Portfolio Re-Structuring/25% CAGR quality-growth for next 2-3 years


(Donald Francis) #83

Some caution pointers:

  1. We WILL NOT clutter this thread with idea listing. Please remember this is not a Recommendations contest/exercise
  2. We WILL ONLY use the specified excel sheets.
  3. We might experiment with one composite mother excel sheet - for work-in-progress idea listing. This might help draw attention of prolific contributors/passionate learners to work on refining understanding of the business, putting up concise justifications, etc
  4. Your Top2 Conviction idea justifications should be uploaded only on specified template - on best effort basis from everyone

This isn’t a small ask.
Sometimes capturing the main strengths/growth /visibility planks in simple and concise words is tough, even when we know the business well. Good news is, it can be done. Sincere pursuit, hardwork and passion is necessary. Let’s see how many of us are upto the task


(Vivek Mashrani, CFA) #84

I think it is a great idea. This will indeed provide a platform to interact the ideas and test our own convictions as well.


(NNaik) #85

I was looking at a common patterns among few of the stocks i like and what can make for a relatively secular growth story. Companies with 2 or more segments of businesses (ideally not a lot) can provide growth story driven by different factors.

Eicher: CV and Bike business
PI Ind: Agi business, CSM
ITC: Cigarettes, FMCG
Torrent: Domestic and Foreign market

Obviously key assumption is that both the businesses are great businesses to be in individually
Such stories apart from potentially providing a more even growth rate can potentially create lollapalooza effect when both business come together to provide a great business - case in point Eicher currently.


(Manish) #86

Normally should we buy the stocks which are currently owned have a fair idea on the company & there valuations or try to find the new set of stocks.

Also is it a good to move from still expensive stocks into beaten down stocks wherein the business would survive & grow eventually.

Regards

Manish


(Janarthanan Natarajan) #87

@Donald

I am glad you brought the below statement to this discussion.

“The ideal business to invest in is one - where we can continue to invest large sums of capital - at high rates of return - for a long period of time.”

Incidentally me and my friends had a long discussion on the exact above statement couple of months back. What triggered the discussion was the below couple of paragraphs which appeared in a book called “Quantitative value”. I am reproducing those particular paragraphs here for the benefit of readers - mainly for new investors (I am sure seniors understand the below well)

The importance of high returns on capital is fully revealed when we think about reinvestment and business growth. Businesses must constantly reinvest capital to maintain existing production capability. If the business’s return on invested capital is lower than the rate of return otherwise available in the market, the reinvestment of capital into the business destroys value. Each dollar reinvested at a rate of return on invested capital below market rates of return translates into less than a dollar of market value. Let’s return to the example of See’s Candies, and examine it in the light of returns on invested capital.
Buffett bought See’s Candies in 1972 for $25 million. Its annual sales at the time of purchase were $30 million, and pretax earnings were less than $5 million. See’s Candies required just $8 million in invested capital to generate those earnings. This equates to a return on invested capital of 60 percent, which is an extraordinarily high return. We can assume that Buffett believed the returns were sustainable, which must have indicated to Buffett that See’s possessed a franchise. If the prevailing market return at the time was around 11 percent, Buffett may have estimated the intrinsic value of See’s at approximately 5.45 times (60 percent / 11 percent = 5.45) its invested capital of $8 million, or approximately $45 million (5.45 × $8 million = $45 million). At a purchase price of $25 million, Buffett paid only slightly more than 3 times ($25 million / $8 million = 3.125) invested capital, or about 56 percent of See’s Candies’ intrinsic value ($25 million / $45 million = 55.56 percent). Viewed in this light, See’s Candies was a steal at $25 million. Buffett, however, not yet fully appreciating the value of a franchise, was ready to walk away if the vendors would not accept $25 million. The vendor was asking $30 million, but Buffett was adamant about not going above $25 million. Fortunately for Buffett, the vendor caved.

In his 1983 Shareholder Letter, Buffett undertook the following thought experiment: Consider a hypothetical ordinary business that, like See’s Candies, also earned $5 million pretax, but required $45 million in invested capital, rather than See’s Candies’ $8 million. An ordinary business earning only 11 percent on invested capital would be unlikely to possess a franchise. A low-return business might be worth the value of its invested capital, or $45 million, which is the same value as See’s Candies. However, See’s Candies is the better business to own.
The value of its high returns on invested capital is best understood if we consider what happens if both businesses maintain the same unit sales in a world of persistent inflation. Imagine the effect that inflation has on the two businesses. A relatively low inflation rate of 2 percent steals half of our purchasing power over 35 years. Both businesses must double earnings to $10 million to keep up with this inflation. How can they achieve this? Given that unit volume remains flat, they must double the price of the product. Assuming profit margins remain unchanged, if we double the price, profits will also double.
Each business is also subject to input higher prices, and this will result in both businesses doubling their assets, since that is the economic burden imposed on business by inflation. A doubling of dollar sales means a proportionate increase in working capital, and fixed assets. This inflation-induced investment produces no improvement in rate of return. The motivation for this investment is maintenance, not growth. Remember, however, that See’s had invested capital of only $8 million, so it need only commit an additional $8 million to finance the capital expenditure imposed by inflation. The hypothetical ordinary business has a burden over five times as large—and therefore needs $45 million of additional capital.
Thirty-five years later, the ordinary business, now earning $10 million annually, is probably still worth the value of its tangible assets, or $90 million. This means that its owners have gained only a dollar of nominal value for every new dollar invested. See’s Candies, also earning $10 million, might also be worth $90 million if valued on the same basis as it was at the time of Buffett’s purchase. So it would have gained $45 million in intrinsic value while the owners reinvested only $8 million in additional capital, which equates to over $5 of nominal value gained for each $1 invested.
What actually happened to See’s Candies? Thirty-five years after it was purchased, See’s Candies’ pretax profits were $82 million. By 2007, the capital required to run the business was just $40 million. This means Buffett had to reinvest only $32 million over 35 years to fund the growth of the business. In the intervening period, pretax earnings totaled $1.35 billion. All of those earnings, excluding the $32 million reinvested in the business, were sent back to Buffett, which he was able to use to buy other businesses and grow Berkshire Hathaway. More than 97 percent of See’s Candies’ return was paid out to Buffett, yet the business grew at more than 7.5 percent a year for 35 years (and to think that the acquisition nearly fell over for want of $5 million). If the vendor had stuck to his guns and demanded $30 million, Buffett might have balked, and that $1.35 billion would have gone to somebody else.

From the above example, one can see how a high ROCE business can throw out huge amounts of cash if it maintains its competitive advantage for long periods of time. In Sees Candy’s case, the Brand is its competitive advantage as it is considered premium but only in the US West Coast (mainly around California). So, Buffet didn’t expand Sees business in other parts of US (just for the sake of growth) because the Brand isn’t considered premium and hence it wouldn’t earn high ROCE. Being the master capital allocator that he is, Buffet did minimal expansion of Sees business and took most of the cash out to invest in other high ROCE businesses. We, individual investors can learn from the above. We need to find high ROCE businesses which can maintain it for long periods of time. Next, we need to also check if the business can continue to reinvest the incremental capital it generates (read as cash profits generated in the previous years) at high ROCE too. If yes, we remain invested. If not, we sell the stock and reinvest in another company which has high ROCE and can reinvest incremental capital at high ROCE for many years forward(we don’t have the benefit like Buffet to continue owning the high ROCE business and just take out the profits generated).

Also do note the quick back-of-the-hand way of calculating the intrinsic value of the business. Other things to remember are - competitive advantage is not permanent and it will erode over long periods of time due to competition. But some companies do manage to hold on to them for long periods of time.


(Rits) #88

Thanks Jana for informative post. Pl tell how can I find amount of Capital Employed in order to calculate the intrinsic value of the company… Thanks


(Vivek Mashrani, CFA) #89

@Donald - Keenly awaiting the template to work on. Hope you are on track in the midst of this market mayhem :slightly_smiling:


(Donald Francis) #90

Guys & Ladies,

Happy to release a first-cut version on a simple Template, that everyone can easily attempt.
Intention is to provide a common framework - that should force everyone to think more concretely about their favourite business - suitability for long term investment.

The Template usability - is illustrated by filling up for PI Industries, a long-term favourite of mine.

Long Term Growth Visibility Template 3.0 -PI.xlsx (66.0 KB)

Let’s remember a few things:

  1. We will use this for illustration purpose only. It should provoke discussion on how to think about the answers to questions that have been asked on the longevity of the business. Please DO NOT make it a Recommendation exercise
  2. What has been supplied are all the FACTS in the business
  3. This is more like a simplified BQ/MQ starting Template. We have stopped short of connecting the Dots
  4. The discussion, we feel should all be about connecting the dots in the picture

We believe this could see thought-provoking discussion/debate, if taken up enthusiastically by many for their favourite business scrutiny exercise. All of us can share perspectives and learn from this, together.

Waiting to see show of hands that would like to attempt a similar exercise using the simple open template to capture the “Longevity” characteristics of your favourite business - in order to get better at the game.

Suggestions/Refinements for Template are welcome.

Cheers


(Donald Francis) #92

While creating this sheet, we learnt a few things too :slightly_smiling:

Re: “The ideal business to invest in is one - where we can continue to invest large sums of capital - at high rates of return - for a long period of time.”

While our BQ/MQ Templates focused on creating a sort of hierarchy of businesses enjoying long competitive advantage period, at high rates of return, we quite Missed the Bus on the remaining part :wink:

Unless I made it a point to ask, how much capital could this business need (read, take-in) if it could grow unhindered for next 5-10 years, our minds are not trained yet to handle this most important aspect of the longevity of the business, and hence returns:) - don’t know about you, applies to yours truly, for sure.

Would urge everyone to pause a bit and focus equally on this part, while thinking about the longevity of your business.

If you find the exercise useful, you could share perspectives on PI - in this thread itself - towards answering the vital questions raised, which we will branch off accordingly.


#93

hi DONALD
valuepickr have made me think and changed my mind set .
from a trader to an investor method.
…thanks .
coming to the point central govt had…
1.no new krushi input shop’s will open without agri diploma or degree.
2.existing shop owners will have two years to comply with norms.
…as this is a credit oriented business this will have a impact for sure.


(Ankit Gupta) #94

Hi Donald,

There are two points that I want to make on ‘invested capital’ point that you have talked about:

  • I think the whole point of deploying huge sum of capital in the existing business and generating high RoCE’s on it can be looked upon few businesses where one has confirmed orders in hands like lets say PI/Shilpa/Divis or some companies having long runway in pharma like Cadila/Sun/Lupin. However, even after confirmed orders in hand, there still remains the risk that business environment of customer may change. I have come across a company which had confirmed orders in hand from a very reputed MNC [although in a cyclical sector unlike pharma or even agrochemicals (in case of PI)] and even had advances from them for capex. However, despite confirmed orders, after the completion of capex, these MNC customer gave orders which were just 1/10th of the commitment. The company had troubles since the capex was also funded through debt. However, PI/Shilpa/Divis have a great track record of execution which was majorly funded through internal accruals and in case of Shilpa through some dilution (I think some of us few investors were concerned about dilution but it might just be the case of a management being conservative). The point I am trying to make is that these companies are still dependent on their customers and any issues with the customers will affect them indirectly. There are risks associated with companies who deploy capital in fixed assets even after confirmed orders from the customers because these customers will always have higher bargaining power against them. Also, having high customer concentration in such businesses is something we should keep a tap upon. However, there are few companies like Shilpa which derive significant revenues (51% of its FY15 revenues) from one single customer (ICE, Italy) but these companies have a long track record of association with customers and customers are very much dependent on them. So, where is less risk - in companies like PI (CSM business)/Shilpa/Divis (B2B business) where you build assets upfront on behalf of confirmed orders from customers but the customer might still have higher bargaining power against you or in companies like Lupin/Sun/Astral where you put in fixed assets for your own sales directly to customers with chances of exponential growth but not as long a revenue visibility as some of these B2B businesses have?

  • In my limited experience of the markets, I still feel that markets will probably assign higher multiples to a company which generates huge returns on capital without needing further capital to grow like Nestle/Symphony/Page which have low capex requirements or have low/negative working capital requirements. However, the point you are making about high dividend payouts leading to lower return generation compared to companies using these capital in the business itself for high return generations because they need more capital to grow also seems pretty interesting.


(Donald Francis) #95

Hi Ankit,

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


(Janarthanan Natarajan) #96

@Rits,

I am glad you found the post useful. Calculating ROCE has its own nuances and there are many ways one can calculate the same. However, I found Grenblatt’s method of calculating ROCE to be more meaningful (my personal opinion). Please find a link below which explains the same well.

http://gregspeicher.com/?p=1742

Again emphasize the fact that the intrinsic value calculation in my post above is a quick back-of-the-envelope way of calculating the intrinsic value of the business. There are many nuances again here too. If you want to explore it in depth, please read “Accounting for Value” book by Stephen Penman. You will gain some more insights about how to value a company. Jana Vembunarayanan (Disc - Neither is he related to me nor do I know him personally) has written a four part series explaining the basic concept of the book in his blog. Find the link to the first part of the series. Go through the other 3 parts too.


(Abhishek shah) #97

Hi guyz,

A great thread…good work Donald…my experience in capital markets is of
just 4 months…so pardon me for any mistakes I make…

I pick stocks through magic formula investing…but but…here’s how I change
my formula of ROE…

Conventional formula - PAT/NW.
My formula - (EPS-D-DDT)/BVf + D/P

D- dividend
Ddt-dividend dist tax
BVf- final book value(closing).
Final book value ensures that the ROE range stays between 0 to 100%. It
cannot go above 100%…
Also it adjusts for any splits or bonus…so the ROE becomes easily
comparable among companies…
Take colgate… Check its ROE according to the old method and check with my
method…colgate would not come in your magic formula screen if u use the
new formula…why? My formula captures growth…company retaining very less
will have low growth compared to company that reinvests…colgate according
to my formula will be rejected upfront…its not a high ROE business by my
formula…because its not a high growth business…I prefer picking companies
having high ROEs…because ROE to me is high growth…if I get a company
with high ROE plus high earnings yield(cheap)…I start digging further…
I insist all the VP members to provide insights/views here…it would be
really helpful for everyone of us…


(Donald Francis) #98

Many have written to me privately asking about progress on this exercise (25% CAGR businesses for next 2-3 years).

First the bad news.
it’s not easy to inspire/energise folks to do things they aren’t comfortable with - take a public stance, with detailed workings, that is.

On the other hand, I have always been comfortable putting up detailed workings because I found
a) taking a public stance helps me take Responsibility - forces me to be as diligent & as thorough as I can (at my current level of investment maturity & refinement)
b) it helps expose my blind spots immediately - by putting up what I know (with detailed workings), I expose enough about what I don’t know! That I have found helps speed up my learning curve tremendously, so I am a sucker for this :wink:

In the absence of any hands being put up, I will continue to feed this with my workings, at my own unhurried pace, as a last resort. But that’s not really a good enough option - as I would probably be feeding in all my biases (everyone has them), without really energising a collaborative learning experience.

Now the good news!
Among the 3-4, who did express interest in going through with the exercise, I have one firm commitment to put up something by this weekend 5th March. This one is about a financial services business with strong visibility for next 2-3 years, simple business model without much competitive intensity, and a long runway in front.

I hope that will inspire some more show of hands.
There are many very good opportunities in this market, if we can keep our heads down, ignore the noise around, keep looking and working hard on the basics.


(devansh_god) #99

Awesome read. I was always interested in learning how to value. This gave me a great starting point. Thanks for the link!!


(Kumar Saurabh) #100

I do not have anything new to contribute as of now except the following points:

  1. Infrastructure : Many agree that infra can be a good story but capital intensive nature of business makes it non-attractive. How about looking at infra based players who have grown consistently without leveraging :

a. J Kumar Infra (10 year of double digit 15%+ sales, profit and ROE CAGR at 0.2 debt equity ratio and healthy order book). Other emerging theme in infra is mass trasnport push with rising city congestion and this company is well placed due to mumbai metro experience.

2 Tier II/III City real estate demand and aging population : b. Ashiana housing : Another great brand with consistent performance and a debt free company. One of most reputed in tier II/III cities. Successfully launched old age society. Demand for old age society will keep on increasing due to rising population and nuclear family concept

  1. Smart City theme (20 tier II cities) contributing to next phase of growth : Which companies can participate. Again, ashiana housing comes to mind but important point is after metros can smart city be the next growth driver for India? That reminds me of one of Mckinsey reports which says emergence of some 50 cities by 2030 if India continues to grow. Who will get maximum benefit out of this?

(jainaj) #101

Hi Donald,
Over past few years, I have picked some good stocks but as you pointed out coming up with detailed workings isn’t easy for everyone.
Recent case in point is after going through Capital First. With 40% loan [email protected] fix cost+ retail focus+ increasing NIM+ increasing ROA &ROE+ low competiton +vaidyanathan + 25-30% CAGR for next few years makes a good combination. But don’t find myself comfortable presenting in detail form. Hoping it is same business some one is coming up by 5th march:slightly_smiling:
But as you said it help us analyse in more intensive way. Will make an effort towards this
Disclosure: Invested 10% in CAPF.


(varun jain) #102

Hi Donald

I would like to take one such responsibility and have my contribution to this forum in any way if possible. However I would need your help, confidence and know how to proceed on the same.

Do let me know.


(Donald Francis) #103

Hi Varun,

Please wait for a few more complete jobs to be put up, to understand the desired output level.

Then choose a business you like best, and find collaborators (probably from that business thread), to thoroughly examine the main growth planks. Those interested in the same business ideally would help you take the exercise forward

Rgds