Thanks for writing in. You are absolutely on the dot, here.
I like the way Bharat Shah drills this home.
1.Capital Intensity is what defines the character of the business.
If the business has a front-loaded capital intensive base, such businesses will face greater challenges as they do not have the luxury of calibrating Capex with emerging business environment realities. Capex is a certainty, while revenues and profits aren’t till they actually come by. If the business conditions alter adversely, heavy capex incurred upfront may be exposed to heavy losses. So if the capex cycle gets elongated for some reason, RoCE will suffer adversely.
Airlines, hotels, theatre screens, retailing, metals & mining, Oil exploration, and many other businesses exhibit this basic flaw in the character of the business. Mr Shah goes on to say. an empty hotel room or aircraft seat at any point of time is a permanent loss of revenue because there cannot be any inventorising of the same.
We should also note that Pricing is often subject to intense competitive dynamics, while costs are largely inflexible and lumpy. Also that such Capex led growth are often funded by huge debts/and or frequent dilutions.
The corollary of high capital intake in such cases, is usually low RoCE. And we all know low/mediocre RoCE is a fundamental negation of value creating capability.
2.Does that mean all businesses with regular and growing capex requirements exhibit the same basic flaw in business character?
Certainly not. So what can we do to filter businesses for above-cited risks?
a) first look at evidence of value creation through sustained high RoCEs over long periods
b) next look at cases where competition dynamics works in the business’s favour - high switching costs, very few alternate suppliers
c) look at funding pattern evidence - judicious mix of debt, internal accruals, no dilutions or infrequent but premium dilutions
d) look at evidence of capex commitments backed by customer requirements/contractual obligations
Although its true that the past can only act as a guide to the future, it cannot guarantee the future, in my book the above filters are good enough to make a successful investment case for businesses like PI, Divi’s, Shilpa, and many others like maybe financial compounders of some repute/branding (as opposed to generic capex guzzlers) - simply because they outdistance effective competition by miles - through pursuing unique business models - the key to sustained RoCEs from them and sustained value/wealth creation.
If we appreciate these business characteristics, get to know such businesses well, and have a good grip over medium-term growth planks/visibility, we will have more confidence of picking these businesses up at discounts to intrinsic value.
Should we have that confidence, then one can’t help draw ATTENTION back to the holy grail
EPA = Economic Profits = Invested Capital x (RoCE - Cost of Capital)
We should be conscious of the ability of such businesses to generate higher Economic Profits for a number of years driven both by growth in Invested Capital and High RoCE