What makes a business a successful business….Sales Growth?? Profit
Growth?? Or both?? Or a good business model?? Scalability?? Leverage??
Low capital intensity?? EPS?? PE?? PB?? Enterprise Value?? ROE??
ROCE?? ………etc….etc????
Probably a combination of all these and even few more are sometimes not sufficient to judge a good investment…For me, three most important factors that should be considered while making any investment decision –
1) Free cash flows- Free cash flows generated by the business should be the key to any investment decision. It’s an indication that the company is effectively managed and has more or less most of the above qualities as sought by the investment gurus
We have seen how companies which have generated and grown their free cash flows year after year have rewarded investors significantly (e.g. HUL, Nestle, Colgate etc)
In some cases the management decides to invest the surplus cash generated back in the business in which case the business may not show any positive free cash flow generation. This is not unhealthy as long as the company generates a sufficiently high ROE (Return on Equity) on the money invested back in the business (e.g. NESCO – A company where most of the cash generated by the business in the form of rentals is invested back in building assets, however this should not be a problem as long as the ROE of the business is high i.e. every rupee invested in the business should at least generate a value equal to or more than that rupee over a period of time)
On the other side, we have businesses which keep investing most of their cash flows generated back into businesses while at the same time not generating an adequate ROE. Such businesses are highly capital intensive and not considered an investor’s friend. E.g. If 100 Rs invested back in business doesn’t earn even 10 Rs means the business is not generating sufficient ROE and is sucking cash (Airlines business e.g. have never been able to reward investors)
2) Separate emotions from investing and challenge your own assumptions – Emotions or biasness are an investor’s biggest enemy. A successful and disciplined investor’s decision is always backed by fundamental analysis and not by any behavioral trait. It’s very very important to separate the two to be successful in investing. Should I buy a stock because everybody else is buying or should I buy because there is a strong fundamental performance of the underlying business??
As Peter Lynch said “Don’t find reasons for buying a stock, find reasons not to buy a stock”. We are always impacted by what’s market or the so called market gurus are recommending than following our own fundamental analysis
(We have seen what has happened to the Facebook IPO)
3) Act once you are convinced – Once convinced, don’t try to time the market. Most of the common man like us just keeps watching the market/stock going up (in anticipation of being able to buy at a lower price) and then having missed the opportunity, we end up buying it at a time when it is highly overvalued.
Some of the qualities that a good business should have (from an investor’s perspective) –
I have an obligation to my shareholders, to create maximum value for whatever they have invested and that’s what my job is and that’s what I am here to deliver. I don’t carry an egoistic or emotional attachment to the businesses. We did a calculation to justify the value that Abbott paid — I would have had to grow the business for 15 years at 20% CAGR with an operating margin in excess of 35%. Now that’s not possible and therefore, the choice was should I leave aside my ego that it is my business and I created it, or should I do what is in the best interest of shareholders. If you look at like that, that’s what a leader ought to do, in my view. Job of a leader is to act like a trustee.”
I would be willing to hear if I have missed out any key parameters
VIJAY
Probably a combination of all these and even few more are sometimes not sufficient to judge a good investment…For me, three most important factors that should be considered while making any investment decision –
1) Free cash flows- Free cash flows generated by the business should be the key to any investment decision. It’s an indication that the company is effectively managed and has more or less most of the above qualities as sought by the investment gurus
We have seen how companies which have generated and grown their free cash flows year after year have rewarded investors significantly (e.g. HUL, Nestle, Colgate etc)
In some cases the management decides to invest the surplus cash generated back in the business in which case the business may not show any positive free cash flow generation. This is not unhealthy as long as the company generates a sufficiently high ROE (Return on Equity) on the money invested back in the business (e.g. NESCO – A company where most of the cash generated by the business in the form of rentals is invested back in building assets, however this should not be a problem as long as the ROE of the business is high i.e. every rupee invested in the business should at least generate a value equal to or more than that rupee over a period of time)
On the other side, we have businesses which keep investing most of their cash flows generated back into businesses while at the same time not generating an adequate ROE. Such businesses are highly capital intensive and not considered an investor’s friend. E.g. If 100 Rs invested back in business doesn’t earn even 10 Rs means the business is not generating sufficient ROE and is sucking cash (Airlines business e.g. have never been able to reward investors)
2) Separate emotions from investing and challenge your own assumptions – Emotions or biasness are an investor’s biggest enemy. A successful and disciplined investor’s decision is always backed by fundamental analysis and not by any behavioral trait. It’s very very important to separate the two to be successful in investing. Should I buy a stock because everybody else is buying or should I buy because there is a strong fundamental performance of the underlying business??
As Peter Lynch said “Don’t find reasons for buying a stock, find reasons not to buy a stock”. We are always impacted by what’s market or the so called market gurus are recommending than following our own fundamental analysis
(We have seen what has happened to the Facebook IPO)
3) Act once you are convinced – Once convinced, don’t try to time the market. Most of the common man like us just keeps watching the market/stock going up (in anticipation of being able to buy at a lower price) and then having missed the opportunity, we end up buying it at a time when it is highly overvalued.
Some of the qualities that a good business should have (from an investor’s perspective) –
- Consistent Topline and Bottomline growth – A CAGR of ~ 15-20% can be considered good growth for a business (e.g. ITC, Castrol, L&T etc). Profit growth rates of the business should ideally be higher or at least equal to Sales growth which indicates that the company has achieved operating efficiency over the years
- Moat/Competitive Advantage – It’s the most important point from an investor’s perspective. The business should definitely have some moat/competitive advantage like pricing power (e.g. companies like ITC and Colgate), lowest cost producer (e.g. Coal India), high barriers to entry (e.g. Banks especially in countries like India where banking licenses are not issued for years), first mover advantage (e.g. Exide Batteries, Crisil, Zydus Wellness), very strong brands (Nestle, P&G, HUL, Page industries), clear market leader/monopoly or duopoly (TTK Prestige and Hawkins cooker, Titan watches, Power Grid Corporation, United Spirits, Castrol and Tide Water oil etc.)
- Circle of competence – The business should broadly fall within the broad circle of competence of the investor. There is no point investing in a sector or business where the complexities involved are too high (e.g. OIL & Gas industry, Nuclear equipments industry) unless the investor understands the drivers of such businesses or the nuances of the respective industry, where the sector is to a larger extent governed by policy decisions (e.g. Fertilizer/Sugar). An investor should look for a simple business which he can understand and is not a very high risk business, doesn’t need high technology (e.g. companies manufacturing toothpaste and paints) and doesn’t have high uncertainty (Companies which are cyclical like steel, iron ore have high amount of uncertainty)
- Scalability – The business should be scalable e.g. Auto, spirits, luxury goods, healthcare industries should all grow up by their inherent nature and changing lifestyle of people. Some of the scalable opportunities exploited by able businessman in the past were Pantaloon retail, Titan etc (E.g. a company like Relaxo footwear is bound to grow in size since it sells a very basic product…footwears, not all Indians want to wear unbranded local footwear; similarly not all Indians can afford expensive imported watches which provides scale opportunity to Titan)
- Leverage – The business shouldn’t be excessively leveraged. As Mr Buffett says “You get to know who is swimming naked only when the tide goes”. An excessively leveraged company (
even if the leverage may have resulted in high growth for few years) feels serious distress during tough times and is likely to succumb to the pressure of external debt-holders (We have seen what have happened to companies like Suzlon, Unitech etc)
- Free cash flow generation – A very important but often neglected measure of a successful business. This is like the life blood of a business. As said above, unless a company earns a high ROE on the reinvested capital, any business which doesn’t produce sufficient free cash flows doesn’t warrant any consideration (Most of the blue chip companies generate good free cash flows)
- Capital Intensity of the business – A capital sucking business rarely rewards an investor (unless it’s an asset play). A business which requires minimum capital employed (Fixed and Working) to run its operations smoothly is the one which will produce free cash flows year on year and will reward shareholders. Some of the companies like VST industries and HUL operate almost on a negative working capital because of the advances they collect from their distributors and hence are the most rewarding business. A Sales/Capital employed ratio of 1 means that the business needs capital worth 100 rs to generate sales worth 100 Rs. Such businesses are always challenging (e.g. Infra/Steel companies)
- High ROCE/ROE – Most of the successful businesses utilize their capital very efficiently measured by high ROE and ROCE numbers year on year (Companies like ITC, Crisil, ITC, Asian Paints, Mahindra, P&G, Colgate, Gillette, VIP Industries have all very high ROE and ROCE numbers)
- Management Quality/Corporate Governance– One of the very very important considerations in investing philosophy. On one hand while we see some businesses getting rewarded for their sheer corporate governance (HDFC, HDFC Bank, Mahindra & Mahindra), at the same time we have seen market severely punishing companies like RCOM, Rpower, IVRCL, Dainik Bhaskar etc. A good governance and sound management is the key to any business. Management should act in the best interest of shareholder, not get into unnecessary diversifications (e.g. a company like Venky’s which is into poultry business going and buying a football team) or inappropriate allocation of capital or taking hefty amounts of payouts from the business. If there are not enough investment opportunities within the business, an ideal management will pay it to shareholders in the form of dividends.
I have an obligation to my shareholders, to create maximum value for whatever they have invested and that’s what my job is and that’s what I am here to deliver. I don’t carry an egoistic or emotional attachment to the businesses. We did a calculation to justify the value that Abbott paid — I would have had to grow the business for 15 years at 20% CAGR with an operating margin in excess of 35%. Now that’s not possible and therefore, the choice was should I leave aside my ego that it is my business and I created it, or should I do what is in the best interest of shareholders. If you look at like that, that’s what a leader ought to do, in my view. Job of a leader is to act like a trustee.”
- Margin of Safety – The price paid for an asset is as important as the quality of the asset. If one purchases a sea facing house in Worli, there is a high likelihood that the property will always be saleable and the owner will be protected against any downside in the value of the asset. It’s definitely one of the best quality assets to own but if the price paid for it is reasonably high in comparison to the market rates, whether the owner will be able to make sufficient returns from the asset is questionable. Same logic applies to stock markets. The investment must be made at a reasonable valuation (so that there is a decent margin of safety in the investor’s hands)…Anything bought excessively costly will take time to reward shareholders (e.g. Jubilant today at 70 times earnings hardly provides any margin of safety to an investor). A lot of measurements like PE/PE/EV-EBIDTA ratio/EBIDTA multiple/Dividend Discount model/Cash flow multiple/Earnings Multiple/ Earnings discounting/Discounted cash flow model etc etc are used by analysts across the world to arrive at what is correct valuation of the business. The basic premise should be whether the business is generating sufficient cash flows/income to justify the valuation
I would be willing to hear if I have missed out any key parameters
VIJAY
