How do you select stocks? What are the parameters you look at? Whatever your strategy might be, the companies in your portfolio fall into one of these four types which we are going to look at in this post.

Let’s see how these four categories are determined.

The value (not stock price) of any company depends on two things:

1. Return on Capital Employed
2. Growth

I had written a thread on Self Sustaining Growth Rate which talks about these two parameters. We’ll be splitting companies based on their ROCE and growth. This will give us four types of companies. All the companies in the universe that have ever existed will fall into one of these four categories. Let’s go through each one of them.

Before you start reading further, let me tell you that I am not a SEBI Registered Investment Advisor and none of the companies that are listed below are recommendations.

Cool? Let’s start.

 

High Quality

Companies having high ROCE (ideally above 20%), can generate high amounts of free cash flow. If they can plow most of that cash back into the business, they will be able to grow consistently. Let me explain this by giving an example. Let’s say that the capital employed is ₹100, and ROCE is 20%. This means the company has generated a free cash flow of ₹20. Now, they have a capital of ₹120 to deploy in the next year. If they earn the same ROCE, they will grow at 20%.

When a company is consistently generating high ROCE, it is highly likely that that they are having a durable competitive advantage. Apart from the high ROCE, these companies consistently grow at a decent pace (>15%). This is the holy-grail you want to be looking for. Most compounders fall into this category.

Some examples that come to mind are the HDFC Bank, ICICI Lombard General Insurance, Titan, and Britannia.

 

Quality Traps

These companies have a solid moat, and also generate high amounts of ROCEs, but they usually don’t have much opportunity to grow. This is the reason why companies like these distribute their free cash flow to the shareholders generally in the form of dividends. These companies are generally well-known and also offer safety during difficult economic conditions.

Some examples are the likes of big, established FMCG companies, like Hindustan Unilever, Colgate, Nestle, ITC. These generate extraordinarily high amounts of ROCEs, but since they don’t have much opportunities to grow, they distribute pay out a major part of their cash flows (with payout ratios close to 100% for some them).

 

Aspirers

Companies in this segment have low ROCEs, but are looking to grow quick. Now, if you try to grow faster than your ROCE, it is obvious that you will have to raise capital — either in the form of debt, or equity — which may be dilutive for the current shareholders.

This has been the case with Avenue Supermarts for a long time. They generate low ROCEs (previosly in the single digits, but now in the lower double digits), but have grown at a great pace. Ideally, you would want to get into these businesses if you think they could possibly move to the first quadrant, i.e., Quality.

 

Value Destroyers

These companies destroy value. You would want to stay away from them, unless you think there is a significant chance of them moving to any one of the above categories. Since the ROCE is very low, any kind of growth is bound to destroy value.

Generally, cyclical businesses like Indian Hotels fall into this category. Ideally, you would want to stay away from such companies.

 

Conclusion

Now that we have seen four types of companies, you know where you should be focusing. You should ideally be investing in the first quadrant (Quality) for solid long term compounders. You can go for the third quadrant (Aspirers) if you strongly think that they will be able to improve their ROCEs. The second quadrant is good for retirees, who want to invest in stable companies that distribute majority of their free cash flows as dividends.

Till next time.

 

P.S.: If you’re interested to get an in-depth guide of analysing ANY company’s financials, click on the image below.