Cheap and durable (price matters !)

Starting note: This is a long post and I am going to cover a lot of ground. I have tried to cover a vast topic in a few pages, which is usually the subject of entire books. As a result, I have tried to simplify and generalize in several cases to make a point.

In the previous post, I tried to make the point that it is not enough to say that a company has a moat and then rush to your broker to put in an order. One needs to answer a couple of questions

 -          Does the company really have a sustainable competitive advantage or a durable moat? A high return on capital is a necessary but not a sufficient condition to demonstrate the presence of a moat

-          It is also important to judge the depth and durability of the moat. Deeper the moat and longer it survives, more valuable is the company

Do not focus too much on the math

I received a few emails asking me about the calculations on how I arrived at the PE ratios. As I said in my previous post, the math is not important for the point I am making - longer a company earns above its cost of capital, higher is its intrinsic value.

I would suggest that you use the standard DCF model and apply whatever assumptions you like for growth, ROE, free cash flow etc and just play around with the duration of the moat or the period for which the company can earn above the cost of capital. It should be quite obvious that longer the duration, higher is the value of the company.

For the really curious, I have uploaded my calculations here. Prepare to be underwhelmed!

Market implied duration

The other point i would like to make is by turning around the equation – If the company has a high PE ratio, the market is telling you that it expects the company to earn above its cost of capital for a long time.

For illustration, let’s take the example of Page industries (past numbers from money control, future numbers are my guess).

Future expected ROE = 50% (roughly 53% in 2014)

Future growth rate = 30% (40% growth in 2010-2014)

Terminal PE = 15

Current price = 14000 (approximately)

If I put in these numbers into DCF formulae, I get a Moat period of around 10 years.

So the market expects the company to grow its profit by 30% per annum for the next 10 years and maintain its current return on capital. This means that the company will earn a profit of  2000 crs by 2025.

So do I think that page industries will maintain its moat for 10 years or longer and grow at 30%?

I don’t know !

However if I did own the stock or planned to buy it, my next step would be to analyze the competitive strength of the company and see if the moat would survive 10 years and beyond, because if it didn’t I would be in trouble as a long term investor.

Precision not possible

In the previous example I used a fancy formulae and a long list of assumptions to suggest that the market considers page industries to have a competitive advantage period or moat (CAP for short) of 10 years.

Once you put a number to some of these fuzzy concepts, it appears that you have solved the problem and are ready to execute.

Nothing could be farther from the truth.

Anytime someone tries to give you a precise number on intrinsic value of a company, look for the assumptions behind it. As you may have read, the best tool for fiction is the spreadsheet.

The above calculation should be the starting and not the end point of your thinking. I typically do the above kind of analysis to look at what the market is assuming and put it into three broad buckets

2-5 years : Market assumes a short duration moat

5-8 years : Market assumes a medium duration moat

8+ years : Market assumes a long duration moat (bullet proof franchise)

Let’s look at some way to analyze the moat and bucket it in some cases

Measuring the moat

A substantial part of my post has been picked up from this note by Michael Mauboussin. The first version of this note was published in around 2002 and the revised one in 2013 (download from here)

If you are truly interested in learning how to discover and measure moats, I cannot stress this note enough (some important parts in the note have been highlighted by me) . Read it and then re-read it a couple of times. The only point missing from this note is the application of the concepts – Michael mauboussion does not provide any detailed examples of applying the concepts to a real life example.

Model 1: Porter’s five forces analysis

I am not going to write a detailed explanation of this model – you can find this here. I have used this model to analyze IT companies in the past – see here. A few more posts on the same topic can be found here and here.

Let me try to explain my approach using an example from the past. Lakshmi machine works was an old position for me (I no longer hold it). As part of the analysis, I did the five forces review of the company/ industry which can be downloaded from here

A few key points about the analysis

-          The entry barriers were quite high in the textile machinery industry. Once a company like LMW has established itself and achieved a market share in excess of 50%, it was difficult for a new competitor to achieve scale. A textile mill with only LMW machines finds it easy to maintain and repair these machines (due to accumulated learning) or get this done from LMW which has a large service network. LMW, due to a large install base, is able to provide a high level of service (network effect) at a low cost (due to scale of operations). So we have a case of positive loop here–  Largest company is able to provide a cost effective solution and high levels of service and still earn a good return on capital

-          The other factors such as Supplier power, substitute products etc are not critical to evaluate the industry

-          There is a certain level of buyer concentration, but the machinery segment has far higher concentration and hence the balance of power is still with LMW

-          Finally rivalry is muted as LMW has a level of customer lockin . A satisfied customer will prefer to continue with the same supplier (Who is also cost effective) as it allows it to achieve a higher uptime in operations and lower cost of maintenance (maintenance team needs to maintain only one brand of machines)

The above is also visible in the form of a very high return on capital for LMW – The company  had a negative working capital for 10+ years and earned 100% + on invested capital at the time of this analysis

As I analyzed the company in 2008, I felt strongly that the company had a medium (5-8) or a long duration moat. It was not important to arrive at a precise number then, as the company was selling at close to cash on books and the business was available for free. Surely a business with a medium term moat was worth more than 0 !

Model 2: Sources of added value

The second mental model i frequently use is the sources of added value – production advantages, customer advantages and government (pages 34-41 of the note)

I have uploaded the analysis for CERA sanitary ware (current holding), I had done in 2011. Look at the rows 14-19 for the details.

A few points to note

-          The company enjoys scale advantages from demand, distribution, advertising etc. As the company gets bigger, these cost advantages would increase ensuring that the company will be able to price its product at the same level as its competitors and still earn a good profit

-          The company also enjoys customer side advantages from brand/ trademarks and availability

As you run through this checklist/ template, you will notice that a company could have either production or customer advantages due to various factors. However a company which has both has a powerful combination. If these two sources of value are working together and growing, then we may be able to say that the company has a medium or long duration moat

In case you are curious, I thought that CERA had a small to medium moat in 2011. This has expanded since then and the company most likely has a long duration moat now.

Model 3: High pricing power

Another key indicator of competitive advantage is the presence of pricing power. The following comment from warren buffett encapsulates it

“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price 10 percent, then you’ve got a terrible business.”

How do you evaluate this ? Look for clues in the annual report or management responses to questions in conference calls. Does the management talk of margins being impacted severely due to cost pressures ?

For example – Companies like Page industries or asian paints are generally able to pass through cost increases to customer without losing volumes. When the input costs drop they can either increase their margins or use this excess profit in advertising and promotions and thus strengthen their competitive position. Can steel or cement companies do the same ?

Other miscellaneous models

1. Is the competitive advantage structural (based on the business) or the management. An advantage based on the management is a weak moat and can change overnight if the same team is not in charge
2. Industry structure : A duopoly or an industry with limited competition is more likely to have companies with competitive advantage. Look at batteries, two wheelers or sanitaryware for example. One is likely to find companies with medium or long duration moats in such industry structures.
3. Govt regulation : This can be due to special ‘connections’. If you find a moat due to this factor, be very careful as this can disappear overnight

A brief synthesis

I have laid out various models of evaluating the competitive advantage of a company. Once you go through this exercise, you can arrive at a few broad conclusions

-          No moat: A majority of the companies do not have a moat. As you go through the above models and are hard pressed to find anything positive, it is an indicator that the company has no competitive advantage. Even if the company has been earning a high  return on capital in the recent past, it could be a cyclical or temporary phenomenon. Look at several commodity companies which did well in the 2006-2008 time frame, only to go down after that.

-          Weak moats : If the moat depends on single a production side advantage such as access to key raw material or government regulation, it’s a weak moat (think mining or telecom companies). The company can lose the advantage at the stroke of a pen, law or whims and fancy of our politicians. In addition the pricing power of such companies is very low. I would categorize such a moat as a weak one and not give it a duration of more than 2-3 years.

-          Strong, but not quite : If the moat depends on customer advantages such as brands or distribution network, the moat is much stronger. A company with a new brand which is either no.1 or no.2 has a much stronger moat. I tend to give the moat a medium duration (5-8 years). The reason for being cautious at this stage is that the company clearly has a competitive advantage, but the strength has not been tested over multiple business cycle. In addition, in some case the business environment is subject to change and one cannot be too confident of the durability of the moat. The example of LMW or CERA in the past is a good one for this bucket

-          The bullet proof franchise :These are companies with multiple customer and production (scale related) advantages. These companies are able to command high margins, can raise prices and at the same time have a very competitive cost structures due to economies of scale. These companies have demonstrated high returns of capital over 10+ years and continue to do so. In such cases, one can assume that duration of the moat is 10+ years. These cases are actually quite easy to identify – asian paints, nestle, Unilevers, pidilite, HDFC twins and so on.

Moats are not static

A key point to keep in mind is that moats are not static, but changing constantly. In some cases the moat can disappear overnight if it depends on the government regulation (such as mine licenses), but usually the change is slow and imperceptible and hence easy to miss.

If you can identify the key drivers of a company’s moat, then you can track those driver to evaluate if the management is strengthening or weakening the moat. For example, the moat of an FMCG company is driven by its brands and distribution network. As a result, it is important to track if the management is investing in the brand and deepening/ widening the distribution network.

In the case of LMW, I think the moat has slowly shrunk due to the entry of Reiter ltd. Reiter was the technology partner and equity holder in LMW. The two companies have since parted ways and Reiter is now competing aggressively in the same space.

LMW has repeatedly indicated that they are now facing a higher level of competition in India and consequently there has been a slow drop in operating profit margins. In addition one can see an increase in the working capital usage too. I cannot precisely state that the moat duration has shrunk from 10.7 years to 6.3 years, but there is increasing evidence that the moat is under pressure. As a result, I exited the stock a few years back.

Putting it all together

Let’s assume that you have done a lot of work and figured out that company has moderate moat possibly 5-8 years. At this point, you can plug in the required variables into a DCF model and analyze the market implied duration of the moat (the way we did for Page industries)

If the market thinks that the company has no moat or a minimal moat, than you have a probable buy. If however the market implied moat is 10+ years, then the decision would be to avoid buying the stock, not matter how good the company

The above sounds simple in theory, but is far more difficult in practice – I never promised that I will be giving you a neat, fool proof formulae of making a lot of money by doing minimal work :)

The moat of a long term investor

If the all of the above sounds too fuzzy and cannot be laid out in a neat formulae, you should actually feel very happy about it. Think about it for a moment – if something is fuzzy and requires a combination of a wide experience, insight and some thinking, it is unlikely to be done successfully by a computer or fresh out of college analysts. 

Can a research analyst go and present this fuzzy thinking to his head of research, who wants a precise target price for the next month ?

So any investor who has a long term horizon and is ready to invest the time and effort to do this type of analysis will find very little competition. It is a general rule of business that lower competition leads to higher returns – the same is true for investing too.

If you buys stocks, the way most people buy shoes, TV or fridges – after due research on features, durability (how long the consumer durable will last) and then compare with price, the result will be much better than average

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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.

Patient Wealth creation

This is a commonly used, but rarely defined word. I am going to argue in this post that the sole purpose of investing is wealth creation.

What is wealth creation ?

Let’s take a numerical example. Let’s say you have 100 Rs. You can invest it in an FD at around 9-10%. At the end of 5 years, you will have around 161 Rs. We can call this the baseline level of return .

However putting money in a Bank FD is not a riskless transaction. If the inflation during this period turns out to be 11%, then you would have lost 5% of your buying power. On the other if we take the average inflation of the last 20 odd years, then the buying power would have risen by 15% over the same period.

Have you created wealth in the above case ? I would say yes, as you have been able to increase your buying power over the investing period, but not by much (15% at best on average).

Let’s say one were to invest in the stock market (via index funds) for a 5 year period. On average, the market has returned around 15-17% per annum over the last 20+ years. If you back out an inflation assumption of 7%, then the buying power would rise by 61% for the period. Now we are talking of some serious wealth creation !

However the above example has a catch – I spoke about an average return of 15-17%. The reality is that the stock market returns are lumpy and you can have a period of 2003-08 of 30%+ returns and then a period of 2% returns for the next 6 years (2008-2013). So in this case, one is talking of wealth creation with an added level of risk.

The above examples are quite obvious , but ignored by many. We need to concentrate on post tax, post inflation returns to evaluate the wealth creation potential of an investment option. If you have a higher buying power after taxes and inflation, then you have created wealth.

The aspect of time
I arbitrarily considered a time period of 5 years in my example. What is the correct period? 1 month, 1 year or 20 years?

I would argue that the time period for wealth creation should be driven by your personal goals. Are you saving (and creating wealth) for the purpose of buying a house or retirement? If that is the case, then the period should be upwards of 10 years.

Let’s put the above two point together – One needs to make a level of post tax, post inflation returns over the investment horizon (10 years +) such that you can meet your personal goals. Why else would you put your money at risk?

Now there a lot of people who invest for the thrill of it (for 100% return in days !!) or to boast of their investing prowess to their friends and impress the other sex , mostly women – who from my personal experience,   don’t care about such silly things  J ).

It is fine to put your money in the stock market to feel macho about yourself – but let’s not call that investing. Bungee jumping off a cliff is also done for thrills, but no one calls its investing !

Following the logic

If you agree that the purpose of investing is wealth creation over a long period of time, it is important not only to earn high returns, but to also do it consistently over a period of time. There is no point earning 30%+ returns for four years and then losing 50% in the 5^th (Which will translate into an 8% annual return)

Why is consistency important ? If you can earn 15% consistently for 20 years, you will have 16 times your starting capital and 40 times if the rate rises to 20% per annum. This is simply the magic of compounding.

Now If you shift your focus from high returns (to feel good or boast about it) to consistent returns (to create maximum wealth), the investing approach changes.

Implication of consistent returns

If you are looking for above average, but consistent returns for the long run what should one look for ? If you are looking at earning a 15-20% return over a 10-20 year period , I would suggest looking for companies which are earning this kind of return on capital now and have the capability to do so for a long period of time.

If you can find a company which has a sustainable competitive advantage (sustainable being the key) or a deep and wide moat, then it is likely to maintain its current high return on capital. If you buy such a company at a reasonable price (around the median PE value for the company), the results are likely to be good over time.

Let’s look at an example here – This is a current holding for me and not a stock tip. The name is Crisil.

You can read the analysis here.
Following is a table of price, and annual return/ CAGR for the last 10 years

As you can see, even if you purchased the company on 31^st December each year (blindly without worry about valuation), you would have done well.  This result boils down to the following reason

-   The company has a wide and deep moat in the ratings industry due to government mandated entry barriers (none can just start a ratings agency),  Buyer power (Companies have to pay to get their debt rated and the cost is usually a small percentage of the debt) and lack of substitutes (even banks insist on company ratings now based on RBI directive).
-   The deep and wide moat has enabled the company to maintain a high return on capital of 50%+ for the last 10 years. The company has been able to re-invest a small portion of its profits to fund its growth and has returned the excess capital to shareholders via dividends and buybacks.

A strong competitive position and good management with rational capital allocation approach has resulted in a very good result for the shareholders.

The catch
There always a catch in investing – nothing is as easy as it looks. For starters, this approach requires a huge dose of patience.

How many active investors (me included) would like to select a stock once in a few years and then do absolutely nothing  for a long period of time ? In every other profession, progress is measured by level of activity – except investing, where sometimes doing nothing is much better.

The other catch is that this approach is very boring. You find a few companies like crisil and then spend maybe 1 hr each quarter and a few hours every year end reviewing the progress. If the company is still performing as it always has, you have no further work left. If you are a professional investor, what are you going to do with the rest of your time ??

The last catch is that this approach has a level of survivorship bias. If you select a wrong company or if the competitive advantage is lost during the holding period, then the returns are likely to be poor or even negative.

Returns over entertainment
Although this ‘rip van winkle’ approach makes a lot of sense, I am unlikely to follow it fully. I enjoy the process of investing, looking for new ideas and doing all kinds of experiments. At the same time, a major portion of my portfolio is slowly moving towards such long term ‘wealth creation’ ideas.

In the final analysis, investing should be about wealth creation and achieving your financial goals.

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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.

Business models of Pharma industry

I have written (see here) earlier on the pharma industry in 2005. A few high profile patent challenge losses in 2005 and 2006, brought down the valuations for several companies. My basic thoughts about the industry have not changed

I have been analysing the industry further recently and can see two different business models.

The Domestic market focussed model

Most MNC’s like novartis, merck, pfizer come under this model. The key characterisitics of the model are

1. Subsidiary of a global MNC operating in india for the last few decades
2. The subsidiary operates as an extension of the global company and due to the patent law in the past, has introduced mostly the off-patent drugs.
3. Strong brands, marketing network and good return on capital and strong competitive advantage.
4. Possibility of introducing the drugs from global portfolio. However in some cases the parent company has an unlisted subsidiary and hence treats the listed one as a cash cow. In such cases the market is rightly giving a lower PE multiple due to the poor corporate governance attitude of the parent.
5. Strong cash flows due to minimal R&D and very low assets in the business as most of the manufacturing is sub-contracted.
6. Low growth in domestic market, marked by constant price controls (DPCO and new pharma policy) by the government on various essential drugs. This has resulted in poor topline and bottomline growth for several companies solely dependent on the domestic market.


The International market focussed model

1. This model is followed by the indian pharma companies such as ranbaxy, dr reddy’s, nicholas pharma etc
2. These companies are in the process of globalizing. Their approach to it has been through the drugs which are coming off patent (generics strategy). These companies have built a strong R&D infrastructure in india to develop these drugs coming off patents. They also have a marketing and legal infrastructure in foreign markets to file ANDA and other applications for these drugs as soon as they come off patents. If these companies win these cases, then they get a 180 day exclusive marketing period for these drugs. Post the exclusive period too, these companies are able to maintain good market shares. Thus these companies have created a value chain of R&D labs in india, and a distribution, marketing and legal infrastructure abroad to funnel these new drugs coming off patents.
3. These companies are following riskier strategy as these legal challenges are costly and if the company loses one, the entire money is down the drain.
4. The market was pricing earlier as if each of these ‘bets’ would pay off. However due to some high profile failures in the past, the market has started pricing the risk of the strategy now.
5. Some companies are also acting as outsourcers for the global pharma companies. This is the contract or custom manufacturing business. There a large no. of FDA approved facilities in india ( second largest in the world). Several indian companies now provide advanced manufacturing facitility to global pharma companies and are now doing accquisitions in this space to accquire complementary assets abroad.
6. The third segment of this model is the R&D segment where some of the top companies are now investing heavily in R&D to develop NCE and NDDS. Some of the molecules are now in the stage I and Stage II trials. Some companies such as DRL have licensed these molecules to other companies and they get royalties based on milestones. This is a high risk, high return startegy. However it is likely the larger pharma companies in india could go down this path and emulate their global counterparts.

It is easier to predict the cash flow and valuation of the domestic model as the overall business risk is lower in that model. The international business model has a higher upside, however the valuation seems to reflect that upside in several instances. All these international market focussed model has ‘real options’ embedded in it. However I do not have the skill to do the valuation of these options. It is often difficult to predict which Patent challenges would be successful and which ones will fail

For additional detail on the pharma industry see here. The article is dated, but useful to understand the various terms such as ANDA, Para I,II etc.

There are several good stocks in the pharma industry available at reasonable valuations. I have discussed about merck earlier. In addition I am looking at novartis and alembic too.

Caution : Stocks which i look at generally perform poorly in the short term as they are undervalued. Please do your own research before investing in them.

Classification of companies based on nature of competition

I was reading a book on economics and found the following basic types of competition

- Perfect monopoly
- Oligopoly or duopoly
- Monopolisitic competition
- Perfect competition

I find the above types instructive and a good way to analyse the long term economics of an industry. Let me define the specifics of each type and add a few more subtypes under each

Perfect monoply – As the name suggest, there is just one firm and can charge any price it wants. Obviously this is more in theory than practise, although we have had several monopolies in india till date. Overall monoplies are very profitable (if private) for the investor and bad for the consumer. Several examples come to mind – BSNL, MTNL, Indian airlines (in the past) and now Indian railways. These were (or could have been) extremely profitable (excluding railways) even after all the mismanagement and waste. In a nutshell a perfect monopoly or a close one is extremely profitable for an investor. I would also define a company a monopoly if it has a huge market share in its specific segment and can hold on to it due to some competitive advantage.


Oligopoly or duopoly – A limited number or just two firms in the market. Although not as profitable as a monopoly, I would say these companies are quite profitable and extremely good investments for the long run. Several companies come to mind in this group. For ex : Crisil and other rating agencies, asian paints and other paint companies. One specific point worth noting is that the barrier to entry in this industry are high and hence new entrants cannot enter easily into the industry. As a result the incumbents can earn good profits.

Monopolistic competition – A large number of companies with limited profitability. Barriers to entry are not too high and as a result new companies can enter the industry more easily. I would say most of the commodity companies fall under this group. For ex: cement, steel, Auto, Telecom etc. Few companies in this kind of industry enjoy high profits and generally the lowest cost provider has some kind of competitive advantage. As an investor I would look at companies which have some kind of low cost advantage, some other local or national competitive advantage and a good management. Bad management in such an industry can kill the company.

Perfect competition – A ideal or theorotical construct more than a practical scenario. In such an industry there is no competitive advantage at all, all companies are price takers and they earn only the cost of capital. I would say very few industries would fall in this group. Brokerage firms come close to perfect competition, but still this is more theory than reality.

The way to classify an industry in anyone of the above groups is to look at the following variables
- no of companies in the industry controlling 60-70% of the sales in the industry
- Avg profitability of the companies
- Relative Market share changes between companies over a period of time

By doing the above analysis, one can figure out the level of competition and as a result have a rough idea of the long term economics of the industry.

The above analysis is just a rough guideline or a starting point of a more detailed analysis of the industry and individual companies. However by doing the above assesment, I am able to understand the intensity of competition in an industry over a period of time

Further thoughts on pricing strength of a business

The following question was posed to me by Prem sagar on my previous post. The question made me think and I am posting my thoughts on what I think is a fairly important issue in investing (earlier post on pricing )


But what would u say for an industry like say auto ancillaries or retail-proxies like Bartronics, control print, etc where the opportunity is huge, but they have little or no pricing power?


According to me, pricing is an important variable to evaluate the presence of a competitive advantage or strength. A company with strong pricing power, will be able to sustain high returns for a long time and can increase its intrinsic value over time too. So if one were to buy a company with strong pricing power (with other factors in favour), then it is likely that the investment would work out well with passage of time as the company increases its intrinsic value. So such companies can be long term holdings in a portfolio

That said, it does not mean that companies without pricing power would not be good investments. If one can find a company with low pricing power (commodity business), but with some kind of competitive advantage and selling below its intrinsic value, then such a company can be good investment. I would however not hold such an investment too long, once the stock price is close to the intrinsic value as the likelyhood of an increase in the intrinsic value is less.

I do not have much insight into retail-proxies. However as far as auto-ancillaries are concerned, I have done a bit of analysis ( see here, and here) and have not found too many companies to invest in (mainly due to valuation issues). By the very nature of the industry, these companies have poor pricing power (except for retail), have a few large buyers (OEM) and not many have achieved economies of scale in their operation (this industry is still fairly fragmented). However some auto-ancillaries do posses a few competitive advantages such as a low cost position due to focus on specific segment (fasteners for sundaram clayton?) and good growth opportunities. However as I have written earlier, I would invest in these companies only at a fair discount to intrinsic value and sell once the stock reaches the intrinsic value. I would really not hold the stock for a long term.

Difference between a brand and a franchise

I have always thought that a strong brand equates to a strong franchise (profitable businesses). However over the course of time, I think I have started to understand that both are necessarily not the same

For ex: Brands like Starbucks, Tiffany, coke etc are strong brands and good franchise (earning huge profits for the companies). But at the same time there are strong brands such as Mercedes, Taj (?), titan etc which are not very profitable franchises for their companies.

I am still not absolutely sure of the reason behind it. Maybe each case is different.

Please share your thoughts with me on this

Relationship between PE, ROE and Competitive advantage period (CAP)

I have been working on various permutations of ROE and CAP (period for which the company can earn over cost of capital) using the DCF model to see the PE ratios which are thrown up by the model.

Its fairly intuitive that a company with a high CAP and high ROE should have a high PE. But these permutations have thrown a few insights

• For similar CAP and growth rates a company having an ROE of 20 % should have a PE which is 1.3-1.4 times that of a company with an ROE of 10%. Similar ratios come up for every 10% increase of ROE


• Companies with moderate ROE ( 10-15 %) need CAP of more than 10 years to justify a PE of 20 or higher


• Companies with PE of 30 or higher need a CAP of 10 + years with a growth of 15% and ROE of 25% or higher

So any time I see a company with PE of 20 or higher (which is high these days), the first question I ask is – Given the ROE of the company, does the company have substantial duration of CAP ( 10 years or higher ).

A company with a PE of 30 or higher must have a great return on capital, very strong growth and 10 years or higher CAP. A point worth thinking about when looking at such high valuation companies.

This way of think is detailed in the book ‘expectations investing’ by micheal maubossin and is definitely worth a read.

Pricing strenght - A key indicator of competitive advantage

I was reading an interview of warren buffett a few days back. He was asked on what kind of businesses he prefers. His replied the ones where he can increase the price of the product ahead of inflation (he gave the example of see's candies ). He also noted that one should avoid businesses where one has to pray before increasing the price by one cent (he gave the example of berskhire hathway - the textile company where they found it diffcult to increase prices )

The above comment got me thinking. Pricing strength of a business is a very powerful indicator of competitive advantage enjoyed by the business. Think of FMCG companies like HLL, P&G, marico . These companies have been able to increase their prices (although that ability has come down in recent past due to higher competition ). On the other end companies like steel , cement typically can increase prices only when there is supply shortage (which is only for a limited period of time)

I have found the above way of looking at a business a very powerful tool of checking if a business has enduring competitive advantage.

How about telecom companies or IT services companies ...their pricing ability does throws up interesting insights ..although i have not been able to come to a conclusion

Measuring the moat - framework for evaluating competitive advantage

found this article on Michael Mauboussin's website. Absolutely fantastic article. Extremely helpful in developing a framework for evaluating a companies competitive advantage.
http://www.capatcolumbia.com/Articles/measuringthemoat.pdf

In addition , micheal has published this new article on the legg mason website. A must read !!

http://www.leggmason.com/funds/knowledge/mauboussin/Aver_and_Aversion.pdf

Distinguishing between a commodity business and franchise

One of the analysis i have been doing for some time is to analyse various industries like cement, steel, media, gas , FMCG etc and try to asess their competitive scenario. The reason for doing this analysis is to gain a better understanding of these industries, compare them with each other and also to develop some kind of models / categorisations.

One of the frustations i have felt , is the lack of litreature on the various types of business models. The typical one that get discussed are the ideal franchise like business models like coke ( at global level ) or nestle, asian paints, HLL etc at an indian level. The other extreme are the absolute commodity type businesses like airlines, steel ( i agree that within these commodity type business there are some value creating companies).

But there are businesses out there, which lie between the two extremes. For example auto components, power , banks, branded textiles etc. I am trying to analyse these various industries on porter's five factor model and other variables so that i can conceptually think about a business and assign it to a model (not the best approach, but makes it easier to analyse a company and gives a starting point

While i was doing this, yesterday, i came across one such exercise being done ( http://pink-sheets.blogspot.com/ <http://pink-sheets.blogspot.com/> ). Should be helpful to me in my exercise