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”.
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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
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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.