Applying Capital Allocation Framework: Part I - Conviction Rating

First two months of 2012 have been stupendous for the market. Many of the investors(including me) have had the feeling of being left out. At the same time I am reasonably confident that in time to come, market will again create lots of interesting opportunities for value investors. How can we remain prepared to take maximum advantage of such opportunities? I have always struggled in deciding as to what criteria one should adopt while allocating capital to existing stocks or new stocks. Should one buy more of some of the existing stocks in one's portfolio, or reduce positions in existing ones to allocate money to new opportunities that have better risk-reward ratios? Even though most of the investment I have made are based on careful study of business and valuation, relative merit of each stock in my portfolio was elusive and was doing capital allocation on "gut feel" basis rather than  a systematic process. When I come across the forum initiated by veteran value blogger Mr.Donald on capital allocation framework, I was thrilled to find a perfect answers to my quandary. Mr. Donald and fellow forum members have engaged in a very insightful discussion to deliver a fairly robust and methodical approach to capital allocation within one's portfolio and new opportunities.  

Here is the link to this discussion 

http://www.valuepickr.com/forum/valuepickr-scorecard-aug-2011/399834292

What I have tried to do here is take the capital allocation framework suggested by Mr.Donald and try to illustrate the whole process step by step by applying those parameters to one of the stocks in my portfolio Cera Sanitaryware (once again!). This may  be helpful in understanding outlined methodology slightly better. 

In order to keep the post interesting and readable, I have decided to write it in 2 parts. 

Part I- Discussion of basic idea of Mr. Donald's framework and two attributes of "conviction rating" i.e. Business Quality and Fundamentals

Part II - Remaining two attributes of "Conviction Rating" i.e. Growth Prospects  and Management Quality. I will also cover "Value Rating" and arrive at a composite rating for Cera in the second part. 

Before starting the illustration, let me first discuss the basic premise proposed by Mr.Donald. He has suggested that one can broadly rate a stock based on "conviction" and "valuation" on the scale of 1 to 10. As name suggests, conviction rating is based on how convinced one feels about the business attributes of one's investments. It is measured through business quality, management quality, fundamentals and growth prospects. 

On the value side, though there is no clear guidelines given in the discussion forum, I would like to  suggest looking at P/E ratio, P/B ratio, PEG ratio,net working capital + investments as % of total market cap, Cash + Investments as % of total market cap and P/E after deducting cash + investments to arrive at appropriate rating.

After rating a particular stock on both "conviction" and "value" parameters, we shall evaluate how much weight is to be given to "conviction" and "value" to arrive at composite score. One may want to put 50% to each rating. However,  personally, I would tend to go with Mr. Donald's line of thinking where slightly higher weight is given to "conviction" rating (60%) compared to "value" (40%).In my opinion, higher weight to "conviction rating" is justified as growth in intrinsic value of any company is driven by its business attributes and even if one pays slightly higher value, he is generally rewarded richly. 

Hence in the end final formula will look like

Composite Ranking = 0.6* (Conviction Rating) + 0.4 (Value Rating) 

I would strongly suggest reading Mr.Donald's blog as it would help one in appreciating the evolution of framework. So let's start to drill down this further.

Conviction Rating:

We will rate each attribute under conviction rating on the scale of 1 to 10 with 1 being the least convinced and 10 being the completely convinced. 

Business Quality (weightage-20%):

Nature of Business: One can classify a business into commodity/commodity processors/high tech/ cost plus/price setters/ monopoly/oligopoly/ fiercely competitive

 Cera is engaged into business of branded sanitaryware which operates in oligopoly with three major players Hindware/Cera/Parryware. Even though off lately there are many players entering in the market, they cater to a different target segment altogether. Score:8

Moat/Competitive Advantage: Cera's product offering of value for money positions it uniquely. It's closest competitor is HSIL which has similar product offering but slightly pricing. It's distribution network of 600 dealers and 6000 retailers combined with its brand equity gives it a tremendous advantage of reach across country which is difficult to replicate for many of the new entrants. Score:9

Industry Attractiveness: Cera operates in an industry that is slow changing and has steady growth prospects due to unmet sanitation/housing needs of a billion people. Industry is likely to grow at 12-15% in next few years. Hence Cera operates in a slow changing industry with steady growth rate for many years to come. Score: 8

Cyclicality: There is no cyclicality observed in the results of Cera or other sanitary ware players in past many years. Cera's sales and net profit have increased consistently for last many years. Score:8

Raw Material Dependence: Cera's RM cost/Sales ratio is in the range of 0.4-0.45. Even though Cera's margin may get impacted due to higher RM price, it has the ability to pass on the price increase to its customers due to relative price inelasticity of the market and oligopoly nature of business (for more understanding http://www.valueinvestinginpractice.blogspot.in/2012/02/my-first-tryst-with-scuttlebutt-cera.html). Score:8

Average Score= (8+9+8+8+80/5 * 20% = 1.64

Fundamentals (Weightage:25%)

debt to equity/ long term debt to equity ratio: 0.34/0.15. Leverage in the company is very less in absolute terms as well as compared to its peers (HSIL has D/E ratio of 0.79) Low D/E ratio will give Cera an ability to withstand turbulent times without much of worry. This is a big plus for Cera.  Score:9

ROE/ROCE: Cera has maintained very decent ROE/ROCE  of 24%/30% in 2011 indicating brand equity of its products and superior margins.It fares much better on this aspect with its closest peer HSIL (13.72/15.18). This also indicates that company management is good at managing capital allocation. Score:8

Consistency in ROE/ROCE and NPM: Cera has  not only consistently maintained ROE/ROCE but also increased it steadily. Same is the story with NPM. This indicates traction in company's business. Score:9 

Cash flow compared to net profit: In business, cash is always king! Hence, it is very important to understand how effectively a company is able to translate profit into cash flowing into its coffers. I have come across many companies that have excellent net profit growth, but cash flow is paltry or negative. Reason for such difference can be attributed to working capital intensive business, aggressive accounting practices or poor inventory and receivable management. Each of this, in its own right, may lead to serious problems. Cera has maintained a decent records with NP matching reasonably well with operating cash flow barring FY11 where there was a large gap in NP and cash flow (due to introduction of new line of product i.e. faucets which moved relatively slowly compared to sanitary ware product). Score: 7 

Average Score = (9+8+9+7)/4 * 25% = 2.06

Remaining two aspect of conviction rating growth prospects and management quality along will be discussed in Part II. Meanwhile, I would be glad to receive feedback on the same.