Notes of WCS - May2020 PDF

Notes of MOSL Wealth Creation Studies
- Venkatesh Jayaraman (@EWFA_)
Contents
WCS 2015 – Mid to Mega ........................................................................................................................ 4
1. Summary ................................................................................................................................................................... 4
2. Introduction .............................................................................................................................................................. 5
3. What is Mid-to-Mega ................................................................................................................................................ 5
4. Why Mid to Mega?.................................................................................................................................................... 6
4.1 Performance profile of Mid-to-Mega portfolios .................................................................................................................. 6
4.2 Specific examples of Mid-to-Mega....................................................................................................................................... 7
4.3 Matrix of three cross overs and associated probabilities .................................................................................................... 7
5. What is takes to achieve Mid-to-Mega? ................................................................................................................. 10
5.1 M – Mid-size ....................................................................................................................................................................... 10
5.2 Q – Quality ......................................................................................................................................................................... 11
5.2.1 Quality of business ...........................................................................................................................................................................11
5.2.2 Quality of Management ...................................................................................................................................................................13
5.3 G – Growth ......................................................................................................................................................................... 13
5.3.1 Importance of growth ......................................................................................................................................................................15
5.3.2 High-growth situations.....................................................................................................................................................................15
5.3.4 Sustained sector tailwind .................................................................................................................................................................15
5.3.5 Small base with large opportunity ...................................................................................................................................................15
5.3.6 New large investment getting commissioned ..................................................................................................................................16
5.3.7 Inorganic growth through M&A .......................................................................................................................................................16
5.3.8 Consolidation of competition ...........................................................................................................................................................16
5.3.9 Operating & Financial leverage ........................................................................................................................................................16
5.3.10 Turnaround from loss to profit .......................................................................................................................................................16
5.4 L - Longevity ....................................................................................................................................................................... 16
5.4.1 Extending CAP ..................................................................................................................................................................................16
5.4.2 Delaying mean reversion of growth rate ..........................................................................................................................................17
5.5 P – Price .............................................................................................................................................................................. 17
6. How to shortlist potential Mid-to-Mega stocks ...................................................................................................... 18
7. Mega to Mid ............................................................................................................................................................ 19
7.1 Why Mega-to Mid happens? .............................................................................................................................................. 19
7.2 Key takeaways from Mega-to-Mid ..................................................................................................................................... 20
WCS 2016 – FOCUSED INVESTING – POWER OF ALLOCATION IN WEALTH CREATION ............................. 20
1. Backdrop ................................................................................................................................................................. 21
2. Kelly’s Formula – Insights for Equity Investing........................................................................................................ 22
2.1 Kelly’s for Equities – Meaning is more relevant than Mathematics .................................................................................. 22
2.1.1 Insight #1: Look of Asymmetric Payoff .............................................................................................................................................23
2.1.2 Insight #2: Create an edge ...............................................................................................................................................................24
2.1.3 Insight #3: Big Bet ............................................................................................................................................................................24
3. Focused Investing .................................................................................................................................................... 25
3.1 Diversified Investing ........................................................................................................................................................... 25
3.2 Concentrated Investing ...................................................................................................................................................... 25
3.3 Diversified/Concentrated Investing and Nature of Capital ................................................................................................ 26
3.4 Focused Investing – Golden Mean ..................................................................................................................................... 26
4. Four Keys to Successful ........................................................................................................................................... 26
4.1 Clear portfolio goal ............................................................................................................................................................ 26
4.2 Superior Stock Selection – QGLP ........................................................................................................................................ 27
4.2.1 Quality of Business and Management..............................................................................................................................................27
4.2.2 Growth in Earnings ...........................................................................................................................................................................27
4.2.3 Longevity of Quality and Growth .....................................................................................................................................................27
Notes of Wealth Creation Studies Page 1 of 90

4.2.4 Price .................................................................................................................................................................................................27
4.3 Rational Allocation ............................................................................................................................................................. 28
4.4 Active Monitoring and Improvement ................................................................................................................................ 28
4.5 Common Mistakes of Allocation ........................................................................................................................................ 28
Conclusions ................................................................................................................................................................. 29
ANNEXURE: Warren Buffett on diversification and allocation ................................................................................... 29
WCS 2017 – CAP & GAP ........................................................................................................................ 31
1. Preamble ................................................................................................................................................................. 31
2. Two Dimensions of Longevity ................................................................................................................................. 32
3. Measuring Longevity of Moat ................................................................................................................................. 35
3.1 What is CAP? ...................................................................................................................................................................... 35
3.2 Factors determining CAP .................................................................................................................................................... 36
3.2.1 Industry Structure.............................................................................................................................................................................36
3.2.2 Corporate Strategy ...........................................................................................................................................................................39
3.3 CAP Matrix ......................................................................................................................................................................... 39
3.3 Why CAP may end? ............................................................................................................................................................ 39
3.3.1 Disruptive Competition .....................................................................................................................................................................40
3.3.2 Business Downturn ...........................................................................................................................................................................40
3.3.3 Regulatory Shocks ............................................................................................................................................................................40
3.3.4 Capital Misallocation........................................................................................................................................................................40
4. CAP – The Indian Context ........................................................................................................................................ 40
5. Measuring Longevity of Growth ............................................................................................................................. 41
5.1 What is GAP? ...................................................................................................................................................................... 41
5.2 Factors Determining GAP ................................................................................................................................................... 43
5.2.1 CAP ...................................................................................................................................................................................................43
5.2.2 Industry Growth ...............................................................................................................................................................................43
5.2.3 Company’s Growth Mindset .............................................................................................................................................................45
5.3 Two Dimensions of GAP – Length and Height .................................................................................................................... 45
5.4 The GAP Matrix .................................................................................................................................................................. 46
5.5 Why GAP may end ............................................................................................................................................................. 46
5.5.1 End of CAP ........................................................................................................................................................................................46
5.5.2 Industry Maturity .............................................................................................................................................................................46
5.5.3 High Base Effect ...............................................................................................................................................................................46
6. GAP – The Indian Context ....................................................................................................................................... 46
6.1 Short listing methodology .................................................................................................................................................. 46
6.2 GAP Matrix – Key findings .................................................................................................................................................. 47
7. Putting it all together .............................................................................................................................................. 49
7.1 The key characteristics of CAP-cum-GAP companies ......................................................................................................... 49
7.2 Applying the CAP-cum-GAP learnings to Nifty stocks ........................................................................................................ 51
8. Case Study – HDFC Group ....................................................................................................................................... 53
8.1 What is the secret sauce behind HDFC group? .................................................................................................................. 55
8.1.1 Huge Profitable Business Opportunity..............................................................................................................................................55
8.1.2 Consumer Facing Business ...............................................................................................................................................................55
8.1.3 Strong Leadership.............................................................................................................................................................................55
8.1.4 Understanding the 90% Rule ............................................................................................................................................................55
8.1.5 Judicious Capital allocation ..............................................................................................................................................................56
8.1.6 Corporate culture .............................................................................................................................................................................56
Conclusions ................................................................................................................................................................. 56
WCS 2018 – Valuation Insights .............................................................................................................. 56
1. Introduction ............................................................................................................................................................ 59
2. Evolution of Valuation ............................................................................................................................................. 60
3. What is Value .......................................................................................................................................................... 60
3.1 Intrinsic Value for Bonds .................................................................................................................................................... 60
3.2 Intrinsic Value of Equity ..................................................................................................................................................... 61
4. Two key drivers of Equity Value .............................................................................................................................. 61
4.1 Interplay between RoE and Growth determines Free Cash Flow ...................................................................................... 63
4.2 All Growth is not necessarily good ..................................................................................................................................... 64
4.3 Beyond a point growth adds more value than RoE ............................................................................................................ 65
4.4 Earnings Growth and Stock Valuation are exponentially related ...................................................................................... 65
5. RoE, Earnings Growth and Stock Returns – The Indian Experience ........................................................................ 66
6. Reasonable Price ..................................................................................................................................................... 68
6.1 PE ....................................................................................................................................................................................... 68
6.2 PE relative to Market ......................................................................................................................................................... 68
6.3 PEG ..................................................................................................................................................................................... 69
6.4 Payback Ratio ..................................................................................................................................................................... 69
7. Current State of Valuations ..................................................................................................................................... 69
7.1 Built in Expectations of the Current Sensex Valuations ..................................................................................................... 69
Annexure – RoE and Earnings Growth Drivers ............................................................................................................ 70
Drivers of RoE ........................................................................................................................................................................... 70
External - Attractiveness of Industry Structure..........................................................................................................................................70
Internal - Effectiveness of Company’s Strategy .........................................................................................................................................70
What Hurts RoE .........................................................................................................................................................................................70
Drivers of Earnings Growth ...................................................................................................................................................... 71
External - Industry Growth ........................................................................................................................................................................71
Internal - Company Growth Mindset .........................................................................................................................................................71
What hurts growth? ..................................................................................................................................................................................71
Interesting Insights...................................................................................................................................................... 71
Conclusions ................................................................................................................................................................. 72
WCS 2019 - Management Integrity – Understanding Sharp Practices ..................................................... 73
1. Backdrop ................................................................................................................................................................. 73
2. What is Management Integrity ............................................................................................................................... 75
3. Why Management Integrity is Critical .................................................................................................................... 76
4. Why Management Integrity gets compromised ..................................................................................................... 77
5. When does Management Integrity typically gets compromised ............................................................................ 78
6. What are Sharp Practices ........................................................................................................................................ 78
6.1 Accounting Sharp Practices – The backdrop ...................................................................................................................... 79
6.2 Common Accounting Sharp Practices ................................................................................................................................ 82
6.3. Non-accounting Sharp Practices ....................................................................................................................................... 84
7. Sharp Practices in Financial Sector.......................................................................................................................... 84
7.1 Upfronting income and amortizing expenses .................................................................................................................... 84
7.2 Recognition of bad assets .................................................................................................................................................. 85
7.3 The issue of “large” ............................................................................................................................................................ 85
7.4 Trade checks and Sample study ......................................................................................................................................... 85
7.5 Organization structure ....................................................................................................................................................... 85
8. Other checks on Management Integrity ................................................................................................................. 86
8.1 Auditors Report .................................................................................................................................................................. 86
8.2 Top management changes ................................................................................................................................................. 86
8.3 Promoter pledging ............................................................................................................................................................. 86
8.4 360 degree feedback .......................................................................................................................................................... 86
Conclusions ................................................................................................................................................................. 87
ANNEXURE .................................................................................................................................................................. 87
Sharp Practices – A few Indian Case Studies ............................................................................................................................ 87
Sharp Practices Case Study #1 - Satyam Computer Services .....................................................................................................................87
Sharp Practices Case Study #2 – Manpasand Beverages ..........................................................................................................................88
Sharp Practices Case Study #3 – Educomp ................................................................................................................................................88
Sharp Practices Case Study #3 – Gitanjali Gems .......................................................................................................................................89
Other Insights ........................................................................................................................................................................... 90
Biggest Wealth Creators .......................................................................................................................................................... 90

WCS 2015 – Mid to Mega
Highlights
• Value Migration is increasingly the key for Wealth Creation

• Industry leadership is a pre-requisite to be a mega Cap
• Market cap ranking is a very powerful tool to assess a company’s current standing and future
roadmap
• Mid to Mega marks a big change in ranks, driven by Lollapalooza effect of MQGLP
100x Vs Mid-to-mega
• There are difficulties in picking up a 100x

• Far few ideas: 47 stocks over 20 years from 1994 to 2014
• These are very aspirational and theoretical
• The average time taken to achieve 100X is 12 years, which translates to 47% CAGR returns
• To enjoy high returns over a long period requires high level of patience, which is rare among
investors
• So creating a 100x portfolio is a challenge
Mid-to-Mega is more practical, as the number of ideas are more and achieving high returns is possible
within a time frame of 5 years.
1. Summary
1.1 Definitions
Mega: Top 100 stocks, Mid: Next 200 and Mini: rest
1.2 What is Mid to Mega?
• A company rising over Mid ranks (101 – 300) to Mega (<100) ranks.
• This cross over is significant for any company in achieving critical mass and scale of its operations,
and recognition of the same by the stock market
1.3 Why Mid to Mega?
• There are three cross overs possible

o Mini to Mega
o Mid to Mega
o Mini to Mid
• Of the three, Mid to Mega is the most profitable in terms of risk adjusted returns and more
plausible in terms of associated probability
1.4 What is takes to achieve Mid to Mega
• Industry Leadership: The most striking feature of this study is key role of industry leadership in the
pecking order of Market cap ranks.
• Among the top 100 companies, 88 are leaders in their respective industries
• Even among companies that moved from Mid to Mega, 70% of them are industry leaders
1.5 Mid to Mega, a Lollapalooza effect
• “Lollapalooza effect” - really big outcomes arising from multiple factors acting together.
• Mid to Mega is one such effect
• Multiple factors: MQGLP is needed for achieve this
2. Introduction
• The ultimate objective of all investors is to profit from a massive and rapid expansion in the value of
their stocks, i.e. higher stock price and market capitalization, without major issuances of fresh
equity.
• investors – more so individuals rather than institutional investors – prefer to buy small and midcap
stocks and see them appreciate into large cap stocks.
• In this report, mid and small cap stocks are called as Mega, Mid and Mini.
• There is no standard definition of what constitutes Mega, Mid and Mini.
2.1 Why Ranks
• In any journey, it is highly advantageous to have full clarity on the three key elements – (1) the
starting point, (2) the destination, and (3) the shortest path thereto.
• market cap rank analysis offers investors – and even company managements – a clear roadmap of
the journey that lies ahead.
3. What is Mid-to-Mega
• A cross over from Mid to Mega implies handsome return to shareholders
• Shorter the time taken for such cross overs, higher the returns
• This report focus on a practical time window of 5 years from the year of purchase
3.1 Why Mega?
• Top 100 mega companies form the bed rock of India's corporate sector and capital markets
• Currently they are 75% of total market cap and more than 88% of total corporate profits
• 88 of the top 100 companies are industry leaders i.e. No 1, 2 and 3 in their respective business
• It is increasingly difficult to dislodge mega companies from their top 100 category (However one
Mid to Mega happens, some of the companies in Mega gets dislodged)
4. Why Mid to Mega?

The most profitable-cum-plausible crossover
• There are 9 possible cross overs within these 3 categories of stocks

• Of these 9, only 3 are relevant to investors
o Mini-to-Mega
o Mini-to-Mid
o Mid-to-Mega
• One simple answer to the question “Why Mid-to-Mega?” of the 9 cross overs – it is the most
profitable-cum-plausible category crossover for investors.
• This conclusion comes from three sources –
o Performance profile of the Mid-to-Mega portfolios from 2000 through 2015
o Stock-specific examples of Mid-to-Mega and
o A 3x3 matrix capturing the crossover returns and associated probabilities.
4.1 Performance profile of Mid-to-Mega portfolios

The healthy RoE and modest P/E in the year of purchase indicate lower risk to earn the high expected return
CAGR and alpha over benchmark.
4.2 Specific examples of Mid-to-Mega
• Mid-to-Mega to be time and sector agnostic.
• Thus, every 5-year window offered Mid-to-Mega opportunities across sectors.
4.3 Matrix of three cross overs and associated probabilities

• Previous sections prove why Mid-to-Mega is the most profitable turnovers
• This section makes a case as to why it is plausible, based on probabilities of successful cross overs
• For this study 9 cross over possibilities in 3 time frame i.e. 2000-2005, 2005-2010, 2010-2015 was
considered
• Refer the image, an illustrative reading of the 3 buy-case crossovers is as follows –
o Mini-to-Mega : 68% return; 3 stocks out of 1,908, i.e. low probability of 0.2%
o Mini-to-Mid : 38% return; 64 stocks out of 1,908, i.e. again low probability of 3.4%
o Mid-to-Mega : 33% return; 24 stocks out of 200, i.e. higher probability of 12%.

The above trend was broadly similar to the other two time windows as seen in the next image. Thus the
probability of Mid-to-Mega is the highest among all three cross overs

Based on the above findings, we draw up a matrix, which captures the returns and probability of the same
in each crossover
• Mid-to-Mega may indeed have the highest probability among the 3 buy crossovers.
• However, in absolute terms, probability of success is still very low at 5-12%.
• This implies significant effort is required to achieve the high returns delivered by a successful Mid-
to-Mega stock/portfolio.
• To improve the chances of success, investors need to first understand what it takes to achieve Mid-
to-Mega.
5. What is takes to achieve Mid-to-Mega?

MQGLP powered by “industry leadership inside”
The process to achieving Mid-to-Mega is captured in the acronym MQGLP, powered by “industry
leadership inside” (inspired by the phrase, Intel Inside)
5.1 M – Mid-size
• The starting point of the Mid-to-Mega journey is Mid-size of the company, defined herein as market
cap rank from 101 to 300.
• Companies in this category have already achieved certain size and scale of operations, and are well
known in the stock market.
• They typically have a fairly long track record of published financial data, which allows for informed
investment decision making.

5.2 Q – Quality
5.2.1 Quality of business
We discuss two issues under Quality of business – (1) Industry leadership and (2) Economic Moat.
Industry leadership:
1. The most striking feature emerging from this study is the key role of industry leadership in the
pecking order of market cap ranks.
2. currently, among the top 100 Mega companies, as high as 88 are leaders in their respective
industries.
Note: For the purposes of this report, industry leadership implies that a company is No. 1, 2 or 3 by
revenue in its industry or market segment.
• Equally interesting is that even among the companies that have moved from Mid-to-Mega in recent
years, 70% are industry leaders
• The rising trend of industry leadership statistically confirms the intuitive understanding that the
larger companies are increasingly becoming more relevant to the economy and the stock markets.

Economic Moat
• The concept of ‘Economic Moat’ has its roots in the traditional moat.
• A moat is a deep, wide trench, usually filled with water, surrounding a castle or fortified place.
• In many cases, the waters are also infested with sharks and crocodiles to further keep enemies at
bay, and the inhabitants safe.
• Akin to the traditional moat, Economic Moat protects a company’s profits from being attacked by
competitive forces.
• Two key indicators to test whether a company enjoys Economic Moat or not are:
o A distinct value proposition that gives the company an edge over its competitors, and
o Return on Equity consistently higher than cost of equity (in the Indian context, cost of equity
is 15%, which is the long-period return of benchmark equity indices).
• 73 of the top 100 Mega companies have 5-year average RoE higher than 15% (See image below).
• This juxtaposed with the fact that 88 of the top 100 are industry leaders establishes presence of
strong moats, and partly explains why it is increasingly becoming difficult to dislodge the Mega.

5.2.2 Quality of Management
• Most important factor for its successful Mid-to-Mega journey
• There are 3 key aspects to quality of management
o Unquestionable integrity
o Demonstrable competence
o Growth and profit mindset
• All of the above are subjective and non-quantifiable issues.
• Thus, assessing quality of management is a true art rather than science
• Some indicators which can serve as a broad checklist for this process
Management Quality Indicators

Aspect
Unquestionable Integrity • Impeccable track record of corporate governance, fully respecting
the law of the land
• Concern for all stakeholders (and not only the majority
shareholders). Other stakeholders include customers, employees,
debt-holders, government, community, and minority
shareholders
• Paying full tax and a well-articulated dividend policy are key
favorable indicators of management integrity
• Corporate empire building to the detriment of minority
shareholders is a negative indicator
Demonstrable • Excellence in strategic planning and execution
Competence • The above should mainly reflect in the company enjoying a
sustainable competitive advantage over its peers, reflecting by
way of above-average return on capital (RoE, RoCE)
• “Keeping the growth going” is yet another key indicator of
management competence
Growth & Profit mindset • Long-range profit outlook, i.e. ensuring sufficient resources go
into long-term issues like product development, brand building,
capacity creation/expansion, succession planning, etc.
• Efficient capital allocation including decisions like organic or
inorganic growth, same-franchise or diversified growth, domestic
or overseas growth, etc.
• Persisting with growth plans despite temporary setbacks.
Change in management/ownership: All cases of change in management and/or ownership also need to be
closely examined as they hold potential to alter the fortunes of companies, e.g.
• Induction of N Chandrasekaran as MD & CEO of TCS
• Induction of Ramesh Sobti as MD & CEO of IndusInd Bank
• Acquisition of United Breweries by Heineken
• Acquisition of United Spirits by Diageo.
5.3 G – Growth
• For long-term investing, Quality or Moat is a necessary condition, but not sufficient.
• There is enough empirical evidence that long-period stock price returns are almost equal to long-
period earnings growth
• High quality without growth leads to what we call the Quality Trap i.e. typically healthy RoE, high
free cash flow and high dividend payouts, which keeps valuations high, but no earnings growth.
Brief details of Matrix quadrants

• Low-Quality-Low-Growth: Such companies and their stocks are clearly avoidable.
• Low-Quality-High-Growth: Such companies may prove to be Growth Traps. The high growth in
these companies is most likely due to cyclical upturns, but gets mistaken for secular high growth. If
bought very cheap, such stocks may still end up as multi-baggers, but at best transitory.
• High-Quality-Low-Growth: Such companies may prove to be Quality Traps. The high quality in these
companies blinds investors to the possibility that these companies may not be able to grow their
earnings at a healthy pace due to low underlying base rate (e.g. Castrol in lubricants, Colgate in oral
care, Hindustan Unilever in soaps & detergents, etc). As a result, stock performance remains
muted.
• High-Quality-High-Growth: These are the Enduring Multi-baggers, especially if bought at favorable
valuations.
Some of the recent Quality Traps.

5.3.1 Importance of growth
• Earnings growth is a conundrum – it is a very important determinant of stock prices, and yet, very
difficult to determine!
• Further, growth is uniquely specific to each company, and hence, does not yield itself to standard
frameworks
• Our view is that while one may not be able to precisely estimate growth, there are situations that
favour occurrence of high earnings growth
5.3.2 High-growth situations
5.3.2.1 Value Migration
• "Value migrates from outmoded business designs to new ones that are better able to satisfy
customers' most important priorities." - Adrian J Slywotzky
• Value Migration results in a gradual yet major shift in how the current and future profit pool in an
industry is shared.
• Value Migration is one of the most potent catalysts of the Mid-to-Mega journey, as it creates a
sizable and sustained business opportunity for its beneficiaries. It has two broad varieties –
o Global Value Migration e.g. value in IT and healthcare sectors migrating to India, global
manufacturing value migrating to China, etc.
o Local Value Migration e.g. value in telephony migrating from wired networks to wireless
networks; value in Indian banking migrating from public sector banks to private banks.
5.3.4 Sustained sector tailwind

A few sectors provide a sustained tailwind for all their constituent companies to clock high growth over
long periods of time e.g. banking, IT, pharma, autos, housing finance, telecom services (both voice and
data), etc.
5.3.5 Small base with large opportunity
Some companies have managed to launch a new or niche business with a huge opportunity. Their own
small starting base ensures sustained growth for several years to come e.g.
• Bajaj Finance - consumer finance
• Page Industries - branded innerwear
• GRUH Finance - mortgages
• Eicher Motors’ - niche leisure bike
• Symphony - air coolers.
5.3.6 New large investment getting commissioned
Companies that commission new large investments are likely to reap benefits of the same for the initial
few years at least, e.g. Cairn India’s oilfields in Rajasthan getting commissioned
5.3.7 Inorganic growth through M&A
Successful mergers and acquisitions translate into high sales and earnings growth for the acquiring
company e.g.
• Motherson Sumi acquiring several auto ancillary companies overseas
• Tech Mahindra acquiring the beleaguered Satyam Computers
• Ultratech acquiring several cement plants, the latest from Jaypee group.
5.3.8 Consolidation of competition
In rare cases, consolidation of competition ensures that incremental business growth accrues to the
remaining incumbents, e.g.
• Marico acquired Nihar, a key competitor to its coconut oil brand Parachute. This lowered the level
of competition, and ensured high growth for the company.
• In malted drinks, Nestle withdrew from India its global leading brand, Milo. This left the
marketplace wide open for incumbent GlaxoSmithKline Consumer’s brand, Horlicks.
5.3.9 Operating & Financial leverage
In specific situations, usually due to management action, companies manage high earnings growth without
significant revenue growth. This is mainly triggered by trimming fixed costs (leading to operating leverage)
or controlling interest cost (leading to financial leverage).
5.3.10 Turnaround from loss to profit
In rare cases, again led by management action, companies manage a successful turnaround from loss to
profit, e.g. Tata Motors and more recently Gujarat Pipavav Port.
5.4 L - Longevity
Mid-to-Mega companies also need to sustain both quality and growth. In the context of longevity,
competence of management is tested at two levels
5.4.1 Extending CAP
• Competitive advantage period (CAP) is the time during which a company generates returns on
investment that significantly exceed its cost of capital.
• Economic laws suggest that if a company earns supernormal return on its invested capital, it will
attract competitors who will accept lower returns, eventually driving down overall industry returns
to economic cost of capital, and sometimes even below it.
• However, a company with a great business and great management sustains its superior rates of
return and keeps extending its CAP.
• This creates incremental excess return both for the company and in turn for its equity investors.
(Refer the below image for the idea of CAP and its extension)

5.4.2 Delaying mean reversion of growth rate
• The other aspect of longevity is about delaying the mean reversion of growth rates.
• After the initial hyper and high growth phases, rates tend to taper off to the mean rate (which is
usually the nominal GDP growth rate).
• This is due to both competition and also the company’s own high-base effect.
• However, competent managements can delay such reversion to mean either by (1) new streams of
organic growth, and/or (2) inorganic growth via judicious, earnings accretive and value-enhancing
acquisitions.
5.5 P – Price
• Growth in stock price is a multiplicative function of growth in earnings and growth in valuation.
• The Mid-to-Mega phenomenon ideally needs both these legs of growth to kick in.
• The G of MQGLP addresses earnings growth whereas P (i.e. favourable Price of purchase) is
designed to address valuation growth.
• The simplest way to improve the odds of valuation growth is by ensuring favourable valuation at
the time of purchase, typically implying low P/E. However, in the Mid-to-Mega situation, expecting
to get stocks at very low P/Es is unreasonable, as they are well-known and widely tracked by
analysts and investors.
• Further, in certain situations, low P/E may not be the sole determinant of favorable valuation e.g.
during bottom-of-cycle, earnings of cyclical stocks are depressed, leading to high P/Es; likewise,
where companies are expected to turn from loss to profit, current P/E cannot be calculated.
• The last 10 5-year windows suggest Mid-to-Mega portfolio P/E of 15x in the year of purchase.
• However, in the last 5 periods, the purchase P/E of Mid-to-Mega portfolios has been higher at 20x
(Refer image below)

6. How to shortlist potential Mid-to-Mega stocks
Backtesting the MQGLP lollapalooza
We backtested MQGLP to examine its efficacy in picking Mid-to-Mega stocks and/or delivering superior
portfolio returns. The findings are presented and in the process, suggest a 6-step approach to shortlist
stocks which hold the potential to successfully complete the Mid-to-Mega journey.
The back test approach

• Starting list: Start with the 200 Mids (i.e. ranks 101 to 300) for the respective year (M of MQGLP).
• 20% RoE for Quality of business: Filter these 200 stocks for year of purchase RoE of at least 20%
• Industry leaders:
o From the above list, select industry leaders (complying with MQGLP’s “industry leadership
inside” phenomenon, discussed earlier).
o Further, we find that in cases of Value Migration (e.g. IT, healthcare) and very high industry
tailwind (e.g. mortgages), even non-leaders scale up significantly.

o So, we include them along with industry leaders.
• 20% PAT growth:
o From the list arrived at post step 3, select companies with preceding 2-year PAT CAGR of
20%.
o The rationale here is that the growth momentum expected ahead should already be visible
in the recent past).
• Seculars for Longevity: Prefer seculars over cyclicals (MQGLP’s Longevity is best exhibited by secular
companies rather than cyclicals).
• Favorable purchase price:
o Finally, decide a suitable P/E for the stock based on a subjective call on competence,
integrity and growth mindset of the management.
o Still, as a thumb rule, prefer P/Es below 25x, barring exceptional cases. (This corresponds to
matching MQGLP’s Quality of management in deciding favorable Purchase Price).
6.2 Mid-to-Mega: A Lollapalooza effect
• Lollapalooza effect: really big outcomes arising from multiple factors acting together.
• Mid-to-Mega is one such lollapalooza effect.
• Many of the multiple factors – Size, Quality, Growth, Longevity and Purchase Price – need to act
together for a stock to raise its rank from Mid to Mega.
7. Mega to Mid
Lessons on how equity investing could go wrong
• Assessment of its converse – Mega-to-Mid i.e. companies whose rank slipped from the top 100.
• 2005 through 2015, there are 161 cases of companies slipping from Mega-to-Mid category (the
number of companies is 112, implying some companies have slipped in more than one 5-year time
window.)
7.1 Why Mega-to Mid happens?

• Cyclical downturns: Stocks from sectors like metals, capital goods, construction, and real estate
exited the top 100 market cap ranks during a cyclical downturn in their sales and profits.
• Management lapses: In several cases, stocks’ exit from the Mega category was due to management
lapses in one or more of their key required traits – competence, integrity and growth-cum-profit
mindset.

• Reverse Value Migration: This was mainly true of public sector banks, which saw their value migrate
to private sector counterparts.
• Capital misallocation: This too is a form of management lapse, but merits separate mention e.g.
unsuccessful global acquisitions of companies have caused them to exit the Mega category.
• Fads: Some companies enter into the top 100 ranks on the back of temporary investor fads (e.g. in
the mid-2000s, companies supposed to have huge land banks became fads). When the fad fades
away, these companies slip out of the Mega category.
• Quality Trap: As discussed earlier, some high-quality companies cease to grow their earnings at
least in line with that of the benchmark. As a result, over time, their market cap ranks falls below
the top 100.
7.2 Key takeaways from Mega-to-Mid
• Cyclical downturns are the biggest cause of Mega-to-Mid. This reinforces the fact that cyclical stocks
(commodities, capital goods, etc) do not yield themselves to a Buy-and-Hold strategy. Investors who
choose to invest in cyclical stocks need to exit them before the cycle turns negative, even if it means
selling a bit too soon.
• Management holds the key not only for Mid-to-Mega but also Mega-to-Mid. Management issues
are a major cause of Mega-to-Mid. Investors need to be on the watch out for management’s lack of
competence and/or integrity and/or growth mindset and/or capital misallocation.
• Importance of industry leadership is reinforced. In Mid-to-Mega, 2 in every 3 companies are
industry leaders. It is almost the exact opposite in Mega-to-Mid cases, with 4 in 5 companies being
non-leaders.
Insights: Consumer/Retail emerges as the biggest Wealth Creating sector
WCS 2016 – FOCUSED INVESTING – POWER OF ALLOCATION IN WEALTH

CREATION
Highlights
• Stock allocation (How much to buy?) is a powerful tool for portfolio performance, but under
researched when compared to Stock selection (What to buy?)
• Kelly’s formula gives three insights for equity investing (a) Asymmetrical Payoff, (b) Create edge, and
(c) Big bet
• Opportunities for big bets are less; ‘Focused Investing’ is a sound strategy to capitalize on such
opportunities
• Key to successful focused investing are (a) Clear portfolio goals, (b) Superior stock selection, (c)
Rational allocation and (d) Active Monitoring
• Disciplined practice gives exceptional returns and not acceptable returns.
Highlights of Wealth Creation Studies 2011-16
• TCS – Biggest Wealth Creator for the fourth time in a row

• Ajanta Pharma – Fastest Wealth Creator
• Asian Paints – Most consistent Wealth Creator
• Consumer/Retail is the biggest Wealth Creating sector
• Commodity – Wealth Destructor
Theme 2016 – Focused Compounding
Power of allocation in Wealth Creation
"Bet seldom, and only when the odds are strongly in your favor, but when you do, bet big, hold for the long
term, and control your downside risk." – From the book Concentrated Investing, by Allan C Benello, Michael
Van Biema, Tobias E Carlisle
1. Backdrop
20 Studies on “What to Buy”: First one to “How much to Buy”
• Two aspects of equity investing

o Stock selection – What to buy
o Stock allocation – How much to buy (Weightage in a portfolio)
• 20 Studies in the past for stock selection, but the first study for stock allocation
• An example of hypothetical portfolio where stock allocation has impact on portfolio returns to the
extent of -8.5% to 18%
• Despite the above impact, it is surprising to find that very little literature is available on this critical
aspect of investing
• Academicians believe that stock allocation, even more than stock selection borders the art more than
science, thus greatly depending on individual style and temperament

• Investment practitioners do stock allocation more by intuition and emotion rather than reason
This study attempts to bring out insights to stock allocation and a rational approach for the same, with the
main ideas being
• Kelly’s Formula – Analyze the only semblance for a framework of allocation and derive insights for
equity investing
• Focused Investing – enable to exploit the power of allocation by placing sizeable bets on 15-20 stocks
to generate exceptional returns over the long term
• Keys to successful Focused Investing
o What to Buy – QGLP
o How much to Buy – CAP (Confidence Adjusted-Payoff)
2. Kelly’s Formula – Insights for Equity Investing

Look for asymmetric payoff, Create edge, Bet big
• John Larry Kelly Jr (Mind 1950), Scientist with Bell Labs

• Developed a formula for optimum bet-size given (1) Payoff and (2) Win-Loss probabilities
Where:
f is the fraction of the current bankroll to wager,
b is the net odds (expressed as rupees to be won for every rupee bet) or win-loss ratio,
p is the probability of winning, and
q is the probability of losing
Betting this fraction (f) repeatedly maximizes the long-term growth
2.1 Kelly’s for Equities – Meaning is more relevant than Mathematics

Equity investing is starkly different from gambling in many ways
Odds/Payoff and Wins-Loss Probabilities
• In gambling:
o Both odds/payoff and Win-Loss probabilities are known in advance
o The payoff is usually 1:1 and win-loss probabilities are 50:50
o In cases of Roulette the payoff is higher while the win probability is lower
o Net-net, a win or loss is purely an outcome of luck
• In Equity investing,
o Neither payoff or the win-loss probabilities are fixed
o Stock price is known, and an investor has to calculate the upside-downside and associated
probabilities
o Investors with better knowledge, skill and process can identify (1) Favorable pay out and (2)
Favorable probabilities for a big win

Role of Time
• In gambling the outcome of a win-loss of a bet is instant

• In equity investing there is a time gap to decide if a bet was a Win or Loss
Nature of Bets
• In gambling the bets are sequential – The outcome of one bet decides the strategy for the next
• In equity investing a investor has to make simultaneous bets on multiple stocks
Given these differences Kelly’s formula is not relevant to equity investing. However, there are some
meaningful insights.
2.1.1 Insight #1: Look of Asymmetric Payoff
• The ‘b’ variant (odds) of the Kelly’s formula can be modified slight to suit the needs of equity
investing
• In gambling:
o Odds are quoted as b:1 i.e. Rupees ‘b’ to be one for every Rupees 1 bet
o Losses are always 100%
• In equities:
o Losses are not 100% (Unless a company goes bankrupt)
o The b can be interpreted as the ratio of “Upside-Downside”
• Substituting this U/D in the formula:
which simplifies to
Where:
f is the fraction of the current bankroll to invest in a stock,
U is the possible Upside in the stock,
p is the probability of such Upside,
D is the possible Downside in the stock, and
q is the probability of such Downside.
• The above variant of Kelly’s formula clearly outlines the factors that influence stock selection and
allocation
o Upside
o Downside and
o Their probabilities
• The most favorable situation that an investor must look for is:
o Asymmetric payoff (High upside and low downside) coupled with
o High probability of win
2.1.2 Insight #2: Create an edge
• Another variation of Kelly’s formula is by author William Poundstone in his book, Fortune’s Formula
Where:
f is the fraction of the current bankroll to invest in a stock,
edge = bp – q or Up – Dq, i.e. the expected value of the financial proposition, and
odds = b or U, i.e. the amount expected to win if one wins.
• This variant can be interpreted mathematically and non-mathematically

o Mathematically: f is positive only when the numerator is greater than 0 i.e. No edge, No bet
o Non Mathematically: Edge is defined as knowing something that others don’t i.e. No edge,
No bet
• Markets are family efficient and to make big money, Investors must create an edge
• There are two sources of edge available to investors:
o Information edge – In modern day market significant information edge is unlikely
o Analytical edge – This includes time tested framework and process to (1) analyze various
aspects of business and (2) valuation. A few to name are:
▪ Nature of Industry
▪ Competitive landscape
▪ Size of Opportunity
▪ Quality of Management
▪ Channel checks
▪ Earnings forecast
▪ Peer Valuation etc.
2.1.3 Insight #3: Big Bet
• When investors get (1) asymmetric returns and (2) edge, they should make big bets
• This is possible with focused investing

3. Focused Investing
Golden mean for Concentrated and Diversified Investing
An important aspect of investing is risk-return tradeoff. There are two contrasting investing styles revolving
around it (1) Diversified Investing and (2) Concentrated Investing
3.1 Diversified Investing
• The strategy is to hold a fair number of stocks across sectors so that any unexpected adverse in a
stock or a sector does not impact portfolio performance
• In the active version of diversified investing, portfolio managers constantly buy and sell stocks to
outperform the broader index
• This involves a high level of (1) Management and (2) Transaction cost
• An alternative approach evolved in 1980 called the Index Investing (Passive version)
• In the Passive version of diversified investing, Portfolio managers buy-and-hold the stocks that are
part of the indices
• The idea is to generate better returns than active investing by keeping the fund cost low
• Both the above versions give a modest return, thus not harnessing the full power of equity
3.2 Concentrated Investing
• Propagated by few investors like Warren Buffet, Charlie Munger, Phil Fisher and John Keynes
• This involves buying a few stocks (Usually less than 10) which can deliver above average returns,
allocating a bulk of money to these stocks and holding it for a long time across cycles and fluctuations
• Investors believe that the knowledge on the business they buy reduces the risk of owning them
• Phil Fisher: “buying a company without sufficient knowledge of it may be even more dangerous than
having inadequate diversification.”
• Warren Buffet: “Diversification serves as a protection against ignorance. It you want to make sure
that nothing bad happens to you relative to the market, you should own everything. There is nothing

wrong with that. It’s a perfectly sound approach for somebody who doesn’t know how to analyze
businesses.”
3.3 Diversified/Concentrated Investing and Nature of Capital
• Nature of capital determines which of the two styles is followed
• Diversified investing style is used by mutual funds and when managing public money
• Concentrated Investing is suited for personal / private capital
• Public money is guided by short-term performance
• Portfolio managers are worried of short-term volatility associated with concentrated investing and
hence settle for safe and lower returns
3.4 Focused Investing – Golden Mean
• Focused investing can be seen as the Golden mean of both investing styles
• Focused investing has 15 stocks in portfolio, instead of having 50 stocks in Diversified Investing or
10 (or fewer) stocks in Concentrated Investing
• This option gives the best of both the worlds – adequate risk diversification and meaningful return
magnification
4. Four Keys to Successful

Portfolio goal, Selection, Allocation, Monitoring & Improvement
Four keys to successful Focused Investing:
1. Clear portfolio goal,
2. Superior stock selection,
3. Rational allocation, and
4. Active monitoring and improvement
4.1 Clear portfolio goal
• Setting a simple, clear and measurable portfolio goal is the starting point for investing
• Portfolio goal can be expressed as absolute returns or relative returns
• For focused investing absolute returns is preferred
• Portfolio goals serves as a guideline for the next two stages (1) Stock selection and (2) Stock allocation

4.2 Superior Stock Selection – QGLP
• Focused portfolio has 15-20 stocks with meaningful allocation in each stock to have a meaningful
impact on portfolio performance
• Investors with time tested philosophy / process of stock selection are better off
• The end objective is to:
o Finding asymmetric payoff (High upside potential with low downside risk)
o Create edge
o Meet portfolio goal and
o Diversify risk (Stocks from different sectors which are not having high correlation)
4.2.1 Quality of Business and Management
• If either quality of management or business is Zero, the result ends up in Zero.
• Clearing the quality filter lowers the risk of permanent capital loss
4.2.2 Growth in Earnings

• Earnings growth drive the value of a stock
• Growth is unique to each company and does not fit in a standard framework
• Certain high growth situations are:
o Exponential opportunity in discretionary expenditure coupled with linear growth in GDP
o Value Migration
o Small base with large opportunity
o Inorganic growth through M&A
o Consolidation of profit
o Turn around from L-P
4.2.3 Longevity of Quality and Growth
• Focused investing is essential buying and holding selective stocks for a long term
• The selected stocks should sustain Quality and Growth for a long time
4.2.4 Price
• QGL analysis gives the investor an edge with understanding of Business, Management and earning
prospects
• Price helps to determine if the selected stock will meet the portfolio goal
4.3 Rational Allocation
• The governing principles are:
o Bet big when the odds are in favor and at the same time,
o Increase the certainty of achieving portfolio goal
• To achieve both the objectives use the CAP (Confidence Adjusted Payoff) Framework
• This framework draws inspiration from methodology pursued by Warren Buffett in his partnership
letters in the 1960s
• He says “The question always is, ‘How much do I put in number one (ranked by expectation of
relative performance) and how much do I put in number eight?’"
The steps for CAP based allocation:
• Rank the stocks in descending order of their expected 3 or 5-year returns

• To this upside add confidence factor ranging from 0-100%
o The idea is to deflate the expected upside for risks that might not have been captured in
calculations
o If the confidence factor is low, then the very stock selection is questioned
• Calculate the CAP for each stock i.e. Upside x Confidence factor
• Rank the stocks in descending order of CAP and align the final allocation
• More accurate the assessment of CAP, higher the performance of portfolio aligned to this allocation
• Additional check points could include:
o No stock has allocation greater than 10%
o No stock has allocation less than 3%
o Not having more than 5% equity of any company
4.4 Active Monitoring and Improvement
This is very important as odds of a stock change frequently due to change in underlying fundamentals or
stock price or both. It includes several things like:
• Estimating quarterly/annual earnings and comparing with actuals to ensure that the original thesis is
on track
• Keep self updated on the latest development in company and sector including periodic interaction
with management
• Maintain corroborative evidence: Interaction with suppliers, competitors, dealers and ex-employees
• Watch irrational stock price movements (Both up and down) and action plan for such cases
• Constant search of investment ideas better than the current one
4.5 Common Mistakes of Allocation
• The common mistakes are (a) Overestimating, (b) Underestimating and (c) Overstaying with losers
and winners
• These mistakes are associated with common psychological/behavioral biases

Conclusions
Adopt Focused Investing for exceptional rather than acceptable returns
• Investors focus on stock selection, but the power of “Stock allocation” is a area still untapped
• Kelly’s Formula
o Provides some semblance for portfolio allocation
o This is suited for gambling like situations where payoff and odds are known
o There are some take aways for equity investing
▪ Identify asymmetric payoff – High upside potential with low downside risk
▪ Create edge – Information or analytical
▪ Bet big - When both the above coincide
• Focused investing
o Markets are fairly efficient and opportunities for such big bets are seldom
o Focused investing helps to capitalize on such opportunities by investing on 15-20 stocks with
strong favorable odds
o Focused investing is a golden mean of Diversified and Concentrated Investing
• Four keys to successful focused investing
o Set portfolio goal – Guide post for stock selection and allocation
o Superior stock selection based on time tested philosophy or process
o Rational allocation
o Active monitoring and improvement
• Disciplined practice of above leads to exceptional rather than acceptable returns
ANNEXURE: Warren Buffett on diversification and allocation

(extract from letter dated 20 January 1966 to partners in Buffett Partnership Limited; key sections are
highlighted in bold by MOSL)
Diversification

Last year in commenting on the inability of the overwhelming majority of investment managers to achieve
performance superior to that of pure chance, I ascribed (Meaning: Certified) it primarily to the product of:
"(1) group decisions - my perhaps jaundiced view is that it is close to impossible for outstanding investment
management to come from a group of any size with all parties really participating in decisions; (2) a desire
to conform to the policies and (to an extent) the portfolios of other large well-regarded organizations; (3) an
institutional framework whereby average is "safe" and the personal rewards for independent action are in
no way commensurate with the general risk attached to such action; (4) an adherence to certain
diversification practices which are irrational; and finally and importantly, (5) inertia.”
This year in the material which went out in November, I specifically called your attention to a new Ground
Rule reading, “7. We diversify substantially less than most investment operations. We might invest up to
40% of our net worth in a single security under conditions coupling an extremely high probability that our
facts and reasoning are correct with a very low probability that anything could drastically change the
underlying value of the investment.”
We are obviously following a policy regarding diversification which differs markedly from that of practically
all public investment operations. Frankly, there is nothing I would like better than to have 50 different
investment opportunities, all of which have a mathematical expectation (this term reflects the range of all
possible relative performances, including negative ones, adjusted for the probability of each - no yawning,
please) of achieving performance surpassing the Dow by, say, 15 percentage points per annum. If the 50
individual expectations were not intercorrelated (what happens to one is associated with what happens to
the other) I could put 2% of our capital into each one and sit back with a very high degree of certainty that
our overall results would be very close to such a 15 percentage point advantage.
It doesn't work that way.
We have to work extremely hard to find just a very few attractive investment situations. Such a situation by
definition is one where my expectation (defined as above) of performance is at least 10 percentage points
per annum superior to the Dow. Among the few we do find, the expectations vary substantially. The
question always is, “How much do I put in number one (ranked by expectation of relative performance) and
how much do I put in number eight?" This depends to a great degree on the wideness of the spread between
the mathematical expectation of number one versus number eight. It also depends upon the probability that
number one could turn in a really poor relative performance. Two securities could have equal mathematical
expectations, but one might have .05 chance of performing 15 percentage points or more worse than the
Dow, and the second might have only .01 chance of such performance. The wider range of expectation in
the first case reduces the desirability of heavy concentration in it.
The above may make the whole operation sound very precise. It isn't. Nevertheless, our business is that of
ascertaining facts and then applying experience and reason to such facts to reach expectations. Imprecise
and emotionally influenced as our attempts may be, that is what the business is all about. The results of
many years of decision-making in securities will demonstrate how well you are doing on making such
calculations – whether you consciously realize you are making the calculations or not. I believe the investor
operates at a distinct advantage when he is aware of what path his thought process is following.
There is one thing of which I can assure you. If good performance of the fund is even a minor objective, any
portfolio encompassing one hundred stocks (whether the manager is handling one thousand dollars or
one billion dollars) is not being operated logically. The addition of the one hundredth stock simply can't
reduce the potential variance in portfolio performance sufficiently to compensate for the negative effect
its inclusion has on the overall portfolio expectation.
Anyone owning such numbers of securities after presumably studying their investment merit (and I don't
care how prestigious their labels) is following what I call the Noah School of Investing - two of everything.
Such investors should be piloting arks. While Noah may have been acting in accord with certain time-tested
biological principles, the investors have left the track regarding mathematical principles. (I only made it
through plane geometry, but with one exception, I have carefully screened out the mathematicians from our
Partnership.)
Of course, the fact that someone else is behaving illogically in owning one hundred securities doesn't prove
our case. While they may be wrong in overdiversifying, we have to affirmatively reason through a proper
diversification policy in terms of our objectives.
The optimum portfolio depends on the various expectations of choices available and the degree of variance
in performance which is tolerable. The greater the number of selections, the less will be the average year-
to-year variation in actual versus expected results. Also, the lower will be the expected results, assuming
different choices have different expectations of performance.
I am willing to give up quite a bit in terms of leveling of year-to-year results (remember when I talk of
“results,” I am talking of performance relative to the Dow) in order to achieve better overall long-term
performance. Simply stated, this means I am willing to concentrate quite heavily in what I believe to be the
best investment opportunities recognizing very well that this may cause an occasional very sour year - one
somewhat more sour, probably, than if I had diversified more. While this means our results will bounce
around more, I think it also means that our long-term margin of superiority should be greater.
WCS 2017 – CAP & GAP

Highlights
• Companies with long run of profit growth are few.

• Understanding Competitive Advantage Period (CAP) and Growth Advantage Period (GAP) helps to
identify them
• Moat without growth leads to underperformance. Growth without Moat ends soon.
• Longevity and high growth rates are inversely co-related.
• Three characteristics of CAP-cum-GAP companies are (1) Clear strategy, (2) High Growth mindset and
(3) High Growth industry situations.
"The strategy is to find a good business – and one that I can understand why it's good – with a durable
competitive advantage, run by able and honest people, and available at a price that makes sense. Because
we are not going to sell the business, we don't need something with earnings that go up the next month or
the next quarter; we need something that will earn more money 10 and 20 and 30 years from now."
– Warren Buffett, in Forbes Magazine's 100th Anniversary Issue
Theme 2017 – CAP & GAP

Power of longevity in Wealth Creation
If you don’t have competitive edge, do not compete. — Jack Welch

If you don’t have growth advantage, do not invest. — Raamdeo Agrawal
1. Preamble
• Longevity in general is “Duration of anything”.

• Longevity in the context of study is the duration a company can maintain its competitive advantage
and earnings growth.
• Why is study of longevity important? Equities as an asset class has the ability to give high returns
for a very long duration of time.
• Such long term, high return opportunities are very few.
• In order to earn high, long term returns in equities, two questions must be answered.
o How long can the company survive?
o How long will profitability grow?
Company lifecycle
• Every company has a life cycle (Ref. exhibit 3.)

• It is important to identify the high profit growth phase (in
this life cycle) along with longevity.
• Profit growth is what increases the value of the company.
• Stock prices are a reflection of the underlying value of the
company .
• In order to get multifold increase in stock prices, we need
to invest in companies during the multifold profit period.
• This is easy said than done.
• There is no science or technique that can help to figure
out the profit growth which is complex and multivariate.
• As a result we are unable to value long term profitable growth.
• Given this mystique any insights into estimating (1) Length of growth (2) height of growth and (3) limits
of growth would be useful. (Consider these as a right angled triangle)
• Growth is useful only, if the return on capital is higher than cost of capital.
• This can happen only when the company enjoys a distinct competitive advantage over its rivals.
• So, it is not only important to study about the growth alone, but also the durability of competitive
advantage.
This study attempts to:
• Measure the longevity in both growth and competitive advantage.

• Combine the learnings to identify companies with a high, long profit growth
2. Two Dimensions of Longevity

Moat and Growth
• The two dimensions of a company longevity are

1. Longevity of competitive advantage – Popularly called as ‘Moat’ or ‘Economic Moat’ by
Warren Buffett
2. Longevity of profit growth
• Moat protect the company’s profit and profitability from being attacked by its competitors for a
extended periods of time.
• Companies with high moats enjoy high quality business – High RoE and cash flows.
• The Moat and Growth can be plotted in a 2x2 matrix
o Quality Trap: Company with Moat and no Growth – Likely underperform benchmark indices
o Growth Trap: Company with no Moat but a high Growth – Transitionary multi baggers. If not
sold at the right level, may come down to where it started or even below that.
It is established that long term Moat and Growth advantage is important, how to measure it?
1. Longevity of Moat – Competitive Advantage Period
2. Longevity of Growth – Growth Advantage Period

3. Measuring Longevity of Moat
Competitive Advantage Period (CAP)
3.1 What is CAP?
• Competitive Advantage Period is the duration or the number of years that a company earns returns
above the cost of Capital.
• When a company earns above average returns than cost, more players (Competitors) enter the
business who operate at lower returns.
• Thus moving the overall industry returns to the cost of capital or even lesser than that.
• CAP is the measure of longevity of a Moat.
Two real examples are given below. It is to be noted that the returns during the CAP is meaningfully higher
than the non-CAP.

3.2 Factors determining CAP
There are two factors:
1. Attractiveness of Industry Structure – External factors
2. Company’s own strategy – Internal factors
3.2.1 Industry Structure
Five Force Analysis of Michael Porter is a good frame work to assess the attractiveness of the industry
structure.
Porters Five forces – Implications and Examples

Force 1: Interfirm Rivalry
Implications • This lies in the core of the industry structure analysis.
• The more the rivalry between the incumbents, lesser the attraction of the industry.
Examples • Indian Telecom industry is a huge opportunity with 3 major players, but there is
intense competition and tariff wars, making it unattractive. Profits are declining.

• Gold Mortgage sector is also a huge opportunity with large number of players. But
the benign rivalry between the firms keeps the sector profit growth healthy.
Force 2: Threat of new Entrants

Implications • Threat of new entrants forces the incumbents to operate at lower profitability as a
strategy towards them off.
Examples • Realty sector is always in threat of new entrants hurting profit of incumbents.
• Paint industry need an extensive distribution system sees a lesser threat of new
entrants and profit of the incumbents is intact.
Force 3: Threat of substitute product and services

Implications • Threat of substitutes forces the incumbents to operate at lower profitability.
• This is very rare
Examples • Print and TV media is substituted by Internet.
• Two wheeler sector, Scooters are substituting bikes

Force 4: Bargaining power of Customers
Implications • Higher the bargaining power of the customer, lower is the attractiveness of the
industry and vice versa.
• Big and concentrated customer have a higher bargaining power than fragmented
customers.
• High brand pull and switching costs reduces the bargaining power of customers.
Examples Auto Industry:
• Ancillary company that supply parts to car manufacturer have lower margins. (Big
and Concentrated customers).
• The car manufacturers supply to huge volumes of retail customers and enjoy higher
margins (Fragmented).
Force 5: Bargaining power of Supplier

Implications • Higher the bargaining power of the supplier, lower is the attractiveness of the
industry and vice versa.
• Big and concentrated suppliers have a higher bargaining power than fragmented
suppliers.
Examples • Packaging sector – Buys their raw material from large suppliers (polymer and
Aluminum manufacturers). Their profit margins are less. [Suppliers are big and few]

• Cigarette industry – Buys their raw material tobacco from large number of farmers
across the country. They have lesser bargaining power and the industry enjoys higher
profit margins.
3.2.2 Corporate Strategy

• The second aspect of CAP is corporate strategy. (Individual companies within the same industry)
• Strategy is all about creating, maintaining and increasing the competitive advantage against their
rivals.
• A company with sound strategy enjoys longer CAP and vice versa.
• There are three strategies according to Michael Porter (1) Differentiation, (2) Low Cost and (3)
focus.
For details of these three strategies refer the Appendix of WCS 2018.
3.3 CAP Matrix
• The industry structure and company
strategy can be favorable (F) or
unfavorable (U).
• This gives a 2x2 Matrix with 4
quadrants and associated CAP.
• F-F is the most favorable having the
longest CAP.
3.3 Why CAP may end?

CAP may be adversely affected by various factors:

3.3.1 Disruptive Competition
• Amazon was disruptive to America’s largest book chain Barnes and Noble.
• Now recently they are disruptive to retail like Walmart.
• Similarly Reliance Jio offering free voice calls is disruptive to the industry as a whole.
3.3.2 Business Downturn
• Business down cycles tend to drag down CAP
3.3.3 Regulatory Shocks
• Regulatory shocks affect CAP.
• In 2008-2013 Oil Marketing companies were affected due to price control regime.
3.3.4 Capital Misallocation
• All above were external to the company, but this aspect is the ONLY internal aspect that can affect
CAP.
• Tata Steel, before and after acquisition of Corus.
4. CAP – The Indian Context

• Rated all industries based on Porter’s Five Forces to arrive at Industry Structure Score (Exhibit 24
directly from the WCS in page 18). Industries with rating higher than 2.5 were rated Favorable (F) and
those with rating of 2.5 or lower were rated Unfavorable (U).
• Classified all 116 companies into relevant industries and assigned the Industry Score.
• We then assessed the strategy of each company – whether Differentiated, Low-cost or Stuck in the-
middle. Those companies with strategy were rated Favorable (F) and those without an apparent
strategy were rated Unfavorable (U).
Key Takeaways
• Beyond 8 years most of the companies were in the F-F or U-F quadrant i.e. The ones with strong
corporate strategy
• All the 16 companies with full 20-year CAP are in the F-F quadrant i.e. Favorable Industry structure
and Favorable corporate strategy

Key Takeaways
• Companies in the favourable industry with a strategy enjoyed long CAP (Ability to maintain RoE
above Cost of Equity for a long period of time.)
• A portfolio of such longevated CAP companies meaningfully outperformed the bench mark indices.
5. Measuring Longevity of Growth

5.1 What is GAP?
• Growth Advantage Period (GAP) is the time during which the company grows its profit at a rate
higher than the bench mark indices. (15% in case of Sensex)
• The pace of wealth creation by the stock is highest during this period
• Since stock prices are correlated with the profit growth, it is logical that the company outperforms
the indices during this period.

Real life examples, where the returns were significantly higher in GAP than the Non-GAP.

5.2 Factors Determining GAP
Three factors that determine GAP are (1) CAP, (2) Industry Growth and (3) Company’s Growth Mindset
5.2.1 CAP
• CAP is the foundation for sustained GAP.
• Beyond this if other two factors fall in place then the company have a long GAP
5.2.2 Industry Growth
This is the primarily driver for GAP which depends on a few growth situations:
Global and/or Domestic Economic Growth
• This forms the base rate for growth in most of the industries
• Domestically rising per-capita income leads to exponential spends in discretionary consumption.
• Increased saving and investment leads to higher derived demand for capital goods, construction
and engineering. (Not able to understand or convince)
Linear increase in Per-capita income leads to exponential growth in discretionary
• India has added its 1st Trillion dollars of GDP in 2008, after 60 years.
• It is expected to add every NTD at a faster pace.
• This would give rise to demand in consumption of goods and services.
Value Migration

• “Value migrates from outmoded business designs to new ones that are better able to satisfy
customers’ most important priorities.” - Adrian J Slywotzky.
• Value migration is a gradual but a major shift of how the current and future profit pools is shared in
the industry.
• Value migration is one of the potent driver of growth which creates sizeable and sustained business
opportunities for its beneficiaries.
• There are two important varieties
1. Global Value Migration
▪ IT and Healthcare sectors migrating to India
▪ Manufacturing migrating to China
2. Domestic Value Migration
▪ Wired to wireless telephones
▪ PSU to Private banks
Low Product Penetration
• Products with low penetration enjoy high level of growth for prolonged period of time
• Cars and air conditioners in Indian market compared to China
• Such companies have a long favourable GAP
New Industry / Product
• Completely new industries have a long run way till they reach maturity
• Such companies enjoy a high level of GAP
• Example: Ipod in US and Air Coolers in India
Change in Five Force Structure
• Any change in industry structure would have a favorable or unfavorable impact on GAP
• Nestle withdrawing Milo, benefited GSK Horlicks – Favorable impact
• Patanjali entry affects incumbents like Colgate, Unilever and Dabur – Unfavorable impact
Regulatory Changes
• This has favorable and unfavorable impact on GAP

• Price deregulation favorable for OMC
• Price control is unfavorable for pharma

5.2.3 Company’s Growth Mindset
Psychologically there are two kind of mindsets
1. Fixed Mindset
a. This assumes our (a) character, (b) intelligence and (c) creative ability is static and cannot be
changed
b. Attributes success to intelligence
c. Hence the focus is more to avoid failures
2. Growth Mindset
a. This mindset thrives on challenges
b. Failure is not seen due to unintelligence, but a chance to learn and stretch existing capabilities
A company with growth mindset may take one of the several forms:
• Aggressive capacity expansion – to gain market share.

o Sometimes even ahead of the future growth in demand.
o Shree cements grew its capacity aggressively and increased its profits, even as the industry
profits remained same.
• Launches new products or business initiatives regularly
• Active inorganic growth
• Improves operating and Financial structure
o Outcome of pursuing aggressive growth strategy.
5.3 Two Dimensions of GAP – Length and Height
The two dimensions of GAP are:
1. Length – Period of High Growth
2. Height – Magnitude of Growth
o Studies indicate that supernormal growth can sustain only for a short term.
o Such high growth can be found in cyclic companies and secular companies (in their initial
growth stage)
o In such investments the sell point is equally important as the buy decision
o Should the exit decision be wrong, the investor could end up coming down to where they
started or even lower than that.

5.4 The GAP Matrix
5.5 Why GAP may end

GAP get hurts due to three reasons (1) End of CAP, (2) Industry Maturity and (3) High-base effect
5.5.1 End of CAP
• End of CAP is a definite reason for end of GAP.
• End of CAP implies that RoE is slipping down below the cost of Equity and profit growth is slow or
negative.
• All factors leading to end of CAP lead to end of GAP.
5.5.2 Industry Maturity
• A industry moving from growth to maturity phases affects the profit growth of companies in the
industry ending the GAP.
• E.g. Salt, Tooth Paste, Tea etc
5.5.3 High Base Effect
• Even if a company is in growth phase (not reached maturity), a large company will have a slower
growth on account of high base effect.
• Indian IT is a best example. Even as the global demand is huge and large, many leading companies
are showing growth slow down.
6. GAP – The Indian Context

6.1 Short listing methodology
GAP Definition: The long-term profit growth rate of benchmark indices was around 15%. GAP is defined as
the number of successive years, where the profit growth was 15% with PAT of every year higher than the
preceding year.

6.2 GAP Matrix – Key findings
GAP is dependent on two factors. The ratings for them was as:
1. Industry growth – Companies with growth greater than 15% were rated as H and less than 15% as L
2. Company’s growth mindset – Company with growth mindset was rated as H or L
This led to a 2x2 Matrix with 4 possibilities
The following are the inferences from the matrix:
• Sustaining profit growth of 15% for a period more than 9 years was challenging
• Only 30 companies had 15% profit growth for a 9 year period. Out of this:
o 20 companies (67%) were in H-H quadrant
o 4 companies (12%) were in L-H quadrant
• Thus 80% of the companies with a GAP of 9 years and profit growth of 15% comes from company
growth mind set (Second factor)
• Two outlier companies in the L-L quadrant had a GAP of 11 years. They are GSK and Colgate.
This same analysis was carried out for secular and cyclic companies. Which had the following outcomes
• Irrespective of secular or cyclic, it is difficult for companies to have GAP more than 9 years.
• Of the 30 companies that had GAP of 9 years, 80% of them were from secular industries.
• In terms of GAP height, cyclicals tend to have higher growth than seculars at the beginning of the
cycle. However, on a longer duration, seculars have a higher growth.
Shortlisted companies
Top 15 companies with long GAP:
Top 15 companies with highest GAP:

Takeaways:
• Long GAP companies are secular business which have high profit growth over long periods of time
• High GAP companies are typically cyclical business that give super normal profit in a short burst.
7. Putting it all together

The CAP-GAP Confluence
Combining the learning of CAP and GAP arrive at:
1. The characteristics of CAP-cum-GAP companies
2. Apply this to Nifty to arrive at likely earning growth outperformers
7.1 The key characteristics of CAP-cum-GAP companies
• There were 112 GAP companies. Out of which 103 companies had CAP.
• These 103 companies were fitted in a 4x4 CAP-GAP matrix
How to read this table – Illustrative example

Of the 52 companies with High Industry Growth and High Company Growth Mindset (GAP
Quadrant H-H):
• 21 have Favorable Industry Structure and Favorable Company Strategy (CAP Quadrant
F-F).
• 23 have Unfavorable Industry Structure but Favorable Company Strategy (CAP
Quadrant U-F).
• 4 have Favorable Industry Structure but Unfavorable Strategy (CAP Quadrant F-U) and
• 4 have Unfavorable Industry Structure and Unfavorable Strategy (CAP Quadrant U-U).
The maximum number of occurrences can be seen in two quadrants shaded in grey. They determine the
characteristics to determine CAP-cum-GAP companies.
• Look for industry with high growth situation (First H)

• Within this look for companies with high growth mind set (Second H)
• Look for companies with a favorable strategy (F).
In short, the three key characteristics of CAP-cum-GAP companies are
1. Clear strategy
2. High growth mindset
3. High growth industry situations
Two of the three strategies (Growth mindset and strategy) related to the company management. Hence a
high level understanding and assessment of company management is important for investment success. As
Phil Fisher says in his book, Path To Wealth Through Common Stocks, “in evaluating a common stock, the
management is 90%, industry is 9% and all other factors are 1%.”
The list of 44 H-H + F-F/U-F companies (as in the two grey shaded cell) have a health PAT CAGR of 39% and
Price CAGR of 36%.

7.2 Applying the CAP-cum-GAP learnings to Nifty stocks
The CAP-cum-GAP learnings was applied to Nifty stocks
GAP Quadrant
• A industry was applied to every Nifty Stock

• The PAT Growth rate for the last 20 years of every industry was calculated
• Companies with growth above 15% rated as High (H) and below 15% as Low (L)
• The growth mindset was also rated as High (H) and Low (L)
• This gave the GAP quadrants H-H, H-L, L-H, L-L
CAP Quadrants
• Industry score more than 2.5 was assigned a favorable (F) and below assigned as unfavorable (U).
• Clear company strategy assigned a favorable (F) and no strategy was assigned as unfavorable (U).
• This gave the CAP quadrants F-F, F-U, U-F and U-U
Putting GAP and CAP together
• Out of the 50 companies, 30 from H-H was selected.

• Of this 29 companies with F-F and U-F were selected.
• Some 8 had to be unselected as the future growth was evident will be lesser than base rate. i.e IT (5
Companies), Two-Wheelers (2 Companies) and Reliance (Due to uncertainty of their telecom
venture).

• Maruti was added back to the list as the future growth is higher than industry base rate.
• So the remaining 22 companies are expected to give a higher growth rate for a long period of time
than the remining 28 excluded companies.

8. Case Study – HDFC Group
Financial Powerhouse
The HDFC group performance in terms of CAP and GAP is worth highlighting as a case study.
HDFC bank has 20 year long CAP with a RoE greater than 15% for every single year. HDFC closely missed
this feat in 2009 due to some fund raising.

The HDFC twins have a long 20 year GAP with PAT growth greater than 15% for every single year. Infact the
GAP story starts from 1980 and had a wonderful run for 37 years. The 37 year PAT growth for HDFC bank is
35% and HDFC is 30%.
Given this CAP and GAP performance it is no surprise that their stock returns have been wonderful. HDFC
Bank had price CAGR of 27% and HDFC had price CAGR of 25%.
This performance is not limited to the main companies, but also by Gruh Finance (58% Subsidiary of HDFC).
This company however does not appear in the study because of not meeting the cut of PAT INR 5 Billion.
There is more to follow from the HDFC house. HDFC Standard Life and HDFC Asset Management company
are already listed. At a later date this could be followed by HDFC Ergo General Insurance.
8.1 What is the secret sauce behind HDFC group?
We analyze some industry level and company lever factors what may serve as a checklist to analyze any
long-term prospect of any company in general
8.1.1 Huge Profitable Business Opportunity
• Finance services a profitable and growing business all over the world (not only in India).
• The opportunity size is so vast that the companies need not engage in competition fight within
themselves.
Implication to investing:
High growth industry with a favourable competitive structure gives enough room for new and old
players to have a high and profitable growth
8.1.2 Consumer Facing Business
Most of the business of HDFC group are Consumer facing business, which is secular in nature.
As a rule of thumb, consumer facing business are generally secular in nature. If companies offer a
unique value it gives rise to consumer royalty and potential for repeat business.
8.1.3 Strong Leadership
Group companies have dynamic leaders – Mr Keki Mistry in HDFC, Mr Aditya Puri in HDFC Bank, Mr
Amitabh Chaudhry in HDFC Standard Life, and so on.
A strong leadership with entrepreneurial mindset is a common feature of CAP/GAP companies.
8.1.4 Understanding the 90% Rule
• Every company has the ’90% Rule’, the one factor that is essential for success of business.
• In Finance industry the ‘90% Rule’ is “Underwrite Well”.
• Nobody understands it better than HDFC.

Identify the ’90% Rule’, in the business that you invest in. Make sure that the management has a deep
understanding of the same.
8.1.5 Judicious Capital allocation
HDFC is good in capital allocation. It has allocated capital to fortify its finance powerhouse house-Banking,
Insurance, Asset Management and as on.
Capital misallocation is one of the key factors which lead to breakdown of CAP and subsequently GAP.
Investors must avoid companies having poor capital allocation. Also exit the companies at first sign of
capital misallocation.
8.1.6 Corporate culture
Investors must analyze companies for its culture particularly Integrity and Transparency. Lack of this will
haunt stock prospects, sometimes sooner or later.
Conclusions
CAP and GAP help to harness the power of longevity of wealth creation
• Longevated profit growth companies are very few. CAP and GAP frameworks increase the probability
of identifying those companies.
• CAP is the time during which the company RoE is above cost of equity. Longevity of CAP is ensured
by (1) Favorable industry structure and (2) company strategy.
• GAP is the time during which the company grows it profits above the benchmark indices. Longevity
of CAP is ensured by (1) Industry growth coupled with (2) Company’s growth mind set
• There are two aspects of GAP height (Growth rate) and length (Length of time). Longevity and speed
of growth are inversely proportional.
• There are three characteristics of CAP-cum-GAP companies (1) Clear Strategy (2) Growth Mindset
and (3) High growth industry situation.
• Two of the three characteristics above pertain to management. Hence in analyzing the industry,
through assessment of management. In words of Philip Fisher, Management is 90%, Industry is 9%
and all other factors are 1%.
WCS 2018 – Valuation Insights

Highlights
• The two drivers of Intrinsic Value (1) High RoE and (2) Earnings growth are important
• Intrinsic Value can grow only when the RoE is higher than Cost of Equity
o Low RoE companies must focus to increase the RoE
o High RoE companies must focus on Earnings growth
• Difficult to sustain high RoE and high Earnings growth for long periods of time
• PE-G < 1 is near infallible method to create outperformance
• Current valuation are very high indicates earnings growth expectations. Hence market to remain
soft
Objective, Concept and Methodology

Objective
• The foundation of wealth creation study is to identify and buy stocks substantially below “Intrinsic
Value” or “Expected Value”
• Higher the Intrinsic Value to the current market valuations, greater is the margin of safety
• YoY WCS aims to cull out the characteristics of business that create value to shareholders
• Phil Fisher - “It seems logical that even before thinking of buying any common stock, the first step is
to see how money has been most successfully made in the past.”
• WCS uses the past as a guide to gain insights into various dynamics of stock market investing
Concept and Methodology
• Wealth creation is the process of enhancing the market value of shareholder’s capital.
• This is the basic measure of success for any business venture.
• Wealth creation can be defined as the difference in market capitalization in the last five years after
adjusting corporate events like buy-backs, mergers, demergers etc.
2013-2018 Wealth Creation Study highlights
Three categories of wealth creators: Biggest, Fastest and the most consistent:
• HDFC Bank is the Biggest Wealth Creator for the first time ever
• Indiabulls Ventures is the Fastest Wealth Creator
• Titan Company is the Most Consistent Wealth Creator (All the top 10 Consistent Wealth creators
are consumer-facing companies)
• Financials is the biggest Wealth Creating sector for the second consecutive year
o Biggest Wealth Creator (Private banks and NBFCs)
o Biggest Wealth Destroyer (State-owned banks)
PEG is a solid formula
• For the purpose of PEG calculation, the trailing 12 month PE and 5 year future earning CAGR is
considered.
• If a stock in 2013, had a PE of 20 and the 5 year (2013 -2018) CAGR was around 25, then the PEG
ratio is 20-25 = 0.8

Theme 2018 – Valuation Insights
What works, what does not.
1. Introduction
The success in equity investing is buying and staying investing in a stock with a significant Value-Price gap.
Buffett says, “Price is what you pay, Value is what you get”. So, equity investing process can be put into
three simple steps:
1. Assessing the value of a stock.
2. Comparing this value with the prevailing price.
3. Buy and hold only, if there is a sufficient Margin of Safety. (The price should be significantly less
than value to account for any risk in investing)
MOSL follows QGLP philosophy, where the QGL constitutes the value component. This is compared with P
(Reasonable price). Many past studies focused on QGL. This study focus on P (Reasonable Pricing).
The financial triad of QGLP

1. RoE – Reflects the Q (Quality of
Business and Management)
2. PAT Growth – Reflects G
3. P/E – Helps to determine reasonable
price

• These three variables were studied independently.
• A simplified version of Discounted Free Cash Flow to Equity (DFCEE) offers an intelligent integration
of RoE-PAT Growth-P/E triad.
• Other insights on a few pricing heuristics covered in this study
o PE Ratio (Absolute and Relative to Market)
o PEG
o Payback Ratio
2. Evolution of Valuation
• Different valuation was used in different times – The concept is evolving
• The journey is from Book value-based bargains from the times of Benjamin Graham to RoE based
approach by Warren Buffett
• There is never going to be a final say for valuation
• New tools and techniques will evolve
• Practitioners use what is best suitable for them
3. What is Value
Investopedia defines Intrinsic value as “The perceived or calculated value of a company, including tangible
and intangible factors using fundamental analysis. The intrinsic value may or may not be same as current
market value”
• The word ‘perceived’ in the above definition is very important

• People know the price of everything, but the Value of nothing – A famous quote
• This is because Price is universal to all, but Value is in the minds of investor
• This is the very reason that stocks trade
o A person who sees the price as less than their perceived value buys it
o whereas the person seeing the price as more than their perceived value sells it
• Irrefutable definition of any asset – The present value of all future cash flows
• This method is useful to value fixed income instruments
3.1 Intrinsic Value for Bonds
Initial investment: 1000, Coupon 8% and Annual interest 80.
• Investor 1 considers Discount Rate 10%. Intrinsic value is INR 877.

• Investor 2 considers Discount Rate 12%. Intrinsic value is INR 774.

3.2 Intrinsic Value of Equity
It is not easy to do a similar calculation for equity, unlike the above example for bonds. This approach is
increasing being adopted.
No Fixed Coupon
• There is no fixed coupon in equities unlike the bonds.

• Dividend is the equivalent of coupons.
• This dividend is not consistent and depends on:
o The earning for the year and
o The Dividend payout policy of the company.
• Sometimes even with good earnings, company don’t pay out dividends to accommodate future
growth requirement.
No Fixed tenure and terminal value
• Unlike bond there is no fixed tenure and terminal value.

• Lack of this dimension adds a level of uncertainty in arriving at Intrinsic value.
• It is very difficult to arrive at how long the company would produce the earnings.
Challenge in discount rate
• Intrinsic value calculation is very sensitive to required return (discount rate is the term as used in
the bond/fixed income securities).
• In stock market, every investor has their own expectations on return.
• Accordingly, they arrive at their own Intrinsic Value.
• Choosing the appropriate return value is very crucial for calculation of Intrinsic Value.
4. Two key drivers of Equity Value

The book on Valuation (Check reference to other reads) shows an interesting perspective that DCF is
essentially driven by two factors (a) RoIC and (b) Sales growth
This study is simplified by considering (a) RoE as proxy to RoIC an (b) Profit growth as proxy to Sales growth

4.1 Interplay between RoE and Growth determines Free Cash Flow
• Growth is a choice – It is for the company management to choose embark on growth.
• If they want to grow, what is the growth rate?
• The decision on growth rate determines the amount of incremental reinvestment needed.
• This reinvestment depends on the RoE.
• Let us assume that a company currently enjoys a PAT of INR 100.
• The company chooses to grow at the rate of 20%
• There are different scenarios based on varying RoE.
RoE (%) Reinvestment Free Cash Flow

(INR) (INR)
25 80 20
20 100 0
15 133 -33
• The last case of RoE – 15% would need fresh capital infusion.
• Takeaway: RoE must be above the growth rate to avoid any additional capital requirements.
Balance Sheet and Core RoE
• Many Indian companies over a period of time have accumulated a huge amount of cash, more than
what they needed for their immediate requirement.
• This huge cash may earn 4-5% post tax.
• This low return on cash component mutes the overall RoE
• Thus, comes two kinds of RoE –
o Balance Sheet RoE
o Core RoE
• The issue now is which of the RoE must be considered in the calculation that we discussed in the
previous section.
• Market is efficient to compute the core RoE and value the companies accordingly.
• But in some cases, market fears of capital misallocation and hence have low valuations.
• Companies must reduce the gap between Balance sheet and core RoE by a combination of:
o Higher dividend payout and
o Share Buybacks

4.2 All Growth is not necessarily good
Market reward earnings growth. In the short and medium term, companies with high earnings growth are
rewarded by investors by the way of higher stock prices and market value. But not all growth is good.
• If RoE < Cost of Equity, then higher growth reduces firms value, as more capital has to be raised from
equity holders to fund growth. (Refer case of RoE 10% in the table).
• If RoE = Cost of Equity, there is no use of any level of growth. The PE in this case is 1/(Cost of Equity)
= 1/13 = 7.7 (Refer case of RoE 13% in the table)
• Growth adds positive value only when RoE > Cost of Equity
• If Growth = 0, any level of RoE does not add value to the company. The PE in this case is 1/(Cost of
Equity) = 1/13 = 7.7

4.3 Beyond a point growth adds more value than RoE
• Different iteration in DFCFE shows that increase in RoE beyond a certain level does not add value
correspondingly
• Beyond RoE > 40-50% leads to lesser rise in PE ratio. (Refer Exhibit 10)
• Once RoE is comfortably above Cost of Equity, investors (and company management) must focus on
earnings growth to drive value, instead of expanding RoE
• In the other end of spectrum, companies with low RoE add much value by raising RoE than growth
Exhibit 10 is for companies with high RoE, higher growth gives benefits. / Exhibit 11 is for companies with low RoE, higher RoE
gives benefits.
4.4 Earnings Growth and Stock Valuation are exponentially related

• Once the RoE is above Cost of Equity, the Earnings Growth and Stock value are exponentially related.
• A stock with 40% growth commands a forward PE of 67x where as a company with 50% growth
command a forward PE of 108x.
5. RoE, Earnings Growth and Stock Returns – The Indian Experience
The 20 year RoE data of 1500 top listed companies were studied and following were the inferences:
High RoE is rare
On an average:
• 52% companies have RoE less than Cost of Equity (13%).

• 19% companies have RoE greater than 25%.
Sustaining RoE above Cost of Equity is a Challenge
• In 1998, there were 136 companies with RoE above 13%.

• This dropped steeply in next 7-8 years, followed by a gradual decrease.
• There are only 22 companies in 2018.
Like High RoE, High Earnings Growth is also difficult

On an average:
• Nearly 60% of companies have a 5 year PAT CAGR of less than 15%.
• Remaining 40% companies are almost equally divided to 15-25% PAT CAGR and 25%+ PAT CAGR.
• Hyper Earnings Growth is rarely retained above 5-6 years.
Implications to Stock Investing
• Market tends to extrapolate recent earnings into the future.

• If a company is in phase of hyper growth, then markets extrapolate too far into future and there by
bidding up valuations.
• Hyper Growth does not last beyond 5-6 years.
• This prevents smart investors to invest in such companies based on unrealistic growth expectations.
• Investors holding companies in the Hyper growth must seriously consider exiting the stocks, if the
valuations are very high. (Refer Section 6 which suggest that PEG > 3 or Stock PE twice the Market
PE).
What works - High Roe, High Growth stocks
• Classified stock on the basis of 10 Year:

o Average RoE below and above 15%
o Earnings CAGR below and above 15%
• This gives to a 2x2 matrix with 4 possible combinations.
• Returns generated by this 4 categories is shown in exhibit 17.
• The High RoE / Growth stocks has outperformed:
o The bench marks for all periods of study.
o All the other strategies have underperformed – except in 1998-2008 slow, which is a
aberration.
• Emphasize this approach with reasonable valuations.

6. Reasonable Price
What works and what does not
• What is the difference between valuation and pricing of any asset, in our case stocks?
• Valuation is fundamental assessment of intrinsic value of a stock based on the expected future cash
flows.
• Pricing is more empirical and heuristic.
• The basis of such pricing is using appropriate multiples PE, Price-Book, Price-Sales and EV/EBITDA etc.
• Pricing is likely to relative more than absolute i.e. depending on what the comparable stock or
benchmark is priced at.
• Four pricing techniques were studied PE, PE relative to market, PEG and Payback Ratio.
6.1 PE
• This is the most used pricing ratio.
• The common mantra is ‘Buy Low-PE Stocks’
What Works What does not Work

• Buying low PE gives some chance of an • Buying PE > 50 does not work.
insignificant alpha. • High PE suggest that most of the optimism in
• This is not consistent. Many times, has given stock has been already priced.
negative alpha.
6.2 PE relative to Market

• When market is buoyant, individual stocks appear to be expensive.
• Pegging their valuation to market levels would appear justified.
• Stocks with superior performance would be expected command a premium over the market PE.

• Buying stocks below market PE gives some • Buying 2x above the market PE is a recipe for
chance of an insignificant alpha. underperformance.
• This is not consistent. Many times, has given
negative alpha.
6.3 PEG
• PEG is a short form of PE to Growth Ratio
• For calculation purposes
o PE considers the training twelve-month (TTM) value
o Growth considers the forward 3-year earnings growth
• This forward earnings growth could be for any number of years.
• However, for the purpose of study MOSL has considered it as 3 year period.
• Thus, if March 2015 P/E is 30x and 2015-18 PAT CAGR works out to 25%, then March 2015 PEG is
1.2x (30÷25).

• Buying PEG less than 1 is handsomely • Avoid PEG > 1.5
profitable. • PEG > 3 is a warning sign.
• PEG < 0.5 is much better.
• PEG < 1 is profitable even for different growth
periods ranging from 1-5 years.
• This depends on the number of years of insight
that the investor has on growth
6.4 Payback Ratio

• This is the proprietary ratio of MOSL
• Lower the ratio, higher the stock returns.

• Buying with a Payback Ratio of < 1 is highly • Payback Ratio > 3 is a clear sign of
rewarding. overvaluation.
• Even a ratio of 2 times, gives some chance of
outperformance.
7. Current State of Valuations
7.1 Built in Expectations of the Current Sensex Valuations
Different iterations in DFCFE was carried out to calculate the built-in expectations in the current Sensex
Valuations. The results:
• RoE of 17% - against the 13% currently.

• 5 Years Earnings CAGR is 16% - against 3% in the last 5 years.
Robust corporate profit growth is elusive, else market to remain soft.

Annexure – RoE and Earnings Growth Drivers
Drivers of RoE
Two major factors drive company RoE:
1. External – Industry Structure
2. Internal – Company Strategy
External - Attractiveness of Industry Structure
• RoE varies across industry based on the competitive dynamics governing them.
• The Five Forces Framework of Michael Porter helps to understand the attractiveness of an Industry
structure. (Refer WCS 2017 for details of this framework)
• Higher each force, lower is the attractiveness of the industry.
• Companies in the industry with score above 3.5 tend to have higher RoE than those with the ones
in the industry with lower score.
Refer WCS report for Porters Five Forces score for different Industries.
Internal - Effectiveness of Company’s Strategy
• Within the same industry, different companies could have different RoE.
• This is because the company’s strategy plays an important role in determining the RoE.
• Strategy is all about creating, maintaining and improving the competitive advantage over its rivals.
• A company with sound strategy is likely to enjoy and sustain high RoE.
• Michael Porter identifies three kinds of strategies (1) Product Differentiation (2) Low Cost and (3)
Focus
Product Differentiation
• This is about offering a unique value proposition to the clients which is not easily replicated by the
competitors.
• This ensures consumer royalty, higher sales, profit and RoE.
• E.g. All the consumer facing companies offer something unique to its customers
Low Cost
• Where product differentiation is not possible, low cost in comparison with peers is the only option
to sustain competitive advantage.
• E.g. Products like paper, steel, cement etc. are undifferentiated in the eyes of the customer.
Focus
• Special case of companies with focus in one segment or a niche area.

• E.g. Symphony for air coolers and JK bank only for the state of JK.
Stuck-in-the-middle
• Companies not having any of the above strategies.

• E.g. Many of the PSU.
What Hurts RoE
• External Factors
o Disruptive competition

o Prolonged business downcycle
o Regulatory shocks
• Internal Factors
o Capital Misallocation – Mega acquisition or unrelated diversification
Drivers of Earnings Growth
Two Major Factors
• External – Industry Growth

• Internal – Company Growth Mindset
External - Industry Growth
Global and Economic Growth
Refer WCS 2017
Value Migration
Refer WCS 2017
Internal - Company Growth Mindset
Refer WCS 2017
What hurts growth?
• Industry maturity
• Weakening competitive advantage
• High base effect
Interesting Insights
Wealth Creation, Valuation parameter analysis

Conclusions
• Two drivers of value (1) RoE and (2) Earnings Growth.
• Value is created only when RoE is greater than Cost of Equity. If RoE is equal to Cost of Equity, any
amount of growth is of no value.
• Low RoE, companies must aim for higher RoE.
• High RoE companies must aim for increasing earnings growth.
• Both High RoE and High earnings growth are not sustainable, particularly high earnings growth.
• PEG < 1 is an infallible formula for healthy outperformance.
• Any growth insight, even if it means one year.
• PE > 50 have less chances of market outperformance.
• Use QGLP where longevity of growth is around 5-6 years and PEG < 1.
• Investor must consider selling even, if any of them is higher:
o PEG > 3
o Stock PE is 2 times the Market PE
WCS 2019 - Management Integrity – Understanding Sharp Practices

Highlights
• In equity, Management is 90%, Industry is 9% and rest all is 1%. Hence getting the management
right is the first and critical step.
• There is only one way of writing honest accounts and infinite ways to manipulate them
• Sharp practices are intended to inflate profits and stuff “Financial Trash” in balance sheet
• P&L statements are easy to manipulate and hence companies must be mandated to present a
simplified Cash Flow statement
• Auditors must be made accountable to minority shareholders to avoid sharp practices by
management
• Investor must have forensic mindset to get management’s explanation for perceived sharp
practices
• Discuss with all stakeholders – Customer, employees, suppliers and competitors – Till you arrive at
a moment of integrity
“The best defence against fraudsters is to run away from them as fast as possible at the first hint of sharp
practice. With more than 50,000 different stocks available to investors in this country, it is not only
unnecessary but downright stupid to buy into a company run by men of doubtful integrity.” (Thomas
Phelps, in his book, 100 to 1 in the stock market)
1. Backdrop
• Number of companies listed in 2014: 3440
• More than 1/3rd of the companies have lost market value of more than 70%
• The reasons are due to business down turn and corporate governance issues

MOSL QGLP Philosophy
There are three metrics to assess Quality of Management

1. Unquestionable Integrity
2. Demonstrable Competence and
3. Growth Mindset
There are sufficient experience that investors when stuck with management of low integrity the result is
wealth destruction. This study focusses on few aspects related to management integrity
• The motivations behind compromised integrity

• Quantitative signals of suspect Management Integrity with relevant examples and
• Indian case studies where Management Integrity was seemingly compromised
2. What is Management Integrity

Honesty and sense of trusteeship towards all stakeholders. In the Wikipedia definition of Integrity there
are two key words
Practise: Management Integrity should be practise and not simply a statement in its corporate value
system
Wholeness: The scope of management integrity i.e. The management needs to be honest, fair and
consistent to all stakeholders like employees, customer, supplier, shareholders, government and
community at large
Stakeholder Company Behaviour

Corporate parent / founders • No or minimal conflict of interest (e.g. Royalty for brand,
technology)
• No or minimal related party transactions
Senior Management Reasonable compensation relative to company median
Calibrated stock options
Employees Courtesy and respect to all employees
Adequate opportunities for personal and professional
development
Fostering sense of ownership through calibrated stock options
Customers Offer products/services matching their expectations
Retaining customer through loyalty programs
Fair post sale dealings i.e. Warranties, repairs etc
Suppliers Fair terms of trade
Collaborating for innovations, where relevant
Shareholders Presenting a true and fair view of company’s affairs through
annual and interim reports (I would include concalls and
investor presentations)
Rational policy of pay-out (Dividends and/or buybacks)
Government Timely payment of tax dues, both direct and indirect
Abiding by law of land in all matters
Community & Environment Have a active CSR program
Ensure compliance to all community norms e.g. Effluent
treatment, waste management etc
3. Why Management Integrity is Critical

Else it is a race to Zero!
• In the QGLP philosophy all elements are multiplicative rather than additive
• So even if one of the element is zero, the output is zero
• Q -> Quality of Business and Management
For the purpose of simplicity, this study combine growth mind set as a subset of demonstrable
competence. This is to create a 2x2 grid with Management Integrity and Competence. Only those
companies with rank high in both these aspects needs to find place in an investor’s portfolio.

Note: It is important to distinguish between integrity and competence. Not all failures are due to integrity.
There may be business externalities, lack of competence and mistakes in ill-timed capacity expansion or
acquisition.
Maintaining high level of integrity is beneficial to all stakeholders including the owners and senior
management. Yet managements are motivated to compromise on integrity. We will see the reasons in the
next section.
4. Why Management Integrity gets compromised

The lure of the lucre
Management Integrity is mainly compromised to present a favourable view of the company to equity
markets. Such attempts to “manipulate stock prices”, is motivated due to following reasons
• Growth mania
o Wide spread reason for Sharp Practices is to demonstrate (or even manufacture) growth
o Growth mania is not only with investors but also with owners/entrepreneurs
• Raising equity capital
o Many business (Especially Finance sector) need regular infusion of capital for its growth
o This capital is mainly raised through equity
o Higher the stock prices, better it is for the incumbent shareholders
• Compensation linked to stock performance
o Many senior manager compensations are linked to stock price performance
o Hence, they are motivated to maintain elevated stock prices
• ESOP
o Many senior managers own ESOP of their respective companies, which again motivates to
have higher stock prices
• Mcap is currency
o Companies with high growth mindset use their Mcap currency to acquire another business
through equity swap route rather than cash purchases
• Personal wealth enhancement / Halo of Mcap
o Higher market cap significantly enhances the worth of owners in a social setting
o Some promoters are in the contention for the global pecking order of the wealthiest
individuals
Apart from these factors, there are other motivators like meeting debt covenants, maintain credit ratings,
meeting stock market expectations of previously given guidance and a penchant (Meaning: Liking) for tax
evasion are a few to name
5. When does Management Integrity typically gets compromised

No checks and balances
It can happen when the following conditions prevail
• Weak Board of Directors, which fail to challenge the senior management on issues like accounting
policy, related party transactions, senior management compensation etc
• Management devoid of checks and balances, invariably leads to an alpha leader who takes all major
corporate decisions
• Auditors lacking objectivity, independence and due diligence
Where does compromised Management Integrity reflect? Enter Sharp Practices! The management now
uses all tricks in trade to present a rosy picture of its affairs, when it is not.
6. What are Sharp Practices

Only one right way to present accounts, infinite ways to manipulate them
• Sharp Practices – Ways of behaving, especially in business, that are dishonest but not illegal
• One Sharp Practices is started, it is tough to say when it degenerates into intentional fraud

Two major areas of Sharp Practices by companies
• Accounting related
• Non-accounting related
Note: The Sharp Practices covered here pertain to non-financial sector, where money gets converted to
raw materials, finished goods leading to sales and back to cash. There is also a capital expenditure overlay.
However, in financial sector, money retains its forms in all stages of business. This makes it difficult to
identify Sharp Practices and Management Integrity in financial sector.
6.1 Accounting Sharp Practices – The backdrop
“I can’t afford the operation, but would you accept a small payment to touch up the x-ray?“ — Warren Buffett
• Authors Howard Schilit, Jeremy Perler and Yoni Engelhart use the above quote in their book
“Financial Shenanigans”.
• A company’s financial statements, X-ray of its financial health.
• Buffett warns investors about companies that try to hide their true and fair financial view by merely
“touching up” the financial statements.
• Buffett adds, “In the long run, however, trouble awaits managements that paper over operating
problems with accounting manoeuvres. Eventually, managements of this kind achieve the same
result as the seriously ill patient.”
• Schilit et al identify two broad categories of accounting shenanigans or Sharp Practices –
o Earnings manipulation
o Cash Flow shenanigans
• The relationship between Earnings and Cash Flow is somewhat similar
• Companies try their best to project the best earnings, only to dump financial trash in the Balance
sheet, reflecting in Cash flow
• The double entry accounting term for this is: Credit P&L A/C, Debit Balance Sheet
• There are two components of Balance Sheet debit side in the asset side
o Working Capital
o Fixed Capital
• Items credited in P&L, charged to Working Capital side (E.g. Debtors) gets captured in Operating
Cash Flow
• Smart investors are aware of this and hence closely monitor OCF apart from profits
• But now companies have become much smarter
• They now charge operating cash outflows to the Fixed Capital side, so that OCF remains robust
• To complete the cycle resort to lower depreciation policy, so that the loading of Fixed Capital side
does not hurt P&L
Example:
A hypothetical example presents P&L, Balance Sheet and Cash Flow Statement in 3 cases –
1. True Case i.e. how the books should actually have been in Year 1 compared to Year 0
2. Case A of Sharp Practice 1 in Year 1, inflating Sales by 200 in the P&L and Debtors by 200 in the
Balance Sheet
3. Case B of Sharp Practice 2 in Year 1, capitalizing R&D costs of 200.
The P&L, Balance Sheet and Cash Flow Statement of all these 3 cases will appear as follows.

6.2 Common Accounting Sharp Practices
6.2.1 Recording Bogus Revenue
• Clearly is an outright fraud on all stakeholders of a company

• It is invariably masterminded by the top management of the company.
• The accounting entry: Credit Sales A/c, Debit Debtors A/c
• Impact: Sales gets boosted but Operating Cash Flow (OCF) gets deflated
• Key metric to monitor in such situation: OCF-to-PAT i.e. how much of PAT is getting converted to
Operating Cash Flow.
• Indian cases
o Case study 1: Satyam Computer Systems
o Case study 2: Manpasand Beverages
6.2.2 Shifting current expenses to a future date
Deflating depreciation by changing accounting policy
• Depreciation is a non-cash charge in the Profit & Loss Statement.

• The spirit of this accounting head is to provide for the renewal and/or replacement of the Fixed
Assets currently being utilized by the company.
• In most cases, depreciation is equally amortized over the life of the asset - This is invariably an
estimate by the management.
• The following table illustrates how depreciation expenses can be deflated and profits inflated by a
mere change in policy
Inflating profit by capitalizing expenses
• Accounting standards offer company managements the leeway to capitalize some operating
expenses (labor cost, interest on loans, etc) in specific situations such as projects under
construction.
• Sharp Practice: Over-capitalize such expenses, thus inflating current profit and bloating fixed assets
on the Balance Sheet.
• The double-entry here is: Credit Expense A/c, Debit Fixed Assets A/c
• Similarly some companies may capitalize R&D expenditure or heavy brand-spend on grounds that
the benefit of such expenditure will accrue for multiple years in future.
6.2.3 Recording revenue too soon
Sharp Practice: In cases like construction companies, which may bill revenue before the due share of
contract is completed, or at times, before getting the customers’ approval.
6.2.4 Boosting income using one-time activities
• During bad times, companies may resort to practices such as one-time sale of land or other assets.
• At times, companies may even resort to sale and lease-back of their core operating assets, optically
boosting profits and return on capital.
6.2.5 Shifting current incomes to the future or future expenses to the current period
• Most companies are focused on inflating current profits, and hence, this Sharp Practice is rare.
• Still, some companies may prefer to smoothen their annual earnings growth by shifting some
incomes to a future period, or by creating floating provisions for expenses which may be incurred in
the next accounting period.
6.2.6 Sharp Practices during acquisitions
• Many times, companies try and clean up their accumulated Sharp Practices only via acquisition of
another company.
• Satyam Computer attempted to acquire Maytas Infrastructure from the promoter group to settle
the inflated cash balance.
• Sharp Practices such as unrelated acquisition or overvaluation of assets acquired are commonplace.
6.2.7 Off-Balance Sheet Sharp Practices
• Companies can even take some items of the Balance Sheet.

• For instance, companies may discount some debtors (i.e. trade bills) with the banks.
• If there is recourse to them (i.e. they are still finally liable), then such discounting gets mentioned
under Contingent Liabilities, but off the Balance Sheet.
• In other cases, companies may stand guarantee for loans taken by associates or other related
parties, which again will appear as Contingent Liabilities, off the Balance Sheet.
6.3. Non-accounting Sharp Practices
6.3.1 Related Party Transactions
• Companies many have many RPT with subsidiaries, associate companies and key management
personnel
• This is the key modus operandi for siphoning funds by managements with low integrity
• RPT details are available in annual reports
• Investors must go through this to get vital clues to Management Integrity
6.3.2 Earnings guidance
• Companies hold investor calls with equity analysts and investors post quarterly results
• During these calls, it is common for managements to give guidance on future revenue and earnings
• Managements with low integrity misguide investors or conceal known future disappointments
7. Sharp Practices in Financial Sector

If you don’t know jewellery, know the jeweller
• Financials form 40% of India’s leading indices

• Despite being a big sector, much literature is not available on the Sharp Practices of this sector
• For other sectors, cash flow filters can be used to separate wheat from chaff
• But this filter cannot be used for financials
• Lending companies are leveraged entities, running with 3x to 5x leverage
• With this level of leverage, a smallest Sharp Practice can lead to significant erosion of net worth and
shareholder value
• Investors need to be careful when investing in Banks and NBFC
• A few of the practices used in the financial sector is below
7.1 Upfronting income and amortizing expenses
The most common Sharp Practise is aggressive recognition of income which can be in the form of:
1. High Fee Income on a loan in exchange for lower Annuity Interest Income
2. Upfront recognition of Income received on sell down of loans
3. Aggressive Third Party Product selling target
4. High Debt Syndication revenues.
Most of these the values are above industry average or sudden jump/volatility in margin trajectory

7.2 Recognition of bad assets
• This was the trickiest in Indian Financial Sector prior to implementation of IBC (Insolvency and
Bankruptcy Code) and AQR (Asset Quality Review)
• It was easy to evergreen, pass the loan or even hide it altogether
• NPA have risen post RBI audits
• With IBC, system of SMA (Special Mention Accounts) in reporting, and immediate disclosure of RBI
audit results have given little room for misuse in this area
• The other part of financial system is HFC and NBFC where the RBI AQR has not been done
• Investors should stay in caution – This sector can throw up a few negative surprises like DHFL
7.3 The issue of “large”
Granularity is the key to mitigate risks in lending. The biggest errors are made in “large” sizes.
7.3.1 Large ticket size
• Large ticket size lending, increases the lumpiness of stress for lenders and makes it difficult to
navigate during tough times
• Classic case the power crisis – Low demand and lack of consistent fuel availability led to significant
crisis to lenders
• This sector had increased its loan book drastically over 2005 – 2010
7.3.2 Large Collateral
Biggest folly in collateral based lending
• In collateralized lending, liquidity is as important as the size and value of the collateral
• Larger the size of the collateral, lesser the liquidity and hence lesser is its worth (Rendering the
collateral useless)
• Example: Loan against shares – A 20% stake of promoter with Loan to Value (LTV) of 50% may be a
tougher collateral to liquidate than a 0.1 stake in the same company of a retail investor with even a
higher LTV
7.3.3 Large Loan Book
• Not even a single NBFC was rated below AA whose loan book was greater than INR 300 Bn as on
Sep 2018
• Size begets rating and rating begets more funding which in turn leads to bigger size
7.4 Trade checks and Sample study
• There are shenanigans in every sectors and most of them are perennial borrowers
• These persons are mostly black listed in the trade but have favour of some lender
• A quick check of industry participants can give a good sense of quality of the borrower and in turn
the process of lender
7.5 Organization structure
• Look at the organization structure of lending institutions i.e. Segregation of Credit Appraisal and
Business
• The credit team is the most effective internal auditor had a bank has, and if its incentives are linked
to the business of the firms, then it is recipe for disaster
• They are like brakes to car and imagine a situation brakes not working in a speeding car
• The second aspect is look for the subtle difference between retail and wholesale lending structure
o With the advent of credit score and big data analytics, the function of collections can be
undermined
o In retail lending getting collection is more important than credit and lending
o In whole sale lending, appraisal takes centre stage
• This difference should be investigated before investing in lending organisation
8. Other checks on Management Integrity

Auditors report, top management changes, pledged shares and a 360 feedback
8.1 Auditors Report
• In India the auditors are expected to give a report on the state of company’s financials not only at
the end of the year, but also a limited review report for every quarter
• Investors should closely monitor the remarks for any evidence of Sharp Practices
8.2 Top management changes
• Top management: CFO, CEO and Company Secretary
• Frequent changes are a sign of trouble brewing
• Resignation of statutory auditors is almost a certain sign of financial irregularities
8.3 Promoter pledging
• Promoters pledging shares is a serious concern for minority share holders
• Promoters pledge their holding with banks or NBFC to raise funds and pursue their personal
business ambitions
• If that project fails, the lender begins to offload the pledged shares
• This creates a domino effect driving the value of all shareholders
8.4 360 degree feedback
• “You can fool some people all the time, and all people for some time. But you cannot fool all people
all the time.”
• 360 degree feedback on Management Integrity must be must in every investor’s checklist
• Such a checklist would minimum include
o Non executive members of the BoD
o Employees – Current and Ex
o Customer
o Dealers / Distributors
o Suppliers and
o Competitors
The purpose of this exercise is to look for various Sharp Practices is to identify the “moment of integrity”
which Michael Shern mentions in his book “The Investment Checklist”. It is the final piece of clinching
evidence of whether a management is honest in its dealing with its stakeholders
Case for a simplified Cash Flow Statement
• It is easy to manipulate P&L but much more difficult to escape its aftermath in the Cash Flow
Statement.
• However, the current three-tiered Cash Flow Statement – Operations, Investing and Financing –
does not present investors with a clear picture of the P&L-Balance sheet sharp practices.
• Hence, we propose that companies be statutorily asked to present a simplified Cash Flow
Statement along the lines shown below.
Conclusions
Invest only if you can arrive at that Moment of Integrity
• In equity investing, management is 90%, industry 9% and 1% everything else. Hence, getting
Management Integrity right is the critical first step.
• There’s only one way of writing honest accounts, and infinite ways of manipulating them.
• The first hint of compromised Management Integrity can be found in the published financial
statements of companies.
• Most Sharp Practices are to inflate profits and stuff the “financial trash” in the Balance Sheet
(Credit P&L, Debit Balance Sheet). Hence, it is very important to juxtapose a company’s Cash Flow
Statement along with its Profit & Loss Statement.
• Profit & Loss statement is easier to manipulate; hence, managements must be statutorily asked to
present a simplified Free Cash Flow statement.
• Auditors must be made more accountable to minority shareholders to avoid Sharp Practices by the
management.
• As an investor, have a forensic mindset to get management’s explanation for all the perceived
Sharp Practices.
• Finally, interact with various stakeholders – customers, employees, suppliers, competitors, etc – till
you arrive at that moment of Management Integrity.
ANNEXURE
Sharp Practices – A few Indian Case Studies
Sharp Practices Case Study #1 - Satyam Computer Services
Satyam Computer’s case study arguably takes the dubious distinction of the mother of all corporate frauds
in India.
Modus operandi
• The key behind Satyam’s fraud appears to be its promoter’s keen interest in real estate.
• Ramalinga Raju even inflated the payroll and embezzled money out of the company by way of
salaries to fictitious employees.
• All the while, he also inflated the company’s cash balances which were visible in the system.
• By 2008, the “cash balance” had ballooned to over a billion US dollars.
• That’s when Raju sought to merge the group’s real estate business into the company, so that there
may be real assets created against the fictitious cash.
• However, that deal did not go through, forcing Raju to do the confession
The red flags & the bust
• The fraud was so well managed (most likely in collusion with internal and statutory auditors) that
there was hardly any trail of evidence.
• In hindsight, the only weak case was the company’s Other income, which was very low compared to
its cash balance. (Not clear)

Sharp Practices Case Study #2 – Manpasand Beverages
Modus operandi
• The company is alleged to have overstated its revenues and profits.

• The company set up 30 fake units across the country. Purchase and sale transactions were then
shown with values inflating with each transaction in order to claim a cumulatively large.
• These inter-unit transactions were worth over INR 3 billion and their input tax credit would come
up to INR 0.4 billion.
• Incongruence in market share data, too-good-to-be-true growth and industry-leading margins were
the red flags prior to the auditors resigning in May 2018.
• In FY19, the company wrote down its sales and receivables by issuing a credit note of INR 1.8
billion, and providing for a credit loss of INR 1.2 billion on its receivables.
• To divert funds, capital work in progress and capital advances seem to be inflated as well.
• An amount of INR 2.7 billion has been provisioned for losses in FY19.
• The promoters were jailed for GST fraud in May 2019. The company has deposited INR 178 million
with the GST authorities under protest to secure their release.
Sources:
[1] – Business Today, 9-Oct-19 – “Is Manpasand Beverages among the biggest corporate frauds in India?”
[2] – Money Control, 31-May-19 – “How a Rs 40-crore GST fraud unfolded at Manpasand Beverages”
Sharp Practices Case Study #3 – Educomp

Modus operandi
• The company sold equipment to schools which was financed by Educomp and recognized it as
revenues.
• The schools were unable to repay the loans and the assets (mostly computers) had lost significant
value leading to little recovery.

• The intent here may not have been malafide but it was a case of providing funding to a weak set of
clientele on basis of poor collateral.
• Educomp used a subsidiary, discounted its receivables, and stood guarantee for the same. This
helped it manage debt levels by moving it off the Balance Sheet (in this case, Contingent Liability).
The guarantee was with recourse and should have been deemed as leverage.
• Aggressive Accounting with respect to booking revenues upfront for asset sale. This led to creation
of assets through borrowings and the same was booked as revenues and profit.
• Continuous negative cash flows meant that the pace of asset sale was much faster than the
revenues coming in.
• In FY13, the company went into debt re-structuring and by FY17, the company’s net worth was
negative.
Sharp Practices Case Study #3 – Gitanjali Gems

Modus operandi
• High Receivable days of at least 150 days and going up to 300+ days in the period FY08-14.
• Inventory buildup was also significant which eventually saw significant write down in 2014.
• Promoter pledge and share price – In July 2013, SEBI barred the promoter of the company Mr
Mehul Choksi and 26 other entities from trading in the market for a period of 6 months. It is
believed that the promoter along with these entities was indulging in market manipulation of
company's shares. This led to a huge correction in stock price.
• Tax rates and dividend payouts were mostly in single digit.

• Operating Cash Flow conversion was consistently low.
• Sales to related parties were in the range of 15-22% of total sales. (How to identify this?)

Other Insights
Trend of wealth creation
• INR 49 trillion Wealth Created during 2014-19

• Over the 5-year period 2014-19 (ended March), the top 100 Wealth Creating companies created
wealth of INR 49 trillion. This is the highest ever in any 5-year span in the past.
• The pace of Wealth Creation is also robust at 22% CAGR vis-à-vis 12% for the BSE Sensex
Key take away: Top wealth creators have created more wealth than the bench mark indices – Forget
Markets, think stocks
Biggest Wealth Creators
• After a gap of 7 years, Reliance Industries has once again emerged the biggest Wealth Creator over
2014-19.
• INR 5.6 trillion wealth created by Reliance is the highest ever so far by a huge margin.
• Reliance’s P/E re-rating from 15x in 2014 to 22x in 2019 is a key driver behind the 24% stock return
CAGR. Its PAT CAGR along the while was only 14%.
Key Takeaway: Reliance’s resurgence too may be partly attributed to Value Migration – expected value
unlocking in Reliance Retail (VM from mom-n-pop stores) and Reliance Jio (VM from voice to data).
Consumer and Non Consumer facing companies

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Notes of MOSL Wealth Creation Studies

- Venkatesh Jayaraman (@EWFA_)

Notes of Wealth Creation Studies Page 1 of 90

Notes of Wealth Creation Studies Page 3 of 90

• Value Migration is increasingly the key for Wealth Creation

• There are difficulties in picking up a 100x

• There are three cross overs possible

4. Why Mid to Mega?

• There are 9 possible cross overs within these 3 categories of stocks

4.1 Performance profile of Mid-to-Mega portfolios

Notes of Wealth Creation Studies Page 6 of 90

4.3 Matrix of three cross overs and associated probabilities

Notes of Wealth Creation Studies Page 7 of 90

Notes of Wealth Creation Studies Page 8 of 90

5. What is takes to achieve Mid-to-Mega?

Notes of Wealth Creation Studies Page 10 of 90

Notes of Wealth Creation Studies Page 11 of 90

Notes of Wealth Creation Studies Page 12 of 90

Management Quality Indicators

Brief details of Matrix quadrants

Notes of Wealth Creation Studies Page 14 of 90

5.3.4 Sustained sector tailwind

Notes of Wealth Creation Studies Page 16 of 90

Notes of Wealth Creation Studies Page 17 of 90

The back test approach

Notes of Wealth Creation Studies Page 18 of 90

7.1 Why Mega-to Mid happens?

Notes of Wealth Creation Studies Page 19 of 90

Insights: Consumer/Retail emerges as the biggest Wealth Creating sector

WCS 2016 – FOCUSED INVESTING – POWER OF ALLOCATION IN WEALTH

• TCS – Biggest Wealth Creator for the fourth time in a row

• Two aspects of equity investing

Notes of Wealth Creation Studies Page 21 of 90

2. Kelly’s Formula – Insights for Equity Investing

• John Larry Kelly Jr (Mind 1950), Scientist with Bell Labs

Betting this fraction (f) repeatedly maximizes the long-term growth

2.1 Kelly’s for Equities – Meaning is more relevant than Mathematics

Notes of Wealth Creation Studies Page 22 of 90

• In gambling the outcome of a win-loss of a bet is instant

• This variant can be interpreted mathematically and non-mathematically

Notes of Wealth Creation Studies Page 24 of 90

Notes of Wealth Creation Studies Page 25 of 90

4. Four Keys to Successful

Notes of Wealth Creation Studies Page 26 of 90

4.2.2 Growth in Earnings

• Rank the stocks in descending order of their expected 3 or 5-year returns

Notes of Wealth Creation Studies Page 28 of 90

ANNEXURE: Warren Buffett on diversification and allocation

Notes of Wealth Creation Studies Page 29 of 90

WCS 2017 – CAP & GAP

• Companies with long run of profit growth are few.

Theme 2017 – CAP & GAP

If you don’t have competitive edge, do not compete. — Jack Welch

Notes of Wealth Creation Studies Page 31 of 90

• Every company has a life cycle (Ref. exhibit 3.)

• Measure the longevity in both growth and competitive advantage.

2. Two Dimensions of Longevity

• The two dimensions of a company longevity are

Notes of Wealth Creation Studies Page 33 of 90

Notes of Wealth Creation Studies Page 35 of 90

Porters Five forces – Implications and Examples

Notes of Wealth Creation Studies Page 36 of 90

Force 2: Threat of new Entrants