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Couple of decades ago the world’s wealthiest man Warren Buffett said that growth was not always a good thing. What? Aren’t companies of the world doggedly pursuing growth? If any economy today has two quarters of negative growth, we call it a recession and recessions are bad. Everyone wants more sales, more profits, and more products. It is all about ‘more’.

But growth is not always good. They might not know it but for some investors, growth has destroyed wealth both quickly and permanently.

Look around you, let’s look at the Reliance Industries or even Bharti Shipyard for example. In March 2009 Reliance Industries shares were trading at Rs 760 per share factoring the bonus shares issued later that year. Profits from 15,000 crore rupees have gone up to 21,000 crore in March 2013. Many brokers and analysts have the stock rated a ‘buy’ or ‘strong buy’. The problem however is return on equity is declining.

Return on equity contraction foretold the sluggish price performance of the company, which was accelerated by the increase in retaining profits. It is return on equity that will help you identify the great companies to safely invest in. and it is return on equity that will save your portfolio from permanent destruction.

To understand what Warren Buffett was talking about decades ago when he said not all growth is good, you need to know something about return on equity.

Imagine you have a business, even a good one. You invested 10 lac rupees in it, bought a shop and in the first year, produced a real cash profit after tax of rupees 4 lac. That’s a 40% return. Now suppose another shop came up for sale in another area for rupees 4 lac and you decided to buy it. As it happens you are really good at running the first store you bought but you have found running the second store a little harder. Travelling between them has been challenging and so you decide to bring in a manager for the second store. The result is that after a year of owning the second store it produces a profit of rupees 20,000. Meanwhile the first store produces another rupees 4 lac. The second store has generated a return of just 5%. Many business owners – including my dad – and I know one or two – would say this is still satisfactory, because profits have gone up. In first year your business made rupees 4 lac and in the second year, profits have gone up to Rs 420,000. Profits of your new ‘group’ grew by 5%.

Thinking about this situation another way reveals what a poor investment the second shop is. You first have to remember that you gave your business more money, so profits should have gone up. A rocking chair and a bank account is all you need to make profits go up. Invest 10 lac rupees in bank account and then put another 4 lac rupees the year after and the interest you earn in the second year will be higher than in the first. You have grown the profits and it has been no effort at all

So when a company increases its profits it is nothing spectacular if the owners have invested more money in the company. This is purchased growth. Shareholders have funded the opportunity for the directors to look good. The situation is even worse if that additional money generates a return that is less impressive than the rate available from a bank account. And if a higher return can be earned for the same risk or the same return for less risk, somewhere else, then the reality is that you don’t want to put more money into the business. You don’t want it to grow. It is better that the rupees 4 lac is taken out of the business, rather than employed to purchase another shop. The rupees 4 lac should be invested elsewhere at a higher rate or even at the same rate in a bank account, which has a lot less risk.

If, each year, you invested the rupees 4 lac from the original shop into a new one that produced a return of 5%, the business would eventually have many more shops earning 5%. And each year the business would be worth less and less even though profits would be growing.

Many investors don’t understand this- that there is growth that will destroy wealth. They happily allow management of a company to keep money “to grow the business” and willingly accept low return. That low return is actually costing you money because you could have earned a better return elsewhere. It is called opportunity cost.

If you look at the table1 it shows that an investor in a company that generates a ten percent return on equity and that keeps all the profits for growth rather than paying those profits out as a dividend, will lose half their money.

Table 1.

Year 1

Year 2

Equity at beginning

Rs 1,000,000

Rs 1,100,000

Return on equity

10%

10%

Net profit

Rs 100,000

Rs 110,000

Dividend

Rs 0

Rs 0

Equity at end

Rs 1,100,000

Rs 1,210,000

Price earnings ratio

10

10

Market capitalisation

Rs1,000,000

Rs 1,100,000

Let me show you precisely how a company that is growing its profits but generating a low return on its owner’s equity, loses your money. Table 1 shows a company listed on the stock exchange and whose shares are trading on a price earnings ratio of ten times. The price earnings ratio is simply the share price divided by its earnings. So if share price is Rs 100 and earnings are Rs 10, the price earnings ratio will be ten (Rs100/Rs 10=10). If the price earnings ratio is ten, it means that buyers of the shares are happy to pay ten times the profits for the company.

In year 1 when the company earned a profit of Rs 100,000, the stock market was willing to pay ten times that profit or Rs 1,000,000 to buy entire company. Another way of thinking about it is that the stock market thinks the company is worth Rs 1,000,000. What the stock market thinks the company is worth and what actually worth are very often two different things. Don’t listen to what the stock market thinks.

The company begins year 1 with one million rupees of equity on its balance sheet and in the first year, generates 10% return on equity or Rs100, 000. Management decides that they need that money to “grow” the business and so decide not to pay any dividends. As you are about to discover, that decision has cost shareholders a small fortune.

By keeping the profits, the equity on balance sheet grows from rupees one million at the start of the year to Rs 1,100,000 at the end. In the second year, the company again earns 10 percent on the new, larger equity balance. A ten percent return on Rs 1,100,000 is a profit of Rs 110,000.

So on the surface things look rosy. The company is growing. The equity has grown, the profits have grown and management are no doubt drafting an annual report that reflects their satisfaction with this turn of events.

But not all is as it first appears. Indeed management have, perhaps unwittingly, dudded shareholders.

As a shareholders your return is made up of two components – dividends and capital gains. If hundred rupees is earned and you don’t receive rupees hundred as a dividend, then you should receive it as a capital gains. If, over time you don’t, it has been lost and management may be to blame. Every rupee that a company retains by not paying a dividend should be turned into at least a rupee of long term market value through capital gains.

The company in table 1 has not achieved this and unfortunately lost its investors money. Even though the company appears to have grown – remember equity and profits are indeed growing – the reality is that as a shareholder you have lost money. How? The company ‘retained’ all of the Rs 100,000 of the profits it earned in year 1. You received no dividends. All you got was zero capital gain. In other words the company failed to turn each rupee of retained profits into a rupee of market value. And so investors have lost Rs 100,000. If the situation were to continue, you should insist that the company stop growing and return all profits as dividends and if that is not possible, the company should be wound up or sold.

Table 1 showed us that by retaining money, the company was hurting investors as it expands. The financial pain occurs because some of the profits were retained. The reason for retention of profits is largely irrelevant because, either the money needs to be retained which makes it a poor business or management choose to retain which makes them poor decision makers.

Many investors don’t understand this very real way of losing money even when the company is reporting profits. But investors aren’t the only ones upon whom this lesson is lost. A very large number of company directors don’t understand this ‘loss ’either or, if they do, they apply their knowledge with a close of schizophrenia.

The above example demonstrates that a company with a low rate of return on equity will lose money for its shareholders if profits are unwisely retained and as Warren Buffett further observed, if profits are unwisely retained it is likely that management have been unwisely retained too.

There are four steps to investing successfully in equities over long periods of time. The first step is to have the right framework. Done. The second step is to understand the economics of a business. Done. The third step, and one that seems to be over emphasized by many investors, is the calculation of estimated intrinsic value. Its tendency to distract the investors attention away from understanding a business’s quality and prospects is the reason I have deliberately left it out of this discussion. The final step, and arguably the most important one is a lesson that cannot be taught; applying the right temperament to the execution of the investment strategy – being patient and having the fortitude to swim against the status quo – are necessary investing qualities that we have observed not everyone has.

Finally, we have pulled out Karur Vysya bank from our watchlist after looking at its first quarter earnings. Also in next post we will be looking at IT companies for opportunities to invest with, till then happy investing.