Saturday 18 February 2012

Identifying a Great Business: Typical Characterization

Almost all great investors have made serious money by making investment in great businesses at reasonable price or dirt-cheap price and staying invested in those businesses for long period of time. Warren Buffet has created enormous wealth through his investments in Coca Cola, Gillette and Washington Post  while Peter Lynch made billions by owing Fannie Mae. Rakesh Jhunjhunwala has made tons of money through his investment in Titan. Now the question is how do we identify great businesses? Is there any framework that will help us in identifying great businesses? 

Even though there is no definitive framework or quantitative ratios that separate great businesses from mediocre businesses, I have tried to put together certain characteristics of great businesses. One should look for these traits in a business to understand the quality of business. Even though,   a high quality business may not possess all the traits, it will have many of the characteristics outlined below.

Quantitative Aspects: 

  • Generate very high return on capital employed (ROCE) and return on equity (ROE) consistently excess of 25%.  
  • Most of the times these businesses have ROCE/ROE substantially higher than their nearest competitors. (e.g. Exide, Asian Paints, Titan)
  • Generate substantial free cash flow consistently. (e.g.Castrol, Nestle)
  • Very low debt to equity ratio unless the company is involved in asset intensive businesses. 
  • Maintain healthy net profit margins consistently and net profit margins are either steady or growing.This trait may signify pricing power as company may be able to pass on increase in cost/expense to customer without impacting top line.
  • Working capital cycle is steady and increase in working capital in line with or less than sales growth.

Qualitative Aspects:

  • Company or company's product has very strong brand recognition with customer. Many a times brand becomes synonymous with product ( i.e. Favicol by Pidilite; Maggi by Nestle;)
  • Company is a market leader in its industry and way ahead of its peers in terms of market share/sales. (Exide dominates branded automative battery market with 70% market share; Asian Paints has market share thrice that of its nearest competitor!;)
  • Company operate in an industry that enjoys monopoly or oligopoly with few large players and rest of the players are small and operate in unorganized sector ( Castrol in lubricants; Gillette in shaving needs; Colgate in oral care)
  • Company displays pricing power as the demand for products/services   will be price inelastic most of the times.
  • Company may have strong competitive advantage that shields company from competition. This shield is the most essential aspect for maintaining the quality of business. Competitive advantage may be in terms of
    • strong brand recognition; 
    • well developed distribution network; 
    • geographical monopoly; 
    • extremely loyal customer base due to product traits (mainly cigarette; alcohol ; beverages type of industry) 
    • Understanding or knowledge base (e.g. Shriram Transport Finance has developed an understanding about financing to truck owners and developed appropriate risk matrix over a period of years based on their understanding of customer segment)
    • Sourcing network ( reclaim rubber manufacturers like Gujarat Reclaim  who collect used tyres/tubes etc from various sources across the country)
    • or any other aspect of the business that provides edge to the company compared to its competitors. 
  • Company may have strong barrier to entry such as extremely high replacement cost for new entrants, rights to extract and market natural resources (mining lease for Hindustan Zinc) or patented technologies developed in house (e.g. Vinati Organics, largest producer of IBB in the world have developed their own technology;) or natural monopolies (natural gas pipeline companies like GAIL and GSPL) 
  • Company may have developed their own niche in the product/service offerings (Shriram Transport for financing of pre-owned commercial vehicles to small truck operators ) 
  •  Great businesses become great because it is run by great people. Hence many of these businesses are run by management that is competent and ethical. They follow rational capital allocation policies ( e.g.higher dividend pay out or buy back in case of large cash generation without utilization). Management meticulously maintain high standards in financial reporting, disclosures and act as trustees for the shareholders.

As mentioned above, most of the times a great business may not possess all the characteristics, however if you can identify a business that has many of these characteristics, you may have probably come across a great business. 

Once you have identified such business, the next things to focus on is inherent value of the business as approximated by you and margin of safety that you would like to apply to approximate inherent value! If Mr. Market is irrational enough to value the company much less than your worst possible estimates, go load up!

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