March 6, 2015

It is all about durability


The easiest way to justify a high PE stock is to say that it has a moat or in other words a sustainable competitive advantage. Once these magic words are uttered, no further analysis or thinking is needed. If there is a moat, it does not matter if the stock sells at a PE of 30 or 70. It is all the same.

On seeing this type of analysis I am reminded of the following the quote from warren buffett
“What the wise do in the beginning, fools do in the end.”
Moat =high PE, but high PE is not always = Moat

A company with a moat may be justified to have a high PE, but a high PE does not mean the mean presence of a moat.

Even if the company supposedly has a moat, it is important to judge the depth and durability of this moat. In addition , the company should also have the opportunity to re-invest future cash flows into the business at high rates of return to create further value.

Lets explore some of these aspects in further detail

More than knee deep

The depth of the moat is simply the excess returns a company can make over its cost of capital. If a company can earn 30% return on capital, we can clearly see that the moat is deep (18% excess return).

This aspect of the moat is the easiest to figure out – Just pick the financials of the company for the last 10 years and check the return on capital of the company. If the average returns are higher than the cost of capital , then we can safely assume that the company had a moat in the past (the future is a different issue).

I personally use 15% return on capital as a threshold. Any company which has earned 15% or higher over an entire business cycle (roughly 3-5 years) is a good candidate for the presence of a moat in the past. Its important not to consider a single year in the analysis as several cyclical companies show a sudden spurt in profitability, before sliding into mediocrity.

The durability factor

The presence of a moat in the past, is only the starting point of analysis. 

The key questions to ask are
-          Is the moat durable -  will the moat survive in the future ?
-          How long will the moat survive ?
-          Will the moat deepen (Return on capital improve), remain same or reduce.

All these factor are very important in the valuation of a business.  Let try to quantify them. I will be using the discounted flow analysis (without doing the math here) and will also be making some simplifying assumptions
  1. EPS = 10 Rs
  2. Return on capital (ROC) = 22%
  3. Growth in profits = 15 %
  4. Company is able to maintain this return on capital and growth for 10 years. After that the ROC drops to 12% and growth to 8% (leading to a terminal PE of around 12)
If you input the above numbers into a DCF model, the fair value comes to around 230 (PE = 23) 
Lets play with these numbers now – Lets assume we underestimated the durability of the moat. The actual life of the moat turns out to be 20 years and not the 10 years when we first analysed the company. If that is the case, the fair value comes to around 430 (PE=43)
I just described the case of several companies such as HDFC bank, Asian paints, Nestle etc. In case of these companies, the markets assumed a certain excess return period, which turned to be too conservative. Anyone who bought the stock at a high looking PE, was actually buying the stock cheap.



The above point has been explained far better by prof. sanjay bakshi in this lecture.
Lets look at a few more happy cases. Lets assume that the company actually ends up earning an ROC of 50% with a growth of 20%. If you plug in these numbers, the fair value  turns out to be around 440 (PE=44). I may have just described what has happened to page industries since 2008.

 So what are the key points?

The market  when valuing a company is making an implicit assumption on the future return on capital, growth and the period for which both these factors will last (after which they regress to the averages). 

An investor makes an above average return only if these numbers turn out to be better than the assumptions built into the stock at the time of purchase.

What happens if the moat turns out to be weak or non existent ?

You have a dud !

Lets assume in our example, that the business tanks after you buy it. It is never able to earn more than 12% return on capital and grows at around 8%.

If the above unhappy situation happens, then the true fair value of the company is around 120 (PE=12). If this turns out to the case, then you will suffer from a 50% loss of capital as the market re-values the company.

Examples ? Look at the case of  bharti airtel. The company was selling at around 470 or PE of 23 in 2007. The company had an ROC of 31% and growth in excess of 15%. The market was assuming an excess return period of 8-10 years at that point of time.

What has happened since then ? The stock price has dropped by around 25% from its peak over the last 8 years – a loss of 2% per annum, which is not exactly a great return.

The reasons are not difficult to see (as always, in hindsight). The telecom market after growing at a breakneck speed till 2007-08 started slowing down. In addition the competitive intensity of the industry increased with almost all other players losing money for most of the time. If these problems were not enough, Bharti went ahead and made an expensive acquisition (Zain) in Africa which suppressed the return on capital further.

In effect all the key drivers of value, turned south from 2007-08 onwards resulting in a loss for the long term investor.

We can derive some key points from the discussion till now
-          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  

So how does one figure out the durability of the moat. There is no magical formulae where you can punch in a set of numbers and out will pop the duration. It is a highly subjective exercise and the topic of the next post.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

18 comments:

Anonymous said...

Truly great. I loved reading the above sir

Anonymous said...

But some assets are largely mispriced. One example is Ahmednagar Forging. With ROE,ROCE and revenue growth being at 25+ for the entire cycle, its trading at a PE of 5 !

impaddi said...

Thanks Rohit for such a wonderful 'Holi' read. Moat is the thing every long term investor is looking but difficult to identify in mathematical terms. But this write up and the one from Prof you mentioned will help a lot. Happy Holi to you and your family.

Vikas Rana said...

Great post Rohit, you covered quite a few aspects..loved the examples.

Thanks.

Vikas

Anonymous said...

Why do you assume a cost of capital of 12%, any particular reasons?

Rohit Chauhan said...

hi anon1
thanks

hi anon2
maybe ..i havent looked at the company, but yes some companies which do have such high returns are mispriced. thats what investor need to look for

Rohit Chauhan said...

Hi impaddi, vikas
thanks for the comment

Rohit Chauhan said...

Hi anon
i have taken 15% as a threshold .as that seems to the long term returns of the market or one can say cost of equity in india. if a company earns less than that, then u will make market returns in the long run. if that is the case, why buy the company ? just invest in the index for same returns and lower risk

rgds
rohit

Varenya said...

Hi Rohit,

A small technical question, how does one calculate the cost of capital for a company? If it's a company funded by equity, isn't it want the investor demands of top of risk free rate? But do we quantify that? And won't it change over time?

Thanks.

Lajuana said...

Could you attach an excel for the dcf number of 230

Srinivas Duvvuri said...

Could you show the DCF calculation on how the 230 value was arrived at

Srinivas D said...

Rohit,

Could you also post how the DCF Calculation yielded Rs 230 as present value.

Anonymous said...

Hi Rohit,

Great post. I have a query. In the post you referred, Dr.Bhakshi has mentioned ITC available at 25 PE is a great buy. Now, it is available at 25 PE.

Do you think it is a great buy ? I think their capital allocation is not good and they may not be able to replicate the success of past 10 or 20 years..

Also, can we buy P&G, Colgate, HUL and Nestle which are all quoting at 40- 60 PE ( one year forward) ?

Appreciate your view on this.

Regards
Balaji

D Srinivas said...

What is the discount rate you used ? I tried with 12% then cease very close to 230 but using 22% the dcf calculation is very far off . Why I am asking this this is one of the critical components in the analysis and whited to get this right ? Thanks in advance for your help

nraj jain said...

Hello,

I am new to ur blog. thanks very much for all the info and analysis.

I would like to know about Selan Exploration and the recent promoter selling in the open market.

Thanks

Rohit Ajmera said...

Hello Rohit,

Really interesting post. Look forward to the next post on durability of moat.

Can you pl share the math/send the excel sheet behind the DCF calculation to arrive at the fair value of 230? Thanks.

Harsha said...

@ Anon2 (Ahmednagar Forgings) - saw your comment on this. Was something that I had looked too sometime back as it was popping up on my screener for consistent high ROE. To prevent you some heart burn - here's my few cents..

-if you look at the asset turnover ratio, its been on decline YoY (infact less than 1).. so you have to put in over Rs1 to have incremental business of less than Rs1.

- debt is way you finance that growth..if you do a quick back of envelop calculation debt increased 42 times in ten yrs for sales increase of 11 times.

I looked no further after this. Good luck with investing. High ROE is not always = moat.

-Harsha

Anonymous said...

Hey Rohit,

Just waiting for your next post on the durability of a moat. Thought I would nudge you a bit as the market is so high that most of us value investors are so bored with nothing to do but wait patiently :-) . One funny observation i made is that most of the value investing blogs are all so quiet for the past one year.. thanks to the bull market..

Regards
Ravi