Tuesday, 1 October 2013

Reflective Thinking: Few insights during dormant period

I must admit my failure of not living up to the repeated statements/comments made on this blog that I will start writing posts after a small hiatus. Even though, it was difficult to get enough mind space and time to crystalize my thoughts on any new ideas that periodically crossed my mind, I should have overcome these excuses to live up to the commitment made by me. But as it is said it is better late than never! 

Even though, during past few months, I have remained a passive investor, I have tried to keep track of how the dynamics of the businesses that I part own in my portfolio have changed. As I was spending 2 hours every day on travel, I have utilized this travel time to gain better insights into evolution of Buffet-Munger investing philosophy and  the importance of moving up the value chain by moving from "bargain hunting" to owning superior businesses. As I gained better insights into how and why Buffet has moved from buying "cigar butts" to purchase of "great businesses" by paying up fair price, I started evaluating the performance of my portfolio over last few years and why some of the companies have fared better and are likely to demonstrate superior performance going forward as well. I have drawn some inferences (which may turn into conclusions, after a while if validated consistently for a larger sample size!) which I am putting up for discussion.

Pricing power is extremely important for value creation:
Even though, this may sound like a foregone conclusion where there can not be two opinions, I have ended up buying into companies where I have shown utter neglect for this key attribute of the business. As a result of this, many of these companies which lacked pricing power, when started facing headwinds in terms of tapering demand , rising raw material costs or declining commodity prices, their performance started to falter. In other words, when tides went out, it became clear who was swimming naked! A case in point: Gujarat Reclaim Rubber (GRP). An excellent company with consistent track record and run by capable and ethical management . Even though  the world fell into deep recession post 2008, company was still able to grow its top line at more than 15% CAGR. However. price realization for GRP's product remained almost constant while there was significant increase in the operating cost of the company due to rise in power cost and marginally higher RM prices. Thus, in spite of selling the same volume of reclaimed rubber, company's net profit declined by 15% in last 5 years! On the other hand Amara raja batteries was able to successfully weather the storm of depreciating rupee and increasing raw material prices (over last decade, lead prices have increased four fold!). Amara Raja batteries' top line grew at roughly 15% CAGR but its bottom line grew at almost twice the rate!  This attribute is clearly reflected in the value creation done by these companies in last five years. GRP's market cap increased by 138% in last 5 years while that of ARBL increased by 726%!

Opportunity size can make a big difference in potential for value creation over a long period of time:

Another hypothesis that I want to put forward is: opportunity size can be second big differentiator in value creation potential of the company over a long period of time. The basic premise of the hypothesis is that in order to ensure consistent growth over long period, the business should have enough room to grow over a long horizon. Now,  large opportunity size is not only function of current market size, but expected growth in market size over a period of time and shifting preferences from alternative products. Thus, if a business is operating in benign competitive environment(duopoly/oligopoly) and caters to a growing market size, its earning will have higher predictability hence lower risk. This does not mean that companies having niche market/products addressing specific needs of the customer/market will not create value. However businesses catering to market having large and expanding opportunity can be good places to look out for 50 bagger in next 20 years! Hence, the odds are in favour of a battery manufacturer (Amara Raja) or sanitary ware company (Cera) to sustain earning growth over next 10 years as compared to earning growth of a engineering company selling vacuum system (Mazda) or business making fluid couplings (Fluidomat) (Note: I have given example of these companies to drive the point while I have investment in both these companies currently!).

Asset heavy businesses have odds stacked against them to create large value over a period of time:

Most of us know that while analyzing the business, Warren Buffet (and many other investors) focus on return on equity rather than earning per share. It will be factually more correct to say that these great investors focus on the ROE generated on incremental equity deployed in the business. A great business will generate high return on equity consistently over a long period of time. However, my hypothesis is that quality of ROE is key determinant for sustaining high ROE. To put it simply, ROE is product of asset turnover, profit margin and leverage:

ROE = (Sales/Total Assets)* (Profit/Sales) * (Assets/Equity)

Let's take two businesses A and B. Business A and B both have target of generating ROE of 25% and both of them maintain debt at 30% of assets giving Assets/Equity of 1.42. Now business A generates revenue of 100 Rs. for 100 Rs. of assets created giving asset turnover of 1 while business B generates Rs. 300 revenue for Rs. 100 assets giving an asset turnover of 3. This means that company A has to generate 17-18% profit margins to achieve target ROE while company B an get 25% ROE with 6% margins! Now unless company A is a monopoly with extremely high pricing power, maintaining 17-18% margin over a long term is not sustainable. Thus, eventually, the only way for company to achieve target ROE is to increase the leverage. Thus odds are stacked against company A to maintain leverage at current level over long period of time. 

Businesses operating on asset light business models, over a long period of time,  generate substantial free cash flow  which may be distributed to the shareholders in terms of dividends or may be utilized by management to buy back shares. Thus, even market, assigns higher valuation to companies having high ROE combined with asset light business model than companies having high ROE but low asset turnover! 

It is extremely important to highlight here that, only one of these attributes without looking at the other two can be very damaging.  Hence, one should look for businesses which demonstrates all these three attributes. It is also apt to mention here that some of the conventional checks on consistency of past performance and track record, management integrity and capability should obviously be done before reaching any conclusions. Even though, one may not encounter many such businesses with these three attributes, I believe there are enough if one ardently looks for them. 

Last but not the least, as Charlie Munger puts it, no matter how great any business is, it is not worth the infinite price! So, after we come across such businesses, it is equally important to get a stake in that business at reasonable price ensuring margin of safety! Hence, no matter how good the quality of business is, I personally avoid buying a business trading at P/E of 40 (yes, I admit that I have made a mistake of omission, but I am comfortable living with it!) because two golden rules of Warren Buffet  still serve as guiding lights to me: the first rule is don't lose money and the second rule is never forget the first rule. 

19 comments:

  1. Glad to see your post.. Posting this even before reading the complete post..:)

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    1. I am equally glad to be back and posting! hopefully, this will not die down..

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  2. Dhwanil,

    I great article after a long hiatus. Saw you back on valuepickr and just came to check your blog and there you were with fantastic insight. Looking forward to more from you.

    Tony

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    1. Thanks Tony for the compliments. I intend to be more active henceforth, so look forward to more interactions.:-)

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  3. Hi, I have come across your blog last year, found interesting and tracking since then. Good to see you back !!. You portfolio has mostly small companies. Just out of curiosity.. do you always search for hidden jems :-) ..appreciate if you can publish your current portfolio like you did last year around same time... Vishnu.

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    1. Hi Vishnu,

      Thanks for posting comments and hopefully will be more active in 2014. On your questions on my portfolio consisting of mostly small companies, let me tell you it is not by design and the perception is not entirely true also. Yes, I do not have any blue chip in my portfolio, but that is for a reason. When I look for investment opportunities I look for "mispriced bets" in the market where odds of winning are in my favour. It is more likely that one can find such companies in 100-1000 crore market cap than companies having 40-50,000 crore market cap. Though, I have realized that for some great businesses, even if one pays a fair value, one can still make money over long term. So, I am indulging in a small way to test out this investment style as well So may be Page/Pidilite/Asian paints will form a very small proportion of my portfolio.

      In terms of my existing portfolio, I will soon post it. But broadly, I have made it more balanced with 12-15 stocks with first 7-8 stocks representing 80% of portfolio. They are Cera, Amara Raja, Atul Auto, Mayur Uniquoter, Piramal Enterprise, Swaraj Engines and Shriram transport finance.

      Regards,
      Dhwanil Desai

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    2. Hi Dhwanil, Thank you for prompt reply !! .. I am a software manager, tried my luck with stocks in the past and burnt my fingers. I started my second innings with a better understanding and determination to make money in the long term. As I was searching for businesses oppurtunities that are new, niche and can create wealth in long run, I came across Orient green power company and Ion exchange. Being a consultant in energy space, I believe you can throw some light on Orient.

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  4. Continue posting... I enjoy reading your blog!

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  5. Hey Dhwanil,
    U have covered Sintex earlier on your blog, with latest results out & management commentary, any updates u have from your end ?
    thanks

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    1. Hi Kunal, first of all apologies for delayed response. Yes, I did cover Sintex earlier on my blog. I have observed developments in Sintex in last couple of years and I feel that capital allocation decisions made by the management leaves much to be desired. Take example of doing fresh investment on textile side when the company is already fighting to mend its balance sheet which has substantial debt on it. Also, management's decision to invest in power plant (though they said that Sintex will not invest money in power business, there were related party transaction with Durha) which as such is not a very attractive business perplexes me. In nutshell, I feel that as long term investor, I am not comfortable with some of the capital allocation decisions taken by the management and hence have exited the stock. Regards, Dhwanil

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  6. Hey Dhwanil, good to have you back, Have you by any chance read 'The Warren Buffet way' by Robert Hagstrom---- the reason i ask is that tho im half way thru the book, it has made me come to similar understanding as above. to add to your points as much as the focus is on Pricing/Asset light model/Opportunity size/High ROE- with minimum or no debt ,and the companies ability to retain & grow Owner Earnings consistently . This also gets the company high ROE, In the end what matters to WB is if every dollar applied in the business has earned the equivalent dollar or more. My 2 bits rgds

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    1. Dear HG,

      I have read "The Warren Buffet way" and have gained immense insights from the book and the thought process described in the book while WB made investment decision.

      Best Regards
      Dhwanil Desai

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  7. I have been looking for information on value investing and stock ideas focused on Indian markets, and your blog is one of the niche placed to find this valuable information.
    The Amar Raja and Guj Reclaim comparison was interesting. This clearly shows the importance of Moat or the Pricing Power. The best companies are those that can sustain the Moat over the long-term. The moat can be good as long as the company is able to command profit margins (due to pricing power). A strong brand or a company with leadership can thrive in bad markets - in worst case they may lose a few %age points of margin in a year and then come back to strong growth again.
    Expanding opportunity is a good point - cos that identify opportunities at the right time are able to capitalize on it. There can be positive and negative examples here- take the case of watch makers/retailers - HMT and Titan. While HMT has lost it sheen despite being a great watch company, Titan innovated and stood the test of time by moving in to different verticals such as jewelery, eye care, etc. So personally feel that the ability to innovate and diversify (judiciously) and build a large opportunity could prove to be successful in the long-run.

    Looking forward to more ideas in value investing.

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    1. Hi Sridhar,

      Apologies for very delayed response and thanks for the compliments. Yes, I do agree that ability of companies to innovate and diversify judiciously. One such demonstration by Shriram transport is to start auto malls by leveraging strong relationship with truck owners and their ability to finance the transaction. Though, currently the contribution from this business is small, it can contribute significantly over a period of time. So, yes, I agree that in addition to the attributes that I have discussed, ability to continuously innovate and differentiate can be an important factor.

      Regards,
      Dhwanil Desai

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  8. A brief background about me: I was the co-founder & CTO of Circle (crunchbase.com/company/circle-inc), a silicon valley startup. I left recently, and want to innovate on my other passion -- finance.

    We are launching niveshi.com - to rapidly lower the cost of mutual fund creation, using the power of the internet, and make it accessible to the masses. I like your approach and we built something very close to it at niveshi.com; Would love to discuss the idea with you and possibly get your portfolio on board with our platform?

    Prasanna S
    admin@niveshi.com

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    1. Hi Prasanna,

      My sincerely apologies for delayed response. Though, I am not yet very clear about your business model, we can surely connect up to discuss the possibility and take it further. Let me know what can be good time to interact and your coordinates. My e-mail id is desaidhwanil@hotmail.com

      Regards
      Dhwanil Desai

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  9. Hi, Dhwanil

    I am very new to investing as i am just starting out on the voyage to acquire knowledge about it and understand the implications of the same. I found your blog educating and helpful with valuable insights to develop upon. I hope you can excuse the alibi of asking silly painful question but please help me with it. How did you find that ratio of 1.42 that you have mentioned in the blog. ?

    Thanks.

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  10. Hi,
    It's good to know that you are starting on this voyage in investment world. May your journey be rewarding and satisfying both! To answer your query,

    Let's say company has total asset of Rs.100, So, what I am saying is that if company finances asset with 30% debt, equity will be Rs. 70 while debt will be Rs. 30. So Asset/Equity ratio will be (100/70) = 1.42.

    Hope this clarifies.

    Best Regards
    Dhwanil

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