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Identifying Great Businesses
Identifying Great Businesses
Soggy cigarette Buds philosophy
Buying the bad business in crisis at great price
Suppose share price is low at Rs 100 and company collapse
Buy at Rs 100
Now if company gets dismantled and sold, every share may still get Rs 150
This is buying business dearth cheap, where assets valuation happens to be more than market value of business
This method is not scalable
Great company at good price
This is scalable and long term return
Filters to identify the Great Company
Baseball game, 3 hits allowed. Way to increase score is to wait for sweet spot to hit for 2 turns, 3rd one always hit whatever it comes
Apply similar philosophy, In investing world also hit at the sweet spot what you understand, even that sweet spot might be very limited
This is to identify some of the great business with-in our understanding, there might be many other great business and filters as well.
We call companies Great who have Sustainable\Durable Competitive advantage
Company that has Economic moats around it
What are moats - There have been attractive big kingdom which as safety guard dig huge holes around and cover with wooden planks. When attacker comes they just pull up the wooden planks called as Moats to .
Big business are also like big attractive kingdom, many people may want its profit share and attack to get its share.
These business have to create Economic Moats around it for safety - Sustainable Moats
Now, how to identify these Moats
Business that are difficult to start - can't be attacked easily and by many
What's Moat of Coca cola
How many may want to start such business (nearly none from early entries from college)
Negligible, since the kingdom has grown huge and can't be attacked directly
Now people are trying to attack from different ways - like Sugar (its bad for health)
Sugar Problem was since beginning, but only attacked now since other brands are getting collapsed\bought & not able to attack
Earlier other competitors were able to launch its products and sell its products. Slowly found difficult to attack and compete coca-cola
Coca cola gibe 2 Billion serving in a day, Even if price is raised by 1cent, its 20M $ in a day. Its pricing power of coca-cola. It has such good Moats that it can't be attacked even after such a great business.
People have discovered not able to attack in core-area so looking to attack on other surface (Lassi, Narial Pani) which has not become a preference brand for customers
People calling sugar itself is bad to attack Coca cola, and looking to make shift to other products like Lassi, Narial Pani
That's a way to attack Coca cola
What's Moat with existing Cigarette business
Advertisements cant be given
It is not possible for new brands to launch products
Since the kingdom has safe moat, the attackers looks to destroy the kingdom by calling cigarette is bad for health (even-though it was bad even before)
Business when grow big and being attacked
How to find if Business has a Moat
How to find if Business has a Moat
Grade-A Moats
Grade-A Moats
Low cost product
Moat is easy to develop and sustain for low-cost product (The product expense is low in your yearly expense). Loyalty is easy to sustain.
e.g. when to buy a cola, Coke and other brand - You would buy coke even if 30-50% expensive
e.g. Maggi is preferred Vs other brands
e.g. you go to buy a Phone, you might see a difference and evaluate other brand given the difference it would make in your budget. And may prefer to choose alternative option
Brand
Difficult to break e.g. Coco cola. People prefer brand even at higher cost
e.g. Chalk - anyone could be picked, not have a Moat
Distribution
Even if you develop a good cold drink, making it available at distributed area isn't easy
Distribution moat is harder to break even after Low cost and Brand
R&D Negligible
R&D cost should be negligible
e.g. in mobile market the R&D can differentiate phone and beat the competitor
e.g. coka cola there is hardly any R&D cost applicable, customer wants same flavor
e.g. Maggi, the new variation like wheat Maggi is low R&D and failure cost is low
Technology investment is unpredictable with high R&D
Disruption with technology change, even without competitor - Difficult to stay ahead
e.g. Blackberry, Motorola, Nokia, Kodak
Intel identified its difficult to increase price due to B&B and price control in hands of consumer products like Dell. Intel was finding tough to make premium money
Intel has to go to Dell and give up to Dell's terms in pricing
Intel smartly played game, attack on consumer with Ads on Intel inside to customer. Customer starts looking for Intel inside with purchase. Now consumer brands like Dell, IBM has to reach to Intel to buy processor at premium.
Taste
Nearly impossible to break this Moat
e.g. Coco cola has taste moat and it works for all e.g. chinese, indian, pizza. Works for all
Health conscious people hate coca cola
Coca cola attack at the healthy food sight, e.g. give it nearly free at Subway and get people addicted to the taste
e.g. Parle G taste etc
e.g. kinderjoy for kids
Companies don't change taste, share of product package to retain moats
Businesses with Grade-A Boats
Ketchup - Kissan, Del mont
Ice Cream - Choco bar
Great Business need to come with good pricing for buying it
Company to be good
Good pricing
Whatever is made for a penny (negligible), sold for a $ (margins huge) and customers keeps on coming back
Who can tell about Great Companies
Customer himself - If you are a customers or surrounded by the customers of a company - You know how to find Moats
Consider a cigarette business
Low cost (compared to yearly expense)
All 5 moats apply
Grade-B Moats
Grade-B Moats
All 4 Moats except Taste
e.g. RIN, Areal - These have strong Moats
Why customer loyalty - Low cost product, not much saving - with effort of trying different product
Fevicol, Fevi-quick, Prestige, Gillette, Harpic, Domex
There is no Ads now for Fevicol, Gillette - Already captured major market
However Ads for Coca cola, Cadbury, 5-star - They make you realize to get these and have it
Grade-B Moats easier to break than Grade-A
Grade-C Moats
Grade-C Moats
Capital intensive business
Relatively difficult to break this Moat
e.g. National Stock Exchange NSE big and getting bigger, L&T kind of scale
Index funds, bigger size keeps cost low
L&T
B2B, having lower pricing power
Scale : L&T did wonderful thing to create brand by attack on consumer mind. Builders require L&T. Also L&T can do certain scale project.
Complicated projects could done only by L&T
Quantitative Parameters
Quantitative Parameters
Moats
What are the Moats in business
P/E ratio
Not much useful for Stock, as for Index
High variation in earning
Bank PE 100/5 = 20
No Brainer is Stock < 20 PE (Usually not a case)
Need to pay premium for Great companies, PE > 20
Premium to be paid, if you see future earnings are going to increase at fast rate
PEG Ratio
PE/Growth in profit in last 10 years in CAGR
Profit could be Net profit, or free cash flow
Suppose PE=26, Growth=26% in net profit
PEG = 26/26% = 1
PE = 26/1, if 1 i.e. earnings grows at 26% than high PE of 26 is also fine
If PEG is less than 1.2-1.3, Good to pay premium, since paying premium for earnings growth
Predictable business with Moats have high chances of continued future growth at same rate
Now, instead of last 10 years growth, you may also read the industry reports for sector growth
You may pick the sector leader
P/B Value
Book Value is Net Assets\Worth of a company. Or Equity = (Assets - Liabilities) of a company
Premium given over BV for Brand, customer accusation
If P/B is 1, its cheaper since assets with brand
If P/B is < 1.5, it is fine not expensive
For B2B companies, BV is very important than earnings since brand value is not present\important. e.g, oil & gas company, chalk
FMCG, IT companies P/B is not important, should be ignored. Evaluated by P/E or free-cash-flow
For B2C companies, Earning is very important. e.g. kinderjoy
D/E
Debt by Equity ratio
2L - Liquor i.e. Bad addiction and Leverage i.e. Debt lead to collapse for big empires
High Debt not able to sustain when growth slows down
Debt is used for fast growth
Net Income = 20%, Equity Investment = 100
ROE = 20/100 = 20%
Debt Taken 900 (D)
Net Income = 20%, 200 => 100 for interest, Net Income = 100
ROE = 100/100 = 100% means, total equity 100+100 => 200
Same cycle starts with 200 Equity, Take 1800 debt loan and return 200
Debt: Benefit: Equity growth keeps on increasing 100% per year, this gives exponential growth
Debt: Problem: Bankruptcy cost
If returns slow-down, If return reduce to 10% all return 100 would go in interest. If return reduce to 0%, company would bankrupt
Think as businessman, Should big debt be taken to risk a collapse?
Great companies should not have debt, free cash flow should fund the growth expansion. Slow-down would not cause the collapse
D\E < 0.5. High ratio may risk collapse on business slow-down
Gross Profit margin - Steady
Gross Profit margin = Gross Profit * 100/Sales = 5 * 100/ 10 = 50%
If company is growing sale big to bigger and able to keep the GPM steady, it is strong MOAT
If your business has to give discounts to grow sales, its a bad sign - someone is able attach your business
Operating Profit Margin
OPM = EBIT * 100 / Sales
Difficult to keep Steady, as it includes Operating Expenses e.g. R&D, One-time Advertising expense
Has OPM fluctuated to -ive in any year say e.g. -200%
Volatile may be fine with small -ive, should be not be high -ive
Interest Coverage Ratio
Is company earning to easily pay the interest
Interest payment is done from EBITDA - D & A are non-cash expense
ICR = EBITDA/Interest > ~7. If EBITDA reduces it should manage paying the interest
ROE: Return on Equity
Equity : How much money is invested in business
NI\Equity
Should be ROE > 15% (i.e. Average long term Nifty returns)
Free Cash Flow
Accounting - Accrual: Revenue recognized if work is done, even if revenue is not received. Same for expense.
Accounting - Cash: Revenue recognized when money is received - Less chances of manipulation
NI is a better picture than FCF, it represents future
However NI could be manipulated, FCF has less manipulation chances, we would use FCF
Cash Flow
Cash from Operating Activities
Net from Revenue - Expenses i.e. for Operations
Free Cash Flow = CFO - CapEx (e.g. laptop purchase)
Cash from investing Activities
Buy an Asset e.g. land. In future land sale might give big money. This is from investing.
Not much applicable for investor
Cash from Financing Activities
Money raised from borrowers as Debt or lieu of equity
Not much applicable from investor
FCF\Sales > 20% - Cash Machine company
Company with high FCF gives high dividend
Otherwise Equity will increase, will lead to lower ROE, Net Income is same, Equity is keep on increasing
Earnings
Chances of earning manipulation
Earning manipulation unethical Vs illegal
Used for screening not company evaluation
Free Cash Flow
Low chances of manipulation
Used for Company evaluation
Understand Income Statement
Understand Income Statement
Profit and Loss statement
It starts from sales\revenue\turnover\topline
Cost of goods sold (COGS), If manufacturing cost of Pen is Rs 5, COGS is RS 5. Say pen is sold for Rs 10
Sales, is Rs 10
Gross Profit = Sales - COGS, 10-5=5
Operating Expenses: To run the business Selling General and Administrative expenses (SG&A)
Depreciation Expense (Tangible)
Amortization expense (Patent\License has 10yrs life) (Intangible)
Earnings before Interest and Tax (EBIT)
Operating profit (EBIT) = Gross Profit - OPEx - Depretiation expense - Amortization expense
Profit before Tax (PBT)
PBT = EBIT - Interest
Net Income (NI, Net Profit, PAT, Bottom Line) = PBT - Tax
Entrepreneurs usually look for Sale for topline growth
Investor look for profit increase focus, top-line could be by-product
Every Entrepreneur should be in the business of making profit
Flipkart - Business Analysis
Flipkart - Business Analysis
Business does not make profit
Looks, It is in the business of making Sales
Kishore Biyani (Big Bazar) was asked why not sale online
Kishore told what is this online business, it doesn't make profit
Online Customer doesn't let earn even Rs 5 premium to the seller (by comparison)
Kishore was told, that after culture shift online would start making profit
Kishore told, yeh its investing for culture shift if they have huge money. But we are not going to burn money over it.
Flipkart was asked on online business philosophy
Told customer was used to buy with look and feel on product
Now we are in the culture change with online
After culture shift, we would look to earn money
E-commerce model is just a platform to sell, isn't business in itself
What's MOAT in online business of Flipkart
Industry development require lot of money to burn
But at the end it becomes commodity, won't benefit the starter
Customer wont have loyalty
In last 5-8yrs, valuations were being given on Sales (burning money and into deep loses) rather than earnings
This has been a cultural change
Weird investments started with idle money in Banks with low interest rates in West
How to calculate valuate of such company with 0 net profit
Check Operating profit EBIT in such case
Suppose a company generate 1cr EBIT, let's say would provide 30cr valuate
Company with net company 1crm say has 40cr valuation
Now Flipkart has has EBIT also -ive, how to calculate valuation
Check EBITDA, Earning before Interest , Tax, Depreciation, Amortization
Suppose company has 1 cr EBITDA, lets say give valuation of 20cr
Now Flipkart has EBITDA also -ive, how to value
Let consider Gross profit only
With scale of business, Gross profit might increase in future with non-linear OPex growth
Now Flipkart has Gross Profit also ive, as they sell on discount from cost
Now let consider only sales
Let say for 1 cr sales, consider a valuation of 5cr
Now everyone made Sales as valuation metric standard
Entrepreneurs start using Sales as business metric, and start increasing sales for valuation of company and not focussed on profit
Why people are investing and not thinking on profit
It started in beginning, money flowed in with potential of scale
Say 1M sale happened quickly with loss
Ask for 1B to make profit, sale happened with loss again. It was called that culture change is yet to happen
Ask for 10B, all peer Amazon, etc jumped in more discount. All money burnt in
Ask for 100B, Flipkart told if you wanna recover 11B, invest more. It become a trap of investing more
Looking for exit path if someone could buy the business some day, or if some value is created around business
Stock Screening - Valuation
Stock Screening - Valuation
Step by Step
Step by Step
Screener.in
morningstar.in
ITC
ITC
Benchmark for understanding a great company in terms of business model (not on price)
Moats - Cig, FMCG, Hotel, Paper
Biggest business is Cig has Taste moats
FMCG is next bigger has brand moats
PE: 30.23 (Not very low)
PEG: 1.6 (Not horribly cheap)
P/B: Not Applicable - This is B2C Company
D\E: 0 (Morning Star) Financial key-ratios => financial health
GPM: Steady ~60% (Morning Star) Financial key-ratios => Profitability
OPM: No major (~100-200) -ive
ICR: Operating Profit/Interest = ~300 Good, very high
ROE: NI\Equity = Profit\Assets = 29% (from Screener last 10 years)
FCF: Always +ive and ~25% (from Morning star)
References
Book : Little book on Common Sense Investing
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