Never mind the vision and mission statement of a company, the raison
d'etre of an enterprise is to compound the shareholder's capital at a
reasonable rate. Do that and survive, or fail and die.
An equity investor should understand that when buying a stock, she is
not buying an entry into her stock account but a piece of a company.
Efforts should be made to understand the company and its prospects for
the future. But how do you understand whether a business is successful
or not in its endeavors?
As a shareholder, the company in which you invest should be able to
compound your capital at a healthy rate. To ensure this, the business
should operate in an industry where it feels it has an edge over
competitors in order to extract a reasonable return for every rupee of
shareholder money it puts to work.
The first aspect an investor should then look at when selecting a
stock is the attractiveness of the business. This would involve the
various competitive edges the company has such as brand, technology,
distribution, and so on. There is one more important aspect that needs
to be considered-sustainability of this edge.
India has witnessed reforms since the early 1990s. In the initial
phase, India opened up its manufacturing sector and this unleashed
global competition on Indian companies. When we compare the end of 90s
with the beginning of that decade, we would realise that many
manufacturing companies did not survive. Even though many had huge
advantages, most of those advantages were good only in a closed economy
and could not survive the global onslaught. Today, the domestic services
sector, which has been protected to a large extent from global
competition, is being opened up. One would assume that if you are
investing in a company operating in this space, you would need to be
sure that the company's competitive edge would survive in a more open,
global environment.
The second aspect of evaluation would be how high the business
compounds the capital it employs. Clearly, if one wants high levels of
compounding, then it is better to have a small base. The higher the
capital employed, the more difficult it is to produce returns sufficient
to justify the employment of such a high amount of capital. A good
business would be one which can employ low amounts of capital, for it is
easy to compound smaller sums of money.
There are various measures used to evaluate this aspect. One such
measure is ROCE (return on capital employed). This measure is a
reasonable one if the debt levels are low. If debt is a significant
component of funding, then as an equity holder, the risk of significant
economic losses is high. One should remember that as an equity holder,
one gets paid last and hence, if there are more mouths to feed before
dividends are paid, the higher is the chance that the leftovers will not
be sufficient to take care of the equity holder's appetite.
Metrics such as EBITDA (earnings before interest, taxes, depreciation
and amortisation) are dangerously inaccurate. Sawing off the profit and
loss statement needs to be undertaken with discretion. One wonders
which right minded businessman will accept that his fixed assets are
"cashless". Yet there is no dearth of reports which state that
"depreciation" is not a cash expense. I wonder how exactly peddlers of
such a theory expect a business to invest in plant and machinery.
Strangely, it also ignores interest cost, which is fine if the evaluator
is a lender but not if she is the owner.
Another metric used to show attractiveness of a business is "growth
rate". Higher growth rates can mask basic business problems for a while
but will rarely be able to reverse the basic economics of business.
Warren Buffett frequently points out to the two great inventions of the
20th century-air travel and automobiles-which grew phenomenally but were
a disaster to the providers of capital to these industries.
An example here would illustrate the uselessness of the above two
metrics. There is one investment which any one can make easily. It has
100% EBITDA margins and one can generate as high a growth rate of
earnings as one desires. Yet, it probably will not even beat inflation!
This investment is a bank deposit.
Since, margins did not consider the capital employed, it had no use
in judging the attractiveness of the "investment". And one can easily
increase the amount one earns from a bank deposit by increasing the
amount of principal that is deposited. It is fairly common to find such
businesses that keep increasing the capital employed to produce growth
rates even though the return per unit equity capital is low.
Surely, great economics in a business is not possible if it is not
run by competent individuals. And hence, evaluation of management is
critical for ensuring the continuation of favourable economics. A good
manager would be one who keeps enhancing the competitive edge of the
business and would also simultaneously respect the equity holders and
reward them appropriately.
