A good discussion again.
If there is one person who has spoken the most on this topic it is Warren Buffet. The concept of incremental return on equity is one of his favourite topics. He defines his earnings in partially owned businesses not only by the dividend payments he receives but also by his proportionate share of the retained earnings. His annual reports have the usual GAAP earnings that he is expected by the law to report but also economic earnings which is his share of the retained earnings in the listed companies. He is happy to let the companies retain the earnings as in his mind the capital is growing at a faster rate than what he could have achieved in his wholly owned companies.
On the issue of incremental rate of return on capital and growth, the former is more important without a shadow of doubt. However, high returns accompanied with high growth is the icing on the cake.
Let us take the example of Hawkins. It has very high return on capital and a decent return on incremental capital,though it is dipping. The issue with Hawkins is that the growth is very anaemic.
There are only two ways that you can invest capital to run any business. Either the money goes to fund the fixed assets or to fund the working capital.
It doesn’t take a lot of capital to erect machinery or buildings to bend aluminium sheets or rivet handles to them. This is not to advocate that we should invest in asset heavy businesses. The superior returns on capital is on account of this asset light business.
Therefore, the only recourse Hawkins has to suck in enormous capital is to grow very rapidly and deploy incremental capital as working capital. This is clearly not happening. Therefore one vital ingredient in the equation is missing and we have seen the results. I as an investor would have been happier if Hawkins had retained all the earnings and deployed it in the business with the ROCE that it has.
A better business still to own is something like HLL. It takes large amount of dealer capital and deploys it at very high rates of returns. However, such businesses with negative working capital are few and far between and quickly priced by the market.
The last 15 years has seen a radical change in Warren Buffet’s portfolio. Starting in 1999 he started investing in the utilities business. Utilities are a regulated business and the regulator determines the return that an investor can earn on his investment. For obvious reasons, there is a positive spread of a few percentage points the cost of capital and the allowed returns.
I don’t think that Warren Buffet had a choice. He was dealing in ever bigger numbers and his insurance businesses were churning out a lot of positive float every year. He had to invest large amounts of money every year and the US utilities with a sensible regulatory framework was the perfect avenue for him to deploy this capital and earn the spread. Given that the US power grids needed upgradation after years added to the allure of this sector which demanded large capital.
If we look at the VP portfolio, Astral, Kaveri, Atul Auto etc have managed to achieve both of the above and were probably rewarded by the market in terms of higher valuations.
Another case in point is JB chemicals. The incremental ROE is almost double the headline ROE for the last two years, a point not being appreciated by many in the market today. This coupled with the growth could probablylead toan appreciation in the stock price ( I am invested in JB Chemicals and this is for illustrative purposes only and not a recommendation to buy the stock). Spotting these trends early could be a rewarding exercise for investors.