The ART of Valuation


(Donald Francis) #1

I have been meaning to capture the next phase of refinement for our Capital Allocation Framework based on our learnings from 2011 onwards. It's a tough ask! Several of you have egged me on to try and put together our incremental learnings in a way that is meaningful and useful for the community.

Ever since that fateful discussion and consequent starting of the ValuePickr Public Portfolio and Scorecard, we have been sticking our neck out! We made certain choices consciously on the way dropping some and adding some in our combined (ValuePickr) wisdom of the moment.

Fortunately, most of the calls seem to have worked out. Valuations have got much stronger over the years where we continued to advise BUY/HOLD. Fortunately again, most of the EXIT decisions also seemed to be right (Suprajit Engineering being the notable exception, as it has continued to grow reasonably), in hindsight.

So there is some method to the madness after all - to the ART side of Valuation/Allocation. However getting a real HANG of this sometimes takes a full investing lifetime. We all know some guys who are pretty good at this, and we realise some of us are not so good at this. Some guys are good at getting-in early and equally good at jumping-out early :-). And then there are some who after taking the call, are very very good at sitting-tight!!

Remarkably, all of us have had access to almost the complete information-set (on individual businesses) in good time, and direct and/or email access to the best of the lot at ValuePickr, yet actions taken have been different (even by the veterans).

It is indeed difficult to imbibe the ART of Valuation!! That does not mean we can't speed up the process for everyone! We believe we can! This thread is about trying to capture some of the essentials from our experience of the last 3 years...so newbies/learners can make a reasonably good headstart, and us practitioners can attempt becoming more refined at the ART form.

Making bold to start this new thread on the ART of Valuation (provokingly titled) smile - setting high expectations and inviting the risk of falling flat in delivery - but hey, we have always liked to stick our necks out - challenge and be challenged - in our bid to become more refined investors.


Shilpa Medicare -Racing away on the Oncology API highway!
Kalyan Kapse Portfolio
Welcome to ValuePickr Investing Forums
Business Quality: Refining our thinking on "Great Businesses"
Assigning a Terminal Value to a business
Valuation of stock
VP CHINTAN BAITHAK GOA 2017: Experience Sharing
Investing Basics - Feel free to ask the most basic questions
(Donald Francis) #2

VALUATION ART #1

Mr D: All your stock picks are good but I can't help observing almost all of them are processor-type stocks.

Processor-types? What do you mean? Most of these are strongly differentiated businesses with management having a good track-record at the helm - Mayur Uniquoters, Astral Poly Technik, Suprajit Engineering, Gujarat Reclaim, Vinati Organics, Balaji Amines. They have been doing well too.

Mr D: Ya. But all seem to be taking in some input, processing that and selling the output. Not much value-addition don't you think?

This time I am stumped. Even though I was always looking out for strongly differentiated businesses, I had to admit I hadn't thought about things deeply enough. I countered, as long as these are growing strongly and are obviously under-valued why shouldn't I be allocating more capital there?

Mr D: Maybe you should examine what is the valuation range accorded to processor-type businesses

Frankly till that moment I had invested zero time on finding out for myself -practically )- what kind of valuations Mr Market awards different kind of businesses. Let alone spend time thinking about it and the why's? And I was already completing 3 active years in the market (`close of 2011, I think), had read all the Must-Have-Investing-Books, and been turning dozens of stocks!

Please tell me what's the range for my processor-type companies. I pleaded.

Mr D: Just check. It's rare to find Processors crossing 1-1.5x Sales in their lifetimes. And do we have examples of businesses that add-value. Haven't you noticed Piramal Health being acquired at 9x Sales. There's a clue there!

What a clue that was, Sir! We got hooked to the next refinement in our -Separating the Wheat from the Chaff. We graduated from trying to identify "strongly-differentiated businesses" to identifying those with "High Business Quality".

)-----

We started thinking differently about businesses. Even with most things being equal, we realised there ARE a few things that mark out businesses as significantly more value-added, if you like. We graduated to slotting businesses according to business Quality.

B Category - Balkrishna industries, Gujarat Reclaim, Suprajit Engineering

A category - Mayur Uniquoters, Astral Poly Technik

A+ category - Ajanta Pharma, Poly Medicure, Kaveri Seed, PI Industries

)-----

I can't think of any other input that has had as dramatic an impact on our Capital Allocations, and subsequently Portfolio Performance, as this one single input.

It all seems deceptively SIMPLE, right. We all seem to logically, inherently know and understand this. But probably it's not an ingrained mental-model for most of us. Once you have that ingrained (hard-coded into your decision-making that is) though, there will be no looking back! Our experience suggests so :-).

Perhaps some folks can take the lead to illustrate the learnings from slotting our picks into Category A+, A, and B kind of businesses by exemplifying these from ValuePickr forum discussions.

That will give us some time to develop the flow for Valuation ART #2.


(Donald Francis) #3

At this time I was pretty obsessed with oligopolies - only 2-3 players in the world! Vinati Organics (ATBS #2 in the world and growing share), Balaji Amines (NMP, PAP - among top 5 successfully challenging the dominance of the BASFs of the world) !! and the like.

In my naivety - I was ignoring 2 crucial things:

a) The size of the opportunity - pretty small, and that is why the oligopoly exists. It's just not worth the while for big chemical giants to pursue that kind of a market opportunity

b) Critical Dependence on crude RM - No matter how excellent a Management, they are vulnerable to crude (petrochem) volatility

The above Business Quality insight led us to prune first Vinati Organics and Balaji Amines off the VP Portfolio in a bid to concentrate more on A and A+ category businesses. Next was the turn of businesses showing clear signs of cyclicality like BKT, GRP and Suprajit. B category businesses - we decided we will ride opportunistically - when valuations were really cheap and additionally there is evidence of cycle turning, etc.

There is another oligopoly -Oriental Carbon - only the 2nd alternate supplier of Insoluble Sulpher to most Tyre majors world-wide, that we reluctantly had to prune off the Opportunistic Portfolio list. This didn't have the RM volatility as above, but had Auto cyclicality as the other problem and slotted as B category - as were BKT, GRP and Suprajit Engineering.

Oriental Carbon is getting HOT now as an Opportunistic Portfolio candidate, by the way. And we should get to reviewing GRP which looks pretty warm too, maybe even re-look at BKT too.


(Mallikarjun) #4

Poly medicure A+ --- High quality business with entry barriers, almost a lone player, sustainability, scalability and potential to leapfrog into more value-added products..

Most of the pharma formulation companies and FMCG A+

Avanti feeds A- --- Variables like weather, disease can affect the business..We must always be on our guard if invested..Unless valuations catch up it may remain so as A- or else B i guess..And need temperament to ride the volatility which most of us lack..Unpredictability but an opportunity to veterans..

B --- Some cyclicals like Indag etc..


(Donald Francis) #5

There are businesses which may seem to be in a cyclical industry - as we are apt to paint with the same broad brush - but are able to handle the cyclicality much better.

Evidence from VP Portfolio - Atul Auto and Indag Rubber . They continue to remain in VP Portfolio as the business continues to do reasonably well, and we could see that happening based on our understanding.

Another example is Suprajit Engineering which has surprised many of us. Clearly we hadn't paid much attention/followed the business closely to read the signs of their ability to keep growing reasonably.


(Mallikarjun) #6

Thanku donald.. May be caused a barrier to free flowing and in depth discussion which you were contemplating.. Sorry..


(Donald Francis) #7

Everyone please feel free to participate, make your observations, supply data and cross-question our findings or submissions - and make this a vibrant discussion - not a monologue. I am also clarifying my thoughts as I try to pen down the essentials - to influence essential discussion pieces.

@ Mallikarjun - your comments/thoughts are welcome just as anyone else's. Just thought to clarify that Indag shouldn't probably be clubbed as a pure cyclical - it does well with the CV industry in recession - so your comment was very timely to illustrate a point.

Only if we have free-flowing uninhibited comments coming in, will points and counter-points be raised - and that is essential while trying to refine our thoughts - challenge and get challenged - with the aim to get better at what we do.


(Dhwanil Desai) #8

Hi Donald,

Great start! As you very succinctly put it, it's time to leap to the next level. I have been currently compiling data for last 10 years on "high quality businesses" to understand

1) what attributes make a any business high quality of A+ category business

2) How rewarding it is to pay up for high quality businesses. How do they behave in a buoyant market and in a lackluster market.

Though, I am still compiling more data, here are some inferences from the analysis of the data compiled so far! I think there are few factors which are "must have" for a business to be qualified as A+. Of course, it goes without saying that high ROE/ROCE; free cash flow, low leverage etc are required as such.

1) Inherent strength of high quality business enables it to operate business with least capital deployed. All the companies which have strong moat, working capital requirement grow at much slower rate than top line growth. As moat gets stronger, many of them do business on OPM (other people's money!). This "float" is a great booster as every rupee earned generates infinite return! Have a look at the data below. 6 out of 9 companies have negative working capital. In last, four years, 6 out of 9 companies have reduced working capital (even if it was already negative to start with). Take example of GSK Consumer healthcare. It reduced working capital from 52 crore on sales of 1700 crores to -355 crores on sales of 3400 crores!

Company name P/E W.Cap 2009 W.Capital 2013 Revenue 2009 Revenue 2013 % change in Revenue % Change in W.Cap
Gillette India 82.55 52 30 673 1458 117% -42%
HUL 47.27 -1383 -2518 21868 28487 30% -82%
ITC 37.11 1200 1880 24363 44224 82% 57%
Pidilite 30.98 243 310 2132 3898 83% 28%
GSK Consumer 38 52 -355 1700 3367 98% -783%
Nestle 42.73 -102 -698 4471 8614 93% -584%
Asian Paints 40 240 330 6300 12600 100% 38%
P&G 42.56 -51 -101.54 774 1698 119% -99%
Colgate 36.21 -318 -469 1758 3324 89% -47%

Pricing power: Another attribute, which often get overlooked,but crucial is pricing power. Some times it is evident and sometimes it is dormant. However, if you look at all the companies above, all of them, as a whole, or in some large categories have ability to raise prices without impacting the demand. Here is what Buffet opined in 2011

âThe single most important decision in evaluating a business is pricing powerâ
âIf youâve got the power to raise prices without losing business to a competitor, youâve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then youâve got a terrible business.â
Hence while assessing the quality of business, if company can raise price for its product without affecting demand (Price for Maggie/Nescafe), chances are hight that it is a high quality business.
Opportunity size: As Donald mentioned, the opportunity size does matter.All these companies are in a business which have achieved scale 10 -20 times of what it was 20 years ago and can still grow 10 times in next 20 years! My hunch is that as the large opportunity size is important for high quality business so is the time for "repeat" buy! One may consume Maggie/Nescafe/Horlicks every month and buy it again. However, replacement for CPVC pipe or sanitaryware happens after a decade. This implies that market has to be sustained through new buyers and not through repeat buyers. And all people who have worked in marketing/sales would agree that it is tough to get your foot in for the first time!
Best Regards,
Dhwanil









(Donald Francis) #9

Some more qualifying comments to bring everyone on the same page about the intent of this thread.

This thread is about the ART of Valuation. It is NOT about the SCIENCE of Valuation :-). There is not much debate/discussion needed on the science part. Gurus have documented everything there is to document and it's easy to grasp for anyone serious about investing. However in my experience that is only about 20-30% of the job. And it is mostly about helping you AVOID making mistakes. The Science part helps you avoid traps. The Science part (may give some lead indicators) but mostly does not lead you to the best-performing businesses in your portfolio - THINK about this!

My favourite quote on Valuation is from my Guru Buffet who says you do not need complicated spreadsheets and/or complicated models to tell you a business is undervalued. It should simply scream UNDERVALUED!

The ART part of Valuation is more difficult to put across. And normally it takes years and years and churning of businesses by the 100's before some clear patterns emerge in your head and then become aids in quick decision-making - rejecting stocks/businesses by the dozen before landing up with a few high-quality ones.

The ART of Valuation is about being able to decide for ourselves the ODDS of high-quality performance delivery by the business in question**BEFORE there is consensus/conviction in the market**. Useful to keep this important premise in our minds.


(Donald Francis) #10

@Dhwanil

Thanks for the data, and glad you brought this up. Helps to illustrate my next point and just to steer you gently towards the right sort of data collation for this thread.

Some FMCG businesses inherently possess many desirable characteristics as branding (mind-share),repeat purchase, pricing power (probably this holds really true though only for Horlicks, Maggi kind of iconic brands and not for Soap/Shampoo brands per se), and so on. Many of them are high-quality businesses, but they are not the ONLY ones smile and there lies the OPPORTUNITY!

Also everyone knows about them, it's apparent to any serious investor. There is no ART in getting steady 20-25% compounders out of well-known high-quality FMCG-like mature businesses - you normally do not get exceptional out-performance from these.

This is because the expectation of the high-quality business performance is already built-in into the price. Everyone knows about them - there is consensus in the market about the conviction about these companies delivering high-quality performance.

The ART of Valuation is in someway, therefore - about being a little prescient!. A little ahead of the average investor in the market, about being able to decide for ourselves the ODDS of high-quality business performance delivery in question BEFORE there is consensus/conviction in the market about it. Which means there exists a big gap between expectation (current P/E) and actual business performance!

Which in effect means a power-packed combo of**HIGH-CONVICTION** vs HIGH-UNDERVALUATIONin a business under scrutiny, in our Capital Allocation terms! This important premise perhaps forms the CORE of the ART of Valuation.

So on to Valuation ART #2 then.


(JatinK) #11

Interesting- very interesting topic Donald. Hope to learn a lot from this.

Thought a bit on this. Here is how my thinking is going-

There are essentially four kind of Moats-

1) Intangible Assets/ Brands

2) Customer Switching cost

3) Network Effects

4) Low cost advantage

Let me give a few example for the benefit of those, who don't know this.

1) Intangible Assets/ Brands-- Nestle, Sun, Ajanta, PI, Kaveri, Page, Cera, Astral, Hawkins, Prestige.

2) Customer Switching cost-- Mayur, Eclerx, IT comps like Infosys, Accelya etc.

3) Network Effects-- Winner gets all here. NSE, Google, Facebook, MCX.

4) Low cost advantage-- Kewal kiran, GRP, Indag (can be due to absolute low costs or due to economies of scale).

So, this thread indirectly asks to rate the Moats.

IMHO**Network >> Intangible Assets >> Switching cost >> Low cost advantage **

because in Network effect... winner takes all. So, he can charge anything.

Intangible assets/ brands... you are a lot better than your competitor. So, you have pricing power.

Switching cost... You are better than your competitor. So you have pricing power but not very high in bad times.

Low cost advantage... You can charge an amount so that you still remain low cost for your customer but can't ask for infinite amount here.

So, Network Effect will have A+ business.

Intangible Assets will have A+, A.

Switching cost will have A, B.

Cost Advantage will have B. (going as per Donald's classification)

Views invited.


(Abhishek Basumallick) #12

Network effect needs to be backed by long term sustainable business model. Look at what happened to Nokia, Nortel etc to understand that network effect can as quickly get destroyed as it is created.

Getting an investment call right has two aspects to it, betting on a good business vs betting on a good price (severe undervaluation). When we talk about FMCG or Pharma, typically the good businesses leap to mind. The ones which have a "brand".

The interesting aspect though is to look for those businesses where the brand is not yet fully established, there is potentially a large scale of opportunity and where the price is cheap (due to ignorance or small size of the company where it has not yet drawn institutional observers). Here the potential risk-reward is very high.

For example, Astral, a stock which has been very well discussed at ValuePickr. It is a wannabe brand, large scale of opportunity, was available cheap a few years back when most of us bought.


(Donald Francis) #13

This was also the time when we had had a few good successes. However most of us seemed to be stuck on under-valued differentiated businesses.

A 25-30% ROE business with positive operational cash flows, low debt, growing at 30%, and available at 5-6 P/E was a formula that was working great for us. We could generate the 30-35% annual CAGR we desired from these businesses.

And before Mr D's "processor-type" challenge, that's where we exactly were. Even an Ajanta Pharma got into our Portfolio when it was available 6x earnings with major improvements in OPM :-). It's another matter that we articulated the Capital Allocation framework with Mr D's intervention, however Mayur and Astral continued to hog the really high-allocations. Within a year, we saw Ajanta out-performing every other business in the Portfolio and we sat up and said hey, why the hell did we not allocate much more to Ajanta?

)----

VALUATION ART #2

High Conviction vs High Undervaluation. Right!

Getting to grips with "High Conviction" was easy for us. All of us were capable of putting in enormous amount of homework/dig up data/local scuttlebutt/field reports to establish that. Hard work no doubt, but simple enough. No ART in that :-).

Getting to grips with "High Undervaluation" was not so simple. This was mostly the ART part!

**How do I decide which business is intrinsically more valuable? **It is easy for me to KNOW a ~5-6 P/E, ~30% RoE ~30% grower is a STEAL! But it gets more complicated when anything is available >10x - say 12x and 15x or more.

Mr D: Well, historical valuations do provide some pointers. But it is far more enriching to think about it from a buyer of the business perspective. Suppose someone has the 5000 Cr needed to buy out an entire business, which type of business is he going to value more?

Is he going to value and pay more for Mayur or Astral or Ajanta Pharma or Poly Medicure or PI industries or Kaveri Seeds? Think about it, and there lies the clue! And you will not find the answer from your Excel spreadsheets/ratios mind you. (He knew about my exhaustive number-crunching excels :-))

_
)-----_

In many cases some of these businesses were growing splendidly. Some of them outstripped others just by the phenomenal growth they were recording.

But if we were to have say all things being equal (say Execution track, Growth record, Management pedigree, Financials), two things became clear immediately:

1.The lesser the number of variables in the business, the greater are its ODDS of delivering consistent business performance. In essence, the more predictable a business is, the more valuable it is.

2). The higher the intellectual capital brought into the processes, systems and by extension the products/services of the company - the more valuable it is.

)-----

No marks for guessing now that we started seeing why a PI industries should be much more valuable than the 12-15x it used to quote at. Same goes for a Poly Medicure at 12x or a Kaveri Seed at 10-12x, and an Ajanta Pharma at 12x!!


(Vinay) #14

Very little experience in the capital market, so trying to learn as much by vicarious experience.

W.Buffet in his 1984 letter to shareholders expresses his views on A+ businesses. " My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic Goodwill. This bias caused me to make many important business mistakes of omission, although relatively few of commission.....

Ultimately, business experience, direct and vicarious, produced my present strong preference for businesses that possess large amounts of enduring Goodwill and that utilize a minimum of tangible assets."

I suppose businesses like ILFS Investment Managers, Accelya Kale, DRG acqured by PEL requires very minimum tangible assets and have enduring Goodwill.

Regards


(Dinesh Agrawal) #15

Thanks Donald for this wonderful community.

My 2 cents.

3 parameters that affect valuation are

1). ROE/ROCE

2). Growth

3). CAP - Competitive Advantage Period.

Lot has been discussed in this community about first 2 and even all valuepickr stocks share first 2 and did exceedingly well but may not necessarily have a very long CAP (upwards of 10 years). Now that most of the valuepickr stocks have run up a lot it may not give similar return as in the past (although I missed out of most of the multibaggers Luntil recently) and hence need for the quest for the next multibagger.

This seems to be the best moment for applying another strategy to the portfolio, stocks with sustainable higher CAP (upwards of 10 years).

Advantages if stocks with higher CAP

1). Current valuation does not matter to some extent since even if you buy at an expensive price over the long term (10/20 year), you will earn returns similar to the business.

2). Even though these may look expensive based on P/E, P/BV valuation but market consistently undervalues these stocks (check some recent posts from prof. Sanjay Bakshi).

3). Generally these stocks command similar valuations even after 5-10 years due to CAP expansion.

4). Minimum reinvestment risk. We donât need to keep searching for next big thing.

5). Good candidate for SIP investors.

6). During crisis, these stocks are least impacted.

7). Large diversification may not be required.

8). Easier to get conviction on these stories.

eg; Nestle, Page, HDFC twins, Gruh, etc.

These consistent growers can complement valuepickr portfolio and add lot of stability to the portfolio during crisis time.

Happy Investing!!

Regards,

Dinesh


(Mallikarjun) #16

VALUATION ART #2

)--- Spot on.. Few months back guess most of us were in two minds..i was.. Almost all the A+ picks were richly valued.. It was getting tricky to allocate fresh capital..

Donald if Ajanta Pharma, Pi Industries and Polymedicure are valued at more than 25 pe then which stock among these will Mr D allocate fresh capital and why..Will love to hear from veterans..

( Or do we need to constantly monitor/think in terms of 'what can go wrong' in the underlying business and then increase allocation )

Regards
mallikarjun


(JatinK) #17

Abhishek correct me if I am wrong-

Nokia, Apple were technologically driven moats which are more risky & unpredictable. Better to stay away from these as Buffett does.

But look at multiples Network effect driven moats get especially when currently captured market is very less than future perceived market.

Look at Facebook, Twitter or Just-dial valuations.

Donald, am I on the right track OR you are talking some very different point here?


(Nikhil gupta) #18

There is an interesting checklist on how to think about sustainable moats (based mostly on Porter 5 forces) from a Mauboussin paper that I have cut and kept. While not all elements on the checklist are equally important, this has started to serve as a nice guiding tool for me. Hopefully the VP folks may find it useful as well:

**Value Creation Checklist **

**Economic returns **

  • What stage of the competitive life cycle is the company in?

  • Is the company currently earning a return above its cost of capital?

  • Are returns on capital increasing, decreasing, or stable? Why?

  • What is the trend in the companyâs investment spending?

**Lay of the Land **

  • What percentage of the industry does each player represent?

  • What is each playerâs level of profitability?

  • What have the historical trends in market share been?

  • How stable is the industry?

  • How stable is market share?

  • What do pricing trends look like?

  • What class does the industry fall intoâfragmented, emerging, mature, declining, international, network, or hypercompetitive?

The First Three of the Five Forces (Suppliers, Buyers, Subsitution)

  • How much leverage do suppliers have?

  • Can companies pass supplier increases to customers?

  • Are there substitute products available?

  • Are there switching costs?

  • How much leverage do buyers have?

  • How informed are the buyers?

**Barriers to Entry **

  • What are the entry and exit rates like in the industry?

  • What are the anticipated reactions of incumbents to new entrants?

  • What is the reputation of incumbents?

  • What is the level of asset specificity?

  • What is the minimum efficient production scale?

  • Is there excess capacity in the industry?

  • Is there a way to differentiate the product?

  • What is the anticipated payoff for a new entrant?

  • Do incumbents have pre-commitment contracts?

  • Do incumbents have licenses or patents?

  • Are there learning curve benefits in the industry?

**Rivalry **

  • Is there pricing coordination?

  • What is the industry concentration?

  • What is the size distribution of firms?

  • How similar are the firms in incentives, corporate philosophy, and ownership structure?

  • Is there demand variability?

  • Are there high fixed costs?

  • Is the industry growing?

**Disruption and Disintegration **

  • Is the industry vulnerable to disruptive innovation?

  • Do new innovations foster product improvements?

  • Is the innovation progressing faster than the marketâs needs?

o Have established players passed the performance threshold?

o Is the industry organized vertically, or has there been a shift to horizontal markets?

**Firm Specific **

  • Does analysis of the value chain reveal what activities a company does differently than its rivals?

  • Does the firm have production advantages?

o Is there instability in the business structure?

o Is there complexity requiring know-how or coordination capabilities?

o How quickly are the process costs changing?

  • Does the firm have any patents, copyrights, trademarks, etc.?

  • Are there economies of scale?

o What does the firmâs distribution scale look like?

o Are assets and revenue clustered geographically?

o Are there purchasing advantages with size?

o Are there economies of scope?

o Are there diverse research profiles?

  • Are there consumer advantages?

o Is there habit or horizontal differentiation?

o Do people prefer the product to competing products?

o Are there lots of product attributes that customers weigh?

o Can customers only assess the product through trial?

o Is there customer lock-in? Are there high switching costs?

  • Is the network radial or interactive?

  • What is the source and longevity of added value?

  • Are there external sources of added value (subsidies, tariffs, quotas, and competitive or environmental regulations)?

**Firm InteractionâCompetition and Coordination **

  • Does the industry include complementors?

  • Is the value of the pie growing because of companies that are not competitors? Or, are new companies taking share from a pie with fixed value?

**Brands **

  • Do customers want to âhireâ the brand for the job to be done?

  • Does the brand increase willingness to pay?

  • Do customers have an emotional connection to the brand?

  • Do customers trust the product because of the name?

  • Does the brand imply social status?


(Abhishek Basumallick) #19

Jatin, so Facebook, Twitter & Just Dial are not technology companies? wink Remember Orkut, MySpace, Yahoo - companies which flattered to deceive? In response to your question on whether to invest fresh capital at 25PE, my personal take would be that I would not (would look at valuation metrics other than PE but if all/most metrices show its overvalued, I would pass).

Sir John Templeton had a few rules for investment success. Two of them which are relevant in this discussion are as follows:

  • When buying stocks, search for bargains among quality stocks
  • Buy value, not market trends or the economic outlook
    So, I would continue to keep looking till I get "bargains among good quality stocks". That is why its important to track a reasonably good number of stocks which are not in one's current portfolio.

Dinesh, I get very uncomfortable whenever anyone talks of ignoring current valuations.We should be very very careful of creating an investment thesis based on short term trends (5-10 years). We have to look at history of atleast 2-3 complete business cycles to get some level of comfort that what we are talking about is correct and works. Please go back to the US Nifty Fifty boom. Your points are exactly what people used to make back then. And we all now how that ended. So, be careful of what others say (including such eminent people like Prof Bakshi, whom I have a lot of respect for). Over the last 100 years, the ONLY trend that has worked over the largest duration of time, is value investing. And it continues to work simply because it is psychologically very very difficult to implement.


(Dhwanil Desai) #20

Hi Donald,

May be I was not able to put across my point clearly. The reason for putting up data was to illustrate the characteristics that a high quality business should possess eventually and not to suggest those businesses mentioned in the list are good investments in the context of our discussions. As you rightly mentioned, all these stories are well known and priced in! However, when we come across a business which demonstrates gradual movement towards such qualities such as negative working capital/float and pricing power, we should acknowledge them as potential high quality business "in the making". Only then, we can be ahead of the curve.

I think at this juncture, I have observed bias for slow contrast effect come into play. Many a times we ignore small incremental changes that, eventually result into large impact. Take for example, Amara Raja, in last 10 years, W.Cap as % of sales have decreased from 30% to 9%, gradually. This is equivalent to what industry leader Exide used to achieve in 2000 when it operated in almost monopolistic environment(and continues to do so even today).Slowly but steadily, company has more bargaining power with dealers and customers, indicating expanding moat. Same is the case with pricing power. Lead prices, increased by 3 times (i.e. CAGR 12%) in last 10 years and ARBL not only maintained but improved its margins even surpassing market leader Exide's margins. And now ARBL has decided to decouple its pricing policy from that of competitors! So, ARBL is charging premium to Exide in replacement market and still gaining market share. So is ARBL inching towards "high quality business"? If so, isn't it attractive at current price, trading at 15 P/E?

So,as an investor when we aspire to be ahead of the curve in identifying high quality business, I feel as an investor we may have two separate approaches at their disposal

1) We identify clear and visible trends towards "predictability" and "intellectual property" or other such high quality business attributes and invest when every one else in the market is still waiting for "proof" (like many of the members would have done in case of Page or TTK prestige few years ago). Here the conviction level may be subjective to each individual. But hey it doesn't matter, we are talking about the "Art" part anyways :-).

2) Invest when high quality businesses are facing headwinds due to macro factors slows the momentum down. Be contrarian. So may be companies like Triveni Turbines and Shriram Transport Finance can be good bet. Economic down turn has resulted into below average results for these companies but both of them demonstrate all the attributes of high quality business. Both of them are leaders in their segment by virtue of intellectual capital.GE, which is one of the most technologically advanced company especially in Turbine technology, has formed JV with Triveni to market 30-100 MW range steam turbines world over. It is a vote of confidence for Triveni's intellectual capital, technological prowess and process orientation in <100 MW steam turbine market. Triveni is undisputed leader is <30 MW segment in India with close to 60% market share. Having been associated with energy sector, I have experienced its phenomenal reputation which puts its product comparable to world's best offerings from Siemens/Alstom/Nippon. Triveni's growth has slowed down due to challenging economic environment in Indian and globally. But, once the economy turns around, there is high predictability of Triveni doing very well.

Same goes for Shriram Transport. It has got a vote of confidence from one of the best capital allocators in India, Mr. Piramal. It's offering is unique and it will be very difficult to replicate the unique systems/processes for risk and cash management that STFC has evolved over last many years. It is competing largely with private moneylenders and hence in spite of charging hefty margin for "perceived" risk, it still lends at competitive rates as compared to rates charged by private moneylenders. And look at its new offerings such as "Auto malls" and "new look" which not only compliments its core business but also can "de-risk" it by infusing fee based income. So, again, attributes of high quality businesses.

But the moot question here is, how much one should pay up for "high quality businesses" considering the additional risk one is taking either by jumping in early or taking the risk of being wrong? How should we still ensure that we do not lose capital by overpaying?

Best Regards

Dhwanil