Wide-moat investing in India an analysis

Transcription

1 By Krishnaraj Venkataraman Date: 15 June 2012 Wide-moat investing in India an analysis It would help an investor prospecting for good businesses at reasonable prices in India to have a field guide of sorts. The last few years have been a minefield with seemingly well run, well capitalized firms imploding for varying and unanticipated reasons (a) on account of cooking up books of account (Satyam Computer Services, an Information Technology business with a board constituting at least one global Corporate Governance guru), (b) adverse regulatory changes (affecting SKS Microfinance, India s only listed microfinance firm) or (c) caught in unlawful activities (Unitech, a home builder, which incidentally had generated among the best stock price returns for seven years ending 2008). This note attempts to devise an approach for uncovering likely places with good businesses in the hope that it will meaningfully narrow down the search leading to a superior selection of stocks for an investor. The note is divided into 3 parts. The first part paints a picture of the listed securities in India; i.e. the universe for picking stocks and provides elementary information for familiarization. The second part lays down a possible analytic approach to identifying wide-moat businesses. This approach is useful in narrowing down areas of wide-moat businesses but is handicapped by (a) the risk of excluding some good businesses in order to be more certain of what s included and (b) the maladies of applying arithmetic blindly. The third part shares the results and lists down industries with a higher likelihood of wider-moat businesses and shares some of experience and insights on what makes a business widemoat in India. Indian securities market The Indian securities market consists primarily, rather, almost only, of common stocks. There is really no deep market for bonds, debentures, preference shares or convertibles although there are a few issues that are thinly traded. The aggregate of quoted value of these stocks is approximately 1 trillion dollars against India s GDP of approximately 1.5 trillion dollars at current prices and exchange rates. At my last count there were 6740 listed companies permitted to trade in various stock exchanges (mainly two). When all listed businesses are arranged by the size of their quoted equity value we get a very long tail. The top 50 and top 500 stocks account for 62% and 95% of quoted value respectively and about half the listed firms, i.e firms have less than a million dollar in quoted value. There are 2 key benchmark indices provided by the two exchanges separately, called the Sensex 30 and S&P CNX Nifty, and the latter (often called Nifty 50) constitutes 50 firms selected using a variety of criteria. The other important benchmark index is the S&P CNX 500 comprising 500 stocks. These 500 businesses represent 71 industries, sub-industries or business categories and not all of these 500 businesses get studied by research houses. This index is the sample for our analysis. An approach to identifying wide-moat businesses A wide-moat investment can be characterized as investing in a business that is assessed to provide good returns with a high degree of protection and available at a price that incorporates a margin of safety. There are two parts of the assessment; understanding the business to assess the moat and assessing the price at which it is available. We can follow Buffett s advice of looking at the business prior to its price. So can we have a ready approach to narrow down the search for wide-moat businesses out of the meaningful universe of businesses? My own observation has been that some industries have more

2 businesses that are wide-moat than some other industries. This may be possible because of varied reasons including capital intensity, historical business environment, regulatory requirements, competitive behavior, industry structure and so on. If these observations can be tested against reality and found to be true, investors can thus be helped with a field-guide of industries that can be a good filter in their search for wide-moat investing. The analytic procedure Taking this forward, we take the constituents of S&P CNX 500 and put it through an analytic procedure below. While the procedure will surely not stand the rigors of academic research it will probably cut out some fog out of the search for wide-moat businesses. To begin with we make the following assumptions: 1. Past performance is, statistically speaking, a reliable indicator of the future. On average, a business that did well in the past is likely to do so in the future. 2. Return on opening equity capital, or return on equity, is a reliable measure of the width of the moat in most cases. Further we take only the standalone business, i.e. the main legal entity, even if the business has many subsidiaries. That s because publication of consolidated accounts was made mandatory only recently and in any case not many businesses had material subsidiaries until recently and not many do even now. So though measuring standalone ROE is not the best we persist with it because it s the most practical for our purposes. 3. The duration for which high returns on equity (ROE) has been maintained reflects how well the moat is protected. We assume that a track record of 10 years is a reliable and a practical time frame other than that 10 is a nice number. Also hopefully a business tested for 10 years with a business cycle thrown in will likely continue to do well. From the CNX 500 we take out those firms that have been listed only recently and thus have not provided a 10 year record with year ending 31 st March Most Indian companies have their fiscal ending on 31 st March. Further we take out extreme turn-around cases, where firms had negative equity and had to be restructured during this time period. This exercise took out 99 firms and we applied the following statistic on the remaining firms. 1. We computed the annual ROE for every year from 2001 until This gave us the annual ROEs for a 10 year period for each of the remaining 401 firms. 2. We computed the average ROE of their 10 year annual ROE. Let us call this as the ROE. This is the average annual returns the firm has delivered over the past 10 years. 3. We then sorted the firms by their ROEs and put them in 2 groups based on whether the firm was above the median ROE or below. 4. Any firm which is above the median can be said to be a better wide-moat prospect than a firm below the median. Now here s the punch line If far more firms in an industry are above the median ROE than below, we can conclude that that industry offers more wide-moat prospects than others. Results of the analysis The median ROE was 22% probably reflecting the good years enjoyed on account of above average growth in the Indian economy.

3 These 401 firms we analyzed above from the S&P CNX 500 are classified into 71 industry groups by the index provider. Though this seems like an over classification for our purposes leaving an average of 5 6 firms per industry group, we stick to this classification as it is widely used. Of the 71 industry groups, about 30 industries provide opportunity for better than median ROE. Of these about 17 industries have 5 or fewer firms making the effect of pure chance much higher and thus have been removed. That leaves us with 13 industries that have more firms with above median ROEs. Table 1: Ranking of industries based on 10 year return on equities of S&P CNX 500 firms* Industry # of firms with above median ROE # of firms in the industry Percentage of above median ROE The above table makes it clear that wide-moat businesses are more likely to be present in some industries than others. I have marked Steel and Steel Products for attention because the danger of applying blind arithmetic became apparent here. A closer examination of companies in this industry, not covered here, revealed excessive Debt / Equity ratio, higher profits via amalgamation, waiver of prior loan dues shown as income in the period lead some of the firms to show high ROEs. The appendix shows the list of firms in these industries what have shown high ROEs. My experience of what kinds of business have wide moat in India Ranking ELECTRICAL EQUIPMENT % 1 TRAVEL AND TRANSPORT % 2 FOOD AND FOOD PROCESSING % 3 PERSONAL CARE % 3 PHARMACEUTICALS % 5 STEEL AND STEEL PRODUCTS % 6 COMPUTERS - SOFTWARE % 7 GAS % 8 MINING % 8 CEMENT AND CEMENT PRODUCTS % 10 AUTO ANCILLARIES % 11 CONSTRUCTION % 12 BANKS % 13 *Only 401 firms considered out of 500 for reasons explained earlier As with every investor, I have my own notions of what kinds of firms have a wide-moat in India. I cannot claim to understand all the industries listed. There are some common themes that some wide-moat businesses I understand share. Firms that have brands with history and heritage. Years of Government control on business ensured that firms already in existence built their brands with little competition and far lower spends. These brands have earned a very high degree of awareness especially in difficult to reach places and thus are implanted deep in the customer s mind. It is no joke that in India more people are aware of Lifebuoy (a

4 Unilever brand) than the current head of state. Some firms I know of that have or are strong brands are Nestle, Glaxo and State Bank. These brands are surely widen the moat for the companies that own them. Firms that have built a wide infrastructure to reach their products or service. Reaching all markets of this populous country is either prohibitively expensive or takes a long time to build. Thus firms that have been around for longer have built distribution and supply chain networks that are cost-effective and time-tested for delivery. This acts as a formidable entry barrier to any newcomer who cannot get this distribution built overnight and has to work in a different cost environment. For instance India s largest car maker Suzuki has far wider outlets and service centers than a relative newcomer like Volkswagen can even think of putting up in the next 3 5 years. Thus any new launch by Suzuki will see far more sales than a similar launch by VW. It may surprise a few that the firm with the widest reach of consumers is Eveready Industries which makes batteries and flashlights supplying to remote corners of the nation with no electricity. Erstwhile state-owned firms that enjoyed near monopoly and are now listed. The firms that were set-up under the order of the Govt. and have subsequently been listed had enjoyed near monopoly for a substantial period of time allowing them to build or own resources that make them far ahead in the race. Firms like Container Corporation of India, Gas Authority of India or firms which have mining leases issued to them long ago. Industries that have lower taxes. For instance the software industry enjoyed nil taxes until recently for all their export earnings. This helps boost ROEs for the industry in general. Conclusion To conclude the Indian stock market is vast and varied and also a minefield. An investor looking for widemoat businesses would do better if he knows where to look. We say that it s possible that certain industries offer better wide-moat businesses than others. We then test that making some assumptions coming out with a list of industries that an investor can investigate further, having narrowed his search. I can be reached at krishnarajv@gmail.com for seeking additional information on the analysis and raw sheets. Side-bar: Investing in India an area of watch-out Unlike more developed stock markets, I find that, in general, though with exceptions as well, there is no clear separation of ownership and management. This results in owner shareholder benefiting at the cost of other shareholders. Use of corporate assets for owner s exclusive benefit. Many Indian listed firms are owned and managed by the founding family or its members in large proportion and it wouldn t surprise me to know that many do not maintain separate family and corporate accounts; and that corporate assets, including company brand identity, will be used for personal benefits though owned by the company; without adequate compensation. These are unlikely to be captured into the books of accounts. Entering into transactions to evade taxes, benefit owner-manager at cost to shareholders. Revenues are part realized in cash, for sale of goods or services by the company but handed to the owner-manager and not recorded in books of account. Likewise expenses are over-invoiced to vendors with an understanding that the excess of amount over the agreed value will be paid back to the owner-manager in cash. These will have the effect of showing lower revenue and increasing expenses and hence lower taxes, with the result that other shareholders suffer.

5 Increasing ownership through mergers without bringing in anything. The standard tactic involves ownermanager setting up another firm, getting it valued through independent valuers and merging it with the parent for benefits of scale / synergy / consolidation and so on. Shares are issued to the owners in-lieu of bringing in this independently valued business. Similarly assets are also removed from the firm via de-merger Of course it should also be mentioned that there are also many firms that practice high standards of governance and deliver value to non-owner shareholders. Bio: I am Krishnaraj Venkataraman, called Kimi. I have been buying stocks for the past about 20 years and after reading Buffet, been investing in undervalued Indian stocks. I have been a business man while studying Buffett so I hope to be a better investor because I have been a business man and vice-versa. I think nothing has excited me more than finding a good business at a cheap price. When I am not engaged in investing, I work with small businesses providing advice, arranging funds and so on. I live in Bangalore, India, with my wife and 2 daughters. Despite my best efforts to produce a surplus we run a balanced budget at home. I think I account for all the credits and they, for all the debits. But they tell me the intangible asset they created is not captured by any accounting standard i.e. love.

6 Appendix List of firms in identified wide-moat industries ELECTRICAL EQUIPMENT A B B Ltd. Alstom India Ltd. Alstom T & D India Ltd. Bharat Heavy Electricals Ltd. Crompton Greaves Ltd. Havells India Ltd. Siemens Ltd. Suzlon Energy Ltd. Thermax Ltd. TRAVEL AND TRANSPORT Allcargo Logistics Ltd. Balmer Lawrie & Co. Ltd. Blue Dart Express Ltd. Container Corpn. Of India Ltd. Cox & Kings Ltd. Gateway Distriparks Ltd. Thomas Cook (India) Ltd. FOOD AND FOOD PROCESSING Advanta India Ltd. Britannia Industries Ltd. Glaxosmithkline Consumer Healthcare Ltd. Rei Agro Ltd. Zydus Wellness Ltd. PERSONAL CARE Colgate-Palmolive (India) Ltd. Dabur India Ltd. Emami Ltd. Marico Ltd. Procter & Gamble Hygiene & Health Care Ltd. PHARMACEUTICALS Astrazeneca Pharma India Ltd. Aurobindo Pharma Ltd. Aventis Pharma Ltd. Biocon Ltd. Cadila Healthcare Ltd. Cipla Ltd. Divi'S Laboratories Ltd. Dr. Reddy'S Laboratories Ltd. F D C Ltd. Glaxosmithkline Pharmaceuticals Ltd. Glenmark Pharmaceuticals Ltd. COMPUTERS - SOFTWARE 3I Infotech Ltd. C M C Ltd. Eclerx Services Ltd. Financial Technologies (India) Ltd. H C L Technologies Ltd. Infosys Ltd. K P I T Cummins Infosystems Ltd. Mastek Ltd. Mphasis Ltd. Oracle Financial Services Software Ltd. Rolta India Ltd. Tata Elxsi Ltd. Tech Mahindra Ltd. Wipro Ltd. Zensar Technologies Ltd. GAS Everest Kanto Cylinder Ltd. G A I L (India) Ltd. Gujarat Gas Co. Ltd. Indraprastha Gas Ltd. MINING Gujarat N R E Coke Ltd. Mercator Ltd. N M D C Ltd. Sesa Goa Ltd. CEMENT AND CEMENT PRODUCTS A C C Ltd. Ambuja Cements Ltd. Birla Corporation Ltd. Grasim Industries Ltd. Madras Cements Ltd. Prism Cement Ltd. Shree Cement Ltd. AUTO ANCILLARIES Asahi India Glass Ltd. Automotive Axles Ltd. Banco Products (India) Ltd. Bosch Ltd. Exide Industries Ltd. Motherson Sumi Systems Ltd. Shanthi Gears Ltd.

7 Ind-Swift Laboratories Ltd. Ipca Laboratories Ltd. J B Chemicals & Pharmaceuticals Ltd. Jubilant Life Sciences Ltd. Lupin Ltd. Merck Ltd. Opto Circuits (India) Ltd. Pfizer Ltd. Piramal Healthcare Ltd. Sun Pharmaceutical Inds. Ltd. Torrent Pharmaceuticals Ltd. Unichem Laboratories Ltd. Wyeth Ltd. STEEL AND STEEL PRODUCTS Bhushan Steel Ltd. J S W Steel Ltd. Jai Balaji Inds. Ltd. Jindal Saw Ltd. Jindal Steel & Power Ltd. Maharashtra Seamless Ltd. Monnet Ispat & Energy Ltd. Steel Authority Of India Ltd. Tata Sponge Iron Ltd. Tata Steel Ltd. Welspun Corp Ltd. CONSTRUCTION Anant Raj Inds. Ltd. Century Plyboards (India) Ltd. D L F Ltd. Era Infra Engg. Ltd. Godrej Properties Ltd. Hindustan Construction Co. Ltd. Hubtown Ltd. I C S A (India) Ltd. Jaiprakash Associates Ltd. Lanco Infratech Ltd. Omaxe Ltd. Patel Engineering Ltd. Puravankara Projects Ltd. Unitech Ltd. Unity Infraprojects Ltd. BANKS Allahabad Bank Andhra Bank Axis Bank Ltd. Bank Of India Canara Bank Central Bank Of India City Union Bank Ltd. H D F C Bank Ltd. Indian Overseas Bank Jammu & Kashmir Bank Ltd. Karur Vysya Bank Ltd. Punjab National Bank State Bank Of Bikaner & Jaipur State Bank Of Travancore Syndicate Bank Uco Bank Union Bank Of India Vijaya Bank