Musings with Analyst – November, 2022
Understanding Growth Score
Most seasoned investors have a specific investment style. Investment style refers to the style / philosophy followed when selecting stocks for the portfolio. Aspects like risk preference, investment orientation, degree of intervention required etc shapes investment style. A basic distinction in investment style is growth vs value investing.
Let’s first get value investing out of the way. Value investing refers to buying stocks of quality companies that are trading significantly below their real worth to earn higher returns.
Growth investing focuses on capital appreciation. Growth investors invest in companies that are yet to reach their full potential. Such companies have the potential to grow at a faster rate than the market average. Growth companies typically do not pay dividends and reinvest the earnings. An obvious form of growth investing is to buy into smallcap companies that have been growing at a fast pace and expecting the growth rate to continue in the future.
There is no consistent definition of how to measure growth. Investors use one or a combination of the following metrics to shortlist growth companies : historical earnings growth, projected earnings growth, historical revenue growth, projected revenue growth, stock performance etc.
The Windmill Capital team, after intense research, created a proprietary growth score. The score uses a combination of earnings per share and total revenue metrics to measure historical growth rate.
Based on the growth score, companies are classified into different quartiles. Companies in quartile 1 (Q1) have the highest growth score, indicating high growth rate, and so on. The chart below displays the quartile wise break up growth score across different GICS sectors.
Companies in the materials sector have been growing at a fast pace over the last 5 years. At ~42%, the sector has the highest proportion of Q1 companies. The materials sector includes companies from sub-sectors such as chemicals, construction materials, containers & packing, metals & mining etc.
Within the materials sector, metals and mining companies have been the stand-out performers. Improved spending towards infra projects, demand from realty, power and cement industries and a favorable policy environment with the launch of the National Steel Policy have all been driving the growth of the sector.
Chemical companies have also recorded good growth recently. With the rise in demand from end-user industries such as food processing, personal care and home care, China plus one strategy, policy support via 100% FDI under the automatic route and setting up of exclusive Petroleum, chemicals and petrochemicals investment regions have all been driving the growth of the sector.
Communication services consist of sub-sectors such as advertising, broadcasting, movies & entertainment, publishing, telecommunication services etc. 33.3% of companies operating in the Communication Services sector are in Q1. Surprisingly, ~46% of the companies are in Q4 as well. The growth issues in this sector need to be studied at a company level. Companies like Affle India, Nazara Technologies, TV18 Broadcast and Network18 Media have recorded significant topline and earnings growth during the period under study. On the other hand, companies like PVR, Inox Leisure, Bharti Airtel and Vodafone have recorded poor growth due to specific issues such as covid lockdown and industry dynamics.
The real estate sector has the worst growth score profile; 72% of the companies operating in the sector are in Q4. While the long-term prospects of the sector remain strong, events like demonetisation in 2016, Infrastructure Leasing and Financial Services crisis hit in September 2018 and covid related lockdowns in 2020 have significantly impacted the historical growth of the sector.
Growth score analysis has been incorporated in creating and rebalancing smallcases. Comparing the growth score of companies from the same sector helps shortlist entities that have displayed higher historical growth due to factors like efficient management, superior capital allocation techniques etc. The growth score in conjunction with the quality score, discussed in our previous newsletter, helps choose above-average growth companies devoid of any signs of financial distress.