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!