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. de Spike Inthatsenaggaod investing a heady mix of otha lovely, beauteous at ands very precise looking science Butitisnot just one of the two. Science illuminates while the arts pregnant with possibilities andimbuedwith, 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 robust 4nd 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 investi discipline, patienc 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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. * itis one of the mostimportant 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 isnot large today but may get much bigger later on. It has lot 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 finction of capiabitities and character of the management of the firm.? ‘The idea of size of opportunity: ‘The real issue is all about figuri jan be understood within thd framework of size of fish and the size of a pond, ‘ut the size of the pond, while often, the debate in the investing world is, 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 past ithas been successful. But like Buffet says, the investor of today will not benefit from the profits of the pastbout only from the profits of the future /Ana/the large size of fish merely . Teflects the fact that ithas had successful past but a small pond would mean that future growth is constrained’ afidchallenged. 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. fie’ idea Of growth is derived from the idea of the size of opportunity and the idea of sustainability of high growthis derived from the character of the opportunity, size of opportunity and vision and competéné@ ofthe Management. When the two get combined, it creates power of compounding. When a business grows well ‘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 but it hasa very déepbéaring on thé longevity of compoundingand the extent of value creation de 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 ok ‘current growth rate and yet it may fail to create efficient compounding, simply because it may be about to hit a {1888 Gling 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 itis 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 reasonable (current) growth rate and yet increasingly crimped value cre 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) n. But that is no denoueme s 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SIZE OF OPPORTUNITY 7 opportunity is very strong and the current numbers may not fully reflect that reality while unlocking may happen in future. Tibllant Foodworks (quick delivery pizza service) and?Tatalbeverages (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 enormou: 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 BUt initial enth 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. Ediscation sector has thrown up similar frustrations and dilemmas: either, business has generated economic profits but low growth or high growth but real, economic jiasm'came 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 willbecomeisMore Critica. ./ “There is no need toWorry 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.Y 4 a (EARNINGS GROWTH: QUANTUM, CONSISTENCY, PREDICTABILITY, 7 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 i.e. 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. internat or short-term aberrations will get evened out over a period oftime. We have used aconceptof (Compounding Mltipieh(cM) to illustrate this umbitical cord of a relationship between earnings 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, is likely to be the normal condition. eeeEARNINGS GROWTH: QUANTUM, CONSISTENCY, PREDICTABILITY, DURABILITY TABLE 3B : SNAPSHOT Brora’ Eee roe | op | par | oR | od coma ROCE ‘Investment Return (Compounded annualy) 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). ase of Monsanto is interesting where the profit growth has actually been ina 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, tHésiz8{6f opportunity, the strength of the earnings prowth to grow ata high rate fora long period, | asset value rather than income streams, all would result in altering the Compounding Multiplier, to be well “above or below the level of 1.,Asset businesses fall in different category and they are unlikely to obey the iormal operating rule ©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 > Hafl got opyxtosty > Ky Roce” Trunk D> Monagorurd TH > Pdeort valuation 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 of the 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. SUehBUsinesses, unfortunately, become treadmills: one has to keep working harder just to be squhere%oneis. They produce less output (returns) for the same effort or require much more efforts just to get thesame-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 goss over-valuation to begin with now being corrected over time, low or little faith in the management in 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. or no alth 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 Ge oro | oF Gee | noe | op | rar | im cm>20 547% | 298% | 50% | 47% | 20.6% | 363% | 165 | 35m | oan | sax om 15-2.0 ~ fasa.9%| 25.0% | 279% | 18.2% | 31% | caaw | 23.7% | 13.6% | 9.0% | eam owia-as 773% | 283% | 220% | 2xs% | 320m | saan | 205x [ anon | a69x | 95x | cmo8-12 ~ | aa.ox [19.9% | 206% | 266% | 255% | 51.7% | 29.3% | 18.1% | 185% | a7 cinos-08 30.6% | 15% | 216x | 26an | 160% | 287% | 17-76 | 156% | 12.7% | 19% omo-05 ~ | 195% | a7.ax | 17.6% | 203% | 3.0% | 15.27% | 66x | 11.9% | 10.2% | 25.0% cm 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) siffeSses 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 sferile all the intermittent capital raised since then. The correlated condition is that even for a good business, a 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, a= 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 ts like having children: don't get involved with more than ou 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. doy, Age panking and Finance: ASpecial 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 thereafter, (iste finance businesses represent a very unique opportunity in several respeaSil}ithey 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. J 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 capitat is part ofthe geme and is nota crime! as it would be regarded in the other businesses simpiy 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. REfUei Diiassels.(ROAT 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.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 Ww counts can be counted.” (Albert Einstein) Y Py 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. if the business 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QUALITY OF BUSINESS: CAPITAL INTENSITY AND CAPITAL EFFICIENCY anempty seatandisa permanent loss f revenue. ricingis 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 wellas the capital structure all represent challenges and beyond ‘one's control. This is what makes airlines such a terrible business. In general, itis really hard to make profits in thisbusiness, while economic profits beinga sheer ? Sylar P Ase ane . ne ig Stpeveed Captalintae/intensty fundamentally avery stubborn and rig element ofa business. Almostinvaraby 2 yp capital intensive business i il:designed to create lasting and/or superior value and thats not very hard to.) anderstand. High capital intensity ales operating leverage of business, andinturn, enhances the operating, REE. risk. That stems from more than proportionate change in profitability ofa 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 inthe 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, overtime, tovulnerabilitiesif not failure Sle 4? \Woskeing Cop S, ae capital intensity can stem from two elements: the need for fixed assets (fixed capital) and/or working pital (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 changein the scale of the business and hence, provides greater flexibility is possible that a business may be capital-light and yet has mediocré capital efficiency. Itis 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-light. But, empirical data does not show that there are many trading businesses which have 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. i | i | |QUALITY OF BUSINESS: CAPITAL INTENSITY AND CAPITAL EFFICIENCY ma Persistent and Superior Capital Efficiency is the Single Most Important Evidence of Quality. “Profits are merely costs of staying in a business.” (Peter Drucker) “ofits 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 asa 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 Growth is Necessary but not a Sufficient Condition for Value Creation. z Vv, kK WA me “Growth for the sake of growth is the ideology of the cancer cell.” (Edivard Abbey) Varun 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; NAVA Will have possibility of experiencing rising gradient only if EVA is [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, diminish if not actually 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 a 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 svanansnsenerntesueneeneesensett anesUALITY OF BUSINESS: CAPITAL INTENSITY AND CAPITAL EFFICIENCY at 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. AMBETUINg’S tight ship for both fixed assets:and working capital, in many ways, emanates from ityandl strength of a management; profits have airelatively greater externality, whileabalance ¢ sheet as eater internality’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 strui ixediiess' element while profit and loss has a more re Serusturat esr dynamictluidity. Gro 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 aggregatés, rate of earnings growth pnd quality of earnings (viz}fhe return on capital employed), determine the character of fertilization (or investment returns) Key possibilities are (as shown in Table 2): ligh 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. Ses 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 growths / akintoloveless labour ities ROCE with plunging earnings can lead to value destruction despite high ROCE 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 Ifthe 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 muttipier of over one. Some of the finest names are to be found in this list. ITC, Marico, Pidilite, Sun Pharma, Lupin, Nestle, Asian Paints, CRISIL, Titan, Shree Cement, 3M, Gillette- all befong to this list with exceptional investment returns. What is noteworthy is .gibup i the daty'one erate positive investment returns (CAGR of 129), even over the , FoF FY 2007:12, This group is a celebration of superb capital efficiency and outstanding growth tate. Ths is the fertile ‘territory for finding multi-year 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 40-50% for both the time periods with an ‘earnings growth of ~15% for the fonger period. Clearly, the market has been generous with the business, probably, 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 .er.Blue Dart and many more enjoying CM at a considerably high level. The reasons for such high performance qvera longer period of time includgaery favorebe entry price) thrgeand) growing size of opportunity pene clarity of earnings growtfd) higher predictability of earning) Luperior management qualitff)o itstanding capital efficiency, apd) ho capital dilution for a 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 fetumns are lower than the Winnersand sois 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. Treadmils: 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 returns at impressive 26%, CAGR of profits at even more impressive 3296 ut with modest average ROCE atonly 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, the notable names are fataiPoiwek ApOIIO Hospital, Dr Reddy's Lab, Reliance Industries, Hindalco and otherSsTn | such’ €2865; the value creation will track higher of thé ROCE and the earnings growth Ina buoyant phase of the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QUALITY OF BUSINESS: CAPITAL INTENSITY AND CAPITAL EFFICIENCY ‘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... “Me chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.” (Benjamin Graham) to Preservation of value Is one of the two most important objectives of any serious investment or investor avoid permanent [oss of capital and b} to grow the capital, over time. Preservation of capital (or avoiding ianent loss of capital), over a period of time, comes from ands aided by quality of the business, quality of fe management and the margin of safety (or the price-value en) ). rE ean ies isa joff qeremnaeneone But of these three factors (quality, growth and margin of safety), the real root for preservation of capital stems he quality: quality f the business and quality ofthe management. One ofthe most important and pe jeOs SUSTAINED for’ aiTONg period. oF Aime, consis ‘absolute and relative levels. Absolute minimum ROCE {.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. i 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 jGalethe lhdiet tore oF a business. tt'shows that thé character of a business isso much hardér 2 is character whether beautiful or ugly, has a profound bearing on the ROCE, and in tun, its potential fo create value. An ugly business cannot be whitewashed and be made to look like a 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. ' I petiority of a business is inferred from the superiority of the ROCE and the superiority of a management ‘from the supériority-of the ROE. Both the ideas have qualitative and quantitative dimensions. Intuitive and Jaagvental aspects of inferring the quality ofa business and of a management have their own place. ROCE and ROE are critical quantitative parameters to compare, on a consistent basis, across businesses and managements. Integrity, vision and execution capabilities are key intangible determinants for judging the quality of a management. 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. Thatiis easy to see when itis realized that ROE, substantially, emanates and derived 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) Pye rea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 | PASS] | oF [or | om | CoreROcE> 00% 2o13%| 260% | max | 240n | 909% [oss.ax| 26m [ina [sox | saw 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. | jen Business is Mediocre but Payout is Strong, Markets View it as an Unaffordable Luxury. in SUEH CASES, 35 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.Gn a A ee Le fee es ea Be Ee UE A ae LAL ee ee LR ie eae __ Aro al esto Managemen : Capital Allocation and Capital Distribution. Smit compassion and courage are the three universally recognized moral i 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 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 to be poor. Darwi businesses where there is lack of core competence. This ability to allocate capital intelligently and wisely is a i ' i 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. > Add to FT Pe eee eeeQUALITY OF MANAGEMENT: TRAITS, CHARACTER AND CALIBRE at for funding the growth (capex + working capital) of the business{2-To fund any possible may be used, acquisition ‘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 ies off. Misadventure into ‘greener’ new pastures (diversificatiog} Loose operational management and slackened efficiency (more cash = no hurry to collect your arnounts receivable on time or unnecessary build-up of inventory benevolently ignored) and’3 Control-freak orientation of management. In comes also indicates possi such cases, markets tend to puta lower value on cash surplus than itis really worth. J ‘So, a management which doesn't display sagacity and wisdom of distributing away excess amount of cash, by of sere ents 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. glomerate 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 | |