Biggest Lessons of 20 Years Investing

equitymaster’s

SECRETS The Biggest Lessons From Our Entire 20-Year Investing Journey

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Table of Contents Welcome to a New Chapter in Your Investing Journey

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Business Models & Economic Moats Chapter 1

Introduction to Value Investing...............................................

3

Chapter 2

Analyzing Business Models.....................................................

9

Chapter 3

Identifying Economic Moats I.................................................

23

Chapter 4

Identifying Economic Moats II................................................

33

Chapter 5

Identifying Economic Moats III...............................................

51

Accounting Basics & Financial Analysis Chapter 6

Accounting Basics...................................................................

65

Chapter 7

Financial Ratio Analysis I.........................................................

69

Chapter 8

Financial Ratio Analysis II........................................................

81

Chapter 9

Identifying Accounting Red Flags..........................................

91

Separating Good Management from Bad Chapter 10

Separating Good Management from Bad I........................

105

Chapter 11

Separating Good Management from Bad II.......................

113

Chapter 12

Separating Good Management from Bad III......................

127

Valuation Methods Chapter 13

Introduction to Valuation..........................................................

141

Chapter 14

Earnings Power Value and Franchise Valuation................

155

Chapter 15

Franchise Valuation With Growth & Multiple-based Valuation......................................

165

Stock Screeners Chapter 16

Stock Screeners..........................................................................

181

Behavioral Finance Chapter 17

Behavioral Finance....................................................................

195

Portfolio Analysis Chapter 18 Portfolio Analysis........................................................................

209

Welcome to a New Chapter in Your Investing Journey

Dear Reader, When we launched Equitymaster in 1996 - India’s first financial website - we could not have imagined we would emerge as one of India’s most trusted research houses. Our vision…to empower the small investor…to be ‘investor’s best friend’…has guided us through many challenges these past two decades. And today, when we look back, we take immense pride in what we’ve delivered. And how we’ve remained committed to delivering clear, honest, and unbiased views. This book, which commemorates our 20th anniversary, has the potential to change the way you invest. That’s because these pages include the culmination of our two decades of experience picking out money-making opportunities. In these pages, we reveal the complete Equitymaster Way…the secrets we’ve run our business on for 20 years. We hope you find these lessons richly rewarding in your wealthcreation journey. Happy investing, Rahul Shah & Tanushree Banerjee Co-heads, Equitymaster Research Team

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PS: Three years ago, we decided to put together the best investing secrets, lessons, and experiences we’ve gathered over the years. We wanted to keep it simple and practical for the lay investor. As such, the examples explained in the book pertain to that period. While some facts may have changed, the essence of the lessons is timeless. We have strived to present the book in a highly objective and concise manner, and as a result, have used bullet points in many chapters. We hope you find the reading experience easy and enriching.

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Business Models & Economic Moats

Chapter 1

Introduction to Value Investing

Definition of Value Investing “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” - Benjamin Graham Value investing is an investment approach that seeks to profit from identifying undervalued stocks. It is based on the idea that each stock has an intrinsic value, i.e. what it is truly worth. Through fundamental analysis of a company, we can determine what this intrinsic value is. The idea is to buy stocks that trade at a significant discount to their intrinsic values (i.e. they are cheaper than their true value). Once we buy an undervalued stock, the stock price eventually rises towards its intrinsic value, and makes a profit for us in the process. Value investing is conceptually simple, though requires effort to implement. Research process focuses on finding out the intrinsic value of a company. Primary tool for researching a company is called fundamental analysis.

Chapter 1: Introduction to Value Investing

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Philosophy of Value Investing Benjamin Graham - The founder of Value Investing 4 components that define the philosophy behind value investing:

First component: Mr Market Imagine you are in a partnership with Mr Market, where you can buy or sell shares. Each day, Mr. Market offers you prices for shares depending on his mood. If Mr Market is in a very optimistic mood, he will offer very high prices. In this case, an investor should cash out of shares. If Mr Market is in a very pessimistic mood, he will offer low prices, and this is the time to buy.

Second component: Intrinsic Value Intrinsic value represents the true value of the company based on fundamentals. In the short term, market prices deviate from their intrinsic values due to changing market sentiments. In the long term, market prices return to intrinsic values. This process allows us to make profits, because we can buy stocks when they fall below their intrinsic values. We then hold them until they return to their intrinsic values in the long term.

Third component: Margin of Safety Margin of safety is the difference between the current market price and the intrinsic value. “A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.“ - Seth Klarman 4

Equitymaster’s Secrets

Fourth component: Investment Horizon “In the short run, the market is a voting machine but in the long run it is a weighing machine.” - Benjamin Graham Value investing works in the long term, because that is when prices return to their intrinsic value. Value investing does not aim to predict what stock prices will do 2 days or 2 months from now. Instead, it aims to pick undervalued businesses that will outperform in the long term. This will eventually reflect in the stock price.

Evolution of Value Investing Value investing started as a purely quantitative approach that has now evolved to incorporate a qualitative approach. Benjamin Graham’s view was that one only needed to look at the financial statements of a company in order to determine its value. There was no need to analyze qualitative factors such as a company’s management, future product offerings, etc. The numbers told the investor everything they needed to know about whether they should invest in a company or not. This approach is known as the cigar butt approach. The advantage of the quantitative approach is that it is based on hard facts alone. The analysis is objective, and less reliant on assumptions. Unfortunately, the quantitative approach does not account for all the factors that determine a company’s true value. Qualitative factors such as the management quality, industry dynamics, competition, future products, consumer behavior, etc. are all relevant to a company’s performance. Warren Buffett’s approach incorporated these qualitative factors into his analysis, along with the quantitative factors.


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Concept of ‘Economic Moat’ A company‘s ability to maintain competitive advantages over its competitors to protect market share and long-term profitability. If a company has a high economic moat, it means it has an edge over its competitors. Warren Buffett’s approach aims to identify companies with a high moat that are trading at reasonable prices. The moat is inherently a qualitative factor, and this represents the difference between Buffett’s and Graham’s approaches.

Coca-Cola Company - A classic Buffett stock One of Buffett’s most successful investments. Exemplifies the difference between the approaches of Graham and Buffett. Buffett admired the company due to the presence of a strong economic moat. He also analysed other factors like management quality, consumer behaviour, scalability of business, long term growth visibility, etc. He was able to conclude that Coca-Cola could earn much more 10 years from now than today. Graham on the other hand would have seen Coca-Cola as just another company. He would have analysed it based on existing earnings and ignore future growth potential. Graham was of the view that competition does not allow any company to earn extra profits for a prolonged period of time. Hence, he did not believe in paying any premium price. Buffett, however, focused on just those companies that could keep competition at bay for a prolonged period of time due to the presence of a strong economic moat. He was also willing to pay a slightly higher price for them.

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Warren Buffett’s Four Filter Approach Warren Buffett’s four filter approach is a process by which we can arrive at an investment decision. It is like a checklist that we apply to any stock we are interested in. We identify companies that have:

1. A business we understand A business we understand is critical because we need to know what we are buying into. We stay away from companies that have overly complicated products and business models.

2. Favorable long-term economics Favorable long-term economics means the company should have a competitive advantage (economic moat) that we believe is sustainable over the long-term.

3. Able and trustworthy management Able and trustworthy management means that management consistently demonstrates competence and works in the interest of shareholders.

4. A sensible price tag Finally, a sensible price tag is nothing more than having a margin of safety.


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Equitymaster’s Approach Here at Equitymaster, we closely follow Warren Buffett’s investing approach for many of our recommendation services. We believe in identifying companies that have a high moat and sell for reasonable prices. Our investment philosophy can be summarized as follows: “Don’t try predicting where markets will go tomorrow or 6 months from now...Don’t lose your calm over changing market sentiments... Buy stocks as if you are buying businesses...only the ones with solid long term fundamentals... only when they’re selling cheap... And stay invested for the long term...Period”

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Chapter 2

Analyzing Business Models

Investing in a Business When you invest in a stock, you become a part-owner of the business. Would you ever put money in a business that you don’t understand? Understanding businesses thoroughly and investing in only those businesses that you understand is the cornerstone of value investing.

Analysis of Business Models When we study a company, we start by analyzing its business model and the industry structure. A company’s business model is a description of how a company operates within an industry/ economy and creates value for its shareholders. Porter’s Five Forces is a very powerful framework that can help you analyze a company’s business model and the overall industry dynamics.

Porter’s Five Forces- Basics Firms in an industry compete for profits. Competition is not limited to direct competitors alone. Factors such as potential new entrants, customers, suppliers and substitute products also impact an industry’s profitability. An analysis of Porter’s Five Forces gives us a solid understanding of a company’s business model, the industry structure and the long term profitability.

Chapter 2: Analyzing Business Models

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Porter’s Five Forces- Benefits √√ Helps analyze a company’s business in the context of the industry in which it operates √√ Helps filter away short term market trends and understand root factors that affect long term profitability of firms in an industry √√ Helps understand why some sectors command premium valuations while others do not

Porter’s Five Forces Threat of New Entrants

Bargaining Power of Suppliers

Competitve Rivalry

Bargaining Power of Customers

Threat of Substitutes

1. Threat of New Entrants The barriers to entry determine how likely it is that new firms will enter the market. The threat of new entrants determines how long high profitability in an industry can last. If a company is making high profits, this will attract other firms into the market, ultimately driving profits lower. Factors such as high fixed costs, distribution network, network effects, use of patented technologies, brand loyalty, government regulations, etc. tell us how easy it is for new firms to enter the market.

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2. Bargaining Power of Customers The bargaining power between a firm and its customers can affect the company’s profit margins. In particular, if buyers are concentrated (i.e. a small number of buyers), they are likely to have considerable bargaining power. Other factors include how easy it is for buyers to switch suppliers, whether buyers are price sensitive, whether they can afford not to buy temporarily, and how dependent the firm is on individual customers.

3. Bargaining Power of Suppliers The bargaining power between a firm and its suppliers also significantly impacts the company’s profitability. The concept is similar to the analysis of the bargaining power of customers; the difference is that the company is a customer of its inputs. If there are a small number of suppliers, then they will hold considerable bargaining power. Also important is how easy it is for the firm to switch inputs and suppliers; the harder it is to so, the more bargaining power the supplier has.

4. Threat of Substitutes A company faces competition from not just other firms in the same industry but also firms from other industries that have products that offer the same benefits as the company’s products. The threat of substitute products determines whether profit margins can remain high over long periods of time. The more likely a customer is to switch to a substitute product, the lower the company has to keep its prices (and thus profit margins) to attract the customer. If profit margins are low, it is more difficult for a company to withstand external shocks; e.g. a rise in the price of its inputs.


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5. Competitive Rivalry Competitive rivalry looks at the way in which companies compete with each other within the industry. If companies compete heavily on price, this is likely to keep profit margins low; this occurs primarily when the companies’ products are very similar. Competitive rivalry is low if there is differentiation between products and brand loyalty is significant. Competitive rivalry is also low if exit barriers are low and vice versa.

Applying Porter’s Five Forces: We have selected three companies - Arvind Ltd, Nestle India Ltd, and Asian Paints Ltd, due to their distinct business models. Let us see how they fare as per Porter’s Five Forces model. The analysis is performed as of June 2013. Many of the facts come from company websites, annual reports, data providers, etc.

Arvind Ltd

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•

World’s fourth largest denim manufacturer.

•

India’s largest denim exporter.

•

Annual capacity: 110 m metres of denim and over 72 m metres of shirting fabric.

•

Vertical integration in garments, strong brand franchise and a wide distribution network in branded apparels has placed the company in a strong position in domestic as well as global markets.

•

Well-known in-house brands like Flying Machine, Excalibur, Newport University and Ruggers.

•

Licensed brands such as Geoffrey Beene, Cherokee, Elle, US


Polo Association, Arrow, Izod, Energie, and Gant. •

Master franchisee of Tommy Hilfiger through a joint venture (JV).

•

Business-to-business clients include brands such as Miss Sixty, Diesel, Gap and Zara for denim.

Despite having a leadership position in the denim industry, company has failed to create value for shareholders. Once a large cap stock, Arvind Ltd was part of the BSE-Sensex from 1996 to 1998. However, company has consistently lost value and today is a mid cap stock. Porter’s analysis helps understand how the adverse dynamics of the textile industry have impacted the company’s long term profitability.

Arvind Ltd - Porter’s Five Forces 1. Threat of New Entrants - Very high •

Denim is a highly commoditised product and does not require a lot of capital investment. It is easy for any new player to enter the market and take away market share from existing players.

•

Even in apparel retailing, threat of new entrants is high on account of numerous Indian and global brands entering the market across all price points.

2. Bargaining Power of Customers - High •

Given that there are several players in the denim space starting from those vending unbranded, low priced ones and going up to higher priced branded ones, the bargaining power of customers is especially high in the mid-market segment, where Arvind operates.


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3. Bargaining Power of Suppliers - High •

Cotton and power costs put together comprise nearly 40% of Arvind’s manufacturing expenses. The volatility in the prices of cotton due to shortage in global markets has made the bargaining power of suppliers very high. Also, the bargaining power of the foreign licensee companies is very high.

4. Threat of Substitutes - Very High •

Most other fabrics can act as substitute for denim.

•

Demand for denim tends to move as per fashion trends in global markets.

5. Competitive Rivalry - High •

There exists a huge unorganized market for both denim and shirting in India.

•

In each of the product segments, there exist other players that compete in both the premium end space as well as in the economy space.

•

An apparel manufacturer without strong brand recall amongst customers and a strong retail franchise has very little pricing power.

Nestle India Ltd

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•

Indian arm of Swiss MNC Nestle S.A.

•

Largest food company in India.

•

Third largest FMCG company in India.

•

Leader in branded processed foods.

•

Commands a large market share in products such as instant coffee, weaning foods, instant foods, milk products.


Nestle India has been among the best shareholder wealth creators with over 2300% returns in 18 years (19% CAGR). Low capex model with excellent return on capital. For nearly two decades, Nestle has paid out on average 76 out of every 100 rupees of net profits as dividends to shareholders. How has the company managed to do this? Porter’s Analysis provides some useful insights…

Nestle India - Porter’s Five Forces 1. Threat of New Entrants - Low •

Although launching a product is relatively easier, making it a success is based on establishing its brand presence.

•

The brand equity is built over a period of time through promotions that develop a brand recall and a robust distribution network to ensure availability.

•

Nestle with its 100 years presence and powerful brands, enjoys a definitive advantage over entrants.

2. Bargaining Power of Customers - Moderate •

In mass segments where volumes play a major role, customers enjoy bargaining power.

•

Customers also benefit in well penetrated and mature product categories that are relatively more price sensitive.

•

Barring instant noodles, majority of the company’s products are in the premium categories.

•

As such, the bargaining power of customers is moderate.

3. Bargaining Power of Suppliers - Low •

Since there are no major suppliers of inputs, they do not have considerable clout and hence have low bargaining power.


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4. Threat of Substitutes - Low •

Most of the food products do have readily available substitutes but it is difficult to rid people of their deep rooted habits.

•

Those who prefer coffee over tea or instant noodles over any other snack will seldom give up their preferences.

•

Threat of substitutes, therefore, is low for company’s products.

5. Competitive Rivalry - Low •

The competitive rivalry is low in all product categories such as noodles, chocolates and milk & milk products.

•

This is borne by the company’s dominant market share in most of the categories it is present in.

•

In instant noodles, it enjoys a market share of about 80%.

•

Nestle is also the market leader in other categories like baby food, instant coffee and milk products.

Asian Paints Ltd

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•

Founded in 1942, market leader in paints since 1968.

•

India’s largest paint company and Asia’s third largest.

•

Nearly 4 times the size (in terms of FY13 sales and net profits) of its biggest competitor in India.

•

Manufactures a wide range of paints for decorative and industrial use.

•

Operates in 17 countries, has 24 paint manufacturing facilities and services consumers in over 65 countries.


•

Driven by its strong consumer-focus and innovative strategies, it has several strong brands and has consistently pioneered new concepts in the industry.

Asian Paints ranks among leading shareholder wealth creators with over 3300% returns over 18 years (22% CAGR). It was included in Forbes Asia’s ‘Fab 50’ list of Companies in Asia Pacific in 2011 and 2012. It has a low capex model with excellent return on capital. Over last 12 years, Asian Paints has paid out on average 45 out of every 100 rupees of net profits as dividends to shareholders. How has the company managed to do? Porter’s Analysis provides some useful insights...

Asian Paints - Porter’s Five Forces 1. Threat of New Entrants - Moderate •

Since there are no major regulatory hurdles and relatively low fixed costs, starting the business is easy.

•

However, scale, reach and brand are major barriers to entry.

•

Also, there is some element of technology involved in industrial paint segment which may act as a barrier.

2. Bargaining Power of Customers - Low •

Asian Paints is the largest player in the decorative segment. Since individuals are typical customers here, they lack bargaining power.

•

However, in the industrial segment, the customers have high bargaining power since they buy in bulk.

•

The company has strong presence in the decorative segment. Hence, bargaining power of customers could be deemed as low.


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3. Bargaining Power of Suppliers - High •

Major raw material inputs include crude-based derivatives and certain solvents.

•

Crude prices move based on global demand-supply dynamics.

•

Availability of titanium dioxide is also scarce.

•

Hence, bargaining power of suppliers is high.

4. Threat of Substitutes - Low •

The use of limestone as a substitute is limited to rural markets.

•

In urban markets there is no real substitute to paint.

•

As such, the threat of substitutes is virtually absent.

5. Competitive Rivalry - Moderate

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•

There is stiff competition in organized market since there are many players.

•

Advertising and distribution are the key to attract customers as there is minimal product differentiation.

•

Asian Paints has certain advantages because it is the largest player and also has the biggest distribution network.

•

But margins are not very lucrative and hence, the competitive rivalry can be termed as moderate.


Conclusion Understanding businesses is fundamental to value investing. Porter’s five forces is a powerful framework to analyze business models & industry structures. The five forces are: Threat of New Entrants, Bargaining Power of Customers, Bargaining Power of Suppliers, Threat of Substitutes, and Competitive Rivalry. How companies rank on the five forces impacts long term profitability and shareholder returns.


19

20


0.0

Dividend Payout ratio (%)

1.5

9.8

Return on Equity (%)

Total Debt to Equity

5.3

1.6

17.2

10.1

5.5

1.6

0.0

9.2

5.7

1.7

0.0

1.5

0.7

Data Source: Ace Equity

1.4

25.5

6.3

3.8

2.3

0.0

-9.6

-4.0

1.8

0.0

4.9

1.6

Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10

Net Profit margin (%)

(Consolidated)

Arvind Ltd.

Key Performance Indicators- 10 years

Appendix 1

1.6

0.0

12.8

4.0

Mar-11

1.2

5.8

27.9

8.7

Mar-12

1.2

17.1

13.4

4.6

Mar-13


21

73.3

0.0



5.5

28.7

56.3

0.3





(Consolidated)

0.0

93.8

77.0

10.6

0.0

78.0

84.8

10.7

0.0

76.9

102.5

11.3


0.0

77.9

91.9

11.7

0.0

76.7

119.8

11.9

0.0

71.4

124.2

12.5

0.4

52.3

33.0

6.2

0.4

44.4

39.8

6.9

0.3

39.9

48.6

8.7


0.4

56.5

34.7

6.1

0.3

42.2

38.4

6.9

0.1

31.0

60.7

12.4

Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10

84.3


Asian Paints Ltd.

11.5

0.1

36.4

45.2

10.1

Mar-11

0.0

57.1

114.0

12.8

Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10


(Standalone)

Nestle India Ltd.

0.1

38.8

41.4

9.4

Mar-12

0.8

48.6

90.3

12.5

Dec-11

0.1

39.6

37.8

9.2

Mar-13

0.6

43.8

69.5

12.4

Dec-12

Chapter 3

Identifying Economic Moats I

The Way Capitalism Works “The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns.” – Warren Buffett Money flows where it sees the highest possible return. High return on capital in an industry leads to entry of new players. As competition intensifies, return on capital shrinks. However, some companies do manage to earn high returns for long periods of time. What is it that protects them from the onslaught of competition? The answer is economic moat!

What is an Economic Moat? The term ‘economic moat’ coined by Warren Buffett refers to the competitive advantage a firm has over its peers. It is a structural feature that helps to ring-fence a firm’s profitability and enables it to earn return on capital much higher than the cost of capital. We can also think of moats as entry barriers that prevent competitors from reducing the firm’s profitability. If there is no moat, competition will eventually drive return on capital down to the cost of capital or even lower.

Chapter 3: Identifying Economic Moats I

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Why do Economic Moats Matter? Assume two companies that are growing sales and profits at the same rate employing the same amount of capital. The only difference is that one company (A) has a moat while the other (B) does not have one. While B will see its returns decline with rising competition, A will manage to earn superior returns for long periods of time. Economic moats show the durability of a company’s future earnings. Companies with wide moats are the most resilient businesses and the best shareholder wealth creators.

Types of Economic Moats The two main factors that define a firm’s profitability are Price and Cost. Firms can boost their profitability in two ways: √√ Increase product prices √√ Cut down costs But not many firms can do this. The one’s that can do so on a sustainable basis can be said to be enjoying an economic moat. All moats can be divided on the basis of price and cost advantages. Let us discuss them in detail…

Types of Moats: Price Advantages Economic moats that allow a firm to charge a premium over its competitors could be referred to as moats arising from price advantages. The most important moats under this type: I. Real Product Differentiation II. Intangible assets

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•

Brands

•

Regulatory licenses

•

Patents & Intellectual Property

III. Switching Costs IV. Network Effects

I. Real Product Differentiation Real product differentiation refers to distinctive attributes in a company’s product that set it apart from competition. Differentiating factors could include appearance, features, durability, performance quality, technology, etc. Product differentiation enables a firm to command a premium price over its competitors. Firms can earn very high returns by staying ahead of competition in terms of quality and innovation. However, this kind of moat may not ensure long term durability due to the following reasons: •

Competitors will replicate the product and grab market share.

•

Customers may be unwilling to pay a high premium if competitors’ products are only slightly inferior and may be selling at a significantly lower price.

•

It is pertinent to constantly innovate, improve the product and add new features in order to stay ahead of competition.

•

Innovation requires substantial R&D expenditure.

A market leader today may be replaced by a competitor who manages to offer better products at a lower price. Hence, a moat arising out of product differentiation is not only difficult to sustain


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over the long term but also requires huge capital investments. Example: Consumer electronics, technology sector, etc. Companies such as Nokia and RIM were once ahead of the curve but later on failed to adapt themselves to changing customer preferences and needs.

II. a) Intangible Assets: Brands A brand is a name (or other feature) that creates a perceived product differentiation in the minds of the consumers. The company’s products may or may not be very distinct from those offered by competitors. But the perceived superiority and trustworthiness of the product allows the firm to charge a premium price. Because customers have loyalty towards a particular brand, they may be reluctant to switch to other similar products. Brands tend to create a moat by not only making it difficult for new competitors to enter the market, but also limiting the scope of existing players to expand. But do all brands imply an economic moat? A well-known brand does not imply an economic moat unless it gives the company pricing power and brand loyalty (repeat business). Examples of brands that have an economic moat: Coke, Colgate, Nestle, Titan, Cadbury etc. Examples of well-known brands that do not have an economic moat: MakeMyTrip, Flipkart, Videocon, etc.

II. b) Intangible Assets: Regulatory Licenses Regulatory licenses can create a strong moat as new players cannot enter the market without the requisite approvals. As a result, a few number of firms have control over the entire market. This must, however, not give the impression that all sectors that require regulatory licenses may enjoy a strong moat. The key condition that makes regulation a strong moat is when only entry

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to the market is regulated, whereas there is no regulatory control on pricing of products or services. Take the case of state-run electricity boards and private banks. Entry to both sectors is highly regulated. But most utility companies are under heavy losses because they have no pricing power. On the other hand, profitability in the private banking sector is determined largely by market forces and as such, banks tend to enjoy higher returns. However, the moat in case of regulatory licenses is dependent on an external factor and as such any adverse change in regulation could be a major risk.

II. c) Intangible Assets: Patents & Intellectual Property When a company innovates a new product, it can patent the product so that no other firm is legally allowed to sell this product. Think of a patent as the financial reward for creating a new product, or as intellectual property the company can use. The pharmaceutical industry makes heavy use of patents whenever they create a new drug. The patent allows them to recoup the high capital expenditure that goes into research and development of new drugs. Companies that have a patent on a particular good are immune from competition. Patents provide a very strong moat and allow the firm to earn very high returns. However, moats arising out of patents do not assure long term durability because patents have a finite duration. Once a patent expires, it brings in heavy competition in that market and drives down the profitability. As such, a company has to keep innovating new patented products to enjoy high returns. Patents are often vulnerable to legal battles and could be revoked. As such, the moat of firms that have just a few patented products may lack long term durability.


27

III. Switching Costs Switching costs refer to factors that make it difficult or undesirable for consumers to switch to the products/services of a competitor. The factors include time, capital, convenience, etc. If the switching costs are high, a firm is able to lock in its customers. It can charge its existing customers higher prices because it knows the customers are reluctant to switch to competitors. Think about the difference between a bank and a retailer. Do you change your bank account every time some bank offers higher interest and lower fees? Would you continue to buy things from the same retailer even if he charges more than his nextdoor competitor? Another example is Microsoft Office. Users are reluctant to switch from Microsoft as learning a new product would be inconvenient and time-consuming.

IV. Network Effects Network effects refer to the fact that the value of a product or service increases with the increase in the number of users. This effect is largely observed in fields where businesses rely on information sharing or linking users together. Consumers are unlikely to move to a new competitor because there would be very few people using the new product/service. Take the example of the National Stock Exchange. The higher the trading volumes on the exchange, the more efficient is the pricing process. This creates a self-reinforcing pattern, bringing in more volumes on the exchange. Another example is Facebook. Facebook is valuable to a user because many other people they know also use it, making it difficult for new social networking sites to succeed in the market.

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Types of Moats: Cost Advantages While price advantages refer to how a firm can charge a premium to its customers, cost advantages refer to supply-side factors that enable a firm to be a low cost player. The most important moats under this type: I. Economies of scale II. Cheaper access to resources III. Process-based cost advantages

I. Economies of Scale In an industry where the fixed costs are relatively much higher than the variable costs, the greater the size of the firm, the greater are the cost benefits that it can enjoy over its peers. Due to high fixed costs, new competitors are discouraged from entering the market. The absolute size of a firm is not as important as its size relative to its competitors. For instance, a small cap firm could be a dominant player in a niche industry and enjoy scale advantage within that industry. Cost advantages based on economies of scale can be divided into two main types:

a) Large distribution network A firm that possesses an extensive distribution network can enjoy a remarkable edge over competitors and new entrants. The higher volumes and lower lead times thus enable companies to cut costs. It can not only achieve higher volumes but can also introduce various new products through the same channel. Example: ITC Ltd


29

b) Large scale operations For a manufacturing firm with high fixed costs, the average cost per unit decreases as the output increases. Example: Maruti Suzuki For a retailer, the cost advantages lie in its ability to procure merchandise on a large scale at a price that is significantly lower than what its competitors can get. Example: Wal-Mart

II. Cheaper Access to Resources In many commodity businesses, the access to key raw materials or assets is an important component of their success. Usually, firms will buy/lease access to a land/onshore/offshore asset and use that asset to access raw materials. Cheap access to a resource or raw material can lead to significant cost savings and, in turn, high profitability. Examples: oil, gas, mining companies. Energy and mining companies can be very profitable due to their ability to cheaply access raw materials.

III. Process-based Cost Advantages Process-based cost advantages refer to cost savings occurring due to efficient and cheaper production or supply processes. By innovating and building better processes, a firm can produce or supply its products more cheaply than other competitors. Competitors may not have access to these processes, and cannot necessarily implement it themselves. However, competitors could catch up and erode the moat over time. Example: Amazon.com (online retailer), Toyota (Total Quality Management), Dell (sold direct to buyers) Tata Steel (low cost steel producer), etc.

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Determining a Moat √√ Has the company consistently earned high returns on capital? √√ Does the company enjoy better profitability relative to its competitors? √√ Identify the key factors that enable the company to earn such high returns. √√ Can the company continue to enjoy these high returns for a long time? If the answer to these questions is in the affirmative, the company under consideration does have an economic moat. Note: Certain industries, by their very inherent structural characteristics, offer economic moats to a relatively large number of firms. Example: Consumer goods, pharma, etc.

Durability of a Moat Once we identify a company with a moat, the next step is to determine its long term durability. How long can the company earn higher returns while keeping competitors at bay? Certain moats tend to erode over time, while few get more durable over time. The Buffett test: Can a well-financed competitor erode the company’s profitability? “Give me $10 billion dollars and how much can I hurt Coca-Cola around the world? I can’t do it.” – Warren Buffett


31

Avoiding False Moats √√ Temporary favourable economics should not be confused for moats. Example: High profitability due to supply shortages will end once new capacities come on stream. √√ Advantages that cannot be scaled up do not imply a moat. √√ Popular products, strong market share or technological superiority do not guarantee a durable long term moat. √√ Never confuse a great management for a moat. “Go for a business that any idiot can run -- because sooner or later, any idiot probably is going to run it.” – Peter Lynch

Conclusion

32

•

Moats are entry barriers that prevent competitors from eroding a firm’s profitability.

•

Economic moats are indicative of the durability of a company’s future earnings.

•

Price advantage moats are competitive advantages that allow a firm to charge a premium price from its customers.

•

Cost advantage moats are supply-side factors that ensure a firm’s high profitability.

•

It is important to determine durability of a moat & avoid getting trapped by false moats.

•

Now that we have discussed the conceptual framework of economic moats, the next two chapters will be entirely dedicated to discussing practical examples of economic moats in listed Indian companies.


Chapter 4

Identifying Economic Moats II

Examples of Price Advantage Economic Moats:

1. WABCO India – Real Product Differentiation Company overview •

WABCO India, a majority owned subsidiary of WABCO Holdings Inc., is a leading manufacturer of air-assisted and air brake systems for commercial vehicles in India.

•

It has about 85% market share in the original equipment manufacturers (OEM) market.

•

It also enjoys a market share in excess of 75% in the replacement market segment

•

The company has a strong aftermarket network with more than 7,000 outlets and 320 service centers all over India.

Economic Moat- Real Product Differentiation •

WABCO’s strength is the performance quality and the technology behind its products that sets it apart from competition.

Chapter 4: Identifying Economic Moats II

33

•

The company’s parent has been a pioneer of breakthrough electronic, mechanical and mechatronic technologies for braking, stability and transmission automation systems for over 140 years.

•

WABCO’s track record of technology leadership features many of the commercial vehicle industry’s most important innovations.

•

With intensive R&D efforts and high quality standards, its products have found global acceptance. It exports to countries such as Australia, Malaysia, UK, Singapore, South Asia, North America, Venezuela and the Middle East.

•

It consistently tries to increase revenues per vehicle through introduction of new products and upgradation to higher end technologies.

•

Given the support of its parent company in terms of technology and brand name, we believe it would not be so easy for one to displace WABCO from its leadership position.

Financial performance •

WABCO India has generated returns on equity (ROE) of around 30% on average over the last five years.

•

It does not have any debt on its books.

•

Its profit margins are way higher than its peers in the industry, indicating strong pricing power. ( Please see table in Appendix 2 on page 46 )

34


2. Colgate-Palmolive (India) – Brands Company overview •

Promoted by Colgate-Palmolive USA, the 51% subsidiary company commenced its Indian operations in 1937.

•

Colgate manufactures and distributes oral care, personal care & household care products.

•

In oral care, the company is the market leader with 55% share in the Indian toothpaste market, and 42% share in the toothbrush market.

•

The oral care segment contributes over 95% of the company’s total sales.

•

Colgate has a wide distribution network of 4.9 million stores.

•

Its flagship brand, Colgate Dental Cream, is the largest distributed product in the toothpaste market, and is available in 4.1 m stores.

Economic Moat- Brands •

Colgate has built an extremely powerful brand over its 75 years of existence. The brand is consistently ranked among the most trusted brands in India.

•

Its products are approved by the Indian Dental Association and this lends strong brand equity. Medically approved dental products find greater acceptance and act as powerful entry barrier for new launches.

•

The company has oral care products straddling price points and catering to niche categories.


35

•

The company partners with dentists and schools to increase oral care awareness, thereby promoting its products.


Over last 10 years, Colgate has generated a return on net worth (RONW, same as return on equity) of over 90% on average.

•

As of year ended March 2013, Colgate had zero debt on its balance sheet.

•

The company spends heavily on advertising and sales promotion, averaging nearly 16% of sales over the last 10 years.

•

Colgate’s brand value coupled with one of the widest distribution networks in the country has resulted in a strong economic moat for the company and has led to significant shareholder wealth creation over the long term. ( Please see table in Appendix 2 on page 47 )

3. Solar Industries - Regulatory Licenses Company overview

36

•

The company is the largest and the fastest growing manufacturer of industrial explosives and initiating systems in India.

•

The company commands 29% market share in the domestic explosives market. Apart from 17 manufacturing facilities in India, Solar exports explosives to over 19 countries and enjoys about 70% market share in exports from India.


•

The company also has two overseas manufacturing units in Zambia and Nigeria, Africa.

•

The company is also in the process of setting up a manufacturing plant that would supply specialty chemicals to the defence sector.

Economic Moat- Regulatory Licenses •

Government regulations provide a strong moat. The industrial explosives sector is one of the very few industries that require industrial licenses. It is mandatory to get clearance from the Home Ministry.

•

Given the hazardous nature of the product, clearance from the Intelligence Bureau (IB) is required regarding safety of location.

•

A lot of other permissions, NOCs (No Objection Certificates) and licenses are required from various other government agencies. This creates a strong barrier against new players planning to enter this industry.

•

In addition, the pricing is not subject to regulatory oversight. This allows the company to earn high returns on capital.


Solar Industries’ robust financial performance is testimony of its economic moat.

•

The company’s return on capital has been robust, while operating margins have remained within a stable range. ( Please see table in Appendix 2 on page 48 )


37

4. Bosch Ltd – Patents and Intellectual Property Company overview •

Bosch Ltd is a subsidiary of German auto components firm Robert Bosch GmbH.

•

It manufactures fuel injection systems with focus on both diesel and gasoline.

•

It is the market leader in this field and has a share of around 70% in the diesel space.

•

Given the increasing dieselization in the country, the company stands to benefit as diesel systems account for around 85% of the company’s total revenues.

•

It has supply contracts with most of the major players in the commercial and passenger vehicles segment and even caters to three wheelers.

Economic Moat- Patents and Intellectual Property

38

•

Bosch Ltd’s strength is the patented technology of its parent firm, the German auto components behemoth Robert Bosch GmbH.

•

In terms of patent application numbers, Bosch occupies a leading position in important markets.

•

Bosch Group associates had together filed 4,700 patent applications in 2012 alone.

•

The Bosch Group spends over 8% of its sales revenue for research & development. As the leader in the fuel injections


space, Bosch Ltd has continuously improved technology and introduced new products in this area. •

The company has been working closely with most original equipment manufacturers (OEMs) to introduce products that will help smooth the transition to Bharat Stage 3 and Bharat Stage 4 emission norms.

•

Given the support of its parent company in terms of patented technology, we believe it would not be so easy for one to displace Bosch Ltd from its leadership position. ( Please see table in Appendix 2 on page 48 )


Bosch Ltd has generated a return on equity (ROE) of over 25% on an average during the past 10 years.

•

This is commendable given the cyclical nature of the industry.

•

It has ample cash and investments and virtually no debt on its books.

•

Whatever capex requirements it has had in the past have all been met through internal accruals with no recourse to debt. ( Please see table in Appendix 2 on page 49 )


39

5. HDFC Bank – Switching Costs Company overview •

Incorporated in 1994, HDFC Bank is the second largest private sector bank in the country in terms of asset size.

•

HDFC Bank has very successfully merged with Times Bank and much later acquired Centurion Bank of Punjab. On both occasions the bank benefitted from the expansion of its franchise.

•

Its group companies, HDFC Standard Life (insurance), HDFC AMC (mutual funds) and HDFC Securities (equities) add scalability to the bank’s offerings.

•

The bank is well-positioned in urban and rural markets with a nationwide network. It is a leading player across retail loan categories.

•

Besides the extensive branch network, the bank has made significant headway in its multichannel servicing strategy, such as ATMs, internet, phone and mobile banking to serve their banking needs.

•

The bank boasts of a total customer base of 28.7 million.

Economic Moat- Switching Costs

40

•

HDFC Bank’s strength is its strong national network with expanding semi-urban and rural footprint.

•

The bank at present has an enviable network of 3,062 branches and 10,743 ATMS spread across 1,845 cities. 88% of the bank’s new branch setup is located in semi-urban and rural areas.


•

The bank enjoys a market share of 4.1% and 4.7% in total banking system deposits and advances respectively, offering competitive rates.

•

Given the market leadership, accessibility and wide range of product offerings, it is very unlikely that the customers may switch to the competition for a few more percentage points on deposit rates.

•

Parent HDFC, which is a significant player in retail home loans, distributes its loans through HDFC Bank. Hence the customer stickiness tends to be high.

•

Additionally, the bank benefits from cross-selling opportunities through its parent’s subsidiaries that are into life and non-life insurance and broking services. This provides a wide and sticky customer base. The variety and quality offers competitive advantage.


HDFC Bank has demonstrated a proven ability to generate shareholder value over the past 17 years of its operations.

•

With a healthy balance sheet and consistent profitability growth, the bank’s return ratios are the highest in the private sector space. For last 10 years, the bank has recorded average return on assets (ROA) at around 1.5%, and average return on equity (ROE) at above 15%.

•

Supported by a rich liability franchise, HDFC Bank enjoys highest current and savings account (CASA) ratio of 47% (FY2013) in the industry.

•

HDFC Bank has historically had higher net interest margins between 4.0% to 4.4% over the last 5 years.


41

•

The bank has, over the last 10 years, had net non-performing assets (NPA) levels below 0.6% and has one of the most conservative provisioning norms.

•

Note: The banking industry, due to its inherent structural characteristics, tends to offer this economic moat to most of the firms in the space. Evidently, HDFC Bank has managed to capitalize well on this characteristic feature of the industry. ( Please see table in Appendix 2 on page 49 )

6. Info Edge (India) Ltd - Network Effects Company overview

42

•

Established in 1995, Info Edge Ltd is India’s premier on-line classifieds company in recruitment, matrimony, real estate, education and related services.

•

The company runs India’s largest job site - Naukri.com. It is the market leader in this field with over 60% traffic share.

•

Its matrimony website, Jeevansathi.com is currently ranked at number 3 in the country.

•

The property listing service for real estate purchases, sales, and rentals is conducted through the website 99acres.com.

•

Shiksha.com is the company’s offering in the space of education. It carries online education classifieds.

•

In recent times, the company has invested in different start ups as well as new businesses that present opportunities for scaling up. This includes leading names like Zomato.com, mydala.com, Happily Unmarried, etc.


Economic Moat- Network Effects •

The network effect is significant in this business. Because Info Edge has the maximum number of listed jobs, it is able to attract the largest share of traffic.

•

As it is able to attract the largest share of traffic, its users get the most responses.

•

Because they get the most responses, the company gets more clients.

•

This virtuous cycle enables the company to make higher profits and earn higher returns on capital than its peers even through times of slowdown and economic recession.

•

The online portal is complemented by a strong sales force.

•

The company has a nationwide network through 57 branch offices in 36 cities.

•

This makes it the only online (dot com) company with such a strong sales force.

•

As other players do not have such a strong network, Naukri has the largest database of both jobs as well as resumes.

•

The network helps it maintain a leadership over its peers.

•

The traffic gap with Monster India and Times Jobs (its closest competitors) has widened from a mere 10% in 2007 (only with Monster India) to 45% and 52% respectively in March 2013.

•

The company’s increasing market share is the result of a strong moat due to network effects.


43


Info Edge has generated a return on equity (ROE) of around 18% on average over the past 6 years.

•

The company has been completely debt-free post its initial public offering.

•

Its operating margins have averaged at over 30% during the past 6 years.

•

As of year-ended March 2013, the company had a cash balance of Rs 3.1 bn (cash + short term investments).

•

It has been investing a part of this cash in investee companies which are predominantly startups or small but powerful brands that present opportunities for scaling up. Despite the investments, the cash balance remains strong.

•

With minimal capex requirements and negative working capital, the cash pile is just set to grow. This provides adequate safety to the company when the times get tough. ( Please see table in Appendix 2 on page 50 )

Conclusion

44

•

We discussed price advantage economic moats with examples of listed Indian companies.

•

WABCO India’s moat is its superior technology.

•

Colgate’s moat arises from its strong brand and extensive distribution network.

•

In case of Solar Industries, regulatory licenses deter new player from entering the market.

•

For Bosch Ltd, the patented technology of its parent firm is


the moat. •

HDFC Bank enjoys the high switching costs that are inherent in the banking sector. Its vast branch network further widens the moat.

•

Info Edge benefits from the network effect on its online job portal Naukri.com.

•

Companies that have multiple moats tend to enjoy much higher return on capital.

•

In the next chapter, we will discuss examples of cost advantage economic moats.


45

46


FY09 15.2 9.8 9.8 FY09 19.5 4.4 6.3

Operating margin (EBITDA, %)

WABCO India

Rane Brake Linings

Sundaram Brake Linings

Return on Equity (ROE, %)

WABCO India

Rane Brake Linings

Sundaram Brake Linings

6.7

18.8

38.8

FY11

9.5

10.8

21.1

FY11


7.4

14.1

33.4

FY10

11.0

11.8

21.2

FY10

0.6

17.7

33.5

FY12

8.2

11.0

20.3

FY12

Comparison of Key Financial Ratios

Appendix 2

NA

9.2

22.2

FY13

2.7

8.5

19.4

FY13

5.2

12.8

29.5

5-Yr Avg

8.2

10.4

19.4

5-Yr Avg


47

Advertising & Sales Promotion/ Net Sales (%)

(EBITDA, %)

15.7

15.6

75.6


Operating Profit margin

44.2

Return on Net Worth (RONW, %)

FY04

14.2

18.0

84.1

45.3

FY05

16.0

16.1

80.7

57.1

FY07

FY09

FY10

FY11

FY12

FY13

17.4

17.0

75.0

16.0

16.8

71.7

15.3

22.2

63.1

15.3

20.3

75.0

15.3

19.4

75.0

15.5

18.2

76.7

140.9 132.2 130.5 104.8 102.5 100.1

FY08


17.6

17.3

74.1

50.8

FY06

Colgate Palmolive (India) Ltd - 10 Yr Key Financial Ratios

15.8

18.1

75.1

90.8

Avg

10-Yr

48


12.2 16.2


Operating margins (EBITDA, %)

18.0

21.9

30.6

8.8

38,174

3,348

2009

Data Source: Company website

8.4

45,127

Sales Revenue

2008 3,810

R&D cost as a % of Sales

22.0

20.8

23.7

FY10

18.9

24.5

31.5

FY11

6.5

47,259

3,073

2010

Bosch Group - R&D Expenditure

Research & Development cost

(Figures in million euros)

15.2

Return on Capital Employed (ROCE, %)

FY09


FY08

(Consolidated)

4,190

2011

20.4

28.9

33.3

FY12

8.1

51,494

Solar Industries - Key Financial Ratios

9.1

52,464

4,787

2012

19.1

21.7

26.8

5-Yr Avg


49

0.11

Total Debt to Equity ratio (times) 0.10

30.5

13.8

0.10

26.5

12.8


0.11

24.5

10.4

0.09

22.4

12.5

0.08

18.2

11.6

0.07

23.0

12.1

CY10

3.9 54.7 20.6

CASA/ Total Deposits (%)


17.7

55.5

4.0

19.5

57.7

4.3

17.7

54.5

4.4

17.2

44.4

4.3

Data Source: Company website, Ace Equity

18.5

60.7

3.9

16.3

52.0

4.4

FY04 FY05 FY06 FY07 FY08 FY09 FY10

16.8

52.7

4.2

FY11

HDFC BANK - Key Financial Ratios

Net Interest Margins (NIMs, %)

(Standalone)

34.6

29.0

Return on Equity (ROE, %) 0.12

14.5

CY03 CY04 CY05 CY06 CY07 CY08 CY09

Profit after Tax margin (PAT, %) 11.20

(Standalone)

Bosch Ltd - Key Financial Ratios

0.04

18.6

10.2

CY12

18.7

48.4

4.1

20.3

47.4

4.0

FY12 FY13

0.06

25.4

12.8

CY11

18.3

52.8

4.2

10-Yr Avg

0.09

25.3

12.1

Avg

10-Yr

50


20.7 29.5 14.5



Profit after Tax margin (PAT, %)

29.5

27.3

18.3

FY09

25.4

29.5

14.9

FY10

30.5

34.1

18.1

FY11

Data Source: Equitymaster Research, Ace Equity

FY08

(Standalone)

27.3

38.3

21.3

FY12

Info Edge (India) Ltd - Key Financial Ratios

28.2

34.3

15.4

FY13

25.9

32.2

18.1

6-Yr Avg

Chapter 5

Identifying Economic Moats III

Examples of Cost Advantage Economic Moats:

1. Container Corporation of India Ltd – Economies of Scale Company overview •

Container Corporation of India (Concor) is a public sector undertaking under the Indian Ministry of Railways.

•

Primary business is transportation through containerization. Also offers terminal and warehousing services in India.

•

Concor uses the Indian Railway’s network for its operations for more than 90% of its inland transportation, and also gets wagons and operational support.

•

Market leader in container rail business segment, with a market share of 75%.

•

Huge network of around 62 terminals and over 9,600 high speed wagons. The company does business through two main segments – EXIM (export-import) segment (80% of the business) and the Domestic segment.

Economic Moat- Economies of Scale •

Company has unmatched pan-India strategic assets and

Chapter 5: Identifying Economic Moats III

51

network of rail terminals that provide a strong moat. •

High cargo volumes (75% market share) bring down average cost per tonnage.

•

Before 2006, Concor had a monopoly in containerized train transport. In 2006, the sector was opened up to private players.

•

However, Concor continues to be the lowest cost operator as the new players have not even achieved minimum economies of scale.

•

Scale advantage and lower costs compared to peers allow the company to dominate a market where competition is mainly price-based.

•

Being the pioneer, it also has the benefit of getting Indian Railways’ surplus land at key locations at very attractive long-term lease rates.


The company is debt free and its average return on equity (ROE) over the last 7 years is about 21%, signaling a strong moat.

•

The competitors do not have such high returns, and they are also highly leveraged.

•

The company’s dominant market share gives it considerable bargaining power.

•

Despite a tough macroeconomic environment, the company’s financials have not been very severely hit. ( Please see table in Appendix 3 on page 59 )

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2. Coal India – Cheaper Access to Resources Company overview •

Established in 1973, Coal India Ltd (CIL) is a state controlled coal mining company in India.

•

It is the largest coal producing company in the world (based on raw coal production).

•

Coal India has the largest reserves of coal in the world at 67 bn tonnes, with proved reserves of 52 bn tonnes (47% of India’s proved reserves) and extractable reserves of 22 bn tonnes.

•

CIL operates 471 mines in 21 major coal fields across 8 states in India, including 163 open cast mines, 273 underground mines and 35 mixed mines.

•

It is the primary supplier of coal in India, accounting for 82% of the country’s coal production.

Economic MoatCheaper Access to Resources •

Coal India’s cheap access to raw materials creates a strong moat.

•

Given India’s abundant coal reserves and the absence of other sustainable fuel sources, the company plays a strategic role in meeting India’s energy requirements.

•

It has one of the lowest strip ratios at 1.69x. The strip ratio refers to how much waste they have to mine per unit of what they want to extract. The low strip ratio ensures


53

easily extractable reserves and high margins due to lower production costs. •

Nearly 90% of the company’s production is from open cast mines. Most of these open cast mines have low stripping ratios, which provide the company with a significant cost advantage.

•

Coal India is expected to contribute 80% of the Indian coal production in FY14, and thus maintain its dominant position.


Despite the economic slowdown, profit margins and ROE remain high.

•

The company is almost debt free and has an average return on equity of over 32% over the last 8 years, signifying a strong moat.

•

The company makes further profits due to auction sales, as they can sell at a much higher price than the reserve price of coal.

•

Due to their monopolistic business model, high reserve to production ratio, and cash rich balance sheet, they are well poised for future success. ( Please see table in Appendix 3 on page 60 )

3. Ambuja Cements – Process-based Cost Advantages Company overview •

54

Founded in 1983, Ambuja Cements is today one of the


leading cement manufacturers in India. •

Ambuja has been a pioneer in the Indian cement industry with several laurels to its credit. It is one of the most profitable and innovative cement companies in India.

•

The company has grown at a rapid pace over the last three decades and its cement capacity stands at 27.3 mtpa.

•

Ambuja has a pan-India with 5 integrated cement manufacturing plants, 8 cement grinding units and 3 bulk terminals.

•

The company is particularly strong in the northern and western markets of India.

Economic MoatProcess-based Cost Advantages •

Ambuja is one of the most efficient and low cost cement manufacturers in the world.

•

Strong management focus on continually fine-tuning efficiencies and upgrading facilities.

•

Ambuja Cements pioneered the concept of transport of cement by sea. This has not only led to lower freight costs but has also brought the coastal markets of India within its reach.

•

Moves like owning ships for movement of cement within India, early emphasis on captive power plants, captive jetties and emphasis on branding have yielded rich dividends.

•

Swiss-based global cement major Holcim acquired management control in 2006 and now holds a 50.6% stake in the company. Post Holcim acquisition, Ambuja Cements has benefited from the MNC’s expertise in several areas


55

including waste-based power generation.


Ambuja Cements is ahead of its competitors on some of the most important financial parameters, indicating a strong economic moat. ( Please see table in Appendix 3 on page 61 )

Example of a false moat:

Suzlon Energy Company overview •

Suzlon Group was ranked as the world’s fifth largest wind turbine supplier, in terms of cumulative installed capacity, at the end of 2011.

•

The company has over 21,500 MW of wind energy capacity installed in 30 countries, across Asia, Australia, Europe, Africa and North and South America

•

Suzlon has operations across 33 countries and a workforce of over 13,000.

•

Regulatory mandates in the US, Europe and India for investments in green energy projects were a huge positive for Suzlon, which until a few years back had the first mover advantage in wind energy capacities.

False Economic Moat •

56

Suzlon Energy’s first mover advantage in being able to capitalize on the worldwide regulatory support to the fast-


growing wind energy sector was considered to be its biggest moat. •

The company, however, failed to deliver on quality and lost customer trust. There were several legal cases filed against the company over the poor quality of wind turbines.

•

Suzlon also went on to do big ticket acquisitions (Hansen Transmission in 2007 and REpower Systems) which took its debt to equity ratio to unreasonable levels.

•

Finally the stimulus packages awarded by governments in the US, Europe and India to the wind energy sector eventually dried out as the focus shifted towards the economic crisis in 2009.


After earning healthy profits and return on capital, Suzlon Energy’s fortune tumbled in the aftermath of the financial crisis.

•

The company has been loss-making over the last four financial years.

•

The company’s debt to equity ratio has shot up substantially over the years.

•

Despite the bleeding bottomline and negative return ratios the management refused to restructure the businesses.

•

Finally Suzlon had to accept a corporate debt restructuring package of Rs 95 bn from its bankers in April 2013. ( Please see table in Appendix 3 on page 62 )


57

Conclusion

58

•

We discussed cost advantage economic moats with examples of listed Indian companies.

•

Container Corporation’s moat is its scale of operations and its extensive rail network.

•

In case of Coal India, the cheap access to vast reserves of coal is the company’s competitive advantage.

•

Ambuja Cements’ moat arises from its highly efficient low cost processes and pan-India reach.

•

Suzlon Energy is a classic example of how first mover advantage and market leadership are not sustainable moats.

•

All moats are not equally durable; it is important to evaluate the quality of a company’s moat.

•

Long term trends in the financial performance of a company often indicate if the moat is eroding or strengthening over time.



59

FY07 23.0 26.8 33.2

(Consolidated)

Profit after Tax margin (PAT, %)

Return on Equity (ROE)

Return on Capital Employed (ROCE)

29.1

22.6

22.6

FY09


31.8

25.3

21.8

FY08

24.7

19.4

20.8

FY10

22.8

19.0

22.5

FY11

22.2

16.5

21.1

FY12

19.4

15.0

20.9

FY13

Container Corporation of India - Key Financial ratios

Appendix 3

26.2

20.6

21.8

7-Yr Avg

60


FY06 23.6 41.3 0.2

(Consolidated)



Total Debt to Equity ratio (times)

0.1

30.5

17.6

FY08

0.1

10.9

6.1

FY09

0.1

37.2

21.8

FY10

Data Source: Equitymaster Research

0.1

35.2

21.5

FY07

0.1

32.6

19.6

FY11

0.1

36.6

25.1

FY12

Coal India Ltd - Key Financial Ratios

0.1

35.8

26.5

FY13

0.1

32.5

20.2

8-Yr Avg


61

27.6 16.8 0.2 34.9


Profit after tax margin (%)

Total Debt to Equity ratio (times)

Dividend payout ratio (%)

33.1

0.5

12.1

21.0

28.0

ACC Ltd**

8.1

0.8

9.3

20.7

22.3

UltraTech#

Data Source: Ace Equity *Consolidated, Jun 2004 to Dec 2012; **Consolidated, Mar 2004 to Dec 2012; #Consolidate, Mar 2004 to Mar 2013; ^Standalone, Mar 2004 to Mar 2013

30.7

Return on Capital Employed (ROCE, %)

Ambuja Cem*

16.7

1.6

10.3

24.9

19.2

Madras Cem^

Comparison of Key Financial Ratios - 10 Year Average

62


FY03 15.9 14.3 15.0 15.2 0.4

(Consolidated)

Operating Profit margin (EBITDA, %)

Profit afte Tax margin (PAT, %)


Return on capital employed (ROCE, %)

Total Debt to Equity ratio (times) 0.6

35.3

46.0

16.9

18.9

0.4

45.9

62.8

18.8

25.4

FY05

0.2

39.3

43.5

19.8

24.8

FY06

1.5

21.0

28.3

10.8

17.7

FY07


FY04

1.2

13.3

17.7

7.4

17.2

FY08

1.7

8.6

5.2

1.6

12.4

FY09

1.9

3.9

-13.1

-4.8

6.2

FY10

Suzlon Energy - Key 10-Yr Financial Ratios

1.9

1.3

-20.1

-7.3

6.4

FY11

2.7

8.0

-8.1

-2.2

9.1

FY12

Accounting Basics & Financial Analysis

Chapter 6

Accounting Basics

Accounting •

Accounting is the reporting of the financial statements of a company.

•

A company’s accounts are a summary of all the transactions conducted by the company. They provide us with a picture of how the company is performing.

•

When we analyze a company, the first place to start is the company’s accounts. We use accounts to come up with a valuation for the company.

•

All company accounts are audited, but sometimes they can be misrepresented. A company’s financial statements consist of four elements.

•

The first is the Balance Sheet, the second is the Profit and Loss Statement, the third is the Cash Flow Statement, and the fourth is Notes to Financial Statements (including changes in Equity).

•

Companies publish a summary of their accounts every quarter, and a full set of accounts every year.

Balance Sheet •

The Balance Sheet is a snapshot of the company’s financial balances at a particular point in time.

Chapter 6: Accounting Basics

65

•

It is composed of three parts: assets, liabilities, and shareholders’ equity.

•

Assets represent items of economic value that can be converted into cash. Assets are used to generate income.

•

Assets include current assets, long-term assets, and intangible assets.

•

Liabilities represent the firm’s financial obligations that have resulted from previous transactions.

•

These include current (short-term) and non-current (longterm) liabilities.

•

Shareholders Equity is equal to Assets minus Liabilities and is the book value of the firm.

•

It consists of investment from shareholders and retained earnings.

Profit and Loss Statement •

The Profit and Loss statement summarizes the company’s revenues, expenditures, taxes, and profits over a particular period of time.

•

They include non-cash transactions such as depreciation.

•

The Profit and Loss Statement is measured over a time period (e.g. one year or one quarter), whereas the Balance sheet is a snapshot and measured at a single point of time.

Cash Flow Statement •

66

The Cash Flow statement is a summary of all the cash inflows and outflows by the company over a particular period of time.


•

There are differences between cash flows and profits.

•

Revenues can be recorded before the actual cash is received and vice versa.

•

Cash flow is more difficult to manipulate as compared with earnings.

Cash versus Accrual Accounting Method •

Imagine being asked to run your Dad’s set up for one year. You are a complete novice in accounting. This is how your financial statements would look:

•

Business related cash flows Cash received from customers ------------------ Rs 6,000,000 Cash paid to suppliers ---------------------------- Rs (3,000,000) Tax outflow (this year plus some of last year) -- Rs (500,000) Interest on working capital ------------------------- Rs (200,000) Other expenses -------------------------------------- Rs (1,000,000) Total cash inflow/ (outflow): -------------------- Rs 1,300,000

•

What we just saw was cash based financial reporting. It is useful but suffers from a serious drawback. It records transactions based on when cash was received or paid out. It does not record it when the actual transaction happens. For instance, in cash received from customers in the previous slide, some of the cash could be from sales of previous year. Also, the company must have bought raw materials on credit which is not reflected in cash based accounting because cash has not yet gone out.

Chapter 6: Accounting Basics

67

•

So, what to do in such a scenario? The answer is accrual based accounting. In accrual based accounting, the transaction is recorded when it actually happens and not when cash is received or paid.

•

E.g. If a customer buys goods on credit, the company will record it even though the cash has not been received for it. Also, the company will also record expense related to sales even if the cash has not gone out yet.

•

Cash based accounting suffers from a disadvantage that it is not good at tracking historical growth. It is difficult to compare quarter on quarter or year on year sales using this approach. Accrual based accounting records transactions as they happen and hence, is a better system of providing like to like comparison.

•

A statement that is prepared based on accrual based accounting and the one that shows whether a firm is making profit or not is known as the income statement or the Profit & Loss statement.

Notes to Financial Statements

68

•

Most companies usually have additional statements to supplement the first three.

•

These include more detail on how certain items were calculated, etc.

•

As a result, they are very important for valuation analysis.

•

Companies may also include a statement of changes in equity within this.

•

Notes also include various provisions that the company has made.


Chapter 7

Financial Ratio Analysis I

Financial Ratios •

Financial Ratios examine the relative magnitude of two or more variables related to a company.

•

These can include accounting based variables (e.g. earnings) and market based variables (e.g. stock price).

•

Financial ratios allow us to draw conclusions about a company’s stock that we are interested in analyzing.

•

We can think of them as summary statistics that paint a picture of a particular company.

1. Profitability Ratios – Operating Profit Margin •

Operating profit margin is the ratio of operating profit to total revenue.

•

Operating profit is profit before depreciation, interest and tax.

•

So from revenues, you deduct all expenses related to operations, such as cost of raw materials, manufacturing, salaries, marketing, logistics, etc.

•

Operating profit is the most important profitability ratio since it gives a clear picture about the health of the company’s core business. It also reflects the management’s efficiency.

Chapter 7: Financial Ratio Analysis I

69

•

It does not include expenses such as interest and taxes which depend on external factors.

2. Profitability Ratios – Net Profit Margin •

Net profit margin is the ratio of net profit to total revenue.

•

Unlike operating profit margin, it takes into account all of a company’s costs.

•

Net Profit Margin = Profit after tax/Revenue

•

It measures the percentage of sales that the company keeps in profits.

•

For both Operating and Net profit margin, higher numbers are obviously better.

3. Profitability Ratios – Effective Tax Rate •

Effective tax rate is the average rate at which a company’s profits are taxed.

•

Effective Tax Rate = Tax Expenses/Profit before Tax

•

Marginal rates vary for companies, and there are many deductions, tax incentives that can determine how much a company pays in tax.

•

The effective tax rate is an easy way to summarize how much tax a company pays.

4. Profitability Ratios (Banks) Net Interest Margin •

70

Net interest margin examines how much a firm makes from its investments relative to how much it pays on its debt.


•

For a bank, it represents how much they earn from making loans to borrowers, versus what they have to pay when taking deposits from savers, and what they pay to their creditors.

•

Net Interest Margin = (Interest Income– Interest Expenses)/ Average Earning Assets

5. Profitability Ratios (Banks) Net NPA to Loans •

NPA refers to non performing assets, which means loans that may be in default.

•

From the perspective of a bank, they expect that these loans they have made will not be repaid.

•

Net NPA to Loans = Net Value of Non Performing Assets/ Total Value of Loans.

•

If this ratio is high, the bank may have to write off bad loans, and this will reduce its future profitability.

6. Return Ratios – Return on Equity •

Return on equity measures the net profit generated by the company relative to the shareholders’ funds.

•

Return on Equity = Net Profit/Shareholders’ Funds.

•

It is another measure of profitability, and it measures how productively a company uses its equity capital.

•

Limitation: The ratio does not take into account debt capital. As such, if a company’s growth is heavily funded by debt, it will boost the ROE. Hence, one must consider other ratios as well.


71

7. Return Ratios – Return on Capital Employed •

Return on capital employed measures how much profit the company has generated relative to the capital it uses.

•

Return on Capital Employed = Net Operating Profit After Tax (NOPAT)/ Capital Employed

•

NOPAT= Profit before interest and tax (PBIT)*(1-tax rate)

•

Capital employed= Shareholders’ funds+ Total debt

•

ROCE provides a more complete assessment of how well a management is deploying capital.

8. Return Ratios – Return on Assets •

Return on assets measures how much profit a company generates relative to its total assets.

•

Return on Assets = Net Profit/Total Assets

•

We include all assets to calculate ROA, including productive and non-productive ones.

•

For example, if a company has a large cash balance that it is not investing, this will increase total assets and bring down ROA.

9. Debt Ratios – Debt to Equity

72

•

Debt to equity measures how much leverage a company has.

•

Equivalently, it measures what proportion of its assets are financed with equity or debt.

•

Debt to Equity = Total Debt/Shareholders’ Equity


•

Using higher levels of debt is more risky, as interest liabilities go up.

•

However, debt can be cheaper due to the tax deductibility of interest, as well as lower returns for investors as compared to equity.

10. Debt Ratios - Interest Coverage •

The interest coverage ratio measures how easy it is for a company to meet its debt obligations.

•

Interest coverage = Earnings before Interest and Taxes/ Interest Expense

•

If this ratio is close to 1 (or below 1), then the company is having problems meeting its debt obligations.

•

In general, companies with higher debt to equity ratios will have lower interest coverage ratios.

11. Debt Ratios – Free Cash Flow to Debt •

Free cash flow is the cash a company generates after paying for its capital expenditures.

•

It is the operating cash flow minus capital expenditures

•

Cash flow is more difficult to manipulate than earnings.

•

Free Cash Flow to Debt = FCF / Total Debt

•

FCF= Cash flow from Operations Minus Capex

•

The ratio measures the ability of a company to finance its debt obligations from its cash flow.


73

12. Liquidity Ratios – Current Ratio •

The current ratio measures the ability of a company to meet its short term obligations.

•

Current Ratio = Current Assets/Current Liabilities

•

If this ratio is less than 1, it indicates that the company would be unable to meet its current obligations if they came due.

•

Short term usually refers to any obligations due in the next 12 months.

13. Asset Utilization Ratios – Fixed Asset Turnover •

Fixed asset turnover measures the company’s ability to generate sales relative to its fixed assets.

•

Fixed assets include property, plant, and equipment.

•

Fixed Asset Turnover = Net Sales / Fixed Assets

•

A higher number indicates that the company is more effective in using its assets to generate sales.

•

This is a common ratio used for manufacturing companies.

14. Asset Utilization Ratios – Inventory Days

74

•

Inventory days represent the average number of days that a company’s goods remain

•

in inventory.

•

Inventory Days = (Inventory/Cost of Sales) *365 Days

•

In general, a lower figure is better, as it implies the company can shift its stock quickly.


•

We would usually use average inventory over the relevant time period.

15. Asset Utilization Ratios – Receivables Days and Payables Days •

Receivables days measures how long it takes for a company to collect revenue after a sale has been made.

•

Receivables Days = (Accounts Receivable/ Revenue) *365 Days

•

Payables days measures how long it takes on average for a company to pay its creditors for inputs purchased.

•

Payables Days = (Accounts Payable/Cost of Sales)*365 Days

16. Cash Flow Ratios – Operating Cash Flow to Sales •

Operating cash flow to sales measures how well a company is able to turn its sales into cash.

•

OCF/Sales = Operating Cash Flow/Revenue If we see a rise in a company’s sales, we should see a corresponding rise in operating cash flow.

•

If this is not the case, then we need to understand why sales are not converting into cash, and question how sustainable their sales might be.

17. Cash Flow Ratios – Free Cash Flow to Operating Cash Flow •

Free cash flow is equivalent to what is left over from operating cash flow after capital expenditures.


75

•

FCF/OCF = (Operating Cash Flow – Capital Expenditures)/ Operating Cash Flow

•

The higher the ratio, the greater the financial strength of the company.

•

New businesses are likely to have high levels of capital expenditure, pushing this ratio lower.

18. Cash Flow Ratios – Dividend Payout •

The dividend payout ratio measures the proportion of the company’s earnings that are paid out as dividends.

•

Dividend Payout = Total Dividend/Net Profit

•

Most companies like to maintain a steady dividend payout ratio, and a fall in this ratio is often a bad sign for a company.

•

Falls in this ratio also hurt the stock price, as investors will seek higher dividend paying stocks.

19. Valuation Ratios – Price to Earnings

76

•

The price to earnings ratio measures the price of a company’s stock relative to the earnings per share.

•

P/E = Market Price per Share/Earnings per Share

•

From an investor’s perspective, it measures how much we are paying for a given level of earnings.

•

Higher P/E ratios indicate that we pay more for a given level of earnings, and vice versa.

•

However, a high P/E stock is not necessarily expensive and vice versa. It is important to consider future earnings growth while evaluating P/E.


•

It is generally relevant to compare the P/E multiples of companies within the same industry.

20. Valuation Ratios – Price to Book Value •

The price to book value measures the market price per share relative to the book value per share.

•

The book value is equal to a company’s net worth or shareholder’s funds.

•

It is the value of the company that would remain if it were to go bankrupt immediately.

•

P/BV = Market Price per share/Book Value per share

•

A higher P/B means we are paying more for the stock relative to its book value.

21. Valuation Ratios – EV to EBITDA •

Enterprise Value (EV) is the sum of market capitalization, debt, minority interest, and preferred shares, less cash.

•

It measures the takeover value of a company (i.e. how much one would pay to takeover the company)

•

EBITDA is earnings before interest, taxes, depreciation, and amortization.

•

EV/EBITDA ratio is used to determine the company’s value, in a similar way to the P/E ratio.

22. Valuation Ratios – Price to Sales •

The Price to Sales ratio the measures the price per share relative to the sales per share of a company.


77

•

Price/Sales = Market Price per Share / Sales Per Share

•

It measures how much we are paying for a given level of sales.

•

The P/S ratio is used as an alternative to the P/E ratio.

•

Sales are more difficult to manipulate than earnings, but don’t provide as much information.

23. Valuation Ratios – Dividend Yield •

The Dividend Yield measures the dividend per share relative to the market price per share.

•

Dividend Yield = Dividend per Share / Market Price per Share

•

It measures the dividend return from holding the stock.

•

Note the difference between the dividend yield and the dividend payout. The first uses market prices, the other uses net profit.

24. Valuation Ratios – Price to Free Cash Flow

78

•

The Price to Free Cash Flow measures the market price per share relative to the free cash flow per share.

•

Price/FCF = Market Price per Share / FCF per Share

•

It tells us how much we are paying for a given amount of Free Cash Flow.

•

It is used an alternative to the P/E ratio, primarily because FCF is more difficult to manipulate and may be a better representation of the company.


Conclusion •

In this chapter, we have discussed many different types of financial ratios.

•

It is important to know that some ratios are more relevant for certain companies and industries.

•

Also, ratios will vary a lot between industries.

•

Usually, these ratios are best used when comparing companies in the same industry.

•

In the next chapter, we will give you an overview of DuPont Analysis, a useful financial performance measure along with some examples.


79

Chapter 8

Financial Ratio Analysis II

Return on Equity •

Return on Equity measures how well a company uses the shareholder’s funds to generate profits.

•

It is calculated as Net Income (Profit After Tax) divided by shareholder’s equity (Share Capital + Reserves).

Return on Equity =

Net Income Shareholder’s Equity

Keep in mind that shareholder’s equity is the book value of equity, not the market value. •

In general, a higher ROE implies that the company is better at generating returns for a given book value.

DuPont Analysis •

The DuPont identity breaks down ROE into three components.

•

The purpose is to understand what exactly is driving the ROE for a particular company.

•

ROE = Net Profit Margin * Asset Turnover * Financial Leverage

ROE =

Net Income Sales * Sales Assets

Chapter 8: Financial Ratio Analysis II

*

Assets Equity

81

•

This is an accounting identity and always holds.

a) Net Profit Margin •

Net Profit Margin measures a company’s profits as a percentage of total sales.

•

For example, if a company earns revenues of 100, and after all its costs it has 15 left over, the net profit margin is 15%.

•

Net Income is listed on a company’s financial statements, and is the profit after interest, depreciation, and taxes.

Net Profit Margin =

Net Income Sales

b) Asset Turnover •

Asset turnover is equal to sales as a percentage of total assets.

Asset Turnover =

Sales Assets

It measures how well a company uses its assets to generate sales. •

It is often the case that companies with low profit margins have high turnover (e.g. grocery shop) and vice versa.

•

In general, a higher asset turnover is better. We can use average total assets to calculate this.

c) Financial Leverage •

82

Financial leverage measures total assets over equity.


Financial Leverage =

Assets Equity

•

It is implicitly measuring how much debt a company has relative to its total assets, since assets are equal to equity plus debt.

•

When financial leverage is higher, it implies that the company has higher debt levels. But this is not always true as we will see in the case of Hindustan Unilever.

•

Higher leverage leads to a higher ROE.

Using DuPont Analysis •

The purpose of DuPont analysis is to understand how exactly a company is generating its return on equity.

•

What we will usually find is that there are stark differences depending on the industry.

•

For example, retailers tend to generate ROE through high asset turnover.

•

Luxury industries tend to generate ROE through high profit margins.

•

Financial companies (i.e. banks) tend to generate ROE through high leverage.

•

As a result, DuPont analysis is not very useful for comparing companies across different industries.

•

However, it is very useful when comparing companies in the same industry.

•

Higher ROE may not always be a good sign – it depends on what is generating it.


83

•

For example, if a company’s ROE is higher as compared with its industry peers due only to higher leverage it could be interpreted as excessively risky.

Examples •

We’ll look at three companies all in different industries, with the aim of showing how they generate ROE in different ways.

•

The companies we will discuss are: HDFC Bank, Hindustan Unilever, and National Mineral Development Corporation (NMDC).

1. HDFC Bank •

HDFC Bank is a financial services company, and one of the largest in India.

•

They have operations in retail banking, wholesale banking, and treasury services.

•

As a financial company, they generate their ROE primarily through high leverage.

•

HDFC Bank’s 5-yr avg. financial leverage is 11.2 times.

•

This is not unusual for a bank.

•

Banks primarily receive deposits that they lend to their customers, which means that most of their loans are funded with liabilities rather than equity. ( Please see table in Appendix 4 on page 87 )

84


2. Hindustan Unilever Ltd (HUL) •

Hindustan Unilever is India’s largest consumer goods company.

•

They sell foods, beverages, personal care products, and cleaning agents.

•

As an FMCG business, their ROE is driven primarily by high asset turnover.

•

Their 5-yr avg. asset turnover is 2.1, meaning that their total sales is just over double their total assets.

•

However, if one considers just operating assets, this ratio would be even higher

•

This type of number is typical for FMCG companies.

•

Another contributor to the high ROE is the company’s financial leverage.

•

The high financial leverage is not because of debt. In fact, the company is virtually debt free.

•

The leverage is high on account of presence of large noninterest bearing liabilities.

•

The company is able to extract very favorable terms from its creditors due to its high bargaining power. Thus, most of its assets are funded by its creditors.

•

This is also an indication of the presence of a very strong economic moat. ( Please see table in Appendix 4 on page 88 )


85

3. National Mineral Development Corporation (NMDC) •

National Mineral Development Corporation (NMDC) is a state-run company involved in mining and producing various minerals.

•

These include iron ore, copper, and many others.

•

They are India’s largest iron ore producers, and have high exports in this area.

•

NMDC generates its ROE primarily through high profit margins.

•

Their 5-yr avg. net profit margin is 58.8%, and this is due to the fact that the cost of mining and producing the minerals is much less than what they earn in revenues from selling them. ( Please see table in Appendix 4 on page 89 )

Conclusion

86

•

DuPont analysis breaks down ROE into the product of three components: net profit margin, asset turnover, and financial leverage.

•

The purpose of DuPont analysis is to understand the factors that drive the ROE for a particular company.

•

The primary factors vary considerably depending on the industry.

•

The next chapter is on Identifying Accounting Red Flags.



87

14.9% 163,323 22,449

Return on Equity = (1)*(2)*(3)

Interest Earned

Profit After Tax

150,527

12.2

Financial Leverage (3)

Shareholder's Funds

0.1

Asset Turnover (2)

1,832,708

13.7%

Net Profit Margin (1)

Total Assets

Mar-09

DuPont Analysis

[INR-Millions] Data Source: Ace Equity

215,225

2,224,586

29,487

161,727

13.7%

10.3

0.1

18.2%

Mar-10

253,793

2,773,526

39,264

199,282

15.5%

10.9

0.1

19.7%

Mar-11

HDFC Bank Ltd (Standalone)

Appendix 4

299,247

3,379,095

51,671

278,742

17.3%

11.3

0.1

18.5%

Mar-12

362,141

4,003,319

67,263

350,649

18.6%

11.1

0.1

19.2%

Mar-13

88


78.8%

3.8 117.0%


202,393 25,007 81,937 21,375

Net Sales

Profit After Tax

Total Assets

Shareholder's Funds


3.5

2.5

Asset Turnover (2)


26,689

92,580

21,027

175,238

1.9

12.0%

12.4%


Mar-10

Mar-09

DuPont Analysis

27,350

101,405

23,060

197,355

84.3%

3.7

1.9

11.7%

Mar-11

36,811

111,973

26,914

221,164

73.1%

3.0

2.0

12.2%

Mar-12

Hindustan Unilever Ltd (Standalone)

28,648

118,833

37,967

258,102

132.5%

4.1

2.2

14.7%

Mar-13


89

75,640 43,724 168,254 116,369

Profit After Tax

Total Assets

Shareholder's Funds

1.4


Net Sales

0.4

Asset Turnover (2)

37.6%

57.8%



Mar-09

DuPont Analysis


142,724

213,976

34,473

62,391

24.2%

1.5

0.3

55.3%

Mar-10

192,145

283,429

64,996

113,693

33.8%

1.5

0.4

57.2%

Mar-11

244,064

351,588

72,656

112,619

29.8%

1.4

0.3

64.5%

Mar-12

275,110

407,978

63,405

107,043

23.0%

1.5

0.3

59.2%

Mar-13

National Mineral Development Corporation (Standalone)

Chapter 9

Identifying Accounting Red Flags

Accounting Red Flags - Introduction •

Financial statements are a snapshot of the complex web of financial activities of a business.

•

They help us understand how the company is earning its revenue, incurring expenses, raising and allocating capital, and what all it owns and owes.

•

But do financial statements always depict an appropriate and transparent picture of the company?

•

Many corporates tend to exploit accounting loopholes to misrepresent or manipulate their financial statements.

•

Accounting red flags are signs of potential trouble that should draw the caution of investors.

•

These could be misrepresentation, omission of information and aggressive accounting techniques that may be within the purview of the accounting standards.

•

In certain cases, there could be outright financial fraud. But these are usually difficult to detect well in advance.

•

However, by identifying potential red flags, investors could do their best to keep away from dubious companies and protect their capital.

Chapter 9: Identifying Accounting Red Flags

91

Why do Companies Distort Financials? •

The most basic factor that prompts corporates to resort to financial misrepresentation is excessive greed and fear.

•

Senior managers often have bonuses and incentives linked to sales and profits. This could lead them to inflate revenues and profits.

•

Reporting favourable financial performance also helps companies to get better terms from lenders and premium valuations from investors.

•

In certain extreme cases, promoters may resort to fraudulent practices to siphon off money from the company to their personal accounts.

•

Let us discuss some of the key accounting red flags that could help investors identify potential trouble.

1. Dubious Related Party Transactions •

Every company, in its annual report, is required by securities law to report all related party transactions (RPT). These are transactions that have happened between the company and its insiders.

•

The insiders are the promoters and their families, the top executives of the firm, and the directors on the board.

Such transactions may include but are not restricted to:

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•

Providing loans to insiders at favourable interest rates.

•

Providing grants or donations with the cash from the firm to other firms controlled by the promoters.


• •

Using the company’s cash to buy stakes in entities promoted by the friends or families of the insiders.

An unusually large number of such transactions should be a red flag to investors. It might indicate that all is not well within the company.

Example: The Satyam Scam •

The Satyam Computer Services scam provides a valuable lesson to investors regarding the implications of related party transactions.

•

The Satyam scam was India’s biggest corporate scandal.

•

It came to light in January 2009 when the then chairman of Satyam, B Ramalinga Raju, confessed in a letter to the stock exchanges, that the company’s accounts had been falsified by US$1.47 bn.

•

Let us discuss some of the fraudulent techniques employed by Mr Raju…

•

Numerous bank statements were created to advance the fraud.

•

Bank accounts were falsified to inflate the balance sheet with balances that did not exist.

•

The income statement was inflated by claiming interest income from these fake bank accounts.

•

About 6,000 fake salary accounts were created over many years and the money deposited in them by the company was appropriated.

•

Fake customer identities and fake invoices to them were created to inflate revenue.


93

94

•

Board resolutions were forged to illegally obtain loans for the company.

•

The cash raised through American Depository Receipts (ADRs) in the United States was siphoned off.

•

The objective of this scam since it began in 2003 was to divert large sums of money, to other firms that Mr Raju owned.

•

Two such firms were Maytas Properties and Maytas Infrastructure.

•

In December 2008, Satyam’s Board of Directors unanimously approved the purchase of these two firms.

•

The reason provided to investors was that these companies would provide Satyam with ‘greater diversification’.

•

These transactions were a blatant attempt to siphon money out of Satyam and into the hands of Mr. Raju’s family, since they held a larger stake in these firms than in Satyam.

•

Satyam’s share price crashed resulting in the transactions being aborted. But by then, the damage had been done.

•

Widespread fraud began to be suspected by analysts.

•

When the scam came to light, on 7th January, the stock fell by 82%.

•

This carefully orchestrated fraud had only one purpose: to enrich the promoters of Satyam.

•

Money was diverted to various firms promoted by Mr Raju and his family, primarily Maytas Properties and Maytas Infrastructure.

•

These firms used the funds to purchase or develop infrastructure and real estate assets, mostly in the city of


Hyderabad, obtained with the help of several politicians and bureaucrats; contacts that Mr Raju had developed over the years.

2. Distortive Depreciation Practices •

There are assets like plant & equipment or proprietary technology that have a long useful life.

•

Accounting laws allow expenses incurred towards the purchase of these assets to be spread over few years instead of expending all of it in the year the cost was incurred.

•

However, some companies take this flexibility too far.

•

They stretch expenses too far into the future even if the useful life of asset has long been over.

•

Or they take small depreciation charges every year and then take a huge write off every few years.

•

This amounts to artificially inflating profits as depreciation expenses are lower than required.

Example: Jet Airways •

Jet Airways, one of India’s largest airline operators, once showed operating losses of Rs 562 crore in 1QFY09.

•

However, during the same period, they showed a Net Profit of Rs 143 crore.

•

This was courtesy of a write back of Rs 916 crore on account of change in depreciation method.

•

The company moved to a more conservative method and hence wrote back the extra depreciation charges of previous


95

years. •

Investors should be on the lookout for such examples and view such companies with suspicion.

•

Other warning signs are revaluing assets every few years or high fluctuations in the amount of depreciation charged.

3. Misrepresentation of Revenues & Costs

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•

Engineering, Infrastructure and Real Estate companies widely use the Percentage of Completion method for revenue recognition.

•

It is used in the case of the execution of long-term projects that span over more than one accounting period.

•

Revenue recognized = % of work completed (often on milestone basis) / Total project value.

•

Revenue, cost and profits are recognized based on the percentage of the completion of the contract activity at the end of each accounting period.

•

The method can be exploited by companies to overstate their revenues.

•

Companies may want to meet their quarterly/annual internal targets or meet market expectations.

•

In this method, the companies can assess the work completed at their own discretion and raise the bill on the client.

•

At the same time, they recognize revenues in the books and increase their debtors by the same amount.

•

However, approval of entire amount billed is dependent on whether the work completed fulfills the client’s milestone


criteria. •

In case of non-acceptance of the amount billed by the client, the amount can be reversed.

•

However, this can be difficult to capture in the subsequent accounting period, as companies may follow the same practice with another client.

•

To recognize red flags, investors can keep a tab on receivables, if they take too long to get converted into cash (as per industry standards).

•

Other warning signs can be gauged from interaction with the industry and company clients.

•

Also, cost over-run is quite rampant in the execution of large projects, which can also lead to overstated revenues.

•

However, acceptance of claims for cost over-run takes long and can only be settled when the project is complete.

•

Exceptions can be companies which recognize revenues only when the client accepts the bill.

•

These companies can be said to be following conservative revenue recognition policy.

4. Spurt in Debtors & Inventories •

Spurt in debtors and inventory is a sign that the company is facing working capital issues.

•

This can threaten the balance sheet as the company may have to borrow to finance working capital.

•

However, viewing an increase in debtors and inventory in isolation as a working capital concern is inaccurate.


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•

As the size of the business increases so will it sales. This will lead to an increase in inventory and debtors.

•

Effectively, investors need to focus on inventory and debtor turnover to gauge whether there is a build up in either of them.

•

Inventory turnover = Net sales/Inventory

•

Debtor turnover = Net sales/Account receivable

•

A decrease in these ratios over time indicates build up. This is a sign of working capital concern.

Example: Reebok India

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•

Reebok India (not listed), one of the largest retailers, faced a build up in receivables. In short, customers were holding back payments to the company.

•

While this is a normal business practice when liquidity is tight it was later discovered that sales and debtors were inflated.

•

A proper analysis of receivables management could have enabled in detecting the fraud earlier.

•

The debtor turnover ratio declined between FY08 to FY10 signifying a build up. However, a perfect warning sign came up in FY10.

•

In FY10, debtors stood at Rs 699 cr and were 90% of its sales. Now this figure in FY09 was at 42% of its sales (The company later restated this figure)

•

A combination of increase in debtors and collection period (in excess of 300 days) should have raised alarm bells.

•

Investors should look out for such instances and view them with suspicion.


•

They should also be careful in analyzing working capital position of infra & engineering companies where cycles are generally long.

5. Contingent liabilities •

Investopedia defines contingent liabilities as liabilities based on the outcome of a future event.

•

These are not really recorded as a part of balance sheet liabilities as the exact outcome is not clearly defined.

•

You can find them in the notes to the accounts.

•

As such, if a company has provided for contingent liabilities or has adequate funds in place to cover them if and when the liability arises, then there is no problem.

•

However, if they don’t, or if the contingent liability itself is dubious, it warrants further investigation.

Example: Shree Ganesh Jewellery House Ltd •

Shree Ganesh Jewellery House Ltd manufactures and exports hand crafted jewellery.

•

On the face of it, the company seems to have good financial numbers. It has delivered healthy returns on equity. At the same time it has been continuously paying off its debt.

Standalone (nos)

FY09

FY10

FY11

FY12

FY13

Return on Equity (ROE) 33.3%

30.9%

24.6%

22.2%

15.7%

0.72

0.51

0.57

0.37

Debt to Equity (x)

1.01



99

•

A deeper look into the company’s accounts presents a different story.

•

The company has contingent liabilities of around Rs 19.6 bn in FY13. Of this nearly Rs 14.9 bn were on account of bills discounted.

•

Bills discounted essentially mean that the customers owe some money to the company which they will pay at a later date.

•

Rather than accounting for these as receivables/debtors, the company discounts the bill with the bank and takes the money on a date earlier than the due date.

•

The contingency is that on the due date if the customer defaults, then the bank will recover this money from the company.

•

If this is a normal practice, then the company’s debtors and therefore its debtor days should be coming down right?

•

But if you look at the trend of the same over the past 5 years, you get a completely different picture.

•

While contingent liabilities have been going up largely due to increasing amount of bills discounted; at the same time, debtors and therefore the debtors days have been on the rise as well. ( Please see table in Appendix 5 on page 102 )

•

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Investors should view such companies with suspicion.


Concentrate on Cash •

Cash flow from operations (CFO) depicts the amount of cash that a company is generating from its business operations.

•

Ideally, increasing profits (as per the Profit & Loss Statement) should broadly result in corresponding increase in cash flow from operations over time.

•

If the increase in profits is corresponded by a decrease (or maybe significantly slower growth) in cash flow from operations, it could be seen as a potential red flag. This could indicate one of the following scenarios: •

Company is aggressively propping up revenues by selling products on credit without collecting payments from customers.

•

Company is boosting other income by selling investments and assets.

Conclusion •

Financial misrepresentation is widely prevalent in India because of the weak regulatory environment.

•

Keeping a vigil eye on the Cash Flow Statements & Notes to Financial Accounts can be useful in spotting potential red flags.

•

One must also look out for any qualified or adverse opinions by auditors in Auditor’s Report (included in Annual Report).

•

It is best to avoid companies that do not make sufficient disclosures and display aggressive accounting methods.

•

Identifying accounting red flags is not always easy. It comes with study and experience.


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102


5,415

Bills discounted

21,485 1,754 30

Revenue

Debtors

Debtor days

73

5,898

29,499

92.5%

57.5%

8,526

9,217

FY10


89.8%

Bills discounted as % of contingent liabilities

-

6,032

Contingent Liabilities

YoY (%)

FY09

Standalone (Rs m)

78

11,250

52,432

90.6%

10.1%

9,391

10,362

FY11

Shree Ganesh Jewellery House Ltd

Appendix 5

117

21,147

65,936

72.3%

22.9%

11,545

15,966

FY12

140

35,463

92,223

76.0%

29.6%

14,965

19,695

FY13

Separating Good Management from Bad

Chapter 10

Separating Good Management from Bad I

What is Management? •

Management refers to the control and oversight of running a company.

•

When we talk about management, we mean the people involved in running the company.

•

There are many levels of management.

•

At the top end, we have CEOs, high level executives, directors, etc.

•

Throughout the company there are upper, middle, and lower level managers.

The Importance of Management •

The management type we are most interested in analyzing is at the CEO and executive level.

•

Those individuals are responsible for looking after the operations of the entire company have the biggest impact on the company’s performance.

•

They take decisions on how much to invest, what products to sell, how to sell it, how many people to hire, etc.

•

Management is important because it is a significant

Chapter 10: Separating Good Management from Bad I

105

determinant of how well the company performs. •

Since management is a critical factor in a company’s performance, we need to consider it when we are evaluating a company.

•

Two companies that look identical on paper may perform very differently if they have different management.

•

When the industry or the economy goes through a rough patch, it is up to the management to see the company through this successfully.

•

And so, management is a huge factor in a company’s performance and ultimately their stock price, and that is why we will spend time learning about it.

Analyzing Management •

Analyzing management is different to most of the other analysis we do.

•

When we analyze companies, we typically look at their financials, and perform quantitative analysis.

•

When we analyze management, the analysis is more qualitative.

•

The Management Discussion and Analysis section in an annual report is a clue to how the management operates and their future plans.

•

Reading up on the news also helps us learn what a company’s management is doing.

Role of Management •

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What is the role of management in a company?


√√ Creating a business model √√ Formulating a long term strategy and vision √√ Determining the growth rate of the the business √√ Employing the right people and aligning their goals to the overall goal of the management √√ Taking capital allocation decisions •

Let’s examine each of these in turn.

1. Creating a Business Model •

A business model is a blueprint for how the company will operate.

•

It includes what products to sell, how much to charge for the products, how to sell the products, how to make the products, etc.

•

It is management’s job to create the company’s business model.

•

A good business model is critical to the success of a company.

2. Formulating a Long Term Strategy and Vision •

This is closely aligned to determining the future growth rate of the business.

•

The management is in charge of deciding the company’s future path.

•

How will they improve their profitability and performance in the future?


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•

How do they intend to grow the business?

•

How will they deal with perceived future threats?

•

All these fundamental questions need to be answered by the management.

3. Employing the right people •

In many businesses, the quality of the individuals employed has a significant impact on the company’s performance.

•

Management must hire the right people and create working conditions that encourage high productivity and success.

Capital allocation decisions •

Management must decide how to raise funds for future projects.

•

This involves deciding how much debt or equity to issue, and how to raise the funds from them.

Qualities a Management Should Have •

Now that we know what a management is supposed to do, let’s look at what are the qualities they should have.

•

Ideally, the more they possess these qualities, the better they will fulfill their roles and deliver strong results. Qualities include: √√ A strong understanding and knowledge of the business under consideration. √√ Honesty and transparency in dealing with stakeholders. √√ Passion for the business.

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1. Understanding and knowledge of the business •

This is more critical that we might first imagine.

•

When working in an industry, one develops knowledge and expertise over time relevant for that industry.

•

If a management attempts to grow the business in an area completely unrelated to what they know well, this can be a problem.

•

Management should expand where they have knowledge and understanding of the business.

2. Honesty and transparency in dealing with stakeholders •

A stakeholder is anyone that is impacted by the company’s actions.

•

This includes stockholders, bondholders, employees, clients, customers, regulatory authorities, etc.

•

It is important for a management to deal with stakeholders correctly, and build up trust between themselves and their stakeholders.

•

Management that tries to deceive others can end up hurting the company in the long run (e.g. accounting scandals).

3. Passion for the business •

This is another quality that is easily overlooked but is nonetheless extremely important.

•

If you are passionate about your work, you will do a better


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job at it as compared with if you disliked your work. •

Likewise, a management that is passionate about the business will end up more profitable as compared with if they were not passionate.

Management Background Inspection •

A management background inspection means that we look closer at the individuals running the company and examine their credentials. Some factor we consider are: √√ Is the owner also the CEO or are they separate? √√ Is the CEO from within the organization or outside? √√ If the CEO is from outside, do they have relevant experience?

1. Is the owner also the CEO? •

The CEO is the person in charge of running the company, while the owner is someone who has shares in the company.

•

Ideally, we want a situation where the CEO is also an owner in the company.

•

If they own shares in the company, their interests are more aligned with those of other shareholders.

•

They want the stock price to go up just like investors do.

•

If they don’t have shares, this reduces their incentive to work for shareholder’s benefit.

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2. Is the CEO from within or outside the organization? •

It is not always clear whether an inside or outside CEO is better for the job.

•

A CEO from the inside has much better knowledge of how the company is run, and it that sense is well place to perform well.

•

However, if a company is performing poorly, it can be beneficial to hire a new CEO from outside.

•

They can bring new ideas to the company that insiders may not have had.

•

We must analyze this on a case by case basis for a company as to whether one is better or not.

3. If the CEO is from outside, do they have relevant experience? •

If a company does hire a CEO from outside, we should check their credentials to determine whether they will do a good job.

•

Ideally, we would like them to have experience in the industry, as this would help them run the company more effectively.

•

A CEO that is completely new to the industry is more likely to struggle.

•

We inspect management’s background to make a forecast of how they will perform.


111

Conclusion •

In this chapter, we started our discussion on how to separate good management from bad.

•

Some of the points we discussed are: √√ The importance of management √√ Role of management √√ Qualities a management should have √√ Management background inspection

•

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In the next chapter, we’ll continue our discussion on management, and move to case studies.


Chapter 11

Separating Good Management from Bad II Management Compensation •

Management compensation refers to how much the management is paid for their services, and crucially how they are paid.

•

It is natural to expect that CEOs will earn more than anyone else in the company.

•

Some important issues include: √√ Is management pay linked to performance? √√ Do they receive a high fixed salary, or do they mostly earn variable pay? √√ How much do they earn when the business does poorly?

•

Management compensation comes down to whether they are incentivized to behave in the long term interests of shareholders.

•

The first issue is whether their compensation is linked to the overall performance of the company.

Chapter 11: Separating Good Management from Bad II

113

•

“If we owned a copper-mining company in its entirety, we’d base compensation on costs of production, which management has control over, rather than things based on market prices, which they don’t control. Costs won’t fluctuate a lot. Compensation should tie to what is under the control of management. Try to understand what management can have impact on.” -Warren Buffett on management compensation

•

The next important issue is the composition of total pay, i.e. how much is variable and how much is fixed?

•

A good scenario for shareholders is to have a low fixed salary with a higher variable component that is based on long term performance.

•

If the fixed component is relatively too high, management has less incentive to improve the performance of the business.

•

It is also important for the compensation structure to punish poor performance.

•

In some companies, we will often find large pay packages for CEOs even when the company is doing poorly.

Executive Pay - Jindal Steel & Power Ltd •

Jindal Steel & Power Ltd is a steel and energy company based in Delhi, and is a division of Jindal Group Conglomerate.

•

They were founded in 1952 and they are the third largest steel producer in India.

•

They also have operations related to mining, oil, gas, and infrastructure.

114


•

In addition, they have investments outside India.

•

The company is headed by Mr Naveen Jindal, son of the founder O. P. Jindal.

•

This case study is about excessive executive pay.

•

Naveen Jindal earned nearly Rs 550 m in FY 2013.

•

This was among the highest compensations for CEOs in India.

Naveen Jindal - Chairman, JSPL (Rs m)

FY11

FY12

FY13

Salary

106

120

121

-

0.04

0.04

Shares in Profit / Incentives

566

615

429

Total Compensation

672

734

550

Consolidated Net Profit

37,539

39,649

29,101

Total Salary / Net Profit

1.8%

1.9%

1.9%

Perquisites


•

His pay was roughly 10 times the pay of the Managing Director of Tata Steel, India’s most efficient steel producer.

•

Ideally, there should be some parity between the compensation packages of top management of companies from the same industry.

•

However, in most companies where promoters control the company’s management, the executive compensation tends to be typically high.


115

H M Nerurkar - Managing Direction, Tata Steel (Rs m)

FY11

FY12

FY13

Salary

9

11

13

Perquisites

5

5

7

Commission

28

48

38

Total Compensation

42

64

57

68,657

66,964

50,630

0.1%

0.1%

0.1%

Standalone Net Profit Total Salary / Net Profit


•

In the case of Tata Steel, they have much lower compensation for their top management, yet better corporate results.

Management’s Way of Running the Business •

Management’s way of running the business refers primarily to how the company operates internally. Some important questions include: √√ Are all the interests of stakeholders taken into account? Management that considers all its stakeholders is likely to make better decisions. √√ Is the management hands-on or primarily involved in the big picture? The more hands on they are, the more they will understand the needs of the business. However, it is also important for management be be involved in the big

116


picture, i.e. have a long term strategic vision and plan for the company. •

Other questions include: √√ Does management give quarterly and yearly earnings estimates? This type of information is useful for investors when we try and forecast the company’s earnings and value their stock. Of course, we have to keep in mind that management may wish to inflate or deflate their estimated earnings for various reasons. √√ Is there too much bureaucracy in the company? High levels of bureaucracy are obviously bad as they slow down business. A de-centralized structure is usually more effective.

•

Some final questions: √√ What is the hiring policy of the management? For example, do they like to promote people within the company to executive positions, or prefer to hire from outside? √√ How does the management allocate capital? What kind of projects do they tend to invest in, and how are these decisions made?

•

For many of these questions, there are no right or wrong answers. The purpose is to build an overall picture of the management of the company we are interested in investing.


117

Bureaucratic Culture - Government Owned Companies •

Most of us have witnessed or experienced the bureaucratic culture in the government, and the slow results it produces.

•

A bureaucratic culture is one where there are many layers of management, with a top down control mechanism.

•

Each individual generally has a specific role and function, and they do not deviate from it.

•

In theory this may not be a problem.

•

However, in practice it is associated with high levels of inefficiency, lack of flexibility or creativity, too many unnecessary rules, and lots of red tape.

•

Government owned companies are good examples of bureaucratic culture. We can compare government vs. non government companies in the same sector to get an idea of the impact.

•

For example, in the banking sector, we have State Bank of India and HDFC.

•

Over the years, HDFC has consistently outperformed SBI, both in share price and company performance.

•

SBI’s bureaucratic culture means they respond more slowly to new opportunities, and fall behind the competition over time.

•

Another example exists in the Steel Sector.

•

We can compare Steel Authority of India Ltd (SAIL) with Tata Steel.

•

SAIL has an inherent advantage due to their large size.

118


•

Despite this, Tata Steel is way ahead in terms of efficiency and expansion.

•

Bureaucratic culture is primarily found in government owned companies, but this need not be the case.

•

Private sector companies can also be run in a bureaucratic way.

•

In general, we should avoid stocks where a company’s bureaucratic culture is significantly hurting their performance.

Extravagant Use of Company Funds •

Next, we will consider some other issues that are important when analyzing management.

•

Does the management lead an extravagant lifestyle or does it care more about the business?

•

For example, spending money on private jets to travel may not be the best use of the company’s capital.

•

It indicates that management is happy to waste the company’s money for their own private benefit.

•

It is important that the actions that the management takes are consistent with the overall goal of increasing shareholder value.

•

This next case study will give an example of management living an extravagant lifestyle at the expense of shareholders.

•

Most of us accept that managers should be well compensated for good performance, but there is a limit to this.

•

Sometimes, managers can use company money to fund extravagant lifestyles, and call it business expenditures.


119

•

We will discuss a company named Crompton Greaves that has been guilty of this type of behavior.

•

What is an example of using business expenses to fund an extravagant lifestyle?

•

For example, when someone goes on a business trip, they could fly economy or business class, and each would cost a different amount to the company.

•

If a business executive flies business class, we would be unlikely to view this as a waste of money.

•

But Crompton Greaves took this to a whole new level.

•

In 2011, the company spent Rs 270 crore on their own private jet for use by management to travel.

•

This was at a time when the company’s profits were under pressure.

•

This was a large expense, and the sole purpose was to fund the extravagant lifestyle of the management.

•

If an individual uses their own personal fortune for these types of expenses, we may not bother if there is a genuine need for the same.

•

But when this is done using company funds and that too without a genuine need, it is clearly not correct.

•

It is a poor use of the company’s capital that should instead be used to make investments that generate returns for shareholders.

•

In the end, Crompton Greaves was forced to sell their private jet after pressure from large institutional shareholders.

•

When the jet purchase was noticed by investors, profits were

120


falling, and the company’s stock price fell 44% over the course of a month. •

When management misuses a company’s funds, this is a big red flag.

•

It is a clear violation of the job of management, which is to maximize value for shareholders.

•

In this case, it was good that shareholders protested this move, and the company had to sell the jet.

Does management fall prey to herd mentality? How does management communicate with shareholders? Do they regularly address shareholders’ concerns? Are they transparent in their dealings with shareholders? As an investor, you own a piece of this company, and you are entitled to a management that deals with you in the correct way. Does the management get easily influenced by herd mentality, or do they make independent decisions? The best managers think independently and creatively, and aren’t distracted by undue outside influence.

Not Going by Herd Mentality HDFC Bank •

This next case study is on management not following Herd Mentality, and the company benefiting as a result.

•

Herd mentality refers to people getting influenced by what others around them do, and then following what they do.


121

•

Often, it is easier to just follow the crowd.

•

If things turn sour, everyone is negatively affected and not just you.

•

If things go well, then you benefit.

•

Though following the crowd is easier, that does not make it the best course of action.

•

We admire a management that is bold enough and smart enough to make the right decisions rather than follow everyone else.

•

HDFC Bank is an example of a bank that has significantly outperformed its peers, and this is due to its management not going by herd mentality.

•

HDFC bank is more conservative than its peers when it comes to making loans, and as a result has the lowest percentage of non performing loans compared to other banks.

•

They have generally avoided many risky investments that their peers made, especially exotic and risky financial instruments/products.

•

While the rest of the industry chases high yields by taking too much additional risk, HDFC Bank has not done so.

•

They have done a much better job assessing the potential risk of borrowers and of investment projects.

•

Their investors have been handsomely rewarded as a result.

•

From January 2008 levels, HDFC Bank shares have nearly doubled while their rival ICICI Bank’s shares are still lower by about 8%.

•

HDFC Bank trades at nearly 4 times its book value, and

122


a result is one of the most expensive banks traded in the world. •

When management follows herd mentality too often, it is a sign that they are not capable of making good decisions themselves.

•

They would rather do what the rest of the industry does, so that there is less responsibility on their shoulders should anything go wrong.

•

HDFC Bank is an example of a company whose management has done a stellar job by not following what everyone else does, and making good independent decisions instead.

•

When analyzing companies, we should look for signs of independent thinking and action.

Strong corporate culture or Superstar CEO? •

Does the CEO focus excessively on himself?

•

Is the CEO making himself the brand rather than the company?

•

The CEO should work hard and focus on improving the company’s brand and performance.

•

With any management related questions, we should always come back to one central question:

•

Are the management’s actions consistent with maximizing shareholder’s long term value?

•

If so, then they are doing the right thing. If not, then they are doing the wrong thing.


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Process Oriented Culture - Tata Group •

Our last case study is on a company following a process oriented culture, and its success as a result of it.

•

A process oriented culture means the company takes great care in doing things the correct way.

•

There is a high focus on teamwork, accountability, and customer satisfaction. In addition, process oriented companies take measured risks, and stick to what they know works well.

•

The opposite of a process oriented culture is a results oriented culture. A result-oriented culture is highly focused on the bottom line (i.e. profits) without much attention the process of making those profits.

•

Tata Group is one of the most successful companies in India.

•

Today, they are a large multinational organization with operations in 80 countries.

•

They produce cars, consultancy services, software, steel, tea, coffee, chemicals, hotels, among others.

•

A large reason for Tata’s success is its reliance on its process oriented culture.

•

By focusing on the correct processes, rather than short term earnings goals, they end up doing better over the long term.

•

For example, they place a strong emphasis on fostering innovation. One such example is ‘frugal innovation’ – creating products that appeal to poorer people and the rising middle class.

•

The Tata Nano car & the Tata Swach water purifier are examples of ‘frugal innovation’.

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•

Their process oriented culture also means that they are much less prone to corruption and scandals that can bring down a company.

•

The management practices of Tata are a big reason for their success, and continued strong returns for shareholders.

•

We want to avoid companies that do the opposite, i.e. focus purely on meeting earnings targets.

•

Results oriented companies may do well in the short term, but are much riskier in the long term.

Conclusion •

Excessive management compensation relative to peers and poor linkage between pay and performance is a sign of bad management.

•

How a management runs the business has a significant impact on operational efficiency and long term profitability.

•

Management extravagance at the cost of company’s funds should be seen as a red flag.

•

Avoid companies that follow herd mentality and are too focussed on the bottomline.


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Chapter 12

Separating Good Management from Bad III Treatment of Minority Shareholders MNCs and Subsidiaries •

A subsidiary is a company that is partly or wholly owned, and partly or wholly controlled by the parent company.

•

Many multinational corporations (MNCs) have subsidiaries around the world.

•

These subsidiaries may be separately listed on local stock markets.

•

Minority shareholders are investors who own less than 50% of a company’s shares.

•

This case study is about the treatment of these shareholders by the management of the parent companies (the MNCs).

•

It is sometimes the case that parent companies will find a way to transfer profits to themselves, at the expense of the subsidiary.

•

For example, the parent can sell products to the subsidiary at inflated prices, or purchase finished goods at very low prices.

•

MNCs often engage in this type of behavior to reduce their overall tax burden (i.e. shift profits to countries where tax rates are lower). This is known as transfer pricing.

Chapter 12: Separating Good Management from Bad III

127

•

In addition, subsidiaries of MNCs are often obliged to pay royalty payments to the parent firm for use of brands, trademark licenses, technology, technical know-how, etc.

•

Other examples include mergers and restructuring done between parent and subsidiary companies in ways that clearly benefit the parent at the expense of the subsidiary.

•

When analyzing a company that has a foreign MNC parent, we should examine how the foreign management treats the minority shareholders of the Indian subsidiary.

Treatment of Minority Shareholders Royalty Payments to MNCs •

Earlier, the royalty payments to overseas parent firms were capped by the Indian government.

•

However, effective December 2009 onwards, the govt. removed all caps on royalty payments by Indian firms to overseas parents.

•

This has resulted in almost all domestic subsidiaries doling out higher royalty payments to the foreign parent.

•

While minority shareholders resist unreasonable increases in royalty payments, the MNCs tend to have their way because of their controlling stake in the company.

•

Higher royalty payments not only impact the subsidiary’s profits but also eat into the dividends of minority shareholders.

•

Let’s examine the trend in sales, royalty payments and dividends of some of the leading Indian companies that are subsidiaries of foreign MNCs.

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Treatment of Minority Shareholders - HUL ( Please see table in Appendix 6 on page 136 ) •

Royalty payments have continuously increased over the last five years.

•

Dividends to shareholders have grown by less than half the rate during the same period.

•

Starting Feb 2013, HUL has announced that it will increase its royalty payments in a phased manner to 3.15% of annual sales by March 2018. This will further eat into the company’s earnings and dividends of minority shareholders.

Treatment of Minority Shareholders Maruti Suzuki ( Please see table in Appendix 6 on page 137 ) •

Royalty payments to Suzuki Motor Corporation have increased at a compound annual rate of 38% since FY08.

•

Dividends to shareholders have grown at just 10% CAGR during the same period.

Treatment of Minority Shareholders Whirlpool & Asahi India Glass •

Another example is two MNCs, Whirlpool of India and Asahi India Glass.

•

Both the companies remit significant sums to their parent companies in royalty payments.

•

Asahi and Whirlpool have paid on average Rs 200 m


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and Rs 321 m per annum, respectively, as royalty to their respective parent firms over the last five years. •

However, both of these companies do not pay any dividends to their Indian shareholders.

•

This clearly shows the parent MNCs care more about their own investors than the minority investors of their subsidiaries.

How promoters’ greed & recklessness can ruin a great business •

In the previous chapter, we discussed process oriented corporates with the example of Tata Group.

•

We will now discuss the management failure of Ranbaxy Laboratories, a leading corporate entity, and how the shortsighted and opportunistic approach of its top management adversely impacted the company’s reputation and fortunes.

Case study - Ranbaxy Laboratories •

Incorporated in 1961, Ranbaxy Laboratories is one of the leading Indian pharmaceutical companies.

•

It was among the first few early entrants into the lucrative US market.

•

The company sells products in over 150 countries and has an expanding international portfolio of affiliates, joint ventures and alliances, and ground operations in 43 countries.

•

In 2008, Ranbaxy’s Indian promoters sold their entire stake to Daiichi Sankyo of Japan, which now holds a 62% stake in Ranbaxy.

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Ranbaxy’s claim to success •

For Ranbaxy, the US market has been a focus area and also forms a major revenue contributor.

•

It is worthwhile to note that Ranbaxy was among very few generic companies to identify the importance of Para IVs and thus had made filings in most of the mega blockbuster products.

•

A generic company that challenges the patents of the innovator with an intention to launch the drug before the expiry of the patent is called a Para IV filer. The company that makes the first successful filing is entitled to 180 days exclusivity.

•

Ranbaxy was quite successful in taking advantage of first to file (FTF) 180-days exclusivity.

Ranbaxy’s fall of fortune •

After having been so successful, what went wrong?

•

The golden days of Ranbaxy came to end when two of its facilities received warning letters and import alerts from United States Food and Drug Administration (USFDA).

•

A ‘Warning letter’ means that the company can continue manufacturing but new approvals are not given clearance.

•

An ‘Import alert’ is considered even more severe as the company cannot export medicines manufactured in those facilities to the US market.

•

These adverse events resulted in delay to get approvals for the drugs and thus, the company had no option but to enter into deals that trimmed away a significant share of their


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revenues and profits. •

In addition, even the existing revenues were impacted on account of the import ban.

Erosion of shareholder wealth •

How was the company’s overall business impacted? The irregularities in Ranbaxy’s facilities resulted in huge penalties worth US$ 500 m.

•

The company has hired consultants to whom huge fees are paid to resolve the issues in manufacturing facilities and take corrective measures. This has been impacting the company’s margins. All this has resulted in great overhang on shareholder wealth.

•

The table below shows the change in market cap of Ranbaxy and its Indian peers since 2008.

Change in Market Capitalisation: 2008 to present 1-Jan-2008

18-Nov2013

Change

Ranbaxy Lab

157,753

181,295

14.9%

Sun Pharma

41,444

1,263,410

423.3%

Lupin Ltd

51,283

386,953

654.5%

Dr Reddy's Lab

121,316

419,117

245.5%

Rs million


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What was wrong with Ranbaxy’s management? •

The organizational culture of any corporate flows from top to bottom.

•

The behaviour and aspirations of the top management have a significant influence on how the organization conducts its business.

•

In its pursuit of quick profits, Ranbaxy’s top management compromised on critical corporate processes and good governance.

•

The following brief excerpt from Fortune magazine about Malvinder Singh (Managing Director & CEO from 2006 to 2008) gives a clear view of the promoters’ attitude: “I want profit!” he would yell in meetings, two former employees recall. Among the staff, he was known for being preoccupied with his ranking on the Forbes list of India’s 40 richest people. When he and his brother Shivinder fell from No. 9 in 2004 to No. 19 in 2005, despite $1.6 billion in assets, Singh seemed to blame the decline on a lack of employee loyalty, a former employee recalls.

•

This is a clear sign of bad management.

Management’s negligence takes a toll •

The top management did not respond to alarms raised by a senior employee about the issues at its manufacturing units. As per whistleblower Dinesh Thakur, the company used fraudulent data to get USFDA approvals.

•

Various instances of non-adherence to good manufacturing practices (GMP) were also observed.


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•

The management did not take conscious steps to keep the facilities up to the mark.

•

If the company had kept its facilities up to the mark, it would have been able to run its US business smoothly.

•

The margins, too, would not have been impacted.

•

More importantly, the company would have been able to take advantage of lucrative Para IVs it had filed, without sharing the same with other players.

Management’s short-sighted approach ruined long term prospects •

The management’s focus on short term profits may have helped in saving some near-term costs. However, in the long term the company has incurred huge costs to resolve the issues.

•

The Indian promoters bailed themselves out by selling off their entire stake to Japanese pharma firm Daiichi Sankyo before the irregularities came to the fore.

•

The troubles for Ranbaxy haven’t ended with exit of the Indian promoters. A third plant has received an import ban from the US drug regulator over quality concerns.

•

This seems to reflect that the culture of negligence has become so ingrained in the company’s DNA that even the new promoters haven’t been able to put an end to the company’s troubles.

•

All in all, shareholders have had to suffer due to the management’s greed, brashness and negligence.

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Management and Valuation •

We have seen many examples of how good management can lead to a company’s success, and how bad management can cause its failure.

•

One of the difficulties with analyzing management is translating the impact onto its stock valuation.

•

Imagine there were two identical companies except that one had a good management and the other had a bad management.

•

How would we value one company’s stock relative to the other company’s stock?

•

Unfortunately, this is not an easy question to answer.

•

The impact of management is difficult to quantify.

•

Instead, we should think of good management as something that can sustain a company’s success over the long run.

•

When we value a company, we have to make assumptions about their future earnings and performance.

•

Companies with good management are much more likely to sustain strong performance over time.

•

Companies with bad management become increasingly risky over time.


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136


138,711

772

0.6% 9.0

Revenue from Operations

Total Royalty Payments

Royalty as % of Net Sales

Dividend per share

7.5

0.6%

1,184

205,011

FY09*

6.5

0.9%

1,579

177,643

FY10

6.5

1.4%

2,689

196,910

FY11


CY07

Rs million (Consolidated)

Hindustan Unilever Ltd

Appendix 6

7.5

1.3%

3,072

34,363

FY12

18.5

1.5%

3,923

70,040

FY13

16%

38%

14%

5-Yr CAGR


137

2.7% 5.0

Royalty as % of Net Sales

Dividend per share

3.5

3.3%

6,777

205,579

FY09

6.0

3.5%

10,168

293,028

FY10

7.5

5.2%

18,925

366,112

FY11


4,931

180,208

Net Sales

Royalty Payments

FY08

Rs million (Consolidated)

FY12

7.5

5.1%

18,031

351,972

Maruti Suzuki India Ltd.

8.0

5.7%

24,540

432,159

FY13

10%

38%

19%

5-Yr CAGR

Valuation Methods

Chapter 13

Introduction to Valuation

Time Value of Money •

Renowned Greek story teller Aesop (600 BC) had once said, “A bird in hand is worth two in the bush.”

•

Warren Buffett has often referred to this line as the basis for valuing all assets.

•

Investing is about laying out a bird now to get two or more out of the bush. The ‘birds’ refer to money and the bush refers to the underlying asset.

•

In the investment context, Aesop’s axiom translates as the Time Value of Money concept

•

In simple words, Time Value of Money means that you can make people part with their money only if you promise to repay more money in the future.

•

How much more? Well, that depends on the rent that the money earns. This rent is nothing but what we popularly know as the interest rate.

•

Say you are asked to choose either of the two: Rs 10 million (m) today OR Rs 10 m three years from today. Which one would you choose?

•

It goes without saying that you would go for option 1.

•

Let’s assume you take Rs 10 m today and invest it in a fixed income security. Let’s say the rent or the interest rate is 8%.

Chapter 13: Introduction to Valuation

141

Compounded annually, you would get Rs 12.6 m at the end of three years. •

10*(1+0.08)^3 = 12.6

•

In other words, Rs 10 m today has a future value (FV) of Rs 12.6 m three years from now.

•

Alternatively, you could use the same interest rate to find out the present value (PV) of Rs 10 m that is offered 3 years from today. This is called discounting.

•

By discounting the future payment of Rs 10 m at 8% interest rate, you arrive at a present value of Rs 7.9 m.

•

10/(1+0.08)^3 = 7.9

•

Discount rate is nothing but interest rate in reverse.

•

The concept of time value of money is the most fundamental principle of finance. It forms the bedrock on which the values of almost all the assets are based.

•

These values are nothing but what we call the ‘intrinsic value’.

Determining Intrinsic Value •

A financial asset is something that generates cash flows.

•

Thus, intrinsic value of any asset can be defined as the present value of all the distributable cash flows that the asset generates during its lifetime.

•

Please note we used the term ‘present value’ above. This means that all cash flows in the future have to be discounted by an appropriate discount rate.

•

The formula for intrinsic value applies to any kind of asset

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whether it’s a farmland, a coal mine, an office, a bond or a company’s equity. •

Warren Buffett expands Aesop’s ‘a bird in hand…’ concept by adding three very relevant questions that can help an investor find the intrinsic value of any investment asset: 1) How certain are you that there are indeed birds in the bush? 2) When will they emerge and how many will there be? 3) What is the risk free rate?

Intrinsic Value of a Bond •

Let’s apply the 3 questions to find the intrinsic value of bond.

•

Let’s say a 10-year government bond has face value of Rs 1,000 and 8% coupon rate. 1) How certain are you that there are indeed birds in the bush? 2) When will they emerge and how many will there be? 3) What is the risk free rate?

•

In the case of this bond, these three questions have clear and definite answers.

•

Bonds are fixed income securities. The tenor is fixed and the interest rate is known. Government bonds are presumed to be risk-free. As such, the coupon rate offered on the bond is also the risk free rate.

•

In this case, the intrinsic value of the bond is the same as its face value.


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Intrinsic Value of Equities •

Can we extend the analogy of a bond to equity?

•

Like a bond, the intrinsic value of a company’s equity (or stock) can also be seen as the present value of all the future net cash flows that the company is likely to generate during its remaining life.

•

Let’s ask the same three questions for equity. 1) How certain are you that there are indeed birds in the bush? 2) When will they emerge and how many will there be? 3) What is the risk-free rate (or discount rate)?

Discounted Cash Flow Method •

One of the most widely taught valuation methods is the discounted cash flow (DCF) method.

•

The DCF Method attempts to determine the intrinsic value of a company’s equity by forecasting the future cash flows that the company will generate during its lifetime and then discounting them to arrive at the present value of the company’s equity.

•

Let us first broadly explain how this method really works.

•

There are 2 key elements in the DCF method:

1) Forecasting future cash flows •

Under the DCF method, you first forecast cash flows for the current and future periods out to a reasonable date.

•

So the general practice is to forecast yearly cash flows for a period of 5 to 10 years.

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2) Determining the discount rate •

The next step is to determine the discount rate or cost of capital that reflects the riskiness of the asset.

•

In essence, the discount rate is the required annual return on investment.

•

Now, there is one limitation with forecasting for a limited period of around 10 years.

•

A fundamentally sound company would typically have a fairly longer life.

•

How do you account for those years?

•

To remedy this shortcoming we have the concept of Terminal Value.

•

The terminal value is calculated by assuming that beyond year 10, the cash flow grows perpetually at a constant rate.

Limitations of DCF Method •

Theoretically, the DCF method sounds quite appropriate.

•

However, the problem lies in its practical application.

•

Here are some limitations that make the DCF method less reliable.

•

DCF valuations rely too heavily on future forecasts.

•

For most businesses it is impossible to forecast 10 years into the future with any degree of certainty.

•

Several factors such as changes in technology, higher competition, etc. can completely derail your estimates.

•

Moreover, even slight changes in assumptions pertaining to


145

discount rate and perpetual growth rate (for terminal value) can substantially alter the valuations. •

As such, DCF method may not be of great use to value investors.

Asset Based Valuation •

As we just saw, there are quite a few flaws with DCF valuation.

•

Therefore, it is necessary that we look at other methods of valuation.

•

Here, we will study one such method called as the asset based valuation (ABV).

•

Unlike DCF that uses too many assumptions, asset based valuation approach relies on currently available information

•

It is more realistic and does not involve making future estimates.

•

It is useful for firms that have hardly any competitive advantage.

•

It does not take into account future growth.

•

The approach assumes that intrinsic value comes merely from investment in the assets of the firm and does not generate any positive cash flow for investors thus creating no value for them.

•

This valuation approach is useful under two scenarios.

•

Scenario 1: The company to be valued is making losses and generating negative cash flows.

•

If the industry to which the firm belongs is in serious decline

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phase, assets should be valued on what they will bring when sold (Liquidation value method). •

Scenario 2: The company to be valued is earning just enough to pay for the cost of capital it employs.

•

In other words, there is no competitive advantage that enables the firm to earn more than its cost of capital.

•

Thus, if the industry is stable and profitable but with no competitive advantage then assets can be valued based on reproduction cost method.

•

Thus, we have two methods under asset based valuation, liquidation value and reproduction cost method.

Liquidation Value Method •

This method can be applied in cases when the industry is failing, or when the firm’s profits have collapsed and are unlikely to improve or when the firm is facing financial bankruptcy.

•

Assets are valued based on the funds they will bring in when sold.

•

Specific assets (that serve the particular industry) will not have any market; hence they are valued (sold) at scrap.

•

Goodwill /intangibles are worth nothing.

•

Deferred tax assets can be offset against deferred taxes owed.

•

Cash/accounts receivables can be more or less fully valued.


147

Reproduction Cost Method •

It can be defined as the value a firm’s competitor would have to pay to replace it today at the currently most efficient way of production.

•

In other words, it is the amount of money an investor or business has to lay out to acquire/replicate competitor’s assets.

•

It is applicable when the industry is stable/growing but the firm enjoys no or limited competitive advantage in the industry.

•

Relevant when industry enjoys free entry (no competitive advantage, no entry barriers and offers level playing field).

•

As such, the company is worth identifiable value, unless mismanagement impairs their worth or the industry is suffering from over capacity.

Reliability of Information •

Reproduction value is calculated as assets net of liabilities for the latest period.

•

Net Asset Value (NAV) = Assets – Liabilities.

•

Since accounting values for assets and liabilities will not always be accurate/unambiguous, they should be adjusted to arrive at realistic valuations where accounting values can’t be relied upon.

•

Reliability issue depends on how far in the balance sheet one goes.

•

For example, cash and current assets, expected to convert into cash within a year are likely to be recorded close to

148


reproduction value. •

However, as one goes down the balance sheet, with items like intangibles and fixed assets, the margin of error is wider.

•

As such, these items need some adjustment, based on industry knowledge, judgement and experience.

Adjusting Items with Wider Error Band •

Here’s a short summary on how one can go about valuing various assets:

•

Property/Land: Will be reproduced at more than book value, at current market value adjusted for any advantage the competitor may have in acquiring land (if competitor can get a similar land at lesser prices).

•

Plant: Includes office buildings, oil refineries, etc. Here, the gap between recorded cost and reproduction cost is likely to be high. The different rules of depreciation and depreciation rate applied on historical asset values (ignores inflation) does not reflect economic value of the asset. In some cases, plants may have been depreciated down to zero while they still remain the basis of all business operations of the firm. As such, it needs massive adjustments.

•

Equipment: Since it is depreciated over the useful economic life, the adjustments are unlikely to be huge and will depend on a case to case basis, on the basis of specific knowledge of the firm and industry.

•

Goodwill: This can be a bit tricky and treatment will depend on case to case basis. For example, while calculating reproduction cost of a firm like Coca Cola, one cannot


149

ignore the goodwill, loyalty and the distribution network that the brand enjoys. That said, in cases where goodwill has no economic value (assuming the acquirer overpaid for no good reason), goodwill should be ignored. •

Licenses: For instance, to sell alcoholic beverages one needs license. To assign a value, one needs to see what similar rights have sold for in the private market to a knowledgeable buyer who is paying for the entire business.

•

Other items: Other items that need to be considered include aspects such as developing customer relationships. While this may never appear as assets, some multiple of selling, general and administrative expenses (SGA) line should be added to value it.

Reproduction Value of Liabilities •

Liabilities and equity are the sources that fund the assets.

•

As we saw before, Asset Based Value = Assets – Liabilities. Thus, we will have to subtract all the liabilities from the asset value.

•

Liabilities can be grouped into three main classes : 1) Spontaneous liabilities (SL): For example, accounts payable, wage costs due, etc. These arise intrinsically from normal business, are due within a year and are like a credit for which a company need not pay interest. The larger these spontaneous liabilities are, the less investment a company needs to fund its assets.

•

Reproduction value of net assets = Reproduction value of total assets less book value of spontaneous liabilities 2) Circumstantial liabilities (CSL): These arise from

150


circumstances not relevant for the new entrant. For example, deferred tax liabilities incurred due to adverse legal judgements against the firm. These should be subtracted from asset value to see what a firm is worth to investors, though they don’t reduce the investment a potential entrant might have to make. 3) Outstanding formal debt of the company: This is most relevant for someone who is looking to make an equity investment. Once we reduce SL and CSL from reproduction cost of assets, what is left is enterprise value to which debt holders and equity holders have the claim. An equity investor needs to reduce the value of debt to know the equity value.

Beware of highly leveraged firms •

A slight error in estimating asset value for highly leveraged firms can lead to huge errors. Let us understand this by the following example of a highly leveraged firm: Estimated asset value of company less SL (Adj AV) = Rs 100 m Debt (D) = Rs 80 m Resultant value of equity (E) = Adj. AV – D = Rs 100 m – Rs 80 m = Rs 20 m

•

In case we are 5% off in estimating asset value, let us see how it affects resultant equity value. Estimated asset value of company less SL (Adj AV) = Rs 95 m Debt (D) = Rs 80 m Resultant value of equity (E) = Rs 15 m

•

Hence, a 5% error in estimating asset value can lead to 25% error in estimating equity value.


151

No wonder investors like to stay away from highly leveraged companies as margin of safety gets completely wiped out.

When to invest based on Asset Based Valuation •

First find out Asset Based Value (ABV) as discussed earlier by subtracting liabilities from values of all assets put together.

•

Now find out the market cap plus the value of debt of the firm under consideration. Call this the market enterprise value.

•

Compare market enterprise value (EV) (market value of equity + market value of debt less cash) with ABV.

•

If EV < ABV, it’s a good investment opportunity.

•

This approach is more relevant when new comers enter an industry to take advantage of overvaluation.

Limitations of Asset Based Valuation •

Does not differentiate between good management/bad management (franchise value).

•

In cases of overcapacity in the industry/poor management, asset value will be on the higher side.

•

Resultant value can be biased depending upon industry knowledge/experience as it involves estimating/adjusting asset values to some extent.

•

Does not take into account earnings, cash flows or growth rates.

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Conclusion In this chapter, we discussed the time value of money concept and its importance in determining intrinsic value. While the DCF Method is a sound theoretical framework, it’s practical application has too many limitations. For companies that do not enjoy any economic moat, future growth has no value and hence are well-suited for asset based valuation. In the next chapter, we will discuss valuation methods for companies that have an economic moat.


153

Chapter 14

Earnings Power Value and Franchise Valuation Earnings Power Valuation •

In the last chapter, we saw Asset Based Valuation (ABV), the first of our three valuation methods.

•

ABV can be used where firms either earn less than their cost of capital or are just about able to match their cost of capital.

•

For e.g. if the cost of capital is 12% and if the ROE or ROIC of the firm is around 10%-12% on a sustainable basis, it makes more sense to use asset based valuation than any of the others.

•

ABV’s entire focus is on the valuation of assets on the balance sheet.

•

It does not aim to value the earnings or the cash flows of the company.

•

But what if the firm consistently earns above its cost of capital?

•

For such cases, we use what is known as the earnings power value method.

•

For e.g. if the cost of capital is 12% and if the ROE or ROIC of the firm is around 15%-20% then the earnings power value method can be used.

Chapter 14: Earnings Power Value and Franchise Valuation

155

What does EPV mean? •

Earnings power value (EPV) is determined using the current earnings of the company after making all the adjustments.

•

Since it considers current earnings, future earnings and cash flows do not enter the picture.

•

The adjustments to earnings would mean not including one time charges, adjusting for maintenance depreciation etc.

•

Further, for companies in a cyclical industry, there would be wide swings in earnings during the peak and the downturn in the business cycle. Hence, in such cases earnings would have to be considered on a normalized basis.

Assumptions for EPV •

Graham and Dodd have made certain assumptions with respect to EPV.

•

First, current earnings, properly adjusted, are considered to be nearly the same as the cash flows to shareholders.

•

Second, this method is more suited for firms where earnings remain constant and are not likely to increase by much in the indefinite future.

•

By making these assumptions, we arrive at the following formula for the valuation of a firm using EPV: EPV = Adjusted Earnings * 1/R

•

Over here, R refers to the current cost of capital.

•

Since the earnings/ cash flow is assumed to be constant, the growth rate (G) would be zero.

156


How does one interpret EPV? •

There is a close connection between EPV and the ABV we studied in the previous chapter.

•

This connection can be evaluated by considering three scenarios.

•

In the first scenario, let us assume that a company’s EPV is substantially below the reproduction cost of the assets. This implies the management is not using the assets to the maximum potential to earn the kind of returns that it should. What this means is that the management will have to change the way it is doing things.

•

In the second scenario, let us assume that a company’s EPV is equal to the reproduction cost of the assets. This situation typically arises in highly competitive industries.

•

Let us assume, that company A operating in a particular industry has earnings, properly adjusted of Rs 10 m a year.

•

If the cost of capital is 10%, then applying the earlier mentioned formula, the EPV comes to Rs 100 m.

•

If the cost of the assets using the reproduction cost method of the previous chapter is Rs 30 m, then there is a differential of Rs 70 m. What this means is that investing Rs 30 m in assets has the potential to generate earnings of Rs 100 m.

•

This would naturally attract other players. So let us assume that Company B enters the fray.

•

Naturally, with two players now present, Company A would see its earnings reduce to Rs 8 m per year.

•

As long as the differential exists, more players will enter the field till the EPV equates the reproduction cost of assets.


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•

This phenomenon is typically seen in commodity type businesses or industries where the barriers to entry are quite low.

•

Here competitors enter the industry and drive down the excess returns to the same level as the cost of capital.

•

In the third scenario, let us assume that the EPV is significantly higher than the reproduction cost of the assets.

•

More importantly, it is likely to stay this way for the company for some time.

•

This means that the company is operating in an industry where the barriers to entry are high and where competitors are not able to drive down returns to the cost of capital.

•

And for the EPV to remain higher, the barriers to entry must be sustainable at the current level for the indefinite future.

Importance of a Franchise •

The difference between the EPV and the asset value is the value of the franchise enjoyed by the company.

•

The defining character of a franchise is that it allows the company to earn more than it needs to pay for the investments that fund its assets.

•

For this, the company should have a strong competitive advantage and this also needs to be sustainable.

•

It should be noted that the franchise concept is nothing but the economic moat of a company that helps it to earn significantly higher than the cost of capital.

•

Thus, if EPV is much greater than reproduction cost and

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this difference is sustainable, the firm is said to have a sustainable competitive advantage with its value being the difference between the two.

Advantages & Limitations of EPV •

The main advantage of EPV is that it considers current information without having to make predictions for the future.

•

This means that it can be considered more reliable than assuming the rate of growth and cost of capital many years into the future.

•

However, the limitation is that assumptions are based on earnings which are less reliable than the value of assets.

Summary of EPV •

In this chapter so far, we discussed the concept of earnings power value (EPV) and its importance as a measure of a firm’s intrinsic value.

•

Since, it takes into account current earnings, it is more reliable than estimating earnings and cash flows into the future.

•

If the EPV is substantially higher than the asset value for a company, then it means that it enjoys what is known as a franchise.

•

Therefore we now have two methods of valuation. One where the firm’s return on capital is less than or equal to its cost of capital. Here, we used the asset based valuation method where we valued the assets. The assets were valued using the liquidation method or the reproduction cost method.


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•

The second method considered the case where the return on capital is greater than the cost of capital but there is no growth in the earnings/cash flows of the firm.

How to Value a Franchise? •

Franchise value is simply the difference between the asset value and EPV of any company.

•

As highlighted earlier, EPV = Adjusted earnings*1/R, where R is current cost of capital.

•

Let’s assume that adjusted earnings for XYZ Ltd are Rs 25 m. Assuming cost of capital at 8% we get EPV value of Rs 313 m.

•

The next step is to estimate the asset value or the reproduction cost of assets.

•

The asset value is simply the book value of assets with some adjustments.

•

Let’s assume that total assets (tangible + intangible) of XYZ Ltd are Rs 70 m.

•

The next step is to find reproduction cost of assets which includes some adjustments.

•

Let’s assume that XYZ Ltd has a strong brand and is a highly profitable company. Hence, competitors are lured to enter into the industry.

•

This would entail even higher advertising and promotion (A&P) expenses for competitors as XYZ Ltd is already a brand in the eyes of consumers.

•

Thus, in correctly estimating the reproduction cost of assets A&P expenses have to be capitalized.

•

Though recurring in nature the benefit of these expenses is

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realized in future years in terms of increased market share. Hence, they can be considered as off balance sheet assets. •

Within one year a competitor cannot pose any material threat to XYZ Ltd. Hence, we need to decide the period (number of years) over which the expenses have to be capitalized.

•

Deciding on the number of years depends upon your judgment as to how long the competition will take to build a brand as strong as XYZ Ltd and replicate its distribution pipeline.

•

For the sake of simplicity we assume a period of 3 years and total A&P capitalization cost of Rs 50 m.

•

Our total reproduction cost of assets now stands at Rs 70 m + Rs 50 m = Rs 120 m.

•

From this we reduce the spontaneous liabilities like advances from suppliers, workers etc (Rs 20 m).

•

We can also deduct cash in excess of what the company needs to run the business (Rs 10 m).

•

Spontaneous liabilities are reduced as it reduces the outgo of competitors. For instance, advances from suppliers reduce the investment in working capital.

•

Excess cash is reduced as competitors can invest the same in other profitable areas.

•

Adjusting for these items total reproduction cost of assets would be:Total Assets: Rs 70 m Add-Three years of A&P expenses capitalized: Rs 50 m Less- Advances from suppliers: Rs 20 m


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Less- Excess cash: Rs 10 m Total net reproduction cost = Rs 90 m •

Our initial EPV estimate was Rs 313 m. Thus, franchise value is equal to Rs 313 m (EPV value) – Rs 90 m (net reproduction cost) = Rs 223 m

•

Please note that the firm’s franchise value would have been zero if its EPV were equal to reproduction cost of assets. But since it is much higher, the firm has some sort of strong competitive advantage or a franchise.

•

The franchise exists because the firm’s return on capital is much higher than cost of capital.

•

On reproduction assets of Rs 90 m, it earned Rs 25 m. This translates into a return on capital of around 28%. Since this is much higher than cost of capital that we assumed of 8%, it signals the existence of a strong franchise.

Key Points about Franchise Value •

Franchise value increases if EPV increases and vice-versa.

•

EPV increases if profitability of XYZ Ltd increases. This can happen when competitors are unable to make any inroads into the market share of XYZ Ltd.

•

However, if competitors cut their price and spend heavily on marketing they would be able to garner market share at XYZ’s expense. This will reduce XYZ’s profitability and thus its EPV and hence franchise value.

•

As such, franchise value is dependent upon how successfully the company is able to maintain its market share and profitability.

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•

For that to happen the company should have a strong competitive advantage. It should also be sustainable. If not, EPV will erode and franchise value will fall.

Advantages and Limitations of Franchise Value •

The main advantage of franchise value is that it involves inputs which are less subjective in nature.

•

Most figures like earnings, book value of assets are readily available. The limitation is that franchise value is susceptible to changing values in cost of capital.

•

For instance, in our earlier example if we increase the cost of capital to 10% instead of 8%, the value of franchise will fall.

•

Also, if companies frequently change their accounting techniques to record transactions, franchise value estimate may not be accurate.

Conclusion •

In the second part of this chapter, we discussed the concept of franchise value and what it indicates.

•

Since, it takes into account book values, it is less reliable for companies that fudge books or change accounting methods frequently.

•

If the franchise value is substantially higher, then one must find out the competitive advantage the company enjoys. If the advantage is sustainable franchise value will sustain or else it will deplete.

•

In the next chapter, we will discuss another variant of the EPV approach.


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Chapter 15

Franchise Valuation With Growth & Multiple-based Valuation Recap of ABV Method - Liquidation Value •

In the previous two chapters, we discussed the Asset-based Valuation and Earning Power Value method.

•

In both the methods, we did not lay any emphasis on growth in future earnings.

•

In fact, in the liquidation method, growth in earnings destroys value. If your cost of capital is 12% and return on capital is 10%, you are earning Rs 10 and paying back Rs 12 as cost of capital. This is a straight loss of Rs 2 per Rs 100 of invested capital.

•

This way the more you invest, the more you will lose.

•

As a result, the best way to buy companies like these is to buy them at a huge discount to their asset values.

Recap of ABV Method - Replacement Cost •

For replacement cost method, we had assumed cost of capital to be the same as return on capital.

•

Here, every extra Re 1 invested in the business will be valued at exactly that, Re 1. Consequently, the intrinsic value will increase at the same rate at which capital invested in the business increases.

Chapter 15: Franchise Valuation With Growth & Multiple-based Valuation

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•

If the capital base of the company increases by 100, its intrinsic value will also increase by Rs 100.

•

Contrast this with the liquidation method where every Rs 100 invested is valued at Rs 80 or thereabouts.

Recap of EPV Method •

The third method we discussed was the EPV method. Here we assumed the return on capital to be higher than the cost of capital.

•

But what we did not take into account was the growth in earnings.

•

We assumed no growth in earnings and then derived a formula to value such firms.

•

The intrinsic value using EPV method gives a value higher than the ABV method for the same capital base.

•

This is because of the presence of a franchise. It is this same franchise that enables the firm to earn greater than the cost of capital.

•

With this, let us now move on to our last valuation method.

Franchise Valuation With Growth •

Imagine a business that has a franchise as well as growth in earnings.

•

In other words, imagine a business that has a return on capital comfortably higher than its cost and is also seeing its earnings grow at a decent rate.

•

Such a business will certainly be valued higher than the one with franchise but with no earnings growth.

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•

This is because growth requires investment and on this investment, the return on capital will be higher than the cost of capital.

•

As a result, the company’s capital base will go on increasing leading it to be valued higher than the firm with no growth or the EPV method.

•

Let us try and arrive at a valuation method for a firm with a franchise as well as growth in earnings.

•

For this, let us go back to the formula we used for the EPV method and build on it.

•

If you remember we had the following formula:

•

EPV = Adjusted Earnings * 1/R (R refers to the current cost of capital)

•

Now, let us introduce three more variables in the equation C, ROIC and G

•

C is the capital base of the company. In other words, it is the total tangible invested capital of the business.

•

ROIC is the return on invested capital of the business and can be calculated as: ROIC = EBIT (1-tax rate)/C

•

Please note that the EBIT (1-tax rate) is the adjusted earnings we used in the EPV formula.

•

And lastly, G is the expected growth rate of the business from now until perpetuity.

•

Now, we are sure our readers are familiar with two of the most basic formulas in finance.

•

These are the perpetuity and perpetuity with growth formula. These are CF/R and CF1/(R-G) respectively.


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•

In the first, the numerator stays constant or does not grow for an infinite period of time.

•

In the second, the numerator grows at a fixed rate every year for an infinite period of time.

•

Now, for the EPV, we used a formula similar to the perpetuity method because there was no growth.

•

But since for franchise with growth method, we are assuming a fixed growth rate G, our denominator for the formula will be (R-G). Of course, R here is the cost of capital and G the expected growth rate of the business from now until perpetuity.

•

Now, let us move on to the numerator of the valuation equation.

•

In the EPV formula, we had the adjusted earnings as the numerator. This was after tax and it also took into account the maintenance depreciation outgoings for the company.

•

This adjusted earnings can also be written as C*ROIC. It is the capital base of the company multiplied by its ROIC.

•

Therefore if capital base is Rs 100 and ROIC is 15%, the adjusted earnings equal 100 times 0.15 i.e. Rs 15. As a matter of fact, ROIC, C and adjusted earnings are the three variables in the equation and the third can be easily found out if the first two are given.

•

It’s time to bring growth into the equation now.

•

C*ROIC will remain the numerator for an equation with no growth as we saw in the EPV formula. But what happens when we bring growth into the picture?

•

Please note that growth requires investment in the capital base of the company. If ROIC remains constant, for a 10%

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growth in adjusted earnings, capital base will also have to increase by 10%. •

This investment in growth will essentially have to come from the cash flow that the company generates. And this cash flow is nothing but the adjusted earnings for the company.

•

As a consequence, the funds for growth will come from the adjusted earnings of the company. We can get the funds that we required for growth by the formula C*G.

•

Please note that we have taken ROIC to be constant. Therefore for a 10% growth, 10% more capital is required. So if the capital base is Rs 100 and expected growth is 10%, the extra capital required will be Rs 10 which we calculate from the formula C*G.

•

Similarly, if the capital base is Rs 500 and expected growth is 15%, the extra capital for growth under a constant ROIC will be Rs 75 (500*15%).

•

As a result, the numerator of the valuation formula will no longer have the adjusted earnings.

•

It will now have the equation (C*ROIC) – (C*G)

•

This is the cash that will remain after investing for growth.

•

If we recall, (C*ROIC) is nothing but the adjusted earnings of the firm or the cash flow for a no growth firm. (C*G) on the other hand is the extra capital required for growth. Thus, the formula is nothing but cash generated minus cash invested. The difference between the two gives us the final distributable cash flow.

•

Putting it all together, in the numerator we now have a distributable cash flow which under constant ROIC is growing at a fixed rate G every year and in the denominator we have


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a perpetuity that’s growing at the same fixed rate G. •

The final formula will thus look like this:

•

PV = ((C*ROIC) – (C*G))/(R-G)

•

This can be further reduced to PV = C*(ROIC-G)/(R-G)

•

We have borrowed this terminology and most of our discussion on valuation from Prof. Bruce Greenwald’s famous book ‘Value Investing’. PV refers to the present value of the future cash flows and hence the term.

•

The formula for PV shows us the way in evaluating firms that not only have competitive advantage but also have strong earnings growth going for them.

•

Imagine a hypothetical scenario where we have two firms having the same capital base, return on capital as well as cost of capital. The only difference is the growth rate between the two.

•

While firm A is not able to grow its earnings, firm B has a sustainable, constant growth rate of around 5% for many years into the future.

•

Now let us try plugging these numbers in the two formulas for EPV and PV respectively.

•

Let us assume the ROIC to be 20% for both companies, capital base as Rs 100 and R to be around 12%.

•

For the no growth firm, we will have to substitute the respective values in the following formula C*ROIC/R (Please remember that C*ROC is nothing but the adjusted earnings). This gives us 100*0.2/0.12 = Rs 167. Thus, the EPV of the firm is Rs 167 with no growth in earnings.

•

Now, let us calculate the intrinsic value of the firm with

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growth in earnings assumed at 5% per annum. For this, we will use the equation we just developed. PV = C*(ROIC-G)/(R-G) •

Putting in the values, we get 100*(0.2-0.05)/(0.12-0.05). This results into an intrinsic value of the firm of Rs 214.

•

For a firm that has a franchise or in other words where the return on capital is higher than the cost of capital, growth in earnings will create a value greater than where there is no growth.

•

In the case we just studied, the intrinsic value of the firm where there is a franchise as well as growth is nearly 30% higher than the firm with franchise but no growth.

•

Now, here’s another interesting observation. If one takes the ROIC down to just 10% and everything else remaining constant, then both the EPV as well as PV change to Rs 83 and Rs 71 respectively!

•

Did you see what just happened here? PV, which takes into account growth came in lower than EPV where there is no growth.

•

This leads us to a very important conclusion. Growth adds value only when return on capital is greater than cost of capital or where there is a sustainable competitive advantage. If the same is not there, growth destroys value as we just saw.

•

So next time you see a firm that is growing earnings at a strong pace but does not have a competitive advantage, we think it will be better to give it a miss unless it is trading at a significant discount to its asset value.

•

So how will the ratio of PV/EPV look like at different levels


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ROIC, R and G. We have a table below that will give you some idea about the same. G/R

ROIC / R 1.0

1.5

2.0

2.5

3.0

25%

1.0

1.1

1.2

1.2

1.2

50%

1.0

1.3

1.5

1.6

1.7

75%

1.0

2.0

2.5

2.8

3.0

G = Growth Rate, R = Cost of Capital, ROIC = Return on Invested Capital

•

As can be seen, even with a very high ROIC and growth rates in relation to cost of capital, the maximum one should pay for a firm over its EPV is 3x.

•

In fact very few companies on the face of this earth are able to command even that high a valuation. For competition constantly chips away, trying to bring both growth rates and ROIC down in the process.

•

This brings us to the end of our discussion of the third and the final method of valuation.

Summary of the 3 Valuation Methods •

Just to recap, we now have three methods of valuation.

•

The first is the asset based valuation where we value the stock based on its liquidation value or replacement value.

•

The second method is the earnings power value or the EPV method where we value a company having a franchise but with practically no growth in earnings.

•

And finally we saw the present value method or the PV

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method whereby we valued a company having both a strong franchise as well as witnessing a growth in earnings. •

We believe the three methods will be best demonstrated by the image below. It nicely summarizes the three approaches with the help of slices of value.

Value of Growth: Only if the growth is within advantage Earnings Power Value: Franchise value from current

Asset Value: •Free entry •

cost of assets

•

We would also like to use a great Warren Buffett analogy to describe the three different types of businesses we discussed using the three valuation methods

•

As per him, a ‘Gruesome’ business is a kind of a savings account which pays an inadequate interest rate.

•

This is the business that can be valued using mostly the asset based valuation method as the return on capital is less than cost of capital.

•

On the other hand, a ‘Good’ business is a one that pays an attractive interest rate. This is the business that can be valued using the EPV method.

•

And finally, Warren Buffett talks about a ‘Great’ business


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as a type of savings account that pays an extraordinarily high interest rate that will rise as the years pass. This is the business we discussed in the current chapter that not only has a franchise but also a growth in earnings. •

As per Buffett, the more sure money tends to be made in the first kind of business when it is bought at a significant discount to the company’s liquidation value or the replacement cost value.

•

However, the big money tends to be made in the third kind of business where the company has a sustainable competitive advantage or a franchise which is backed by growth in earnings for many years to come.

Multiple-based Valuation Approach •

Despite their practical utility, the valuation methods we talked about seldom get quoted in company research reports.

•

Instead, what we see is nothing else but multiple based valuations like Price to Earnings, Enterprise Value / EBITDA or Price to Book Value.

•

Please note that like our three approaches, these multiple based methods are not another set of independent methods of valuation.

•

On the contrary, these are nothing but a variation of the three approaches we just discussed with some assumptions and simplifications thrown in.

•

Therefore, if we are familiar with the original approaches to valuation, we can easily derive the multiples that can be assigned to companies in the multiple based approaches.

•

With this background, let us discuss one of the most

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common methods of valuing companies i.e. the P/E (price to earnings) method.

Price to Earnings Multiple Approach •

What should be the ideal P/E multiple for a stock? Let us try and answer this question using our three valuation methods.

•

We know that asset based valuation method values a company based on its assets. Here, earnings do not enter the picture.

•

However, the P/E method requires that one give a certain multiple to the earnings of a company. Consequently, we cannot use the asset based valuation method to arrive at an ideal P/E multiple for a firm.

•

Now, let us turn our attention to the second of the three methods i.e. EPV method.

•

You would recall that here we assume the company’s return on capital to be greater than the cost of capital. Also, the company under consideration has a stable earnings profile with no growth.

•

You would also recall the formula i.e. EPV = Adj. Earnings* 1/R

•

Therefore, in order to arrive at a P/E for such kind of firms, all you need to know is the cost of capital of the firm and also calculate the adjusted earnings.

•

So say if the cost of capital of the firm is 12%, then the maximum P/E multiple you should give to such stocks is 1/12% i.e. 8.3 times. And if the cost of capital is say 15%, the maximum P/E would drop to 6.7x. And if it is 10%, then the P/E would come to 10x.


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•

You would notice all that one needs to do is find out if the company’s return on capital is higher than its cost on a sustainable basis and if this is true then the maximum earnings multiple one should give the stock is 1 / Cost of Capital.

•

Some assumptions are in order. One, the PAT or the earnings of the firm under consideration is the same as adjusted earnings.

•

Two, the company is either debt free or its cost of debt is the same as its cost of equity with the interest expense being non-tax deductible.

•

Thus, once you’ve factored in these two assumptions, the expected P/E of a stock with stable earnings and with its return on capital higher than cost of capital is nothing but a very simple formula as we just saw.

•

So, this was about a firm with earnings staying constant. But what about the case where the firm has a competitive advantage as well as growth in earnings?

•

To find an ideal P/E multiple for such stocks, we will have to turn to our last of the three methods of valuation viz. the PV method.

•

We will reproduce the formula here again for easy reference. The formula was: PV = C*(ROIC-G)/(R-G)

•

Now, by plugging in the observed values of ROIC, R, G, we get the intrinsic value PV of the firm in the form of a multiple of C.

•

And invested capital C can be expressed in terms of adjusted earnings by the formula E/ROIC. Please recall that E was nothing but C*ROIC i.e. capital base multiplied by the return on the same invested capital base.

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•

Thus, what we now have is the intrinsic value of the firm expressed in multiple of its earnings, E.

Price to Earnings: Example •

An example will help make things clearer. Say there is a firm with an ROIC of 20%, G of 6% and the cost of capital being 12%. Substituting these values in the PV equation, we get PV = C (0.2-0.06)/(0.12-0.06). Simplifying this further, we get PV = 2.33 C.

•

Now, we need to go one step further and replace C with E/ ROIC. Therefore the final equation in terms of E will now be PV = 11.7 E.

•

Consequently, an ideal P/E for a firm with the characteristics we just outlined is approximately 11.7x or about 12x.

•

Thus, if you know the long term expected ROICs, Gs of the firms you are studying, one can calculate the approximate P/E that the stock can command after taking into account a suitable cost of capital

•

Please note that this formula will not work for G>ROIC. But this is not much of a problem because for most firms, long term growth on a sustainable basis is lower than it’s ROIC.

Summary of Multiple-based Valuation •

The beauty of the Present Value (PV) formula is that it can be used to arrive at not just an approximate earnings multiple but also multiples like price to book value and EV/EBIT.

•

If the company under consideration is debt free then effectively C becomes the book value of the company and ROIC becomes RONW.


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•

Therefore the PV that we get is nothing but an intrinsic value by way of a book value multiple of the stock.

•

This now brings us to the conclusion of the chapter on franchise with growth as well as multiple-based approach to valuations.

Conclusion •

We discussed a formula that needs to be brought into use when the firm under consideration has both growth as well as some form of sustainable competitive advantage.

•

We then saw the PV varies with different combinations of ROIC/R and R/G with valuations getting higher and higher as both ROIC and G increase.

•

Subsequently, we arrived at the multiple based approaches to valuation using the same PV formula we studied in the first part of the chapter.

•

We now have approaches to value practically all kinds of firms. These are firms that earn less than or equal to their cost of capital, firms that earn more than the cost of capital but with a stable earnings profile and lastly, firms that not only earn more than their cost of capital but also witness stable, long term growth in earnings.

•

Of course, it must be remembered that firms that grow their earnings at a strong pace but do not earn more than cost of capital do nothing but destroy value over a long term period. Consequently, such companies are best avoided unless available at a significant discount to their asset value.

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Stock Screeners

Chapter 16

Stock Screeners

What is a Stock Screener? •

In the book so far, we have covered the qualitative and quantitative aspects of value investing that will enable you to evaluate a potential investment.

•

With this, you would now be in a position to apply the principles of value investing for your own stock portfolio.

•

At this point, you may have a question: How to get started?

•

There are two broad approaches to fundamental investing top-down approach and bottom-up approach.

The Top-Down Approach •

The top-down approach lays greater emphasis on the macro factors.

•

An investor would first evaluate the macro economy.

•

Based on the analysis of macro trends, he would pick up a sector or sectors that would be likely beneficiaries.

•

And then from within those sectors, an investor would pick up fundamentally-sound companies.

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181

The Bottom-Up Approach •

While the top-down approach is logically sound, it depends on certain macroeconomic assumptions that may or may not materialise.

•

On the other hand, the bottom-up approach has a more company-specific focus.

•

An investor’s investment decision would be primarily based on the individual merits and demerits of a stock.

•

Some of the most successful value investors including Mr Buffett have followed this investment approach.

•

This, however, does not mean that one should ignore the larger sectoral and macro trends. The idea is to be wary of risks from top-down perspective but invest bottom up.

The Need for a Stock Screener •

If an investor were to follow the bottom-up approach, how should he go about selecting companies that he would like to research on?

•

There are more than 5,000 companies listed on the BSE.

•

It is humanly impossible to peruse through the business and financials of every company.

•

To remedy this, one can take the help of stock screeners.

•

Stock screeners are financial and valuation filters that can help you zero down on companies that could be prospective investment candidates.

•

This can be useful to eliminate all the companies that don’t fit the prerequisite financial criteria.

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Types of Stock Screener •

The next question is: How do you choose the right stock screener? Ideally, the choice of the screener must reflect your investment philosophy.

•

The various parameters that you use in a stock screener are business and performance attributes that you expect a prospective stock to possess.

•

You can create your own stock screener based on factors that you believe are critical in a sound business.

•

We will discuss some important stock screeners based on the principles of some noteworthy value investors.

Benjamin Graham Stock Screeners •

Benjamin Graham, known as the ‘Father of Value Investing’, largely focused his stock picking approach on finding deep bargains.

•

During his earlier years, his investment strategy was to buy stocks that were available at a price below their net current asset value. This methodology produced very good results.

•

However, after the long bull-run commenced in 1949 such bargain opportunities became increasingly rare.

•

In 1973, just three years before he passed away, he presented an elaborate study which showed that in every two-year period between 1958 and 1971, stocks had either risen or fallen by at least 33%.

•

This finding encouraged him to find a quantitative framework that would be able to take advantage of such volatility in the stock markets.


183

•

As per Graham, such a quantitative system would have to be logical, easy to implement and capable of producing satisfactory financial returns.

•

Which financial criteria would be able to fulfill all three conditions across time periods?

•

Based on the principles and criteria laid down by Graham, we will discuss three stock screeners that could help you pick value stocks trading at a steep discount.

Benjamin Graham - Stock Screener #1 •

The first stock screener has two parameters- Price to Book Value ratio and Debt to Equity ratio.

•

The conditions are as follows: 1) Stock price must be less than two-third the book value per share; 2) Debt to Equity ratio less than 1.

•

Please note that in addition to the above conditions, P/BV ratio must be greater than zero and D/E ratio must be greater than or equal to zero.

•

This will ensure that you eliminate companies with negative net worth.

•

As you saw, the first parameter in this stock screener is Price to Book Value ratio.

•

This ratio shows the relationship between the stock price and the balance sheet.

•

Book Value is what remains for the equity holders if the company were to go for liquidation (Total Assets - Total Liabilities).

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•

Book Value = Net Worth = Shareholder’s Funds

•

By setting a condition to screen stocks that are trading at less than two-third their book value, you would get stocks that are trading at a deep discount to their net worth.

•

The Debt to Equity condition ensures that you avoid highly leveraged companies.


The second stock screener has two parameters: Price to Dividend Yield ratio and Debt to Equity ratio.

•

The conditions are as follows: 1) Dividend yield must be at least two-thirds of the bond yield or greater; 2) Debt to Equity ratio less than 1 (and greater than or equal to zero as mentioned previously).

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Dividend yield is a financial parameter that shows the returns earned on a stock investment from dividends.

•

Dividend yield = Dividend per share / Stock price

•

Say you bought stock X at Rs 100 per share with dividend per share of Rs 8, the dividend yield on the stock is said to be 8%.

•

Why is dividend yield important?

•

Dividend yield ensures that investors earn a return on their investment even in the absence of stock price appreciation.

•

It provides a steady stream of income for long term investors without them having to sell their stocks.

•

Going back to the screener, the first condition said that the


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dividend yield of a stock must be at least two-third of the bond yield or greater. •

The corporate bond yield in India is close to 10%.

•

So assuming a bond yield of 10%, the dividend yield must be 6.7% or greater.


The third stock screener has two parameters: Earnings to Price ratio and Debt to Equity ratio.

•

The conditions are as follows: 1) Earnings to Price ratio must be at least twice the bond yield; 2) Debt to Equity ratio less than 1 (and greater than or equal to zero).

•

Earnings to Price ratio (also known as Earnings Yield) is nothing but the inverse of Price to Earnings ratio.

•

The first condition of the screener said that the Earnings to Price ratio must be at least twice the bond yield.

•

So if the bond yield is 10%, the earnings yield must be at least 20%.

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A 20% earning yield means that if the stock price is 100, earnings per share is 20.

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Taking an inverse of the Earnings to Price ratio, you get a Price to Earnings multiple of 5x (100/20).

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Hence, you could rephrase the first condition as Price to Earnings ratio of 5 or less.

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Warren Buffett Stock Screener •

Benjamin Graham’s most astute student Warren Buffett kept the principles of value investing taught by his mentor intact.

•

However, he redefined his approach to focus more on quality.

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He focuses on companies that have a very durable economic moat and are trading at ‘fair’ valuations.

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This is in contrast with his mentor’s focus on deep discount stocks without much emphasis on a firm’s qualitative factors.

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Let us try and understand the typical qualities of a stock that Warren Buffett would buy and how an investor could create a screener to find such companies.

•

We have identified some key parameters that can help you zero down on stocks that possess the attributes that a typical Warren Buffett stock is likely to possess: •

High return on equity

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Strong Dividend payout ratio

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Low debt to equity ratio

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Fair price to earnings ratio

Magic Formula Stock Screener •

We just went through a stock screener that was derived on the basis of Warren Buffett’s value investing principles.

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However, it must be noted that it was just one of the various ways of finding a quantitative interpretation of Buffett’s stock picking approach.

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We will now go through Joel Greenblatt’s Magic Formula


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stock screener. •

In his stock screener, Greenblatt has tried to arrive at a quantitative translation of Buffett’s investment strategy of buying a great business at a fair price.

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As you can see, there are two key factors in Buffett’s approach - Great business and fair price.

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How can these qualitative factors be defined in quantitative terms?

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Greenblatt uses the following algorithm to arrive at a financial metric that would be an approximate translation of the two qualitative terms. 1) Great business: As per Buffett, a great business is one that earns a high return on capital (ROC).

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Now, there are various ways to look at a company’s ROC.

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Let us see how Greenblatt defines the ROC…

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Return on Capital = Earnings Before Interest & Tax (EBIT) / Capital

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As per Greenblatt, Capital = Net Plant, Property and Equity + Net Working Capital

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It is noteworthy that he has excluded excess cash and interest-bearing assets.

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In other words, he has included only those assets in his definition of ‘Capital’ that are actually used in the business to generate a return. 2) Fair price: Buffett prefers a great business at a fair price than a fair business at a bargain price.

•

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Let us see how Greenblatt defines the financial parameter


that would determine a company’s fair price. •

For this second factor, he uses ‘earnings yield’. As we have noted earlier, earnings yield is nothing but the inverse of price to earnings ratio.

•

However, Greenblatt differs in his approach in that he uses EBIT instead of net profit in the numerator and Total Enterprise Value (TEV) instead of just market capitalisation in the denominator.

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As per Greenblatt’s equation,

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Earnings Yield = EBIT/TEV

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Let us understand what Total Enterprise Value is and why Greenblatt chooses to compare EBIT/TEV instead of P/E.

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Total Enterprise Value is the cost an acquirer would have to pay to buy out the entire company. TEV = Market Cap. + Total Debt - Cash & Cash Equivalents + Minority Interest + Preferred stock

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The reason Greenblatt uses EBIT/TEV instead of P/E is to facilitate a like-for-like comparison between all stocks irrespective of their capital structure.

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When you use the P/E ratio, you compare a company’s net profits to its market capitalization.

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However, market capitalization does not provide you any clue about a company’s capital structure and how it finances its business.

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This would make it difficult to compare debt-fee and debtladen companies.

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On the contrary, when you use Greenblatt’s formula, you’re comparing EBIT with the entire value of the company.


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•

So when you’re comparing the valuations of a large number of companies using a screener, this formula can prove to be more effective.

•

So as we discussed, Greenblatt’s Magic Formula has two metrics: 1) Return on Capital (EBIT/ [Net Fixed Assets + Net Current Assets]) 2) Earnings Yield (EBIT/ TEV)

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You run these two metrics on all the companies in your set.

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Arrange the companies in the descending order of their ROC. Assign the rank 1 to the company with the highest ROC and go on assigning ranks in that order.

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Carry out the same process for Earnings Yield.

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Once you have all the companies with two respective ranks, then next step is to do a combined ranking.

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Greenblatt assigns equal weightage to both ROC and Earnings Yield. Hence, you simply have to do the summation of the two ranks to arrive at the combined rank.

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As per Greenblatt, the lower the combined ranking, the better the stock.

Things to Keep In Mind •

While stock screeners are great stock picking tools, there are some things that investors must bear in mind. 1) Stock screeners are statistical tools. They may not always be reliable indicators a company’s quality and intrinsic value. 2) Stock screeners indicate a company’s past performance.

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They provide no input about a company’s future prospects. 3) The results of a stock screener must not be taken at face value. Investors can take the results as a starting point for further research and analysis.

Conclusion •

Stock screeners are excellent tools to scan the entire universe of stocks and to find stocks that possess the attributes that you are looking for.

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They are effective tools to filter away undesirable stocks.

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In the chapter so far, we discussed 5 different stock screeners based on the principles of Benjamin Graham and Warren Buffett.

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If used diligently stock screeners can yield great results.

•

In the next chapter on Behavioral Finance, we will discuss the psychological aspects of investing and how investors can minimize biases and thinking errors from their investment decision-making process.


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Behavioral Finance

Chapter 17

Behavioral Finance

Are Stock Markets Efficient? •

Normally, an investor buys a stock believing that it is worth more than the price that he pays for it.

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When he sells it, he assumes that the worth of the stock is less than the price at which he is selling it.

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But as per one investment theory, this is just a myth.

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The Efficient Market Hypothesis, put forth by Nobel laureate Eugene Fama in 1970, states that it is impossible to beat the market.

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This is because it assumes that stock prices fully incorporate and reflect all relevant information at any given point in time.

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In other words, stock prices are always trading at a fair value and hence, stock selection and market timing have no value in the long run.

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If markets were truly efficient, then how would it be possible for value investors such as Warren Buffett to consistently and substantially outperform the markets for decades?

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In our view, the Efficient Market Hypothesis has several flawed assumptions.

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It presumes that investors are perfectly rational in their behavior and that they are acting on the same public

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information. •

In making these assumptions, the Efficient Market Hypothesis ignores the crucial element of human behavior and its impact on the markets as well as the economic landscape at large.

•

This brings us to Behavioral Finance, a field of study that argues that human behavior is not as rational as presumed by the traditional finance theories.

What is Behavioral Finance? •

Behavioral Finance is an interdisciplinary field of study that integrates finance, economics, psychology and sociology to offer a holistic understanding of human behavior in financial markets.

•

While traditional economics and finance theories presume perfectly rational behaviour and eliminate irrationality and bias as noise, behavioral finance puts forth that human emotions and biases play a critical role in economic activity and stock price movements.

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Let us understand why it is critical to have a basic grasp of behavioral finance in the context of stock investing.

Natural Science v/s Social Science •

At the outset, let us understand the basic differences between natural sciences and social sciences.

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Natural science looks for explanations of the various phenomena in the world around us.

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It studies events that consist of a sequence of facts.

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The chain of events leads directly from fact to fact.

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•

In social science, events have thinking participants.

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This means that in natural science what a person or a group thinks does not have an impact on the final outcome. In social science, however, we can influence the very outcome we are thinking about.

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This particular characteristic feature of social science means that we cannot come to a definite conclusion as we do in natural science.

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The conclusion in social science will always be colored by what the participants think about it.

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Thus there can be no generalizations, predictions and explanations in social science like the kind we see in natural science.

Behavioral Finance: Stock Markets •

In the context of social science, let us understand two important behavioral concepts – fallibility and reflexivity espoused by legendary hedge fund manager George Soros.

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The world is so complex that no individual can understand it fully.

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Hence, one can say that in situations that have thinking participants, the participants’ view of the world is always partial and distorted.

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This is known as the principle of fallibility. It means that human perception is inherently flawed and biased.

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In theory, stock prices attempt to continuously incorporate and reflect all available news, information and future expectation.


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•

But both ongoing as well as future economic events are highly dynamic, variable and impacted by a large set of factors.

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It is humanly impossible to fully comprehend and appropriately price in all the information and news.

•

So effectively, market participants base their buying and selling decisions not on objective conditions but on their limited and imperfect interpretation of those conditions.

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The concept of reflexivity applies only in situations that have thinking participants.

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There are two key functions that the participants’ thinking serves.

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The first is the cognitive function which is to understand the situation.

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The second is the participating function which involves action aimed at changing the situation to one’s benefit.

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In the cognitive function, the outside reality (news, information, stock price movements, etc.) is supposed to determine the investors’ view.

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In short, the direction of causation is from the outside world to the human mind.

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But in the participating function, the direction of causation reverses as the actions and decisions of the investors have an impact on the outside reality (stock markets).

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Since both the cognitive and participating functions operate simultaneously, they tend to interfere with each other.

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The actual course of events influences the participants’ views.

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•

At the same time, the participants’ views also shape the actual course of events.

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This is easier to understand in the context of stock markets.

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The markets tend to shape the investors’ views. But the markets are not an independent variable. They are simultaneous being shaped by the investors’ views.

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This results in a two-way reflexive feedback loop between the participants’ views and the actual course of events.

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Since the participants’ perception is inherently biased and there exists a reflexive relationship between the participants and the market, it follows that market prices present a biased view of the future.

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This, effectively, debunks the premise that stock markets are efficient.

Behavioral Finance & Value Investing •

In the chapter so far, we discussed some characteristic features of social sciences, and stock markets in particular.

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The presence of thinking participants in the market makes stock price movements less than a perfectly rational process.

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The allegory of ‘Mr Market’ was coined by Benjamin Graham on exactly this premise.

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Mr Market is nothing but a collective embodiment of collective behavior of the market participants.

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The manic-depressive tendencies of Mr Market often result in markets swinging between the extremes of optimism (bull market) and pessimism (bear market).

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The value investing approach is designed to take


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advantage of opportunities that arise because of Mr Market’s often irrational and emotion-driven behavior. •

To be able to take advantage of the inefficiencies in the market, participants need to not only recognize the mood swings of Mr Market but also to take steps to minimize their own thinking errors and biases in their investment decisionmaking process.

Inside the Human Mind •

We will now shift our focus from market behavior to the mind of an individual.

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First, we will try and understand why human thinking is inherently biased and partial.

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The human brain is constantly stormed by millions of sensory impulses.

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However, our consciousness can only process a few subjects at a time.

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The impulses need to be condensed, ordered and interpreted under huge time constraints.

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As a result, thinking errors and distortions are direct consequences of the brain’s limited capacity to process the flood of sensory impulses.

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It is clear, then, that it is practically impossible to eliminate thinking errors and biases.

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But with greater understanding and self-awareness, one can certainly minimize the negative consequences of such biases.

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Four Quadrants of Awareness •

Our awareness can be broadly categorized into four quadrants.

1. We know what we know 2. We know what we do not know 3. We do not know what we know 4. We do not know what we do not know •

This is a useful mental framework that can help increase selfawareness, and, thereby minimize thinking errors.

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We will briefly discuss each of these four quadrants and how they affect our investment decision.

First Quadrant We know what we know •

Most of our waking conscious self we live in this quadrant.

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This quadrant includes all the things that we think are consciously known to us.

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But sometimes, our ego tends to artificially inflate this quadrant by including things that we don’t really know.

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For instance, simply possessing an academic degree in a certain field does not make one an expert.

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But people often confuse academic qualifications with actual internalized knowledge.

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How does this impact stock investing?


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•

The maximum investment mistakes happen in this quadrant.

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People do not fail because of what they do not know, but because of their failure to understand their circle of competence.

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One of the biggest reasons for Warren Buffett’s immense investing success has been his ability to clearly understand his circle of competence and to stay strictly within it.

Second Quadrant We know what we do not know •

This quadrant relates to the state of awareness that pertains to learning and enquiry.

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All good investors reside largely in this quadrant as they understand the limitations of their knowledge.

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Just like it is important to know one’s circle of competence, it is also important to clearly know what lies outside that circle.

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For instance, Buffett never invested in Microsoft despite having been a long-time friend of Bill Gates, the billionaire founder of Microsoft.

“The fact I could have made billions of dollars from Microsoft doesn’t mean anything because I never could understand Microsoft. We’re willing to trade away a big payoff for a certain payoff.” – Warren Buffett

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Third Quadrant We do not know what we know •

This quadrant relates to our subconscious self.

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It includes genetic and socio-cultural learning.

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People belonging to a certain social unit usually tend to bear certain common behavioral characteristics.

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Example: Characteristics that we generally describe as exuding ‘Indianness’.

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These characteristics are passed on from generation to generation and become integral to one’s psyche and often determine our ‘instinctive’ responses to various situations.

•

In the investing context, this quadrant is responsible for the instinctive responses that we apply to economic situations without knowing why we do what we do.

•

From an evolutionary perspective, the brain does not have the mechanism to deal with stock markets.

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Stock markets came into existence just a few hundred years ago.

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That is too trivial a period for the brain to evolve a mechanism to deal with it.

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So the brain uses the reward centre in the brain, the amygdala, which was developed to deal with food (satiation) and sex (drive) to deal with money and markets.

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It goes without saying that it is this response-mechanism that is responsible for all the chaos in financial markets.

•

This is the reason why investors get lured to buy when


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markets are rising and when everyone else is buying. •

This is also why investors confuse volatility as a risk in stock investing rather than focusing on the risk of fundamentals going bad.

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There is another human instinct that causes investors to make big mistakes.

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As a self-preservation instinct, each individual believes in his own ‘uniqueness’.

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It leads us to believe in the uniqueness of our thoughts and ideas.

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It may prevent us from assessing whether others too hold the same belief.

•

This instinct proves to be dangerous when a person is susceptible to herd mentality.

•

It could so happen that an investor may think that his thoughts are independent and unique.

•

He may fail to recognize that other investors too are thinking along similar lines.

•

The history of bubbles and crashes shows the dangers of ignoring this quadrant of one’s awareness.

Fourth Quadrant We do not know what we do not know •

This quadrant of awareness relates to the realm that is ‘beyond all knowns’.

•

Our knowledge of the world is distorted, limited and incomplete.

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•

As such, all our thoughts, ideas and beliefs exist as mere possibilities as we do not know enough to be absolutely certain.

•

This quadrant is not only the largest but also the least understood.

•

Let us discuss this quadrant in the context of investing.

•

In the investing business, it is impossible to be right all the time. As such, a successful bout in stock markets can be dangerous if it creates an illusion of genius.

•

Great investors tend to recognize the limits of their knowledge and understand that humility is the best way to survive unexpected outcomes.

•

“Once we realize that imperfect understanding is the human condition there is no shame in being wrong, only in failing to correct our mistakes.” – George Soros

Conclusion •

In this chapter, we studied how the presence of thinking participants in social science gives rise to different set of conditions that are not generally seen in natural science.

•

Market participants base their buying and selling decisions not on objective conditions but on their limited and imperfect interpretation of those conditions.

•

The value investing approach is designed to take advantage of opportunities that arise because of Mr Market’s often irrational and emotion-driven behavior.

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An understanding of the four quadrants of awareness can help an investor in developing self-awareness, a key ingredient to achieving success in stock investing.


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Portfolio Analysis

Chapter 18

Portfolio Analysis

Need for Portfolio Analysis & Asset Allocation •

In the chapters so far, we have mainly focused on evaluating individual stocks based on the strength of their business fundamentals and attractiveness of the valuation.

•

But how should you go about building your investment portfolio? How many stocks should you own? How can you minimize risk? When should you sell a stock?

•

In this chapter, we will focus on all the above mentioned factors.

•

We believe this will be helpful in managing your investment portfolio and maximizing the risk-reward equation.

•

Say you find a stock that has the attributes of a great business and is available at a bargain valuation.

•

How much should you invest in such a stock? Should you put all your money into it?

•

Intuitively, putting all eggs in the same basket may seem risky.

•

A risk-averse investor may want to spread out his investments across a portfolio of stocks and other assets so that risks arising from any single investment would not significantly impact the overall portfolio returns.

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•

What he is actually trying to do is maximize his chances of reward while at the same time minimizing the risks.

What is Modern Portfolio Theory? •

Pioneered by Harry Markowitz in 1952, the Modern Portfolio Theory (MPT) is an investment framework for the selection and construction of investment portfolios.

•

The theory is based on the maximization of expected portfolio returns and simultaneous minimization of investment risk.

•

It aims at constructing a portfolio of diverse investments whose collective risk is lower than that of each individual investment.

•

As per MPT, an investor must not select assets in his investment portfolio based on their individual merits.

•

Rather, he must consider price behavior of each asset relative to that of every other asset in the portfolio.

•

For instance, different types of assets such as stocks, bonds and gold are known to respond differently to different economic cues.

•

As such, a portfolio that has an optimal mix of different types of assets would bear lower risk than a portfolio consisting of only one type of asset.

•

MPT puts forth that investing is a tradeoff between risk and expected return.

•

It shows how to build an investment portfolio with an optimal risk-expected return equation.

•

At the core, MPT is nothing but a mathematical formulation of

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the concept of diversification. •

It attempts to show how an investor can achieve the best possible diversification strategy.

Modern Portfolio Theory- Assumptions •

Let’s go through some of the key assumptions of MPT: •

All investors aim to maximize profit and minimize risk.

•

All investors are risk-averse and act rationally.

•

The correlations between various assets are always fixed and constant.

•

The returns on assets follow a normal distribution.

•

Investors have a very clear and precise idea of expected returns.

MPT - Risk and Expected Return •

As we saw, MPT assumes that all investors are risk-averse and they are trying to achieve profit maximization and risk minimization.

•

In other words, it puts forth that there is direct correlation between risk and return and that investors are willing to accept more risk for higher payoffs and will accept lower returns for a less risky investment.

•

So broadly, there are two important factors that an investor needs to balance and optimize: 1) the expected portfolio return, and 2) the portfolio risk.

•

Let’s delve a bit into how Markowtiz looked at risk and return…


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•

As per MPT, risk is the same as volatility, a measure for variation of returns of an investment over a period of time.

•

But MPT does not look at the risk of individual investment in isolation.

•

It considers how each investment contributes to the risk of the aggregate portfolio.

•

Hence, the greater the portfolio volatility, the greater the risk.

•

On the other hand, the expected return on an investment is based on the average return it has offered investors over some historical time period.

•

The risk therefore, is the deviation away from expected historical returns during a certain period.

Why is the Modern Portfolio Theory flawed? •

Like the Efficient Market Hypothesis that we discussed in the previous chapter, Modern Portfolio Theory too has some serious flaws.

•

It must be noted that both the theories have several common assumptions.

•

Firstly, both the theories are based on a simple assumption that risk is defined by volatility.

•

But is volatility a good measure of risk?

•

Investors are very concerned by downside volatility.

•

But would you call a portfolio that is going up a risky one?

•

The answer is no. But volatility regards upside and downside movements as equally bad.

•

The other misconception that the theory suffers from is the

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assumption that there is direct relation between risk and return. •

But in reality, high volatility does not necessarily produce better results, nor does low volatility produce poor results.

•

Moreover, volatility measures do not remain constant over time.

•

So while MPT’s basic idea of diversification is reasonable, it fails miserably when it attempts to theorize it and to create a mathematical formulation for portfolio selection.

•

The philosophical premise of MPT is in sharp contrast to value investing and behavioral finance.

•

Let us now understand the views of value investors such as Warren Buffett and Benjamin Graham on aspects such as portfolio selection, risk, diversification and when to sell.

Portfolio Management – Graham Approach •

“Mathematics is ordinarily considered as producing precise, dependable results. But in the stock market, the more elaborate and obtuse the mathematics, the more uncertain and speculative the conclusions we draw therefrom. Whenever calculus is brought in, or higher algebra, you can take it as a warning signal that the operator is trying to substitute theory for experience.” – Benjamin Graham

•

The above mentioned quote from Benjamin Graham is a good indicator of his philosophy in both stock selection as well as portfolio management.

•

As per him, simple, easy to follow rules are all that one


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requires in order to beat the markets over the long term. •

As a result, concepts like the modern portfolio theory, CAPM or Beta are not likely to find a place in his book.

•

He firmly believed that risk to an investor comes not from the volatility in stock price but from a permanent loss of capital.

•

It turned out that Benjamin Graham was indeed right.

•

We just saw that the modern portfolio theory has one important assumption at its core. It argues that returns go hand in hand with risk.

•

Therefore, if this was true, high beta which is a measure of risk would automatically mean high returns.

•

However, this theory has been proven wrong on numerous occasions.

•

It has usually been observed that growth stocks (stocks with high P/E and high P/BV) are the ones with high betas.

•

But they have invariably ended up giving lower returns than low beta value stocks.

•

The Modern Portfolio Theory thus stands proven wrong.

•

Thus, if modern portfolio theory is of little use in constructing a market beating portfolio, what method should an investor use?

•

Graham was of the view that trying to exploit the behavioral deficiencies of humans would serve an investor much better in portfolio construction as well as management than theoretical concepts like modern portfolio theory.

•

He therefore greatly promoted the idea of buying beaten down stocks that are trading at a significant discount to their

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readily ascertainable intrinsic values and ignoring stocks that have a great deal of growth priced into them. •

Successful portfolio management then is not a function of higher order mathematics or calculus as per Graham.

•

It is all about having considerable will power so that the temptation of following the crowd can be minimized.

•

And what is the number of stocks one should have in the portfolio? No more than 20-30 as per Graham.

•

And the moment a stock reaches its predetermined intrinsic value, it should be sold and replaced by another stock that trades at huge discount to readily ascertainable intrinsic value.

•

If no such opportunities are found, one should simply invest in liquid bonds and wait till enough such opportunities show up again.

•

To conclude, if you think about it, Graham’s views on portfolio management do make a lot of sense.

•

After all, how can one produce a superior performance unless one does something different from the rest of the crowd. And Benjamin Graham has tried to inculcate exactly this philosophy through his teachings about value investing and portfolio management.

Portfolio Management - Buffett Approach •

Buffett’s investing philosophy has been largely influenced by Graham’s ideas.

•

However, he has evolved his own investing style to focus more on qualitative factors.

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So how does Buffett select stocks and build a portfolio?


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•

He focuses on the merits of an individual stock and does not bother about its volatility or correlation with other asset classes.

•

He prefers to buy great businesses with a durable economic moat that are available at attractive valuations.

•

As per Buffett, volatility (or price fluctuation) is not a risk at all.

•

On the contrary, volatility throws up great investment opportunities for value investors.

•

“The stock market is there to serve you and not to instruct you. That’s a key to owning a good business and getting rid of the risk that would otherwise exist in the market.” – Warren Buffett

•

What is real risk to investing then?

•

Buffett focuses only on business-specific risks.

•

Business risks could arise from various avenues.

•

For instance, for a highly leveraged company, insolvency could be a risk. For a commodity business, the risk arises from intense competition.

•

From an investor’s point of view, paying too much for a stock could be a risk.

•

What does Buffett do to mitigate risk?

•

Firstly, he invests in businesses that are inherently low risk and do not have too much debt.

•

The second thing is to buy stocks only when the price tag looks attractive.

•

The next question is: How many stocks should an investor own? How much should one diversify?

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•

For lay investors who do not have much time to focus on investing, Buffett suggests total diversification. He suggests investing in a low-cost index fund.

•

But for avid investors who have confidence in their research, he suggests having a concentrated portfolio of about 5-6 stocks.

•

As per him, if you have been able to identify great businesses at a fair price, then there is no need for further diversification.

•

Instead of trying to find more investment ideas, invest more in your best investments and you are likely to be wellrewarded.

•

“Charlie and I operated mostly with 5 positions. If I were running 50, 100, 200 million, I would have 80% in 5 positions, with 25% for the largest. In 1964 I found a position I was willing to go heavier into, up to 40%. I told investors they could pull their money out. None did. The position was American Express after the Salad Oil Scandal. In 1951 I put the bulk of my net worth into GEICO.” – Warren Buffett

•

Lastly, the most important question: When should you sell a stock?

•

Buffett is famous for often emphasizing that his preferred holding period is ‘forever’.

•

It means that once he has bought a great business at a good price, he does not bother about where the stock price goes.

•

As long as the business fundamentals are intact, he prefers holding the stock for a fairly long period of time.


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•

In other words, he would sell off an investment if he sees the long term business fundamentals deteriorating.

•

It is worth noting that he does not focus much on the stock price movement.

•

He buys a stock like he is buying a business and follows the same approach when it comes to selling it.

•

In some cases, he would consider selling when the stock valuations are way overstretched.

“If you own great businesses, you should just hold on most of the time, maybe sell if the valuations get extremely high and buy more if they get really cheap.” – Warren Buffett

Conclusion •

Despite being a sophisticated mathematical formulation, Modern Portfolio Theory is based on the flawed premise that risk arises from volatility.

•

We then studied Graham and Buffett’s views on stock selection, investment risk, portfolio diversification and when to sell stocks. We would like to end with one of Buffett’s famous quotes which very aptly lays down the roadmap that we would like you to pursue hereafter:

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“You should approach investing like you have a punch card with 20 punch-outs, one for each trade in your life. I think people would be better off if they only had 10 opportunities to buy stocks throughout their lifetime. You know what would happen? They would make sure that each buy was a good one. They would do lots and lots of research before they made the buy.”

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Biggest Lessons of 20 Years Investing

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