What creates value in a company?
Updated: May 11
A look at growth at a reasonable price.
A simple answer to this would be growth. Future growth can be of two forms, one negative or zero growth, which obviously will lead to either a price decline or no change in price.
Therefore, positive growth is a pre-condition for value creation. This positive growth must be combined with a high Return on Invested Capital (ROIC). If a company has high growth but a negative ROIC, it will incur massive losses. These days often we ask this question, how come Zomato or Paytm or Byju, etc incur so heavy losses? The answer is that they have a negative ROIC and high growth, it will continue to eat away capital from the business and that is the reason they continue to raise equity capital.
A solid business will have high growth and high ROIC. A high-growth company may be due to a growing market and/or market leadership. This requires in-depth industry analysis.
Why would a company have a high ROIC over the long term? First, what qualifies as a high return? 15% + every year ROIC over 10 years plus period is a high return. However, less than 10% ROIC is a low-return business, and you should not look at those companies from a long-term investing standpoint.
So, what is it that keeps a High ROIC for such companies?
Simply speaking, these companies can keep the competition at bay. They can do this because they have a certain advantage over their competition. Here is a broad range of these advantages:
Low cost of capital: HDFC offers the lowest rates on the borrowings they do from the market. Long-term history, brand, etc. helps them borrow at a low cost. This advantage a lot of other companies lack. This becomes a source of advantage for HDFC.
Network effect: When people tend to use the same product or service, there may be a network effect. Can you imagine not knowing MS Excel or not using WhatsApp? These products have created massive network effects. Similarly, an HR person or a job seeker must be on Naukri.com. This creates a network effect for info edge, the parent company of Naukri.com.
Economies of scale are when large companies process thousands of transactions, they can enjoy lower costs for each transaction and then pass the savings along to the customer in the form of lower prices. This helps massive retailers sell goods for prices that would send a smaller retailer into trouble. For example, DMart negotiates with the seller and passes the benefit to its customers, keeping its competition at bay.
You need to understand what creates the competitive advantage for the company and once you understand the competitive advantage you need to understand how sustainable it is. You read reports, and quarterly fillings to ensure that the advantage is not fading away.
How to identify these companies?
Not on CNBC and not in the newspaper.
Themes - As you read more about changes in your environment, you develop certain themes. In today’s context, the theme of Electric vehicles, green energy, infra, real estate, China+1, etc. Then within the theme, you understand which all companies stand to gain because of the wave.
Another way is what big investors are doing. Do not try to clone but get ideas. You are independent to reject if it does not suit your objectives.
Watch out for a basket of quality companies. A bad quarter, a bad report, etc. can easily create good entry points.
GDP growth, inflation, global news, etc. have no bearing on the investment portfolio as far as you have picked the right businesses.
Pick the businesses, but at what price?
A lot of people do DCF modeling to understand what a fair price should be. There are too many assumptions and things can go wrong. A better approach is to reverse the DCF and understand what the market expects. If you have to make complex excel models to identify good investments, you are anyways on the wrong side.
Another way is to look at price multiples. You can look at price to book or price to earnings for a financial company and a non-financial company, EV / NOPLAT.
You can still go wrong, so always built some margin of safety or margin of error. This margin of safety will protect you from a bad investment experience.
When to sell?
If you have identified some great companies and if you do not see any dilution of their competitive advantage, the answer is never to sell them. Do not be worried about short-term movements.
If you think the business may not be a long-term investment, you may look at a 30-50% gain, and gradually plan to exit during this range.
Another area to look at is portfolio sizing. If you have identified a great company and if you allocate only 1%, even with a hundred percent increase your portfolio would rise by only 1%. So, if you identify a great company, you must build your conviction to allocate a higher percentage.
How to start?
You always start small, allocate 0.5 to 1%, and then continue to build a deeper understanding. As you feel more comfortable with the incoming data, quarter on quarter or yearly you can continue to increase allocation. This allocation may increase to 10-15% of the overall portfolio. Do not sell to maintain a certain range within the portfolio, over the long term, you should be comfortable with your top positions making 80% of your investment portfolio.
This is the way you can grow your capital peacefully by allocating to high-quality businesses and staying invested for the long term.
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.
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Details of the advisor
Advisor: Ankur Kapur
SEBI RIA No.: INA100001406
BASL Member ID: BASL1337