Companies that are able to deliver consistently high profit growth each year have the potential to generate large stock price returns for investors. The favorable effect of higher profit growth on stock prices is relatively well understood. However, the meaningful impact that such increased regularity can have on stock prices is often less appreciated. We try to explain this through a simple exercise.
For this, we assume that a person stays invested in shares for seven years. While investors may have different time horizons, this period reflects the overall point. The exercise gives similar results whether done for a longer period of five years or 10 years. From the current composition of BSE 500 companies, we selected those stocks which have a listing history of seven years or more. There are 366 such names, or about 70% of the constituents of the BSE 500 index.
We expect a minimum of 10% annual profit growth from these firms: 10% is the minimum nominal GDP growth that India has achieved every year, during the 7-year period from FY2016 to FY2022 (Covid-19 (excluding the financial years affected by 2020 and 2021). It is reasonable to expect a company to grow its earnings at roughly the rate of growth of the economy. For profit growth, we have considered the financial position of the company till FY2022 only, as FY2023 results are yet to be declared by all the companies. Some ups and downs in business profits are inevitable. Therefore, we expect this minimum threshold of 10% profit growth to be delivered in most years during this evaluation period — so at least four out of these seven years. There are 212 firms that meet the previous criteria, or about 60% of the 366 companies.
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While the share prices of the entire basket of 366 stocks increased by an average of 15% per annum during the 7-year period from 2016 March-end to 2023 March-end, the share prices of the pool of these 212 names increased significantly. more than 19%.
If we expect the 10% profit growth threshold to be achieved in five of the seven years, instead of the four years taken earlier, the above pool will reduce to less than 30% of the original selection of 366 stocks, or only 102 names. It happens. The average increase in stock prices per year for this pool is higher at 23% compared to 19% for the previous one. If we further expect that the threshold 10% profit growth will be achieved in 6 out of 7 years, the above pool will now shrink to just 25 names. For this pool, the average increase in stock prices per year is a dramatic 28%, which is nearly double that of the entire original selection of 366 stocks.
While the exercise has drawbacks such as a walkthrough, the key point of having all money invested in equally related stocks, on day 1, at a specific time, and without any portfolio changes whatsoever, is highly powerful and are simple:
First, only a few companies can consistently deliver high profit growth. The ability to be coherent is relatively rare. As we have seen, with each additional year of the minimum profit growth requirement, the number of eligible firms decreases significantly.
Second, these few pools of companies are better rewarded by the markets over longer time horizons than the overall basket. As we saw, returns increased substantially for each subsequent pool, with an additional year of minimum profit growth requirement.
Also, this exercise is more relevant to investors who post their research into equities directly or seek assistance from advisors. There are likely to be other parameters for investing in mutual funds rather than just the criteria used above.
Sandeep Bansal is an Assistant Director at ASK Investment Managers Limited.
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