https://indianinvestingconclave.com/recordings/45
Fragility & Optionality in Business Models
Prof Sanjay Bakshi
Turkey fed: On the 1000th day, man cut turkey till then he feeds daily.
Fragility is a sudden down of business with hidden risk.
Types of Fragilities are:
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Excessive Debt
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Absence of Entry Barrier (ex go pro camera)
In today’s highly competitive business high margin and high assets turnover is so desirable that competition is must to occur.
High profit margin is an open jar of honey, it attracts hungry insects.
Amazon did it beautifully – As per bezos there are 2 kinds of business – those that work to raise prices and those are to lower them. -
Disruption
We have $ 900,000 worth of applications in today’s smart phone which disrupted many businesses like Video conf, GPS etc. -
Fragility on dependence
Customer or vendor’s concentration risk
He gave an example of symphony. Symphony has higher margin and ROCE due to out-sourced manufacturers. When its margin got higher, competition started pouring. -
Fragility from protectionism
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Fragility of low margin business
Example = IBP – pure petrol pump player
In petrol pumps business margin is low. However Capital returns are very high.
Consider land as 3 CR + 1 CR of other equipment. They just have 2 days of inventories hence capital return is high.
(If petrol pump sale 5 lakhs business per day, its 18 cr annual on cap employ of 4 cr.)
ROCE is margin * Cap returns; even with lower margin its very high.
However with govt policy of not passing the cost to the consumer, the margin becomes negative. Negative margin with high cap turnover is a disaster – hence IBP got shut down and merged with IOC.
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From hidden structural risks
Example of PG&E – electric company from California. Who (instead of insurance) has to pay for forest fire to consumer and ultimately filed bankruptcy -
From a rigid cost structure Like airlines (Jet airways)
We are generally more attracted to margin, however we need to take view on longevity, how long this margin will sustain. Hence N year of longevity is equally important as R – margin.
Fragility from multiple risks are multiplies:
Like there is a chance of occurrence of bad event is 10% in a yr. If company has 4 such events than,
0.9 * 4 = 65.61% chance of it won’t occur instead of a single event whose chance was 90% of non occurrence.
If you take 5 yrs instead of 1 yr then the chance of occurrence will be 99.52%.
He insists don’t think of probability instead of think of occurrence. What happens if that occurs?
Finally how to handle fragility
- Walk away
- Size it appropriately
- Value it appropriately (pay less of high occurrence vs pay more for more safety)
Opposite of fragility is optionality: Where you have small errors followed by big wins. If you have got a low downside and big upside (optionality) you go and do it. If you have a big downside and small upside (Fragility) run away.
End…