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Wednesday, February 19, 2020

Return on Capital and Stock Return kcchongnz

Author: kcchongnz | Publish date: Tue, 18 Feb 2020, 6:30 PM





In my previous articles, “Quality Investing” below, I have brought to your attention the extra-ordinary return of a random portfolio of quality stocks.

https://klse.i3investor.com/blogs/kcchongnz/2020-02-04-story-h1483049632-Quality_Investing_kcchongnz.jsp

The portfolio returned 331% over 10 years as on 17th February 2020, more than 10 folds of the return of the broad index of 31% during the same period. The compounded annual return, CAR, including dividend yield of the portfolio was a whopping 16.5%, 4 times the CAR of 5% of the broad index. RM100,000 invested in this portfolio of stocks with equal weighting multiplied to RM462,000 over the period, 3 times more than the RM163,000 of a portfolio invested in the 30 component stocks in Bursa during the same period. The stocks in the random quality portfolio were Petronas Dagangan, Nestle, Public Bank, Dutch Lady, Heineken, LPI, Aeon Credit, and Carlsberg.

I have discussed at length the qualitative attributes of high-quality companies in the link above.

In the following article, “Quantitative Metric No. 1: Return on Capital”, I suggested that the most important quantitative measure for quality is the return on capital, ROC.

https://klse.i3investor.com/blogs/kcchongnz/2020-02-09-story-h1483733832-Quality_Metric_number_1_Return_on_Capital_kcchongnz.jsp

I have also discussed in detail what ROCs are and how they are computed in the above article. I stressed that a quality company must earn a ROC higher than its cost of capital and hence should generally be a double-digit figure. That is a no-brainer.

Here, let us examine the ROCs of each individual stock in the random portfolio above which produced extra-ordinary return over the last 10 years and see if it is true that they have high ROC.

“Quality investing focuses on a company’s ability to invest capital at high rates of return: post-tax levels of high-teens (and higher) are possible.”

First, we look at the share price movement and ROC of Carlsberg Brewery Malaysia, a producer of short-live consumer products with a well-known brand name.

Figure 1: Share price and ROC of Carlsberg



Carlsberg’s share price rose from RM4.62 ten years ago to RM36.20 at the close on 17th February 2020, for a gain of 684%, or a CAR of 23%! Its ROC has always been in double-digit figure, rising from 30% to 133% in 2019 as shown in Figure 1 above. Ignoring the valuation expansion part of it, that has proven the power of high and rising ROC in stock return.

Carlsberg competitor, Heineken Malaysia, performed very well too with 329% gain over the ten years period, or a good CAR of 15.7% as shown in Figure 2 below.

Figure 2: Share price and ROC of Heineken Malaysia



We can see from the chart that Heim has consistent high ROC of more than 60%, rising to 80% in 2018. Its share price rose in tandem from RM6.90 to close ten years at RM29.58 on 17th February 2020.

Next, we have Nestle, another high-quality company with high ROC, rising from 30% in year 2011 to 134% in 2019. Its share price improved the same magnitude as Heim, rising from RM33.76 ten years ago to RM145 at the close on 17th February 2020 as shown in Figure 3 below.

Figure 3: Share price and ROC of Nestle Malaysia



For the rest of the companies in the random quality portfolio, all their share prices have also way outperformed the broad KLCI as shown in Figures 4 to 8 below and Table 1 in the Appendix.

For Financial Institutions and credit companies such as Aeon Credit, Public bank and LPI Capital, we use ROE as a measure of its return of capital as ROC is not an appropriate measure for them.

Figure 4: Share price and ROC of Aeon Credit



Aeon Credit also has high ROE above 20% all these years. Its share price has also performed well with a CAR of 13.9% over the last ten years. In the most recent year in 2019, ROE has dropped from the peak of 35% in 2013 to 20%, but still way above its cost of capital. With the drop of ROE, its share price has been stagnant for the last few years.

Figure 5: Share price and ROC of Dutch Lady



Dutch Lady has extremely high ROC of more than 100% for the last few years, propelling its share price from RM11.80 ten years ago to close at RM42.50 on 17th February 2020, for a gain of 260%.

Figure 6: Share price and ROC of LPI Capital



LPI has reasonably good ROE of 12% or more over the last 10 years. This ROE is considerably higher than the required return of equity shareholders for a stable company like LPI, and Public Bank. Its share price also has a high CAR of 12.2%, way outperformed that of the broad market.

Figure 7: Share price and ROC of Public Bank Berhad