A lot has been made of the recent bull-run which followed the market capitulation in March 2020 due to the coronavirus pandemic. The tech based NASDAQ Index in the US is trading at all-time high levels, whereas the Dow Jones Industrial average 30 stock index is just 10% shy of its all-time high. In India too markets are on the rise, and it comes as a surprise to many seasoned investors. While the NIFTY is down about 13% from its all-time high levels (Jan 2020), different sectoral indices are at various levels, as on July 6th 2020. Please refer to the table below for a snapshot:
At its lowest, the NIFTY index hit a low of 7511.1 of March 23rd which translates to about a 40% decline from all time high level of 12430 on Jan 20, 2020. In contrast to the horrific low point, the present NIFTY levels of 10700-10800 seem to be at a great relief. Everything is at the end of the day relative. As seen from the above table however, the recovery is not broad based. There clearly are some leading sectors (pharma, IT, FMCG) and some laggards (metal, fin services, banks and realty).
From an investing perspective, this data is of little help as not every company within an outperforming sector has done well and not every company in a laggard sector is languishing. Our attempt in this article is not to look at whether stocks are valued correctly. Instead, we try to flesh out another way to analyse macro level stock data and make some inferences which can be useful to understand which companies the markets are rewarding and which ones are being punished.
In a recent video shared by Prof. Aswath Damodaran ( https://www.youtube.com/watch?v=215r6v4bfhQ ), he proposed that companies which are “flexible” have been investor favourites in these times. In his endeavour to validate his thought of “flexible stocks” he has gathered data from over 30,000 listed companies across the globe. It is a formidable effort to make sense of such a large amount of data and we highly recommend interested readers to watch the video. The professor defines 4 parameters of flexibility: Investment flexibility, operating flexibility, financing flexibility and cash flexibility. He tests all the companies on these 4 parameters, and collates them to find meaning and insights into investor behaviour. In this post, we see if the same applies to the 250 largest companies by market cap in India. We take the study one step ahead and assess the overall flexibility of firms as well. Finally, we share a list of the 10% most flexible companies we found in our study.
1. Investment Flexibility: measures how much you have to invest to achieve a given level of added sales. The more you have to spend and wait for a given growth, the less your investment flexibility is (think utilities, power, etc vs technology and services). The metric we use to measure this is the asset turnover ratio (ATR) which captures the revenue to capital assets of a company. A company with ATR of 3 would mean that for every 1 rupee of capital asset it adds, it can add 3 rupees to revenue. The higher the number, the higher the investment flexibility. Below are the results in decile format. 4th decile would mean that the company ranks between 30 and 40 percentile of all 250 companies, and the 10th decile would mean the 90% -100% ranks. Therefore, the 1st decile indicates the stocks with lowest investment flexibility and 10th decile represents the top 25 companies by investment flexibility. For each decile, we measure the average change in share price in 6 months. The results are indicated below.
From the table and chart, it is noted that the 5th decile has shown the highest positive change whereas the 1st to 3rd deciles have performed poorly. The top 5 deciles have in general performed better than the index as a whole. One thing is clear. The markets are punishing companies that have poor investment flexibility!
2. Operating Flexibility: measures how much a company’s operating income is affected by a given change in revenues. This boils down to measure the proportion of fixed costs that a company has to its total expenses. A company with higher proportion of fixed costs will face the rough side of the sand paper in times like a lockdown where revenues are hit. Higher fixed costs mean that regardless of sales, these fixed expenses have to be met. In comparison, a company that has higher proportion of variable costs will be impacted lesser if revenues fall, and hence have a high operating flexibility. There is a difficulty in measuring the ratio of fixed to variable costs, as financial statements don’t have an metric to clearly define this. As a proxy for lack of a better metric, operating margin (OPM) is used. The assumption here is that a company with high op margin is likely to have lower fixed costs, and hence higher operating flexibility. Check the results in the table below:
It is evident that operational flexibility based market preference is dominant. As in the case of investment flexibility, companies that are not operationally flexible have been beaten down by the market whereas operationally flexible ones have performed better than the index. Here the 1st to 3rd decile of companies (75 data points) correspond to companies with OPM of lesser then 12%. Clearly the companies with low operating flexibilities are out of favour whereas the ones with better OPMs are in vogue.
3. Financing Flexibility: measures for a given change in operating income, how much the net income changes. The net debt (debt – cash+ Cash equivalents) of a company will impact financial flexibility. The more the debt, the higher the interest expense and lower the net income. A good cash position despite high debt can help a company meet its interest expense, and hence net debt is considered. To standardise for all companies, we take a ratio of net debt and EBIT to measure financial flexibility. The lower this ratio is, the more the financing flexibility is. There are some companies who have negative net debt (as cash is greater than the debt making net debt negative) and this is a good thing as the ratio is negative (remember, lower is better in this case). There are some companies with negative EBIT margins, which also make the ratio negative, but this is clearly incorrect. In our study, we have separated 6 negative EBIT companies so that they don’t interfere with the statistics.
Here it is observed that companies in the bottom 3 deciles are severely punished by the markets. The notion that high net debt is bad for such times is factored in the way stocks are priced. However, it is observed that the 4th decile and upward have done quite well. This corresponds to net debt/EBIT of 2.2 or lower. So it is not that all debt is being punished. Companies with low financing flexibility have lagged whereas companies with moderate and high financing flexibilities have done better.
4. Cash Flexibility: measures how much cash you return to your shareholders for every change in net income. The idea here is that when net income reduces, free cash flows to equity reduce and hence space for paying dividends reduces too. If a company can afford to reduce dividend pay-outs when net incomes reduce, it can be said to have high cash flexibility. It always a plus if a company has cash in such times as it can not only meet its own needs but also look to make acquisitions of stressed assets at bargain prices. On the contrary, if the shareholders of the company expect high dividends regardless of net income, the company has low cash flexibility, which is not ideal in this market. To measure cash flexibility, we use dividend yields. For our statistic, we assume that companies with high cash flexibility have low dividend yields and vice versa. Refer to the table below:
The evidence is clear even in this case. Markets have rewarded companies that have low dividend yields and high dividend yielding companies are out of favour. The 5th decile and higher are companies which have a dividend yield of 1% or less. An anomaly here is that companies paying no dividends have not done as well so readers may take note of this.
Overall Flexibility: We took Prof. Damodaran’s concept a step further and ranked the companies by how they cumulatively fared in all the flexibility aspects i.e. Investment Flexibility, Operating flexibility, financing flexibility and cash flexibility by creating our own ranking system. In this system, each of the 4 flexibility metrics are given equal weights and a net score is calculated. Based on the net score, we have ranked the 250 companies in order of their overall flexibility.
Here are the results.
The results are for you to see. The data clearly reveals that flexible stocks have outperformed stocks which are not. Investors would do well to review their portfolio of stocks and see whether their stocks are flexible and can survive difficult markets.
If you think about it, this simple flow of finding flexibility makes a lot of sense. In a difficult market, would you choose a company that can increase revenues quickly without too much capital expense over one that requires a large capex and time? Off course you would and hence you favour investing flexibility. Would you prefer a company with a smaller proportion of fixed cost to total cost? Yes, and that is simply what we term operational flexibility. High Debt in such times is always an unwanted liability and hence investors prefer companies which have financing flexibility. And finally, cash flexibility makes sense as the ability to have surplus cash by curtailing dividend payments is good in such trying times. In simple terms, flexibility should be rewarded and markets have broadly done that!
Besides revealing a lot about investor psyche, we feel that such a study can also be useful in identifying cheaply valued stocks which are flexible! There is a good chance that such companies will do well if the markets continue to sustain their bull run. So is your portfolio flexible enough? Below is a list of the top 25 most flexible stocks as found from our analysis.
Disclaimer: Please do not treat this post as a piece of investment advice. It was written purely from an educational perspective.