Prof Sanjay Bakshi needs no introduction to the value investment community of India. He has a big fan following across the globe. Prof. Bakshi teaches a very popular course titled Behavioral Finance and Business Valuation to MBA students at Management Development Institute in Delhi, India. He has shared invaluable content on investing in stock market on his blog and youtube channel which can be a guide to anyone who is just starting up his investment career. Recently, I came across a podcast of Prof. Bakshi, which gives away pearls of wisdom, especially for equity investors.
The podcast touches on the following:
- How to factor disruption technologies into your investment thesis
- How to locate an emerging moat for a business
- Why we should evaluate our stock performance using stress adjusted returns
- How to read Warren Buffett’s letters to shareholders
- Ask The Investors: How do I choose the best stock broker?
I would highly recommend you to listen to this episode of The Investor Podcast by Preston Pysh and Stig Brodersen.
This post, however, focuses only on the point of locating an emerging moat for a business. In the subsequent posts in this series, we’ll look at examples of Indian listed companies from this emerging moat lens.
Investopedia, a popular website on investment education, describes the term moat as follows:
The term economic moat, popularized by Warren Buffett, refers to a business’ ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms.
Prof. Bakshi breaks down the components of moat to simpler data points. He says —
…when you think of moat or competitive advantage, it has to show in numbers. If not now, eventually.
The quantitative markers which Prof Bakshi touched upon are explained in detail below:
- High ROIC (Return on Invested Capital): In simple words, this metric helps us make out how efficiently a company is allocating its capital. When you compare a company’s ROIC with its weighted average cost of capital, you can make out whether the company is using its capital effectively or not. Putting it simply, if you borrow ten lac rupees at 10% interest rate, your cost of capital is 10%. So, you need to pay a lac every year to your lenders. If your business earns 8% return, it means you earn eighty thousand rupees a year. When you need a lac to serve your yearly interest payment and earn only eighty thousand a year, how will you arrange for the balance? Remember, it is not just the interest payment. You also have to return the original sum borrowed. This explains why a business should always aim for a high ROIC. A high ROIC indicates that a company is earning enough to service its cost of capital and have sufficient buffer for investing in growth.
- Growth: ROIC in isolation does not makes sense if there is no growth. So, if a business has a strong competitive advantage, it should be able to grow and invest its incremental capital at high ROIC. If a company fails to grow at a decent pace, eventually it will lose its competitive advantage.
- No Dilution or minimal dilution: Dilution in earnings is caused if you raise equity or debt for running your business. Earnings per share (EPS) can be mathematically explained as:
Equity issuance leads to higher number of equity shares, thereby diluting the EPS. Similarly, increase in debt leads to interest outgo which declines the profit thereby diluting the EPS. In pursuit of growth, many businesses pile up a mountain of debt which often leads to a disaster. While there has been cases of businesses where debt has been managed efficiently for growth, moat cannot be developed if you perennially depend upon outside capital. Hence, if your business possesses a strong competitive advantage, it should allow you to earn enough cash internally which takes care of your investment for growth. In fact, the best businesses are those which have enough cash in the books after meeting the operational requirement and investment for growth. Since they do not have any requirement of outside capital, they do not witness dilution in earnings.
EPS= Profit / Number of Equity Shares
The above points can act as a good quantitative checklist for evaluating a business. Professor then went on to explain how the investing around the world has evolved over the years from deep-value investing to investing in high quality businesses which have a strong competitive advantages. Hence the above data points can easily be pulled out from multiple database available to an investor. This results in too many people looking for the same set of businesses. This drives up the prices of these companies so much that there is hardly any margin of safety. Hence, the future returns on these businesses would not be exciting for an investor.
This makes a case of why you should rather focus on finding emerging moats. So, as an investor, you need to identify businesses which are generating may be a low or average ROIC today. But they have the potential to generate high ROIC in the future. These businesses, which inherently have the moat characteristics, would not show up in any financial database as the earnings in the near term will be depressed. An investor cannot solely depend upon the quantitative metrics to find these emerging moats. But the advantage of finding them early is that you may get them at an attractive price as not many are looking at them. And as it is going to become a moat in the future, eventually it will reflect in numbers and investors will recognize it.
Now how do you find these emerging moats?
Prof Bakshi outlines an important set of patterns to look at:
- Fixing past misallocation mistakes: A common road to failure in business is misallocation of capital. In our efforts to finding an emerging moat, therefore, we should look at business owners who are good learners. They are just humans like us and are bound to make a few mistakes. The important pattern to note is are they smart enough to fix their mistakes early. Another aspect to look at is whether they are repeating the same mistake again. A small improvement in operations or capital allocation can do wonders to the fortune of a business. Sometimes, the business witness that change when a new management comes in. Often, a new management does wonder to his/her business by just shutting down the operations which are bleeding. So, an investor must look out for these cues.
- Intelligent initiatives artificially suppressing the earnings: Some owners have a very long term view in mind. They do not operate to delight investors and analysts at the quarterly results. Instead, they only focus on the lifetime value of their customers. They would constantly think of innovating ways to delight the customers. Continuous efforts of building the brand, widening the sales distribution channel and increasing the bond with the customers require a lot of money being spent. Hence, reported earnings look mediocre in the near term. However, these intelligent initiatives serves the purpose of increasing the competitive advantage of the business in the long run. And upfront pain along with back-ended benefits would eventually show up in the numbers.
- Geographical expansion pulling down the near term earnings: A company which already has a strong moat will have a lot of cash in its books. When that company makes a geographical expansion intelligently and slowly, the return ratios would surely be pulled down in the near term. The sales in the initial years would not be enough to cover the cash allocated on expansion. However, this geographical expansion can act as a serious competitive advantage for the company in the long run. The other competitors in the same industry who do not have moat would not be in a position to go for expansion. Firstly, they would not have enough internal funds for the expansion. Opting for outside fund would be expensive and run the risk of seriously impairing their balance sheets as growth in new territory would take its own time. However, as the moated business can afford to do it, it will realize the benefits of a larger sales distribution over the long term. Thus, a moated business funding geographical expansion through internal accrual would give up near term earnings in quest of gaining long term sustainable competitive advantage over its competitors.
- Inorganic growth by buying businesses at bargain value and then turning them around: There are a few business owners who are excellent allocators of capital. After creating a moat in their business, they continue to expand it further through acquisitions. They have the knack of buying bad businesses at bargain values and then turning them around through their operational efficiency. Since the new business does not earn good returns immediately, it will penalize the Profit and loss account of the acquiring company in the near term. Hence the reported ROIC would go down and not impress the investors. However, the acquiring company in the meantime deepens its competitive advantage by using the assets of the acquired business. Often market players fail to spot this as the near term earnings are so depressed that the real future potential is not visible on the surface.
With the above patterns in mind, you may have an advantage over others. When the whole market is focused on the current financial performance, having a long term view of how the company might be looking, three to five years from now, will truly make you stand apart. Reminds me of the famous quote by Walter Gretzky:
I skate to where the puck is going to be, not to where it has been.
In the end, I would just like to caution you against over-optimism. All the four patterns which Prof Bakshi has mentioned in the podcast require strong commitment, capability and desire from the management for execution. For one moated business there are hundreds which appear to be moated but are not. However, the above mentioned patterns may create an edge for an investor who is willing to wait for the company’s story to be played in the future. So, first you need your analytical mind to find out such companies from the stack of thousands of listed companies. And, then you must have a temperament to hold on to these stocks when market continues to look at near term earnings and punish their price.
And that is easier said than done.
In subsequent posts, we would try to look at some of the businesses in the listed universe of India and see if they show any of the patterns above.