnings figures is that not only can it be manipulated
according to the whims of the management (long live accrual accounting!), it only
provides information about how much profit a business can generate every year,
NOT about the re-investments of those earnings necessary to keep the business
running. The cash flow figures on the other hand describe clearly how much (of the
profit) is actually left for the shareholders. Using these free cash flow figures and
plugging them in a simple DCF model with an assumption of 5% growth rate (forever)
discounted at cost of capital of 15%, results in Company X valued at `500k vs.
Company Y which is valued at `750k. An obvious answer given that Company Y
requires less reinvestment (for same earnings) and consequently generates more free
cash flow.
Now let’s look at what the conventional methods of ascertaining value would project
in this case. Assuming both companies were trading at fair price, company X would
have a P/E of 5 vs company Y which has the P/E of 7.5. The PEG ratio for company X
would be 1 while for company Y it would be 1.5. Most investors would look at these
two companies and conclude that Company X is a better value than Company Y,
because you are paying a lower P/E and a lower PEG ratio for the same earnings and
the same growth in earnings. While this assessment is not harmful as both companies
at this price are fairly valued, issues arise when we change the prices. For instance, if
Company X was trading at `600k while Company Y was trading at `650k, Company

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X would have a P/E of 6 vs 6.5 for Company Y. PEG for these two companies would
be 1.2 and 1.3 respectively. In this scenario, concluding basis the P/E and PEG ratios
that Company X was a better value than Company Y would be wrong. It’s actually,
just the contrary.
Company Y was able to justify higher valuations for same levels of growth and
earnings because of its higher ‘marginal return on capital’. As the example above
clearly highlights, Company Y was able to generate incremental earnings of `5,000
in year 2 by investing `25,000 into the business as compared to Company X which
had to invest `50,000 to achieve same growth. This, in effect means that marginal
return on capital for Company Y was 20% vs 10% for Company X. Once this finding
comes through, one realizes the flaw in traditional metrics of plainly using earnings
as a determinant of ‘value’.

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Section 2: Is ‘net’ return on capital for

companies persistent?
“Based on our year-to-date performance, we are raising our full-year core constant
currency EPS growth objective”
- Pepsico Management in 2Q, 2016 results release
The obsession with revenue and EPS growth is not just limited to corporate executives.
The investor community at large also tracks these numbers extremely closely.
However, as we have highlighted in the previous section, such a growth in these
measures only provides the partial information about the company’s true value
generation for shareholders. That said, given what we discussed in the previous
section, the obvious question that arises is – how do we use this information? If one
was to not use the traditional metric of P/E or PEG, how does one utilise the
‘marginal’ return on capital metric given that it is not publicly available? Given this
limitation, we go to the next best alternative, i.e. using the overall return on capital
vs. cost of capital data. While doing so, we highlight how such a metric is a much
more stable measure of performance for any corporate rather than growth (whether
revenue or EPS).
For this exercise we look at the last 15 years (since FY2002) and using the top 500
firms (ex-BFSI) basis market cap every year, determine the persistence of: a) ‘Net’
return on capital (RoCE – WACC); b) Revenue growth; and c) EPS growth. To do so,
we divide the firms into quartiles basis RoCE-WACC (for [a] above), basis revenue
growth (for [b] above) and EPS growth (for [c] above) at June-end every year when
annual results are available and calculate the churn from one year to the next in the
constituents of each quartile. The persistence under each quartile over one year has
been calculated as the percentage of firms that were in Q(x) in year T-1 that end up
in Q(x) in year T as well. So a high persistence would imply that a significant
proportion of firms in Q1 in year T-1 continue to remain in Q1 in year T as well.
Both RoCE and WACC have been calculated on post-tax basis and the WACC for
each stock has been calculated by using its:
 Cost of debt: We use the interest expended in any year over the total debt. For
simplicity, the corporate tax rate has been kept constant at 34.5% (calculated as
an average of tax rates over the last 15 years (source: https://goo.gl/7o2kD7)
 Cost of equity: Arrived at using beta for a stock applied on the equity risk
premium of 8% (while we realise that the risk premium varies during times of
crisis versus times of euphoria, we have taken a constant number for simplicity. At
present various sources place this value to be close to 8% for Indian equities – see
for example https://goo.gl/9ND5bJ)
As can be seen in the charts below,
a) For the firms in the top quartile, the median ‘net’ return on capital, i.e. return on
capital – cost of capital is much more stable as compared to median revenue growth
or median EPS growth.

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Exhibit 3: The ‘net’ return on capital has remained stable for the top quartile companies across the FY02-16 period…

Source: Capitaline, Ambit Capital Research. Note: The numbers above are computed using median RoCE-WACC numbers for each quartile for each FY over FY02-
16

Exhibit 4: …while the revenue growth has tapered down for the top quartile companies over the same period

Source: Capitaline, Ambit Capital Research Note: The numbers above are computed using median revenue growth numbers for each quartile for each FY over
FY02-16

Exhibit 5: EPS growth too has been volatile and trending down for companies in top quartile over the FY02-16 period

Source: Capitaline, Ambit Capital Research Note: The numbers above are computed using median EPS growth numbers for each quartile for each FY over FY02-16

b) The persistence of firms featuring in top quartile is much higher in case of RoCE-
WACC as compared to revenue growth or EPS growth (both from a one-year and
five-year perspective).

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Note: As we highlighted above, the persistence over one year has been calculated as
the percentage of firms that were in Q(x) in year T-1 that end up in Q(x) in year T as
well. The numbers shown below are average numbers over the FY02-16 period. So
for instance in exhibit 6 below, 71% under Q1-Q1 implies 71% of the firms (on
average) in Q1 in year T-1 continue to remain in Q1 in the year T as well. Similarly,
in exhibit 7 below, 44% under Q1-Q1 implies 44% of the firms (on average) in Q1 in
year T-5 continue to remain in Q1 in the year T as well. A ‘no persistence’ scenario
would imply an equal probability, i.e. 25% of firms ending up in each quartile.

Exhibit 6: The net return on capital has high persistence on Exhibit 7: …and five-year perspective
one-year…
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
Q1 71% 21% 6% 2% Q1 44% 23% 18% 15%
Q2 18% 50% 26% 7% Q2 20% 32% 31% 17%
Q3 4% 23% 51% 22% Q3 16% 30% 33% 21%
Q4 2% 7% 20% 72% Q4 11% 18% 25% 46%
Source: Capitaline, Ambit Capital Research Note: The numbers above are Source: Capitaline, Ambit Capital Research Note: The numbers above are
computed using firms that are present from one year to next in the universe computed using firms that are present in year T and T+5 in the universe
considered for analysis. The no. of firms absent is almost same for each considered for analysis. The no. of firms absent is almost same for each
quartile at around 10-20% of observations. quartile at around 30-35% of observations

Exhibit 8: Revenue growth has much lower persistence on Exhibit 9: …and five-year perspective
one-year…
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
Q1 39% 26% 18% 17% Q1 22% 24% 25% 29%
Q2 20% 34% 28% 18% Q2 18% 30% 25% 27%
Q3 13% 24% 34% 29% Q3 16% 28% 31% 25%
Q4 17% 18% 25% 40% Q4 16% 24% 29% 32%
Source: Capitaline, Ambit Capital Research Note: The numbers above are Source: Capitaline, Ambit Capital Research Note: The numbers above are
computed using firms that are present from one year to next in the universe computed using firms that are present in year T and T+5 in the universe
considered for analysis. The no. of firms absent is almost same for each considered for analysis. The no. of firms absent is almost same for each
quartile at around 10-20% of observations quartile at around 30-35% of observations

Exhibit 10: EPS growth has much lower persistence on one- Exhibit 11: …and five-year perspective
year…
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
Q1 24% 25% 22% 29% Q1 23% 24% 25% 28%
Q2 17% 31% 34% 19% Q2 21% 26% 28% 25%
Q3 16% 28% 31% 25% Q3 21% 26% 28% 24%
Q4 36% 18% 16% 31% Q4 26% 24% 20% 30%
Source: Capitaline, Ambit Capital Research Note: The numbers above are Source: Capitaline, Ambit Capital Research Note: The numbers above are
computed using firms that are present from one year to next in the universe computed using firms that are present in year T and T+5 in the universe
considered for analysis. The no. of firms absent is almost same for each considered for analysis. The no. of firms absent is almost same for each
quartile at around 10-20% of observations quartile at around 30-35% of observations

These takeaways are important because they highlight the fact that while basis
economic theory it makes sense that reversion to mean would reduce the excess
returns for any company as the competition increases, this process takes time. Such
companies are unlikely to lose their competitive advantages to their competitors in
the short term due to an amalgamation of multiple factors. The ‘Return on Capital
Employed’ (RoCE) is a function of both operation profit (EBIT/Sales) and capital
efficiency (Sales/Capital employed). Thus, companies that earn higher RoCE are
potentially either able to charge a higher price, incur lower costs, or run their
business with less capital. While there might be variations across companies within an
industry, a large part of different RoCE is driven by the industry structure.

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Why this might be the case can be identified through how these sectors (and then the
companies within them) stack up with respect to the Porter’s five forces. The forces
that Porter identified are: 1) threat of new entrants; 2) threat of substitutes; 3) the
bargaining power of suppliers; 4) the bargaining power of buyers; and 5) rivalry
among existing firms. The first two factors determine whether the company can enjoy
higher pricing power or not while the bargaining power (of suppliers and buyers)
influences the degree of cost control that can be affected by the company. Finally
with respect to the fifth force, a higher industry concentration is likely to reduce
pricing power and raise costs (advertising related for instance) as companies compete
for customers.
In addition to these factors, some companies have higher RoCE as they require less
capital, which is the denominator in the RoCE calculation. Cyclical companies by their
very nature lose out because of this factor as generating a dollar of revenue by
making steel for instance, requires a bigger capital investment than generating a
dollar of revenue by writing software. As a result, given the difference in the industry
structure itself, there are good reasons why some companies enjoy higher RoCE than
others and continue doing so in a sustainable manner at least for a decent period of
time till structural changes like technological disruptions, change in consumer tastes
or companies’ own complacency lead to a downturn in fortunes.
Thus, given the sustainability of excess returns by such businesses, any portfolio
designed around investing in top companies, basis highest ‘net’ return on capital is
unlikely to face too much churn in the short term.
Further, and more importantly the reason we think from a long-term point of view
looking at the ‘net’ return on capital number makes sense rather than absolute
measure of return on capital is because as highlighted in our macro team’s October
04, 2016 note titled ‘M+R+T resets A revolution in access’, we expect the cost of
capital for businesses in India to come down over the course of next 4-5 years.
Specifically, we’d highlighted in that note how we expect the cost of debt in India
(proxied by the SBI advance rate) to fall by another 250bps (between now and FY20)
on the back of three factors:
 The shift of black savings into the white economy as the Government’s drive
against black money continues. A larger pool of financial savings (supply of
funds) vis-à-vis the investments (demand for funds) will reduce the cost of
funding.
 The crackdown on ‘crony capitalism’ is likely to help lower inflation in India
structurally, allowing the RBI to maintain a lower interest rate structure in India.
 The development of the corporate bond market is likely to lower the cost of
funding for corporates.
What such a scenario means for investors is that as the cost of capital for the firms in
India comes down, the return expectations of investors too should come down. As a
result, rather than using an absolute level of return on capital to be used as a
threshold for determining worthy investments, it would be more realistic to use the
‘net’ return as a parameter for making investment decisions.

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Section 3: Investment implications

In the previous section we highlighted why investors are better off looking at a ‘net’
return on capital measure as cost of capital in India comes down rather than an
absolute return on capital measure. Further, we also showcased how companies that
feature in top quartile basis their net return on capital tend to show: 1) high degree
of stability in the magnitude of ‘net’ return on capital; and 2) high persistence to
feature in top quartile both form a one-year and five-year perspective. While these
takeaways sound great in theory, they would not amount to much if on ground
performance of investments made using these results do not generate requisite
results.
To check how such investments perform, we compared performance of investments
made over the last 15-year period (Jun’02-Mar’17) in top quartile companies (equally
weighted and rebalanced every year at June end) basis all three parameters shown
above - net return on capital, revenue growth and EPS growth. The findings are
shown in the exhibits below. Churn is defined as percentage of new stocks in portfolio
each year (an average over FY02-16 is used in cases below). Note: To see how
quartiles (Q1-Q4) perform for each parameter, please refer to the Appendix on page
14.
Exhibit 12: Top quartile BSE500 companies basis RoCE-WACC generate attractive returns at much lower churn both on a
median returns basis…

CAGR Churn
17.1% 35.6%;
7.8% 65.8%
14.6% 79.2%

Source: Bloomberg, Ambit Capital Research Note: The results above are shown by using the annual median returns of the top quartile companies under each
strategy. The companies which had no price data available either at start or end of period (due to delisting/acquisition/merger etc.) are excluded.

Exhibit 13: …and on an average returns basis vs. the strategies based on revenue and EPS growth

Source: Bloomberg, Ambit Capital Research Note: The results above are shown by using the annual average returns of the top quartile companies under each
strategy. The companies which had no price data available either at start or end of period (due to delisting/ acquisition/merger etc.) are excluded.

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As can be seen clearly, an investment in the top quartile formed basis the net return
on capital (RoCE-WACC) generates spectacular returns both on a median and
average basis at a much lower churn than the other two strategies. Given the
transaction costs involved in portfolio turnover, this is a critical point to note for
portfolio strategies that work on rebalancing the portfolios each year. Note that this is
not really a surprise given what we saw in the previous section with regards to the
persistence of companies under each strategy – a higher persistence would mean
lower churn!
Further, given that each quartile has anywhere between 100-125 stocks making it
too big a portfolio to be practically implemented, we also analysed how each of these
strategies would perform if we chose a more manageable portfolio size i.e. the top
30 stocks under each category. As can be seen below, the results are much starker in
this case!
Exhibit 14: The returns of top 30 companies basis RoCE-WACC are much better and at much lower churn both on median
basis…

Source: Bloomberg, Ambit Capital Research Note: The results above are shown by using the annual median returns of the top 30 companies under each strategy.
The companies which had no price data available either at start or end of period (due to delisting/acquisition/merger etc.) are excluded.

Exhibit 15: …and on average returns basis vs. the strategies based on revenue and EPS growth

Source: Bloomberg, Ambit Capital Research Note: The results above are shown by using the annual average returns of the top 30 companies under each strategy.
The companies which had no price data available either at start or end of period (due to delisting/acquisition/merger etc.) are excluded.

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These findings corroborate nicely with what we highlighted in the first section of this
note, i.e. the businesses which chase ‘growth’ (whether revenue or earnings)
irrespective of the amount of capital that is required to achieve that, rarely turn out to
be a great investment choice. While such stocks might look like star performers over
a short-time frame (over the liquidity infused 2003-07 period for instance), any and
every businesses amongst these which has just been ‘buying’ growth at the cost of
free cash flow to shareholders is in effect destroying shareholder value over the long
term – something that market realises and punishes over a long term.
Not only is a ‘net’ return on capital strategy better than blindly chasing stocks with
high revenue and EPS growth, such a strategy has also given returns better than both
the broader market as well as another strategy that looks at selecting stocks based on
absolute measure of return on capital and earnings yield – the Magic score.
Exhibit 16: The RoCE-WACC strategy also does better than BSE500 and the ‘Magic score’ both on median…

Source: Bloomberg, Ambit Capital Research Note: The results above are shown by using the annual median returns of the top 30 companies under both ‘RoCE-
WACC’ and ‘Magic Score’ strategies. The companies which had no price data available either at start or end of period (due to delisting/acquisition/merger etc.)
are excluded.

Exhibit 17: …and on an average returns basis

Source: Bloomberg, Ambit Capital Research Note: The results above are shown by using the annual average returns of the top 30 companies under both ‘RoCE-
WACC’ and ‘Magic Score’ strategies. The companies which had no price data available either at start or end of period (due to delisting/ acquisition/merger etc.)
are excluded.

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The reason the ‘Magic score’ portfolio fails to perform and this strategy in our belief is
that it assigns equal weightage to both the quality aspect (i.e. RoCE) and the
cheapness aspect i.e. Earnings yield. However, as we’d highlighted in our note dated
October 24, 2016 ‘Why does value investing not work in India?’ and summarised in
the first section of this note, such ‘cheap’ stocks are hardly able to perform in India.
Thus, selection of those stocks which are extremely cheap with moderate RoCE (thus
providing a net high rank basis Magic score) is likely to hamper the performance of
the portfolio formed on magic score.
Not surprisingly, our Coffee Can approach that focuses on choosing companies with
consistent revenue growth (>10%) and RoCE (>15%) over past decade has been able
to beat the benchmark BSE200 index in all of the past 17 iterations (Breakdown of
returns for each of the portfolios initiated over 2000-2016 is given on page 18 of the
Appendix). One of the reasons it has been able to do so is the fact that it has
effectively focused on the ‘net’ return on capital criteria by choosing companies with
RoCE>15%.
To recap, what we’ve highlighted in this note is the fact that investors are better off
investing in companies that are able to generate growth in earnings while ensuring
that they are not destroying shareholder value. They do this by ensuring that for every
new investment that gets them growth the marginal return earned on capital is
higher than the marginal cost of capital. We then highlighted how from a portfolio
standpoint investing in top companies basis net return on capital (RoCE - WACC) is
more beneficial than simply investing on basis of revenue growth or even EPS growth
on account of both 1) lower churn in such portfolio and 2) market punishing firms
that simply ‘buy’ growth and destroy shareholder value over long term.
What we’ve discovered in this analysis might seem a little puzzling as it implies that
investors are probably not assigning adequate value to firm with high ROCE-WACC.
We think part of the blame resides with the fact that many investors continue to
employ metrics that do not take into account the importance of ROCE in creating
shareholder value. The fact that such an investor community uses measures like P/E
and PEG ratios to make investment decisions only opens up opportunities for a
different class of investors who can analyze and identify companies that enjoy high
levels of RoCE-WACC but might have (incorrectly) lost favor due to their supposed
‘expensive’ valuation.
As we close this note, we provide the current top 30 list basis the ‘net’ return on
capital strategy basis the FY16 numbers. We will update this list when the FY17
results are out by June 2017.
As for the question asked in the title of the note – YES it does, as long as the investors
realise what TRUE value is and have the patience to stay put for long term!

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Exhibit 18: Top 30 companies on RoCE-WACC basis FY16 numbers

Price perf (30
Mcap Mcap
Company Name Ambit Stance RoCE* WACC* Jun’16- 07
(` mn) ($ mn)
Apr’17)
Castrol India Ltd. NR 209,348 3,257 105% 14% 12%
Hindustan Unilever Ltd. BUY 2,000,941 31,129 85% 13% 3%
Accelya Kale Solutions Ltd. NR 21,823 339 69% 12% 28%
Colgate-Palmolive (India) Ltd. SELL 275,045 4,279 59% 13% 10%
Hawkins Cookers Ltd. NR 16,042 250 50% 13% 18%
Spicejet Ltd. NR 55,569 864 51% 15% 43%
Alembic Pharmaceuticals Ltd. NR 117,050 1,821 43% 13% 8%
Britannia Industries Ltd. SELL 402,897 6,268 44% 14% 22%
Page Industries Ltd. BUY 159,653 2,484 42% 12% 2%
Kushal Tradelink Ltd. NR 39,410 613 37% 9% 117%
Avanti Feeds Ltd. NR 36,850 573 39% 14% 54%
Tata Elxsi Ltd. NR 47,821 744 44% 19% -10%
Caplin Point Laboratories Ltd. NR 29,517 459 44% 19% 96%
Bajaj Corp Ltd. NR 59,774 930 34% 13% 4%
VST Industries Ltd. NR 45,132 702 35% 14% 72%
eClerx Services Ltd. SELL 55,537 864 32% 11% -3%
Interglobe Aviation Ltd. SELL 375,493 5,842 37% 16% 2%
Triveni Turbine Ltd. NR 46,163 718 36% 17% 17%
Hero MotoCorp Ltd. SELL 642,085 9,989 34% 16% 1%
Tata Consultancy Services Ltd. BUY 4,786,268 74,460 31% 14% -5%
Ajanta Pharma Ltd. SELL 151,597 2,358 33% 15% 15%
Symphony Ltd. NR 105,740 1,645 34% 17% 22%
Torrent Pharmaceuticals Ltd. BUY 246,244 3,831 30% 13% 6%
Atul Auto Ltd. NR 10,356 161 34% 17% -4%
Indo Count Industries Ltd. NR 38,592 600 32% 16% 1%
Jet Airways (India) Ltd. NR 56,441 878 27% 11% -11%
Oracle Financial Services Software Ltd. NR 326,121 5,073 30% 14% 11%
Dr. Lal Pathlabs Ltd. NR 79,810 1,242 28% 13% 13%
TVS Srichakra Ltd. NR 27,843 433 33% 18% 52%
Procter & Gamble Hygiene & Health Care Ltd. NR 238,739 3,714 27% 12% 17%
Source: Bloomberg, Ambit Capital Research *Both the numbers are computed on a post- tax basis with tax rate as the average of last 15 years at 34.5%.

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Appendix
The performance of quartiles (Q1-Q4) for each of the strategies i.e. basis ‘net’ return
on capital, revenue growth and EPS growth basis average returns. The returns have
been computed over the last 15-year period (Jun’02-Mar’17) assuming equal
weighted portfolio rebalanced every year at June end.
Exhibit 19: The returns of each quartile basis RoCE-WACC strategy (basis average returns)

CAGR
25.2%
22.3%
20.4%
12.9%

Source: Bloomberg, Ambit Capital Research Note: The results above are shown by using the annual average returns of each quartile. The companies which had no
price data available either at start or end of period (due to delisting/acquisition/merger etc.) are excluded.

Exhibit 20: The returns of each quartile basis revenue growth strategy (basis average returns)

Source: Bloomberg, Ambit Capital Research Note: The results above are shown by using the annual average returns of each quartile. The companies which had no
price data available either at start or end of period (due to delisting/acquisition/merger etc.) are excluded.

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Exhibit 21: The returns of each quartile basis EPS growth strategy (basis average returns)

Source: Bloomberg, Ambit Capital Research Note: The results above are shown by using the annual average returns of each quartile. The companies which had no
price data available either at start or end of period (due to delisting/acquisition/merger etc.) are excluded.

The performance of quartiles (Q1-Q4) for each of the strategies, i.e. basis ‘net’ return
on capital, revenue growth and EPS growth basis median returns. The returns have
been computed over the last 15-year period (Jun’02-Mar’17) assuming equal
weighted portfolio rebalanced every year at June end.

Exhibit 22: The returns of each quartile basis RoCE-WACC strategy (basis median returns)

Source: Bloomberg, Ambit Capital Research Note: The results above are shown by using the annual median returns of each quartile. The companies which had no
price data available either at start or end of period (due to delisting/acquisition/merger etc.) are excluded.

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Exhibit 23: The returns of each quartile basis revenue growth strategy (basis median returns)

Source: Bloomberg, Ambit Capital Research Note: The results above are shown by using the annual median returns of each quartile. The companies which had no
price data available either at start or end of period (due to delisting/acquisition/merger etc.) are excluded.

Exhibit 24: The returns of each quartile basis EPS growth strategy (basis median returns)

Source: Bloomberg, Ambit Capital Research Note: The results above are shown by using the annual median returns of each quartile. The companies which had no
price data available either at start or end of period (due to delisting/acquisition/merger etc.) are excluded.

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Exhibit 25: CCP has outperformed benchmark indices over all its 17 iterations
Absolute Alpha
Start year CCP Sensex BSE200 v/s Sensex v/s BSE200
2000 22.6% 16.0% 17.5% 6.6% 5.1%
2001 32.2% 20.5% 22.4% 11.7% 9.8%
2002 25.4% 20.3% 20.5% 5.1% 4.9%
2003 27.4% 20.2% 19.8% 7.2% 7.7%
2004 32.6% 19.9% 19.3% 12.7% 13.4%
2005 22.1% 16.1% 15.9% 6.0% 6.2%
2006 20.4% 11.4% 12.3% 9.0% 8.1%
2007 19.1% 9.0% 10.0% 10.1% 9.1%
2008 21.4% 11.1% 12.3% 10.4% 9.2%
2009 22.3% 11.3% 12.7% 11.0% 9.6%
2010 19.0% 9.5% 10.5% 9.5% 8.6%
2011 12.6% 9.8% 11.6% 2.8% 1.0%
2012 22.9% 13.5% 15.7% 9.5% 7.2%
2013 33.1% 13.5% 17.2% 19.5% 15.9%
2014 20.9% 3.7% 7.8% 17.2% 13.0%
2015 18.7% 9.1% 13.3% 9.6% 5.4%
2016 16.0% 12.9% 15.0% 3.2% 1.0%
Source: Bloomberg, Capitaline, Ambit Capital research. Note: Portfolio at start denotes an equal allocation of
`100 for the stocks qualifying to be in the CCP for that year. *The Portfolio kicks off on 30th June of every year.
CAGR returns for all the portfolios since 2007 have been calculated until 31st Mar’16 (except for the live
portfolios for the years 2014, 2015 and 2016 for which CAGR returns and absolute returns (for 2016 start)
have been calculated since these portfolios were launched in November of each year).

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Institutional Equities Team

Saurabh Mukherjea, CFA CEO, Ambit Capital Private Limited (022) 30433174 saurabh.mukherjea@ambit.co
Pramod Gubbi, CFA Head of Equities (022) 30433124 pramod.gubbi@ambit.co
Research Analysts
Name Industry Sectors Desk-Phone E-mail
Nitin Bhasin - Head of Research E&C / Infra / Cement / Home Building (022) 30433241 nitin.bhasin@ambit.co
Aadesh Mehta, CFA Banking / Financial Services (022) 30433239 aadesh.mehta@ambit.co
Abhishek Ranganathan, CFA Retail / Consumer Discretionary (022) 30433085 abhishek.r@ambit.co
Anuj Bansal Consumer (022) 30433122 anuj.bansal@ambit.co
Aditi Singh Economy / Strategy (022) 30433284 aditi.singh@ambit.co
Ashvin Shetty, CFA Automobiles / Auto Ancillaries (022) 30433285 ashvin.shetty@ambit.co
Bhargav Buddhadev Power Utilities / Capital Goods (022) 30433252 bhargav.buddhadev@ambit.co
Deepesh Agarwal, CFA Power Utilities / Capital Goods (022) 30433275 deepesh.agarwal@ambit.co
Dhiraj Mistry, CFA Consumer (022) 30433264 dhiraj.mistry@ambit.co
Gaurav Khandelwal, CFA Automobiles / Auto Ancillaries (022) 30433132 gaurav.khandelwal@ambit.co
Girisha Saraf Home Building (022) 30433211 girisha.saraf@ambit.co
Karan Khanna, CFA Strategy (022) 30433251 karan.khanna@ambit.co
Mayank Porwal Retail / Consumer Discretionary (022) 30433214 mayank.porwal@ambit.co
Pankaj Agarwal, CFA Banking / Financial Services (022) 30433206 pankaj.agarwal@ambit.co
Paresh Dave, CFA Healthcare (022) 30433212 paresh.dave@ambit.co
Parita Ashar, CFA Cement / Metals / Aviation (022) 30433223 parita.ashar@ambit.co
Prashant Mittal, CFA Strategy / Derivatives (022) 30433218 prashant.mittal@ambit.co
Rahil Shah Banking / Financial Services (022) 30433217 rahil.shah@ambit.co
Ravi Singh Banking / Financial Services (022) 30433181 ravi.singh@ambit.co
Ritesh Gupta, CFA Oil & Gas / Chemicals / Agri Inputs (022) 30433242 ritesh.gupta@ambit.co
Ritesh Vaidya, CFA Consumer (022) 30433246 ritesh.vaidya@ambit.co
Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 ritika.mankar@ambit.co
Sagar Rastogi Technology (022) 30433291 sagar.rastogi@ambit.co
Sudheer Guntupalli Technology (022) 30433203 sudheer.guntupalli@ambit.co
Sumit Shekhar Economy / Strategy (022) 30433229 sumit.shekhar@ambit.co
Utsav Mehta, CFA E&C / Infrastructure (022) 30433209 utsav.mehta@ambit.co
Vivekanand Subbaraman, CFA Media / Telecom (022) 30433261 vivekanand.s@ambit.co
Sales
Name Regions Desk-Phone E-mail
Sarojini Ramachandran - Head of Sales UK +44 (0) 20 7886 2740 sarojini.r@ambit.co
Dharmen Shah India / Asia (022) 30433289 dharmen.shah@ambit.co
Dipti Mehta India (022) 30433053 dipti.mehta@ambit.co
Krishnan V India / Asia (022) 30433295 krishnanv@ambit.co
Nityam Shah, CFA Europe (022) 30433259 nityam.shah@ambit.co
Punitraj Mehra, CFA India / Asia (022) 30433198 punitraj.mehra@ambit.co
Shaleen Silori India (022) 30433256 shaleen.silori@ambit.co
Singapore
Praveena Pattabiraman Singapore +65 6536 0481 praveena.pattabiraman@ambit.co
Shashank Abhisheik Singapore +65 6536 1935 shashankabhisheik@ambitpte.com
USA / Canada
Ravilochan Pola – CEO Americas +1(646) 793 6001 ravi.pola@ambitamerica.co
Hitakshi Mehra Americas +1(646) 793 6002 hitakshi.mehra@ambitamerica.co
Achint Bhagat, CFA Americas +1(646) 793 6752 achint.bhagat@ambitamerica.co
Production
Sajid Merchant Production (022) 30433247 sajid.merchant@ambit.co
Sharoz G Hussain Production (022) 30433183 sharoz.hussain@ambit.co
Jestin George Editor (022) 30433272 jestin.george@ambit.co
Richard Mugutmal Editor (022) 30433273 richard.mugutmal@ambit.co
Nikhil Pillai Database (022) 30433265 nikhil.pillai@ambit.co

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 Strategy

Explanation of Investment Rating

Investment Rating Expected return (over 12-month)
BUY >10%
SELL <10%
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