Recently, broking and advisory firm Motilal Oswal Financial Services came out with an interesting study on the return on equity (RoE) trends of India Inc over the last 34 years. Return on equity or simply RoE in financial parlance measures how effectively company’s management is using its capital to create profits.

One of the findings that could interest investors is on public sector undertakings (PSUs). According to it, RoEs of PSUs have remained at par with their private counterparts but their valuation multiples have remained low. RoE of PSUs (excluding BFSI) stood at 15.4 per cent for PSUs and 12.7 per cent for private sector in FY19.

“However, we note a significant divergence between the P/E multiples of these sectors. As at end-FY19, PSUs (ex BFSI) traded at a P/E multiple of 9.4x, as against 28.6x for private sector (ex BFSI), marking a discount of nearly 67 per cent,” the findings of MOFSL revealed.

“Apart from regulatory headwinds and the continuous stake sale by the Government through divestment, the other two factors driving this valuation divergence were: the higher share of earnings contribution from cyclical businesses and the lower earnings growth expectations,” Motilal Oswal analyst Sandeep Gupta reasoned out in the study.

Besides, the study also found that over the past few years, the gap between the RoEs of PSUs and their private counterparts has widened significantly, with the difference in their RoEs (private RoE minus PSU RoE) shooting up from 2 percentage point in FY15 to more than double at 4.9 percentage point in FY19. This widening of the gap was mainly due to the underperformance of PSU banks.

Companies with ‘improving RoE’ and ‘earnings growth’ are the best for market-cap creation. “Our analysis of BSE500 companies over two phases (from FY08-13 and FY13-19) reveals that companies with both improving RoE and earnings are ideal for generating best returns, while those with declining RoE/earnings growth have delivered the weakest market cap returns.

Mid-caps versus large-caps

However, an analysis of the last 10-year performance reveals that the performance of both the Nifty and the Nifty Midcap 100 has been cyclical, with the latter outperforming from a longer-term perspective.

Over the three tested cycles (FY03-08, FY08-13 and FY13-19), mid-cap companies (excluding BFSI) have outperformed large-caps in market-cap creation (percentage wise) by a significant margin. This is despite lower RoEs of mid-caps than large-caps in all the three tested cycles. This is primarily on account of higher earnings growth and thus higher variability (improvement) in RoEs for mid-caps.

Key findings

Based on its ‘root and branch’ study of India Inc RoE, Motilal Oswal reveals some interesting insights. Cyclical sectors are key drivers of India Inc’s RoE. A high RoE is desirable, but an improvement in it is the key to market cap creation. Capital structure-led RoE improvement uplifts valuation multiples. Improving RoE and earnings growth is a lethal combination for market cap creation.

At a time when investors struggling to identifying growth stocks at a reasonable price, these findings could offer some cues. Even mutual funds could launch quant funds based on this parameter. Currently, there are three quant funds — Nippon India, DSP Merrill Lynch and Tata Mutual Fund. They select stocks on the basis of valuation, earnings, price, momentum and quality.

Maybe time has come to consider RoE as a base factor to pick stocks.

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