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.