Thursday 13 December 2012

Playing Second Fiddle: Possibility of First Rate Returns

It is human mind's innate tendency to seek patterns from the past experiences and extend this patterns to predict the future. Even though this innate human trait is very handy on number of occasions,  many a times it leads to visualizing patterns where there exist none! In my opinion, a key differentiator in identifying a useful pattern is the causal relationship or lack of it! In simple words, if our mind visualizes some pattern but there is no logical/rational explanation for why particular pattern exist, more likely than not, pattern may turn out to be misleading. Idea behind discussing this trait of human mind is that this post is related to a pattern that I have observed in some of my investments and there is a common thread binding success of these investments. My personal take is that this pattern can have high predictive value as there are enough logical reasons to explain for the pattern deciphered here.

There is a very interesting thread going on on valupickr forum on identifying success patterns in investment. Donald has done an excellent summary of various patterns discussed on this thread. Do read this thread as some of the patterns there are indeed very interesting.

Let me start the discussion with a question. What is common between Amara Raja Batteries, Cera Sanitaryware and Oriental Carbon & Chemicals? Let me define characteristics which bind them together..

  • All these companies operate in duopoly/oligopoly: Organized sanitaryware industry catering to mass market is dominated by three players i.e. HSIL, Parryware and Cera in that order. Similarly, battery industry is dominated by Exide, Amara Raja and to a limited extent Tata. In insoluble sulfur space, there only few suppliers garner more than 95% market share in insluble sulfur supply to all tyre majors across the world.

  • They are not leaders in their industry but are second/third largest players in their industry: Cera is the third largest player in organized sanitaryware industry catering to mass market. Amara Raja is the second largest player in battery market (both industrial and automotive combined) and OCCL is third largest player in insoluble sulfur market.

  • All three companies have been discussed on this blog based on fundamental and business analysis. (though due to some management actions, I have exited OCCL as I was not comfortable with management quality, however, on quantitative basis, it still looks very good for longer term)

So once I noticed the commonality among these three companies, I sensed that there may be some pattern emerging which may have causal/logical links.

So here is the hypothesis

" Second or third largest players, operating in a consumer-centric industry and increasing/retaining their market shares are good investment candidates if it is acquired before market picks up the thread"

Now the hypothesis seems slightly complicated (may be verbose!), but i put it like that to ensure none of the attribute is left out from the hypothesis!  So what are the attributes one should be looking for in second/third largest players in order to qualify it as good investment candidate?

  • Industry should be consumer centric or product should be used in consumer centric industry to ensure steady demand
  • Industry should be growing at reasonable pace
  • Industry shall have duopoly/oligopoly with market leader enjoying pricing power.
  • overall business economics (return ratios and margins) for industry is good  and consistent while second/third largest players enjoy similar economics as that of industry leader (or may be better!)
  • Second/third largest players should ideally be increasing its market presence/share
  • Second/third largest players trade at significant discount to market leaders.
This may sound like a wish list but the fact that such opportunities existed in the past does build confidence as an investor that one may come across such opportunities from time to time. If one is able to spot such opportunities and invest, it is likely to give first rate returns!

So let me dwell into logical link as to why this pattern makes sense as investment opportunity.

  • Typically in an industry, with duopoly/oligopoly, market leaders enjoy pricing power and hence their margins are generally decent and protected. This ensures that second/third largest players also can take advantage of this dynamics and enjoy protected margins. Thus any major fluctuations on RM price is typically passed on to the end user (though some times with lag). This attribute can be very handy as company's bottom line is predictable as long as company is able to sell same/more of its products.
  • Another advantage second/third largest players have is that they have to grow from much lower base than market leaders.As we all know it is much easier to grow at faster pace from lower base than higher base. Moreover, since company is growing from lower base, it is possible to maintain growth momentum (of course with right products and strategy) for longer. Thus if company is operating in an industry with reasonable  growth it shall be able to grow at pace comparable to industry growth. Now if we combine these two attributes of reasonable growth in top line and protected margins, it will lead to predictable earning growth for some years. 
  • Another interesting fact is that market typically focuses on industry leaders and assigns discount to companies which play second fiddle to leaders. Many a times, this means that one can get opportunity to buy a business which has as good economics as industry leader, higher growth than  industry average (due to lower base) at much lower valuations. It thus may present an opportunity to buy growth companies with superior economics at very reasonable price giving some margin of safety to the investor. 
So apparently, there is some logical link that can explain why investing in second/third largest players in oligopoly/duopoly makes sense. However the moot question here is, does it always work? There may be contrary evidences where in spite of this pattern, playing second fiddle did not work as investment  opportunity. Hence, it is important to recognize that, just spotting an opportunity which fits the pattern is not the end, but the beginning. It shall never be a proxy for fundamental/business analysis that one should perform before making investment decision. Limited point here is that, pattern may be useful in identifying investment opportunities which have higher probability of giving superior returns over a long period of time.

Food for thought: A few other opportunities which can fit in this pattern are Atul Auto, Narmada Gelatines and Fluidomat as all three of them operate in an industry with oligopoly/limited competition. 

Please share your ideas on which other businesses you think can fit into this category. 


  1. Interesting line of thought. I have been thinking about that thread quite a lot, and it appears to me as of today that we are trying to seek patterns which don't exist. Maybe Valuepickr has evolved to pick only the best businesses and we are trying to intrapolate/extrapolate into attributes. Getting into attribute definition is a sub-optimal precedent.

    Secondly, what can we achieve after we have identified patterns? Let's say we found one stock whose name we don't know yet which fit into this criteria. What happens then? Irrespective of the pattern, obsessed as we valuepickrs are, we are going to go the full hog in evaluating stuff from numbers to mgmt to market to growth rates etc. So, what was the point in identifying patterns? And how is it helping getting to a 'reasonable price' concept?

    Anyway, I don't want to even appear to throw paani on some thread when so many ppl are taking an initiative and valuepickr as a whole to me has been very kind, to say the least. Let the great work continue.

    Having said that, the only common pattern (and I am a very lazy guy, so I try to keep it simple) that I follow is a) scale of opportunity b) management integrity. As long as these two are satisfied, I think I am reasonably ok to deep dive (and if you see most stocks you mentioned, which I have also invested in fit into this criteria)

    1. Hi Kiran,

      First of all apologies for late reply as I was pre-ocuupied with number of things.

      Coming to the relevance of identifying patterns and usefulness of such patterns in making investment decision, I look at the whole thing from slightly different angle. As you very rightly mentioned, being ardent valuepickers we would surely do all the research and evaluation of the story at hand and its fundamentals. while we do this analysis/research, it only gives us facts/figures/perspectives based on what has happened in the past and what is happening now. However, value of a company will be equal to its future cash flow discounted at appropriate rate. I feel some of these patterns give us clue to intrinsic advantages/edge that exist in a business which will make future cash flows more predictable and hence tilts odds in favor of investor if bought at decent valuation. So it is the relatively higher predictability of the future cash flow (through topline growth and margin protection) that makes such patterns interesting. If such patterns is supported by sound business logic and slow change, they can be used as good tool to buy growth stocks with reasonable visibility/predictability at reasonable price.

      At the same time, I would also like to point out to its limitation that such patterns only reflect the business aspects and management quality aspect needs to be separately evaluated.

      I hope I have been able to put through my rationale/thought process in my reply.

      Best Regards
      Dhwanil Desai

  2. One example that come in my mind is Kaveri seeds which is second after Advanta India Ltd in listed space.

  3. Hi Dhwanil,

    Good food for thought, but I somehow tend to agree with Kiran in this regard. Looking at the scale of opportunity is far more critical than looking for players in duopoly market protecting high margins while growing.

    Typically take the example of Oriental Carbon,

    With around ~250,000 MTPA of estimated market size, with Solutia (Flexisys) controlling 80% and OCCL playing second fiddle with current capacity of 22,000 MTPA and 7-8% market share.

    Under the assumption of Shikoku catering to Japanese market with 20,000 MTPA capacity and Sinorgchem catering to Chinese domestic demands of 35,000 MTPA we have a virtual duopoly market.

    So OCCL catering to domestic demand and exporting to Europe still have a very limited market to cater to. Hence, we can never envisage a broad based growth (for many years to come) from this low market cap of 140 Cr.

    On the contrary, in an industry facing tremendous growth (CPVC pipes) there is enough room for all players to grow simultaneously as the sheer scale of opportunity is huge.

    Thus looking at fundamentally sustainable growth with sheer size of opportunity is more critical.

    1. Hi Rudra,

      Sorry for late reply as I was preoccupied with few things in past weeks. As I mentioned in my reply to Kiran that value add from such patterns come if it can explain the higher predictability of future cash flow. Having said that, I do agree that opportunity size does matter. However, even in case of opportunity size, especially in oligopoly/duopoly markets, what is more critical is the ratio of current revenue/opportunity size. Higher the ratio, more predictable and sustained growth rate can be expected.

      Best Regards
      Dhwanil Desai

  4. That thread is indeed thought provoking. Another set that fits the above hypothesis is the trio of Supreme, Nilkamal & Wimplast.

    - HG

  5. Aditya Bob Mahendru14 December 2012 at 10:22

    Great post Dhwanil! As always, your thoughts are quite interesting and thought provoking.

    This does seem to be a very interesting and deadly combination. One can identify great companies based on this.

    Some additional examples I can think of are: Hawkins Cookers, VST Industries, Berger paints, Tide water oil, Globus spirits, and ICRA.

    Do let me know your views!!

  6. Hi Dhwanil,

    Interesting thoughts in your blog.
    I personally believe in the philosophy of backing the second or third placed player in the industry and have gained from it. I backed Kansai Nerolac and Berger Paints over Asian Paints and have been handsomely rewarded. Currently am tracking Shalimar Paints.
    The other thing which I typically look for in a company is a low equity base. The reasoning is simple - lower the equity, easier it is to service it. Of course this may not apply to capital-intensive companies like Reliance and L&T, but then we are not strictly talking about large caps here.

    1. Hi Dinesh,

      It is good to know that well ahead of me as I am still dwelling into the nitty gritty of these things while you are actually implementing it. If you have other companies which have similar characteristics, please share the same.

      Best Regards
      Dhwanil Desai

  7. Hi Dhwanil,
    you can easily add Cravatex in this list as it holds 3rd Largest Fitness Equipment Manufacturer Johnson Health tech and 4th largest sports wear co. FILA.

  8. Value investing is always been and will always will be about buying a company thats worth 20 dollars for 10 dollars. I always look at the market cap. Shares outstanding multiplied by the price = 10% or less of a companies sales. Why may I ask is this metric so very important whan it comes to picking great value stocks. The answer is so simply its not even funny. If I purchase shares of stock in a company whose market cap is only 10% of its annual sales. Than I will make over 10 tens my money if the earnings of the company return to their normal ratio say thats a profit margin of 5%. + 4% sales growth per year and than the stock trades around a PE of 16 that gives us a ten fold increase in the price of the shares. Now that was not so hard was it. But how can that be well For example if the stock we are talking about is breaking even not making a profit but not losing money. And over a five year period the company improves a great deal as far as earnings go and a small increae in sales than we could easily see the stock increase by ten fold over a five year period.