why standard valuation matrix is not the best way to value great businesses

FLAME ALUMNI MEET:Why standard valuation matrix is not

the best way to value great businesses

Ashish Kila Perfect Research

Our Chairman - Mr. R.A. Kila

Perfect Research Team

Acknowledgements…

http://www.perfectresearch.blogspot.in/p/about-us.html

My Profile CA MBA from MDI, Gurgaon Worked with - Goldman Sachs &

Religare Securities & Morgan Stanley Currently working as

• Director, Perfect Group • CIO, Perfect Research

With Mr. Ashish Dhawan With Mr. Basant Maheshwari With Prof. Aswath Damodaran

Blessed to have got Vicarious Learnings from my Role Models …

Why Great Businesses

Why the need to think differently

Ranking Moats

How to value Great Businesses

Tough business/Capacity to Suffer/Capacity to reinvest

Illustrative Model Portfolio

Roadmap-

Return per unit of stress.(Link) Reinvestment risk. Power of compounding. Missing out on quality businesses(Large opportunity cost). Gives freedom to pursue other business, family and personal

interests Ultimately it all boils down to hurdle rate ….

Shift to Great Businesses…

Comfortable in this zone

https://fundooprofessor.wordpress.com/2012/04/05/returns-per-unit-of-stress/

Source: http://bit.ly/1iHghY7

Continued…

http://bit.ly/1iHghY7

Past Process

• First run screeners for cheapness (e.g. IFB Ind.)

• Understand and see if the business is sound

• Illusion of Quality Bias – try to justify quality where there is none

Present Process

• Now we start with great business models (e.g. ATFL)

• Then look for reasonable returns over very long periods

• Margin of safety is more in quality than in price

• Mistakes tend to be more of opportunity cost rather than loss of capital

How our stock picking processhas changed …

Rationale behind our thought process

Comparison with running own business:

Owning equity is like owning a business where a hired CEO is working for us. He will quarterly report to us by con calls and investor presentations.

Points to Ponder Owning Equity Running Own Business

Emotional Attachment Minimal, You don’t define yourself with the business you run

Very high, you might continue running business despite low returns

Diversification Yes, buy shares in multiple industries Not easy to manage

Regulatory Requirements You can own stake in existing players with licenses/approvals

Not possible to start certain businesses like liquor, banks etc.

Succession Planning for Underlying Business Professional management is possible Children/Family may not be

competent/interestedAbility to Close/Change

Business Easy, Just Sell the Shares Very Difficult

Scalability Extremely Scalable, managing a 1000 Cr. portfolio might require a few people only Not Easy

Minimum Capital Requirement

You can start with a few thousand Rupees as well High amount of capital is required

As Tim Ferris says, “Be neither the boss nor employee, but the owner. To own the trains, and have someone else ensure they run on time.”

Meaning owners of business are not limited by the amount of time they put in the business

The best doctor can also work not more than 16 hours a day But in Business you can multiply man hours by delegating

Potential to multiply the most scarce resource – “TIME”



Ranking Moats




Roadmap-

For expensive stocks valuations in the near term one can either wait or look for some opportunities as temporary underperformance corrects the stock.

When you wait there is a chance you might miss the stocks Looking at durability of moat etc..start allocating some amount

Source: https://dl.dropboxusercontent.com/u/28494399/Blog%20Links/ October_Quest_2013.pdf

Why the need to think differently for valuing great stocks:-

https://dl.dropboxusercontent.com/u/28494399/Blog%20Links/



Ranking Moats




Roadmap-

Ranking MoatsSources of Economic Moats

Our choice of

moats

Difficult to acquire customers from existing competitors

Source: http://bit.ly/1hLvEJ1

http://bit.ly/1hLvEJ1



Ranking Moats




Roadmap-

Implied Growth rate

Company Name P/E As on date 10 Yrs

Implied Growth Rate

20 Yrs Implied Growth Rate

Gillette India ltd. 154 31-Mar-15 56% 31%

Symphony ltd. 71 31-Mar-15 56% 31%

Agro Tech foods ltd. 43 31-Mar-15 25% 16%

Kaya ltd*(listed on June 30, 2014) NA(Negative EPS) 31-Mar-14 NA NA

Use of P/E multiple: In the above examples if we look at P/E multiple then we might not invest in any company out of above four because they all look so expensive.

Not using P/E multiple: If we don’t look at P/E and we say that I buy all great businesses then we might end up buying Gillette also which is extremely overvalued (will discuss more on it later).

If we face such problems, then what is the solution.

There are 3 aspects – Moats, Size and Limited downside

Using or not using P/E

How to value Great Businesses In “How to value Great Business” we will talk about three important aspects

Moats: How durable and Wide the moats are..

Size: Small size in relation to the addressable size of opportunity

No Earnings: Limited downside when no earnings are there

It is important to judge the depth and longevity or durability of moat and if the moat shrinks and disappears, a buy and hold strategy will not save you.

In a nutshell, can you visualize whether company’s product/services shall be in demand 10/20yrs down the line.

Warren Buffet on Economic Moats Look for the durability of franchise. The most thing to me is figuring out how big a

moat there is around the business. ~ Linda Grant, “Striking out at Wall Street”

All economic moats are either widening or narrowing – even though you can’t see it.

~ Outstanding Investor Digest, June 30, 1993

DURABLE MOATS

source: http://bit.ly/1ODHiZV

A high return on capital in the past is a necessary, but not a sufficient condition

to demonstrate the presence of a moat.

It is also important to judge the depth and longevity or durability of moat.

If your estimate is correct and turns out to be higher than that of the market,

then you will excess returns. If not, be prepared to lose money or at best make

market level returns .

As a corollary a buy and hold works only if you get the durability aspect correct.

If the moat shrinks and disappears, a buy and hold strategy will not save you.

In a nutshell, can you visualize whether company’s product/services shall be in

demand 10/20yrs down the line.

DURABLE MOATS

source: http://bit.ly/1ODHiZV

http://bit.ly/1ODHiZV

Low cost more durable:-

ROE

PATM(%) SALES/TOTAL ASSET ASSET TO EQUITY

Intangible Brands -Invite competition e.g. Zydus Wellness

Example : Relaxo

Footwears ltd

Low cost moat looks stronger thanIntangible assets

Sold 100 million pairs of branded footwear at an average price of just INR 100 per pair & making profit of only INR 4.48 per pair

Low cost advantage arising out of large scale. For exampleo Ad spend of INR 550 million (a fixed cost) spread over 100

million pairs translates into only INR 5.50 per pair.o But for a new entrant with scale of, say, 10 million pairs,

translates into a unviable INR 55 per pair.

Ability to sell large volume enables the company to exert influence over its customers and suppliers

For e.g. ‘Relaxo Footwears Ltd.’

Source: http://bit.ly/1KNibwU

http://bit.ly/1KNibwU

How to value Great Businesses (cont..)

In “How to value Great Business we will talk about three important aspects

Moats: How durable and Wide the moats are..



Base effect – ‘ITC ltd.’

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 20150

50,000

100,000

150,000

200,000

250,000

300,000

net salesmkt cap (cr)

PE=32

PE=24

PE=32

PE=27

Source: annual reports

Years

CRORES

ConAgra Vs Unilever

Source: Google.com/finance, Yahoo Finance, Ace Equity

ConAgra Foods,

Inc. Unilever Plc. Difference in no. of times

Mcap(26 Oct 2015)(in Billion $)

17 135 8x

Revenue(in Billion $)

16(Year ended May 2015)

60(Year ended Dec 2014)

~4x

Agro Tech Foods

Ltd.Hindustan Unilever

Ltd.Difference in no. of

times

M.cap(in Billion $) 0.25 29 115x

Revenue(in Billion $) 0.1 5 50x

Globally

In India

Scope of opportunity ConAgra is present in 99% of American Households

while ATFL has just scratched the surface

Banking Product:-

Product

SameSame

Banking Comparison

DATE:- 31/03/2015

Banking is all about its management quality and Risk management practices

Banks M.CAP(In Rs. Cr.) P/B ROE

2,56,000 4.1 16.9%

26,600 1.3 10.1%

3,137 2.5 12.4%

HDFC Bank management run by Deepak Parekh.

IDFC Management previously run by Deepak Parekh and now by his protégé Rajiv Lal

IDFC: Why not be next HDFC?

IDFC has performed well despite being constrained to lend to Infra Sector

Now, IDFC has got banking license….

DESCRIPTIONMar-14 Mar-13 Mar-12 Mar-11 Mar-10 Mar-09 Mar-08

Gross NPAs to Gross Advances (%) 0.60 0.15 0.30 0.20 0.31 0.37 0.17

Net NPAs (funded) to Net Advances (%) 0.40 0.05 0.15 0.10 0.17 0.21 0.03

Durable Moat/Earning Growth Vs. Market Size

Here, first we do the DCF valuation of Gillette, in which we have assumed the growth rate of 10% for the first 10 years and then a terminal growth rate of 4%. Discount rate is assumed to be 12%.

To calculate the FCF, we have taken the CFO- Capex for last three years and then the average of the three. (Capex is after adding back the Capex of Oral). In this way we arrive at the Intrinsic value of the Gillette by discounting the FCFs for next 10 years back to the present.

We then use Reverse DCF by using the Intrinsic value calculated in the DCF on it to determine what is the growth rate implied in the Free Cash Flow (FCF) by the market in the current valuation of the company

Reverse DCF calculation

Reverse DCF Calculation, after adding Oral Capex

*Price as on 1st April 2015

CMP 490410-years expected Growth rate 51%20-years expected growth rate 29%

Year FCF Growth Present Value (PV)2016E 73 51% 652017E 110 882018E 166 1182019E 250 1592020E 376 2142021E 568 2882022E 856 3872023E 1291 5212024E 1946 7022025E 2935 945

Comparison Between B&R Market size and Gillette performance (Cont.)

If the FCF are to grow by 51%, then sales should grow by at least 25-30%. Assuming, even if sales grow by 25% then also it will surpass the market size itself.

Source: http://bit.ly/1ODFVKR

* Grooming represents about 70-75% of the sales of Gillette.

Blade & RazorPresent Sales(Rs Cr)

(2015) CAGR% Projected Sales 10Yrs(Rs. Cr)

Gillette(Grooming)* 1385 25% 12898

Market 3683 9% 8719

http://bit.ly/1ODFVKR

In the nutshell, for a great business we see how wide and durable the moat is (that can sustain for 10/20/30 yrs)

Then, we calculate the implied growth rate.

We then project market share of the company vis-à-vis size of the market

Then we can take a call whether the implied gain in market share figure looks possible. E.g. ‘Gillette’

Conclusion

In “How to value Great Business we will talk about three important aspects

Moats: How durable and Wide the moats are



How to value Great Businesses (cont..)

We may have missed Kaya if we had our investment thesis based on numbers only. Where there are no earnings- We look at how much downside risk exists

Marico Kaya Total Mcap.~300Cr. at the time of Listing & 180 Cr. Of Cash & Cash Equivalent in its Balance Sheet.

Reputed Marico Brand at this M.cap & a 13 yrs history of the company, at the verge of turnaround, the size of opportunity is huge w.r.t its EV.

Management started buying shares from open market

Active management role taken by Harsh Mariwala in the new company who has a history of scaling up Marico to a size of

Rs 26,000 cr (Sept 2015) from Rs approx 426 cr (Dec 1997).

Look at the Downside Potential



Ranking Moats




Roadmap-

In tough businesses and businesses which are prone to black swan events like financials, backing up of a fanatic management is required.

In his 1990 letter, Mr. Buffett articulated his rationale for investing in Wells Fargo. o He wrote:“The banking business is no favourite of ours. When assets are twenty

times equity – a common ratio in this industry – mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks.

o We have no interest in purchasing shares of a poorly-managed bank at a “cheap” price. Instead, our only interest is in buying into well-managed banks at fair prices.”

Tough Businesses



Ranking Moats


Tough business/Capacity to suffer/Capacity to reinvest


Roadmap-

Source: http://bit.ly/1Ijklb3

Capacity to suffer:



Ranking Moats




Roadmap-

Some companies doesn’t have capacity to reinvest so we used to avoid them earlier e.g. Rating agencies, Exchanges

The money thrown by these businesses can be used to reinvest in these companies alone or can be used to invest in other great businesses in the portfolio or other high value accretive businesses

Dealing with companies which don’t have the “Capacity to Reinvest”



Ranking Moats




Roadmap-

• Reasonable Valuation/ Expensive Valuation1. AAA businesses-Businesses which can reinvest capital at high

ROE’s- Atul Auto, ITC etc.2. AA businesses-Businesses which can reinvest capital at

reasonable ROE’s – ATFL3. A businesses-Good growth but not much reinvestment

opportunity - Kaya, MCX, Crisil4. Tough businesses, but with great management’s – DCB, IDFC,

Wonderla etc.

Ranking businesses on “Business Quality”:-

StockBusiness Quality

Fanatic and Intelligent

Management Capacity

to reinvest Capacity to

Suffer Corporate Disclosures

Capital Allocation

Trailing P/E* 10Yrs Implied Growth Rate

Atul AutoYes Yes

Quarterly Concalls 5% 21X 27%

ITCYes Yes Annual PPT 3% 28X 22%

Agro Tech Foods

Yes Yes Yes Quarterly Concalls 10% 40X 25%

MCXQuarterly

PPT 2% 45X 39%

DCB BankTough Yes Yes Yes

Quarterly Concall and

PPT 5% 2.2X NA

IDFCTough Yes Yes Yes


PPT 3% 14.1X NA

WonderlaTough Yes Yes Yes


PPT 5% 30X 32%

Kaya Yes Yes

Quarterly Concall 3% 55X 20%

Source: ace-equity, annual reports

Stock Business Quality

Fanatic and Intelligent

Management Capacity to

reinvest Capacity to

Suffer Corporate

DisclosuresCapital

Allocation Trailing P/E* 10 yr implied growth rate

Cera Sanitaryware Yes Quarterly Concall 2% 40X NA

Symphony Yes Yes Quarterly Concall 3% 55X 56%

Nestle Yes 1.50% 48X 23%

Relaxo Yes Yes Quarterly PPT 1.50% 50X 35%

Asian Paints Yes Yes Quarterly Concall 1% 55X 32%

Crisil Yes NO Concall or PPT 3% 45X 25%

Accelya Kale 5% 17X 8%

Thomas Cook Yes Yes Yes 5% 70X 27%

Source: ace-equity, annual reports

Cont…

Holdings at T0Price in

July 2014Allocations in Rs term

Allocation in %term

Price in July 2015

Allocation in Rs. Term

Alocation in %term

Atul Auto 300 8 8% 450 12 6%ITC 320 5 5% 320 5 2%

Agro Tech Foods 600 5 5% 600 5 2%MCX 700 4 4% 1050 6 3%DCB 70 2 2% 140 4 2%IDFC 160 6 6% 160 6 3%Wonderla 200 5 5% 250 6.25 3%Thomas Cook 110 5 5% 220 10 5%

Cera Sanitaryware 1200 4 4% 2200 7.2 3%

Symphony 1100 6 6% 2200 12 6%Nestle 5000 5 5% 6000 6 3%Relaxo 200 3 3% 500 7.5 4%Asian Paints 550 5 5% 825 7.5 4%Acceleya Kale 700 7 7% 1050 10.5 5%Marico Kaya 300 10 10% 1545 70 33%Cash 20 20% 35 17%Started Amount 100 209.95

Illustrative Model Portfolio (2015):-

Marico Kaya had become a larger part of the portfolio after price appreciation.

Portfolio composition becomes skewed, as other winning ideas like Agro Tech and IDFC have become close to 2%.

For some stocks we are using blue sky scenario and for some we are not willing to give reasonable scenario consideration.

Analogy - If we have 10 sons and one has performed very well, then we don’t stop feeding our other sons. The same thing applies here – so we reallocate the food (capital)

Some new thoughts on sell decision

Perfect ResearchT-24A Green Park Extn.New Delhi – 16Blog: http://perfectresearch.blogspot.inTwitter: @ashishkila

Please feel free to contact me with any unanswered questions, suggestions & ideas.

[email protected] +91-9999751327

Economy & Finance

why standard valuation matrix is not the best way to value great businesses