The secret of wealth creation

The current market scenario has put investors in a quandary. Markets are at an all-time high and seemingly set to climb higher. Stocks are, well, expensive to say the least, leaving not much chances of making an entry.

Of course, there are plenty of unheard of stocks and its backers who promise the moon. But the classical question is, should you buy such stocks which look tempting or go for trusted names which look a lot more expensive?

The fact of the matter is nothing, just nothing really is going cheap after the substantial run up in stocks prices we have seen in the past two and half years.

But the Motilal Oswal Wealth Creation study this year provides some interesting insights on investing in bluechips, which will probably be better off even when the market reverses direction.

Says Raamdeo Agrawal, managing director of Motilal Oswal Securities and the author of the Wealth Creation study, "Everyone wants to buy bluechips cheap. But unless the stock market is clouded with extreme pessimism that never happens. So, we thought of developing a framework one could follow to pick bluechips with a high probability of outperforming the market and also earning good absolute returns."

Agrawal's philosophy has been to pick stocks really cheap. His slogan, for many years, has been to buy stocks at such an attractive price that even if it is a mediocre sale it still provides handsome returns.

Before we delve further into the finding of the Wealth Creation study, here is what it is all about. The Wealth Creation study seeks to pluck out companies which have added most to their market-cap. The study evaluates companies based on their market-cap performance for a period of five years.

Agrawal and his team have been doing this study for the past ten years and each year there is an all new investing theme to help investors figure out a method in the madness of stock markets.

This years' list of wealth creators have the distinction of adding at least Rs 1 billion (Rs 100 crore) in market-cap during the fiscal period 2000-2005, after adjusting for dilution. Some of this year's fastest growing wealth creators include Matrix Lab, Aban Loyd Chiles and Gujarat NRE Coke and the biggest wealth creators include ONGC, IOC and Reliance Industries.

But this list may be of less relevance for investors looking to pick stocks which are expected do well in the future. For that, Agrawal has analysed the results of all the past ten WC studies done by the firm. Based on the performance of the top 10 consistent wealth creators, the following inference are borne out:

• Only two stocks - Hero Honda and Ranbaxy - have appeared in all the Wealth Creation studies till now
• The average absolute return earned by these companies was 29 per cent
• The probability of earnings positive returns is 90 per cent if one invested in the consistent wealth creators
• The probability of outperforming the Sensex is 87 per cent for the consistent wealth creators. On an average, these companies outperformed the Sensex by 23 per cent
• By investing in consistent wealth creators below their historic median valuation, you have an almost 100 per cent chance of beating the Sensex. The chances of outperformance increases to 35 per cent in such a scenario.
• When you invest below the median valuation, you are almost 100 per cent certain to make an absolute positive return.
• The average absolute return increases to 45.7 per cent per annum, if you were to invest below the median valuation.

What sets them apart?

Besides, there are certain characteristics that set the consistent wealth creators part from the crowd. These companies are usually from non-cyclical business and deliver high return on net worth.

For the record, nine out of top 10 companies are consumer companies, the only exception being Wipro which has been a consistent wealth creator despite the carnage in 2000. Wipro could not make it to the list of wealth creators only in one year, the year when the tech stocks went bust.

Further, five out of the top 10 wealth creators are pharmaceutical companies. All the companies that made the cut are leaders in the respective business segments and are highly profitable in terms of return on net worth.

The safety net

But the wealth creation study is based on past data. Does it really give an indication into the future of these companies or what to buy in future? Agrawal explains why investing in consistent wealth creators can be a worthwhile proposition.

One reason is that since the list of consistent wealth creators contains large, established companies that are leaders in their own fields, the safety capital tends to be very high in such investments. "While the temptation is always to go in for fast wealth creators, these are difficult to find in their early stages and probably more risky too. The fact remains that several consistent wealth creators have been fast wealth creators at some point of time" explains Agrawal.

Typically, even as conventional stock market theories teach us that the speed of wealth creation depends on two main factors - earnings growth and the margin of safety at the time of purchase. Consistent wealth creators are known for their demonstrated earnings power over a long period of time and typically, the demonstrated earnings power continues well into the future, explains Agrawal.

"The future, though uncertain, is usually not vastly different from the immediate past. Keeping this fact in mind, one can assume that that these companies will maintain their high earnings power well into the future" he adds.

Understanding price and value

Having said that, the real challenge is at what price do you buy these companies? Here, Agrawal says, it is imperative to understand the difference between 'price' and 'value.' Price is what you pay, value is what you get. Value is something that exists in the mind.

Earnings, dividends, assets and sentiment all have an effect on price determination. Consistent wealth creators, pretty much like any other stock, must also to be bought cheap and sold when they are dear.

Sure. But is there a benchmark to determine what is cheap and what is expensive? Agrawal relies on the data thrown by the WC study in the past ten years which effectively captures stock performance for the 15-year period 1991-2005.

A detailed analysis of the 5-year rolling returns for consistent wealth creators reveals that such companies do present opportunities to make substantial returns over time.

The trick is to buy stocks at lesser than historic median valuations. Says Agrawal, "It is not always important to buy the stock very early. Stocks do present an opportunity to make good returns even if you have not been an early bird."

For instance, the median price-earnings ratio for the Hero Honda for the fifteen year period ending March 2003 was 14.4. And if one bought the stock in March 1993 when the price-earnings ratio was 12 one would have ended up with a annualised gain of a phenomenal 58 per cent in 1997.

Or if you picked the stock in 1997 when the price-earnings was 12, you would have made an annualised earnings of 63 per cent five years later. Similar is the story with several other wealth creators.

What's is the risk to picking stock based on this model? The risk is in identifying how mature a business is and how far it can go. For instance, the risks of putting your money in a 6-year old horse which has had been on a winning streak is lower than that of putting your money in a 14-year old horse with a similar track record. Now, identifying the age of the horse is the trick. That's easy to figure out - isn't it?!