OF LONG-TERM VALUE & WEALTH CREATION FROM EQUITY INVESTING OBSERVATIONS, IDEAS & REFLECTIONS BHARAT SHAHACKNOWLEDGEMENT Quest for value and wealth creation, through investing, is an eternal one. This search, unlike Physics, is not entirely intuitive or contemplative. Pure Physics (or theoretical one), unlike applied Physics, is very abstract and conceptual. Empirical evidence, usually, comes much later. Take, for example, Higgs Boson or Theory of Relativity. Theory was formulated, in each case, much before it was possible to validate the theory with an observation or an experiment. Fortunately, good investing does not call for such high skills. Also, a body of recorded evidence and a set of observations help in formulating many investment principles unlike the other way round. Some level of intuitive skills is also called for in investing which makesita blend ofartand science. In the enclosed study, covering a period of a decade, an attempt has been made to cull out some investment principles. They have been sought to be affirmed from the observed data in the Indian context. The investment principles have always existed for quite some time. The study has largely focused on validation of the same. Ithas benefited from all the prior good work. The study efforts have spanned well over six months. It has been a tremendous team effort to make it happen. While many have helped, directly or indirectly, some individuals stand out. Sudhir Kedia and ‘Sumit Jain have made enormous contribution with their outstanding data crunching efforts as welll as by being, generally speaking, critical sounding board, in crafting and shaping many thoughts. So much of data has been looked at and appropriately layered. None of that would have been possible without their invaluable efforts, Rajdeep Singh and Darshit Sheth have worked tirelessly at all the stages. Right from the stage of encapsulating of the thoughts, converting them into clean readable copies, formulating them and reformulating them, both Rajdeep and Darshit have played stellar role. They have been actually human machines! Parth Trivedi has also chipped in with a lot of support from Without any over-statement, this study would not have seen the light of day, without the support, help, ‘thoughts and perseverance of al of them. And there have been others who have generally encouraged, cheered and egged on to carry ahead, when the efforts started looking more like workand when often, it became over whelmin ie to time. Hope you enjoyitas much asitwasajoyincreatingit. BHARATSHAH February 08,2013Table of Contents INTRODUCTION 1 SIZEOF OPPORTUNITY + Size of Opportunity isa Foundation for Continual Growth (of profits) and Creating a Compounding Machine: Foundation on which Large Value Creation Rests. It is Less about How Large itis and More about whatiitCan Be, 5 + While Size Helps, What Matters More is the Character. Also, More than the Present Size, What it willbecomeis More Critical. 8 \ + The Debate between Large-Cap and Mid-Cap is Largely an Artificial One, Debate is really between Quality and Lack oft. Debates really about Future Size rather than the Present One, 8 EARNINGS GROWTH: QUANTUM, CONSISTENCY, PREDICTABILITY, DURABILITY | + Priceisa stave of earnings growth 10 + When Growth goes away, Equities reduce to.a Bond. Itwill be Treated like a Bond for a while. ifthe Picture Deteriorates Further, then it will be Treated Worse than a Bond, “4 | + When the Character of the Market is a Growth Market, the Focus has to be on Growth and not Cigar Butt. 15 + Growth has @ Way of Covering Valuation Mistakes and Fighting with Prolonged Period of Market Machinations. 15 ' + For a Same Rupee of Profit, (Capital) Dilutive Growth Results in Lower Relative Value Compounding compared to Non-Dilutive Growth. 35 + Significant Capital Expenditure Projects or Significant Dilution in Comparison to the Existing Scale of Operations or Value of a Firm will almost Invariably end up in Tears. Even more so, when the Time taken for the Fructification of Projectsis very Long and Project Economics is Uncertain. 7 | + Acquisitive Growth vis-a-vis Organic Growth: Market does not Reward Acquisitive Growth in the same way as Organic Growth. In other words, Per Unit Market Returns for a Unit Growth of Profits Is Less or Acquisitive Growth, than for Organic Growth, 18 + Focused and Diversified Growth 19 + Banking and Finance: A Special Compounding Machine. 20 QUALITY OF BUSINESS: CAPITAL INTENSITY AND CAPITAL EFFICIENCY + Quality of Business Ey + TwoVital Tests for Quality are Capital intensity and Capital ficiency. mu + Persistent and Superior Capital Efficiency s the Single Most Important Evidence of Quality 6 + Eamings Growthis Necessary butnota Sufficient Condition for Value Creation 6 + Hygiene of ROCE gets Reflected much more Vividly in Balance Sheet rather than Profit and Loss Statement. 26 * Growth and Quality of Growth are not Co-incidental for Creating Value but they actually cohabit to doso. 27‘TABLE OF CONTENTS Root to Preservation of Wealth Solely Resides in Quality i.e. Quality of Business and Quality of Management... Butofthe Two, the Quality of Business precedes the Quality of Management. Even with Significant but Temporary Earnings Destruction, a High-Quality Business will Manage to Shrug-offthe Blues. Why it is Important not to Surrender a Good Business during Difficult times. Usually Good Businesses find away out and Bounce Back, ‘When Business is Mediocre but Payout is Strong, Markets View it as an Unaffordable Luxury. In such cases, as Faras Investment Returns go, Mediocrity Wins! In Bad Businesses, the Returns, ifat all, an only be Point to Point; which meansit isa very Chancy Transaction akinto Flippinga Coin, QUALITY OF MANAGEMENT: TRAITS, CHARACTER AND CALIBRE Two Vital Tests for Management: Capital Allocation and Capital Distribution, Conglomerate Complexity Leads to Less Value Creation even with Good Businesses and Good Managements. Corporate Governance is not a Jargonistic Buzz-Word. Honest Mistakes, even if Significant, are Punished less by the Markets Compared to Relatively less Significant but Deliberate Violations of the Value System. Capital Allocation has a Deep Impact on the Invest ment Returns. When misallacated, itcould be a Spoilsport even for the Best of the Managements and Businesses. Good Businesses typically seems to Attract Good Management and Vice versa. Funnily, Good (or Bad) Business and Good (or Bad) Management come as a Combo Deal; Buy One and Get One Free! ‘Management Quality has far Higher Impact on Returns than Investors Care to Imagine. Human Integrity is Largely @ Personal Trait. When you expect it from others, it sa self- delusional Idea. (OF VALUE AND VALUATIONS Whats Value? Price is Servant, Value is Master: Investing is about Pricing the Value, rather than Valuing the Price Price-value gap: Margin of safety (or Implied Returns) Higher the Risk, Higher the Gain, and vice versa. Really? Cash Flowis the only enduring reality: Accounting Profits and PE Multiples are Popular, but Unreal, Pastimes. Decent but not Exceptional ROCE can result in Exceptional Compounding if "Margin of Safety” is very High to Begin with. Cree eet 31 32 32 34 35 36 37 38. a 42 42 43‘TABLE OF CONTENTS ‘+ Initial Entry Price Advantage can Diminish the Rigors of the Mediocrity of the Business, 49 ‘| + Inthe Mediocre Sector, Relative Differences in Returns, despite Similar Profit Compounding, will Largely bea Function of intial Valuation Differences. 50 + + Sometimes, Even Average Business may Earn Exceptional Returns..but that is Hard to Sustain. 50 , + For Good Equity Investing, the First Test that it should Pass is that of a Bond or a Debenture. 50 + Really Speaking, there are very Few Things that Matter in Judging the Value. 51 CERTAINTY OF GROWTH OF EARNINGS VERSUS QUANTUM OF EARNINGS, + Consistent and Reasonable Compounding is Superior to Sporadic Bursts of Energy and Predictability of Earnings is a Superior Idea Compared to Merely High Earnings Growth. sz + Secularity versus Episodicity and the Power of Compounding, 53 + A.Business does not have to Grow its Earnings in Fits and Starts; it just needs to do it steadily 53 + Even with a Strong Pedigree and Excellent Sector, Value Creation is Intimately Related to Growth, its Consistency, Predictability as well as Capital Efficiency. s + Even for a Superior ROCE and Superior Earnings Compounding, once the Perception for the Future Growth is Decimated, so is the Market Cap Compounding. Only a Rear View Mirrorisa Poor Guide for Driving Ahead. se | + When Future is Expected to be Better than the Past, then a Modest Profit Compounding | will Produce Superior Price Performance. But when Past is Perceived to be Better than { Future, then the Business becomes aTreadmil 5s + When Markets Believe that the Destiny ofa Business is notin its Control, all Hell Breaks } Loose; and Greater the Time taken in such cases for Recognizing the Reality, Greater will | bethe Destruction (by market). 56 QUANTUM OF EARNINGS VERSUS QUALITY OF EARNINGS + Payout vis 8-vis Earningsis akin to Maternity test versus Paternity test. 58 + ROCE Provides Sails or Wings to the Ship while Earnings Growth Provides the Wind, a + High-Quality Business getting even Better Quality Coupled with Superior Earnings | Growth will Lead to Disproportionate Returns..or... ‘Good to Great’ Business plus Superior Earnings will Lead to Disproportionate Returns. 61 + Even in a Seemingly Commodity Business, the Principles of Investing Apply in the Same Way if ROCE Stays the Course and Earnings are Stable. a | + If Capital Efficiency is Fractured (though still high), even with the Same Consistent Earnings Growth, Compounding will be Less than Proportionate. In other words, the Pendulum will Swing in the Direction of Discount from Premium, 68 OF Longe eee)TABLE OF CONTENTS | + Over Time, Attitude to Avoid Permanent Loss of Capital in Preference to Chasing Growth Produces Better Returns and Lower Volatitity. os 6A ; + Patience and Quality Present a very Potent Potion! - 6 + Investmentsin Commodity or Commodity-Type Businesses. - 6 ‘QUALITY OF BUSINESS VERSUS VALUATIONS / + Superior Business at a Reasonable Price is Wealth Creating rather than inferior Business ata Mathematically Cheap Price. coe . + Arithmetic Cheapnessis Often aHoney Trap, 8 + Itis the Innate Desire of (even a good) Investor to Leave the Footprints, on the Sands of Time, that Makes Him Choose Less Obvious Over the Obvious and to See Virtues in Inferiority Over the Quality, Desire to Shun ‘Boring’ induces Bias to Prefer ‘Poisonous’ Exoties Over the Virtuous Ones, . 6 + Ability to Valueisan Eclectic MixofScience and Art. coe 70 . RISK VERSUS RETURNS + Whatis Risk?....Risk Liesin Not Knowing What Youare Doing, _ cen TH + Markets impute Price Volatility as Risk. ._ ~ + Volatitity in a Good Business is a Friend and Opportunity Whi Poison, an Enemy and a Trap. - - + Text Books and Classroom Suggest that Low Risk means Low Return and vice versa, The Aphorism of ‘Low Risk-Low Retum’ probably may apply amongst the Asset Classes but it MakesNo Sense white Choosing Security within an AssetClass. . + Every Lousy Profits a Foundation for Future tosses. in a Lousy Business, itisa + Riskalso Liesin Not Acting Upon What One Knows, or Believes to be Knowing. + RiskLiesin Not Havingan independent Mind. + Interestingly, inthe Markets, Long-Term is Clearer than the Short-Term! 7s + Why Low BetaisBeautiful? se B BEHAVIORALASPECT + Discipline, Temperament and Character. — ars ” + What is Intuitively and Empirically Evident, but Behaviorally Practiced, ts Radically Opposite, eve nn) ‘+ What Wins in investing is using a Finer Net rather than Casting it Wide. Exclusion (rather ‘than inclusion) is the First Principle of investment. In other words, investment is not a Democracy. . 8TABLE OF CONTENTS + Preservation of Capital is the Responsibility of the Investor Himself. It is both, his ‘Dharma’ and Duty ands Doable also. In other words, Preservation is the Preserve of the Player Himself while Appreciation of Capital additionally needs Externality as well Ea) + Investingis not merely about Intellect; itis also about Wisdom. 80 + &goisan Expensive Hobby to have in the Markets a + Rear View Mirror Effect Blinds Our Mind or Creates a Psychological Bias Incapacitating Mind to Recognize the Snapping of Relationship between the Past and Future, Current and Future and Cause-effect Relationships. a + Endowment and Confirmation Bias. a2 \ *+ Loss Aversion and ‘Plucking the Flowers to Water the Weed’ Behavioral Pattern. a2 + Panic. a2 + Persistence Stereotypes. 8 + Diversification and Concentration, 83 + Investingis Nota Popularity Contest. 33. EQUITY: VALUE CREATION; FIXED INCOME: (AT BEST) MAINTAINENCE + Over Long Enough Period of Time, Over-Allocation to Staid Fixed-Income Investing Compared to Growth (Equity) Investing, is abit ike an Exercise in Minimalism, 385, IS LONG-TERM INVESTING DEAD? AN ODE TO LONG-TERM INVESTING (INSTEAD OF ANOBITUARY), + Long-term Investing is Not Under Threat; Important Point is What Kind and of What Character do You Hold for Long-term 88 * Market Cycles were More Graduated Before; They are More Accentuated Now. 88 DISTANCE IS WISDOM AND PROXIMITY IS POISON 2 | FINALE 4: KBB og- BURMAN SRS MIR cro como kotor sten title growth, constant change, the enjoyment of every new experience. BRR m ec e el NmCene CAM Cure rile Res erctaletave BOR onsccimty o-TeeEcUue thet) CoB te (or ma - Aleister Crowley a aINTRODUCTION ca Crear Good investing is all about getting more in return for what you have already paid. What you pay town a business (or stock) is Price and what you get is Value. Price is certain and upfront. Value is a conjecture (albeit__ an intelligent one) and will unravel only over time in future. Itis this contrast between price and value of a business (or stock) which leaves most market participants in a mystical enthrall of price while holding the idea of value as mythical or treat it in confused derision. In simple terms, value is an estimate of present worth of a business, as judged from estimated income flows (or cash flows) that a business is likely to generate over its assessed lifetime. Clearly, assessment of value will, therefore, depend upon the magnitude, certainty, timing’ pattern (early or late}, volatility and longevity of those income flows: Judgment of these variables will depend upon the skills of the investor and the character of the business ufder consideration and the extent and accuracy of value will depend upon accuracy of judging these variables right. Successful investing will essentially call for judging the value right, setting the purchase price at a good discount (Margin of Safety) to the conjectured value, revisit the equation time to time (more to confirm and convince oneself and less to act) and to enjoy, with patience, the gravy train of investing volatility! As Charlie Munger would say “Allintelligent ‘investing is value investing - to acquire more than you are paying for. Investing is where you find a few great companies and then sitonyourass.” The essential principles of investing have largely remained unchanged for more than 300 years of recorded history of organized investing that is available to the world. The principles and principal ideas for creating wealth through investing and successful investing approach largely remain unaltered. What does alter is the ‘way people seek to apply them at a point of time based on their own understanding and interpretation of the principles or based on what may appear to be convenient or expedient to do so at a particular point of time. But principles per se remain unchanged, There are these famous words (that an experienced investor cringes at) “This time itis different”, but it rarely, if ever, is different. Usually, much like the evolution of the society, which occurs over a series of many incremental steps, the changes in the character of the businesses are built step-by-step over a period of time and all the known principles of investing have the ability to account for and deal with these differences. However seemingly radical at the point of departure these may appear, but they are an invariate accumulation over a period of time and all the principles of investment are able to deal with these quite well. Butitis our mindset which time to time either craves for leaving around our own foot print in sands of time by seeking to discover some new principles of investment or in a mistaken application of mind CyINTRODUCTION Fy (when it may conveniently suit us because certain fads and fashions may overtake the markets) in which we ‘an proclaim to the world about our own ‘discovery’ or ‘finding’ a brand new way of creating wealth. Investments nota get-rich-quick scheme; itis not even a method of making the highest gains in the shortest possible time, though at times such outcomes also occur. But when these outcomes occur, they are merely milestones in the long-term process of wealth creation; the reverse also equally occurs when disproportionate ‘amount of wealth can be erodedin a very short period of time. So over aperiod of time, the great game reallyis in navigating through these twists and turns with knowledge, with discipline, with wisdom and with a due understanding of principles to ensure that navigating is in correct direction, smooth, free from accidents and fruitful Fundamentally, investing is simple, but not easy. Simple, because it is not difficult to understand the essential principles of investing. Essentially what creates value are really simple ideas. It is about identifying a large ‘opportunity (which is rich in possibilities yet possesses existing, strong fecundity) that has earnings growth marshalled with a high degree of character, or, the value accretive growth rather than value destructive growth, that has growth with longevity, predictability and relative smoothness, ensuring that the character of ‘management lets the value of a business be nurtured, protected and shared equitably and applying suitable simple mathematical equation to discount all that future into the present, This is what is at the innards of fundamentals of investing. So investing as a concept is essentially simple in its core connotations, but itis not ‘easy because apart from intellect, investing calls for wisdom, apart from knowledge it calls for discipline, and merely high IQis no guarantee for great investment results, because doing it right, not only knowing it right, is as important. Even some of the best investors falter at doing it right rather than in knowing it right. More failures have occurred, even among the great investors, on account of the former rather than the latter. The difficult partis getting the right psychological traits, a disciplined behavioral make-up, a quiet sense of innate confidence (but not arrogance and rigidity), a sense of serenity in face of adverse market situation and an independent, curious mind, This is more likely to stand in good stead rather than only an ability to accurately predict every single quarter's earnings for the next 20 quarters. In that sense, good investing is a heady mix of both a lovely, beauteous art and a very precise looking science. Butitisnot just one of the two. Sciénee illuminates while the artis pregnant with possibilities anditibued with, vivid imagination. Reality Of investing lies between the'tWo: It is neither a perfect science, like physics and mathematics, nor is it a complete art le painting, of beauty in the eyes of the beholder’ kind. So, reality lies, between the two. The art partis about understanding the quality and character of the business, of the people behind the business, appreciating what makes the business work and what makes it fail, what makes it robust and what makes it brittle. Understanding these traits is the art part. The art part also covers the wisdom, discipline, patience and independent mind aspects of investing, Transcribing the art part into a tangible part and putting that tangible part into a working model including a ‘mathematical one, is what the science part is. So, in some sense, where the art part ends, it feeds into the science part of the investing and then the science part seemingly conjures up the accurate answer. Depending upon their view point, many tend to see investing as completely capricious, arbitrary, a volatile game akin to gambling and almost unpredictable. And at the other extreme, there are some who reduce investing exerciseINTRODUCTION to purely a mathematical model or a heuristic extension of crowd behavior, completely divorced from the underlying fundamental ideas such as the quality of the business, the quality of management, size of ‘opportunity, growth and valuation. But the reality s that the truth lies between the two. Itis a judicious and beautiful confluence of the best ideas ofartand the best that science can give. The resultant melting pot retains the beauty, on one hand, and elegant simplicity and mathematical rigour, on the other: investing is about that. It is about combining these variegated ideas and trying to gaze into the future. When you try to do so, it never really is or can be precise. You are leaping into the dark. Its a leap of faith which takes you there. The past does guide you because the past has helped you in understanding probable contours and shapes of conditions that you are likely to find in ‘the future, but not always so. In final analysis staring into the future and getting there is akin to a leap of faith. No amount of advance preparation completely equips you to handle that probable future and investing is, really about this. tis about collating, assimilating and usingall the insights about a business available at a point of time, analyzing it from diverse perspectives (some more akin to art while others closer to science, translating itall nto a workable model (@7Hl6dious symphony rather than a cacophony of jutting out blocks of data points and information) and finally, forecasting of that future. WheA that process is done with integrity/ intensity and intellect (in that order), the outcome is normally good. In good investing, these 3is combined together produce a vivid image of beautiful future, and a more replicable future on a sustained basis. And the path to outstanding value creation. Lao Tzu says, ‘I have just three things to teach: simplicity, patience, compassion. These three are your greatest treasures.” In good investing, read it as simplicity (of business), patience (of investor) and passion (for quality). Returns are tangible but the risk is not. Hence, the returns appear as real to the investors but risk appears as amorphous. The returns can be real, if and only if, they are earned by undertaking judicious and intelligent risk. Market and investors often behave asif the riskis unreal or an irrelevant trivia, But the truth isa polar opposite. Thisis where the concept of quality of return comes, as contradistinguished from, the quantum of returns/thé ideas of certainty of growth vis-a-vis quantum of growth, quantum of growth vis-a-vis quality of growth and quality of growth vis-2-vis valuation, are the ideas which define the quality of returns or the idea of risk. In the similar vein, markets are not linear and hence, equity returns cannot beso. But investors often behave asif the markets are linear. They would lke to see absolute returns when markets are falling and the relatively superior returns when markets are on ascendance. But absolute and relative returns are like two rabbits. When youtry to catch the both simultaneously, you get neither in your hands. In investing, it is worthwhile to follow the absolute returns. When done well on that count, the relative returns also usually follow. Its impossible to operate only on the good part of the market curve and always being able to avoid the bad one. Those incredible ‘timing’ skils are not well-endowed or proven; certainly, not with the most of the market participants. Equity investing is indeed long-term even though itis not considered fashionable these days, to think or say so. But, that isthe enduring truth of the equity investing Fixed-income investing can, at best, maintain one’s wealth. It cannot multiply. Sometimes, it fails to even ‘maintain the wealth, what with, the rigors of inflation and taxation. Good investing is really about creating future income streams, creating bigger wealth or value and really providing alternatives. In other words, itisINTRODUCTION | the heart of good investing because it lets you be free from the tyrannies of the day- to-day engaging into mundane activities that one is compelled to. Many are good at creating wealth, but only a few are good at ‘managing wealth, by successfully creating a running income stream from the wealth and expanding value is really the crux of investing, so that it lets you do what you . further. To create greater wealth out of wealt! Waiit to rather than what you have to. All these ideas are explored at some length in the ensuing pages. "It is not how much money you make, but how much money you keep, ¢ how hard it works for you, and how many generations you keep it for."} (Robert Kiyosaki) not just about creating wealth but making wealth work for you rather than you working for wealth. That is atSIZE OF OPPORTUNITY ening condi 4 Size of opportunity isa very fundamental point. It really is the foundation of investment edifice, on which the large value creation rests. Simply put, it describes opportunity for and constraints on the size and duration of growth (of earnings) of a business. Whether it will hit a glass ceiling soon or can soar freely for tong will be decided by this idea. Nothing keeps expanding forever (except universel). If trees keep growing tall, they should touch skies. But that does not happen. Practically speaking, itis about the notion of whether a business can grow ata meaningfully highrate fora meaningfully tong duration. itisone of the most important factors for predicting the sustained, long-term wealth creation andoutstanding Compounding, The idea of size of opportunity is not about what the size is at the point of observation, but is more about appraising and understanding what potentially the opportunity size can be in future. That's not contradictory to the fact that what may be already large today can get much larger. Equally, it doesn't preclude what is not large today but may get much bigger fater on. It has iot to do with crystal gazing and figuring out whether fertile conditions exist in the character of business and external environment for the business to get ‘much greater over time. In other words, internalities and externalities have to be robust enough to become a force multiplier over time. How large @ particular firm may become, within a sector with strong potential, will of course bea finclion of capiabitities and character of the management of the firm.” ‘The idea of size of opportunity can be understood within the framework of size of fish and the size of a pond. ‘The real issue is all about figuring out the size of the Pond, while often, the debate n the Investing world is about ee Our pi tions Lafge'fishyin a large: Pond, sirall shy tf Gti Haver over tie: les the bestehole: You can havea diametrically opposite combination of a smat! fish and a narrow pond, Not only the fish is small and vulnerable but also, it finds itself swimming in shallow turgid waters, with inadequate food and nourishment to grow big. This clearly. isthe worst option for any serious long-term investor.SIZE OF OPPORTUNITY The third choice (large fish in a small pond) prima facie may look acceptable but on finer examination, itis not. Ifthe fish is large, it only means in the pastit has been successful. But ike Buffet says, the investor of today will not benefit from the profits of the pastbut only from the profits of the future ARG thie large Teéflects the fact that ithas had successful past but a small pond would mean that futuré growths constiained idj¢hallenged: ast option is interesting: a small fish and a big pond. Large pond would imply that headroom for growth is favorable if the pond conditions are right. If the water is clear and not turgid, food and nourishment available is plentiful and ifthe fish is capable, the conditions are favorable for explosive growth. So this is as good an option as a large fish in a large pond. So the best options are the first and last, with the others being unattractive for value creation. “Thedes of growth is derived from the idea of the size of opportunity and the idea of sustainability of high gfovthis derived from the character of the opportunity, sizeof opportunity and vision and competnéefthe riianagement. When the two get combined, it creates power of compounding. When a business grows wel and sustains the growth over long period, it becomes a compounding machine or outstanding value creator. And this is at the Fundamental roots of long-term value creation for any business because inexorable growth (of profits) creates what is called the eighth wonder of the power of compounding which will eventually create a powerfully large idea, much bigger than what it is today. The idea of the power of compounding works at two levels. One, the very basic idea of any value creation is inconceivable without the adequate size of opportunity and second, outsized value creation (what is popularly described as a multi-bagger investment) presupposes material size of opportunity because it is not important how large an opportunity is today but what it can become which is central to the idea of outsized value creation. The investing result is the matter of delta from where it is and what it can become rather than what it Is actually todayitiisthe delta or the rate of change Which détérmines the value creation, in the sense that fundamentally large and sustained rate of change can only cone when there is large size of opportunity which is yet not fully tappedinto. / More often than not, the importance of the size of opportunity as a concept is intuitively not understood as a material factor butithasa very deep béaring on the longevity of compounding and the extent of value creation thavarcinvestment {in'@ business) can achieve. Busineds may have exemplary profitability, superior capital cefficiency and may enjoy véry favorable economics and competitive dynamics, may even have reasonable ‘current growth rate and yet it may fall to create efficient compounding, simply because itmay be about tohita £1888 Gelling! There are many examples of such businesses: welding businesses like Ador-and Esab,jprovider of lining material for steel foundries like Foseco and similarly, business like Vesuvius. When the eventual size of opportunity is not very large, to begin with, or it is more or less fully exploited, then it has a very cathartic influence on the extent of value creation or its continuation. Such businesses become cigar butts (rather than full cigars). They produce an interesting conundrum: good profitability, decent capital efficiency, even n. But that is no denoueme reasonable (current) growth rate and yet increasingly crimped value cre: s Pearl § Buck said, love dies only when growth stops. Similarly, value creation dies when future growth stops (due to constraint posed by size of opportunity). At times, it may prima facie appear that the valuation of a business is outrageous in the context of the current size of operations or reported profits. That typically would happen when recognition of future size of offish merely .SIZE OF OPPORTUNITY 7 opportunity is very strong and the current numbers may not fully reflect that reality while unlocking may happen in future. Tibilant Foodworks (quick delivery pizza service) andjTatalbivetages (Star Bucks Coffee) reflect this phenomenon. Organized retail, when it initially came by, it was (rightly) recognized as a major opportunity to be tapped into and initially there was a lot of euphoria, massive belief about where these businesses were headed to, Reality set in eventually that while opportunity is large and growth enormous, profitable growth is extremely challenging, execution hurdles are enormous and generating meaningful (or value creating) Return on Capital Employed (ROCE) being a very obdurate barrier to cross. And now, itis reflected in the kind of price and the value destruction that many of these businesses have suffered/BUtinitigl cent ion of the size of opportunity and as the actual evidence of the real ecoriomiic performance did not tally with the broad assessment of the potentially large size of opportunity, the / price'decimation came in swiftly and significantly. Edlication sector has thrown up similar frustrations and dilemmas: either, business has generated economic profits but low growth or high growth but real, economic jiasmcame with the-recognit value-creating profits may be absentand hence, low orno value creation. ‘Two major contradictions may emerge. One, business may be profitable, maybe growing, may have excellent ROCE and yet valuation may look modest or may diminish. That may sound like a contradiction but could happen because markets may realize that the future size of opportunity is unlikely to be much larger and to that extent it becomes an investment in bond rather than an equity investment orit becomes a business with a limited life rather than the going concern, an assumption which we usually apply to an equity investment. Some of the Indian pharmaceutical firms, which have not invested adequately in innovation capabilities or appropriately recalibrated their business models to reflect new emerging realities, illustrate this behavior pattern. Two, the other contradiction may be in which the top line and bottom-line business numbers may look modest compared to the market cap. And again, the answers to the contradiction may lie in the recognition of the fact that future size may be fantastically higher than what it may reflect in the numbers today, Telecom sector, a decade back, is an ideal example, when financial performance looked modest while the relative valuations looked sky high. Since then, it grew as it fantastically unlocked the size of opportunity. That is why markets were running ahead and reflecting the future reality into the then numbers. itis another matter that fortelecom sector, the picture appears to be reverse today! India as a country has outstandingly high growth potential and the giant size of opportunity in many areas. Penetration levels in India are at much lower levels when compared to even many developing countries. Given India's young, hardworking, frugal and well-saving population, large consumption sector, well-developed financial and banking sector, large domestic economy, well-balanced across services, manufacturing and agriculture, forward-looking and aware middle class, healthy capital efficiency, democratic and cultural ethos, opportunities abound in many sectors which look rather virgin. Sector like banking, financial services and insurance is still a very underpenetrated market in the country and thus presents a large opportunity. For ‘example, Housing finance isa very large opportunity in the country. Similarly, consumption is another area of a truly major opportunity driven by increasing income, changing lifestyles, rising aspirations and exposure to the outside world, The consumption story is at ts initial stage waiting to unfold. Consumption will drive many businesses like FMCG (due to low penetration), automobiles (lack of public transportation facility), white goods (changing preferences) and luxury goods (aspirational value). Given the primitive state of IndianSIZE OF OPPORTUNITY healthcare infrastructure and unmet demand of the masses, healthcare and pharmaceuticals present itself a {great domestic opportunity. Changing food habits and general lack of awareness about health can only add to this. The rising cost of healthcare in the developed world will also translate into large opportunities for research based forward-looking Indian companies. Infrastructure in general (across road, railways, airports, ports, energy, capital goods and construction), is virtually callow and offers truly large prospects. Agriculture, given its primitiveness, affords great potential in areas of farm inputs, nutrients, mechanization, storage and distribution, Logistics s another virgin area virtually Selection of an individual business within the high-potential sectors should be done based on what opportunity size they represent. Café should be taken to avoid a business focusing on a very small sub-sector within the sector, specializing in a very small niche area or is under-equipped or unable to tap the opportunity, Though the restaurant or eating out business presents an enormously large opportunity as a whole, itis very difficult for a gourmet restaurant to replicate its business model on a large scale asa chain. ‘While Size Helps, What Matters More is the Character. Also, More than the Present Size, Whatit will becomes Moré Critical. “There is no need to worry about mere size. We do not necessarily respect a fat man more than a thin man. Sir Isaac Newton was very much smaller than a hippopotamus, but we do not on that account value him less.” (Bertrand Russell) This point appears contrary to the first one but itis not. It rather complements it. Character of the business, in simple terms, isits ability to create economié value by generating superior capital efficiency, its ability to ward ‘GFF competitive challenges and to thrive over time. It enjoys some impregnable moat which gives it pricing power or resilience to external threats. Size of opportunity providesa base or headroom for growth. Character creates economic value out of that growth. Size is a necessary condition but not sufficient one for value creation, Size’plus character completes the picture. And while size is very clearly an important factor, it is the character of that opportunity whichis equally vital and important. The Debate between Large-Cap and Mid-Cap is Largely an Artificial One. Debate is really between Quality and Lack of it. Debate is really about Future Size rather than the Present One. “Thope if dogs take over the world, and they choose a king, they don'tjust go by size, because Ibet there are some Chihuahuas with some good ideas.” (Jack Handy) While size of opportunity isa vital point, there isa fetish foror slavish attachmenttto the existing size orthe past performance of the business but that s @ rear view mirror. Butt isnot the Current size but what it will et to be ‘which matters forvalue creation. $o, itisnot the rear view mirror but the front view which isimportant. Much time and energy in markets is devoted about debating investment in large caps or mid-caps. But largely, this debate is an artificial one. Thisis not to disregard large companies. In fact, given the size they have reached, they must have a éertain pedigree, achieved a Scale indicating’a certain level of management capability andSIZE OF OPPORTUNITY maturity; and has stood the test of time, indicating a certain level of business resilience- all of that is a ‘éstirfiony to customer goodwill, relevance of the business to the society and stature. But over-emphasizing a” large cap or a mid cap as a panacea or an investment approach is probably a misplaced investment thinking Ultimately; returns in an investment are a function of an earnings growth, quality and predictability of the» =Eaiings, quality of management and price-value gap (margin of safety).If a healthy combination is found in any business (or investment), that investment will generate areturn Mid-size business may be less discovered, and may take longer time before being discovered adequately, It may also suffer greater price volatility. On the other hand, given the fact that itis relatively less discovered, it may have an advantage of offering a better value. So, really trade-off f not about large and mid cap, itis about quality or the lack oft, whether the earnings are real or cosmetic, whether the earnings are backed bya capital efficiency which will create value or otherwise, and whether earnings will sustain or not. Any if these debates are settled, then whether you put a large cap name on the top or a mid cap one, it does not matter, Markets knownonames.EARNINGS GROWTH: QUANTUM, CONSISTENCY, PREDICTABILITY, DURABILITY Price is aslave of earnings growth “There are no great limits to growth because there are no limits of human intelligence, imagination, and wonder.” (Ronald Reagan) Ofthe five key pillars for creating outstanding value through investing, ane of the most important foundations is earnings and its growth. Itis narrated ad infinitum (butremains universal truth of equity investing) that price is nothing but a stave of earnings and its retentless growth over a period of time. if earnings are real (which means profits convert into real cash) and if they keep growing, then that will definitely refiect in the price and the sustainability of earnings growth into the market cap compounding, Over a period of time (please see the enclosed Table 2 and Table 3B which contain performance data of ten years ie. FY 2003-12], market value creation is usually expected to be aligned to the underlying profit compounding. The most likely outcome for any above average quality business would be that investment returns compounding will track the earnings compounding especially when viewed over along enough period oftime. internal or short-term aberrations will get evened out overa period oftime, Wehave usedaconceptof Compounding Multiplier (CM) to illustrate this umbilical cord of a relationship between eamings growth and Investment returns. CM relates Compounded Annuat Growth Rate (CAGR) of investment returns over time to CAGR of profits. Usually, the CM ratio of one or thereabouts, islikely to be the normal conditionEARNINGS GROWTH: QUANTUM, CONSISTENCY, PREDICTABILITY, DURABILITY TABLE 3B : SNAPSHOT ‘TABLE SHOWING DIFFERENT LEVELS OF INVESTMENT RETURNS (COMPOUNDED ANNUALLY) SORTED ON PAT GROWTH FOR THE PERIOD FY 2003-12 Brora’ Eee od ' core | roe | op | par | in | ROCE or 46.4% | 28.3% | 37.9% | 33.3% | 18.8% Pat | Investment Return > 60% Investment Return 45-60% 75.6% | 20.3% | 35.7% | 41.4% ‘Reinvestment Return (Compounded annual) Positive exceptions will occur when CM is much higher than one. It will be a function of two parameters: 1) typically these businesses will be very high-quality (high ROCE) ones, enjoying sustained and consistent profit, growth 2) these businesses, for some reason, in the initial stage itself were undervalued, Such conditions will resultin the returns compounding being faster than the earnings compounding, Negative exceptions will reveal themselves when the ratio will be significantly below one. These would be linked to materially inferior character of the business or an exceptionally rich valuation to begin with, which then is being corrected over a period of time. These conditions will resultin the returns generated being lower than the earnings compounding. ‘The firms where these conditions are not applicable (either significant superiority or inferiority of the business or significant undervaluation or overvaluation to begin with) and yet CM materially deviates from a value of ‘one, there would be some very specific reasons for the same which will reveal themselves on a deeper probe. Also, asset-heavy and income-light firms (as distinguished from regular income generating firms) would not follow this rule since they won't be valued based on the income streams but asset value. Most of the capital intensive businesses or asset heavy businesses will not follow the normal pattern. ACM ata little higher than 1 anda little lower than 1 is really in the realm of statistical schema of things, in a sense that these are merely statistical adjustment issues, timing issues, topicality issues anditis not important to read too much into that. Let us say, if the fair proxy or approximation for the market cap compounding is compounded earnings growth and its value is one, then, say, range of 0.8 to 1.2 may be regarded as normal. Significantly deviant CM (higher than 1.2 or lower than 0.8), needs to be probed deeper for compounding reasons, ‘And what are these reasons which can cause CMito be mich higher or much lower? They could be: 1. Significant superiority or inferiority of Capital efficiency (ROCE and ROE) 2. Initial valuation itself being much below or much higher than it deserves, also would have impact on distorting these ratios/relationships. 3. Pee errEARNINGS GROWTH: QUANTUM, CONSISTENCY, PREDICTABILITY, DURABILITY | Certain type of businesses, like asset businesses, will not have a cogent relationship of the returns with the earnings because for asset businesses, value is derived more due to underlying asset value rather than the underlying stream of earnings. 4. When there is a significant discontinuity in the assessment (by markets) between the past and future prospects of the business. This could be positive or negative discontinuity: positive when the future is judged to be much better than the past and vice versa. The negative discontinuityis clearly visible in the performance of Software firms over the decade (Table 3A). Clearly, markets believe that future looks harder for software firms and is raising the value of software firms by less than a rupee for every incremental rupee of profit, or valuation is increasingly being derated by markets. For the decade of nineties, CM tended to be well over 1, beginning ofthe last decade marked the CM becoming 1 andoverthe last decade, itislessthan 1. Table 3A throws up interesting insights. The first part of the table has CM greater than 2. Such a high positivity | would invariably have reasons. For example, businesses like Piramal Enterprises, Century Textiles, Nesco and ‘Ansal Properties are asset-backed, Interestingly, just about 11% CAGR in profits has resulted in an astonishing 24% CAGR in returns for Procter and Gamble (PGHH), arich CM of 2.2 Itis so high probably due to two reasons: ‘1E-A great belief about the futtire prospects of PGHH and a large size of opportunity and 2) Rich ROCE (10-year, average‘of 60%) coupled with a very high dividend payout (61%) has helped in rich Valuations by the market, H otherwise than it could have been. Also, the initial valuation (forward PE of 9x for FY 2002-03) being relatively modest has helped. Blue Dart (with 21% CAGR in profits and 42% market value compounding) clearly reflects the great belief about the future size of opportunity in logistics, ability of Blue Dart to tap into that opportunity, major opportunities | sternming from E-commerce, greater international trade and introduction of Goods and Service tax (GST), all favoring high-end solutions firm like Blue Dart and great entry barriers (globally, there are really only four “majorlogistics firm). Case of Monsanto is interesting where the profit growth has actually been in a negative territory but market, cap has still compounded at a respectable double digit, Probably, it reflects belief about huge opportunity in seeds and the agriculture space and its pre-eminent global position (but of which Monsanto has not given as | much account, so faras Indias concerned). So, one or more of the factors such as initial valuation, the future prospects, thesiz of opportunity, the strength of the earnings growth to grow ata high rate fora ong period, | asset'value rather than income streams, all would result in altering the Compounding Multiplier, to be well -above oF below the level of 1.sAsset businesses fall in different category and they are unlikely to obey the normal operatingrule. ©M > 1.5 but < 2: If we look at the table, it is clear that most of the firms enjoy outstanding business proposition, superiority of ROCE, sustainability of it and typically high growth achieved as well as expected. Markets have tended to put such businesses on a pedestal because of the consistent delivery of performance, Many suffered undeservingly low Initial Valuation, which is subsequently corrected. Similar observations apply to firms with CM ranging between 0.8 and 1.5. ‘Treadmill Businesses: Attention needs to be given to the portions of the table where compounding multiplier re eee eetEARNINGS GROWTH: QUANTUM, CONSISTENCY, PREDICTABILITY, DURABILITY isless than 0.8. For software firms, in general, one observes that despite a superior ROCE and ROE and despite very respectable earnings growth rate, the investment returns compounding has not produced the similar picture. This is because of the fact that the assessment ofthe future opportunity is dimmed one in the eyes of the markets. For example, even for a top firm like Infosys, for one unit of earnings growth over the 10-year period, investment returns compounding is only 0.7 times which clearly shows that even for an outstanding business like Infosys which has produced tremendous ROCE all through and even now enjoys enviable ROCE, the growth rate still being at a respectable territory, market has taken a clear cognizance of the fact that the future is not as good as the past was. A unit of profit has not produced the same impact in the returns compounding. SUEABUSinesses, unfortunately, become treadmills: one has to keep working harder just to be where0ne is. They produce less output (returns) forthe same effort or require much more efforts just to get the-sarye'output. Firms in the table with CM ranging from 0.5 to 0, one or more of the reasons may prevail mediocrity of ROCE, future opportunity to grow being squashed, gross over-valuation to begin with now being corrected over time, low or little faith in the managementin terms of being able to carry through the business, Last part of the table: despite a positive profit compounding, investment returns compounding is negative, Now, that is clearly an evidence of destruction of a value of business where despite a positive growth in profits cover a long period, market cap has actually registered a negative growth. All the causes narrated before, probably, may apply in greater extremity. Key reasons are: poor or ruinous misallocation of capital by the management, utter mediocrity of businesses (where ROCE or ROE being single-digit number), assessment of a businessis that of a complete collapse or write-off or no faith about profits and balance sheet. ‘TABLE 3A : SNAPSHOT ‘TABLE SHOWING DIFFERENT LEVELS OF COMPUNDING MULTIPLIER SORTED ‘ON INVESTMENT RETURNS (COMPOUNDED ANNUALLY) FOR THE PERIOD FY 2003-12 Beare Coed ae | not | oF a cm>20 sax | 193% | son | a7% | 206% | 363% | a65% | 35x | oan | sax emas-20 ~_faxa.a%| 250% | a7a% | 28.2% | a24x | oan | 23.7% | 13.6% | 9.0% | eax om12-15 77.2% | 28.5% | 22.6% | 245% | 32.0% | 99.8% | 295% | 18.9% | 16.0% | a5% cmoa-12 ~ Pasiox [19.9% | 206% | 266% | asx | 5.7% | 19.3% | aeax | 185% | 67% cinos-08 306% | 28% | axex | 26am | acon | 28.7% | 27.7% | a66m | 2.7% | 9% emo-05 ~ | 295% | 272% | 176% | 203% | a0% | 157% | 266% | 129% | 103% | as0% aco zasn | 1aan | 94x | 25m | aan | 134% | 107% | a2x | can | 240%) ‘Rs Investment Return (Compounded annually) Oe eeeEARNINGS GROWTH: QUANTUM, CONSISTENCY, PREDICTABILITY, DURABILITY “When Growth goes away, Equities reduce to.a Bond. It will be Treated like a Bond for a while. fthe » "Picture Deteriorates Further, then it will be Treated Worse than a Bond. “Life is growth. If we stop growing, technically and spiritually, | we are as good as dead.” (Morihei Ueshiba) i Investing in equities is all about growth, and that in bonds is all about maintenance. When the growth goes, away, equities become bonds because when the growth is zero, the returns expected are merely the interest | | rates (earnings divided by market value) and not really the compounding. if growth goes away perpetually, | then businesses cannot really quote higher than the net worth and when the outlook deteriorates further and | turns negative, it will quote at a ) ‘ount to the net worth. In other words, when the growth is away, the stocks become bonds. Growth is the key glue which allows the firm value to be much higher than the net worth or the | value to have a power to reflect a strong multiple of the profits rather than being treated as a limited life concern. When growth is there, equities are treated as a going concern, and when the growth goes away, equities are treated as bonds or bond minus. A glance at the Table 2 will reveal that even best of the businesses and managements are not immune to this. Firms like Trigérsoll Rand, TVS Motors, Paper Products, Finolex industries, NALCO illustrate this phenomenon. Even for a firm with a very strong pedigree like Ingersoll Rarid, having access to global technology and having capital efficiency upwards of 20%, meager profit compounding of 6% over ten years has led to the market cap ‘compounding of just 5%. Also, in a consumer business like TVS Motors with large size of opportunity, business growth has been difficult to come by and market cap compounding has been similar to bond returns. ‘TABLE 2 : SNAPSHOT ‘TABLE CO-RELATING DIFFERENT COMBINATIONS OF CORE ROCE AND PROFIT GROWTH AND SORTED ON COMPOUNDING MULTIPLIER FOR THE PERIOD FY 2003-12 porary Gree ry oS oe Winners 24.7% | 281% | 244%6| 29.2%| 32.7% | sox | 28.7% 0% Aspires ~ 112.6% | 28.3% | 11.3% | 11.39% | 18.7% | 78.2% | 26.5% 3.9% Gentry 38.0% | 15.8% | 3.7% | -19% | 4.7% | 24.3% | 10.9% 8.5% Teed re0% | 161% | 252% | 322% | 260% | 163% | 159% a2 strugglers 14.4% | 131% | 97% [aon | 12.4% | 110% | eax | 05% | 74% ‘Rs Investment Return (Compounded annually)EARNINGS GROWTH: QUANTUM, CONSISTENCY, PREDICTABILITY, DURABILITY When the Character of the Market is a Growth Market, the Focus has to be on Growth and not Cigar Butt. “Zxpect poison from the standing water.” (William Blake) Equity is all about growth. When the growth goes away, equity becomes a bond and bond is clearly not equity. Idea of growth is to get a compounding power, to get a value much higher than the net worth or what the near- term profits would suggest and essentially since the equity markets thrive on growth, the idea is to hunt for virtuous market cycles where largely you will see growth sustaining (albeit with some volatility here and there which is a part and parcel of the game). I'Such growth markets like India, moré pronounced is the growthy s:biggeris the amplitude of the growth and greater is the longevity of the growth, stronger is the compounding arid higher is the multiplication. In such markets, it is important to choose the true blue-blooded growth businesses rather than buying cigar butts. True-blue growth markets would create a powerhouse of compounding in essentially those growth businesses which can keep expanding for a length of time. In such markets, ostrich-lke altitude or a behavioral pattern which is akin to ‘shrinking within the shell mentality’ ‘would actually be counter-productive, because in such markets you do not want to buy a scuttle butt or cigar butts, but you wantto buy the growth so that you really tap the growth opportunity to the hilt. Of course, thisis ‘without compromising on any of the prudent parameters of quality, character and valuation, Itis to ensure that the value of growth isnot lost sight of because that would potentially undermine the return optimization. As Walter Schloss says, “timidity prompted by past failures causes investors to miss the most rapa bull markets”! Growth has a Way of Covering Valuation Mistakes and Fighting with Prolonged Period of Market Machinations. “Ever since Iwas a child, [have had this instinctive urge.for expansion and growth. To me, the function and duty of a quality human being is the sincere and honest development of one’s potential.” (Bruce Lee) A quality growth sustained over time will enhance value. Therefore, even if one has misjudged the value and overpaid, rise in value over time will give a chance to catch up and will let avoidance of permanent loss of capital. A pure cigar butt may not enjoy such luxury Also, growth proves to be an antidote against the malady of aclinically depressed market or the market going through a prolonged bear phase. Agenuine quality growth business really helps in dealing with such a phase of markets better. It may help in avoiding falling prey to the temptation of surrendering good business away ata weak point, or capitulating before the markets. For a Same Rupee of Profit, (Capital) Dilutive Growth Results in Lower Relative Value Compounding compared to Non-Dilutive Growth. “A man begins cutting his wisdom teeth the first time he bites off more than he can chew.” ST eee oyEARNINGS GROWTH: QUANTUM, CONSISTENCY, PREDICTABILITY, DURABILITY Inequity markets, itis almost axiomatic that other things being equal, the dilutive growth would resultin lower compounding of returns than the non-dilutive growth, Typically, markets tend to view capital dilution with healthy skepticism, Non-dilutive growth is put on a pedestal by markets, because it reflects that a business has intrinsic character inherently right such that it can grow relentlessly and yet not call for more and more external capital. Market puts this factor as one of the most important kind of motherhood tests in judging the character of a business. In certain situations, some dilution of capital may become essential. A firm may make its first capital issue merely to acquire the currency of the market cap by getting listed in the market. A significant acquisition may need dilution. A meaningfully large project may call for growth capital which may permit a firm to achieve its due place under the sun, by tapping full potential of the opportunity before itself But concerns creep in if the dilution is recurrent, devoid of the economic logic, outsized, is for an unrelated area or is perceived to be for spurious or dubious reasons. Any or all of these situations typically may be met with punishment from the markets. Any persistent capital raising efforts and sustained dilution either reflects poorly on the character of the business, or on the management (because the motive of the management then also may be seen with suspicion), and more often than not, it will bea negative test for both. Some businesses inherently require some amount of dilutionin order to achieve certain level of growth. It may be self-evident in the nature of the businesses. For exampl&"banking and finance firms have raw material itself ‘Geifioney and Would, therefore, from time to time require some amount of additional capital if there Js an opportunity and capability to grow beyond what their ROEs can encompass. But any dilution, deemed excessive to needs or unreasonable in the overalll context, would be met with punishment by the markets. And that can be seen in the best of the sectors for the best of the companies that have diluted needlessly or recklessly and the companies that have not diluted, the differencesin the returns are visible. Table 4 amplifies this well. The purpose of this table isto find out the effect of significant capital dilution on the value ofa business. Thisis being done by comparing actual market cap with ‘Conceptual Minimum’ market cap, which is sum total of the market cap in the initial period (Dec 2006) and funds raised in the interim period (i. FY 2007-11), without taking into account the time value of money for the funds raised. This is the bare minimum market capitalization that should have been achieved if there is to be no ‘absolute’ value obliteration. Market Cap impact is calculated by relating actual market cap (Dec-11) with the conceptual minimum market cap, as a% fall or rise. Any fall would indicate absolute level of market cap obliteration.saa EEE RISE EARNINGS GROWTH: QUANTUM, CONSISTENCY, PREDICTABILITY, DURABILITY TABLE 4: SNAPSHOT | ‘TABLE SHOWING ADVERSE EFFECT OF SIGNIFICANT CAPITAL DILUTION (ON INVESTMENT RETURNS OVER FY 2007-12 preety Tee Notional oF Dilution (%) Mca onee ‘Meap Impact 503% or worse 96% | asx | 155%] 21% | s1a% 24.0% -7a1% [ Map impact less than 50% but greater than O% 143% | 9.7% | 221%] 10.1%] 45.8% 6.2% 2101% | — | — ‘Mcap Impact 0-100% 193% | 144% | 34.2% | 342%] 430% | 74% | a2a% ‘Meap Impact > 200% 299% | 26.4% | 36.7% | sac] 38.6% 24.1% 163.4% {Re Investment Return (Compounded annualy) Significant Capital Expenditure Projects or Significant Dilution in Comparison to the Existing Scale of Operations or Value of a Firm will almost Invariably end up in Tears. Even moreso, when the Time taken for the Fructification of Projects is very Long and Project Economics is Uncertain. “You only have to do a very few things right in your life so long as you don't do too many things wrong.” (Warren Buffett) (BUSIFESSES entailing significant capex and businesses with significant capital dilution are Siamese twins. Typically, both of these are linked conditions where businesses with high capex will have a high capital dilution and vice versa. Arid fVpically, both these issues are an anti-thesisto earning good returns and providea perfct FEcIBsToFTediocre returns f not losses) Significant capex will mean deterioration of ROCE and which in turn violates the fundamental condition for value creation. Significant equity dilution will mean that the value of equity available to the existing investorsis, progressively withered away with constant capital issuances. Significant capex will typically come with deterioration of balance sheet health, raising both financial and operating risk of the business. This, in turn, raises the overall risk of the firm, which will be accompanied by investor returns being eclipsed. Businesses which keep on incurring more and more capex will have significantly high dilution, and will rarely have the ability to create value on a sustainable basis. if they create value in some period, itis like a mirage, but it is virtually impossible for businesses that have a high capex and in turn high capital dilution, to create a ‘sustained value over a longer period. Such businesses end up in tears by eroding market value especially if the projects are convoluted and fructify over along period of time. ‘When ambition overtakes sensible economic logic, business size may be burgeoning, but actual value created may keep diminishing and get impaired. Such businesses not only erode past value created but also render GEGite ail the intermittent capital raised since then. The correlated condition is that even for a good b bad capital allocation decision will have a similar effect. In other words, companies gobble up and try to buyEARNINGS GROWTH: QUANTUM, CONSISTENCY, PREDICTABILITY, DURABILITY businesses which are significantly bigger than their current compass would permit them to digest, the effect, will be that these businesses will witness diminishing returns to scale over a period of time, if not negative returns. Please see table 4 which shows dilution of capital and its effect on the market value of firms over the period FY 2006-11. Many infrastructure firms have current market cap a fraction of what it was 6-8 years back. Not only that, all the large capital raised in the intervening period has been completely vaporized. Simplex Infrastructure, NCC and Hindustan Constructions (HCC) are just a few of such examples. A good business like Tata Steel has transformed (if one can use such a term) since the time Corus was acquired. A proud, cash-rich balance sheet is weighed down with debt. Size has clearly multiplied, but value has become a fraction, even after a passage of six years since the acquisition. Size of Bharti Airtel has gone up significantly since debt: funded large acquisition has been made but ROCE has plummeted to an incredibly low 6% and market value is well below what it stood 6 years back. The story repeats with Crompton Greaves, Suzlon, Aban Offshore, Indian, Hotels, GMR, GVK, Lanco, Educomp, Pantaloon and Bilcare. Many such examples abound, some very large firms and others mid-sized. Context and details may vary for each firm but the outcome is similar. Many retalling businesses, aviation firms, media businesses, hotel chains, film screens or education firms, all have similarstories to narrate. Acquisitive Growth vis-a-vis Organic Growth: Market does not Reward Acquisitive Growth in the ‘same way as Organic Growth. In other words, Per Unit Market Returns for a Unit Growth of Profits is Less for Acquisitive Growth, than for Organic Growth. “Rome was not built in a day Clearly, markets see and make a distinction in the colour of money. When the growth is created internally, compared to the growth which is acquired through a purchase, market values the same rupee of profit, differently. Thisis where the invisible hand of the market in treating the same rupee of profit differently comes by. And there is an economiclogic. When there is an acquisitive growth, typically the acquisition price will be at o above the market value. Therefore, the mere fact of acquisition cannot be value accretive, and from a perspective of economic returns, acquisitions which are done at market value or higher, cannot generate the underlying superior economic returns. Given the history that most acquisitions fail in creating any economic value (globally ~90% or more of acquisitions have failed to create value or have actually destroyed value). Markets tend to view acquisitions with suspicion, especially large or unrelated acquisitions. The suspicion is notill-founded because in empirical practice one has seen that the final results end up in tears. On the other hand, organic growthis created, is built s experiential, has a certain sense of pride attached toit, All this makes it more durable, lasting and sustainable and at a more economically efficient cost. And, therefore, market views and values this sustainability factor of internal growth much-higher than acquisitive growth, ‘Within acquisitions, what has worked better is Goliath (bigger firm) acquiring David (smaller firm), rather thanEARNINGS GROWTH: QUANTUM, CONSISTENCY, PREDICTABILITY, DURABILITY the other way round. Synergistic (in the similar or same line of activity) acquisitions have a relatively better record and acquisitions strategized for cost savings (rather than income expansion) have worked better. Focused and Diversified Growth. “Owning stocks is like having children: don't get involved with more than you can handle.” (Peter Lynch) We have seen that markets tend to view non-dilutive versus dilutive growth and acquisitive versus organic growth differently. It is also seen that conglomerates don't enjoy superiority in the eyes of the markets but actually suffer a discount. The other finer point is that an existing business wants to or is planning to get into new activity which may be similar in reality, similar only in appearance or may be completely different activity. Typically, diversifications occur for many reasons. Bie) when existing business denies adequacy of the growth, GWBi management believes that itis in a position to achieve success in the new activity, which at times may be based on real logic and at other times, a convoluted and contrived logic firde, when purse is heavy and ideas are feweffghi,, when idea of grandeur overtakes the cold rationality of economic logic. Whatever it may be, ‘markets typically have tended to view such attempts with skepticism, if not bordering on suspicion. And during, the period while the experiment is unfolding, markets tend to take a muted view of the situation, till the ‘managementis able to establish their ability in a new area or is able to prove convincingly their forte of getting, into a new area through performance. Experiments of quality businesses like Piramal Enterprises and Numeric Power are interesting. Business of Piramal Enterprises was sold at a very successful price and only a small part of pharmaceutical business was retained and the sale proceeds have been deployed, rather than distributed, in unrelated areas like real estate, finance and telecoms investments. But markets are not convinced about this and the situation is treated as a work-in-progress and not finished goods, as yet. Therefore, the value of the firm is ata discount compared to the value ofits assets. Similarly, Numeric Power, after very successful sale of their uninterrupted power supply system (UPS) business, has chosen to deploy sale proceeds to an unrelated energy project and markets have responded the same way. On the other hand, high-quality firms like Bajaj Auto, Marico and Wipro have reduced the complexity of their businesses. We have seen that Bajaj Auto, which was running a very large treasury and finance operation within a two-wheeler business, eventually demerged these businesses and successfully developed both the lines of the businesses separately, gave each a focused attention and management bandwidth. Markets have actually lapped up both the businesses with a lot of enthusiasm with the rising success of each. Marico diversified into beauty care service business like Kaya, which has some synergy with Marico, but not really a ‘hole lot (a service business married to a product business). Even after a decade, it could not be established that Kaya could run independently and generate its own cash flows. After a long period of nurturing Kaya, finally, Marico has decided that probably itis more value-adding to segregate that business and put it into a separate arm. Wipro, finally, has separated the odd bed-fellows like consumer business and technology business. tis early to forecast the impact but the market bias would beto see it, and rightly so, in positive light. FCs mereceEARNINGS GROWTH: QUANTUM, CONSISTENCY, PREDICTABILITY, DURABILITY So, the logic of markets on the above isnot misplaced. There is only alimited capability that hurrians have and even the best of the managements have capability confined only toa particular area or very himited number of activities at best. You would have loved listening to Ahmed Jan Thirakwa play Tabla, but not him singing. Kapit Dev was 2 great of Cricket, but only good at Golf, When even best of the managements try their hands into unretated or fess-related activities, record oftheir success has been rather patchy and uncertain. Which iswhy that skepticism of the markets when these so catled related or unrelated diversifications are attempted because the track record of success is rather patchy whichis reflected in the kind of discount that markets tend toplaceat these attempts, Buffet puts t well, though he talksabout it in the context of money managers. With a suitable modification, it applies tothe businesses and managements as well. He says, “The stock market iso no-called-strite game. You don't have to swing at everything-you con wait for your pitch. The problem when you're a money manager is that your fans keep yelling, ‘Swing, you bum!” Equally, usuat finding is that there are only afew opportunities worth swinging at, for any businesses. Its probably best to disregard! the cajoting ofthe cheeringcrowd to act. There are, of course, exceptions but that is why the rule prevails! Banking and Finance: A Special Compounding Machine. Within high growth and compounding machine space, banks and finance occupy a special place. Given the ubiquitous need for and lubricating presence of money, and also given the real large size of opportunity, successful finance businesses can get to be very large. Observe the pole position that finance sector occupies ina large and tertiary sector economy such as USA, not just before the cataclysmic events of 2008 but even thereatter, Sank and finance businesses represent a very unique opportunity in several respect$id} they are inherently a compounding machine, especially in a continued phase of high growth of the economy since they represent a proxy on the growth of the economia) typically, these businesses tend to be a lead indicator of the growth rather than a lag, in the sense that typically the growth of the banks and finance firms precedes the GDP growth) it'tends to be a force multiplier compared tothe GOP growth .. the growth of the sector tends tobe amultipie of the growth of the GDP. In terms of the character of business, there are other distinguishing aspects as well, compared to most other businesses) There is no concept of return on capital employed for obvious reasonsff't is legitimate for these businesses tohave a significant leverage as compared tothe other businesses suchas manufacturing’) * Dilution of capitals part of the game and snota crime’ as it would be regarded in the other businesses simply because the raw material is money and to that extent the size of the growth will cal for well-timed and effcienty priced cilution at defined intervals,ATAGE isnot just an outcome ofthe earnings growth, buta cause aswell The key value creating parameters are, typically, a matrix of the quantum of growth and quality of the growth ((-e. the return on equity). The ROE would bea function of how good is the return earned on assets, how well is the balance sheet quality maintained i.e. delinquency is contained {balance sheet is even more critical than profit statement in judging the health of these businesses), how efficiently have the expenses been managed and finally what has been the level and appropriateness of leverage. RERURTT BR @IEE (ROA i i| EARNINGS GROWT! UANTUM, CONSISTENCY, PREDICTABILITY, DURABILITY -fameHlan’OFMiciency of the asset book cost of the liabilities, duration management and asset-liability match. / ‘These aspects would percolate from a given level of ROA toa ROE. So, the critical part of the quality isthe ROE which subsumes within itself all four of the above parameters. The growth again is an outcome of a superior ROE, the size of opportunity in the external space and ability of the management to harness the environment, +o appropriately take advantage of this opportunity by strategic and well-timed dilution of the capital. Thus, ROE and growth in earnings are the key parameters which will have a telling effect on the value creation, Broadly, the matrix would be that superior ROE combined with superiority of earnings growth will provide the ‘most potent combination and clearly a mediocrity of the ROE would have the most telling effect on the size and the extent of value creation, as wellasthesize of growth. Following observations emerge from the Table §: 1) ROE, growth of the earnings and asset quality have the maximum effect on the value creation. 2))ROEvand growth have a mutually interacting, cause-effect type off fionship. 3) Once the sanctity of basic value-creating ROE is established, markets turn their attention to growth, asa major factor for value creation. 4) Inthe short-run, growth seems to swing more weight, but over a longer period, quality including asset quality) seems to be a winner. 5) In more bullish phases of the economy, growth has a greater influence but a challenging period seems to favour quality dominantly. a) High ROE, High Growth: If we look at the first basket of Table 5, where the ROEs are upwards of 20%, (which by global banking standards would be regarded as outstanding) and the growth in profits (defined as Profit After Tax) is higher than the minimum benchmark of 15% CAGR (taking into account the fact that there is about 15-20% dividend payout for most of the firms, implying effective profit growth of over 18%), itis very clear that there is a very strong correlation between the ROE and the superiority of the growth rates and the value creation almost tracks these two parameters as a combination. Over the ten- year period, the value created has been well above the underlying profit growth and over FY 2007-12, the value created is well below the underlying profit compounding. In other words, for the first five years of the ten-year period, the journey has been outstanding. This is not a surprise given that it was the period when the interest rates kept falling, the economy was on a strong growth path, the size of opportunity seemed to multiply very rapidly and with the growth in the economy, there was very little risk on the balance sheet quality due to asset delinquency. So, in general, for the entire sector, the first five years of the ten years have been a fantastic period, where the period 2002-07 has been both of rapid growth in profits as well as fantastic value creation. The last five years has clearly been a period where the interest rate equation has actually gone awry and interest rates have risen along with the inflation which has stubbornly refused to come down. In many cases, ROE has also suffered and the size and quality of growth also has been impacted and very clearly, itis in this period that for even the superior firms, the value creation has been far more modest and in most cases, much lower than the underlying profit compounding. GRUH Finance is one of the clear outliers: not only is its ROE much higher as compared to that of the other firms, but itis the only firm which has materially improved its ROE over the last five years and stands at an outstanding 31%. It is the only firm where the value creation has kept pace with the underlying profit, compounding even for the last five years. in general, this is a basket where the first five years of the last ten years saw superb value creation, while the equation in the last five years has altered and has very clearlyEARNINGS GROWTH: QUANTUM, CONSISTENCY, PREDICTABILITY, DURABILITY shown that markets have given a strong preference to the firms which have maintained the quality parameters of ROE and the strength of the growth. b) High ROE, Modest Growth (ROE > 20%, Growth <15%): coming to the next segment, the observations are similar for the last five years. The lack of growth has had a very telling effect on the value creation and in general, the entire basket in the last five years has failed to create any noticeable level of value creation despite growth still being largely in the double digit, but with considerable deceleration in the growth rate and, more importantly, the asset quality deterioration or the fears of that, have ensured that the value creation has been pretty weak. ©) Modest ROE, High Growth (ROE <20%, Growth >15%) in this group, for the first five years, the value creation has largely been decent keeping in mind the overall opportunity and the breathtaking growth rate that occurred in that period. However, the returns over FY 2007-12 have been significantly impacted. The oniy notable exception is HIE Housing Finance. it addresses not only the large opportunity of mortgage finance, but also itis one of the outliers of the group, in terms of having strongly improved ROE over the last five years compared to the previous five years, and also the growth in profits has been superior over the last five years compared to the first five years. This is the only clear exception in the category where the quality of the compounding has kept a very strong pace and remains well ahead of the underlying profit compounding. Barring that, the underlying inferiority of ROE has had a clear impact on the quality of the compounding over the last five years. d) Low ROE, Low Growth (ROE <20%, Growth <15%): the worst affected category is clearly this one. Over the lastfive years, this category has been virtually torn apart, with a notable exception of S6Uith Indiah Bank (which isa rather small bank). Most others have suffered negative returns over the last five years or very low returns, ingeneral. Thus, the compounding multiplier has taken the highest knock for this group in the last five years. TABLE 5 : SNAPSHOT ‘TABLE FOR BANKS AND FINANCE FIRMS CO-RELATING DIFFERENT COMBINATIONS. OF ROE AND GROWTH OF PROFIT BEFORE PROVISIONS (PPP) AND INVESTMENT RETURNS (COMPOUNDED ANNUALLY) FOR THE PERIOD FY2003-12 or oe | ROE <20%, PPP >15% 1.8% | 15.8% | 22.1% | 23.2% | 27.1% | 1.6% | 15.2% | 25.8% | 28.1% | 11.6% 1: Investment Return (Compounded annually) Size of opportunity in Banking and Finance is huge. While markets are always excited about the growth inEARNINGS GROWTH: QUANTUM, CONSISTENCY, PREDICTABILITY, DURABILITY earnings, especially when the picture is generally buoyant and attractive, they don'tlose sight of the quality of ‘growth (asset quality and ROE). Ultimately, ROE has a very clear impact on the underlying profit compounding as well as the level of dilution which is necessitated to sustain the growth. (figeneral, OE willprovidearrupper (Gif RAFRTEEE Hable profit growth without dilution. To tHat extent, banks which enjoy superior ROE would be able to afford a superior earnings growth without dilution, which is the most potent combination for the highest value creation. A very clear example of that is GHUH Hinace, where the capital dilution has been minimal over the 10-year period and the ROE has been one of the most prolific ones and given the large ‘opportunity in mid-level mortgage finance, it has compounded the earnings growth, within the ambit of the superior ROE, ata breathtakingpace. The value creation has been one of the highest for GRUH Finance which is ro surprise. Markets also reveal that mere size and dominance of a bank would have limited meaning if the parameters of earnings growth, and more importantly, the ROE, are not fully reflected. Among the large banks, ‘HOIETBER stl surfers from negative return over the period of FY 2007-12. itis the largest private bank in the country and yet the markets have taken a complete cognizance of the fact that the growth has been weak over the last five years as @ consequence of deteriorating and low ROE, coupled with asset quality concerns, materially pronounced over the last five years. Allof this has had a telling effect on the value creation. Finance isone area which is a massive compounding machine. One can put in large dollops of money, fora real long time if one is convinced about the growth of the economy and the quality of the firm to manage risk and ‘the growth, then even with occasional dilution (that finance business inevitably has to go through), it will still be one of the most superior vehicles for strong value creation for a long time to which one can allocate serious amount of capital. ASWSRS Capital dilution is concerned, for a finance businéss, money ‘FSW material ata cheap price (meaning at a higher market price as compared to the prevalent price or the; (PrEEEHAEIEPESlly deserves to get!); hasa very positive effect On the value création. Markets tend to reward handsomely the finance entities which have been able to raise money at efficient intervals at an efficient price and have been successful in escaping the rigors of dilution on the value creation. Efficient and timely ability to raise money for a finance entity is an advantage rather than a punishment that you generally witness for the nnon-finance businesses which have diluted frequently or raised funds at a price which is removed from the intrinsic worth of a business and is typically followed by value reversal later on. Finance businesses tend to { escape from these clutches ina rather interesting way. One can see this interesting paradox quite well in value created by private firms versus public ones. Piivatellirnis, gerietally Speaking, have commanded ticher valuations{Price/Book Value) and yet have provided richer returns, over prolonged period despite differences / ig: ROE not being material. Consistency of growth, quality of asset book and timely, efficient capital raising/ @SUIIVRashadsomethingtodowiththis.Py QUALITY OF BUSINESS: CAPITAL INTENSITY AND CAPITAL EFFICIENCY Ba ene Re RE Ne of the fight in the dog.” (Dwight David Eisenhower) Quality of Business “Not everything that can be counted counts and not everything that counts can be counted.” (Albert Einstein) QUAlityOF business, in simple terms, is its a ity to generate superior, consistent, predictable and durable 'ROGE!|t essentially stems from the pricing power of a business - whether business is a price-taker or a price ‘maker in its competitive space. Ability ofa business to be price-maker is likely to stem from an economic moat (aprotective armour, an ability to repel competitive challenges or threats or ability to enjoy durable advantage ahead of competition). Sources of moat can be, but not confined to, protected intellectual advantage, legally sanctioned monopoly, a valuable brand, an exclusive technology, favorable customer goodwill, lasting cost advantage and the like, Absence of moat, or breaching of moat, implies weak quality of business, and, in turn, threatened or impaired value creation or investment returns ‘Two Vital Tests for Quality are Capital Intensity and Capital Efficiency. Quality of business really has two important facets~€apitalTitensity (whether a business fundamentally requires high amount of capital) and Capital Efficiericy (whatever be the amount of capital required in the business, whether it generates a superior return or not). Capital intake basically defines the character of the business. Certain businesses, by their very nature, have a frontloaded and capital intensive base. Obviously, such businesses face great challenges because capex is a certainty while revenues and profits remain conjecture till they happen. So, one doesn't get a chance of calibrating the capex program with emerging business realities. f the busit ess reality alters adversely, heavy capex incurred upfront may be exposed to heavy losses. Often, such capex programs tend to be lumpy and stretch over a long period of time. if for some reason, that gets elongated, ROCE suffers adversely. Airlines, hotels, theatre screens, retailing, metals, oil exploration and many other such businesses have this basic flaw in the character of the business. Take, for ‘example, an airline business. Assumed future demand determines present and heavy capex in capacity creation. But the business itself is subject to material risks in the form of volatile revenue, inflexible costs and recurrent, heavy and lumpy capex. Empty aircraft seat (or for that matter, an empty theatre seat or unoccupied hotel room) at any point of time is a permanent loss of revenue because there cannot be any inventorising of oreo Ceenar QUALITY OF BUSINESS: CAPITAL INTENSITY AND CAPITAL EFFICIENCY ‘an empty seat and isa permanent loss of revenue. Pricingis often subject to intense competitive dynamics and the costs are largely inflexible and lumpy, with fuel costs (uncontrollable) being a significant element of cost. Hence, the cost structure, the revenue side as wells the capital structure, al represent challenges and beyond ‘one's control. This is what makes airlines such a terrible business. In general, its really hard to make profits in this business, while economicprofits being sheer luxury, Capital intake/intensity is fundamentally a very stubborn and rigid element of a business. Almost invariably, a capital intensive business is illdesigned to create lasting and/or superior value and that is not very hard to understand. High capital intensity raises operating leverage of a business, and in turn, enhances the operating risk, That stems from more than proportionate change in profitability of a business, for a given change in the operating scale (or output) of a business ~ due to the presence of inflexible and lumpy costs in the cost structure. Increased operating risk reduces the desirability of the business in the eyes of investors and hence, reduces returns systemically over time. The corollary of high capital intake usually is low ROCE and mediocre ROCE is a fundamental negation of value creating capability. So, high capital intensity fundamentally lowers value creation through increased (operational) risk and reduced capital efficiency, thus exposing business, over time, to vulnerabilitiesifnot failure. ‘The capital intensity can stem from two elements: the need for fixed assets (fixed capital) and/or working capital (circulating capital). A business which requires both high fixed capital as well as high circulating capitalis a business with a rather unfavorable capital intensity profile. In some cases, high fixed capital intensity may be compensated byflewicirculating capitalintensity and vice versa. Ideally, for a business to create a real value, it needs to have low capital intensity both on account of the fixed capital and working capital. But if one has to tolerate capital intensity for any one of the two elements, then it is better to have capital intensity due to working capital rather than due to fixed assets. That is because, as discussed previously, capex is upfront for uncertain possible cash inflows tomorrow. And given the rigidity of the fixed capital, it becomes difficult to maneuver or modify the fixed capital intensity with the change in the business conditions. Working capital, however, can be varied with the change in the scale of the business and hence, provides greater flexibility Itis possible that a business may be capital-light and yet has mediocré capital efficiency. Its not always the case that capital intake has to be high for the capital efficiency to be low. Capital efficiency can be low even in situations when capital intake may be relatively low. For example, a trading business will typically have only circulating capital and very little fixed capital. Such a business would have low operating risk in form of low fixed capital. Working capital, for some reason, could also be low as well, which means the business overall may be capital ability to create superior ROCE. So, the business which is asset-light and income-heavy (rather than the other way) has structurally the capability to preserve and create lasting value, ifit also has superior ROCE. ight. But, empirical data does not show that there are many trading businesses which haveQUALITY OF BUSINESS: CAPITAL INTENSITY AND CAPITAL EFFICIENCY Persistent and Superior Capital Efficiency is the Single Most Important Evidence of Quality. “Profits are merely costs of staying in a business.” (Peter Drucker) Profits are not necessarily an evidence of value creation, though without profits, value creation cannot take place. Even growth (of profits) is not necessarily an evidence of value creation, though without growth, expansion of value creation is muzzled. Value creation can occur only f there are economic profits. Profits are economic profits (and not just accounting profits), only if they are left after charging all real costs of being or staying in the business. For example, an owner working for a business, and not charging remuneration for his, services as.a manager, will merely inflate accounting profits but will not add to any real economic value. Similar isthe case, when a promoter of a business puts in his own capital but doesn't charge a fair cost of capital to the business. Earnings Growthis Necessary but not a Sufficient Condition for Value Creation. “Growth for the sake of growth is the ideology of the cancer cell.” (Edward Abbey) Economic Value Added (EVA) is the measurement of difference between ROCE and cost of capital. Market Value Added (MVA), over a period of time, will be favorable only if EVA is positive; MVA can have possibility of being substantial only if EVA is large; NVA Will have| possibility of experiencing ri 8 Bradient only if EVA is ZFIIFg.[Rise in profits does not necessarily imply rise in market value. Profits may rise even by injecting more capital in the business. Rise in profits with falling capital efficiency can, in fact, diminist jot actially negate, Value creation Therefore, growth of earnings is a necessary condition but not a sufficient one, for investment returns. Growth to be value accretive, has to be capital efficient growth, or growth has to be backed by superior ROCE. ROCE is, sine qua non, of quality of business; Consistency, durability, predictability and superiority/of ROCE is the acid test on which the possibility or otherwise, of economic value creation (or investment returns) is tested. Concept of ROCE operates at two fundamental levels: absolute i.e. the level below which long-term value creation is not possible. An Absolute minima for ROCE is the cost of capital and relative, i.e. how far is the ROCE superior to cost of capital or how much is EVA. Absolute ROCE is the critical level below which permanent loss of capital may arise. Relative ROCE magnitude, along with growth, paves the way for inferring magnitude orlevel of investment returns. Hygiene of ROCE gets Reflected much more Vividly in Balance Sheet rather than Profit and Loss Statement. Itisa simple truth that profit and loss statement is more open to conjectures and variability (fatherhood) while the balance sheet numbers are relatively more a matter of motherhood. The capital employed is @ far clearer number than the stated profit, which is subject to many ‘malleable’ opinions and assumptions. To a large extent, balance sheet is a greater reality than what a profit and loss statement would imply. While ROCE is a derivative of both the profits (P&L statement) and the capital employed (Balance Sheet), clearly the hygiene of tines Se ea EEE‘QUALITY OF BUSINESS: CAPITAL INTENSITY AND CAPITAL EFFICIENCY we ROCE would more likely be evident from the balance sheet and its quality. Whether fixed capital commitment is frugal and sparing and whether the working capitals optimized due to better and efficiently run operations, will havea bearing on the total capital employed, which in turn will have a bearing on ability to maintain a high ROCE. ABGEFUNnINE|A tight ship for both fixed assets/ahd working’capital, in many ways, emanates from sincernatcapabilty and strength of a management; profits havea relatively greater externality, while balance ¢ csheethasgréaterinternality$if we are looking at signs for sustainability of ROCE, then the greater evidence has to be unearthed from the balance sheet and relatively less reliance has to be placed on the profit and loss account. Thus, balance sheet has a more structural ‘fixedness' element while profit and loss has a more dynamictfluidity. Growth and Quality of Growth are not Co-incidental for Creating Value but they actually cohabit to doso. scram Tike gold, is to be obtained not by its growth, but by washing away from all that 1S not gold.” (Leo Tolstoy) | Fusion of the two vital aggregates, rate of earnings growth and quality of earnings (viz. the return on capital ‘employed), determine the character of fertilization (or investment returns) Key possibilities are (as shown in Table 2): a) High ROCE with high earnings growth (ROCE>20%, Earnings Growth>15%): clearly the best combination and potential for the highest possible value creation. These are the businesses with both strength and character, leading to high and sustained value creation. Not only that, this combination has the highest potential for CM to be well over one. b) High ROCE, sub-par or poor earnings growth (ROCE>20%, Growth<5-15% or <5%): high ROCE with sub- par growth is at best a recipe for maintenance and preservation of capital.Gdod ROCE but mediocre growth is / akmtotoveless labour ¢) High ROCE with plunging earnings can lead to value destruction despite high ROCE d) Inferior ROCE but high earnings growth (ROCE 10-20%, Growth>15%): inferior ROCE can be in two situations viz. inferior per se but still higher than the cost of capital. Such businesses may not destroy value but may not also lead to high value creation. It may still be preferred over a business with low ROCE and low earnings growth e) If the ROCE is persistently lower than the cost of capital, then any growth will be destructive rather than productive. Pye en + Equty investingQUALITY OF BUSINESS: CAPITAL INTENSITY AND CAPITAL EFFICIENCY Gentry ‘Aspirer Winner FYO3-12: 5% FYO3-12: 19% FY03-12: 33% FYO7-12: -9% FYO?-12; 4% FYO7-12: 12% Struggler ‘Treadmiit FY03-12: 9% FY03-12: 26% FYO7-12:-7% FYO7-12: -1% Value Obliterator / Sweatshop FY03-12: 636 107-12: -9% ‘The above matrix shows investment returns for different categories in two different time periods (FY 2003-12 and FY 2007-12) Winners: “jos eae over the FY-2002-12 got os companies generaly enjoy superior compounding multiplier af over one. Some ofthe finest names are to be found in this list. ITC, Marico, Pidilite, Sun Pharma, Lupin, Nestle, Asian Paints, CRISI, Titan, Shree Cement, 3M, Gillette- all belong to this list with exceptional invest ment returns. What is noteworthy is grip fs the ontyone erate Positive investment returns (CAGR of 12%), even over the, rof F¥ 2007-12, this group is a celebration of superb capital efficiency and outstanding growth © ate. This the fertile territory for finding multiyear compounding machines and yet offering great safety, during tough times of the market. oe 3M India has an outstanding compounding multiplier of over 2, in both FY 2003-12 and FY 2007-12 time periods, The average Core ROCE of this company is in the range of 40-80% for both the time periods with an ‘earnings growth of ~15% for the jonger period. Clearly, the market has been generous with the business, prohably, due to its outstanding innovative product pipeline, high earnings potential, business efficiency, strong management pedigree and the size of opportunity. Table 2 shows some other star performers like VST.i | | QUALITY OF BUSINESS: CAPITAL INTENSITY AND CAPITAL EFFICIENCY Industries, GSK Consumer, Blue Dart and many more enjoying CM at a considerably high level. The reasons for such high performance qvera longer period of time includgalery favorable entry price) three. andgrowing size of opportunity) greater clarity of earnings growth d) higher predictability of earning) Luperior we eacenualngstandingcaptal efficiency, and) ito capital dilution fora prolonged period. Five companies have suffered CM at less than 0.5, whichisa sharp deviation from the expected outcome. Four ofthese are from the Information Technology sector viz. Wipro, Mphasis, Infotech Enterprises and Polaris. The software pack seems to be a case of increasing uncertainty of earnings growth rate and had a low margin of safety to begin with. Wockhardt is the only non-IT company and has subsequently considerably improved its compounding multiplier. Aspirers: Companies which have a high ROCE and moderate earnings growth should logically provide safety with reasonable value creation due to its superior business characteristics but moderate growth rate. The compounding multiplier for this set of companies should be close to 1 ie. closer to earnings growth. This category is largely a recipe for preservation of capital with at least a reasonable appreciation of capital. But marketsare unlikely to reward them substantially for the reason of low growth. There are 30 companies in this category. Some of the notable names are ABB, P&G, SML Isuzu, Hindustan Unilever (HUL), GSK Pharmaceuticals, BASF, Castrol, Honda SIEL and more. CAGR returns are lower than the Winners and so is the CM. Apart from the Winners, the Aspirers are the only other businesses which have managed to post positive returns (albeit at a modest 4% CAGR) over the difficult period of FY 2007-12. Within the category, companies having exceptional ROCE (Sanofi, P&G and others) have superior CM. For a few companies like ABB and Kirloskar Brothers, CM looks high due to depressed profits of the last fiscal whichis rather temporary in nature. Companies like GNFC, Tata Elxsi, Geometric have suffered inferior CM due to deterioration in earnings growth coupled with falling capital efficiency. Gentry: Companies which generate superior ROCEs but with low or negative growth, would at best be a recipe for capital preservation. While the high-quality character of these businesses would ensure that value is preserved, the lack of earnings growth would not enable these businesses to create long-term value and a ‘more challenging phase would actually result in withering away of value. Names like Monsanto, Merck, BPCL and 1OC are among the prominent ones. Treadmills: Value creation is harder, episodic and unpredictable given that this set of companies has moderate ROCE and high growth. These businesses have to pump up extra efforts, just to maintain status quo and to progress ahead, they require strenuous efforts. The category has done rather well, over FY 2003-12, with CAGR of returnsat impressive 26%, CAGR of profits at even more impressive 32% but with modest average ROCE at only 16%. Over the latter period, the picture alters materially, despite average ROCE still being at the same 16%, with CAGR of profits sharply lower at 18% and the CAGR of returns drops even more sharply at(-]1%.Some ofQUALITY OF BUSINESS: CAPITAL INTENSITY AND CAPITAL EFFICIENCY “spmarketand lower of the two in the difficult phase. @xcluding the asset based companies, which do not follow the rule, some companies like Jubilant Life Science, Elecon Engineering and Simplex Infrastructure have a CM of more than 1.2 during the FY 2003-12 period. Favorable entry price has enabled the market returns to be higher than the underlying profit returns during this period. However, there isa stark difference in the picture for the last FY 2007-12 period, characterized with the reduction in the earnings growth, the market returns have nosedived. ‘There are a few companies with a rather poor CM of less than 0.5. While Hexaware and Kale Consultants (now Accelya Kale Solutions) are both from IT sector, Kalyani Steel and others have seen a fall in their earnings as well as ROCE, resulting in adverse market returns. Strugglers: Life is perpetually a struggle for this category and it never is easy. Even with the best and most favorable circumstances, value creation is very modest and rather patchy. The businesses have moderate ROCE and mediocre to low-growth such that itis in a range which is manageable even with these mediocre ROCEs. They are not the ideal candidates in a portfolio from a value creation perspective. While a cheap entry price could lead to market returns being higher than the underlying earnings growth for a given period, but that may not be sustainable. The table shows that there are a few companies which have given annualized returns of 2076+ in the FY 2003-12 period, possibly due to the very favorable initial entry price, however, in the FY 2007-12 year period, there are very few companies that have given even positive returns, highlighting the inferiority of the character of businesses. Some of the prominent names here: Great Eastern Shipping, Indraprastha Medical, "Sundaram Fasteners, TVS Motors, Zee Entertainment. | Sweatshops/Value obliterator This set of companies, where the ROCEs are lower than even the cost of capital, should lead to value destruction in the long run. Asset based companies will not follow this general rule. While a cheap initial valuation may have led to accidental investment returns, itis not a sustainable or a consistent compounding and would typically be sporadic in nature. ‘TABLE 2 : SNAPSHOT ‘TABLE CO-RELATING DIFFERENT COMBINATIONS OF CORE ROCE AND PROFIT GROWTH AND SORTED ON COMPOUNDING MULTIPLIER FOR THE PERIOD FY 2003-12 Brae’ FY 2007-12 Cd i Gee | noe | op | rar | im Winners 24.7% | 28.1% | 24.4% 90.6% | 28.7% | 20.0% | 206% | 12.4% [acres fran ann | na ran |a6sx | x68 | sam | 29m entry 389% | 152% | 37% | 29m | 47% | 243% | 109% | 26% | a246| 25% Treadmill 160% | 163% | 25.2% | 32.2% | 260 | 16.1% | 15.3% | 21.0% | 18% | 1.2% strugalers aan [aaan | 97% | 29% | 94% [azn | ao | eax | osx | 72% valves Obiterator/Sweatshop | 72% [7.3% | 40x [10.2 | sox | a6x | 74m | 42% | 107% | oa {Rs Investment Retum (Compounded annually) ye eee ce ere a‘The above analysis shows clearly that ROCE and Growth have a deep impact on value creation. From the investment perspective, only the Winners and Aspirers create lasting and predictable value and It fs best to focus on these two categories only. Root to Preservation of Wealth Solely Resides in Quality i.e. Quality of Business and Quality of ‘Management... “The chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.” (Benjamin Graham) Preservation of value Is one of the two most important objectives of any serious investment or investor: a) to avoid permanent [oss of capital and b} to grow the capital, over time. Preservation of capital (or avoiding permanentloss of capital), over-a period of time, comes from andis aided by quality of the business, quality of ‘the management and the margin of safety (or the price-vatue gap). GrsWeHt the earnings also Nasa Way off Sank ‘Helping the cause Sf avoiding petinanent loss oF capital: Even ifane has: Ithelpinobviatingthiserrorefcommissions But of these three factors (quality, growth and margin of safety), the real root for preservation of capital stems from the quality: quality of the business and quality of the management. One of the most Important and consistent ways of judging the qualityOPs Busines ‘to generate an outstanding return. on c ‘SRR RORTOVERY SBtaltIed ora orig period oF dime, consistently and predictablyf ROCE is important both at absolute and relative levels. Absolute minimum ROCE fi.e. above cost of capital) is important for the preservation and at a relative level, it can be compared to its own past or that of the other firms, either in the same or different sectors, While qualitative dimensions (like consistency, predictability and longevity) are important to judge quality of business, ROCE provides quantitative dimension for comparison. Buffett puts it eloquently: business has to be such a high-quality one that even if a monkey were to run It it should run fine because eventually a monkey will! What it indicates is that the high-quality of a business is the ‘most important foundation for preservation of the value of the business or an investment made in such a business -AOCEFevealethe Inet tore of a business: tt shows that thé character of a business isso much hardér ‘Stgietianger This character whether beautiful or ugly, has @ profound bearing on the ROCE, and in turn, its Potential to create value. An ugly business cannot be whitewashed and be made to look like @ Cinderella. Equally, a high-quality business even if faced with a temporary setback or a challenge, wil! be able to fight back and recover, ‘A quantitative data can affirm such a conclusion. One can validate that a high-quality {high ROCE) business és being able to preserve the vatue if held over a reasonabe period of time, even if thas no or low growth; or, @ ‘quality business with good growth, manages to shrug off temporary over-valuation paid for such a business. In other words, even with a negative margin of safety at the time of purchase, such a business will have @ chance of catching up eventually ae eeeQUALITY OF BUSINESS: CAPITAL INTENSITY AND CAPITAL EFFICIENCY .»Butof the Two, the Quality of Business precedes the Quality of Management. “When a management team with a reputation for brilliance joins a business with poor fundamental economies, it is the reputation of the business that remains intact.” (Warren Buffett) Quality of management is not as intangible an idea asitis usually believed to be. As Phi Fisher says, “Holy grail ofa good management is good ROE over a period of time.” Consistent, superior, and a predictable ROE over a long period of time, is without doubt, one of the most important indicators of a quality of management. ThE: Siperiority of a business is inferred from the superiority of the ROCE and the superiority of a management from thé superiority of the ROE. Both the ideas have qualitative and quantitative dimensions. Intuitive and judgmental aspects of inferring the quality of a business and ofa management have their own place. ROCE and ROE are critical quantitative parameters to compare, on @ consistent basis, across businesses and managements. Integrity, vision and execution capabilities are key intangible determinants for judging the quality of amanagement. Quality (of business and management) itselfis an over-arching and powerful idea for long-term value creation andits sustenance. But within the qualitative pyramid also, there isa kind of hierarchy between the quality of a business and the quality of a management. Itis unambiguous that within the qualitative hierarchical structure, the quality of business precedes the quality of management. It is much harder to change the core character of a business. An ugly duckling can't be brushed up to be a swan. But management can indeed be changed or improved upon (though that also is easier said than done). However, the fact remains that it is well-nigh impossible to change the innate character of the business. Management is a relatively changeable variable, but not so simple to emancipate oneself from the clutches of the constraints posed, if not imposed, by a business. Even the best of the management will have difficulty in managing a low-quality business and achieving lasting success or creating economic value. For outstanding value creation, both the superior business quality and good management are essential. But of the two, value creation is more intimately co- related to ROCE than ROE. That is easy to see when itis realized that ROE, substantially, emanates and derived fromROCE. Even with Significant but Temporary Earnings Destruction, a High-Quality Business will Manage to ‘Shrug-offthe Blues, “A wise man is superior to any insults which can be put upon him, and the best reply to unseemly behavior is patience and moderation.” (Moliere) eee quQUALITY OF BUSINESS: CAPITAL INTENSITY AND CAPITAL EFFICIENCY Evenif a high-quality business faces an adversity for a short-term, markets may create, fora while, an llusion of permanent destruction (by decimating price) in the mind but in reality that may not happen. Good businesses inherently have a capability to fend off and repel the threats and finally, overcome them. So, one is unlikely to ‘witness a spectre of permanent loss of capital. The headwinds can be specificto the business or to the markets ingeneral. The latter is relatively easier to deal with. Even ifitis former, quality businesses will have character to fight out for a very long period of time, and only if earnings destruction continues for period beyond short: term, only then permanent destruction will begin to happen. When there is a (temporary) setback to a business, markets tend to create optical illusion, by projecting the adversity as a permanent one, and thus, lowering its market value. However, as the tide turns, quality businesses tend to bounce back strongly with a force. For example, Alstom Projects, after suffering a drop of 111% in 3-Year Profit CAGR (from FY03-06), delivered a very strong comeback when the external environment improved. Even when the setbackin a high-quality business is because of someinternal issues, markets tendto be generous by giving time to the management to take course corrective actions. Even a bellwether lik@HUL} after suffering a prolonged period of low growth due to loss of connect between customer desires and its ‘value’ offerings, bounced back with much more vigor, when it recalibrated the character of its business by greater innovation, improved product quality and by making more strategic, rather than tactical, moves and engagements, in its own market space. SimilarlyjGastrol went through a rough phase during the first half of last decade. However, by repositioning its value proposition, pricing policy, product superiority, creating more awareness and behaving like a leader by creating a brand business in a somewhat commodity business, has recordeda very handsome growth in profitability n the latter part of the decade. ITChasbeen able to maintain its profitability, in spite of continual headwinds that is faces in its core tobacco business, because of its sheer market presence in the tobacco business and an exceptionally robust business, permitting pricing revision and other leadership actions that it takes from time-to-time. Table 6 shows, how quality businesses fend off and repel the threats and finally, overcome them. ‘TABLE 6 : SNAPSHOT ‘TABLE SHOWING RESILIENCE OF HOW HIGH-QUALITY BUSINESSES REBOUND FROM TEMPORARY DESTRUCTION OF EARNINGS . Core | PSE | | oF [or | om | CoreROcE> 00% 2o13%| 260% | mx | 200% | 909% [ossax| 96m [ina [sox | sw cor nocesos008 coax [ nam [ine [aia [oan [esa | soe [iran [ia [ 5 {Rs Investment Return (Compounded annualy)QUALITY OF BUSINESS: CAPITAL INTENSITY AND CAPITAL EFFICIENCY Why it is Important not to Surrender a Good Business during Difficult times. Usually Good Businesses find a way out and Bounce Back. “When written in Chinese, the word "crisis" is composed of two characters. One represents danger and the other represents opportunity.” (John F Kennedy) ‘A good business may face two challenges: tt may face a fundamental challenge or adversity in the business at some point in time, or there can be a general challenge when markets are passing through tough times. Both ‘may lead to drop in market value. More often than not, itis the good businesses which are still in profits when markets are falling, and there is an overbearing temptation to surrender them away when things look bleak, outlook negative and pain-points in the markets appear high /“Plucking the flowers to water the weed]. Butt isimportant not to surrender away good businesses due to the trying times of the market, And even fit faces a fundamental challenge, but a temporary one, then it may be all the more important to embrace the stock than to shunit. Equally, when the general markets are passing through a tough phase and the sentiments are down, the tendency to give away a good one for a temporary mental satisfaction may prove to be an expensive gambit. Itis important not to use a broom to sweep away the good ones while keeping the dirtinside. Table 7A shows yearly high/low prices of firms over the FY 2003-12 period. It shows that even for the outstanding businesses, the year-after-year gap between a high and a low of each yearis quite high, but over a period of time, they have registered higher highs and higher lows. Also, the table shows returns generated over running five-year cycles, for each cycl@jarER@ stockis purchased at the RighEst price ofthe initial year, and Sola, vatsthe:lowest price of the last year (of the five-year period). Incredibly, quality businesses have generated utstanding 5-year CAGR despite this tough condition\All this goes to indicate that why we need to retain ~ positive bias for quality stocks, through thick and thin, if fundamental trajectory of the business retains its purity, despite intermittent volatility. Whién Business is Mediocre but Payout is Strong, Markets View it as an Unaffordable Luxury. in "BURR ESSES, 25 Far as Investment Returns go, Mediocrity Wins! “In investing, what is comfortable is rarely profitable.” (Robert Arnott) When a business is mediocre, it essentially means that itis unable to pay for its meals andit will have a greater appetite for capital than what it can generate, and obviously such a business will have a poor payout. But when a mediocre business has a good payout, it becomes paradoxical and then markets view it with suspicion and treat tas an unaffordable luxury. In such cases, as faras the investment returns are concerned, markets are not deceived and the mediocre quality of the business wins over the superiority of dividend payout ratio. “Analysis thie companies with average coré ROCE of less than 20% and average dividend payout of more than 309% over the 10-year period gives a vivid demonstration of the above idea (Table 8). Average returns for this group.of 29. companies) over FY 2003-12}petiod, is sedate at 14% despite average dividend payout of 42%. The Average returns of 14% have tracked profit growth of 9% in the FY 200312 period: Notwithstanding the high dividend payout of 33%, TVS Motors has delivered CAGR returns of 896 inline with its low profit growth. Essel mshi initet QUALITY OF BUSINESS: CAPITAL INTENSITY AND CAPITAL EFFICIENCY Propack, Finolex Industries and Tamil Nadu Newsprint are afew other companies that show similar trend, ‘TABLE 8 : SNAPSHOT ‘TABLE SHOWING CO-RELATION OF WEAK ROCE AND YET HIGH DIVIDEND PAYOUT WITH INVESTMENT RETURNS (COMPOUNDED ANNUALLY) FOR FY 2003-12 Geeed Bee core oct | ROE TP coe noe <20% ‘Re Investment Return (Compounded annually) inesses, the Returns, if at all, can only be Point to Point; which means'ttis@ very Chancy ri akin to Flipping aCoin: “There are two times in a man’s life when he should not speculate - when he can't afford it and when he can.” (Mark Twain) For the inferior or the mediocre businesses, the returns if at all, can only be point to point. In other words, capital committed for purchasing these businesses represents a chancy affair - more akin to flipping a coin. In such businesses, oneneeds to be lucky twice, while purchasing and while selling, However, in good businesses, returns are, over a period, throughout the continuum. It means that if you miss a point in the continuum, it doesn't mean that you have missed the game. But in the bad ‘investments’, missing that perfect point can, sometimes, have very disastrous consequences and, therefore, it becomes very chancy because getting such a fine closure at all points of time, both on the purchase and sale, isan art which has yet not been established, as widely pervasive skill, in the world of investing. Therefore, investment in a bad business is dependent on good ‘timing’ while a good business, like good wine, gets more valuable with the passage of ‘time’ The good businesses, because they possess compounding power, represent a continuum rather than a point- to-point participation which is the case with bad businesses. Therefore, good business is actually an atrade, Hence, good invest ment.is a matter of skill, while profiting from the bad businesses boils down to a game of chance. Also, an investment does not have to be a zero-sum investment compared toa bad one whic! game while a trade (in a bad business) is, of necessity, a zero-sum game, in which somebody has to lose for you togain inthat trade.36 QUALITY OF MANAGEMENT: TRAITS, CHARACTER AND CALIBRE Gn a EE ee Le feed es ea Be Ee UE A ae LAL ee ee LR ie eae ‘Two Vital Tests for Management: Capital Allocation and Capital Distribution. “Wisdom, compassion and courage are the three universally recognized moral qualities of men.” (Confucius) scapital/allocation is the fundamental test for judging the calibre, temperament arid ‘character of the, janagemiéhit: Pdople rarely have skills extending beyond one or at most two activities. And the ability to manage a particular business is as important as the ability to know what one is not competent to, or should not, manage, which means a success in one particular activity (business) doesn't automatically guarantee success in other diversifications. Empirical evidence of success of new activities attempted is generally found to be poor. Darwi ian principles of evolution derived from the ideas of natural selection, competitive advantage and adaptability suggest the same principle. Thisis why businiéssés which require you to be smart i6fV day lave high proclivity for fllure because nobody can be smart every day, Equally, the smartest and the brightest people are smartest only in the chosen few areas. Laws of nature, constraints imposed by span of attention and competitive capability limitations to constantly adapt to fast-changing world ~ all suggest natural limits to success in diverse areas. Wisdom lies in the ability of a management to know, where to allocate capital (as well as where to deny it) and having courage and conviction to remain focused (and yet have confidence to grow) and having the character to judiciously remain away from allocatingincremental capital to businesses where there is lack of core competence. This ability to allocate capital intelligently and wisely is 2 fundamental test of discipline, character, temperament and stamina of amanagement, Other important capability of the management is the capital distribution. Even when capital allocation in a business is good, there can be poor capital distribution. This means inability to recognize how much of capital should be kept on the balance sheet and how much should be distributed back. Even successful businesses, which generate large amount of free cash, often keep hoarding the free cash (needlessly) on the balance sheet. Thisis when fundamentally erosion of economic value will occur without even realizing that inefficient capital distribution is diluting the value creation. Nominal interest, that free cash hoarded will earn, can never match the superior return that a business earns and hence, over total capital (business + surplus), there will be a dilution of overall ROCE. business which typically generates free cash can use it for four purposes, 1. Some amount of cash generatedQUALITY OF MANAGEMENT: TRAITS, CHARACTER AND CALIBRE at may be used, for funding the growth (capex + working capital) of the business%@. To fund any possible acquisitio€f Some amount of cash may need to be put back into the balance sheet to build a cushion and resilience against any shock or contingency. Balance amount left is the amount which must be given away because itis @ real surplus. Anditis the fourth element where lies the true test of the management. Even good managements fail to recognize that unwanted cash stored is actually a dilution of economic value and it doesn't really indicate a good or strong balance sheet. Sure, it does indicate liquidity of balance sheet, but it also indicates poor understanding, on the part of management, of value creation principles. The liquidity at an expense of economic value creation because of dilution of ROCE. Excess cash on balance sheet comes ies off. Misadventure into ‘greener’ new pastures (diversificatiog} Loose operational also indicates possi 10 hurry to collect your amounts receivable on time or management and slackened efficiency (more cash unnecessary build-up of inventory benevolently ignored) and’3 Control-freak orientation of management. In such cases, markets tend to put alower value on cash surplus thanitisreally worth. So, a management which doesn't display sagacity and wisdom of distributing away excess amount of cash, by way of dividends, is failing to recognize that fundamental trait. Also, in a very important way, a high dividend payout ratio or capital distribution builds faith that profits are real and not illusory because only real profits will convert into cash and only cash will find its way in the form of dividend payout to the investors. Much as {qualitative aspects are important for judging the character of management, ROE isa very vital quantitative test forjudging the same. Conglomerate Complexity Leads to Less Value Creation even with Good Businesses and Good Managements. When a firm has more than one business as a part of it, overall firm valuation tends to gravitate towards the lowest rated business in terms of the valuation. If a firm has a basket of multiple number of different businesses under its fold, markets would get puzzled by the complexity of trying to evaluate many diverse point of time, Markets tend to respond to the complexity with set of [BKEpUEIHTand even, disdain. And this confusion would typically lead the market to value the overall firm based on the valuation of the least favored business, so that markets would like itself to be surprised on the positive side by better performance than what it forecasted, rather than having to deal with the complexity and confusion to value the multiple number of businesses simultaneously, just to evaluate one firm for investment, Ifa firm has many businesses ranging from high-quality to mediocre one, then chances are that even the higher quality business would suffer from the mediocrity of the other business/es and hence, itisimportant to unbundle businesses in a more focused manner. Conglomerate complexity is one of the important enemies against the unlocking of the value. Ifa firm has got the good, the bad and the ugly business, the firmis likely to suffer from the valuation of the ugly one and it will not average out the good, the bad and the ugly. The markets abhor the complexity and prefer simplicity. When faced with complexity, it prefers not to give a benefit of doubt and leaves the burden of expectations on the firm to prove its point of view for creating such complexity.QUALITY OF MANAGEMENT: TRAITS, CHARACTER AND CALIBRE ‘The burden for managementto prove itself usually remains forever. Interestingly, even the best regarded and high-quality managements are not spared and valuations of firms of even highly respected managements suffer when their businesses are housed ina complexstructure. Ifyou see Table 14, this point gets vividly exemplified. Take, for example, the case of Infosys and Wipro, the two high-quality bellwether firms of Indian software space. Infosys is a pure software firm while Wipro has diversified presence in software, FMCG, Electrical products and others. While both have compounded their profits at almost similar rate (~25% CAGR over the 10-year period), Infosys has delivered 19% CAGR of returns whereas Wipro has given only 10% CAGR. Attributable to its complex structure? After many years of running this complex structure, Wipro has chosen to unbundle software and the other businesses recently, ITC which is so dominant in its tobacco business, having outstanding capital efficiency in its tobacco operations, should have ideally delivered an even higher compounding for the solid growth that it has delivered consistently over the FY 2003-12 period. The CM for the period stands at a solid 1.5, with CAGR returns of 28%, while VST industries (which is a much smaller tobacco business, with relatively weaker brands) has enjoyed a relatively superior CM of 1.9 with CAGR returns of 30%. Larsen & Toubro, Aditya Birla Nuvo and Mahindra & Mahindra are some of the other large and dominant players in their respective domains and have delivered good returns over the FY 2003-12 period, Mahindra & Mahindra has done well over more difficult period of FY 2007-12 as well. However, there are reasons for believing that the investor returns could have been much better if these firms were to be run with less complex business structure. A firm with multifarious businesses clouds the investor judgment, resulting in sub-optimal value creation. ‘TABLE 11 : SNAPSHOT ‘TABLE SHOWING THE EFFECT OF CONGLOMERATE COMPLEXITY ON INVESTMENT RETURNS (COMPUNDED ANNUALLY) ees ‘core, =| Roce 36.1% | 19.7% | 21.0% | 275% | 20.7% | 37.7% RoE | oP Conglomerate Complexity saan [anon [pone [22% | 1 Investment Return (Compounded annually) Corporate Governance is not a Jargonistic Buzz-Word. Honest Mistakes, even if Significant, are Punished less by the Markets Compared to Relatively less Significant but Deliberate Violations of the Value System. “It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently.” (Warren Buffett) | i | |QUALITY OF MANAGEMENT: TRAITS, CHARACTER AND CALIBRE Mis-governance is believed to be prevalent when minority equity holders perceive that their interest in the business will not be treated on the same side of the table as that of the promoters. It can emanate from the folly of poor capital allocation and/or capital distribution, from arrogance of not caring about the opinion of other equity holders in cases of conflict of interest and from greed to grab, what essentially belongs to the minority, AIBEREES Haves I6fig memory muchilike'thatofélephants! Creative and colorful accounting treatment falls in the same category. When parent firm of a multinational seeks to charge a royalty, as high as 5% of sales (you read it right, on sales, not on profits) for selling soap, oil, coment, paints, cars, et al, in perpetuity, on entire current (not just incremental) sales, one doesn't need a consultant to figure out that itis mis-governance. Mind you, business is being built from the Indian territory by selling to Indian customers and brand building expenses are also charged to the local balance sheet and yet, such high and unconscionable royalty is being charged, it is being permitted and it doesn't even require approval of minority shareholders. Businesses get sold but cash is kept in the balance sheet (Instead of being distributed) to be deployed as promoters deem fit, never mind, ifthe original business itself may have ceased to exist. Several instances have been seen in which significant funds travel from the listeaparentfirmn tora assotidte (which is personally controlled by promoters) without any disclosure anywhere about the purpose, cost charged and the period for which funds are taken away. Interestingly, the law permits this. The above and many other practices abound, which are acts of mis-governance: many deliberate, some mistaken; some subtle, many gross; some errors of omission, the others errors of commission; some significant, others less so but still material; some onetime, many ongoing. These are just a few of the misdemeanors. Several pages will be required to make only a summary list. Markets clearly draw distinction between honest mistakes vis-d-vis those emanating from the corrosion of character of the managements. Deliberate misconduct will be treated very differently from the accidental mistakes, even for exactly identical issues and their economic impact on the business. In other words, the {governance remains a core issue. This may sound as if itis running contrary to the principle that prices are slaves of earnings power. Butts not. Value put on two identical earnings streams will be very different when these earnings are represented by two managements with polarized value systems. Markets will, of course, reduce the value of firms for an economic oss incurred, whether due to a mistake or misconduct. But for the latter, markets will extract an additional (and enduring) penalty as an extra, by reducing market value beyond just the economic impact. Pure errors of judgment and deliberate mis-actions will follow the identical way as before, Markets take cue from intent, WHEATAKENtTS Wot trusted, the value put onthe numbers will diminishy SInge=markets’will prefer to: shrink value to cover for a possible future shock and thus, systemically iindervaluingsuch a business and management, for along period till, if atall, the credibility isrestored ‘A relatively larger mistake, but an honest one, would have less impact on the business performance, market value and compounding process compared to lack of integrity, even if smaller. For the latter, more than the actual impact of the event, itis the toll taken on the credibility and, in turn, on the fundamental rating’ of the business itself. An honest mistake would have a relatively limited and one-time impact but, the lack of integrityQUALITY OF MANAGEMENT: TRAITS, CHARACTER AND CALIBRE has lasting impact of de-rating the value of the business. This aspect is extremely material and critical, but more often than not, itis disregarded or not adequately given thought to, because itis seen as an intangible factor. Reputation, unfortunately, doesn't qualify as a number on a balance sheet or in a spreadsheet of the investing community. But, it goes at the very heart of therassumptionof going:concern, sustainability and "Bevity Of association with the business. Buying, of even a few shares, is still a partnership in that firm and all partnerships are founded on the principle of utmost good faith and trust (an uberrimae fideicontract) and has to be settled by a continued evidence of maintenance of that standard and integrity. When that is diluted, so willbe the value of the business. This is not a comparison between an inferior sector and a good sector or an inferior business and a good business. itis about management intent: whether itis perceived to be fair, honest, and objective or otherwise. Impact on market value for genuine mistakes is confined to economic loss and temporary but for willful defaults, the impact tends to be severe and more permanent, which will happen by way of either permanent. lowering of the value of the business or by making market value lag the performance of the business. It has been seen that despite material improvement in economic performance, the market value may witness prolonged period of stagnation. A hand in till may get repulsed by markets, with much more than a pound of flesh. Even in a good sector, the valuation for similar earnings streams may reflect valuation differences, mirroring the perception of management quality differences. A look at Table 2 will reveal, how over time this has played out, when robust earnings are not adequately reflected in the value (systemic derating of value), absolute value stagnation despite robust earnings (rapid degradation) or actual decline in market value (seizure and collapse) Quality of management is revealed by two very important facets.:1) Capital Allocation: How good is the management skill in allocating surplus capital (after meeting the need for incremental capital to support growth and leaving some on the balance sheet for contingencies) across existing line of business and/or anew activity and/or for paying dividends. Whether management is prudent and sagacious enough to allocate surplus capital meaningfully only to good businesses or it has demonstrated tendency to allocate to inferior businesses. Even best of the managements, typically, have their capability confined to only one or at best two great businesses, Great management may prove to be ‘also-ran in a new activity. This is the case for a great entrepreneur also. A great technology entrepreneur is unlikely to be good at textiles or steel entrepreneur and. a great entrepreneur in the field of pharmaceuticals may prove to be a failure in managing a consumer business. Management skills are not easily transportable from one business to another. Howsoever much you may think about it, itis not so easy. So, given the fact that management skills, capability and competence are not easily portable from one business to another, the capability a management to allocate capital to newer opportunities is a suspect idea, even ifit isa great management and has made a great success of its bu: When management displays a penchant for foraying into newer and newer activities, then one has view it with deep suspicion because risk of it going kaput would be high. So, how well is capital allocated is a key sign of a great management, which means sometimes not doing anything may prove to be more rewarding. fone hasa great idea of a business, it has large size of opportunity and one is competent to make a success oft, itis better es[QUALITY OF MANAGEMENT: TRAITS, CHARACTER AND CALIBRE to ride that business rather than to create too many new ones becauseléhanices are that by law of averages} qneTaIEOAET OWA rele ot ncompetence and that could not only have animipacton thatnew opportunity) (Git could fave deleterious impact on the existing business as well. 2) "Capital Distributiof: whether management has wisdom not to hoard unnecessary cash on balance sheet which is not required in the business, in preference to giving it back to the investors. When excess cash is hoarded on balance sheet, ithas likelihood of the following bad consequences¢4) dilution of ROCE and RoE gs ‘slackening the tightness of the operations, and{3) possible flirtation into inferior and/or new activities in which management may not have competence. Allofthis has consequences of diminishing or eroding of value creation Capital Allocation has a Deep Impact on the Investment Returns. When misallocated, it could be a Spoilsport even for the Best of the Managements and Businesses. “All human evil comes from a single cause, man’s inability to sit still in a room.” (@laise Pascal) Even a good business and/or an excellent quality management cannot escape the impact resulting from the indiscipline in management action or capital misallocation. The capital misallocation may occur, in many ways, when fundamentally the extant ROCE gets diluted in a material/permanent manner over a period of time. This can occur when a business acquires, in a similar line but a business 'too big to chew’. Capital misallocation can also occur when a sizeable expansion of existing business fails to carefully evaluate demand-supply dynamics, or very ‘bold! gambits are made, with insubstantial economic rationale, and which may permanently water down the ability of the business to earn respectable returns. It could also occur by venturing into an unrelated area in which the firm has little or no competence. All these are actions of capital misallocation and even the best of the businesses and managements, when they fall victim to capital misallocation, would witness for a prolonged period, significantly lower, if not negative, returns, When markets perceive that further capital will continue to be allocated to the businesses with sub-optimal capital efficiency and/or prospects, or, that in face of sub-optimal outcomes of the extant capital allocation, theres unlikely to be any behavioral change, markets would further impair the value creation. Whenifferent ‘businesses with disparate quality are’allput together in a single firm or corporate structure, there is always'a ‘Goneernmthatithe inferior businesses will suck away capital generated by the good business/es and overall Sutcomeswill be: sub-optimal. Als aie BUSINESSES) ike problem children demand" more tine’ and attention, High quality firms like Wipro and Mahindra & Mahindra would probably have created even greater value by unning diverse businesses under a more focused corporate structure. United Breweries group has a market leadership position in Beer and Spirits market in India, both being superb large-* with dominant leadership, offering immense growth potential, Diversification, in unrelated areas like airlines, Sports and non-synergistic international acquisitions, has taken their toll. The group has lost a fortune in ized consumer businesses Promoting these new ventures with poor capital efficiency. To keep these businesses floating, it had to continuously infuse capital in these new ventures dragging down the core spirits business in the process andQUALITY OF MANAGEMENT: TRAITS, CHARACTER AND CALIBRE eventually leading to stake dilution and management control of United Spirits, which was and is a fantastic business per se, having strong brand visibility, great prospects and recession-proof, strong growth ina country which has growingper capita income Telecom sector asa whole is also similar story. The sector was one of the sunrise sectors and among the most successful stories of the liberalized India. However, the participants became very aggressive, indulged in cut- egregious sum for 3G licenses. With dwindling capital efficiency, the sector has virtually become a commodity business. To acquire growth, players like Bharti Airtel went for costly acquisition. This has led to deterioration of business characteristics and results, resulting in value dilution for investors. throat competition and pai Tata Steel's acquisition GECEFUS'Is’even more stark a case in point. After the acquisition, the ROCE of consolidated entity has plummeted, Corus is yet to make even profits (for which large sum was paid) and consequently the valuations suffered quite significantly. Cash-rich balance sheet has become debt-laden and ‘eventhen, the outlook is still mired in deep uncertainty. Sudion and Hindalco also illustrate the same point. Barring a few notable exceptions and success stories like acquisition of Taro by Sun Pharma, Visiocorp by Motherson Sumi, surprisingly successful turnaround of JLR and some others, most of the other acquisitions have not succeeded in creating any value; rather they have resulted in diminution in value. Andin many other.. cases;where the acquiring businesses themselveshad mediocre ROCE, capital misallocation has added fuelto athefire. | a - Good Businesses typically seems to Attract Good Management and Vice versaFunnily, Good (of "Bad Business and Good (or Bad) Management come asa Combo Deal; Buy One and Get One Freel. / “A good head and a good heart are always a formidable combination.” (Nelson Mandela) There is one important link between the quality of business and the quality of management that doesn't come easily and intuitively to the mind but is real: typically, a good business is a magnet to attract a good management and equally, a good management gets drawn to a good business. Vice versa is also true for both the propositions. In other words, rarely it is seen that a high-quality business is managed by 2 weak ‘management. Also, low-quality businesses typically have the effect of repelling good managements away from such businesses. So, typically itis seen that good businesses also beget good managements and conversely, bad businesses typically seem to beget bad managements. This is also why, itis important to focus on high- quality business because along with a good business, there isa high probability of getting a good management aswell. And equally, itis vital to avoid a bad business because there isa very high probability of inheriting bad ‘management along witha bad business. Management Quality has far Higher Impact on Returns than Investors Care to Imagine. ‘When the going is good, investors tend to think that the management quality is a rather theoretical and Pree eee ee ed |‘QUALITY OF MANAGEMENT: TRAITS, CHARACTER AND CALIBRE ASK abstract, if not irrelevant, idea, but management quality has a far bigger impact on the real returns to be had than most people care to understand. Management quality is not as inscrutable or undecipherable, as is generally believed. Its a real factor, with a real impact on value of a firm, only if we care to believe so. Good girls have been observed to have an inexplicable fatal attraction for the bad boys. Similarly, when markets are hot, and want to wear its colors on its lapels, the inferior firms, managements and balance sheets (so called “"high-beta companies”) become the darlings of markets. In such a phase, (perversely), these firms often produce better returns ina shorter time. Market participants acquire unbounded faith in, and enthusiasm for acquiring, such businesses. But the quality of the management (and businesses) has a deep impact on the returns. Eventually, at any rate, to dismiss away management quality as a fuddy-duddy notion or as an irrelevant idea, will be setting oneself for a deep trap and a big mistake. Ethics, vision and execution capability of a management have an indelible impact on the returns to be obtained. This can be easily verified, by making intra-sector comparisons across the firms in that sector, and observing that for the same unit of profit, how ‘and good managements get asuperior CM (Table 3A). good governance Human Integrity is Largely a Personal Trait. When you expect it from others, it is a self- delusional idea. “There are truths which are not for all men, nor for all times.” (Voltaire) Human integrity is essentially a pursuit, in attainment of an ideal, at 2 level of individual, Dilemma in ethics arises when it is sought to be applied at societal level (would you say itis ethical for America to bombard Iraqi citizens, whatever may be the cause?). Integrity, in essence, is largely an individual or a personal trait. Applied strictly to one's own self, it can be a pursuit in absolute. But when you expect it from others, at an absolute level; theniit becomes somewhat a self-delusional idea! In other words, one can hope to expect an absolute integrity from oneself or at an individual level, but to expect it from others as an ‘absolute’ is tricky. Similarly, when this thought is mirrored while making investment choices, it may be worthwhile to seek returns at an absolute level (rather than only relative) because that is a purer thought and more crystallized version of investment thinking (that you want to make money at an absolute level, rather than just relatively beat the market). Bitjasifar-as integrity is concerned, itis practical to view it only as a relative idea, so far as it concerns? (Q@NBEBEMTENt quality: tf the concept of absolute is applied to management quality, then investment universe, Wpwllishrinkmaterially.cr OF VALUE AND VALUATIONS ee cen ec Bee a eee ee eR eke ee Whatis Value? “WESHOLivhat you look at that matters, its iwhat you Se.” (Henry DADA Thoreau) - The concept of Value is not so vague like ‘beauty in the eyes of the beholder’, In simple terms, value of a business (or stock) is nothing but the present worth of an assessed or conjectured future. The careful assessment of that future, from the perspectives like size of opportunity, growth (of earnings), quality of growth (ROCE and ROE) and predictability/sustainability/longevity of growth, would provide useful conjectures or mathematical’ forecasts of future cash flows (both inflows and outflows) over the believed useful lfe of the business. This is where the ‘soft! art of investing yields to ‘hard! science. Since a rupee in hand has clearly more value than the one tomorrow, the predicted future (cash flows) needs to be appropriately discounted (at least at a discount rate of minimal expected reasonable returns) to arrive at anet present value (NPV), or simply, Value. Greater's the quantum of earnings growth, its quality, predictability, certainty and longevity, clearly, greater is the present worth or value. Conceptually, for a growing business, value will consist of two elements: NPV of ppreésehitéarnirigs maintainable over the expected remaining life of the business, or, Cigar Butt Value (CB) and b) .NPVof forécast future growth (over and above what is counted in the CB), oF, Growth Value (GV). Sum of the two elements represents Total Value (TV). Any investment at a price equaling value is, therefore, expected to yield annual returns equaling the Discount Rate (assuming that judgment of value is reasonable). If purchase price is lower than value (which is margin of safety), that would be a one-time extra return over and above annual returns (equivalent to discount rate). Thus value is not as amorphous (ike art) nor sit so axiomatic (ike physics or mathematics). But it is a real number. Made by a careful and experienced investor, it has a high probability of being good. Of course, based on emerging empirical evidence, it will be revised periodically, to maintain its integrity and vibrancy. Priceis Servant, Value is Master: Investing is about Pricing the Value, rather than Valuing the Price “Price ts the only thing that pays. Why work when Mr. Market can do it for you?” (Paul Tudor Jones) Thisis a classic situation of whether the dog wags the tail or the tail wags the dog. The markets often behave in ‘a way to put price on pedestal and in the market parlance, “Price is the ruling deity of the markets”. Most market participants at least sometime, and some of them, all the time, succumb to the charms of oscillatingyALUE AND VALUATIONS price andinfer value from price, But without sounding prudish, tis vital to understand the merits of price, as vr deo. gS crresa message orsignal witht, attimes pious and othertimes, valuable BHEHBe it se temay, we must not forget that price isan actual discovered evidence and outtome, after putting money to siork by market participants while value in some sense Is still a belief and conjecture and therefore, isnot discovered, at least, today. Price ite often, very nicely sums up all the fundamental information avaliable / 1o050iFSAVAREE’SO, ha wayitholds the mirror. Whether the pictureis pretty or ugly, blame can't be laid the tendency to denigrate the importance of price needs to be held in check. The ‘with the mirror! So, ince of price lies in (ifitis contrary to the judgment of value) making us revisit the mirror and alerting to importar the possiblity whether there was this acne, wrinkle or a wart on the face, that we missed seeing! If on revisiting the mirror, oneis convinced about no wart, that isgood news, and with conviction, one can hold onto position. This the real value! that price brings onthe table: to hold a mirror and suggest the beholder to re- ‘assess the beauty. However, itis really the value (if judged correct) which is the master and price is eventually expected to obey the master. Price ikea servant, can often be unruly, unpredictable, volatile and temperamental, while values more serene, more enduring and long-term in character. By definition, price will oscillate all the time, while ‘value doesn't go through wild gyrations. Fundamental shift in the character of a business is required for value to alter materially, while price can be affected by various factors (valuable as well as dubious) especially n the short-run. In Grahamian construct, price is like a 'voting machine’, while value acts like a ‘weighing machine’. However unruly though price may be in short-term, eventually it invariably aligns with the value. Over short-term, price ‘and value may diverge, even violently, but over long run, they have to converge. Price-value gap: Margin of safety (or Implied Returns) “Based on my own personal experience - both as an investor in recent years and an expert witness in years past - ré@relgdo more than three or four variables’ reallycount:Euerything else ts noise:" (Marty Whitman) 4 We can say that Price (P) is equal to the fundamental Value (V) plus or minus Noise or sentiments (N). Factors like greed, fear, ignorance and hubris represent noise and sentiments, which intervene and distort the real { discovery of the value. Based on the noise (or the sentiments) being buoyant or downbeat, price in the short- run can be higher or lower than the value. How an investor reacts and responds to the noise and his behavioral pattern, both together add another dimension to the equation. But as the period elongates, over long-run, the value of N comes closer to zero and the price comes closer to the value and they converge, Price= Value + Noise or P= V +N (in the short-run). Price = Value or P=V (over long-run, as N~O) Price is what you pay and value is what you get and like any other economic trade-off, its simple to see that unless the value is higher than the price or price is lower than the value, it cannot be a profitable economic trade-off, But ifthe price is higher than the value and yet one makes money, it would be by chance and itis not 45OF VALUE AND VALUATIONS investing but gambling. The only predictable manner in which you can hope to make consistent and durable returns, is by ensuring that the value is ahead of the price, which calls for a) an ability to understand the real value of a business, b) having the discipline to acquire that asset at a price which is ata discount to that value and c) huntingas high a discount ass possible to the value so that you improve your potential for return asalso increase your margin of safety, and d) having acquired a good asset at a good price, tosit it out and not flirt with itunnecessarily for tactical and 'timing' reasons. Higher the Risk, Higher the Gain, and vice versa. Really? Text-Books teach us this. So, do teachers in the classroom. Popular belief generally is that higher the risk, higher is the gain while lower is the risk, lower are the gains, whereas in empirical equity investing, it is the opposite which is true. Lower risk would mean price at a greater discount to the value which typically would happen when the sentiments are perverse, or worries and concerns are the highest in the environment. If fundamentally the picture is healthy, even though psychologically that may be the period when one may be ill equipped to make a decision to purchase but from an economic rationality and logical perspective, that would be the best time to buy. But since psychology more often than not prevails over the logic, or the hard-headed judgment, market participants end up doing exactly the reverse. When prices are increasingly more favorable i.e. prices are getting cheaper than value, margin of safety is becoming higher, and if so, the risk is becoming lower, which would mean that the implied returns are much higher. Thus, when the risk islow, the returns have a much better probability of being higher and not the other way round, like classroom books would have us believe. Discontinuity between the fundamental world (or value) of a business andits price represents asound opportunity to earn good returns, ata reduced risk (provided, of course, that the judgment of value is sound). Ultimately, the investment game is simple but not easy. It is simple because the fundamental principles are simple to comprehend: investment taskis really to identify a quality business, to have the capability toarrive at the value of a business, then seta target for purchase price (ata discount to the value), notact on the purchase decision until the favorable price arrives giving adequate margin of safety (so as to adequately cover possible errors of judgment of value and also to cover possible short-term risk of the price not behaving in the way you expect it to) and then £0 sit out patiently on the position without losing one's perspectiveyThis is the game. Markets remain obsessed about valuing the price, rather than pricing the value. The real game is exactly the opposite. Cash Flow is the only enduring reality: Accounting Profits and PE Multiples are Popular, but Unreal, Pastimes. There is too much attention paid to, and obsession with, profits reported rather than cash flows and too much attention paid to Profit and Loss statement to the exclusion of Balance sheet. Cash flows over time (not just period cash flows) are a more valuable guide to what is happening to the business than accounting profits. Profit and loss statement, without studying Balance sheet, can provide misleading impressions of the financial health ofa business. Eventually, value creation is intimately (if not solely) inked to the cash flows generated over the useful life of a p OF’Poe VALUE AND VALUATIONS business. What one is paying out today is the hard cash in terms of the market price of a business and what will ‘eventually get over a period of time in form of a return also has to be hard cash. The equation which equates the cash outflow today with cash inflows over a period of time, will determine the productivity of that investment; in other words, these cash inflows and the resultant IRR are the only reality. ‘Accounting profits often are an illusion, based on how the non-cash charges are treated: converting expenses (a revenue item) into a capital item and even vice versa, how the inventories are treated and valued and also sometimes by making creative year-end entries to puff up (or depress) profits. Accounting profits can, at best, givea glimpse into the real affairs of a business, while the only reality s the cash flow. India produces legions of ‘crafty’ and ‘creative! accountants. So, profits reported by firms need to be dealt with due skepticisms Equally, measuring rod cannot be a one year's profit (which in itseltis an inadequate number) compared with today’s price. This approach has two lacunae a) focus on profit and not cash flow and b) focus only ona single year while business (hopefully) is for a lifetime. Hence, PE ratio is one of the simplest but one of the most deficient ways of measuring value which can deflect attention from the reality and present a superior or inferior picture than what it really is. Which means a low PE at times could be hiding a potential lurking problem in the future and a high PE sometimes may blind oneself in duly recognizing an opportunity waiting to happen. Correlating, only immediacy with a weak’ data point like accounting profits, is two deficiencies mixed up together and that can only produce a very dissatisfying result. Immediacy often is a mirage while cash flow isthe only reality. There is also a conceptual infirmity, when value ascertainment is made on the basis of forecast’ or judged! PE target. That results in an ironic situation of deriving value based on ‘targeted! PE whi judgment of value is made, PE cannot determine value; ititselfis determined when a good judgment of values, PE itselfis derived oncea made. The only real measurement is how much cash flow one has laid out to purchase a business (that is complete determinate) and what kind of cash flows are thrown up over a period of time (which is a conjecture). While accounting profits are relatively more susceptible to tweaking and not always easy to detect, especially, over short periods. itis much harder to fudge the cash flows. It will show up somewhere or the other and can easily be detected by careful analysis. Cash flow is a iétharhood test'since itis a matter of reality, while accounting profitisa fatherhdod idea, at best a matter of belief, ‘Oneis not saying that free cash flows (FCF) have to be generated over every single period or every single year. A Particular period, because of capexor certain specific conditionality, may not witness FCF. Buta business has to generate FCF over every reasonable period of time and material FCF over its lifetime, for it to create value. More stringently, a business has:to'@enérate operational cash flows (OCF) (after meeting requirement off incremental Working Capital but before capex) in’ virtually every single period” or year (barting some ‘excepti6hal One-off period). Thatisamustforvalue creation... / Challenge is to evaluate or understand whether these cash flows are sustainable and meet the IRR requirements of the investors. Only those businesses, that have ability to generate superior OCF and ‘meaningful FCF, can grow in a sustainable manner and without much capital dilution, can have enhanced| OF VALUE AND VALUATIONS ability to fund the growth, can sustain bigher dividend payouts and create real value. These businesses have 1 rightly eenincreasing PE muttilesin the past. Long-term empirical data evidencing confirms all this. Table 9 compares FY 2003-12 and FY 2007-42 | cumulative free cash flows vis-a-vis cumulative net profits. Ratio closer to 1 basically means that virtually all | the reported profits have converted into free cash and the reported profits are real and high-quality. When the ratio is low or negative, the actual cash created by the business is much lower than the reported profits and hence, either the profits are of inferior quality or not reat. The incremental capital efficiency in such cases, generally, deteriorates significantly and so does average cumuiative dividend payout. Heiiewith xcéptional HONAECEEOPAT Hianone}t emai een [Bayaut (59%: of netiitantayand 4 very healfivretarhs tor the FY 2003: as cific pid Some of the outstanding value creators (like erg Motor Titans @SK linia Colgate: VST lidustries and othery, all belong here. Firms. enjoying FCF conversion (FCF multiple of 0.7-1) also have done quite well by giving superior investment returns. (28% CAGR FY 2003-12) and strong dividend payouts (37% for FY 2003-12 period} but has not generated very good investment returns during the difficult FY 2007-42 period (21% CAGR}. Many good firms, like'ERISH, ¢ ‘Bayer Cats, Cummins, FEC, Dabur, Asian Points I NRraR gid BIHETS)aresbartOf thiSgroup-Theremaining two groups have 2 weak-to-poor conversion of profits into cash (less than 0.7 to negative}. Understandably, dividend payouts are average (at 31% to 22%), However, as far as investment returns go, they are pretty robust i at 19% CAGR (FY 2003-12) to 24% for both these groups but in the difficult period, returns have taken a dramatic knock (FY 2007-12 CAGR of 2% to 0%). Clearly, performance has suffered during the challenging conditions. it bears evidence of low resilience to tough conditions and relatively inferior character of the businesses. | ‘TABLE 9: SNAPSHOT ‘TABLE COMPARING PROFITS WITH CASH FLOW GENERATION ANO ITS CO-RELATION WITH INVESTMENT RETURNS (COMPOUNOED ANNUALLY} ALONG WITH INITIAL YEAR, (FY 2002-03) FORWARO PE MULTIPLES: Coe | Fr? ted toe oar PT [Soe | fer/eat > van] ia | 186% | seon | 230% |iroor| 12 | 173% | coon | 126% | a32% | tcremrario [uses] 08 | 25% | 36m | 222m [ronan] 07 | inex | ana | 13% | 90m Teimmraso7 [ana] os | eae [sore [anne | soos | 04 | 9em | tae) ae foam Fes/PAT 70% 159.5% | 72.4% | 11.9% | 14.2% | 19.5% | 205.4% | 62.0% [asx | 17.2% | 17.2% LOW: Payout < 15% 25.5% | 17.4% | 26.5% | 31.7% | 28.4% | 25.4% 17.9% | 19.0% 15.4% | 1.4% | = om wax | ‘Investment Return (Compounded annuoly) In the exceptional dividend payout category, we have 10 firms. Interestingly, all of them have delivered returns higher than the profit growth in both the periods for FY2003-12 and FY2007-12 except Clariant and Gulf Oil. Clariant Chemicalsis a case of low earnings growth while Gulf Oilis largely an asset play. Interestingly, Monsanto has generated 12% CAGR of returns (FY2003-12) despite fall in profits and for FY2007-12, has posted lower value decline than profit fall Of the 24 firms that have superior payout, 10 companies have given returns higher or similar to profit compounding in both the periods: Wyeth, ITC, P&G, Foseco India, Crisil, Navneet, Tata Global, and Gujarat Gas. Companies like Indraprastha Medical, Alstom India, Cummins, Ingersoll Rand, Ashok Leyland and Grindwell Norton have given returns closer to profit compounding for FY2003-12, but not during FY2007-12. Most of them are from Industrial space and are currently facing headwinds in the business environment. Companies like Essel Propack and Engineers India have given lower returns despite superior dividend payout. The former is the case of low capital efficiency and the latter is suffering from the headwinds that all the PSU firms have faced foralength of time. There are 63 companies which have paid good dividends. Most of them have generated positive returns ‘though compounding multiplier is less than 1. Companies with superior capital efficiency like GSK Consumer, ‘Astra Zeneca, Abbott India, Asian Paints, Gillette and Dabur have delivered superior compounding. Interestingly, Gillette india has given returns of 18% CAGR in FY2007-12 despite having a negative earnings compounding, However, earnings numbers look optically depressed due to the heavy spend on brand building, initiatives and investments in category enhancement. Opportunity size for Gillette is very large and the future potential looks strong and that has been reflected in the compounding. There are some companies which have given higher returns than profit compounding in FY2003-12 but not in FY2007-12 due to factors like diminished capital efficiency, reduced size of opportunity, misallocation of capital and inconsistent growth, In the average dividend payout basket, there are 77 companies. Most have given returns lower than profit compounding except a few like EID Parry, Marico, Cadila, CMC, Exide, Dr. Reddy's, GMDC, Lupin, SKF India, IPCA Labs, Amara Raja, Nava Bharat Ventures and Bayer CropScience. All these companies have good capitalQUANTUM OF EARNINGS VERSUS QUALITY OF EARNINGS efficiency except Dr Reddy's. Low payout firms have posted the lowest returns, for the period FY2007-12, compared to the higher payout groups. ROCE Provides Sails or Wings to the Ship while Earnings Growth Provides the Wind. {GOCE provides the sails or a backbone to the ship (business) to fight the vicissitudes faced by it and survive « sex(hopefully;tothrive). Winds (i.e. the earnings growth) provide the momentum and progresstothe ship. Witha = strong-sail;the-ship becomes seaworthy and resilient (which means resilience of business and preservation of, (Wal) But. preservationis only one ofthe two objectives of investing; the other objective isto grow. The best combination would be of high ROCE andhigh growth. The ship will not only weather the high seas, but will also progress well and reach the destination nicely. High ROCE and low growth implies that the ship remains sail worthy and it doesn't sink, but it still may not progress well and may not have sufficient momentum going forit. Low ROCE with high growth produces erratic results i.e, the ship cannot be steered in a given direction, at a given speed; it may go one step ahead but five steps back. Itis not a sustainable situation. itimayattimes create / showretardation. | illusion of progress (compounding) but otherwise, wil Low ROCE and low growth shows eventual destruction, The ship will sink, High-Quality Business getting even Better Quality Coupled with Superior Earnings Growth will Lead to Disproportionate Returns...or...'Good to Great" Business plus Superior Earnings will Leadto Disproportionate Returns. sive me a lever long enough and a fulcrum on which to place it and I shall move the world.” (Archimedes) A good business gets better with time, much like good old wine. When a business which is already good is turning great, it potentially unleashes a situation which is conducive to creating 'multi-baggers'. Markets and investors, often display slavish fetish for finding multi-baggers. They happen, when a fortuitous set of conditions germinates; they are not easy to target and get. Also, they are sporadic and episodic. So, it hardly lends itself for sustainable method of investing. Obsession with finding multi-baggers may cast a deleterious impact on the investing style and possibly cause long-term damage. A ttiore straight forward way to get the similarsresults=(albeit over timé but with much less pain) would be to aim to find true, blue-blooded ‘compounding machines} This approach has less risk, similar productivity and success is more replicable and sustainable. When a multi-bagger happens in a very short period of time, then chances of itso sustaining for a prolonged period are rather poor. if a stock goes up disproportionately ina very brief period, then its remaining tobe a agger in the longer term is unlikely to be the case, What is more likely to produce an outstanding, realQUANTUM OF EARNINGS VERSUS QUALITY OF EARNINGS 7) ‘ ‘ mult-baggeris a combination of two things’) Exceptional return on capital employed andjb)a secular bout of not just good earnings growth but exceptional earnings growth. This is what software firms enjoyed in the decade of nineties and the early part of last decade. These businesses were, in any case, outstanding free cash machines, enjoyed exceptional ROCE, had rising margins along with increasing business volumes and improving pricing, Some of the top-notch software firms were generating outstanding ROCE (upwards of 60- 70%) along with almost similar profit growth (40-50%). This is what created a situation in which, ina brief period of about four years, a firmlike Infosys went up an incredible 140-150 times. Another probably less dazzling way to get a pretty decent result would be when a good-to-great type of situation happens i.e. when an already good business, keeps getting better over a period of time. In other words, a business which was already generating a superior ROCE, but which further improves, over time, coupled with a superior earnings growth rate (or, a good growth rate accelerating further), is another conducive condition which may produce outstanding results. Probably, this second situation may not be as, dazzling as the first one, but nonetheless, results in creating outsized returns with limited risk and in a reasonable period of time. Examples include TTK Prestige, Titan, Asian Paints, Shree Cements, Sun Pharma and Marico have been some outstanding champions of wealth creation, achieved effortlessly, without much fanfare. Even ina Seemingly Commodity Business, the Principles of Investing Apply in the Same Way if ROCE Stays the Course and Earnings are Stable. Markets do not know any label. It will not matter whether you label a firm as Asian Paints, a Sun Pharma or a Nestle or a Hindustan Zincor an Infosys. Itis a myth to believe that mental imagery of aname will elicit a higher or a lower PE for any stock. Valuation is linked only to the underlying economic factors and the economic performance. If that is delivered within the ambit of key attributes (size, growth, quality and value}, in a consistent and a sustained manner, then even for a commodity business, the value creation will not be much different. Of course, usually, such a combination is hard to get, especially over long-term, for a commodity business. Given the shackles imposed by cyclical up/down turns and limited pricing power, there is constraining impact on the ROCE and eventually on the profits, and finally, on value creation. But, for some reason, if a commodity or a commodity like business is able to demonstrate pricing power and superior ROCE and consistency, and fits believed to be sustainable, then, such businesses will create similar value. Markets are not held to the tyranny of titles. It is the underlying economic performance, delivery, sustainability, consistency are the rules that markets follow. Mental bias does prevail when you hear a name, but bias remains only for a length of time, till the confidence is acquired about the economic performance. Thereafter, investing rules take over and reward the performance accordingly. Bias applies to an individual. ‘Market usually has-no irrational biases in the mind. That is so since most people belféVé) in‘any case, that farketshavenomind! | ‘ Table 12 shows outstanding value created over FY 2003-12 by firms like Hindustan Zinc (59% CAGR), Shree Cements (52%), GMDC (37%) and EID Parry (41%). GMDC has been able to show consistently high ROCE (upwards of 25% in both the time frames) coupled with strong profit growth. No wonder, the stock has ee eet es|ANTUM OF EARNINGS VERSUS QUALITY OF EARNINGS delivered 37% and 35% compounding in FY 2003-12 and FY 2007-12 periods respectively. A cyclical and regulated business like that of EID Parry, has still managed to generate a very stable ROCE and profit compounding and has delivered very stable returns over both the time frames. Cost champion and a very efficient player like Shree Cements has delivered truly an exceptional performance, aided by the fact that commodity like cementis competitively insulated from imports. HfCapital Efficiencyis Fractured (though still high), even with the Same Consistent Earnings Growth, Compounding will be Less than Proportionate. In other words, the Pendulum will Swing in the Direction of Discount from Premium. Normally, consistent robust compounding of the profits will lead to proportionate or more than proportionate compounding of returns, provided there is iaintenance of capital efficiency! Ifthe growth is achieved at the expense of capital efficiency, even though the reduced capital efficiency is still quite high, the axiom will not operate inthe same way even for the best businesses, The market logic will prevail with its inexorable intensity, inaruthless way. Ifthe growth is achieved but the qualitative parameters are diluted, the market isnot going to mindlessly reward only the growth. When qualitative parameters get diluted, instead of more than proportionate compounding, it may lead to less than proportionate compounding. Premium on growth may, then, shrinkto discount. In some extreme cases, it may result in even negative compounding TABLE 12 : SNAPSHOT ‘TABLE LISTING COMMODITY BUSINESSES WITH HEALTHY ROCE PROFILE AND THE INVESTMENT RETURNS (COMPOUNDED ANNUALLY) FOR THE PERIOD FY 2003-12 Bee Breed One oe or op | or | ok | Se par | IR Cord Core ROCE > 40s 45.5% | 45.7% saan| a92x | s49% 178% | 88% Core ROCE 20-40% 28.2% | 22.1% | 20% | 30.8% | 3e6x | 33.6% | 23.5% | 15.0% | 18.0% | 20.0% | Core ROCE < 20% a7a% | 175% | 244% | 34.6% | 31.4% | 18.6% | 17.0% | 15.1% | 116% | 66% pom JR: Investment Return (Compounded annually) Table 13 shows some examples. Bosch with a large addressable size of opportunity, a strong parentage, great technological edge and consistent profitable growth reveals an interesting contrast between CM of FY 2003-12 and that of FY 2007-12. The latter has shrunk. For FY 2003-12, the company has increased its earnings at 27% CAGR, with outstanding average core ROCE of 212% and returns of 39%, with a robust CM of 1.5 (FY 2007-12), However, the core ROCE has dropped to, stil outstanding, 103% (FY 2007-12). Despite Bosch maintaining its earnings growth tempo of 20% CAGR, returns have dropped sharply to 14% CAGR, with CM shrinking from 1.5 00.7. Similaris the case for Bharat Electronics. When the ROCE deteriorated, the compounding of returns for everyinreriental rupee of profit declined more than proportionately. Cy eyQUANTUM OF EARNINGS VERSUS QUALITY OF EARNINGS ‘TABLE 13 : SNAPSHOT ‘TABLE SHOWING CHANGES IN ROCE, INDICATING IMPROVEMENT OR DETERIORATION IN BUSINESS DYNAMICS, OVER FY 2003-12 AND CO-RELATION WITH INVESTMENT RETURNS (COMPOUNDED ANNUALLY) a Gees Core ROCE Change roe | op | par | im | oct | | Core ROCE Change > 1 59.2% | 243% | 20.8% | 26.8% | 28.2% | 78.9% | 26.0% | 19.6% | 20.4% | 10.8% | Core ROCE Change 06-10 aaa | 192% | s6a% | 172% | a90m | asx | a5a% | s00%| com | aan | Se age OSE [ce a [feos |code {R: Investment Return (Compounded annualy) The above table summarizes the impact on returns with the change in capital efficiency across different categories. Over Time, Attitude to Avoid Permanent Loss of Capital in Preference to Chasing Growth Produces Better Returns and Lower Volatility. “Tquickly convinced myself that the true key to happiness lay in a modest standard of living which could be achieved with little difficulty under almost all economic conditions." (Ben Graham) ‘Attitude to avoid permanent loss of capital (in preference to chasing growth), over a period of time, has a very salubrious effect of better returns and lower volatility. Once the mindset is to avoid a permanent loss of capital, then you don't need to flirt with a large number of inferior businesses, to adopt ‘dangerous’ investment methods to make money, to make flamboyant and bombastic assumptions to see opportunity in a business Where there isnone, and generally speaking, to avoid a mindset of rush’. With this, alarge amount of noise (or Investment choices) gets filtered and leaving behind a relatively crystallized list of opportunities only, which ‘one needs to focus on. Crystallization widens qualitative universe and dwindles the one with dross. And then, one can actually study the filtered choices better, do a good job of it, and select with a greater clarity any confidence~all of this designed to yield actually good return, overtime. The desire to run faster is what produces a gap between what does a mind intellectually suggest and what one ends up doing effectively because of the influence of the heart. The first principle of investing is not to lose money. And once we accept the reality of the fact that under no circumstances do we want to lose capital, automatically you design your investment strategy and calibrate the investment choices in such away, that will ‘automatically knock off the kind of influences on the stock investing which has possibility to lose money. The beauty is that the businesses which typically ward off permanent loss of capital are the businesses which are | ideally designed to create actual compounding, The businesses which inherently have the capability to avoid the permanentloss of capital are the businesses which enjoy superior ROCE, which have an inherent long-term growth potential and which usually have durable growth visibility, spanning a period of time, As we have an eee eaHANTUM OF EARNINGS VERSUS QUALITY OF EARNINGS observed before, good businesses typically attract good managements also. So, one ends up getting the best. ‘ofboth the worlds. Patience and Quality Present very Potent Potion! “patience and Time can achieve more than Passion or Effort.” (Jean de la Fontaine) ‘The desire to preserve capital automatically takes one to a select bunch of quality opportunities. In turn, a quality opportunity represents a combination of characteristics, which is designed to create positive and good returns over a period of time. Allthat tHE quality demands s patience and not immediacy. Rather than chasing, aout (aversion is about chasing, not about growth), if the mindset is reasoned, calibrated and biased for a withiipatience, then that is a game which is a winning strategy in investing. Quality grows over time, fatincewilllétit flower fully. Investments in Commodity or Commodity-Type Businesses. “Ina commodity business, it is very hard to be smarter than your dumbest competitor.” (Warren Buffett) Investment in commodity or commodity stocks should not be confused with investing in compounding businesses. Commodity investing is, by nature, investing into businesses with discontinuous, volatile andles: Ief2BIe economics} On the other hand, compounding businesses possess a certain kind of rugged ‘economics and replicable economicrelationship, which facilitates long-term growth and compounding. That doesn't imply that commodity investing always leads to value destruction or sub optimal returns. But certainly making good and consistent returns out of the commodity stocks is tricky and prone to ‘violence’. History shows that commodity investing in short-run has produced either dramatic gains or losses, and over the long-run, barring some exceptions, poor or sub-optimal returns. Given that, its less likely to be ‘investing’ into commodity businesses. Therefore, skills for good investing may not always help in commodity investing. Timing and agility are important. So is the ability to bear significant short-term reversals and to cut losses. Buti ithas to be investing in commodity businesses, then the following conditions help: one, it still follows the laws \ of economics of investingin the sense that it still needs a healthy ROCE, especially in favorable cycles; two, such a business has to have its destiny under control (pricing power, outstanding cost efficiency and right-sized capacity); three, given its cyclicalty, it is a high risk game. Need to swiftly cut losses and making outsized gains would require a relative felicity, in terms of easy entry and easy exit, because by its very nature, commodity business is not a compounding machine type investment. And to that extent, not only a timely entry but a timely exitis equally critical. You need to be ‘lucky’ twice, while purchasing as well as selling. Andif that. to be achieved liquidity becomes of paramount importance; then only, one can buy and sell it efficiently so as to minimize the wastage that comes through the execution cost and seize the opportunity swiftly so that the net returns are sweetly timed and executed; four, it can acquire ‘investment! characteristics in certain special situations especially during the upward move of the cycle (cyclesin commodities, often, are quite prolongedin either direction) and favorable conditions. For example, cement is basically 2 domestic industry, largely Cee coQUANTUM OF EARNINGS VERSUS QUALITY OF EARNINGS immune from competition of imports, given the rather high transport costs. Because of the consolidation of the industry, among limited players over the last decade or so, it has acquired pricing power, Given also the fact that broad demand-supply equation is favorable, cost warriors and efficient players have now healthy debt- free balance sheets and respectable and consistent capital efficiency. Nonetheless, commodity stock investment doesn't still become an investment in compounding ideas and to that extent, such an investment requires consistently very high level of watch and to be fortuitous enough to get the entire cycle right. Ironically, in another important way, this differs from conventional compounding-for-long-term approach: usually, best returns are likely to occur in commodity investing, when one buys at high PE and sells at low PE, which is counter-intuitive. And to that extent, one has to be either very skilled or very lucky or both, in order to make good and consistent returns. Cee ee eeeQUALITY OF BUSINESS VERSUS VALUATIONS Superior Business at a Reasonable Price is Wealth Creating rather than Inferior Business at a Mathematically Cheap Price. En ee reac Rea) Pea Bat mL aN ‘wihilesconsidering an investment, the basic trick is not to look at valuation as the first filter; quality should / (G@Uivariabiybethie hrst hitter. Only after ascertaining the quality, focus should shift on optimizing the valuation. If ‘we turn our attention to value or ‘cheapness’ first, then chances are that we will acquirea motley crowd of very mediocre businesses; and as they compete with each other for self-destruction, the portfolio fate would be similar. The ideas therefore not to look at valuation as the first filter but quality as the first one. Quality within itself would include two aspects’) huality of the business and’b) quality of the management. Having derived ‘quality, the attention should then shift to what may be the price, which will need to be viewed in context of the value ie. at what discount is the price to the value. The idea of buying merely cheapness at the cost of quality, may appear to be a very popular trade-off and typically the one in which even the brightest investors indulge in. More often than not, we justify buying a mediocre business by offering an argument that it has come witha | more atractive valuation, but that is where we may end up planting seeds of making a classic mistake. Trade- is quality; itis quality followed by valuation. off neveris in terms of valuation. Pure cheapnessis never a virtue; its in quality available at an attractive price. The trickis not to buy an inferior business which may be available at what may look like a cheap price, but to buy an outstanding business at a reasonable price. Table 7A and Table 7B bring out this aspect quite well. Usually, quality businesses are not available at cheap prices unless one gets such opportunity due to a systemic issue with the markets or overbearingly negative sentiments specific to the stock or the market. But a long-term investment strategy \ cannot be built around buying outstanding businesses at very cheap prices, pure based on waiting for the markets to become generally very cheap, because then the game is not in your hands and only when markets get depressed or nosedive that you get a chance to purchase quality at real low prices. That is too passive. Sustainable long-term investing strategy for a portfolio may need to be built, on buying only outstanding businesses but at reasonable prices, so as to have an opportunity to engage your money diligently and appropriately, and at the same time, to ensure that one doesn't fall prey to the charms of honey trap of merely, cheap prices and acquire dubious quality. r and sustainable ROCE rather than just low PE. Table 15 identifies F oF inferior ROCE) vis-a-vis arithmetic cheapness Key is to buy businesses that have super companies based on business capital efficiency (super {Price-Earnings multiple). We have compared returns of superior businesses with high starting PE and of oe eee