Stock Selection Using ROE And Sales Growth

In this article, we focus on a simple technique of identifying shares which have potential to generate abnormal returns. We will use a combination of two ratios which are very simple and commonly used. 

The year 2018 will be full of challenges with the introduction of LTCG and issues concerning growth in earnings and NPAs in banking system. The global issues relating to trade between China and the US will continue to impact the market and the trick to survive is to invest in a stock which has consistency in returns. Any company can generate abnormal returns in a year but generating consistent return is the key. 

In this study, we focus on the time-tested ratio known as Return on Equity (ROE/RONW) for identifying a stock with huge potential. 

The ROE ratio measures the profit earned on the owner’s fund. Shareholders' fund is defined as capital invested plus all reserve and surpluses of the company. The ROE measures profitability earned on the shareholders' funds and is a benchmark for comparing one company with another and the company’s performance over the years. Increase in ROE can be caused by any of the factors such as higher profit margins, higher capital turnover, higher financial cost ratio, higher financial structure ratio, and lastly, due to change in tax structures. If we have to look at this ratio from an investor's perspective, what is important is that a minimum ROE should be achieved year-on-year and it should be consistent over the years. We consider ROE of 10% as a minimum expectation of shareholders and the key is consistency in earning above 10% year-on-year.

Secondly, we consider growth in sales as an indication that the company is able to sell its products and increase its market presence. Increase in sales is the cleanest ratio, as accounting method cannot affect this ratio. The year-on-year sales growth is calculated and we used 15% yearly growth in sales to select companies. 

We considered top 1000 companies listed on the BSE and NSE based on market capitalisation. We obtained ROE, sales growth and share price data between 2009 to 2018. We created a portfolio of companies which had generated ROE in excess of 10% and sales growth of 15% for consistently five years and calculated returns with a holding period of one year. A portfolio created using ratios from 2009 to 2013 will be liquidated in June 2014. This method was repeated every year and the results are as under. 

The data was obtained across all years as on June 1, and for calculating returns of share price for portfolio 2013-2017, we have used the values as on March 23, 2018.

Table-1: The total number of companies qualifying on both the parameters of sales growth and ROE are decreasing every year. This suggests that in the market it is becoming increasingly difficult to generate sales growth of 15% and ROE of more than 10%. The average return of portfolio across all the years is beating the index returns. 

If we generate a table to calculate how much excess return was generated if an amount of Rs 10,000 was invested in 2013 and reinvested using the same investment philosophy, the results are astonishing 

Rs 10,000 invested in 2013 would become Rs 50,263 on March 23, 2018, whereas the same amount invested in S&P BSE Sensex would have become Rs 17,055 and in Nifty the amount would have become Rs 16,621. 

Retail investors who are willing to take risk and open to invest across sectors and are indifferent to large-cap, mid-cap and small-cap can consider selecting stocks which are consistently generating ROE greater than 10% and sales growth of more than 15%.