For the past 20 years Motilal Oswal limited has been coming up with a yearly study on Indian companies that are listed on stock markets. The study is named “Motilal oswal wealth creation study”. Under the stewardship of Mr. Raamdeo Agrawal the study has grown year-on-year to become a seminal study on Indian stock market. 2015 marks the 20th anniversary of the study. The theme for 2015 was mid-to-mega. How to spot a mid (i.e. midcap) company that can grow into a mega (i.e. largecap) company. In the year 2014, the focus was on 100x companies. i.e. how to identify a company that has a potential to grow 100x. The pre-requisite for such companies was that they have to be smallcap companies. Apparently it was felt that such companies may take a decade or more to provide 100x gains, so the focus of this edition was to limit the search to midcap companies that will become mega companies within, say, 5 years. Please note that in another couple of months we may get the 2016 version of the wealth creation study. Hence this article can act as the precursor to the 2016 version of the report.

The study reveals that there are 5 important factors to be considered for identifying mid-to-mega companies. These five factors have been abbreviated as MQGLP which stands for Mid-size (of the company), Quality (of business and management), Growth (in earnings), Longevity (of both quality and growth) and price (favorable valuation). Let us look at what each of these parameters stand for.

Mid-Size:

There are various ways to determine the meaning of midcap companies. One metric is a company whose market cap is between $1 billion to $5 billion can be treated as midcap company.

The other method is to take the market cap data for all the listed companies. Arrange them in the decreasing order of market cap. The top 100 companies would form the mega (or largecap) companies. The companies in the mid rung i.e. 101 to 300 would make up the midcap companies and the companies between 301 to 500 could be treated as mini (or small cap companies).

Quality:

The study indicates that the term “quality” should encompass two aspects, namely, quality of business and quality of management.

  • Quality of Business: Quality of business can be judged based on two factors namely: Industry leadership and Economic moat.
    • Industry Leadership: During the study it was observed that 88 out of the top 100 companies, i.e. mega companies are the leaders in their respective industries. So if you want a company to move from mid-to-mega and you notice that it is a leader in its industry then the chances of it becoming a mega company is high. It was also noted that over the past 15 years the share of industry leaders in mega companies bracket has risen from 63 companies to 88 companies. Hence over the years industry leaders have squeezed themselves from being a mid-company to mega company. Hence industry leadership is a key factor that determines the quality of business.
    • Economic moat: A moat as we know is like a barrier around a company that shields it from its competitors etc. There are two aspects that determine if a company has an economic moat. (a) Does the company have a unique value proposition compared to its peers and (b) Is the Return on Equity (RoE) consistently higher than cost of equity. As per the study, for benchmark indices, the cost on Equity has been around 15%.  It was noted that ,as a 5 year average, 73 out of 100 mega companies have RoE more than 15%, which underlines the fact that if a company has to move from mid to mega then it better have a higher RoE than cost of equity. Hence, a company having an economic moat has a high quality of business.
  • Quality of Management: Judging quality of management is an art rather than a science as there are no numbers to compare and evaluate. The study notes that to assess the quality of management there are 3 aspects one should look at, namely, (a) Unquestionable integrity, (b) Demonstrable competence and (c) Growth and profit mindset.
    • Unquestionable Integrity: A management team that has unquestionable integrity has a track record of corporate governance, respects the law of land, accommodates concerns of all stakeholders (including minority shareholders), pays full taxes and has a well-articulated dividend policy.
    • Demonstrable competence: The Company should show competence in planning and execution, the company should attain above average return on capital (ROE, ROCE) and the company should keep the growth going.
    • Growth and Profit Mindset: The study lists various important and noteworthy aspects under this point. A company that has growth and profit mindset should have a long-range profit outlook. For this to be true, the company should ensure that it has sufficient resources to handle long-term aspects like product development, brand building, capacity creation/expansion etc. The company should be adept in capital allocation which includes decisions on whether the company should do an organic growth or inorganic growth, should it grow domestically or grow international markets as well. The company should also be persistent with its growth plans in spite of temporary setbacks.

Growth

The study believes that growth is a cornerstone for any company. To show the importance of growth, a 4 quadrant chart is drown vis-à-vis Quality as shown below:

  • Low-Quality-Low-Growth: The companies showing low quality and low growth are not worth looking at.
  • Low-Quality-High-Growth: Again the term “quality” could mean either quality of business and/or quality of management. So, a company showing high growth but lacks quality (either in business or management) could become a transient multibagger which cannot sustain itself. The two famous real estate companies from north India come to my mind. During the real estate boom these companies showed tremendous growth but then mounting debt brought down the companies to their knees. Some of these traits could also be seen in one of the largest hyper-market chain which saw huge growth during the 2003-08 market boom, but then the quality of growth was lacking, as debt started to mount, many of the assets had to be sold to pare down the debt.
  • High-Quality-Low-Growth: These companies have exceptional management, good capital allocation, excellent marketing and a very well-known dividend paying track record but the growth is missing in such companies. The study explicitly takes the name of Colgate, HUL, Castrol. I guess HUL epitomizes the High-quality-low-growth aspect. They have the most sought after products in the kitty in both the food and non-food segments, still they cannot replicate their growth of the 90s. I believe many of the largecap stocks get into this growth trap.
  • High-Quality-High-Growth: The study believes that these are the companies that one should aspire to look at. These are the multibaggers of the future.

How should one determine if the company is on a path of high growth? It would be futile to depend on past results as past results are not a true indicator of future growth. It is like driving a car by looking at the rear view mirror. The study provides 9 valuable indicators to judge if a company is on the path of future growth. These are:

  • Value migration: If there is a value migration happening from older business designs to newer ones, it could provide a huge growth opportunity for a company. Some examples of value migration can be seen in IT industry in the 2000s when Indian companies were able to grab a huge share of work from global giants. Another example is the value migration from patent holding pharma companies to the generic pharma companies. This migration is an ongoing process. Another migration I can think of in domestic space was the one seen in banking industry where private sector banks took a huge share of market from public sector banks due to customized products, customer support, and early adoption of technology. The study quotes one value migration that was seen between wired telephony to wireless telephony. Companies like Airtel, spice were able to grow by eating into state owned telecom company’s pie.
  • Sector tailwind: When there is a sector tailwind, all the companies within the sector tend to show higher sales and higher earnings. The study identifies the following sectors as having a sector tailwind: banking, IT, pharma, autos, housing finance, feminine hygiene and telecom services companies (both voice and data). I personally believe that if someone is looking for new ideas to invest, this should be the FIRST step. You narrow down the sectors you wish to focus on based on sector tailwind then look for companies within these sector that have other qualities listed in this article.
  • Small base with large opportunity: Companies have launched niche businesses that have huge growth opportunities. They start small and because of the opportunity side they keep growing. The study lists few companies: Bajaj finance that ventured into consumer finance, Page industries that got into innerwear market
  • New large investments commissioned: Companies like Cairn india, Indian oil commissioning oilfields and refinery could lead to a growth in topline and bottom line. Personally I was not too convinced about this point. Commissioning a plant, factory does add growth but then if it is a one off event, you see a one off growth and then it sustains at that level. If I had written this point, probably I would have written it as “Commissioning investments at regular intervals that breakeven in a reasonable timeframe”. This would ensure a staircase patterned growth for the company.
  • Inorganic growth through M&A: Successful M&A can lead to higher growth. The study lists 3 instances namely: Motherson Sumi acquiring several ancillary companies, Tech Mahindra acquiring Satyam, Ultratech acquiring several cement companies. I believe this is a good point. But they should have added a caveat that acquisitions can sometimes temporarily hit the profits as the acquirer may be funding it via debt. Also in any acquisition, generally the one getting acquired gets a better price than the acquirer.
  • Consolidation of Competition: I did not find this point a very relevant point to delve further.
  • Operating and financial leverage: A company could improve its operations resulting in improved profits even though sales grown is moderate. The improvements in operations could be because of reducing fixed costs (like rents, bills etc.) or it could be achieved by controlling financial costs (if the company can reduce the interest costs on loans). I personally feel there are limits to attain operational and financial leverage. This could add few basis points (or probably couple of hundred basis points) improvement in the bottom line, then again once this is achieved, the company has to look at its sales to boost its profits.
  • Turnaround from loss to profit: Some companies, because of their management action, turnaround and start making profit. The study lists two companies namely Tata motors and Gujarat pipavav. I did not get the intent of the point. Turnaround of a company is the result of growth not a cause of growth. The points listed above like value migration, sector tailwind, small base etc are all the causes that lead to growth. But the last point is an effect of growth. Moreover, a turnaround does not truly reflect the fact that it will grow well in future. It is merely an observation of the current status that is based on facts of the past.

Longevity

The fourth important aspect for a company to move from mid-to-mega is to sustain growth and sustain the quality. Achieving quality and growth for few years might move the company towards mega companies, but if they are not able to sustain it, then they will fall back to being mid companies. If you want to know what it means to sustain growth you should ask Jeff Bezos. For close to 17 years amazon has shown sustained growth with low profits and become a multi-billion dollar enterprise. The study states that there are two ways in which a company can sustain its growth.

  • Extended its competitive advantage: Generally when a company starts to see phenomenal profits, it attracts swarm of other companies that try to replicate the model (for example a boom in e-commerce led to a spade of logistic companies coming up and trying to grab the share). This leads to price war and reduces the profits for all the companies. However, if a company can delay the onslaught of competition, it could lead to a huge growth for the company.
  • Delaying mean reversion of growth rate: During the initial years companies tend to show phenomenal growth rate, but over the years the growth rate tapers due to various reasons and reverts to mean growth rate (for example GDP growth rate). If a company can delay this reversion to mean growth rate, the company would achieve its dream of moving from mid to mega fairly quickly.

Price

However good a company is, if you buy the company at an expensive price (high P/E) then you may not reap the rewards as the company grows from mid-to-mega. Your return would be much less as your initial price was high. So price plays a crucial role for YOU (not for the company). The last 5 wealth creation studies have shown that the mean P/E for all the companies that went from mid-to-mega in the past is 20. This is a very important observation to keep in mind when you buy a potential candidate that can go from mid-to-mega.

After doing an exhaustive study of the factors that make a company grow from mid-to-mega, it is all the more important to know how these can be applied to search potential mid-to-mega companies. The wealth creation study provides pointers to spot the companies. Below are the pointers one should be cognizant about.

  • Starting List: Look at all companies whose market cap falls within the rank of 101 to 300.
  • 20% RoE for Quality of Business: Out of these 200 companies shortlist the companies that have a RoE of at least 20%. The reference year for RoE could be the latest complete financial year.
  • Industry leaders: Select industry leaders. And most importantly keep in mind the companies that are seeing value migration (ex: IT, healthcare) as well as those that are seeing sector tailwind (ex: Mortgages).
  • 20% PAT growth rate: Select the companies that have shown a profit after tax (PAT) growth rate of at least 20% over the past 2 years.
  • Seculars for longevity: The study suggests to avoid cyclicals and choose the secular growth story companies.
  • Favorable purchase price: The study believes that it is an individual call on what the PE should be for the final set of shortlisted companies. However, as a guiding principle, the study asks the readers to have a P/E of 25x in their minds while shortlisting the companies. If you choose to deviate then consider other parameters from the MQGLP to offset the high/low P/E that you have comfortably chosen. I inferred the following from this point: Suppose I decide to choose a company with a PE of say 30x or 32x then I should also ensure that the RoE that the company is showing is more than 20% (let us say it is 26%) or the PAT growth rate for the company should be more than 20% (say again 26%).

Summary:

Motilal oswal wealth creation study is a great study which every stock market investor should read and absorb. Everyone takes something or the other from the study. For me the points Q and G were the key takeaways from the study.

I felt the study was overly punishing on mini (small cap) because the study got itself tied to 5 year time horizon. The study says that in a 5-year time period it may not be realistic for a company to go from mini (smallcap) to mega (large cap). It was also observed from the study that, for a 5 year time period, a move from mini to mid was not as rewarding as a transition from mid to mega. If you notice they have bound themselves to 5 year time horizon and trying to find/justify what does best in this duration and they believe a mid-to-mega is the most optimal choice. This, to me, was a dampener considering the pleasure that I got when I read last year’s wealth creation study. The 2014 study clearly noted that if someone has a 12-15 year time horizon then by employing the SQGLP logic one COULD potentially get a 100x return. If you re-read my very first post on compound interest (here) you get a sense of my way of looking at things.

Nevertheless this study is on par with the best investment material one can get around. I have picked only one aspect from the study. There are plethora of other things that are worth reading in the wealth creation study. I strongly recommend one to read (and re-read) The Motial Oswal Wealth Creation study 2015! Kudos to the Motilal oswal team for keeping it going year after year.

References:

[1] Motilal Oswal Wealth Creation Study 2015

[2] Motilal Oswal Wealth Creation Study 2014

Disclaimer:

The study was conducted by Motilal Oswal and all the rights about the logo and the content related to the original study are reserved with Motilal Oswal company. I have liberally borrowed from the study as the purpose of this post is to give my opinion about the study.

I am not a SEBI registered research analyst. The information provided above is my subjective view based on what I have read on different websites, annual reports, and quarterly reports of various companies which I assume to be accurate. The above information should not be treated as an offer/advise to purchase a specific stock/investment instrument. Since these are my subjective opinions, I could be wrong in my understanding or presentation of information. I do not claim that the above information is complete or can be relied upon as such. I cannot be held responsible for any loss or damage caused due to any inadvertent error in the above information. I will not liable for investment decisions made by readers of this article based on the above information. I am not an investment advisor. Please consult your investment advisor for all your investment needs.