Choose Business Models not Stocks!

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Ever wondered why many famous companies never really generate returns for the shareholders. There are plenty of examples like GMR or Jet Airways. Both belong to India’s rising aviation industry. GMR owns IPL cricket team Delhi DareDevils, it also built Delhi airport. At a high level, it seems GMR should have been a great wealth creator but that is not the case. Same goes for Jet Airways, it has been in aviation industry since 1995 and once it was India’s best private airlines. In the same period, India’s air traffic has grown by leaps & bounds. Starting from just 16 million passengers two decades ago, it has grown 8 times by now & expected to grow another 3-4 times in next two decades. Still Jet Airways continue to struggle for survival.

Same is true for Apollo or Fortis Hospitals. They operate in India’s ever growing healthcare sector. All of us must have queued in OPD of these hospitals at some point in time, depicting healthy demand. Alas, they have also not created healthy returns for shareholders. Same is true for Airtel or Vodafone. This can be perplexing as in why these companies operating in forefront sectors have not grown at all.

The answer lies in the way these businesses are operated. In his 1992 & 2007 annual letters, Warren Buffet spoke about it and he classified three types of businesses. The great, the good & the gruesome. He advised investors to stay away from gruesome and stick to the great & good businesses only. The question is how to identify which business is great & which is not. Today in AI post, we are discussing these three types of business models which can cover almost every type of business. You can apply it to instantly assess the quality of underlying business of a stock.

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From Horse’s Mouth: Warren Buffet Speaks

“Leaving the question of price aside, the best business to own is one that over an extended period of time can employ large amounts of incremental capital at very high rate of return. The worst business to own is the one which does the opposite – that is consistently employ even greater amounts of capital at very low rate of return” . Warren Buffet, 1992 Annual letter of Berkshire Hathway.

Any business in any sector faces multiple challenges to growth. It is upto the management to find a way which will fund growth with proportionate rate of return. What Mr Buffet is emphasizing here is that blindly chasing growth by taking debts is not good. If a company is increasing revenue from ₹10 million to ₹100 million by investing ₹400 million, then it is not productive. Thus the capital allocation skills of management plays a very important role in growing a business and this is somehow directly linked to shareholder’s return as well. Eventually mis-allocation of funds leads to wealth destruction as we have seen in cases of  Suzlon etc. This is well captured by a financial ratio called ROCE (return on capital employed). In Indian context, the risk free fixed deposit saving rate is around 7-8%. If we add a 5-6% risk premium to this amount, it will lead us to around 14% to 15% kind of range. So for a business to have a meaningful return, it should be able to generate an ROCE of at least 15% or more. The riskier the business, higher should be ROCE and vice versa. ROCE has to be seen over a larger time-frame as some businesses may take time to generate meaningful return over investments.

The Great Business

Great business requires very less or negligible amount of investment to produce higher returns. Such businesses are wonderful to own as they keep on generating wealth for shareholders. There are many possible reasons why it happens in case of a great business but mostly such business will inherit below characteristics:

  • These businesses will have some kind of business moat which defends them from competitors.
  • They usually operate in a stable environment.
  • They have a pricing power on consumers.
  • They generate more cash than they consume.
  • They have very low working capital requirements or negative working capital requirements.
  • Typically, companies falling in these segment will have asset light business model.

Examples of great businesses:

  • Hindustan Unilever (ROCE 5 Years: 127%)
  • Britannia Industries (ROCE 5 Years: 62%)
  • Coal India Ltd. (ROCE 5 Years: 50%)
  • Hero Motor Corp (ROCE 5 Years: 50%)
  • Nestle India (ROCE 5 Years: 49%)
  • Eicher Motors (ROCE 5 Years: 45%)

The Good Business

Good businesses are also ideal for investment as they keep on generating good returns over investment. Mostly great businesses are generally overpriced, so good businesses can give us better returns if purchased at right price. There is no point in buying a great business at earning multiples or TTM P/E of 45 or 60 as most of the cream is already gone. Good businesses need to burn cash to generate money, so typically they are from automobile sector, manufacturing, etc. Below are the characteristics of good businesses:

  • They need to deploy cash to continue operations.
  • They are run by management which has great capital allocation skills sometimes even better than management of great businesses.
  • They enjoy moderate competitive advantage.
  • Good in exploiting economies of scale.

Examples of Good businesses:

  • Asian Paints Ltd. (ROCE 5 Years: 42%)
  • Bajaj Auto Ltd. (ROCE 5 Years: 38%)
  • Pidilite Industries (ROCE 5 Years: 37%)
  • Titan Company (ROCE 5 Years: 32%)
  • Dabur India (ROCE 5 Years: 32%)
  • Hindustan Zinc (ROCE 5 Years: 25%)

The Gruesome Business

Don’t own them. These businesses need to eat a lot of cash to generate revenues. This typically results in poor return on investment and poor earnings per share. Some of these companies may have higher growth in earnings which can attract innocent investor but these earnings are fulled by underlying ever growing need of capital. Because they generate low rate of return, they lack enough strength to fund additional inflationary business need, let alone the capacity to venture into new businesses. Please beware as this leads to mostly destruction of capital for owners as well as shareholders.

Warren Buffet talked about these businesses as follows.

“The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers.” – Warren Buffet in 1992.

Typical characteristics of these businesses are as follows:

  • They do not have any pricing power. Consumer will switch to other provider at the drop of a hat. Think of airlines or telecom operator.
  • They need to invest in new assets or maintain costly assets for operational sustainability.
  • Often intervened & restricted by market regulators. Think of TRAI’s spectrum sale at unaffordable rates to telecom providers.
  • They lack good management skills as promoters continue to pour money into the business despite dismal returns. Management is often in love with the business and want to keep it afloat irrespective of ground realities. Think of Kingfisher Airlines.

Examples of Gruesome Businesses:

  • Suzlon Energy (ROCE 5 Years: 9.6%)
  • Jet Airways (ROCE 5 Years: 8.6%)
  • GMR Infrastructures (ROCE 5 Years: 6.09%)
  • Bank of Baroda (ROCE 5 Years: 4.7%)
  • IDBI Bank (ROCE 5 Years: 0.23%)
  • Fortis Healthcare (ROCE 5 Years: -0.8%)
  • Reliance Communications (ROCE 5 Years: -6.1%)
  • Kingfisher Airlines (ROCE Before shutdown -4592%)

Conclusion

ROCE can serve as a good indicator of a business strength & moat. If you find a high ROCE company trading at lower price, you can invest into it for good returns in future. Comparing on basis of ROCE is even more tricky in small cap segment. One of the problem with ROCE is that it focuses on past performance. Even with high ROCE but lower stock price, one has to take care not to invest into a value trap as some companies may be trading lower for a reason. Mostly, their business moat must have been eroded or they are facing some industry headwinds. Similarly, a turnaround company may have a lower ROCE based on past data but in future, it can surprise everyone. Such cases are common in case of change in company management. We have seen a few Indian companies taken over by foreign management or next generation management and this has turned things around. If you can get into such stocks in time, no one can stop you from multibagger returns.

At AI, we continue to explore the hidden and unexplored small cap segment to find potentially great stocks of future at today’s bargain prices. ROCE plays an important part along with other parameters in our stock selection process. This hunt is on and we are very positive that by 2022, we will see emergence of few exponential multipliers from our list of stock recommendations. Till then we need to have patience & courage and multibagger returns shall be ours.

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