Value Investing – 8

Hello friends,

It has been quite some time since my last blog. A lot has happened since then, including the elections. I had written during the last few months about the nuances of the economy and some value investing opportunities in my articles published in a Marathi daily. Also, my thinking about value investing underwent some refinement after I read the book “What I Learned about Investing from Darwin” by Pulak Prasad, an ace investor and fund manager. I wish to bring you up to date with that in this piece and the ones that will follow. But first about the markets.

The markets are climbing higher and higher and there seems to be no end to where the current frenzy will take the indices. The new wave of retail investors is just not ready to pause and think. They probably think that the markets can only go in one direction and that is north. The new government is in place, there is good visibility about the policies, corporate earnings are on the rise, loan disbursements by banks are rising and the economy is doing extremely well. All this keeps on fueling the positive sentiment and I do not see any major factors that could turn the sentiment negative anytime soon. And markets will keep climbing till that happens.

However, every good thing has to come to an end and the higher the indices go, the greater the possibility of a severe correction. The only question is “when” which no one will be able to answer.

Are the markets in a bubble zone? Well, the large-caps valuations are not too high still but the small-caps and mid-caps are definitely approaching that stage. So friends, beware. Get rid of not-so-fundamentally-sound small-cap stocks in your portfolio and hold on to only the good ones.

‘In the short run, the market is a voting machine and not a weighing machine.’ 

– Benjamin Graham

A pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons.

Warren Buffett

Words of wisdom from the stalwarts sound more relevant than ever now.

I have written about value investing principles in detail through seven blogs titled “Value Investing 1-7”. As we all progress on this path, the ideas undergo some subtle changes. I, therefore, thought it would be a good idea to redefine the value investing ideas as I understood them and also provide a preliminary checklist for those who wish to embrace those ideas. I will further elaborate on these principles with an example.

Business: As we know, the first and foremost aspect of value investing is a deep analysis of the business in question to check its longevity, profitability, cash generation capability and management integrity. There are various aspects at which the investor has to look at and ask several questions about the business. Favourable answers to those questions should decide if he wants to own a part of that business. So let us have a list of such questions.

• Does the company product or service have good demand in the market?
• Will this demand be sustainable and growing for at least ten years?
• Is the sector the company is operating in, growing at a reasonable pace?
• Is the sector the company is operating in, has been profitable in the past? For example, airlines are always in demand but they seldom make money.
• Is the product or service of better quality compared to its competitors?
• Does the business need a lot of capital and more importantly does it need frequent capital infusion? Again airlines is a good example.
• Does the company have a moat or a competitive advantage? For example a patented technology, a super brand, a cost advantage due to economy of scale etc.
• Is such a moat or competitive advantage sustainable?
• Does the company generate positive cash and distribute dividends?
• Is the management visionary with unquestionable integrity? Hopefully, we have not forgotten the Satyam saga.

The list is by no means complete but a business satisfying the above criteria is likely to be a very good business. Pulak Prasad in his book has statistically as well as through Darwin’s theory demonstrated that avoiding bad businesses is far more important even at the cost of missing picking good businesses if there are the slightest doubts. The success ratio is highest if one is able to avoid bad businesses. He lists companies with questionable promotors, turnaround stories, leveraged businesses, companies doing mergers and acquisitions, rapidly evolving industries (examples drones, data centres, EV batteries etc), and industries where owners are misaligned (PSUs, Conglomerates, Indian subsidiaries of foreign companies) as businesses that are best avoided. He is ready to give a miss to some very fast-growing businesses in the process.

Financials: Once the question of deciding to own a part of the business is settled, next comes the financials. Financials are actually a record of the company’s past financial performance. There are well-devised ratios that enable the investors to assess the company’s growth profile, returns and profitability. In case, the company has debt, then one has to look at liquidity ratios as well. These ratios provide a quick snapshot of the company’s financial health and growth prospects. However, one must understand that these are not an alternative to an in-depth study of the company through analysis of financial statements and annual reports.

Valuations: Good businesses with sound financials can only give good returns in the long term if they are acquired at a discount to their intrinsic value. The concept of intrinsic value is simple. It means the value of the business today considering its past and future growth and cash generation capacity. Some idea of intrinsic value can be had from the past data but future projections are at best calculated guesses and an element of speculation creeps in here. There are quantitative methods like the discounted cash flow calculation for arriving at the intrinsic value. However, it required loads of experience to arrive at a near correct guess. People like Buffett and Munger do it mentally much faster but for us mortals, it is frought with big risks.

Pulak Prasad advocates completely forsaking this exercise and depends only on past data to make an investment decision. There are many valuation parameters which when used in conjunction with the past financial data could help the investor arrive at a reasonable buying price. Various financial and valuation parameters that are normally looked at are tabled below. There is a great variation sector-wise and company size-wise and therefore these ratios need to be used with relevant frames of reference.

Pulak Prasad recommends in his above mentioned book that ROCE value above 20 as a primary filter. He states that a company returning 20% at the operational level (EBIT) on its capital for a sufficient length of time (Usually 10 years) is likely to have many good attributes of a good business. These include good management, good capital allocation, cash in hand to take business risks and strong competitive advantage. One can readily see that these constitute important ingredients of a robust business. However, such an approach will need further deep diving to assess the business.

I had analysed Asian Paints, PSP Projects, Narayan Hrudayalaya, Praj Industries and HDFC Bank through the value investing lens in some detail through my articles. The last two have since appreciated a bit but the first three are still in buy zone. Let us have a look at Asian Paints as a value buy.

Asian Paints :

1. One of the oldest and most popular companies in paints. A strong brand.
2. Biggest paint company in India commanding 59% market share.
3. As of 2023, the global market for paints and coats was 180 billion dollars which is likely to grow to 256 billion dollars in the next ten years (Source Statista).
4. 45% of this is the Asia Pacific market. Indian market size is 8 billion dollars which is growing at 12% owing to heavy demand in construction, automobile and industrial sectors.
5. Strong tailwinds for construction and industrial sector through Govt backing with schemes like PLI.
6. Extremely strong distributor network of over 70,000 distributors. The company supplies goods to distributors not only daily but three to four times a day. Well-coordinated inventory management.
7. The company has always been ahead of time and competitors. They bought their first mainframe computer in 1970 to make a database. Computerized colour matching, customer care by phone in 1990, computerised warehouses and supply chain are some of the early initiatives. One can appreciate how important this is for a bulky product like paint.
8. The company has state-wise, distributor-wise and season-wise data of consumption and demand. It uses AI to regulate production.
9. The company has entered the home decor business which is growing well.
10. Financials are excellent. Very good sales and earnings growth. Financials are the best among peers.
11. The market has always valued this company highly. This stock was never available cheap. Now, due to upcoming competition by Pidilite and Aditya Birla’s Grasim, the valuations have softened due to fear of the company losing market share. It is therefore available at a 32% discount to its five-year average PE. The numbers are tabled below.

One can see that despite moderation in stock price and PE, the other valuation parameters remain quite high. However, good companies are seldom available cheap and the current valuation is reasonable enough for long- term investment in this blue chip company.

What are your thoughts and strategies my dear friends? Please let me know by way of a comment.

Often the journey is more interesting than the destination

Yours truly

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