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
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.