Why growth without RoE is a risky bet for investors, Harini Dedhia explains

Most investors pose the question of quality vs. growth and boil it down to Return on Equity (ROE) vs. growth. Thinking of these two as mutually exclusive numbers should be done at one’s own peril. The sustainable ROE of a business also denotes the upper limit to the sustainable growth rate for a company. Assuming fair valuation, it essentially denotes the upper limit to the long-term stock price performance for the company, which is inextricably linked to long-term earnings growth. 

 

Earning a 20 per cent ROE implies a generation of 20 per cent return on the shareholder net worth of the company. Assuming no dividends are paid, this is the capital available to reinvest. As mathematical logic dictates, it would generate the same rate of growth on topline, assuming sourcing of demand is not a challenge for the company. 

 

A company that speaks of 30-40 per cent growth excites us all. The first question to ask, though, is what is the sustainable ROE of this business? A growth rate above ROE comes at the cost of the balance sheet; i.e., either by raising more debt or diluting equity. The question to ask then remains: does the company’s balance sheet have the strength to support this growth and for how long?

 

No business illustrates this better than the retail sector, where growing faster than ROEs has resulted in the collapse of the largest companies in the sector. 

 

The question arises then: Why does retail tend to overpromise on growth? Simply put, because it is easy to do so. The capital cost to set up a retail outlet on rent is not very high. So the temptation to chase growth is high. However, accidents are the highest in retail because of this very reason of forgetting the mathematical connection between growth and ROE. 

 

Typically, an organisation in an aggressive growth phase loses sight of operating excellence at its retail assets. Operating margins are thin in any retail setup. Moreover, all operating expenses are fixed in nature: employee, rent, and utilities. There is very little headroom to maneuver on the cost structure once the store is operational. Once stretched on P&L, working capital gets strained, which increases the reliance on the balance sheet even more. Now, in addition to balance sheet funding capex, it is required to fund opex as well. At some point, liquidity dries up as the ability to raise money on the balance sheet goes away, and the company goes through a brutal death. 

 

Let’s take the case for the father of modern retail in India: 

Financial parameters

 

                           Five years preceding its death, the business looked like one with a lot of promise for growth. In fact, year 3 had a record high ROE of 18 per cent (not a sustainable ROE, though). A closer look revealed a P&L propped up by a lot of aggressive sales and therefore receivables (a strange phenomenon in a retail business in hindsight). The year of propped-up ROE was also one of negative cash flow from operations. 

 

Growth higher than ROE needed more cash to fund incremental growth. That required equity capital to be raised eventually, which resulted in an aggressive sales push to pull up profit numbers for the year. Alas, COVID-19 got in their way, and by the time money came in, it was too late to salvage the situation. A debt-free company collected ₹4000 crore of debt along the way, and an additional ₹4000 crore of working capital debt. With a business not making any cash profits, the rooster had come home to roost. 

 

India’s largest discount retailer at the time also met with a similar fate in 2009. 1600 stores to zero in one year. Two poster boys of the industry, both met with a similar fate. Today, when we see companies growing at 50-60 per cent with significantly lower ROEs, a question we must ask: till what point are we investors willing to fund this growth? And how much time, after the funding dries up, does the company have to recalibrate? Businesses with high fixed costs and wafer-thin margins will die faster in that case, as cash burn rates would be significantly higher. 

 

(Disclaimer: This article is by Harini Dedhia, head of research, Tamohra Investment Managers. Views are her own.)