Diwali Picks: 3 Unique Stocks to Watch 

Hello everyone, Rahul Shah here, trying to make investing accessible and profitable for the average investor.

If given a choice, would you like to invest in a company that generates an ROE or the return on equity of 20% or the one that generates an ROE of 10%?

Well, if everything else is constant, then it will certainly make sense to invest in the 20% ROE stock, isn't it?

After all, no one in his right mind would invest money at 10% when a 20% return is there for the taking.

There's one more reason investors prefer the 20% ROE company.

A high ROE company not only meets your growth needs but also makes excess cash available to be distributed back to the shareholders in the form of dividends.

Let me help explain with an example.

Say, both the companies with 10% and 20% ROE, need Rs 10 for investing in plant and machinery and working capital. The 10% ROE company will have to use up its entire profits of Rs 10 to fund this investment.

The 20% ROE company on the other hand, will still have an excess cash of Rs 10 after funding the investment in plant and machinery and working capital. Remember, this company generates Rs 20 on every Rs 100 of equity and hence, it will use up only half its profits for funding fresh investments in the company.

The other half i.e. Rs 10 is still available with the company to perhaps give back to shareholders in the form of dividends.

Hence, it is always better to buy a high ROE company over the one with a low ROE if everything else is constant.

Well, armed with this knowledge, most investors enter the stock market and start looking for high ROE stocks. They completely ignore the ones with low ROEs, calling them bad quality companies.

Investing in a high-quality stock is a very good idea. Even I whole heartedly recommend the same. However, there is a catch here.

One needs to avoid a big mistake while trying to invest in high quality stocks.

And this mistake is the inability to differentiate between a 'temporarily' high ROE and a 'persistently' high ROE.

Hmm....... temporarily high ROE vs persistently high ROE? Allow me to explain.

You see, the place where I stay, there was only one medical store in the vicinity few years ago.

And it used to do very good business.

I always faced a lot of rush at the counter, and it used to take me 10-15 minutes to buy my medicines. In other words, this medical store was easily a high ROE business.

The medical shop's prosperity lasted for only a short period though.

As the news spread that this medical shop is making a lot of money, new medical shops started opening and soon, there were 4-5 medical shops in the same neighbourhood.

Consequently, the business of the first medical shop suffered and its profits fell drastically. In other words, a high ROE business now became a low ROE one.

Well, something similar happens in the business world as well.

A lot of companies enjoy 2-3 years of high ROE because of absence of competition or some other short-term advantage.

But when competition enters or these advantages go away, they become a low ROE business.

There are very few companies that are able to earn persistently high ROEs. Majority of the companies where ROE is high, the phenomenon is temporary.

After 2-3 years, the high ROE usually comes down, thus spoiling the plans of investors who thought they are investing in a high ROE stock.

I believe this is where most investors lose money or underperform the market. They pay premium valuations to stocks thinking that these are high ROE companies.

But when the reality strikes and the high ROE turns out to be 'temporary' in nature, the stock price is negatively impacted. In fact, one can suffer a huge loss if the premium paid is very high.

Michael Mauboussin, a famous strategist, has done very interesting research around this. Mauboussin took 1,000 companies and tracked them between the years 2000 and 2010.

He put the top 200 companies with the highest ROE in the first bucket, next 200 companies in the second bucket and so on. The last bucket had the companies with the lowest ROEs.

Do you know what happened after a few years? Well, the ROEs of all the five buckets nearly converged.

Highest ROE companies saw their ROEs fall while lowest ROE companies saw their ROEs rise.

This is a strong proof that most companies have temporarily high ROEs. There are very few companies that can keep their ROEs persistently higher. A period of high ROEs will be followed by a period of low ROEs and vice versa.

Thus, looking for stocks with high ROEs is a bad idea in my view. Because most high ROE stocks go on to lower their ROEs. There are very few companies that can sustain persistently high ROEs.

You may need a lot of skill and judgement for separating stocks where ROEs are temporarily high versus those where they are persistently high.

I can give you another idea. Instead of trying to find companies where ROEs can be persistently higher, why not invest in stocks where ROEs are temporarily low but can go higher in the coming years.

Because just as high ROE companies see their ROEs fall after a few years, low ROE companies see their ROEs go up in the same period. This was quite clearly highlighted in the Michael Mauboussin study as well.

Hence, looking for stocks where the ROEs are low but can go up can prove to be a very rewarding exercise. It could allow you to earn handsome returns as you would be buying such stocks at depressed valuations because of its low ROE.

However, once ROE improves, the stock can get re-rated and there could be huge gains for the taking. You may even end up with a few multibaggers.

So, are there any such stocks in the current market where the ROEs are low but are expected to go higher?

Well, I have done the hard work for you and shortlisted 3 such stocks. 3 stocks which can turn their ROEs around and thus, create good wealth over the next 1-2 years.

This is our Diwali gift to you for your constant support and encouragement.

Take a good look at these stocks so that you can keep them on your watchlist.

The first stock that should be on your watchlist is Apex Frozen Foods Ltd. Our calculations suggest that the company's ROE had crashed to just 3% in FY24 due to a huge fall in profits. However, its average 10-year ROE stands at an impressive 20%.

So, here's a stock that has the potential to go from 3% to 20%, a jump of almost 7x. If that happens, the stock price could see some good appreciation.

The company processes and exports shrimps, mainly the Vannamei variety.

The promoters' experience of over three decades in the seafood business and healthy relationship with suppliers and customers should continue to support the business. The company's ROE had crashed in FY24 owing to muted demand and lower realisations in the key market of the US.

However, as demand picks up and as realisations also improve, the ROE should start going upwards.

Besides, the company is also awaiting regulatory approvals for selling its ready to eat products in the EU market, which should also boost topline.

The company's balance sheet is strong with very little debt.

It is self-sufficient in terms of cash also as all the capital investments over the last 10 years were made through internal cash accruals and very little reliance on external debt.

Thus, Apex Frozen Foods makes for an interesting ROE play.

The second stock you can keep on watchlist is Heranba Industries Ltd, whose ROE had crashed to just 8% in FY24 against its long term average of impressive 26%. Thus, if Heranba Industries manages to go back to its average ROEs, the stock price could receive a significant boost.

Heranba Industries manufactures formulations and active ingredients for insecticides, fungicides and herbicides at its 3 units in Vapi, Gujarat.

The company's performance suffered in FY24 due to decline in demand in the international market. However, it is expected to gradually improve going forward.

The company's balance sheet is strong with debt being just 20% of its equity and its cash flows have also been robust historically. Agrochemicals has great potential, both domestically and internationally and Heranba being one of the prominent players, will certainly stand to benefit.

So, Heranba Industries is the second stock you can keep on your watchlist.

Now, the third stock that can be on your watchlist is Supriya Lifesciences Ltd. The company's long term average ROE is 32% which had come down to 16% in FY24.

So, can the ROE go back to 32% in the near term and give a fillip to its stock price? There is a good possibility that it can.

Supriya Lifesciences Ltd manufactures and exports APIs.

The company has its own R&D unit at the manufacturing site. Supriya Lifesciences' product portfolio includes around 38 API products that address remedies in therapeutic segments like antihistamine, analgesic, vitamin, anaesthetics and anti-asthmatics, among others. The company has a global footprint across 86 countries.

The company is almost debt free and has regularly paid dividends over the last few years.

It has ambitious expansion plans lined up with capacity enhancement by 50%, plus has also initiated discussions with various companies ranging from pharma to innovator companies to work as a partner for supplying products as per their needs.

All in all, the stock does look like a good stock to have on your low to high ROE watchlist.

So, that was the list of 3 stocks where ROE seems to have seen a temporary fall and has a good chance of going up again. Most investors have this habit of extrapolation where they extrapolate both high ROEs and low ROEs well into the future.

But the reality in the business world is totally different. High ROEs usually come down to a low ROE and low ROEs usually go up to high ROEs provided the business is of good quality and has achieved high ROEs before.

Therefore, investing in a good quality low ROE stock might be a good idea and the three stocks I mentioned may be a good place to start.

So, that's all from me today.

Here's wishing you and your loved ones a happy and a prosperous Diwali.

Take care.