The Business Quality Value Chain

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 !! :slight_smile:

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Thanks for putting this up …

Chetan Parikh has touched few veryimportant points which I have been working for some time…

_Emerging moats _

**_1) _**For established moats like STFC or Thomas Cook, its possible to have a reasonable view for next 5-10 years but in an emerging moat, is it possible to have a view of 10 years or in that case we need to look for 2-3 yrs and then take call. How should our approach differ for emerging moats compared to established moats.

  1. How do we differentiate between emerging moats and those businesses where ROE may never improve. In other words what sort of companies one should avoid. I generally apply the test of secular trend plus People, product, potential and predictability. Whether these businesses are solving some existing problem, where not so many firms are focussing on. What more one needs to look into while selecting or eliminating emerging moats…

  2. In emerging moat there is reasonably high probability of losing capital permanently. How should capital allocation differ between emerging moats and established moats.

  3. Philip Fisher said "A small corporation can do extremely well and, if other factors are right, provide a magnificent investment for a number of years under really able one-man management. " In companies with sales between 50-100crs, generally its driven by one key person. Should we avoid emerging moats which is dependent on just one key man.


Few comments from my side which might add to above discussion.

  1. Bharat Shah said in one of his interview that one needs to think like venture capitalist to make best investment. Off late from reading of various venture capitalist like Peter Thiel, Vinod Khosla I have come to understanding that thinking like venture capitalist is better. Because VCs are locked in for next 10 years. They don’t bet unless they are assured of minimum 10x return on their capital. VCs generally bet on emerging moats and successful one have a concentrated portfolio of less than 10.

  2. Superior ROIC, cash flows etc : One needs to make difference between emerging moats and established moats. These historical numbers will help in established moats and sometimes in emerging moats too like Mayur Uniquoters… but most of the big winners like DFM foods, Relaxo, La Opala ROE was quite low 10 years back. AS both Thomas Phelps of 100 to 1 and Philip Fisher insist one should not give undue importance to these historical numbers. Its the future numbers which matters not past.

Donald under point 2 you mentioned "Its important however to FOCUS and spend a lot of time here establishing this. " Not clear. What we need to establish before we go ahead with collecting lot of info on industry etc…

Here are the exact words of Bharat Shah " Carefully read all the words to understand significance of Chetan Parikh advice to think in terms of next 10-15 years…

The essence is to have a business-like approach to investment. Or, in other words, the typical style should be that of a ‘private-equity’ investor in terms of ownership of few businesses and the time-frame of investments.

Thank you for posting this Donald. I have read a few times already and have been updating my checklist…found the questions he posed for us to ask about a business very useful and can have good impact in our “quest” for gems.

The part on giving a value to IP read together with understanding your own limitations in such an assessment is very useful to have in one’s head.

The following was not clear initially, just see if my understanding is right. This is point number 2 in the first part.

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

On one hand the advice is to look for emerging moat which is not showing up in numbers and may take 2 years to be clear for you. On the otherhand he is asking to decide now itself instead of spending lot of time collecting info.

Points 3-10 are questions which will help you to decide now itself whether to pursue the story further and collect lots of info. The “Hitesh” part of decision making before taking up the “Donald” part :slight_smile:

But have we really pursued any story where the numbers were not already great? The companies were small but the BQ was already reflecting in the numbers. Any story were we took 2 years to understand the story well and then buy or increase allocation?

Hi Donald,

Mr. Parikh indeed pointed out some very important facets to be considered and evaluated within the opportunity set that the investors has. One question that still remains unanswered to me is

" This is excellent as far as first step analysis goes.However, many a times we encounter opportunity set where we can relatively clearly prioritize Risk adjusted- better businesses (where relatively low risk of change, certainty of decent growth and decent moat) on the basis of business quality. However, the decision making becomes more complex the moment VALUATION enters in the equation. Let us take example of Mayur vs. Astral. Clearly, Astral seems to have stronger and more sustainable moat however it trades at 50 P/E on trailing basis while Mayur trades at 30 times trailing P/E. Hence, for a concentrated portfolio, which one should be preferred and why? Doesn’t the margin of safety come into picture while making a decision on capital allocation?"

Another question that I have is on following construct suggested by Mr. Parikh,

It is useful to consider SCALE and Maturity - as of Today also, 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 a much better??

"I do agree that the scale and maturity of business are factors especially for ensuring capital protection (risk containment). However, isn’t it more advantageous to join at the hip the concepts of critical mass and small base effect? To further clarify, considering that the business quality is similar, Isn’t it more reasonable to assume that a company that has achieved critical mass (certain market share/top line) but has small base (as compared to the opportunity size) is likely to be a better investment (due to higher growth rate sustainable for longer time) as compared to company with larger scale? "

hii Dhwanil,

““Risks to Business or Ability to handle Emerging Risks may be a much better??””

Your point is right about scale and opportunity but i think he is talking of risks involved for long term in this specific case.

Your answer is probably in the previous 3 points where he talks about Technology Risk in Shilpa “disruptive new technology (Genetics/Bio-Similars, for example)” and the effects it could have on Shilpa’s business and their need to innovate continuously while there are few risks in SCUF to main business.

Hi Donald,

I have a slightly different way at looking at this problem. Isnt the basic idea of value investing minimisation of risk? Isnt finding emerging quality against this tenet?

Somewhere on this forum someone mentioned that even though an airline might be better run than its peers, it probably is not a good idea to invest in it because if you look at the history of value creation by airlines in the last 100 years, its probably negative. Why then, try to second guess by investing in this company when the odds (and history) are so heavily decked against you!

When the market is at a stage where decent new ideas are unavailable shouldnt we be patiently waiting with a higher allocation to cash rather than trying to spend all this time trying to find a needle in a haystack.

Abhishek

Hi Dhwanil,

A few points …

Margin of safety has to come always while capital allocation decisions. What constitutes the MoS varies from stock to stock. Somewhere, it is the industry (regulated vs open), growth opportunity, scalability of business, strength & dedication of promoters, competitive landscape, business model etc etc.

In my opinion, you have a make a judgement call on the business parameter and valuation and then go by what your investment philosophy is. If you like to buy great businesses even at higher valuations, then that is what you will have to go with. Some prefer buying average businesses at cheaper valuations.In your example of Mayur & Astral where in your opinion Astral has a wider moat but higher valuation, you need to decide which camp you belong to. For example, Buffett in his initial days would have bought Mayur (lesser moat but cheaper) but in the later half of his career would have gone with Astral (bigger moat though more expensive).

You will never be able to answer this question :slight_smile: All you will get is someone’s perspective. Look at all the great investors. They all had their own philosophies and belonged to one camp or the other (more or less). Knowing Chetan Parikh’s will add another data point to that overall knowedgebase but will not solve the dilemma for you. You have to live it :slight_smile:

P.S: I am not sure if it Astral has a clear edge over Mayur on business moat. I think it is your perception. In my opinion Mayur is much much durable advantage than Astral, but then again, that is my perception :slight_smile:

allocation?

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Business Quality Value Chain (Cont): Chetan Parikh, Nov 31st, 2014:

Supplementary questions contributed by VP readership

Q. Company’s “quality of business” is lost or built over time. How much time do you let go before you say that there is permanent erosion of quality. It’s pretty much like when does a frog sitting in a boiling pot know that this is about to boil me to death?

1). Very good question. In our experience, there is no universally right or wrong answer here. It is more about the Speed of Change and therefore Valuations and Alternatives based on your Investor temperament. There is an ART side to this decision-making.

2). The very fact that you are asking this question, shows that you are NOT a frog. You have noticed the deterioration in quality and your assessment is perhaps the House is likely to catch fire, eventually.

3). Now while you know the house is likely to catch fire, you might still decide hey this is still a Castle. The fire may be coming but the Incumbents are well aware of the threats - there are lots of obstacles to deal with and tactical/strategic changes incorporated in business model(s) that are brought in by incumbents - that need to be tackled before the MOATS around the CASTLE are breached.

4). Your “assessment” might well be that breaching the MOATS will take upwards of 10-15 years and you may like to hang on, as you are an aggressive allocator of Capital. Someone with a more “conservative” mindset might be absolutely right to exit.

[Consider newspaper franchise in India getting breached eventually and how it is for the vernacular markets and mainstream markets in India versus what has happened in the West. The speed of change has been very dramatic there, but in India ?]

5). If the speed of change is more discernible and dramatic, then again valuations may be changing equally fast, then it will be suicidal to hang on.

6). In Cyclicals, the response may be different say even after the erosion - and you have seen prices drop,ifyou can see a Valuation upside!. Even at that price, how comfortable are you, do you still want to be there - say where 70% of the business the moat is now eroded but for 30% of the business, the Moat is still intact. Because the cycle upturn is round the corner, and you know that with the cycle upturn, economies of scale will kick in hugely and you may have ended up taking a good call.

Thanks Donald, very instructive and helpful response! If these guys are good that’s because there’s a reason and it shows in their response.

I appreciate the time taken by you / your team to ferret out wisdom to share with everyone.

Business Quality Value Chain (Cont): Chetan Parikh, Nov 31st, 2014:

Q. Mature well-discovered businesses are well-tracked and analysed. It’s difficult for individual investors to have an edge over the average investor in the Market. Small businesses enjoying a nascent niche domination are typically under the Institutional Radar, and thus under-researched. How do we ensure our homework is diligent and complete )- so we can have that decisive EDGE?

Yes, it is possible to be early in quality small businesses, and have lot of wonderful insights into a nascent industry or business - if we do a sincere job.

BUT how many of us have that discipline to do a complete job? All sources of information are important. But the degree of time spent may be different

1). Start with all publicly available, freely information sets incl Reports & filings, company presentations, websites (company, competition, industry body), investment blogs, and the like

2). Trade Journals are a very important source of information for coming upto-speed quickly. Usually lot of info, but not too many useful insights!

3). Phil Fischer Scuttlebutt approach recommended - for an in-depth Business/Industry Eco-System coverage )- especially for small business. Suppliers can become very valuable insight source into the Business as are Vendors, Buyers and Dealer/Distribution chain and the Management. Anywhere that you can** interface with the business/industry ecosystem - should become high-priority**.

4). One, our understanding goes up a lot. We start getting a lot of respect from Management and our understanding goes deeper. Sometimes a small insight or even one piece of news that comes out can change the “perception” of the Industry (Yes, we need to be on the look out and ferret out information). We can cross-check and corroborate authenticity of insight/news item and its impact from multiple sources. That kind of Edge is desirable, and certainly possible in small business research work - for disciplined, passionate, sincere folks.

5). For a large mature business like Nestle say - the insights that one can get from meeting a set of dealers/distributors can also be had from talking to a couple of well-regarded FMCG Analysts!

Business Quality Value Chain (Cont): Chetan Parikh, Nov 31st, 2014:

Q. Business Quality vs Corporate Governance?Suppose we had a great business run by a superb management team; and available cheap. But we also find out that on average 5% of PBT is routinely going out as cash. Should there be a graded approach in our markets, or is that a complete NO GO?

1). This is a tough one. One perspective here is that saying - “there’s never only 1 cockroach”!How do I know that it’s only 5%?

2). The other perspective (in India) - it’s very difficult to find a “pristine” crystal clean Management in India. Small Cash out levels may be needed for managing the environment - not every business (especially when small) has the financial strength or appetiteto fight the environment -both of which can take a heavy toll.

3… This may be a more condonable act compared to other more serious issues. If you ask me, usually the more serious issue is of large scale mis-allocation of capital - by way of large loans and advances or mis-allocation in unwarranted Capex, and the like.

4.If from all other angles, this is a good management running an efficient business and I can buy cheaply - I may have adequate Margin of Safety compensating for the additional risk. But would I ever KNOW it’s only 5%?

Many of you have raised queries on how to identify Emerging Moats, how to get better at the game - which was only captured ion passing in the first draft. Editors subsequently have fleshed this out …but as is our practiced …bunged that back in the main body - for completness sake.

Requesting those who queried on Emerging Moats - Have a look at this again. Was this helpful? Rate it

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 deeperwith 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.

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Hi Donald,

It effect?

_)—_thanku Donald for enhancing us…

@Vinod Ms

Points 3-10 are questions which will help you to decide now itself whether to pursue the story further and collect lots of info. The “Hitesh” part of decision making…

)—Hope vp can decipher/engage hiteshbhai ( his**process**in depth ) and create more like him:-)

Regards

mallikarjun

Most of the companies which pass the threshold and enter the category of emerging moats have good company characteristics like low DE ratio, improving profitability, etc. Differentiation on the basis of business characteristics can be more relevant (e.g RoCE). But among the business characteristics, it is difficult to get a benchmark as most of the company we cater to as emerging moats are one of their kind i.e Astral Poly, Ajanta following differentiated strategy, Symphony leveraging its strong brand equity, etc. Comparison across sectors between opportunities becomes even more difficult with such unique plays. This is where our categorisation into A+, A and B category business really helps.

A pre-mortem of companyâs failure few years down the line helps in deciding allocation between emerging moats. I personally think along similar lines while making a sizable bet. In case of emerging moats, it throws up a lot of possibility because there is a paucity of data to back the perception of the company. Establishing the probability, however, is a mental game and an ART, as we say it. This is in sync with the philosophy of establishing MOAT nature of the business with business not being RUN OF THE MILL. The pre-mortem covers up the entire IBAS framework we talk about, especially Architecture and Strategy. This helps me personally to differentiate on mental level the kind of businesses Iâm comfortable holding.

This all comes with a catch. Forecasting companyâs future strategy like entering new geographic markets and other blue ocean strategies are difficult and putting an optional value to this capability is crucial but highly uncertain. This necessitates conjunction of management quality and business quality while making investment decisions.

The key Point of Difference (POD) between emerging moats is sustainable growth rate. Ajantaâs domestic business can grow for significantly longer period of time as even after being 5th in ophthalmology, its market share is 5.3% whereas in derma and cardio, itâs below 2% due to highly fragmented nature of the industry. The ability to outpace industry growth by capturing rivals market share in the current segments for significantly longer period of time is critical while establishing scalability. Determining how long the company has till it faces demand issues is critical, whatever be the sector. This is along the similar lines as that of opportunity size. Differentiating between opportunities on basis of their types â high penetration, high replacement cycle and low penetration, low replacement cycle. Growing penetration can drive top-line for quite sometimes but personally, I would prefer higher replacement cycle unless itâs something like Indian housing finance market with very low penetration.

Apart from that, one may need to look at product diversification/concentration, e.g. Ajantaâs domestic business is fairly de-risked with its top brand Met-XL contributing less than 40 cr to top-line! Even in this line of thinking, its horses for courses. For pharma, product/therapeutic diversification among chronic segment makes sense, while in other sectors, it might not. Measuring concentration risk is key as most such companies are one product wonders.

I guess understanding if the business is one of low unknown unknowns or high unknown unknowns can help in differentiation too. Categorising the mode of value creation into Production Advantage, Consumer Advantage and External advantage may also help in differentiation.

In the end, an investor has to take a call among emerging moats which can be biased by 100s of variables. For some investors who are not able to put value to intangibles, magic formula investing may make sense and for others, qualitative analysis may hold key. The key is to back oneâs analysis and have FAITH on the process. Eventually, as Donald has said, itâs JUDGEMENT CALL.

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