When we started our private equity investing career around 2008, we were told that it is ok to have 2–3 winners in a portfolio of 10. The winners will make up for the losses in 3/10 duds. Just return capital in the balance 5. In hindsight, this framework was so VC’ish, to say the least. In India, owing to difficulty to scale, smaller addressable markets, rich entry valuation and promoter integrity issues, the winners could never hit the ball out of the park, but the duds could take your investment down to zero, albeit very quickly. Profitable growth was and remains difficult.
Another framework that we had to quickly unlearn was super natural growth projections. Owing to high valuations and best in a decade margins (which never came back), private equity investors were forced to make models that had their top-lines and bottom-lines growing at 20–30% yoy. Why not, this was the only way to justify crazy valuations and white space market assumptions. Give capital to companies and then have them on steroids. Needless to say the survival rate of those on steroids is pretty low. Pretty low for even the 100 mts globally competitive sprinters. In fact for some sectors like lending, this is a recipe for failure (will dedicate a full blogpost on the failed banks in my portfolio).
The reality is however, very very far from this. If these hyper-growth assumptions and portfolio success theory were to be applied to the public investing, one could loose his shirt very quickly. What we learnt from returns made in public equity are as follows:
Phenomenal topline growth rarely translates to commensurate returns. What however does translate is sustainable good quality of business. To prove this hypothesis, we studied listed companies with a time frame of 3/5/10 years. We classified companies into two buckets, those that grew >15% yoy and those that had a sustainable return on equity of >15% (proxy for quality) for the same period. To de-noise, we considered companies that had a market cap of >200 cr 3/5/10 years back.
What we witnessed is as follows:
Companies that had a sustainable high quality of business (ROE> 15 %), returned higher return than the cohort of companies that were growing fast (sales growth >15%).
The deviation in returns of high growth companies is much higher than the deviation in returns of companies that have a predictable quality record.
In investing it is very important to understand and quantify the risk one is taking for a return. One can make infinite returns but also loose ones shirt. Some risks are not worth losing capital. As shown by data, chasing growth also means one could lose capital permanently.
So investing in high quality business doesn’t only give higher longer term returns, it also significantly reduces the risk of losing capital.
If we were to the same analysis for a lower sales growth rate (10%), the findings do not change.
Over the longer run (10 y), high growth and high ROE converge in returns. This also implies that people are looking for more predictable businesses.
A good analogy we are borrowing from a recent blog we read from Nalanda capital: public investing is like playing a test match. One has to only play balls where you know you can hit high quality shots, something like what a Dravid/VVS would do. If you are always racing to a 50/100 score, you better be a god like Sachin/Lara or a maverick like Sehwag.
In the next post will be taking a deeper dive on some characteristics of good quality businesses that can be dug up bottoms up: free cash flow generation, dividend yield, change in promoter stake and management compensation.