Following is part of VP attempts to refine our thoughts/process on identifying a Superior Business over another - in discussion with some of the Legends of Indian Equities market.
[If you have most things being EQUAL - that is, both businesses qualify & surpass VP thresholds of a superior Return on Invested Capital, Cash Flows - & sources of improving Margins/Asset Turn, debt reduction with growth trends, and the like - How do you decide which is a superior business between the two? To get the context right, new readers may like to familiarise themselves with this Eternal VP quest from ourART of Valuation thread]
Excerpts on BQ Value Chain discussions with Shri Chetan Parikh: Oct 30, 2014
Donald: We often see the investor community use the term “Moat” loosely. Ask someone to outline in a tangible way - the “Moats” around the Castle, how wide or deep the Moats are, and we get answers ranging from the inane to the abstract.
Kindly help illustrate the__Moats/Competitive Advantage__concept better, and how we can use that to differentiate or grade Business Quality of disparate businesses, in a much more tangible manner.
1). Business Quality - over time would reflect in the numbers, usually
2). Much of the time though - in the kind of work that you guys are doing - we are striving to identify “Emerging” Moats which
a) may not show up in the numbers, yet
b) may only come to light progressively, as one gets more familiar with the business/industry, usually it takes a couple of years
Its important however to FOCUS and spend a lot of time here establishing this. If one is not convinced enough, spending lot of time that we usually do in collecting lot of other supplementary information/data on the business or industry may not be that worthwhile
3). Give some thought to “who can replace”- why or why not?
4). What is that something in the DNA of this company/Culture or as you put it “Architecture” of the company that makes it SPECIAL
5). Let’s leave all the jargon aside - Moats, or Competitive Advantage - lets try and answer only this - What is making this business special - why is it not Run-of-the-Mill
**6). **Management with the Self-Confidence to do things differently - for Value Creation. We have seen there is usually a very thin line between Self Confidence and Cockiness or Over-Confidence (over time)
7). What/Why is that Ecological niche - that this business occupies?
8). Forget the company also - what/why is this business space special?
9). if you find sometimes- its the KEY MAN - that’s making this company special, then that may not be good enough! Much of the time its usually those who are in Executive control that are responsible - but focus should be on establishing whether this is now Institutionalised - are there embedded processes, a culture, or a way of doing things - in the Architecture of this company
10). One big factor may be responsible, or there may be multiple 5-6 factors that may all together contribute to being special. If you have multiple factors contributing, usually that is better - if you know what I mean - keeping the semantics aside
Donald: As you mentioned, getting to grips with “Emerging Moats” requires us to become a little pre-scient )- to catch the signs of small trenches dug around the house getting wider and deeper with successive milestones being crossed )- which may or may not get to becoming durable moats. How do we get skilled at this game?
1). Well this is the most interesting and satisfying portion of one’s journey as an investor. You have to do all the hard work first and establish the data-points that let you create a simple investment hypothesis - the Strengths and Weaknesses, Entry barriers if any (how soon can someone catch up - why or why not), the distance form the nearest competition, The obvious vulnerabilities in the business and the Risks, any near or medium term triggers, and the like.
2). Investment is never a precise science, because information available will always be INSUFFICIENT, and you have to rely initially a lot on your homework (data points, company, competition, industry) and progressively work on getting a better “Feel” for your Horse (business) and the Jockey (Management). What is the next level for this business? What are the ODDS for the Jockey to successfully steer the Horse past next milestones? Is the Horse healthy, well-fed or likely to wilter under the competitive strain?
3). It’s about sticking to an well-outlined research process. We ask the right questions on current sources of growth and profitability, medium-term plans for enahancing them and sustainability. Evaluate the Responses and decide the ODDS of this business going to the next level. No one can be completely convinced on Day 1.
4). it is about doing a very sincere earnest job, do as diligent a job as you possibly can before you invest. And then it is all about KEEPING FAITH. Stick your neck out, make decent allocations, and track well, keep challenging assumptions in the light of new information that may emerge. If you see Management walking the Talk every 6 months & every year, your conviction should get stronger, so should your allocations. Else, you know what to do.
Donald: Say we find two good candidates. Business A and Business B are both start proving to be special, say.How do we get to establish - between two businesses that pass VP SPECIAL thresholds - which is the more superior business??Could we have decided in 2011 - between a Mayur Uniquoter and an Astral Polytechnik - which is a better business??
Yes. Let’s say unfortunately or fortunately you like to take only concentrated bets; you can’t share the allocation between the two; you need to make only that ONE 30% allocation BET, say. You could spend time thinking on and establishing for yourself - how do the businesses differ on
1). Scope of Opportunity
2). Competitive Intensity
3). Where can Delta/Incremental RoIC have a bigger impact? Why?
4). Capital Intensity -Which will require what order of capital to reach the next level
5). Assuming Execution Capability is same - Once current opportunity at hand is harnessed well, will that put the company on a stronger footing to harness many more/multiple opportunities before it?
6). Multiple opportunities may well expose the company to higher competitive intensity than before??
7). While you may actually allocate only for say 2-3 years, it is extremely useful to mentally widen the horizon to next 10 years
8). Think like the Business Owner )- you have allocated capital now NOT for 3 years but for next 10 years. It is irrevocable, its gone - no easy exits. Where will you be more confident. Which business can I be wedded to for the next 15 years (while actual horizon may be only 2 years)
9). Let’s take your current dilemma - between a Shilpa Medicare and Shriram City Union Finance - Where will you be more confident of continued business execution over next 10-15 years
10). Where are the RISKS higher? The MSME Financial business environment for next 10-15-20 years versus the Oncology (Medical) business environment and changing dynamics, disruptive new technology (Genetics/Bio-Similars, for example)
11). Also finally a lot depends on my own competence levels in evaluating the Risks for myself - my circle of competence. How competent am I to gauge the disruption risks as they happen from - Horse drawn carriages to Motor Cars to Driver-less Cars
12). Also, It is useful to consider SCALE and Maturity - as of Today, versus Future Scalability. Shriram City may be today at a Scale or Maturity that is more Established vs Shilpa Medicare?? They might have much deeper pockets. Risks to Business or Ability to handle Emerging Risks may be much better??
Donald: Hmm! This is bringing in so much more clarity, thanks. But what about Intellectual Capital? How do we account for that? The Upsides from that could tilt the scale of differentiation? Couldn’t it?
1). It certainly can. But isn’t that a somewhat more speculative call? Successful monetisation of Intellectual Capital may blast away everything in sight. That environment in India is certainly improving by the day. Who knows with more sustained PE activity, the ODDS may get better in the years to come
2). If you ask me, a bit more of certainty or durability is more preferable to some extra sizzle!
3). You shouldn’t neglect that altogether though. Do put an Optional Value - a certain speculative weightage, as Graham advised
To be continued. We have been invited for another session today , Yippee !!