ValuePickr Forum

Enterprise Resilience

Earnings resilience: A Resilient Enterprise
Earning resilience is a topic that I have been thinking of from quite some time and have yet to come across anything or develop an understanding to get a very good clarity on this. A Resilient enterprise is one that is generally un-impacted/less impacted from short term disruptions and which has the ability to spot, react and recover from short term disruptive challenges and most importantly, adapts and evolve in response to more significant changes much better than its competition. Generally our focus during a business analysis is on management integrity, growths prospects, competitive landscape, risk mitigation etc and all of these boiling down to MQ (capital allocation decisions) and BQ (return on capital). Although earnings resilience (or lack of) should get captured in the risks but somehow for a bottoms up investor this ends up being ignored largely (unable to appreciate base rate?) and the risks analyzed end up being more at a business level rather than risks which are broader in nature. Just to quote an example while looking at Wonderla how many of us would have thought that Wonderla, an excellent business can be impacted by:

a) Cauvery issue
b) Floods
c) Demonetization

in all three quarters of this year. To cite some of the disruptions which are broader but should impact our investing decision are:

a) POLITICAL AND SECURITY INSTABILITY
b) TRANSPORT DISRUPTION
c) LOSS OF UTILITIES (POWER/WATER ETC)
d) RESSURE GROUP PROTEST
e) OUTSOURCE SERVICE FAILURE
f) LOSS OF TELECOMMUNICATIONS
g) CHANGES IN THE LABOUR MARKET
h) CURRENCY VOLATILITY
i) REGULATORY CHANGE
j) SECURITY/TERRORISM INCIDENT
k) CHANGING MARKET DYNAMICS
l) SUPPLY CHAIN DISRUPTION
m) IMPACT OF NATURAL HAZARDS
n) ACCIDENT PROBABILITY

The idea of this post is to

a) Identify industries/companies which are more resilient (along with all the other attractive features) and to start allocating a resilience premium/discount during valuation.
b) If one thinks that it is a great business to be and that the current disruption is temporary/one off that should help in buying a stock that was otherwise expansive.
c) How to value a business based on its resilience/the broader risks that face?

A consideration of above risks should help us to choose between two industries (Banking vs NBFC vs MFI vs HFC, Pharma vs AgroChem) and also defining which is more resilient between two businesses in the same industry (Alkem with no US exposure to Sun/Lupin/Torrent). It should also help us define valuations ranges for companies which are highly prone to disruptions. A lack of understanding of this aspect has prevented me from getting into certain companies like Shilpa Medicare, Wonderla, Syngene (all of which I admire) and a whole host of others.

The next question one need to answer is how do I value companies since some of these risks are always present in almost all business? I think there are two important things here:
a) The base rate (the outside view): How often that event has happened and how has it impacted other players. For example when looking at a pharma company which has exposure to US clearly the impact derived from a base rate perspective would be:

         1 For pharma industry in last x (subjective) years how many times did a US FDA inspection result in a Warning letter?
         2.What is the frequency of US FDA inspections?
         3.What has traditionally been the loss of topline/bottomline impact and how many years did it take a business to come back to its normal growth (the one we are assuming at the time of investment).

b) The inside view and its accuracy: Generally our inside view is not accurate and we are more confident about it than we should be, relying majorly on our assessment of the management. But there should be a better assessment than just that. Some of the points to ponder while making a conviction call:

         1.Is it based only on management discussion?
         2.Are we aware of standard procedures of US FDA and are we aware of what is being followed by the company?
         3.What has been the track record of the company?
         4.How much investment has been made to mitigate the external risks and the luck factor?

There is much more that can be added to the above lists but I guess you get the idea. A similar inside/outside view can be thought of for WOnderla by assessing the probability of floods hich have happened in Karnataka, the probability of flaring up of Cauveri issue and the assessment of accident risk by using data from other amusement parks.

Just to conclude I am no way saying that we do not invest in such business and that each business is different from other (our assessment, our conviction, the inside view) but at the same time the outside view should help us define better entry/exit (I am not buy and hold forever camp) valuations.

References: https://www.controlrisks.com/~/media/Public%20Site/Files/PDF/The%20State%20of%20Enterprise%20Resilience.pdf
http://www.strategy-business.com/article/8375?gko=1c92d
http://usresilienceproject.org/wp-content/uploads/2014/09/report-Prepare_Why_Enterprise-Resilience_Matters.pdf

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Thanks Anant for taking on the onus of the opening batsman role in the TopContributors Corner.

Good of you to trigger discussions on this aspect. This is a profound topic, and certainly not a strength area of mine. So I will come back after more work and think-thru.

But just to get the discussions going on an important topic, I have following off-the-hat observations to make:

  1. Resilience/disruption-proof nature of an industry/business is an important criteria to incorporate in BQ

  2. As active investors our foremost job is to be able to anticipate/focus on price-performance gaps - i.e zero down where we see expectations of price revisions (superior performance led)

  3. The investing game is about balancing Risk/Reward - again in the light of anticipated superior performance

  4. Relying too much on Resilience/disruption-proof investments - might naturally imply - very little expectation of price revisions - like in FMCG/Consumer businesses

So off-the-cuff reaction from me is that
a) I see much better utilisation of the Resilience concept in exit valuations (where you can still decide to continue to stay despite over-valuations, versus those that are less resilient) than entry valuations. My entry valuations will have to be guided by much superior EPA expectations

b) In times of secular crashes - this Resilience aspect can take centre-stage (all other things passing certain thresholds of BQ/MQ including EPA - how much of future Economic Profit is likely to be added) because that is the only time I can ensure a good price-performance gap in super-resilient businesses

Having said that I cannot thank you enough for bringing this “Resilience” concept center-stage to discussions on Investing Decison-Making. I am extremely conscious that we have been extremely lucky in our choice of businesses, and we haven’t investigated/deliberated enough on Luck vs Skill quotient of sustained business/industry performance.

Most of us have been having these doubts in our heads (ever since VP Chintan Baithak 2016). Me and Omprakash @OM_1417 were having another discussion on similar lines just a couple of days. Inviting him to add his important perspectives here.

Meanwhile all of us new to thinking/gathering data on Resilience (and Luck vs Skill Quotient in business performance) will do well to absorb Mike Mauboussin’s excellent in-depth data-points and conclusions in the Base Rate Book. (@Anant references to base rate, inside view, outside view :slight_smile: will be clearer, as will be the bigger concept of inevitability of Reversal to the Mean)

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Hi Anant,

I would characterise these disruptions you mentioned into broadly three categories

a) short term - like 2-3 quarters

Many of the disruptions you have mentioned in the list are short term in nature. (floods, cauvery issue, telecommunication issue, outsource facility failure etc)
These may last 2-3 quarters. As long term investors I dont think we need to worry too much about these.
The business can recover easily from these temporary hiccups provided it has strength of balance sheet.
In fact its great opportunity to add :slight_smile:

b) more related to business/economic cyclical
I am more worried about slightly long term changes like change in business/economic cycle which is tough to predict.
The earnings may not recover for a few years (like GRP, TD power) and demand collapses.
This will throw the weaker guys out of the market.
But there will be a recovery - be it in a few years.

Again, the company with balance sheet strength remains resilient during this period, increases the market share and emerges stronger when economy recovers (borrowed from Kenneth Andrade interviews). The weaker balance sheet companies cannot invest for the future like R&D spends etc.

c) and finally there is structural change in business due to technological disruption (solar, autonmous cars etc etc), regulatory change, increased competition( can fallinto second category).
There is very less chance of recovery here until the company invests in new technology and adapts itself to the new reality.

I think as investors we have to prioritise our thinking on b and c.

IMHO, One of the most important characteristic way to be resilient to many of these shocks is to have strong balance sheet with zero/less debt and good cash.

Prof Bakshi has written superbly on this topic.

On your questions about pharma regulatory issues, the way I like to think on it is
a) base rate of generic pharma company facility getting audited by US FDA is about two years. So, if we get a generic company, which has its facilities audited in the recent past, then it there is lesser probability of undergoing audits in next two years.
Take the case of shilpa medicare. if iam not mistaken both audits happened in 2016. In fact they got the EIR for The formulations facility was in oct.
so, there is HIGH PROBABILITY of them getting good run for next couple of years without fda audits. So I’am bit more lenient on giving them higher valuations and little more comfort holding it.

b) in the case of CRAMS companies, if I am not mistaken, sygene got audited 2-3 times in last one year. It happens when one of their client file NDA for NCE.
So, if a company gets some 483s, there is high chance of another audit very soon if one of the client another NDA.
Unlike generic companies, the pain may not last for 2-3 years like we have seen ipca and we have to wait for fda come for another 2 years.
if a company has good pipeline of molecules particularly in phase 3, it gives good comfort for CRAMS companies, that there is another FDA audit just round the corner, if in case there are pending 483s. It gives an opportunity to clear them quickly.
c) I have seen Natco file for ANDAs from multiple facilities. Need to ascertain if a company can file from multiple facilities.

I may be wrong on the above, but this is my current thinking.

4 Likes

@Donald Thanks for your response and in taking the idea forward. Just a few observations that I have to make:

a) Business resilience has to be thought of even during entry valuations and the entry valuations should be adjusted accordingly. I am not sure why this should be otherwise. Focusing purely on future EPA without taking into account the probability and the impact of disruptions can lead to sub par results.

I am not discussing cyclicals. To me these are clearly a part of BQ and I tend to not bring them here in discussion.
I am not even discussing structural disruptions. These require great foresight and are a different topic of discussion altogether.

What I am looking to discuss are these kind of (short term?) disruptions, what I think is we tend to oversimplify frequency, impact and outcome. Just a few things to ponder on:

a) Define short term?
a) What is the frequency of short term disruption?
b) What is the impact of a short term disruption?

Let us take the example of some of the largest pharma companies in India and see there performance in last 3 years:

Very clearly except Aurobindo which did not have USFDA issues every other company has delivered below average returns in market cap. It is very difficult for me to believe that these large organizations did not envisage the impact of USFDA on their operations. Also it is very difficult for me to believe that there is no luck factor in play here or else how do you explain a facility passing US FDA and failing inspection after that? On Shilpa specifically if you are taking a call for next 2 years probabilistically you might be right that there would be no US FDA inspection for next two years but that I guess is more like timing it rather than thinking of it from a long term perspective.

One more thing that I have seen is that a lot of time when we discuss Pharma, IT and other export driven companies we tend to ignore the advantage currency depreciation has given them. On the other hand at an industry level I think there are industries which do not have to suffer from these, are non cyclic and do not command FMCG valuations. An example that I have been working on is the hospital industry. Hospital generally categorized within health sector is extremely resilient to these disruptions at the same time the listed players growing at around 15%. It does not suffer (less suffer) from a lot of disruptions like regulatory, currency, shifting base to other country, short term financial disruptions (Narayana Hrudyalaya, Kovai Medical etc) etc.
Another industry that comes to my mind is the color and fragrance industry where there is a definite trend of manufacturing moving to India and at the same there are niche are products which are not replicable (eg. SH Kelkar, Camphor and Allied).

There is a general feeling of higher Macro Economic instability due to multiple factors as Donald had put in another thread. I agree with Donald that the usual defensives like FMCG at these valuations does not provide enough opportunity for growth or for capital protection (IMO). I personally think it is time to look inwards and find companies and sectors which can provide both growth and capital protection.

Discl: Have exposure to PTL Enterprise. Positive bias on Narayana H and Kovai.

It’s very important topic and thanks for initiating discussions @Anant @Donald @ananth . When ever we think of resilience we will get into disruptive technologies and their potential impact on survival of organisations . My thoughts around this disruption would be to keep a tab on technologies , at the same time not to be too much regressive on portfolio businesses , as we can take calls as and when situation demands . But if a business face serious disruption , then it’s difficult to calculate terminal value thus valuations will go for toss .

I have been thinking on similar lines in terms of business categorization by defining the potential risks which can derail the compounding of intrinsic value .We’re all cognizant of pharma risks . I would categorise FDA , currency as short term risks and everybody is learning game and hope companies will evolve on compliance ( As its cultural aspect ) The key risks have been ever increasing competition especially in golden goose , upcoming new technologies like biosimilars , fast approvals by fda which can lead to crash in pricing , client concentration & product concentration risks Etc .

Say if we have to play pharma which model is very resilient where one can allocate more and stay invest at higher valuations ? I would categorise pharma into three business models

~ Branding plays : Generics brands Sanofi , Abbott , Glaxo
~ CDMO : Divis , Syngene , Dishman
~ Generics and api manufacturers

In terms of business architecture branding plays are least vulnerable ( Thought they had impacted by DPCO in the past ) and generics & API manufacturers are most vulnerable to various risks . Still one would argue that despite lot of risks this category has been great wealth generating category and one cannot afford to miss compounding here . Sun and Lupin’s are / have been great compounding stories of this decade and may continue to do well . With global humongous opportunity ,companies with great innovation capabilities , can afford to spend huge sums on new technologies , adoptable business models would do well over longer periods . At the same time these companies are facing tremendous risks . Say oncology market has been a interesting category with fifty percent biosimilar’s launches already and various projections point out that over half of the molecules will be obsolete / get taken over by new set of molecules .

In the case of financials banks and multi-lines are resilient compare to mono-lines ( though we have exceptional examples of gruh , shriram transport ) . Warren says that its always impossible to see a disaster in the making with financial institutions because of their ability to hide problems until they become disasters . There fore its always better to be on safer side when ever we invest in financial institutions . Micro finance businesses have been most vulnerable to regulatory , socio - political games . As an investor what are the important pointers to look for ? Managements strategy ( Broader term :smiley: ) , counter cyclical measures , prudence , past track record especially in adverse scenarios , seasoned loan books etc …

As an investor if we cannot assume how scenario would emerge over five years period ( Forget ten years ) , its very difficult to calculate terminal value of the companies in rapidly changing world . That too when steep valuation capturing coming years earnings . Stock markets are unpredictable beast’s always double count both at optimism and pessimistic scenarios . We cant just be comfortable at steep valuation in all the business models .One size doesn’t fit all . We need to have strategies for exiting chakravyuh .

Say if we are invested into various businesses , categorisation helps us to take fair assessment on exit . Then every business has its own risks , which business i should stay put over longer periods even at higher multiples ? The business with competitive advantage , pricing power , where i can assume picture over longer periods say 5-10 years with reasonable confidence . You can obviously argue that then one should stick to consumer stories , very few B2b business models :smiley: . Probably yes , but at the same time we can do all the above businesses with RESPECT to valuations .In these businesses probably entry & Exit both are very important and i believe very few business models fit into LONG ONLY category .

Another point has been how much we know , what more we can try to understand and what we cannot understand and beyond our competence .Its always better to accept our limited understanding in complex stories ( Especially pharma & IT ) and focus should always be on risk containing . If one holds a position at very steep valuation on misconception based on irrelevant facts , arbitrary articulation that can ruin position .

This statement has been very apt and reflects investing " I thought to myself , I’m wiser than this man neither of us know anything that is really worthwhile , but he thinks he has knowledge when he has not , while i having , no knowledge , don’t think that i have .I seem at any rate , to be a little wiser than he is on this point , i do not think that i know what i don’t know " Socrates

Slowly i started to realise importance of resilient & least variable business models and allocation strategies based on probable risks in the business models .As an investor i can’t take both business & Valuation risks :smiley: and categorisation helps in building portfolio and exits .

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