17th Annual Wealth Creation Study Key Highlights

www.motilaloswal.com17th Annual Wealth Creation Study
Economic Moat
By Raamdeo Agrawal
12 December 2012
17th Annual Wealth Creation Study
2007-2012

www.motilaloswal.com17th Annual Wealth Creation Study 2
Discussion Points
• 17th Wealth Creation Study Findings
• Theme 2013:
Fountainhead of Wealth Creation
• Market Outlook
• Conclusions

Wealth Creation 2007-12
Study Findings

Concept of Wealth Creation
The process by which a company enhances market value
of the capital entrusted to it by its shareholders
Net Wealth Created
Change in Market Cap over the study period (2007-12),
adjusted for corporate actions like dilutions
Study Methodology

Fastest Wealth Creators
The top 100 wealth creators are sorted by
fastest rise in their adjusted stock price
Most Consistent Wealth Creators
Based on no. of times a company appeared
in the last 10 studies
Study Methodology (contd)

Biggest Wealth Creators
Top 100 Wealth Creators subject to a new condition that
stock performance beats the benchmark (Sensex)
Who missed the bus because of the market outperformance filter
Study Methodology (contd)
Company
NWC
(Rs cr)
Price
CAGR
O N G C 40,863 4.0
Wipro 26,602 5.6
I O C L 15,839 5.6
NTPC 10,678 1.7
Company
NWC
(Rs cr)
Price
CAGR
Hindalco 8,838 1.8
B H E L 7,557 2.6
Cipla 5,463 5.3
Oracle Finl 4,594 4.7
NOTE: 5-time topper Reliance Industries did not make it on both counts –
absolute wealth created and market outperformance

Rank,
Company
NWC
(Rs cr)
Price
CAGR
1. ITC 118,681 7
2. TCS 108,186 7
3. HDFC Bank 74,425 5
4. MMTC 67,110 4
5. H D F C 55,793 3
Rank,
Company
NWC
(Rs cr)
Price
CAGR
6. SBI 55,595 3
7. Infosys 51,573 3
8. Tata Motors 49,946 3
9. Hind Unilever 45,746 3
10. Jindal Steel 43,647 3
Top 10 Biggest Wealth Creators
ITC largest wealth creator for the first time ever, beating RIL
Total wealth created during 2007-12: Rs16+ lakh crores
HUL has made it to the top 10 after a long time

Rank,
Company
Mult.
(x)
Price
CAGR
1. TTK Prestige 24 89
2. LIC Housing 10 57
3. Coromandel Inter 9 54
4. Eicher Motors 8 52
5. IndusInd Bank 8 50
Rank,
Company
Mult.
(x)
Price
CAGR
6. MMTC 7 48
7. Jindal Steel 7 47
8. Bata India 6 41
9. Titan Inds 5 40
10. GSK Consumer 5 39
Top 10 Fastest Wealth Creators
TTK Prestige is the Top 10 fastest wealth creator
4 Consumer companies in Top 10 fastest wealth creators;
sector hitherto associated with steady growth seems to be
enjoying tailwind of India’s NTD era

Rank,
Company
WCS
(x)
Price
CAGR
1. Kotak Mahindra 10 48
2. Siemens 10 44
3. Sun Pharma 10 40
4. Asian Paints 10 35
5. HDFC Bank 10 31
Rank,
Company
WCS
(x)
Price
CAGR
6. Hero Motocorp 10 30
7. H D F C 10 29
8. ACC 10 29
9. Ambuja Cement 10 26
10. Infosys 10 21
Most Consistent Wealth Creators
Kotak Mahindra Most Consistent for 2nd year in a row
Holcim Group is getting its act together in India – both ACC and
Ambuja among Most Consistent Wealth Creators

Wealth Creators v/s Sensex
Wealth-creating companies’ financial and stock market
performance is above benchmark.
Mar-07 Mar-12 5-yr CAGR
BSE Sensex 13,072 17,404 6
Wealthex – re-based 13,072 32,884 20
Sensex EPS (Rs) 718 1,125 9
Sensex PE (x) 18 15
Wealthex EPS (Rs) 809 2,102 21
Wealthex PE (x) 16 16

Wealth Creation by Industry
Financials the biggest wealth creating sector for 2nd year in a
row. Absence of new banks has led to widespread profitability
and stock performance.
Consumer sector a very close second.
Industry
(No of cos.)
WC
(Rs cr)
2012
(%)
2007
(%)
Financials (21) 367,223 22 13
Consumer (21) 335,845 21 5
Metals / Mining (8) 209,492 13 9
Technology (3) 173,419 11 10
Auto (11) 163,007 10 6
Healthcare (11) 121,480 7 4
Industry
(No of cos.)
WC
(Rs cr)
2012
(%)
2007
(%)
Oil & Gas (7) 99,634 6 24
Cement (5) 66,842 4 3
Cap Goods(6) 60,902 4 10
Ultility (3) 23,549 1 2
Others (4) 16,629 1 15
Total 1,638,021 100 100

Wealth Creation by PAT growth
Markets can neither price hyper-growth or high quality growth,
resulting in huge wealth creation at a rapid pace.
Price CAGR (%)
2007-12 PAT growth range (%)

Wealth Creation by base RoE
High RoE alone does not guarantee superior Wealth Creation.
Profit growth is equally important. Economic Moat (or compe-
titive advantage) protects profits and ensures Wealth Creation.
Avg Price
CAGR: 20%

Wealth Creation & Valuation Metrics
Unlike most past studies, low P/E alone did not ensure high
speed of wealth creation during 2007-12.
PAT CAGR was a key determinant of Price CAGR.
P/E (x) No. of
Cos.
% Wealth
Created
Price
CAGR %
PAT
CAGR %
<10 18 17 20 18
10-15 21 18 22 24
15-20 19 10 21 20
20-25 13 18 25 24
25-30 13 28 16 21
>30 16 10 25 24
Total 100 100 20 21

P/B below 1x did deliver high returns, but returns from higher
P/B stocks were also comparable (except when P/B > 6)
P/B (x) No. of
Cos.
% Wealth
Created
Price
CAGR %
PAT
CAGR %
<1 6 6 25 28
1-2 20 12 20 19
2-3 10 7 24 21
3-4 11 13 20 20
4-5 13 14 22 24
5-6 11 14 26 21
>6 29 34 17 19
Total 100 100 20 21

Payback ratio (Mkt Cap / 5-years forward PAT) of less than
1x in 2007 did ensure superior wealth creation.
Also, again here, correlation of PAT and Price CAGR is high.
Economic Moats help sustain PAT and PAT growth.
Payback
Ratio (x)
No. of
Cos.
% Wealth
Created
Price
CAGR %
PAT
CAGR %
<1 19 14 26 25
1-2 37 33 23 24
2-3 26 29 20 15
>3 18 23 15 16
Total 100 100 20 21

Wealth Destruction
4 of top 10 wealth destroyers are telecoms.
Breach of Economic Moat causes massive wealth destruction.
Company Wealth Destroyed Price
Rs crores % Share CAGR (%)
Rel. Comm. 67,698 12 -28
Unitech 29,399 5 -32
Suzlon Energy 27,558 5 -34
Satyam Computer 24,948 4 -30
Bharti Airtel 16,918 3 -2
Bajaj Holdings 15,943 3 -20
S A I L 8,280 1 -4
Tech Mahindra 8,161 1 -13
M T N L 7,519 1 -29
Himachal Futuristic 7,367 1 -12
Total of Above 206,425 36
Total Wealth Destroyed 570,246 100

Theme Study

"(Great companies to invest are like) wonderful
castles, surrounded by deep, dangerous moats
where the leader inside is an honest and decent
person. Preferably, the castle gets its strength from the
genius inside; the moat is permanent and acts as a
powerful deterrent to those considering an attack; and
inside, the leader makes gold but doesn't keep it all for
himself. Roughly translated, we like great companies
with dominant positions, whose franchise is hard to
duplicate and has tremendous staying power or some
permanence to it.” – Warren Buffett
Moat Quote

 The concept of 'Economic Moat' has its
roots in the idea of a traditional moat
A moat is a deep, wide trench filled with water, that
surrounds the rampart of a castle or fortified place.
 An Economic Moat protects a company's
profits from being attacked by business
forces
Traditional management theory terms: "Sustainable
Competitive Advantage" or "Entry Barriers"
What is an Economic Moat?

 Without Economic Moat, competition from
rivals will ensure that high returns of a
company are lowered to the level of
economic cost of capital … or even below
What is happening in the Indian Telecom sector is a
classic example of this
Moat Quote
The dynamics of capitalism guarantee that competitors will
repeatedly assault any business "castle" that is earning high
returns … Business history is filled with "Roman Candles,"
companies whose moats proved illusory and were soon
crossed.” – Warren Buffett
Why Economic Moat?

 Economic Moat helps sustain superior
profitability multiple pulls and pressures
Companies do not compete only with rivals for profit,
but also with customers, suppliers, potential entrants
and substitute products
Why Economic Moat?
Porter's Five Forces of Industry
Economic Moat protects profits
being eroded by such forces

 Much like companies, equity investors too
chase high returns on their investments
In the long run, equity investors can only make as
much money and return as the company itself makes
 Investing in companies with Economic
Moats is the only way to enjoy a share of
their high profits and create wealth
Moat Quote
“A truly great business must have an enduring moat that
protects excellent returns on invested capital.” – Buffett
Economic Moat & investing

 Companies with "deep, dangerous moats“
outperform those without, both in terms of
financial performance and stock returns.
Markets worldwide are replete with examples similar
to cross-sector cases given below in India
1. Hero MotoCorp v/s TVS Motors
2. Bharti Airtel v/s Tata Teleservices
3. L&T v/s HCC
4. HDFC Bank v/s Central Bank
Economic Moat & investing

Hero MotoCorp v/s TVS Motors
The facts …
 Both started business around the same time in the 1980s
 Both were Indo-Japanese JVs –
Hero Group with Honda and
TVS Group with Suzuki
MOAT IMPACT:
 Hero MotoCorp: World’s
largest two-wheeler company
 TVS Motor: Struggling to retain
its hitherto No 3 spot in India

Bharti Airtel v/s Tata Teleservices
The facts …
 Both incorporated in 1995 on the eve of India’s telecom
boom. In fact, Tata Tele had the rich Tata legacy
 Both journeyed India’s wireless
explosion – massive value
migration from wired telephony.
MOAT IMPACT:
 Bharti: India’s No1 telecom co
with global aspirations
 Tata Tele: Yet to report a
single quarter of profit

L&T v/s HCC
The facts …
 Both long standing construction players in India. In fact,
HCC was incorporated in 1926, earlier than L&T (1946)
 Both have benefited from
India’s exponential growth in
infra, construction, real estate
MOAT IMPACT:
 L&T: Arguably India’s answer
to General Electric
 HCC: Struggling to make profit
plus issues like BOTs, Lavasa

HDFC Bank v/s Central Bank
The facts …
 Central Bank has recently completed 100 years. HDFC
Bank, in contrast, is less than 20 years old.
 Central Bank’s has 60% more
branches than HDFC Bank
(4,000+ v/s 2,500)
MOAT IMPACT:
 HDFC Bank: FY12 PAT 10x of
Central Bank, Mkt Cap 24x
 Central Bank: Lagging on most
metrics – NPA, RoE, RoTA, etc

1. INDUSTRY STRUCTURE
Interplay of Buyer power, Supplier Power, Threat of
new entrants/substitutes, etc
2. COMPANY STRATEGY
5 elements – (1) Distinct value proposition
(2) Tailored value chain (3) Trade-offs (4) Fit
(5) Continuity over time
Economic Moat: Two factors
Moat Quote
“Why are some companies more profitable than others? … First, companies
benefit from (or are hurt by) the structure of their industry. Second, a company’s
relative position within its industry can account for even more of the difference.”
– Joan Magretta, in her book Understanding Porter

1. The Economic Moat hypothesis
Investing in a portfolio of EMCs (Economic Moat
Companies) should lead to sustained outperformance
over benchmark indices across years, irrespective of
market conditions.
2. Backtesting the hypothesis
Step 1: The backtesting framework
1. Arrive at a list of EMCs as on March 2002 and
invest in them
2. Monitor price performance from March 2002 to
March 2012
Economic Moat:
Applying in equity investing

Backtesting the Economic Moat hypothesis (contd)
Step 2: Deciding Economic Moat criteria
2A. The principles:
1. Economic Moat ultimately reflects in financials, with
RoI significantly superior to peers
2. Competitive advantage is relevant only within sectors
2B. The practice:
1. For each of the last 8 years, calculate for all sectors
RoE of companies and sector average RoE
2. A company is an EMC if for at least 6 years, its RoE
exceeds industry average
3. Discretionary adjustment to the final list based on
then known facts and figures
Economic Moat:

Step 3: The findings
#1 – EMCs handsomely outperform
#2 – EMCs’ outperformance is earnings and valuations
agnostic
#3 – EMCs’ outperformance is sector agnostic
#4 – Future not too meaningful for EMCs,
but critical for non-EMCs
Economic Moat:

Finding #1: EMCs handsomely outperform
 Over 2003-12, overall return of 177 companies was 18%
 EMCs returned 25% whereas non-EMCs returned 12%
 Sensex return was 18%, implying 7% Alpha for EMCs and
negative 6% Alpha for non-EMCs
Economic Moat:
EMCs Non-EMCs Overall
Return 25% 12% 18%
Sensex 18% 18% 18%
Alpha +7% -6% 0%
2003-12 Avg Price CAGR (%)

Finding #1: EMCs handsomely outperform (contd)
 Besides point-to-point outperformance, EMCs outperformed
the Sensex in every year over the 10 years
 Also, after 3 years, EMCs outperformed even non-EMCs
Economic Moat:
Payoff
profile

Finding #2: EMCs’ outperformance is earnings and
valuations agnostic
The most plausible explanation for this:
 Earnings agnosticism
EMCs’ strong competitive advantage which ensures that
they enjoy a more-than-fair share of the growth inherent
in most sectors in India
 Valuation agnosticism
Continuous rollover of EMCs’ competitive
advantage period (CAP)
Economic Moat:

Explaining EMCs’ valuation agnosticism: CAP
 Competitive advantage period (CAP) is the time
during which a company is expected to generate returns
on incremental investment that exceed its cost of capital.
 Markets do assign premium valuations to EMCs,
given their reasonably accurate assessment that such
companies enjoy a very long CAP.
 Where the markets fail is in recognizing that barring a
low mortality rate of less than 15%, EMCs leverage their
moat and sustain high return even with passage of time.
 The CAP of EMCs simply rolls over with each passing
year, creating incremental excess return for investors.
Economic Moat:

CAP rollover plausibly explains EMCs’ valuation agnosticism
Economic Moat:
Return=WACC
CAP in Year 0 CAP rolls over by 1 year

Finding #3: EMCs’ outperformance is sector agnostic
 EMCs are likely to outperform benchmarks across sectors,
even if the sector itself is out of market favor.
 Thus, out of our 22 homogenous sector groupings, EMCs
underperformed the Sensex in only two sectors – Oil
Refining and Textiles.
Economic Moat:

Economic Moat:
Finding #4: Future not too meaningful for EMCs, critical for non-EMCs
 Mortality rate of EMCs is likely to be low. By 2012 only 11 of 74 turned into
non-EMCs (mortality<15%). But even these companies beat the Sensex
 EMCs which remained so did not do much better than initial performance
 Non-EMCs who upgraded into EMCs delivered the highest return at 27%,
albeit with a mortality rate of 75%
 Worse of all, non-EMCs which remained so delivered only 8% return.
Payoff Matrix
2003-12 Yes 27% 26%
EMCs No 8% 20%
No Yes
1995-02 EMCs2003-12 Sensex return was 18%

Economic Moat:
Applying the methodology to Nifty constituents in year 2002
We applied our backtesting methodology to 38 constituents of Nifty in 2002.
The results were similar to that of the broader universe –
 EMCs outperform both non-EMCs and overall Nifty
 Non-EMCs underperform Nifty
 EMCs which maintain status quo do not report materially high returns
 But non-EMCs which upgrade to EMCs deliver high returns
 Non-EMCs which stay so perform the worst
Stock returns on 2002 Nifty
Price CAGR No. of cos.
EMC 22% 29
Non-EMC 16% 9
Nifty payoff matrix
2003-12 Yes 21% 22%
EMCs No 4% 14%
No Yes
1995-02 EMCs
38 stocks return: 20%
Nifty return: 16%

Applying the methodology to current Nifty
We have bifurcated current Nifty stocks into EMCs and non-
EMCs using the backtesting methodology –
1. Company and sector average RoE data 2005 to 2012, and
2. In some cases, discretion based on currently known
information and subjective opinion
Prognosis based on past experience
1. In our view, there are 27 EMCs and 23 non-EMCs in the
current Nifty
2. Expect EMC basket to outperform non-EMCs and Nifty itself
3. Expect about 6 non-EMCs (25% of 23) to upgrade to EMCs
and deliver handsome returns
4. Non-EMCs which maintain status quo will eventually be
replaced in the Nifty
Economic Moat:

Nifty: The Economic Moat classification
Economic Moat:

Market Outlook
Seems poised for new highs

Corporate Profit to GDP should be around 5% for 2013
Market Outlook

Interest rates have softened to 8.2%; expect further fall
Market Outlook

Earnings Yield to Bond Yield at 0.9x is just below parity
Market Outlook

Sensex forward P/E is currently at 14.4x around LPA
Market Outlook

Sensex EPS is expected to grow 11% over FY12-14
Market Outlook

 Consumer sector has bounced back into wealth creation
ITC is the largest wealth creator, TTK Prestige the fastest, HUL back in top 10.
 Financials has emerged the largest wealth creating sector for the
second time in a row. Absence of new entrants is leading to widespread
profitability and stock performance.
 Economic Moat protects the profit and profitability of companies
from competitive attack.
 Extended CAP of EMCs drives superior profits and stock returns.
Over 2002-2012, EMCs in India have meaningfully outperformed benchmarks.
 Breach of Economic Moat causes massive wealth destruction.
The Telecom sector is a classis case.
 Markets seem poised to touch new highs in the next 12 months.
On the back of earnings growth of 10-11%, imminent moderation in interest
rate, and reasonable current valuation.
In Conclusion

Thank You !
&
Happy Investing In
Economic Moats

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