Stock selection is complicated business. Formulaic approches seldom work over a long term. Even super investors such as Walter Schloss had to return back money to investors saying he could no longer find stocks that fit his value framework. George Soros' too shut down his Quantum fund and returned money to investors saying he could not understand the markets.
How can ordinary investors then hope to allocate capital effectively ? I reiterate, there are no fixed answers but some tools provide a broad direction. Hard work is essential.
How do we identify
good companies ?
I recently attended an investment
workshop and had the privilege of interacting with India’s best investors.
Unerringly every legend’s message boiled down to two essential ingredients 1)
high return on capital and 2) business’ ability to deploy large amounts of
capital without reducing return on capital.
This seems like investors’ utopia
but a large sample of companies have been able to demonstrate this ability for
varying lengths of time. Needless to say, the most consistent of these enjoy
very high valuation multiples. Essentially capital allocation decisions create
most of the value
The company has three choices 1)
invest in existing business 2) invest in a new business or 3) return money to
share holders. Markets tend to reward companies opting for options 3 and 1 (in that
order) but abhor option 2. Capital allocation decisions are subject to management
influence. A business earning suboptimal returns and ploughing back cash in the
same business will actually destroy value. By themselves indicators such as
ROCE and capital allocation decisions do not provide a clear picture about
investment attractiveness of the business.
One measure that I use is capex /
unit compared to the margin / unit. This is just another form of estimating
payback. It allows me to rank businesses.
Let me illustrate :
A prominent two wheeler
manufacturer in India has capital expenditure / motorcycle of about Rs 7700 and
margin / motorcycle of about Rs 4800. That its balance sheet exhibits negative
working capital, much larger than its capex requirement is very thick icing on
the cake. Using the same yardstick for an oil refiner, we see capital
expenditure could be approximately Rs 3600 per barrel per day while mid cycle
margins could range between Rs 450 to Rs 550 per barrel at current exchange
rates. A popular car manufacturer exhibits capex of Rs 122000 with margins per
car of Rs 30000.
Ranking these businesses for a long term investment horizon is
very simple now. Additionally this framework can be applied for evaluating
diversification decisions or change in business models.
It saves time and
focuses my attention on the more important and difficult aspects of evaluating
the business, namely, the competitive advantages, the moats and the longevity
of cash flows from the current model. The last being the most difficult.
Consistent and conservative accounting policy is
another time tested indicator of good companies. Generally speaking,
conservative accounting policies lead to understatement of reported profits and
therefore reduce incidence of taxation thereby becoming a cash preserving
strategy. Consistently applied, this becomes a source of wealth creation for
shareholders.
Illustration: Let’s take 2 companies A and B with A depreciating assets over 10
years and charging R&D expense to its P&L. B on the other hand
capitalises 50 % of its R&D expense and depreciates assets over their
estimated useful working life of 20 years. For the next 10 years A’s reported
profits will be substantially lower than B’s assuming identical size of assets,
expenses and income. At similar tax rates, A’s tax bill will be much lower than
B’s and cash flow will be much higher. This additional cash re invested in the
business every year will create substantially more value for company A’s
shareholders than B. For a long term investor, the virtues of conservative
accounting policy cannot be overstated.
Size, brand name, parentage
(MNC’s), even longevity are various factors used to describe good businesses /
companies. However, we think good
companies are not necessarily large, neither the most visible nor grouped in
one or two sectors. In essence these are companies which continually evaluate
themselves internally on stringent benchmarks similar to those used by external
investors.
Typically such conservative companies tend to minimise risk to their
cash flows and thus have a higher chance of succeeding. Their focus on cash
flow over reported profits is reflected in their valuations too.
Identifying good companies
requires familiarity which comes from in depth knowledge which is a result of
tracking these companies and their managers across cycles, interacting with
their customers, competitors and creditors. In short bottom up research.
From time to time, some of these
companies 1) fall out of favour and become cheap (FMCG sector from 2001 to
2006) 2) suffer business setbacks for eg: a failed product line (GSK Consumer’s
ready to drink, bottled Horlicks milk for pregnant women) or 3) suffer
valuation multiple contraction due to adverse publicity which has little impact
on their core business. Investors have to be prepared to invest in these
companies at such times.
Luck favours the prepared mind.
The stock market requires preparedness in the following terms 1) tracking a
sufficiently large universe to be able to spot opportunities in different
market conditions 2) investing strategy should enable deploying significant
amounts of capital in such opportunities and 3) maintaining investment
discipline even under adverse conditions.
A look back in history suggests
that investment opportunities are always present but it is the level of
preparedness that is the key to returns.