The ART of Valuation

Investing Strategies
41

**

Regarding

)–If there is reasonable/big Margin of Safety - it would mean that the market is undervaluing the business, unable to see the high quality A+ category (sustained performance ability and say intellectual property) that we could clearly see - e.g. in PI Industries or Poly Medicure till recently (refer the Mgmt Q&As).

)–Even an Astral’s or Mayur’s A category business quality (sustained and improving performance ability) wasn’t acknowledged by Mr Market for almost 2 years - while we kept finding the Margin of Safety and kept buying post every result/Mgmt Q&A

**

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Thanks for driving the point home Donald. got it.

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Hi Mallikarjun,

There are some very smart folks at ValuePickr.P Sharma has exemplified it beautifully for us, already. Please pay attention to what he has said.

My takeaway from this analogy is that we should look for companies which have laid the building blocks for disproportionate future growth.

Laborious stocks will produce a rupee worth of incremental growth for the extra rupee of incremental input. It is not a one to one relationship but an extra rupee wouldn’t produce two rupees of incremental growth in this category.

“Disproportionate future growth” is a super new concept or mental model Mr M has given us (sorry Mr M I felt compelled to acknowledge, for posterity’s sake :-)). It deserves special attention and its own thread :slight_smile:

Type C Businesses: building blocks laid for disproportionate future growth Link: …/…/…/forum/valuepickr-scorecard-aug-2011/721990029

Everyone - Let us continue exploring Type C now onwards, in its dedicated thread.

I am sure there will be many interesting practical examples thrown about and much more enriching debate/discussions - and reach logical conclusions, soon hopefully :slight_smile:

)-----

Re: Opportunistic bets

None of our opportunistic bets are/can be Type C.

Our Opportunistic bets are huge UNDERVALUATION plays (less emphasis on high business quality) like we had in Atul Auto, Indag Rubber, Manjushree Technopack, Avanti Feeds. The premise is one should be able to make very good money in these in much quicker time, than long term portfolio picks.

My take is the huge undervaluation exists till there is information asymmetry - Market doesn’t know or is slow to understand the real business dynamics.

Fortunately, most of our opportunistic bets (except Oriental Carbon) have demonstrated that investment premise of ours :). We are very fortunate to have some very astute investing practitioners :-).

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44

Let's take forward the 3 main constructs so far. To me it seems our "Business Quality" Value Chain has a hierarchy of sorts. Each level is important and great "differentiator" planks to pit one strong emerging business with another.

To reach the higher levels the business may normally need to to build/invest through from the lower levels. Unless the business shows performance consistency, aspiring for or investing in building process/system/product IP may not be possible? Higher levels may not even be reachable my most strong businesses.

Level 1 Level 2 Level 3
Disproportionate Growth
Intellectual Property
Performance Consistency


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Mr M:If you observe,there are no real numbers or ratios to analysein all this process - looks too laborious to do. If understanding of an investment can simplify to this level, then it's our take on the business that has to go wrong to challenge the Conviction.UNDERSTANDING is the real margin of safety.

It's perhaps time to start pitting our favorite businesses against each other - for a "doodh ka dooth, pani ka pani" exercise.

I am filling in for the first few businesses I am pretty familiar with to ignite the debate. Should there be major dissent against, I am willing to defend these in the way I best can.

Business Performance
Consistency		 Intellectual
Property in
Processes/Systems/Products		 Building Blocks for
Disproportionate Future Growth
Mayur Uniquoter Yes - -
Astral Polytechnik Yes Yes (derived) -
Poly Medicure Yes Yes Yes
PI Industries Yes Yes Yes
Ajanta Pharma Yes Yes (limited) ?
Kaveri Seed Yes Yes Yes
Amara Raja
Shriram Transport
Accelya Kale
JB Chemicals
Il&FS Investmart -

All those pretty familiar with the other listed businesses, feel free to speak up and rate these by posting a similar table. Elaborate as needed in the text following the table. Only caveat - you must be willing to defend/debate your ratings with concrete reasoning.
We aren't keen on an opinion poll! (not yet, at least).
But everyone feel free to critique and ask pointed questions of raters ;-)
Welcome comments/suggestions on refinements for this above exercise.
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45

A really interesting discussion. Nothing much left to be said when so many good investors have put across very thought provoking points. If i may, i would like to add the dimension of ‘time frame of investing’ vis-a-vis valuation, to the discussion

We buy a company (or tiny parts of it) simply because we expect the market cap to go up (preferably, not because of dilution :slight_smile: ) I think there are three factors which drives market cap (leaving aside the khabri, satta and punting stuff)

1). Earnings

2). Cashflow

3). Dividend

The market cap (and valuation) of a company keeps on moving up/down on the overall market’s perception of these three factors.

Now in my opinion, over the short term (for me, thats 3-4 quarters), the most dominant factor affecting market cap and valuation is earnings. Over a longer term, cashflow and dividend also kick in. Hence, if one is investing for a shorter term, one should look more at earnings for determining valuation. As one’s time frame changes, the basis for valuation also should change. So, over the short term (maybe even for a few years), companies which show huge earnings growth will also show a good rise in market cap and valuation. But over longer term, when earnings growth is not accompanied by cashflow (a must) and dividend (maybe optional), the increase in market cap does not sustain. Hence, longer term investors would be better off giving greater emphasis to these factors while valuing a company.

(Till about 4-5 quarters ago, i was in the long term compounding stories camp. These days, i am more in the shorter term/earnings growth/reversion to mean camp. As such, methodology as well as factors for valuation also have changed)

Hope I did not talk much non-sense and was in line with the discussion…

Cheers!

RP

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46

Valuepickr is a platform with power characteristic of a great mentor who nourishes and empowers his mentee constantly! More important as the mentee keeps up the hard work and keeps getting better at things he raises the bar higher!! This evolution has been phenomenal :)The only problem I have with this mentor right now is he keeps raising the bar faster than I can cope with - but that’s the beauty in it…Determined to keep with the pace set here :slight_smile:

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Thanku Donald for your’s/veterans patience … Will need some time off, to gain more clarity about their Art… Believe more mental models are on the cards…

Regards

mallikarjun

48

Amazing discussions in perhaps one of the best threads at Valuepickr. Kudos to Donald and all other contributors. Makes for fascinating reading.

In summary we have seen how market values sustained earnings growth coupled with a moat (of some sort) way higher than only consistent earnings growth. Lesser number of variables to track, strong visibility of future earnings and some visible differentiator (IP/Network/Entry barriers) leading the path for disruptive future growth are key to potential multibaggers.

It is key to note as Donald pointed out, the undervaluation exists for a considerable time even after signs of future potential starts showing up. Whats probably missing during this period is strong UNDERSTANDING of the business and the conviction coming from it. It is essential to pick up new potential multibaggers at this juncture, and not afterwords.

Let us look at two picks which have created humongous wealth in the recent past. One from the Valuepickr portfolio and one outside. It is important, as Dhwanil elaborated to understand the key aspects/traits fromexistinghigh quality businesses .

Both would be Type C businesses, the first TTK Prestige operating at a Oligopolistic market( rather duopolistic at that time with clear boundaries - Hawkins(North) and Prestige(South)) took a clear distinctstrategyof rapid expansion and brand extension across product categories.

Narration 31-Mar-04 31-Mar-05 31-Mar-06 31-Mar-07 31-Mar-08 31-Mar-09 31-Mar-10 31-Mar-11 31-Mar-12 31-Mar-13 Last 5 Yrs Growth
Sales 140 181 222 281 326 402 509 764 1,105 1,358 4.2x
Net Profits 0.2 4 7 12 21 22 52 84 113 133 6.4x
Working Capital 76 68 61 75 59 45 63 80 65 202
Wcap as %age of Sales 55% 38% 27% 26% 18% 11% 12% 10% 6% 15%
Networth 39 40 44 52 67 83 122 189 283 395 5.9x
Market Cap 15 52 172 134 132 103 650 2536 3187 3633 27.5x
P/E (Trailing TTM) 72x 14x 24x 11x 6x 5x 12x 30x 28x 27x 4.3x
Return on Equity 1% 1% 2% 1% 5% 16% 24% 23% 22% 25%
Return on Capital Emp 9% 13% 18% 19% 30% 37% 52% 74% 58% 40%
Increment in Networth 1 4 8 15 16 40 67 94 113
Increment in Mcap 37 120 -37 -2 -29 547 1886 651 446

From FY04 - FY08, while there were clear signs of improving working capital, incremental ROCE what market perhaps ignored was the potential product expansion and size of opportunity with wider distribution reach riding on the brand moat.

The stage was set for disruptive future growth. So while from FY08 - FY13 the market cap improved 27x it was brought about by disruptive earnings growth (6.4x profits in 5 years) and expectatios. (4.3x jump in P/E). Once this was fairly discovered, the returns were nowhere close (FY11-13).


Looking at the second pick from the Valuepickr pf, Ajanta Pharma. Here the somewhat weaker moat derives out of a differentiated strategy of niche offerings and targeting specific low competition niche markets. As in this case the visibility was much weaker in common parlance because of lack of UNDERSTANDING more than anything else. In other words, the moat was not readily discernible.

The company was doing all the right things. Trends like increasing R&D spend, increased no of filings across emerging markets, improved financials - trends that were not very difficult to track, yet mostly ignored due to lack of better understanding. Refer this beautiful summary from Ayush (http://dalal-street.in/ajanta-pharma-and-mps-ltd/#more-1512) last Dec.

Narration 31-Mar-04 31-Mar-05 31-Mar-06 31-Mar-07 31-Mar-08 31-Mar-09 31-Mar-10 31-Mar-11 31-Mar-12 31-Mar-13 Last 5 Yrs Growth
Sales 118 175 206 239 285 319 382 457 604 839 2.9x
Net Profits 0.4 7 10 14 18 21 29 46 66 101 5.7x
Working Capital 100 120 128 143 165 190 154 133 178 186
Wcap as %age of Sales 85% 68% 62% 60% 58% 59% 40% 29% 29% 22%
Networth 173 101 110 121 134 152 176 216 272 356 2.7x
Market Cap 48 68 81 86 94 60 214 237 530 1521 16.1x
P/E (Trailing TTM) 134x 9x 8x 6x 5x 3x 8x 5x 8x 15x 2.8x
Return on Equity 0% 7% 9% 11% 13% 14% 16% 22% 24% 28%
Return on Capital Emp 9% -5% 12% 13% 13% 14% 16% 18% 22% 30%
Increment in Networth -71 8 11 14 18 24 40 56 84
Increment in Mcap 20 13 5 8 -34 154 22 293 992

Thus small incremental and ongoing changes leading to an acquired moat ( differentiated strategy/stronger distribution/increased R&D spend etc. as opposed to Brand moats like a Nestle, GSK) are inevitable much earlier on the ground and reflects in financials if someone is looking to identify the same.
More often than not, this is the ideal time to load up and ride it completely as the (disruptive) profit growth pans out and the market gives the stock true recognition in terms of P/E re-rating.
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49

Hi Donald,

Shilpa is missing from the list and I am sure you have a view on that.

Looks like building blocks are in place for disproportionate growth.

IP value also is strong.

Consistency in performance is yet to be proven…but that is what is giving the opportunity.

Agree on PI, Poly and Kaveri. Kaveri might have a lean period before the next round of disproportionate growth.

Astral - by getting early approvals for Blazemaster, brand building effort and distribution setup can all be looked at as building blocks for disproportionate growth. But yes the number of years of such growth may not be as large as PI or Poly.

Should we score each com on the three parameters?

Cheers

Vinod

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:)) khabri, satta

1). Earnings

2). Cashflow

3).

** Niraj, Good insight for investment.

Does the factor of putting money back into the growth engines affect the valuation of the company?

Does a company which regularly generates the profits and distributes to the shareholders is to be valued higher or a company which also generates the profits but puts a significant amount of earnings back into the business expansion and generates compounding profits?

**

51

Does Biocon fall under category C? The company is known for the disproportionate growth(though on either side)? If available at reasonable valuations and sighting the tailwinds, it has potential to give significant returns over short to mid term time horizon.

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Intellectual Property:

Disclosure: I am invested in Kaveri alone from the above set of scripts.

As everybody else have already said, this is the most enriching discussion that I have gone through on ValuePickr.

Big thanks to Donald and others. To me intellectual property is a double edged sword which could bring great returns in short term but in longer run will almost certainly be replaced. Being from the technology world I have regularly seen companies with great IP faltering whenever a new or disruptive technologies emerge and this happens very regularly. I would value efficiency ingrained in processes and systems in due course of time much more than the product IP in longer run. Another problem with IP based companies is how easily all their moats become penetrable when you have a better technology coming up. Further most IP based companies are almost always faced with the innovatorâs dilemma forcing them to ignore newer trends at the cost of serving current customers.

@Donald: The other thing which I think which is missing from the table is risk of moats being penetrated. Kaveri to me looks the most risky of all stocks in the list mainly due to the following:

a) As explained above IP to me is inherently risky. If say Mahyco or Nuziveedu comes up with a better variety of hybrid seeds it would not take more than two to three years for Kaveriâs bt cotton hybrid Jadoo to be replaced.

b) Any reports of farmer suicide or bad seeds (due to storage, incorrect usage etc.) could involve government and ban of seeds.

c) The acreage size of bt cotton is ~90% of total agricultural area. I do not see the opportunity size to grow. It can only grow at its competitorâs expense. On the other hand I see reduction in crop are for the next year.

d) The R&D expenditure as a percent of sales is low and has come down.

Why I am invested in Kaveri. I think it is underpriced and it does have sufficient catalysts to go for nearly two to three years. I also think in the next few years more bt crops will come up mainly the oil producing cash crops (current imports of cooking oil are generally bt based) and Kaveri might have an edge there in developing hybrid seeds.

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53

Hi Donald/All,

Intellectual property gives a feel about a limited scope on what can be in Column #2. What it encompasses is what IP component that is present in current business.

But I feel it is intangibles which make it broader.

For example, brand building like Astral/Cera are doing, (and Pidilite/Asian paint/Page have done), which change the processor type of stocks into a different kind of moat-based company, and create opportunity for disproportionate growth in future. Even Nestle making maggi, or GSK making Horlics can be thought as processor type business, if one does not understand, what it means to an average indian consumer. All FMCG super-performer are of this type.

Secondly, most of good Pharma cos, which have build phenomenon experties of making drugs, handling FDA, marketing in both domestic/foreign land, ANDA filling can also be thought of as highly IP based business model.
For example the expertise of Ajanta is the speciality segment in making drugs, and Emerging market cant be copied by any one, and hence constitutes IP. IP doesn’t necessarily mean developing novel drugs, or being 1st to file ANDA in US.

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54

Few more examples of #2

Eicher motors - Harley Davidson brand

PVR - Virtual monopoly with 70% share (after buying cinemax) in where it operates, in a segment, which is bound to grow higher and higher

On column #3

It does not need to have clear position in #2 to be in column #3 (Building block for huge growth). Even if a company is undervalued, and slowly moving up in IP chain, like Shilpa/Aurobindo’s API to Formulation transformation, it can create huge growth. Same is true with Cera/Astral trying to build brand around their products, and Ajanta trying its hand in entering US market

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Many thanks Anant, Subash for raising important points. Hope many more will perk up soon.

At this point we are taking in all/especially divergent viewpoints. The time for converging will come once we have plenty more comments come in - once more guys have had a go at digesting and pondering a bit over this. We will evolve better/refined terminology too - to drive home the essence.

I will leave few comments - only for the sake of influencing/broad-basing the discussion - hopefully inviting more comments.

@Anant - Yes, we are talking about intellectual property in a broader sense. Highly complex systems/processes behind products are also considered IP - difficult for others to replicate. And if you have processes/systems that drive the innovation psyche in the company - the business continues to produce more innovative products after the first breakthrough. In as ense the job gets much easier.

For Kaveri too - that holds true. the germaplasm bank and the processes behind delivery of first successful hybrid has ensured better hybrids. ATM is reportedly better than Jadoo in both yield and climatic condition tolerance as per the company - not being bandied about - not to cannibalise the Jadoo magic of the moment.

@ Subash - Distribution strength is important, but perhaps not in the same leagues as above. It takes 30-40 years of consistent performance and consistent growth before distribution alone can become one of your most formidable armoury. Like the FMCG giants ITC or HLL today or the Coke and Pepsis of the world. wherever you go they are there.

Iconic branding like Pidilite/Asian Paints - For sure that is in the disproportionate category. While the intention to follow in these illustrious footsteps is laudable, how seriously would one take that intention today. if you are to rank it as a building block today, perhaps one will give it a rating nearer the bottom.

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If we go back and look at our big winners then I feel under-paying has been one of the key factor in generating big returns. Most of the times these were no-brainer propositions.

Usually these cos come to notice whenever they post good quarterly performance etc…but as the past few years or perception is not great, re-rating takes time. People have their doubts etc. But in VP, the good thing was that we were keen on questioning and seeking answers to the reasons behind the change and see if the same is sustainable going forward. The groundworks we have done are not easy and required lot of efforts and focus. The good part was that in most of the cases the change was not only sustainable rather the story just kept getting better with the size :slight_smile:

So one of the ART is questioning right!

Another key thing is looking at the bigger picture - many of the stocks were faced with temporary issues like forex loss etc. (Astral, Poly) from time to time yet they did well. Its important to think beyond it and see what can happen over next 3-5 years.

Regards,

Ayush

VALUATION ART #3

:)).

Repeating the process having the discipline full honesty and integrity

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57

It is heartening to see so many high quality ideas being generated in such a short time on not so simple topic. It speaks for the quality of participants and forum!

As we are discussing so many diverse ideas/concepts of how “high quality business” should look like, I feel we should simultaneously focus on how do we identify such businesses? As an investor, It may not be enough to have understood that PI/ Poly Medicure/ Amara Raja/Ajanta are high quality businesses. It’s great that we have come across such businesses. But, I somewhere feel that it is equally worthwhile to discuss

)- Going forward how do we identify such high quality businesses on consistent basis? When we identified PI/Poly Medicure/Ajanta did we follow any thought process/screening which we can replicate or was it just a combination of “undervaluation” and “performance consistency”?

)- When we spotted Ajanta, Kaveri, Poly Medicure and partly PI also, apparently we spotted them due to undervaluation and not because of quality (it’s my understanding from the threads, and please correct me if it’s wrong). On further digging we discovered the high quality business and disproportionate growth potential. However, largely we all agree that Poly Medicure/PI at current level, post re-rating also are attractive. But, probably we would have not discovered these high quality businesses in the first place if they were trading at PE of 15-20, in 2011 and would have excluded large and attractive opportunity set of high quality business. Does it imply that Art of valuation is skewed towards identifying high quality business only if they are undervalued on some conventional parameters (and some times to an extent that they are no-brainer, as Ayush so rightly pointed out. Though,personally my vote unequivocally go for such approach)? If not, how do we bridge this asymmetry?

As a corollary to this, another point that Ayush has made on “under paying”, seems so very central, which we have so far not discussed. We are currently discussing A+ businesses and which businesses may qualify. After our views converge on that, we should discuss with same vigour “how much” to pay for the quality? How do we ensure margin of safety and not get carried away by “paying up for quality”? As Donald mentioned earlier, this whole ART is about remaining ahead of the curve and UNDERPAYING!

Frankly, I do not have answers to many of these questions. But hey, this thread is not about everyone knowing everything anyways! It’s more about stimulating a discussion to further refine our thought process and mental models. I have immense faith in collective wisdom of this forum and unbridled enthusiasm of senior valuepickrs to guide us.

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58

Good debates being generated on the forum.

I think while exploring Type C companies (including our A+ businesses), many of us are are still mixing up aUndervaluationa with aQuality of business (or improvement therein)a. These can very often be 2 distinct dimensions.

A business available cheap (say Alembic or PI Industries) can attain a moderately higher multiple, and we feel happy that it has caught up. On the other hand, an already expensive company (Page or Just dial) becomes even more expensive, and we donat know what to say.

But what weare referring to in Type C stocks is disruptive opportunity in creation of market value. Sometimes businesses show a quantum leap in financial indicators over say last 2-3 years backed by something right they are doing in their business positioning, revenue model, and management drive. Usually multiples accorded by Mr Market take time to factor these in?

As I sleep over this, I can easily see examples of building blocks being laid for a disproportionate growth in future mostly by companies who have expertise in productising services/products in niches that they are already laying claim to as their own. Though as Anant mentions before, nothing is (really) sustainable in high-technology sectors (not only IT btw) and is prone to obsolescence but still relatively speaking - given their strong presence in a sector, how often are these factored in the PE multiples of the business (in its nascent stages)?

In that sense, we are not at all talking about the undervaluation catch-up while discussing the Art of Valuation. Undervaluation can add to our “level of comfort” in making an investment entry/exit decision; it has nothing to do with business quality which is an independent variable.

This is essentially different from science of valuation part.That said, beyond a point it’s difficult to convey in words, and Markets are supreme.

I think there are some good examples already, good food for thought and some actions.

Will revert on specifics as I get a good grip on this myself, first:)).

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As hinted at before, getting better at this is process-driven.We have become better at the game in quantum jumps form 2011, every year!! Because We took to Capital Allocation passionately.

Step 1: Take Capital Allocation seriously. Repeat,seriously. That is pit every business against the other and start grading them. Your FOCUS will perforce shift away towards High Conviction, as apart from High Undervaluation.

Step 2: Study/Think about why Mr Market is giving different multiples to different businesses, first in different sectors for a broad understanding or slotting of business types. Commodity, Commodity processors, lowest cost plays, cyclicals, brand plays, intellectual property plays, and the like. And tehn study with in a sector too there are players with varying business quality. Take Pharma for instance and you have all types of players! Study, why Mr Market values them differently.

Step 3A: Start thinking as the “Owner/Acquirer of the business”. This is a simple construct but probably the most valuable construct to think really hard about Valuation. The Copeland Valuation book is a great help in getting “Business Quality” thinking ingrained.

Step 3B: So a useful question to ask is what is the value of a business to a 100% owner-acquirer? Look at the open offers, delistings, takeovers, reverse mergers, amalgamations, special dividends etc with this question in mind to figure out the answers from the aquirer’s point of view.( I am yet to seriously act on this: we do have a specialist in us though, T Anilkumar who used to devote as much as 80% of his energies to this aspect :-).

Step 4: Get smarter about businesses laying/have laid building blocks for disproportionate future growth ;-).

Of course, needless to say minority shareholder like us, have to apply appropriate MoS to determine his/her entry and exit price, holding periods, other opportunities that may arise (to be compared with each other on a risk-reward scale). There is no ‘right’ answer to this exercise and the answers may as well change as the variables change!

Speaking for ourselves: I can easily say 2011 went in absorbing and assimilating Capital allocation basics. But by mid 2012, we had firmly shifted focus first on business quality and only then undervaluation, not the other way around. That is why we had no hesitation in re-recommending Ajanta Pharma at 2x of our first entry levels, Kaveri Seed at 1.5-2x first entry levels, Poly Medicure at 12x was a steal and a PI industries also at 2x earlier entry levels.

Don’t forget Capital allocation is all about the product of conviction and under-valuation. If you have high conviction and high undervaluation then you can bet real heavy. We believed we had that high conviction and high undervaluation combo in each of the businesses cited above, and thus there were unanimous reccos on these in 2012 and 2013!

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60

In essence, I think like what Hitesh mentions, we need to have a list of top ideas, if fully laden with Type C companies - the better, at all times and need to follow them vigorously.

Allocation on these names however will depend a lot on valuation and MoS. The relative undervaluation score combined with the quality of business score might see them move up or down in the ranking of opportunites. But the first cut to the list should be on merit of business quality and that alone.

This is with regards to the long term portfolio.

The scope of pure “undervaluation” plays might come up for the short term opportunistic portfolio with regards to no-brainer investment choices provided to us by Mr. Market. Here of course, conviction would be low and hence would be allocation.