Dividends vs Development: Why Pharma outpaced IT; Harini Dedhia explains

IT companies on an average returned 85% of profits to shareholders via dividends or buybacks, with less than 15% reinvested in capacities and capabilities; the case is almost inverse for pharma firms.

The most sustainable form of compounding is one that's based on reinvestment compounders. Nothing exemplifies this better than the divergent tale of two of India’s largest exports- IT and Pharmaceuticals.  Some may argue that we are making a claim of divergent performance at the worst possible time, i.e. cherry picking. It is however important to understand the fundamental genesis of IT index’s underperformance vs. pharma index in the past 5 years when both have seen the tailwind of a weakening rupee.  The five year CAGR for Nifty IT is -0.85 per cent vs. 12.4 per cent for Nifty Pharma. The cause is however older. When understanding how these companies have deployed cash, one sector has focused on returning cash to shareholders via dividends and buybacks and the other has focused on creating capabilities (via R&D expenses) and capacities (via capital expenditure) and therefore enhanced shareholder value in that manner. 

 

  IT companies on an average have seen 85 per cent of profits generated being returned to shareholders via dividends or buybacks. Less than 15 per cent was reinvested in capacities and capabilities. Of this too, only 1.9 per cent of profits on an average since FY18 were reinvested in R&D. The ratio is almost inverse for pharma companies. 

  Since FY16, 26.5 per cent of profits have been returned to shareholders via dividends or buybacks. A whopping 105 per cent has been reinvested in the future earnings potential of the company. What is staggering is that even within this 105 per cent, close to 40 per cent of profits have been invested in R&D alone.  The difference in stock price CAGR over the past 5Y is partially also because of the difference in earnings CAGR for both the sectors. PAT for Nifty Pharma compounded at 11.2 per cent bolstered by the reinvestments in respective businesses. Nifty IT on the other hand saw a 5Y PAT compounding of 8.5 per cent.  Reinvestment has not simply resulted in a higher PAT CAGR but an accelerating PAT CAGR resulting in 3Y CAGR to be better than 5Y and 5Y to be better than 10Y for Pharma.   

This acceleration in growth of profits showcases an improved reinvestment in future capabilities of the companies in pharma. IT companies on the other hand seem to have missed the bus on reinvestment in profits.  The onset of genAI simply brought the lack of reinvestments by IT companies to the fore. It could very well force their hand to act upon this creating some positive feedback loop eventually in the future.  Reinvestment takes time to yield results, but when done systematically creates a positive feedback loop within compounding itself that helps sustain the compounding of earnings and therefore of stock prices.  (Disclaimer: This article is by Harini Dedhia, head of research, Tamohra Investment Managers. Views are her own.)