Everything has a beginning, a middle, and, most definitively, an ending. This is the first dharma seal in Buddhist philosophy, the Law of Impermanence.
(However, ancient Vedic philosophy believes in the Soul, which is permanent. Let’s focus on the ‘impermanence’ for now)
It is a well-established understanding that even companies have a beginning, a middle, and an end.
The East India Company (EIC) was founded in 1600. Philanderer Mughal emperors allowed East India Company to access and exploit India. However, after ruling India for almost 275 years, even the East India Company was dissolved in 1874.
In the book ‘Ikigai: The Japanese secret to a long and happy life, the author studies a small town in Japan where the maximum number of centenarians are found. A person who is 100 years old or older is a centenarian. There are many centenarians’ habits including eating well, walking regularly, breathing clean air, listening to music, dancing, and the general flow of life. As per the author, these habits as a collection increase the odds of a person having a life of more than 100 years.
A company is an artificial person representing an association of people with a specific objective. A company may also be viewed from an ‘impermanence’ perspective. For example, a company that lasts longer may be taken as a company whose products or services have some endurance or competitive edge.
In the last 20 years, we have encountered several events that severely impacted the economy. Tech bubble, 2008 housing bubble, 26/11, hyperinflation in India (2013), demonetization, and more recently lockdown due to the pandemic. A lot of businesses have flourished despite these challenges.
Strong management navigates through ever-changing conditions while executing its corporate missions. Unlike the west, where technology innovation plays a significant part, in India, many businesses adopt technology rather than innovate.
A of technology firms have a short life because new emerging technologies challenge their products. However, as technology users in India, most Indian companies stand to benefit from this innovation because these more recent technologies often improve the financials by reducing costs.
Innovation is not the primary driver of endurance, so how do businesses survive and thrive in India?
The answer may lie in understanding how a business restricts competition. One of the ways to identify a company keeping its competition at bay is to look at the history of return on equity or return on capital employed. A high ratio indicates a company maintaining or improving margins by using its capital efficiently.
Any business that earns a high return will attract competition. Conversely, if the business does not have a competitive edge, more players will flood in and take away the high returns of the business.
In India, this competitive edge is seen in companies that dominate specifically. For example, Asian Paints has almost 60% market share in the paint industry in India. The same logic may be extended to Pidilite, Colgate, Titan, etc. The source of competitive edge tends to be specific and not general.
Proprietary technology, product differentiation, or branding are insufficient to keep the competition at bay. These advantages must be combined with some edge related to strong habits, high switching costs, or substitutes.
Habits lead us to buy fevicol, Colgate toothpaste, Gillette razor, etc. (Habits may also include more people using the same product, example Whatsapp)
It is the taste of Maggi that restricts people from switching to other instant noodles.
People use Microsoft Excel because an acceptable closest substitute is not available.
Let’s extend the example of Microsoft Excel. The software is written once but can be sold to many customers without adding a lot of expense. This is called economies of scale. As the scale of the product grows, the fixed cost is spread over more units, the variable cost per unit stays the same, and the average cost per unit declines.
A business with these advantages will first grow its market and then defend its market share. A business may be successful for a while, but if it is successful for an extended period, it must protect its market share.
Once the market share is established, the business must ensure customer captivity. This may be done by encouraging habit formation in new customers, increasing switching costs, and searching for more complicated alternatives.
For example, Asian Paint has an edge on its supply chain management. They have used proprietary technology to forecast internal demand for its products. Asian Paints provide unmatched supply chain standards by delivering its products four times a day to nearly 50000 dealers. This way dealers are happy and so are the customers. Asian Paint is still selling paints even after eight decades. They continue to invest in ensuring and strengthening their ‘competitive edge.
A business with a high return, a decent market share, and a relentless focus to guard the market share has a probability of surviving long. Eventually, even this business will die but may allow you to make wealth for your lifetime. So, in a way, the business may outlive you.
If a business operates with no advantage, the only savior is exceptional management. If the management can effectively manage costs across product development, marketing, and financing, the business can survive. However, the lifeline of a business is still challenging to predict because management can always join the competition.
Now let’s reflect on how to incorporate the life of a company into an investment decision. It is better to break the expected return of businesses that earn high returns. There are three parts to this return: the first is dividend payout, the second comes from within the business, and the third comes from outside the business.
EXAMPLE
The organized market of a pressure cooker is around Rs 1600 crores, 55% belongs to Hawkins cooker. 5 years average RoCE is 60% with 8.5% pa sales growth. So, let’s look at this high return business making pressure cookers since 1959.
Part 1: Dividend return
5 years average dividend payout = 57% (excluding 2019-21, 77%)
5 years average net operating profit growth = 9.4%
Dividend return = 57% X 9.4% = 5.36%
Part 2: Organic return
Organic return = Net operating profit growth X (1 – Reinvestment rate) X (1 – Dividend payout)
Reinvestment rate is the capital expenditure and working capital investment required to generate sales. In the case of Hawkins, it is ~16.3%.
Organic return = 9.4% X (1 – 16.3%) X (1 – 57%) = 3.38%
Part 3: Inorganic return
If a company invests outside, i.e., buy businesses, and those businesses generate a certain return. In the case of Hawkins, we do not have that history, so we assume 0%.
Total return = 5.36% + 3.38% + 0.00% = 8.74%
As of 2019, the average Indian life expectancy is around 70 years. There must be an average age of a company as well. Let’s look at how we assess the average life expectancy of a company.
The life expectancy of a company can be roughly estimated as a sum of survival probability and growth. We estimate the half-life of a company, the number of years in the future at which its survival probability declines to 50%. For a durable business such as Hawkins Cooker, the life could be around 80 years. Whereas tech businesses such as Policy Bazaar, Zomato, etc., would be around 15-20 years. The half-life can be translated into annual fade probabilities using the rule of 72 (half-life = 72 / expected life).
Hawkins Cooker Fade Rate = 72 / 80 = 0.90% per year
This is a negative number to the total return.
Expected return = 8.74% (calculated above) - 0.90% (fade rate) = 7.84%
You must now compare this 7.84% to the cost of capital. In the case of Hawkins, with very stable cash flows, we can assume the cost of capital to be 1-2% more than the risk-free rate (10-years government bond yield). Currently, the government yield is around 6.5%. So, the cost of capital for Hawkins would be 7.5%-8.5%.
Comparing the expected return with the cost of capital, Hawkins Cooker does not stand out.
(Every company has a value and there are many ways to assess this value including DCF, multiples, etc. We should consider all indicators; in this article, I am just covering one of them i.e. expected return using fade rates).
The purpose of this article was to give a perspective that companies have a life. It is good to be aware of that life span.
Stable cash flow generating companies that have been in existence for the last few decades are expected to live at least for a decade. In contrast, new-age tech companies may have a short life span. Nevertheless, these new-age tech companies may still command a high valuation if the expected return is high (more than the cost of capital).
If you identify a competitive edge, you must understand whether the company would protect that edge in years to come. Interestingly, if you believe that the company will generate a high expected return with a low fade rate, you have stumbled upon a jackpot. Therefore, do not hesitate in allocating a high portfolio weight to this company.
(In this article, many perspectives are developed from ‘Value Investing: From Graham to Buffett and Beyond by Bruce Greenwald’.)
Disclaimers
Investment in securities market are subject to market risks. Read all the related documents carefully before investing.
The securities quoted are for illustration only and are not recommendatory.
Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.
Details of the advisor
Advisor: Ankur Kapur
SEBI RIA No.: INA100001406
BASL Member ID: BASL1337