Economic moat of a company

Economic moat of a company

How can investors be 100% sure of not losing their capital despite investing in the equity market?

The first step in identifying the right set of companies is to understand ‘what they bring to the table’. You don’t want to be investing in companies whose strategies and products can easily be replicated by competitors.

Economic Moat

In 2007 Berkshire Hathaway letter to shareholders, Warren Buffet gave ‘economic moat’ concept to the world.

Just like a castle has a moat that surrounds the castle with muddy water, crocodiles etc. This moat prevents enemies to enter the castle. Similarly, economic moat represents some sort of protection of business cash flows.

Businesses with economic moats have sustainability.

A competitive advantage is an advantage that currently allows a company to earn premium margins over its competitors. But an economic moat is a sustainable competitive advantage–a competitive advantage that will last.

Here are few “symptoms” to help us identify economic moat:

Intangible assets: Fanatically loyal customers. Profit margins or cash returns on invested capital that consistently exceed the industry average or those of their competitors. Successful companies with high priced, quality products or services for decades, supported by their brand strength.

Customer Switching Costs: Products and services that are not easily abandoned for a substitute or for a competitor’s product.

Networks Effect: Networks that become more useful as more people join.

Example: Colgate India

One way to understand whether a company has an economic moat is to look at financial reports of the last 10 years. High return on capital employed with high growth in sales and profit will indicate economic moat of a company.

Colgate India manufactures and markets oral care products and other toiletries in India since 1937 and has demonstrated high returns (ROCE) and cash flow generation (Growth) over the years.

They have large established brand and distribution network in place. The company spends 15-16% of revenue each year for marketing (protecting the moat).

Toothpaste is one of the first things that someone puts in his or her mouth in morning. Hence, there is switching cost (psychological) if someone wishes to switch their toothpaste.

So does that mean, you go ahead and invest in this company – “NO”

Price is what you pay and value is what you get. You will wait for the price to be in the range where you get maximum value. This is where valuation comes in or what we call as knowing the fair worth of the company/intrinsic value.

There is a lot of literature on DCF based valuation but that value may be speculative. A conservative approach to understanding the fair value of a company is to compare its asset value with earning power value.

Time tested stock investing approach

Time-tested stock investing approach

Ben Graham in 1940 recommended having ‘margin of safety’ while investing in stocks. This approach was practised by many investors including Warren Buffet and it surely worked.

The company’s worth is roughly equal to asset’s worth less any liabilities.

But what about growth and profitability? This class of investors often don’t like paying for future growth but are comfortable paying for asset value and current earnings (Earning Power Value). Let’s just focus on asset value approach for now.

Value based on Assets 

Any company’s value can simply be its asset value. Well, this is the first level of assessment that can represent the baseline of company’s value.  

Any company has two kinds of assets i.e. current and fixed. Most of the current assets represent its fair worth in the balance sheet. However, fixed assets have to be assessed since the likelihood of fixed assets value in the balance sheet is low. For example, land bought fifteen years back will be worth lot more than what is mentioned in the current balance sheet. 

There are two ways to look at a company’s asset value: liquidation value or reproduction value. 

Liquidation value

This is the value assuming the company is closing down. The analyst maybe trying to assess whether to buy distressed debt or equity. 

Here is a sample balance sheet to assess liquidation value: 

Sample balance sheet

Assets

2018

2017

Current assets

 

 

Cash

150

145

Marketable securities

25

70

Accounts receivable

1667

1525

Inventories

2329

2250

Total current assets

4170

3990

 

 

 

Plant, property and equipment

7500

7750

Goodwill

2250

2400

Deferred taxes

150

155

Total assets

14070

14295

 

 

 

Liabilities and equity

 

 

Current liabilities

 

 

Notes payable

2200

0

Accounts payable

1417

850

Accrued expenses

1250

725

Current portion of long term debt

9500

9250

Total current liabilities

5387

2075

Long term debt

9500

9250

Deferred taxes

125

150

Preferred stock

350

350

Paid-in capital

850

850

Retained earnings

(2141)

1620

Total liabilities and equity

14070

14295

Let’s deep dive


Cash and marketable securities are taken as mentioned in the balance sheet.

Account receivable will probably not be recovered in full, but since it is trading debt, we can estimate that we can realize 85% of the stated amount.

Inventory valuation depends upon the type of inventories, more specialized inventory will fetch lower amount.

The same logic applies to plant, property and equipment as well. I have assumed 50% inventory realization and 45% plant, property and equipment realization.

Goodwill will not fetch anything and deferred taxes will get adjusted to the liabilities.

Assets

2018

Percentage realized

Value

Current assets

 

 

 

Cash

150

100

150

Marketable securities

25

100

25

Accounts receivable

1667

85

1417

Inventories

2329

50

1164

Total current assets

4170

 

2756

Plant, property and equipment

7500

45

3375

Goodwill

2250

0

0

Deferred taxes

150

0

0

Total assets

14070

 

6131


Account payable and accrued expenses amount to only 2,667. After paying for these liabilities 12,220 will still be left as liabilities.

Given the condition of the company, if a steep discount is available on debt, investing in this is not a bad option. Stock investing in this company may not make sense. 

Reproduction value

If a company operates in a viable industry then the economic value of the assets is their reproduction cost i.e. what a competitor has to spend in order to get into this business.

Current assets

Cash and marketable securities do not require any adjustment. A new company starting out may not be as effective in getting the payments from the customer. Therefore, adjusting for allowances in accounts receivable is a better idea.

Valuing inventory can be a daunting exercise. Based on the industry, the analysis needs to be performed especially inventory / COGS to understand if there is any pilling up of inventory.

Additionally, if the firm uses LIFO method of inventory reporting, LIFO reserve should be added back because the new firm may not be able to source inventory at last years price.

Fixed assets

Plant, property and equipment may be shown as one item but they are actually three. Land usually appreciates; assessing the market value of the land is a better idea.

Plant and building use depreciation allowance that may not represent the true picture. The competitor has to pay lot more than what is usually shown on the balance sheet.

The adjustment made in the equipment value may be up or down, depending on the industry but it is not so massive.

Value of goodwill needs to be understood rather than relying on the balance sheet number. Goodwill is an accounting entry but a company may enjoy premium due to its reputation.

Goodwill may be linked to R&D and marketing expense of the company. You should be able to answer “How many years will the product take to establish its market?” if the new company were to enter the industry. 

Adjustment required arriving at reproduction costs

Assets

Adjustment required arriving at reproduction costs

Current assets

 

Cash

None

Marketable securities

None

Accounts receivable

Add bad debt allowance; adjust for collections

Inventories

Add last in, first out reserve, if any; adjust for turnover; watch out for changing ratio of inventory/COGS

Prepaid expenses

None

Deferred taxes

Discount at present value

Plant, property and equipment

Original cost plus adjustment; land usually gets a premium and equipment/plant have to be discounted

Goodwill

Relate to product portfolio and R&D and marketing

Asset value needs to be compared with earning power value (EPV)

If you are up to dig into annual reports for the last ten years, EPV can help you find great opportunities.

Well, enough for now, EPV for some other day!

When is a good time to invest?

When is a good time to invest?

When the markets are high, people are concerned. When the markets are low, people are concerned.

IS IT A GOOD TIME TO INVEST OR SHALL I WAIT

– Investors always ask this question.

As a young student of finance more than 15 years back, I always wanted to know an answer to this question.

How does share price emerge?

This is an underlying thought of whether this is a good time to invest or not.

In quest of answering this question, I started reading books on investing. Fortunately, came across a book “Intelligent Investor” by Benjamin Graham.

This line in the book answered my question and changed my perspective on the stock market:

“In the short run, a market is a voting machine but in the long run, it is a weighing machine.”

In the short-term, mood of the market defines where the prices would be going. However, in the long-term, company’s performance defines the performance of share price.

Can there be an analytical tool to assess the market mood?

Let us look at how you can assess the current mood of the market. This factor does not predict the future but focuses more on the present state i.e. whether the market is over or under-bought.

Earning yield + Dividend yield – 10 years government yield

A positive number indicates that market is undervalued; else, you are better off in bond investing. At any point in time, the portfolio may be maximum 75% in equity and minimum 25% in equity.

If you would have followed this strategy for the last 18 years, using purely 10-year government bond yield and Nifty 500 index, the return would have been 15% per annum. Except 2008, for all the rest of the past 18 years, the return was positive. This way you can plan your portfolio better and manage your investment psychology better.

The analysis indicates that current market is overvalued, finding investment opportunities may be a challenge and you are better off parking majority of your investments in bonds.

Here are the investment rules I follow in my firm:

1. Assess the market using the analysis provided above. I use NSE500 as a proxy for equity, dividend yield as 1.57% and current 10-year government bond yield.

2. When my model indicates +2% factor, perform fundamental analysis on selected companies that are deeply discounted. This touches upon the long-term view, “market as weighing machine” analogy.

Where do you find deeply discounted value? A company that is fundamentally strong but has a lot of negative news around it. 52 weeks low is more relevant than 52 weeks high 🙂

3. If the factor is less than 2%, a combination of ETFs, short-term debt funds and a mutual fund may be used. Finding deeply discounted equity is a challenge in this zone.

I like sitting on cash i.e. being invested in bonds if I do not see any opportunity in the equity market. I do not like chasing returns; I like managing my risk better.

Please stay away from people who tell you that they will chase a certain return for you.

No one in the world can predict where the equity markets will go. However, smart investors always know that they can always manage their risk better and returns are generated over a period of time.

The consistency of return while managing portfolio risk is more important than high returns during bull-run.

Interestingly, print and TV news focuses on figuring out the short-term view of the market. There are not many options to get information without opinions. You will be better if you do not read or watch at all than getting opinionated about the markets.

Just keep it simple and manage your portfolio peacefully so that you do not lose sleep!

Investing in share market

Investing in share market

I assume everyone has heard about stocks and the share market. For those who may not be aware, here is quick overview:

Let’s take the example of Reliance Industries. When it was formed, Dhirubhai Ambani and his family privately owned 100% of the company. They sold a certain percentage to the public to raise funds, which they used to grow the company.

A stock or a share is a fractional ownership of the company. Let’s assume the Ambani’s had 100 shares of the company. Now they sold 10 shares at Rs 100 each to raise Rs 1000 in the form of new capital.

If you bought 5 shares, you owned 5% of the company. With Rs 1000 that the Ambani’s raised, they grew the revenues and increased the profits of the company.

As a 5% shareholder, you are entitled to 5% of the profits of the company. Some companies pay a part of the profit to shareholders in the form of dividends.

Some companies retain the profits and invest them back in the business to grow it even further.

As an investor, you are primarily concerned with two things – the price of the stock. You would prefer to see going up year on year and the dividends declared by the company.

So how is the stock price of a company calculated and why does it go up and down.

The share price of a company is affected by three primary factors:

1.) Return on investment.

2.) Cost of capital.

3.) Growth prospects of the company in the future.

The basic idea is that stock prices go up year on year as the company grows and makes more profits.

The stock of Eicher Motors represents one such example – In the year 2004, the stock price of one share of Eicher Motors was Rs 22. After 13 years, the price of one share has reached ~Rs 25,000+. Eicher Motors is able to deliver this phenomenal performance due to superior return on its investments, low debt levels and extraordinary revenue growth.

Investing in quality stocks is one of the best ways to grow your money over a period of time.

So why are some people afraid of investing in stocks?

You must have heard some folks in your social circle say stuff like, “Oh, stocks are very risky, don’t invest in them” or “Investing in stocks is like gambling, put your money in safe assets” or “There are no guarantees in the stock market. Invest in real estate – their prices will only rise.

Yes, stocks are a risky asset class and you can lose almost all your money if you don’t invest your money carefully.

The chances of you losing money arise from 2 scenarios:

1.) You buy a stock of an unknown company based on a tip thinking the stock price will rise. However, the stock price falls and if you need money, you will need to sell it at a loss.

2.) You invest in quality stocks for a short-term period – and due to a temporary fluctuation in the indices, your stock prices may be down – but since you need the money, you may be forced to sell at a loss.

Remember, when you buy stocks, you are actually buying a very small piece of the company – and if the company does well, your stock price will go up.

Now companies don’t grow in one day. They take years to grow. And the same logic applies to shares.

Think about it – do the revenues or profits of a company rise every day or even every month?

Not really right – and since a stock price is supposed to be a function of future growth, but since revenues cannot double every day, why do you expect the stock price to rise and continue rising every day?

Yet, this is what day traders in the stock market hope to achieve – because the prices of stock fluctuate on a daily basis – which they aim to beat.

As a long-term value investor, you should be investing in fundamentals and long-term potential of value stocks instead of short-term movements or forecasts by experts on TV.

If you are a first-time investor and are interested in buying stocks directly, I recommend you first wait, learn more about the process and then take baby steps.

If you wish to pursue this as a hobby or out of interest, I recommend you allocate no more than 5 to 10% of your total liquid net worth to buying stocks directly.

Four pillars of stock investing

Four pillars of stock investing

“Is it the right time to gain equity exposure ?” The answer depends upon the investment portfolio you want to structure.

For a diversified portfolio (mutual funds and ETFs), you need to wait till the euphoric sentiments cool down. For a concentrated pool of equity, there is no right or wrong time to invest in equity market.

Investing and making a return in direct stock investing is an exercise that combines finance and behavioural skill.

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. You only find out who is swimming naked when the tide goes out – Warren Buffet.

With respect to direct equity investment, there are four pillars of value creation:

  1. The core-of-value principle establishes that value creation is a function of returns on capital and growth.

  2. The conservation-of-value principle says that it doesn’t matter how you slice the financial pie with financial engineering, share repurchases, or acquisitions; only improving cash flows will create value.

  3. The expectations treadmill principle explains how movements in a company’s share price reflect changes in the stock market’s expectations about performance, not just the company’s actual performance (in terms of growth and returns on invested capital). The higher those expectations, the better that company must perform just to keep up.

  4. The best-owner principle states that no business has an inherent value in and of itself. It has a different value to different owners or potential owners. A value based on how they manage it and what strategy they pursue.

Ignoring these cornerstones can lead to poor decisions that erode the value of companies.

An intelligent investor will do his analysis, find out the true value of the business and then decide whether the asking price is justified. Anyone who does not follow this process is just speculating in the stock market.

Do not get caught up in the euphoria of a rising or declining stock market. Do your own due diligence or consult an investment firm that can perform the analysis on your behalf. 

Do not try to answer “is it the right time to invest in the stock market” but rather “is it right for me to invest in the stock market”.

Mistakes to avoid in equity investment

Mistakes to avoid in equity investment

Equity investment makes a compelling argument for being included in long-term growth portfolios. This is due to the higher inflation-adjusted returns equity investment generates. Here are a few practices that you should avoid since these practices increase the risk in your portfolio.

Timing entry, exit

Unless you are an expert at interpreting technical indicators, you will not be able to call the market’s highs and lows with too much success.

Most common investors would not have an in-depth understanding of all the events. Frequent entries and exits from any investment instrument lead to additional costs, which eat into your returns.

During the time that you wait for signals to indicate the right time to invest, your money will be lying idle.

Similarly, trying to time your exit according to a market peak has disadvantages too. First, you may not have the money when you need it. Second, the market may decline before you are able to monetize your investment.

Leveraged funds

It is important not to use borrowed funds to invest in volatile assets. Returns from such investments have to go towards servicing the loan. And while returns can be high in best-case scenarios, if such investment tanks the losses will be more with long-lasting impacts on your life.

Leveraging magnifies losses as much as it does the gains and is, therefore, a risky strategy to adopt for volatile instruments.

Short-term investing

Growth assets with high long-term average returns need a long investment horizon.

Higher returns from such investments can be had by giving them time to ride out turbulent markets or economic downturns.

If an investment is made after adequate evaluation of the fundamental factors and it periodically monitored, then it should be held in the portfolio for as long as the goals require.

It is important to tune out the noise of short-term market responses to events and focus on the long-term prospects of the investment.

A high return on long-term investment does not guarantee the same level of returns over a shorter holding period.

Investing funds earmarked for immediate goals in volatile investments, to earn higher returns, may not always be successful. A fall in market values during that period will depreciate the capital invested.

Booking quick profits

Trying to exploit an upward momentum in an investment, to make a quick profit, is a risky strategy unless you have the tools and information required to time and execute such trades.

Inexperienced retail investors are likely to enter into a trade when the momentum has petered out and the prices are retracting.

Sometimes such investors are unwilling to cut their losses and exit. This may happen even as the prices continue to sink further. At other times, greed may make them ignore the signals to book profits and they stay invested in the hope of higher prices.

The availability and regular updates on prices, and ease of making transactions make it tempting to use such strategies to make a quick profit.

But given the hits and misses, as well as the costs and taxes, the cumulative outcome may not be all rosy.

Chasing past performers

Chasing last year’s best-performing asset class, industry, strategy, or product category can put your goals at risk. The risk is that the previous year’s best performers need not be the same this year.

Chasing performance necessitates moving funds from one investment to the next, which implies costs and taxes that affect net returns. It may result also in buying products that are not aligned with the needs of the investor.

The portfolio has to reflect your goals and the ability to take risks. A diversified portfolio that is aligned with the goals will take care of having exposure to multiple asset classes.

Monitor the investment performance and consider a rebalancing only if there is consistent underperformance relative to valid benchmarks and peer groups.

Investments that have the potential to generate higher returns come with greater fluctuations in their returns. Keep the focus away from the volatility and instead focus on your investment plan.

Having a plan that reflects your risk and returns preferences will help ride out the troughs and get you to your financial goals.

How can NRIs in Canada and USA invest in India

How can NRIs in Canada and USA invest in India

It is quite difficult to ignore India’s growth. Until the late 2000s, most of the NRI money was flowing in real estate. However, over the last few years, the trend is changing. Investors are moving away from physical assets and into financial assets.

Simply speaking financial assets can be broken down into debt and equity.

Fixed deposits

Most of the NRIs prefer fixed deposits because it is simple and easy.

NRI needs to open one of the three banks accounts-non-resident external rupee (NRE) account, non-resident ordinary rupee (NRO) account or foreign currency non-resident account (FCNR) with an Indian bank.

NRE Account is best suitable for those who need to make payments in Indian rupees or want to make investments in India from his/her overseas earnings and at the same time want rupee savings to be freely repatriable.

NRO account is suitable for those who want to deposit his/her income in India from sources such as rent, dividends etc. and want the investments in India to give higher returns.

FCNR Accounts are best suitable for people who wish to keep his overseas savings in India but do not want to convert them in Indian rupees.

Debt mutual fund

There are 7-8 fund houses in India that are offered to the investors in the US and Canada. Investing in ultra-short-term and short-term debt is preferred since you don’t know where the $ to INR would move over long-term.

The benefit of debt mutual fund over a fixed deposit is the indexation benefit if the investment stays for more than three years.

At the time of redemption, TDS is applicable.

Equity mutual fund

The fund houses that offer debt mutual funds also offer equity mutual funds to the investors in the US and Canada. You can make investments through an NRO or NRE account.

Redemption proceeds are either paid through cheques or directly credited to the investor’s bank account. All earnings are payable in rupees. Investments made through inward remittances or from NRE/FCNR accounts are fully repatriable. Hence, earnings made by redeeming the units or through dividends are fully repatriable. However, in case of investments made through NRO accounts, only the capital appreciation is repatriable, not the principal amount.

 

Equity Mutual Funds

Debt Funds

 Short-term Capital Gains Tax

Investments held for less than 12 months:

15% + surcharge 12%+ education cess 3% = 17.3% (total)

Investments held for less than 36 months:

As per tax slab

 Long-term Capital Gains Tax       

10% + surcharge 12%+ education cess 3% = 11.65% (total)

20% with indexation

 Dividend Distribution Tax

Nil

29.12%

While tax liabilities of an NRI investing in India are the same as that of a resident investor, the tax is deducted at source in case of the former. Whether an NRI is subject to double taxation-once in India and again in the country of their residence depends on the country of residence. If the Indian government has an avoidance of double taxation treaty (ADTT) with that country, the NRI will be spared from paying tax twice.

Stock investing

In the United States, IRS guideline on PFIC (Passive Fund Investment Company) applies. The guideline explains that as a US tax filer you need to disclose all your investments globally and pay taxes. These taxes also apply to unrealized gains on mutual funds, infrastructure fund and exchange-traded fund. 

One way to avoid paying taxes on unrealized gains is to invest directly. If you invest through a discretionary PMS, PFIC guideline does not apply. A financial advisor can help in facilitating PMS investment in India. There are more than 275 PMS, therefore financial advisor should be able to evaluate the top PMS and create a portfolio.

US and Canada based NRIs must deal with a qualified and SEBI registered financial advisor. This will take care of the compliance and reporting.