How Are You Sleeping?

Summary: Investing is a personal activity. Hence the approach to investing also has to be a very personal activity. One has to investigate a company according to how one views life w.r.t. its important and unimportant aspects.  

Imagine you run a small manufacturing unit in Central India. What scares you most? Is it that you will be unable to withstand the competition from a major player in the industry/region? Is it that you know that if the prices of raw materials increase then you will not be able to pass that on to your customer? Or is it that there is a local trade union forming that will make your workers “gang up” on you? Or is it that you know that 80% of your turnover comes from one customer? Or is it that this customer is having its own survival issues?

Probably, the answer is all of them.

Now assume that you are the same owner of the same unit, but now this unit was inherited by you from your father who inherited it from his old man who set it up in 1967. Isn’t it a slightly better world you are living in? You now know that there have been at least two or three times that your unit has come close to bankruptcy. You know that despite this you have your own network of lenders and suppliers you can rely on and that they will help you in time of need. You know your unit has a reputation in the labor market for its set of policies. Your customers know and abide by your credit policy. Basically, unless the very business you belong to is disappearing, you don’t have to fight for survival on a daily basis.

Darwin was right. It is survival of the fittest out there.

As an investor one has to find out the companies Darwin would admire if he were an investor. I believe one can do so easily if one knows what it takes to survive in an ecosystem. Even though the precise answers will differ depending on the ecosystem we are talking about, I believe we can learn from nature itself to come up with the following broad set of 6 themes to gauge the health of a company.

  • Longevity of life in the jungle: The longer an organization has been public, the longer it is certain that its balance sheets have been vetted and scrutinized by the professionals. All the attempts by the company to make it look healthier than it is (extra ordinary income, inconsistent accounting policies etc) are visible to the professionals and the company has earned an appropriate reputation for it.
  • Position in the food chain: The bigger the role a company lays is in its chosen ecosystem, the more resilient it should be to unwanted changes. Unless the whole ecosystem is under danger, it could be said that this company is here to stay. For e.g., One can say that relatively bigger movie production houses are more resilient as compared to upcoming independent production houses, even though they are a part of fast growing Indian movie industry. But one cannot be so confident about the bigger players in the Indian Music industry as music industry itself is reeling under pressure from increased piracy/P2P sharing.
  • Amount of food and amount of flab:  When was the last time we thought of a successful animal and then found out it was fat. Ok, ignore the Elephant (no natural predator)… or the Whale(no natural predator).. and the panda (who sleeps all the time)…. and the polar bear (who sleeps for entire winter)…Seriously there is no one else! Similarly, a company should be a) able to find food easily and b) do something with the energy obtained from that food. To me, that translates into how easily it does business in its chosen area and what it does with the profits. A company that makes money easily and has proven that it does with that money what it precisely should (invest in business or give back to share holders or maintain reserves or make profitable investments or invest in R&D etc…) is better than a company that does one of these two well but falters in the other.
  • Who Controls Whom: Dogs thrive in the city when they are domesticated where as domesticated wolves get slaughtered in the jungle. Same way, type of ownership of a company makes or breaks a company. Even if one does not know how to gauge the quality of management, which is the case with most of us, it can be said that too much power concentrated in the hands of a few cannot be good; at least in most cases.  That is why one needs to look for a balanced ownership structure so that if the company is not doing well, it can be easily bought by someone else if there is a business case for the same.
  • The fittest part: Being physically and mentally fit is ok, but being fittest is the key. A company that has the fittest balance sheet, the juiciest cash flow and a winning track record is in best position to meet the upcoming challenges.
  • Evolution: Like in nature, companies evolve. One has to look at what the company has evolved into throughout its history and how will it evolve further, if it has to. Any company that is capable of evolving (as demonstrated by its history), if needed, is a company that can be considered as a viable alternative. In its most basic way, the concept of evolution can be related to how the companies manage their competitive advantage. A company with better competitive advantage is able to obtain a higher return on equity.  Conversely, a company that has consistently given high returns on equity, can be assumed to be a company that is evolving appropriately to meet its business challenges .

Personally, I give the most weight to above themes. In terms of conditions, they translate into the following:

1)        Always Believe You Are The Animal: To think like an animal, one has to behave like an animal. So to gauge if the company is getting being run properly, one has to believe that one genuinely owns part of a business when one becomes a shareholder. That makes us appreciate strengths more and weaknesses even more.

2)       Date Of Incorporation: I argue that if a company has been in the stock market at least 10 years, then it has survived all the vagaries of business. It is poised to live longer and learn quicker. Some may say that the cutoff should be higher and I cannot disagree with that. To each his own! All I can say that one carries a good margin of safety w.r.t. encountering fudged balance sheets if one knows that the company has been in business for a long time.

3)       Size Of The Company:  Bigger companies are more resilient. In order to get an estimate of size, one needs to look at the business the company operates in and how the company stacks up w.r.t. competition. The benchmarks have to be stricter for companies in mature businesses and slightly lenient for companies in growing or predominantly unorganized businesses.

4)       Free Cash flows: Abundance of free cash flows to owners on a consistent basis means that the company has confidently discovered at least one way to make money and that method is sustainable and replicable. Apart from that, how much of the money is getting distributed back to the shareholders and how much is  used to fuel new opportunities gives an indication of where the priorities of the company lie.

5)       Ownership Structure: I argue that if the promoters have anything over 60% ownership then it is really important on the existing management to produce consistently good results.  It is because at such high ownership levels it is very difficult for someone else to take the business over in case of poor results, and improve upon it. So unless the management produces exceptionally good results, it is not advisable to trust such companies.

6)       Fiscal Condition – Fittest Or Fattest Or Thinnest?: Remember, whatever a company makes, it 1st owes it to its lenders.  Also, we should always remember that in case the company is sold tomorrow, making money by selling fixed assets is going to be trickiest. In order to get around these problems, I believe I can look at some balance sheet items on a consistent basis to answer the following questions:

  1. How much income is left after paying off lenders?: I look at Interest coverage.
  2. How much of total liabilities can be paid off by only current liabilities?: Look at Total Liabilities Vs. current assets
  3. How much of current liabilities can be paid off by current assets?: Look at current liabilities vs current assets.

7)       Return on Equity: The whole idea of being able to evolve is related to whether the company is able to give superior return on on its equity investments or not. If a company does not do so, it becomes larger but not valuable.

Above are a broad set of themes I ALWAYS look at while observing companies. The specific application of these themes depends on the business (and not the company) we are observing. I will detail each theme in separate articles, but as of now I argue that one cannot go wrong most of the times when concentrating exclusively on these themes.

In the beginning of the article, we wondered about what a small business owner will worry about. I now say that every one worries about the same stuff, only that some can afford to sleep tight where as some have to sleep light.

The Thing About Forward Earnings!

Each day when we read about P/E multiples we get to hear that the market is trading on X times its forward earnings. Essentially, the market analysts believe that they can easily predict the next year’s earnings and so they speculate on the price the stock will command a year hence. It’s easy to bet if you don’t play with your own money! I agree that financial theory talks about growth as a function of reinvestment and return on equity and there is near conclusive evidence that it is indeed the case.  However, all of us know that we cannot even predict our own salary for next year even if we know our present year’s appraisal results and our employer’s present quarter’s performance. Moreover, if all the predictions are so conclusive then it must mean that the fluctuations in the market price happens a) because of factors that are absolutely unknown to nearly everyone in the market or b) because the analysts are not doing such a great job of projecting growth numbers in the first place. In any case, I conclude that the forward earnings cannot be relied upon.

That is why I do not give much weightage to growth. I believe that since it is all about survival, a company that has to grow will grow within its ecosystem. To borrow from the earlier idea of sleeping well, it is said that if you want to have a good day in office then you have to sleep peacefully the previous night. I argue that the ones who are capable of sleeping well tonight are the ones will have a good day in office the next day. All I have to worry is whether the ecosystem as a whole is allowing you to sleep or not!

Sleep well… Sleep Tight…