I have been investing in the stock markets for the past 8 years, mostly because the traditional investment instruments of the country ( India) namely the real estate, bank FD, and the Gold rarely interested me. To be honest, when you start working as a professional you don’t have much disposable income to invest in Gold and real estate. Both these asset classes are very expensive, to begin with, which left me with the option to invest in the equity markets only, Also because apart from real estate and Gold, investing in the money markets was not that easily accessible to retail inventors like nowadays. Based on my understanding of stocks and the hundreds of pages of literature I have read in my finance classes and some real-time experiences of failure and success in stocks and other asset classes following is my understanding.

Real Estate: Most people in the country are active investors in the real estate markets, they think that the money will eventually grow and returns are for granted, plus the volatility is very less. However, if look at the data the house prices to per capita GDP are highest in India, based on the figures ( 2014). Based on the below-mentioned data, it appears that housing markets will correct in the next few decades to come. Apart from the inflated prices in the chart, the transaction costs are very high, there are multiple taxes to be paid, and overall it’s a very grey industry to invest money in ( at least in India).

Gold: There are pre-conceived notions that gold is a safe hedge against the volatility of equities, but there are studies that show that there is a correlation between the gold prices and stocks in the long-term investments, therefore the entire hypothesis of the investors is gold is a haven doesn’t hold truth.

The Graph shows that in the long run(10 years or more) the prices of ounces of gold move more or less in the same way as the stocks index of the country. So, in the long run, even gold doesn’t provide the risk-free returns that investors expect in India.

That leaves us with the equities markets. Here also, there are parameters like whether to invest in growth stocks, value stocks, or small caps to find the next multi-bagger, etc etc. One of the major parameters which I had come across when it came to investing was the PE multiple. Whenever I or my friends used to discuss where to invest, PE multiple was the major criteria, we used to think if something is trending way above like 30x or above, those stocks should be avoided.

However, it is the Free Cash Flow to the firm (FCFF) which drives the stock prices and capital gains rather than the current price levels or the equities or the earnings per share metrics. Various drivers impact the FCFF, namely

FCFF->NOPAT- Capex-Change WC +non Cash expenses

1. Profits: Certain companies run on certain brand recall, no matter what the prices are, they will sell more, garner more revenues, and improve bottom lines. For instance , Apple , Unilever, P&G etc .
2. Improve working Capital cycles: As the world is moving towards Tech, ERP systems and CRM are being used by the companies to reduce account receivables using CRM systems and use Just in Time to increase inventory cycles. All this reduces the working capital cycles. Companies like Asian Paints, Page Industries, and Berger paints are prime examples of this.
3. Asset turnover: This leads to maximum productivity from your fixed assets, these are companies that derive maximum output by bringing their production in-house and having full control over their production processes. For instance Nestle or Toyota.

The crux of the above points is that the Price to FCFF ratio is a far more reliable metric to understand the growth of the stock price than the price-to-earning ratio (PE) because the earning, for one is or can be manipulated, secondly, earnings can’t predict equally higher cash flows to the firm.

Another myth with the Stock prices is that the higher the PE multiple the more you should stay away from the stock, however its not the way to look at firms, return on Capital employed or Return on Invested Capital (ROIC) has far more correlation than any other metrics people can think of.

To summarise, the free cash flow will be guaranteed consistently when the company has the pricing power, and is in a sector that is not cyclical or heavily regulated, has a high return on capital employed, and can reduce working capital cycles with improved asset turnover ratios to reduce capital expenditure.

Written By: Ankur Kushwaha, Consultant, Invest Punjab | Govt of Punjab