Ranking of Business Models for Investing Success | Part 1

Ashish Kila, a distinguished finance professional, serves as the Chief Investment Officer (CIO) and Director at Perfect Group. With a robust background in investment banking, having worked with prestigious firms like Goldman Sachs and Morgan Stanley, Kila is renowned for his expertise in value investing and entrepreneurship. A sought-after speaker, he frequently addresses prominent institutions such as the Indian Institutes of Management (IIMs) and the Indian School of Business (ISB). Through these platforms, he shares valuable insights into investment strategies, productivity, and financial discipline. His contributions extend to media platforms like NewsX and Bloomberg Quint and publications such as Business Standard and Money Today.

In his presentation, ‘Ranking of Business Models,’ delivered to CFA Society India, Kila explores different types of business models and emphasizes their ranking's importance for stock selection and portfolio allocation. The examples cited are purely illustrative and do not constitute recommendations.

The blog is divided into two parts, each focused on essential components of a successful investment strategy. Part One discusses the importance of cloning successful business models and the use of checklists to evaluate potential investments. It highlights the value of learning from the strategies of other successful entrepreneurs, especially in emerging markets like India, and emphasizes the role of structured checklists in filtering out unsuitable investments by focusing on key attributes such as management quality, scalability, and industry structure. Part Two, on the other hand, shifts its focus to capital allocation and portfolio management. It delves into how investors can strategically allocate capital based on factors like company valuations, annuity-like revenue models, and pricing power. The section further explores the importance of position sizing and trimming holdings when necessary, offering insights on how to balance risk and reward in a well-constructed portfolio. It concludes with the principle that an investor should only sell a position when there is fundamental deterioration in the business, thereby ensuring the portfolio remains strong and aligned with long-term goals.

Let’s dive into Part One!

Why Rank Business Models?

Traditional investment frameworks primarily focus on avoiding errors of omission but often neglect to address errors of commission. Investors frequently regret not buying—or not buying enough of—high-performing companies, only to watch them generate exceptional returns. Both winning big and avoiding losses are essential for sustained investment success. Ranking business models aids in identifying and prioritizing opportunities, thus enhancing decision-making.

Most investors don’t rank or compare business models across industries, believing that the idea is akin to comparing apples to oranges. However, as apples and oranges still compete with each other to be purchased, so do businesses. All businesses compete with each other for an investor’s money and time, and therefore must be compared.

The 4C’s of Investing

Cloning – Following Role Models

Role models play a crucial role in shaping investment philosophies, yet their approaches can vary significantly. For instance, Walter Schloss was renowned for his strategy of maintaining highly diversified portfolios, while other investors prefer a more concentrated approach. Howard Marks advocates aligning with market trends, whereas Nick Train emphasizes a long-term perspective, rendering short-term market fluctuations less significant. These diverse methodologies employed by some of the world’s leading investors underscore that there is no universally correct strategy. There are countless ways to achieve success in the stock market, and it is essential for investors to select an approach that resonates with their individual style rather than attempting to amalgamate various strategies, which can lead to confusion.

Investors must also be on the lookout for entrepreneurs in India who have cloned successful businesses from other geographies. Given that India is, at the very least, a few years behind developed markets in terms of adoption, there are ample opportunities for Indian entrepreneurs to start businesses that closely resemble the best businesses in developed markets. In such cases, investors can gauge the opportunities these investments may offer based on the visible success of similar ventures elsewhere.

This strategy, however, is not without limitations. Cloning someone’s approach means being exposed not only to the archetype’s wins but also to their losses. Typically, cloning someone’s top ideas—identified by allocation size—is better than blindly copying all their ideas. However, obtaining such information may be challenging. Additionally, cloners are subject to authority bias, often substituting their own reasoning with the decisions of the archetype.

Checklist

The main problem with bottom-up research is that too many companies are evaluated that do not fit an investor’s investment criteria. The question of the quality of evaluation is secondary to the question of what should be evaluated, in the interest of time and productivity. Checklists serve as important elimination tools, as they increase the probability that an investor is exposed to suitable investments. A good checklist includes categories such as (a) management quality, (b) business longevity, (c) lack of structural headwinds, (d) scalability, and (e) favourable industry structure.

1. Management – Integrity, Intelligence, and Energy

The quality of a company's management plays a pivotal role in its long-term success, and three traits—integrity, intelligence, and energy—are often considered indispensable for effective leadership.

Integrity

Integrity can be measured through the absence of corporate governance issues. First, companies or promoters found guilty of fraud or deliberate violation of laws must be avoided. Second, owners and managers should be evaluated on the culture they have built to empower individuals for the benefit of the business. Third, the intent of the owners and managers must be understood. A lack of alignment with minority shareholders can lead to capital allocation issues, as owners may prioritize suboptimal investments over cash distributions or siphon cash through means such as royalty agreements, capital expenditures, or acquisitions. This is especially concerning when promoter shareholding is low.

Wealth creation over long time frames is another key indicator; its absence could signal poor behaviour. Investors should also be wary of high promoter pledges, as a single down cycle could lead to the promoter's stake being offloaded, creating challenges for minority shareholders.

Intelligence

Intelligence in management is primarily about capital allocation. A company’s first priority should always be internal growth, considering alternatives only when all organic growth possibilities have been exhausted. If the stock is undervalued, the company should consider repurchasing its shares. Failing that, it should explore inorganic growth opportunities or return capital to shareholders. Mediocre or less intelligent managements often pursue acquisitions or unrelated growth avenues even when better organic opportunities exist.

Energy

Energetic management teams execute plans more effectively than competitors and often develop competitive advantages, even in industries where such advantages are rare. While the strategies of these businesses may not be difficult to copy, consistent high-quality execution over long periods creates significant divergence in results.

2. Longevity – Requirement, Medium, and Players

The question of longevity can be illustrated through the example of navigation. Traveling to a new location requires navigation. Historically, physical maps dominated the navigation market, with players like Lovell Johns leading the industry. Over time, as technology advanced, the problem was addressed by GPS devices such as Garmin and TomTom. More recently, digital maps, integrated into devices and applications like Google Maps, have taken over.

This example demonstrates that while the requirement for navigation has remained constant, the medium has undergone significant changes, leading to shifts in dominant players. Put differently, changes in the medium pose a mortality risk even to well-managed businesses. While good businesses can handle competition, new technologies offering dramatically better solutions often render existing alternatives obsolete.

A similar case can be seen in the substitution of radio by platforms like YouTube, JioSaavn, and Spotify for music streaming, as well as news applications for information dissemination.
Because of these risks, investors must remain vigilant for emerging mediums that can disrupt the underlying medium of their investments.

3. No Structural Headwinds – Swimming with the Tide

Longevity concerns permanent shifts whereas structural headwinds refer to partial shifts in the medium.

The film industry offers a clear example. Historically serviced by theatres, the industry now faces headwinds from streaming services such as Netflix and Amazon Prime, which provide on-demand access to movies at low costs. While streaming services are not perfect substitutes for theatres—streaming platforms offer a content library of prior releases, whereas theatres focus on new releases—they represent structural headwinds. This is because streaming services inevitably capture more time and attention at the expense of theatres.

4. Scalability

Scalability is a function of sustainable competitive advantages. Competitive advantages enable a company to earn sufficient profits for growth while simultaneously protecting its existing business from potential damage.

Small Fishes in Big Ponds

The size of a fish matters only in relation to the pond it inhabits. Similarly, the overall market capitalization of a company is less important than its market capitalization relative to the addressable market. For instance, a jewellery player like Titan has a high market capitalization but remains small compared to the overall market size, suggesting significant room for growth. Conversely, a player like Maruti Suzuki has a large market share in the mature passenger vehicle market, limiting its ability to grow at a high rate.

Network Effects

The strength of network effects depends on the degree of usage and the associated switching costs.

The weakest network effects occur when lifetime usage of a network is low, such as on matrimonial sites. A step above this is a ride-booking model, though switching costs remain low as users can easily move between providers. In such cases, players can create local monopolies by consolidating their position in specific geographies, thereby reducing switching costs for users. The strongest network effects are found in social media platforms. These networks benefit from exponential value increases as their size grows, with international networks being far more valuable than national ones. Additionally, user engagement drives content creation, allowing these companies to avoid direct spending on engagement.

Intangible Assets

Intangible assets like brands are proprietary and difficult to replicate. A brand becomes synonymous with certain attributes that distinguish it from competitors. For example, Titan’s strong reputation for trust in its product quality is a significant intangible asset, allowing it to attract and retain customers, often at the expense of competitors. Similarly, Maggi and Coca-Cola have cultivated a "sticky" association in consumers’ minds, making them challenging to displace in the market.

Low-Cost Advantages

Not all low-cost advantages are created equal. Low costs are most advantageous in industries where products are standardized, and lower prices do not signal inferior quality. Additionally, the absence of competitors willing to burn cash for growth strengthens a low-cost strategy. For example, D-Mart enjoys a robust low-cost advantage because it deals in standardized products where lower prices are perceived positively. In contrast, a diagnostic service provider may not enjoy the same benefit, as consumers often associate higher prices with better quality and may avoid low-cost providers. Furthermore, in B2B sectors, the presence of competitors willing to operate at a loss undermines the low-cost advantage.

Switching Costs

High switching costs are crucial for growth. When switching costs are low, newly acquired business can be easily lost, and the same applies to retaining existing customers. In industries with low barriers to entry and limited product differentiation, switching costs tend to be high.

B2B businesses like auto ancillaries benefit from high switching costs due to the lengthy approval cycles required for new suppliers. Existing suppliers can expand their product offerings with less risk of losing business to new entrants, creating a significant competitive edge.

5. Favourable Industry Structure

A favourable industry structure is characterized by a small number of players, where a few hold distinct competitive advantages over others. Inherent disadvantages faced by competitors allow certain companies to capture disproportionate market share and growth, often coupled with strong profitability.

The Indian airline industry serves as an example. With the exception of Indigo, most players have struggled to achieve sustained profitability or significant market share. This imbalance creates an environment where Indigo enjoys a disproportionately favourable position in the industry.