What also matters is the return on incremental capital being employed. If the ROIIC falls below the cost of capital, as a result we get de-rating.
This quotation from Bharat Shah says it all-
Stocks are like bonds, but when the growth stalls. They’re treated worse than a bond. Eg- newspaper companies, Media cos etc.
What really matters is the following in my view:
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Value creating sales growth. Where your Roce is still higher than your cost of capital. Eg- many people in Vinati organics have been saying that the new product has lower margin etc…still the Roce (most likely) of Butyl phenols would be close to 20%. Which by any stretch of imagination in a low yield world, seems great.
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Operating leverage giving a kick to ROIIC- eg- there are few companies like Apl Apollo and Balkrishna industries who have built up the capacities. Yet, the problem is low utilisation levels (below 70%). Once, headwinds recede and volume growth resumes. Roce’s and incremental returns will pick up. This will lead to re-rating.
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Margin expansion plays- biggest driver of Roce’s are Ebit margins and your capital turns. Eg- this story played out in Bata India, when management consciously adopted the strategy of selling products at a higher price. This improved their margins, as a result Roce’s improved. Which led to re-rating.
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Some rare breed of companies which have long runway for growth, competitive intensity in industry is low due to concentrated supply sides or consolidating supply sides. Eg- Asian paints and Berger paints in the paints industry. Alkyl Amines in the Amines Industry. Plausibly HDFC and Kotak bank, due to consolidation that will happen in the finance space.
Crux of investment has to be Roce and RoIIC . This is the essence of capitalism. Not only what do you earn on the capital,but how efficienctly you get there. Some stocks might continue to remain expensive due to this.
When Roce and RoIIC are looked through the lense of Runway for growth, past capital allocation track record, Moat of the company, Product innovation, Margin expansion, Operating leverage, industry cycle and improving capital turns, then it becomes a very potent mental model to generate returns. Could be another one of the reasons why markets rerate the stock before the actual improvements start taking place. This is what gets captured by technicals. Pure hypothesis.