There are two broad classifications for long-term equity investments: growth and value stocks.
Growth stocks are those that offer higher-than-market average growth in terms of earnings and revenue. They are generally characterised by high price-to-earnings ratios (reflecting the higher growth rate), low-cost structures due to network effects (hence lower capital requirements), low dividend yields and lower reliance on debt to fund capital requirements.
Therefore, these companies tend to have manageable debt levels and raise capital predominantly through issuing equity rather than borrowing (lower cost of capital due to low dividend yields).
Value companies
On the other hand, value companies tend to have higher working-capital requirements, greater reliance on borrowing to fund capital requirement, high dividend yields and low price-to-earnings ratios. They generally have lower profit margins than growth companies due to many factors. Value companies tend to operate in commodity markets (resembling perfect competition) rather than the technology industry leading to low product differentiation reducing pricing power (thus, lowering profit margins). Companies in India such as Tata Steel, Tata Chemicals and Vedanta fall in this category. These firms would prefer to fund capital requirement through borrowing rather than equity due to high capital requirements stemming from capital expenditure and working capital necessities.
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Some exceptions
There are, however, exceptions to the rule with firms such as ITC, which have low debt and an average growth rate.
Over the past decade, the interest rate in the U.S. had been next to zero leading to treasuries not being a viable option to yield returns. Value stocks, with low price-to-earnings ratio and high dividend yields, proved to be a way of capturing higher returns.
Growth stocks showed remarkable increases in revenue and profit but did not pose a great alternative to treasuries due to the low dividend yield. Moreover, growth stocks require one to engage in discounted cash-flow valuations (covered in an earlier piece), which prove to be scarcely reliable. A change in the discount rate by a few basis points leads to vastly differing company valuations. Additionally, it is difficult to accurately predict a company’s growth percentages over a few years. Value stocks’ earnings are not volatile and tend to be more predictable than growth stocks. Therefore, value stocks seemed like an attractive prospect to an investor looking to produce reliable returns.
Rising interest rates
However, interest rates in the recent past have been rising, leading to the real debt of value companies to increase. The effect of rising interest rates on value companies can be seen as twofold.
The first effect is the curbing of inflation erosion in their value of debt (lower commodity prices), and the second effect is lower profit from muted economic activity. On the other hand, growth companies are not as adversely affected due to low borrowings and high free cash flow, notwithstanding the rise in interest rates.
In the past year, the U.S. has seen a resurgence in growth stocks despite layoffs and a decline in the performance of value stocks. The case for Indian investors stays entirely different to those in the U.S.
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Indian investors will find they do not have access to the growth companies mentioned above. Most high-growth companies in India (apart from a handful such as Infosys and Dr. Reddy’s in the past) tend to prefer private equity funding rather than a public listing.
For example, companies such as Paperboat have made headway in the FMCG industry over the past decade and have chosen to remain privately owned. The supposed growth companies publicly listed in India, such as Nykaa, have done extremely poorly since listing. Others such as Zomato and Paytm are not worth mentioning, with negative profit and cash flows. Another problem Indian investors find is a lack of transparency in financial documents such as balance sheets (with some exceptions such as ITC and Tata firms), leading to poor decision-making.
The Indian retail investor, therefore, is left playing a value game without wanting to do so and must navigate a minefield of non-transparent balance sheets. However, the lack of access to growth stocks does not imply a lack of returns for the investor.
One must heed the advice of the erudite investor Howard Marks who stated that any asset is an excellent asset at the right price. The Indian investor stands to make exceptional returns through prudent and meticulous analysis of stocks and patiently waiting for appropriate prices.
(Anand Srinivasan is a consultant, while Sashwath Swaminathan is a research assistant at Aionion Investment Services)