Start with the 20/20 rule; 20% ROE and 20% growth

The 20/20 rule is the simplest and most elegant combination of internal and external strength of any business. That is surely the place to start your investment journey!

Oct 01, 2020 08:10 IST India Infoline News Service

Investors who start off with investment in equities often complain that they don’t have enough understanding of the nuances of finances to understand companies. That is true because you tend to get sucked into a plethora of financial concepts, numbers and ratios. That is bound to be confusing. Is there a simpler way to start off with? The answer is to opt for the 20/20 rule.

What exactly is this 20/20 rule?

The 20/20 rule is not a hard and fast rule. You can even substitute that with a 15/15 rule if you feel that is more practical in the context. It is the idea behind this rule that matters. The rule considers two factors viz. ROE and growth. What the company says is that when you start investing in the stock markets, you should prefer stocks that grow at 20% and have ROE above 20%. This pre-supposes two things. Firstly, the company is able to grow at a rapid pace, much faster than most industries or stocks are growing. Secondly, these stocks have generated a high reward for the equity shareholders.

Why ROE matters to equity investing

Return on equity (ROE) is the ratio of the net profit of the company to the equity or net worth of the company. It can be expressed as under:

ROE = Net profit for the Year / Total Equity (share capital plus free reserves)

The logic is that the equity shareholders not only provide the equity share capital but also the reserves that are created out of profits. The reserves could be created only because the shareholders got so much less dividend. As a result, they are entitled to expect a good return on their equity, which is the money that belongs to shareholders. That is what ROE captures. Normally, high ROE is a sign of robust profits and also low capital utilization; both of which are conducive for price performance.

Why growth matters to equity investing

Before we get into the concept of growth, it is first essential to define what we mean by growth. It could be growth in sales, assets, operating profits, dividends or net profits. While the growth in all these parameters is important for any business, it is the bottom line that matters.That bottom line is your net profit. It is OK to grow sales or assets or operating profits. If at the end of the day net profits don’t grow; then shareholders don’t really benefit. So we shall stick to growth in profits.

Secondly, growth in profits has to be compounded over a period of 3 to 5 years. That shows how consistent and sustainablethe growth is. When you combine the 20/20 rule for profit growth and ROE, you have a business that is growing profits and also rewarding equity shareholders. That is the essence of the 20/20 rule.

Sounds great, but does the rule work in practice?

That is the million dollar question. As Mao Zedong once said, “A cat is a good cat, as long as it catches mice”. Similarly, a methodology of stock selection is good if it can outperform the index. Let us back-test this rule in the Indian context. However, this being an exceptional year due to COVID-19, we shall focus on net profit growth on a QOQ basis.

Stock ROE (%) QOQ Net Profit Growth (%) Return since yearly Lows (%)
Affle India 29% 23% 227.91%
India Mart IndiaMesh 54% 66% 213.47%
Alembic Pharma 26% 44% 121.02%
SBI Cards 23% 371% 92.51%
Thyrocare 24% 131% 84.33%
Britannia 32% 46% 77.91%
Chambal Fertilizers 35% 31% 65.56%
Eris Life sciences 23% 59% 64.49%
Bajaj Consumer 28% 133% 57.66%
Abbot India 24% 63% 56.31%
Marico 34% 95% 52.99%
Nifty 49.14%
Petronet LNG 24% 45% 28.24%
Hindustan Unilever 82% 26% 17.07%
HDFC AMC 31% 21% 14.22%
Data Source: NSE

We have selected 13 companies that fit the 20/20 rule and juxtaposed the returns on these companies from the lows March 2020. We have avoided outlier stocks where the ROE and growth may not be representative due to specific factors. If you look at the list above, 10 out of these 13 companies have managed to beat the Nifty returns. Companies that adhere to the 20/20 rule have done substantially better than the Nifty with only 3 companies giving lower returns than the Nifty.

What is the link between the 20/20 rule and outperformance?

This is the most commonsense based rule that you can think off. After all, what do businesses exist for? They do exist for two reasons; growth and shareholder returns. Growth encompasses a number of attributes like volume growth, better pricing, aggressive marketing, product innovations, handling competition, lateral markets etc. High ROE shows that the profits that are being ploughed back are put to good use and the company is not guzzling capital. The 20/20 ruleis the simplest and most elegant combination of internal and external strength of any business. That is surely the place to start your investment journey!

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