While searching for ideal stocks to invest in, there are two aspects one needs to consider:
a) Finding excellent businesses b) Finding great stocks among these businesses
a) Finding excellent businesses - An excellent business is one which has certain economic 'forces' that aid its profitability. There are some characteristics that such businesses display, that allows one to identify them. These characteristics are:
i) High Return on Invested Capital: This is the single most important metric in determining if a business is a good one, or an excellent one. Return on capital invested is the retained earnings in a given period on the total capital that was available to the business at the start of that period. Return on investment can be measured as
RoI = Net margin x Total Asset Turnover
A consistently high net margin indicates a business that has superior pricing power and lower competitive intensity. This ability to raise prices by reasonable amounts in response to market forces (or pricing power) is more often displayed by B2C companies, than B2B companies. B2C companies tend to create brands, their customers are many and diverse, and the customers are sticky. This gives the company leverage over its customers, and the consequent pricing power. In the case of B2B companies, the customers tend to be fewer in number, and a few customers can contribute a significant portion of revenues. In such cases, naturally, the leverage and pricing power is relatively less. Therefore B2C companies in general make for better businesses on a long term basis, from the perspective of an owner of the business. B2B businesses that replicate some of the characteristics of a B2C business can be attractive due to an economic moat - like being in a monopolistic position or having a sustainable lower cost of production than competing businesses.
Increasing consumption => Increased earnings for the B2C companies => Increased earnings for the B2B companies => Higher raw material prices
The above flow diagram indicates the flow of value creation through the value chain. B2C businesses can create value in the long term on a sustainable basis only if consumers are consuming more and increasing spending. B2B businesses in turn can create value only from their customers, the B2C and other B2B businesses. And the value of raw materials only comes from their demand and consumption by various businesses. We see that at each step in the value chain, the flow of value created is in the opposite direction to the flow of price. B2C businesses derive value from consumers, B2B businesses derive value from B2C and other B2B businesses, and raw materials derive their value from all the business that use them. For raw material prices to be high, businesses that use them should do well. For B2B companies to do well, B2C companies need to do well. And for B2C companies to do well, consumers should do well. Hence we see that generally speaking, B2C companies are closer to the consumers, and the source of value, than B2B companies.
Consumers <many to few> B2C <few to few> B2B <few to few> Raw materials
Coming to the other half of the Return on Investment equation, Total Asset Turnover indicates the efficiency of usage of capital invested in the business. This is the ratio of total sales in a given period to the average total assets in that period. The total assets include the net current assets (current assets such as inventories, cash, receivables minus the current liabilities), the Fixed Block (Capital Investments) made by the company and also any investments.
Businesses having the golden combination of high net margins and high total asset turnover, lead to a high return on investment. Such businesses, even in the absence of outstanding managerial skill at the helm, can yield satisfactory returns.
Let me give an example to help illustrate this. Assume you have won a lottery for one million rupees. You have always had a love for coffee and you want to use the one million rupees as your investment in a coffee related business. Say you have the following options: Option A - You could sell coffee beans; Option B - You could set up a factory that manufactures coffee making machines; Option C - You could set up a coffee shop where you make and sell coffee; Option D - You could hire a barista to make and sell a variety of excellent coffees
Option A, selling coffee beans, your margins are very low (you are selling a commodity) and all your returns have to come from asset turnover - a high asset turnover and you are doing okay, but a low asset turnover, combined with the low margin nature of the business, will make it a very difficult proposition for you. Increasing asset turnover is very difficult - you do not have anything differentiating your coffee beans from other competitors’ and owing to their large coffee plantations, your competitors have a much lower cost of production of coffee beans than you. So you are squeezed on both the margin front and the asset turnover front. Low net margin, low asset turnover. Bad business.
Option B, becoming a coffee machine manufacturer, means you have to make capital investment in setting up the coffee machine manufacturing plant. Once the plant is up and running, the success of your business will depend on the quality of your coffee machines. If you make good quality machines and provide good service, you may be able to charge a premium for your coffee machines. But you will have to keep investing in maintenance and upgradation of the coffee machine plant, as well as in improving your sales and marketing and after sales service. So although your margins may be high if you make good machines and have created a good brand, your total asset turnover will be impacted by repeated investments you will have to make in the business. High net margin, low asset turnover. Moderate business.
Option C, where you set up a coffee shop - your margins are still low (since anyone out there can make coffee), but with good service you are able to increase your sales, and thus your asset turnover. Low net margin, high asset turnover. Moderate business.
Option D, where you also set up a coffee shop, but with premium coffees, great service, and great sales and marketing. Over time, owing to your differentiated product, you are able to build a brand and a following of faithful coffee drinkers, who are addicted to your coffee, and cannot go a day without it. Now you can raise the price of your product, and your demand does not drop off. Your big circle of customers only encourages more and more people to try your product out, and in turn your circle of customers gets even bigger. High net margins, high asset turnover. Excellent business.
Note that the above example is obviously contrived – you can encounter excellent businesses even if one of the two – net margins or total asset turnover is low– low margins can be more than compensated for by high asset turnover and vice versa. This example is only manufactured to aid illustration of the points I am trying to make.
ii) Strong cash flows: Businesses that have strong operating cash flows will need lower infusions of external capital for funding future growth. Examining cash flows is an important way to distinguish between really good businesses, and businesses that are only 'paper tigers' - that exhibit strong revenue and net profit growth on their accounting statements, but which are not sustainable - either because they are funding growth through disproportionately higher receivables or through plain accounting gimmickery and window dressing. Ideal businesses will have Low Receivables and High Payables - most of the revenue is realized as actual cash flowing in to their coffers, while the cash outflows for costs and expenses can be delayed. Such companies have a very low or negative net working capital and cash conversion cycle (the cash conversion cycle is = receivable days + inventory days - payable days).
Of course, the debt should be as low as possible, ideally none. Even if it is there, it should be easily serviceable. By this, I mean that the debt service (finance charges, interest payments) should be less than one third or one fourth of the EBITDA of the company for a given period.
While the above are some quantitative metrics that can be measured for any business under evaluation, there are some intangible, qualitative aspects that need consideration as well. One must consider the nature of the industry that the business is in – an excellent business in an industry that does not have a bright future (think Kodak, one of the best photographic film camera companies, being decimated by digital photography or Barnes and Noble, one of the world’s best physical book retailers being killed by digital bookreaders and online retailers or Microsoft, owner of the dominant Windows operating system and Microsoft Office productivity software being threatened by cloud computing) makes for an unsound investment. I think this is the single reason Warren Buffet does not invest in technology companies – however good a business in this industry may be, the nature of the industry itself is so fast changing and unpredictable that it is almost impossible to determine how the technology landscape will look even a decade from now.
The other qualitative aspect to consider is the nature of the management. While it is true that if all the economic forces we encountered till now favor a business, then management has to work very hard indeed to deliver disappointing results, finding an excellent business with superlative management will mean, to paraphrase Wodehouse, ‘all is for the best in the best of all possible worlds’. This is especially true in the Indian context – where it is relatively easier for dishonest promoters to ride roughshod over minority shareholders’ interests.
b) Finding a great stock - Once one had identified a clutch of excellent businesses, the next stop is to pick great stocks from among these businesses. And this is largely a function of the price these businesses are available at. Borrowing from Benjamin Graham, one should view the purchase of stocks or other securities of businesses as not much different than buying a chunk of said business. Based on the historical data, especially the margins, asset turnover, cash flows, and the industry it operates in, one can determine the potential future cash earnings of the business. This steam of future earnings (very conservatively estimated) is used to determine the intrinsic value of the company. One then employs a margin of safety to discount this intrinsic value. The margin of safety is your insurance against even your conservative estimates being wrong. If the current quoted market value of the business is less than this margin of safety discounted intrinsic value of the business, then the business represents an attractive investment opportunity.
The hardest part of undertaking the above exercise is estimating that intrinsic value from the historic earnings and financials results, in conjunction with one’s understanding of the future economics of the industry.
Some industries have the above favourable economic forces automatically aiding them owing to their very nature. Hence it is common to encounter good business from these industries -
• Cigarette/Liquor companies - B2C with inelastic demand, high margins and high asset turnovers, and higher payables than receivables
• FMCG companies - B2C companies with strong brands, slightly less pricing power compared to tobacco/liquor companies but much higher asset turnover more than compensating for lower margins
• Media Distribution companies - Newspapers, television stations - B2B companies with respect to revenues (since most revenue is from advertising), B2C companies with respect to content. The internet and mobile devices might change the dynamics of this industry, especially for newspapers and the print media
• Insurance companies and banks – The business model allows them to generate float (insurance premia and deposits taken on in advance against promise of future payments). Performance completely dependent on investment results of float collected and efficiency of float collecting operations. While banks have the risk of ‘run on bank’ due to fractional reserve banking (a complicated way of saying that all banks under today's banking system employ a high degree of leverage), insurance companies do not have this risk.
a) Finding excellent businesses b) Finding great stocks among these businesses
a) Finding excellent businesses - An excellent business is one which has certain economic 'forces' that aid its profitability. There are some characteristics that such businesses display, that allows one to identify them. These characteristics are:
i) High Return on Invested Capital: This is the single most important metric in determining if a business is a good one, or an excellent one. Return on capital invested is the retained earnings in a given period on the total capital that was available to the business at the start of that period. Return on investment can be measured as
RoI = Net margin x Total Asset Turnover
A consistently high net margin indicates a business that has superior pricing power and lower competitive intensity. This ability to raise prices by reasonable amounts in response to market forces (or pricing power) is more often displayed by B2C companies, than B2B companies. B2C companies tend to create brands, their customers are many and diverse, and the customers are sticky. This gives the company leverage over its customers, and the consequent pricing power. In the case of B2B companies, the customers tend to be fewer in number, and a few customers can contribute a significant portion of revenues. In such cases, naturally, the leverage and pricing power is relatively less. Therefore B2C companies in general make for better businesses on a long term basis, from the perspective of an owner of the business. B2B businesses that replicate some of the characteristics of a B2C business can be attractive due to an economic moat - like being in a monopolistic position or having a sustainable lower cost of production than competing businesses.
Increasing consumption => Increased earnings for the B2C companies => Increased earnings for the B2B companies => Higher raw material prices
The above flow diagram indicates the flow of value creation through the value chain. B2C businesses can create value in the long term on a sustainable basis only if consumers are consuming more and increasing spending. B2B businesses in turn can create value only from their customers, the B2C and other B2B businesses. And the value of raw materials only comes from their demand and consumption by various businesses. We see that at each step in the value chain, the flow of value created is in the opposite direction to the flow of price. B2C businesses derive value from consumers, B2B businesses derive value from B2C and other B2B businesses, and raw materials derive their value from all the business that use them. For raw material prices to be high, businesses that use them should do well. For B2B companies to do well, B2C companies need to do well. And for B2C companies to do well, consumers should do well. Hence we see that generally speaking, B2C companies are closer to the consumers, and the source of value, than B2B companies.
Consumers <many to few> B2C <few to few> B2B <few to few> Raw materials
Coming to the other half of the Return on Investment equation, Total Asset Turnover indicates the efficiency of usage of capital invested in the business. This is the ratio of total sales in a given period to the average total assets in that period. The total assets include the net current assets (current assets such as inventories, cash, receivables minus the current liabilities), the Fixed Block (Capital Investments) made by the company and also any investments.
Businesses having the golden combination of high net margins and high total asset turnover, lead to a high return on investment. Such businesses, even in the absence of outstanding managerial skill at the helm, can yield satisfactory returns.
Let me give an example to help illustrate this. Assume you have won a lottery for one million rupees. You have always had a love for coffee and you want to use the one million rupees as your investment in a coffee related business. Say you have the following options: Option A - You could sell coffee beans; Option B - You could set up a factory that manufactures coffee making machines; Option C - You could set up a coffee shop where you make and sell coffee; Option D - You could hire a barista to make and sell a variety of excellent coffees
Option A, selling coffee beans, your margins are very low (you are selling a commodity) and all your returns have to come from asset turnover - a high asset turnover and you are doing okay, but a low asset turnover, combined with the low margin nature of the business, will make it a very difficult proposition for you. Increasing asset turnover is very difficult - you do not have anything differentiating your coffee beans from other competitors’ and owing to their large coffee plantations, your competitors have a much lower cost of production of coffee beans than you. So you are squeezed on both the margin front and the asset turnover front. Low net margin, low asset turnover. Bad business.
Option B, becoming a coffee machine manufacturer, means you have to make capital investment in setting up the coffee machine manufacturing plant. Once the plant is up and running, the success of your business will depend on the quality of your coffee machines. If you make good quality machines and provide good service, you may be able to charge a premium for your coffee machines. But you will have to keep investing in maintenance and upgradation of the coffee machine plant, as well as in improving your sales and marketing and after sales service. So although your margins may be high if you make good machines and have created a good brand, your total asset turnover will be impacted by repeated investments you will have to make in the business. High net margin, low asset turnover. Moderate business.
Option C, where you set up a coffee shop - your margins are still low (since anyone out there can make coffee), but with good service you are able to increase your sales, and thus your asset turnover. Low net margin, high asset turnover. Moderate business.
Option D, where you also set up a coffee shop, but with premium coffees, great service, and great sales and marketing. Over time, owing to your differentiated product, you are able to build a brand and a following of faithful coffee drinkers, who are addicted to your coffee, and cannot go a day without it. Now you can raise the price of your product, and your demand does not drop off. Your big circle of customers only encourages more and more people to try your product out, and in turn your circle of customers gets even bigger. High net margins, high asset turnover. Excellent business.
Note that the above example is obviously contrived – you can encounter excellent businesses even if one of the two – net margins or total asset turnover is low– low margins can be more than compensated for by high asset turnover and vice versa. This example is only manufactured to aid illustration of the points I am trying to make.
ii) Strong cash flows: Businesses that have strong operating cash flows will need lower infusions of external capital for funding future growth. Examining cash flows is an important way to distinguish between really good businesses, and businesses that are only 'paper tigers' - that exhibit strong revenue and net profit growth on their accounting statements, but which are not sustainable - either because they are funding growth through disproportionately higher receivables or through plain accounting gimmickery and window dressing. Ideal businesses will have Low Receivables and High Payables - most of the revenue is realized as actual cash flowing in to their coffers, while the cash outflows for costs and expenses can be delayed. Such companies have a very low or negative net working capital and cash conversion cycle (the cash conversion cycle is = receivable days + inventory days - payable days).
Of course, the debt should be as low as possible, ideally none. Even if it is there, it should be easily serviceable. By this, I mean that the debt service (finance charges, interest payments) should be less than one third or one fourth of the EBITDA of the company for a given period.
While the above are some quantitative metrics that can be measured for any business under evaluation, there are some intangible, qualitative aspects that need consideration as well. One must consider the nature of the industry that the business is in – an excellent business in an industry that does not have a bright future (think Kodak, one of the best photographic film camera companies, being decimated by digital photography or Barnes and Noble, one of the world’s best physical book retailers being killed by digital bookreaders and online retailers or Microsoft, owner of the dominant Windows operating system and Microsoft Office productivity software being threatened by cloud computing) makes for an unsound investment. I think this is the single reason Warren Buffet does not invest in technology companies – however good a business in this industry may be, the nature of the industry itself is so fast changing and unpredictable that it is almost impossible to determine how the technology landscape will look even a decade from now.
The other qualitative aspect to consider is the nature of the management. While it is true that if all the economic forces we encountered till now favor a business, then management has to work very hard indeed to deliver disappointing results, finding an excellent business with superlative management will mean, to paraphrase Wodehouse, ‘all is for the best in the best of all possible worlds’. This is especially true in the Indian context – where it is relatively easier for dishonest promoters to ride roughshod over minority shareholders’ interests.
b) Finding a great stock - Once one had identified a clutch of excellent businesses, the next stop is to pick great stocks from among these businesses. And this is largely a function of the price these businesses are available at. Borrowing from Benjamin Graham, one should view the purchase of stocks or other securities of businesses as not much different than buying a chunk of said business. Based on the historical data, especially the margins, asset turnover, cash flows, and the industry it operates in, one can determine the potential future cash earnings of the business. This steam of future earnings (very conservatively estimated) is used to determine the intrinsic value of the company. One then employs a margin of safety to discount this intrinsic value. The margin of safety is your insurance against even your conservative estimates being wrong. If the current quoted market value of the business is less than this margin of safety discounted intrinsic value of the business, then the business represents an attractive investment opportunity.
The hardest part of undertaking the above exercise is estimating that intrinsic value from the historic earnings and financials results, in conjunction with one’s understanding of the future economics of the industry.
Some industries have the above favourable economic forces automatically aiding them owing to their very nature. Hence it is common to encounter good business from these industries -
• Cigarette/Liquor companies - B2C with inelastic demand, high margins and high asset turnovers, and higher payables than receivables
• FMCG companies - B2C companies with strong brands, slightly less pricing power compared to tobacco/liquor companies but much higher asset turnover more than compensating for lower margins
• Media Distribution companies - Newspapers, television stations - B2B companies with respect to revenues (since most revenue is from advertising), B2C companies with respect to content. The internet and mobile devices might change the dynamics of this industry, especially for newspapers and the print media
• Insurance companies and banks – The business model allows them to generate float (insurance premia and deposits taken on in advance against promise of future payments). Performance completely dependent on investment results of float collected and efficiency of float collecting operations. While banks have the risk of ‘run on bank’ due to fractional reserve banking (a complicated way of saying that all banks under today's banking system employ a high degree of leverage), insurance companies do not have this risk.
