How capital efficiency and capital intensity creates superior businesses and superior investing opportunities

This article is authored by Satish Kothari, SVP Research and Investments at SageOne Investment Managers. He is also the fund manager for SageOne’s SLMP strategy.

At a recent networking event, one of the investors shared his investment philosophy of ‘Investing in a capital-intensive industry with a capital efficient promoter (i.e. High Return on Capital). This was a very differentiated thought to the traditional rule of thumb of the type of businesses one should be investing in.

There are many examples of stocks following this philosophy which have done well and all had 2 common factors – a) they were in a segment where opportunity size was very high and b) were efficiently managed (high return on capital). Efficiently investing capital in a segment with a huge TAM (Total Addressable Market) should lead to high earnings growth at a high ROCE (Return on Capital Employed) - a potential combination.

Investors generally like capital-light businesses (i.e. low gross block) but businesses which can reinvest a large amount of capital are also great investments. While investors investing in high ROCE companies have some margin of safety, the returns are only limited to their earnings growth potential. For example, certain FMCG companies have ROCE over 70-80 per cent but due to limited growth opportunity or ability to invest, the stock returns mirror the business growth which is just 10-15 per cent. 

The retail industry in India promises a long runway of growth but only a few have succeeded. For example, Trent (which houses familiar formats like Zara, Westside, Star Bazaar and Zudio), is one of the most efficient players in retailing and has consistently invested in business by trying out new formats. This has led to company revenues growing at 3.3x and EBITDA at 4.5x over FY19-23. The growth was achieved without diluting equity and the company remained cash flow positive due to its stringent focus on capital efficiency. New formats are more capital efficient than older ones and hence the incremental ROCE is higher along with a long runway for growth leading to high growth and high ROCE. 

In a highly capital-intensive business and competitive industry like aviation, it is survival of the fittest. Indigo Airlines remains the most cost-efficient player in the aviation industry not only in India but globally. With a long-run way for growth, Indigo’s ability to reinvest in the business and expand its fleet has led to it reaching a market share of 60 per cent in India. Indigo’s efficiency led to its survival during the toughest times (including Covid -19 Pandemic) for the industry and hence during an industry uptick, it will be well-equipped to gain market share.   

To conclude, highly efficient companies with a long runway of growth will be able to generate significant excess returns. However, investors need to constantly monitor these business metrics due to shortening business cycles on account of technology disruption and competition from new nimble-footed companies. The key for any investor is to identify these businesses early and invest. This process is difficult as these stocks don’t score high in conventional methods of screening (High trailing P/E – due to higher depreciation/amortization) or cash flows (Free cash flow is negative). However, a deeper understanding of the business and its drivers along with the ability to see the larger picture will help find such businesses in one's investing journey.

Disclaimer- The views expressed on stocks is not a recommendation.