Ranking of Business Models for Investing Success | Part 2

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 Two!

Capital Allocation

Not all opportunities are created equal. Checklists help investors select companies based on their upside potential, while capital allocation focuses on sizing positions based on potential downside risk. Larger position sizes are reserved for companies with desirable features such as (a) low valuation, (b) annuity-like business models, (c) switching costs, (d) optionality, (e) sidecar investing, and (f) the ability to capture dominant market share.

The more numerous and intense these favourable traits, the higher the allocation such companies deserve. Position sizing serves as the primary driver of portfolio returns, ensuring that the best opportunities are appropriately emphasized to optimize outcomes.

1. Valuations

Investors can use a Reverse Discounted Cash Flow (DCF) analysis to test the plausibility of growth assumptions. A Reverse DCF is a valuation method that determines the implied assumptions about a company’s future growth rate or the market’s required rate of return, based on its current price or valuation. Unlike a traditional DCF, which calculates intrinsic value based on projected future cash flows and a discount rate, a Reverse DCF works backward. It starts with the current market price (either stock price or enterprise value) and deduces the growth or cash flow assumptions necessary to justify that price.

The lower the market’s growth expectations relative to the investor’s own expectations, the higher the allocation that investment deserves.

2. Annuity Revenues

Business models can be ranked based on the presence of annuity-like revenues and market share dynamics:

Low Rank: Non-Annuity, High Market Share

Businesses with non-annuity revenue models and high market share rank lowest. These businesses lack recurring yearly revenues and may also have limited growth potential due to market saturation. Examples include Maruti Suzuki and Royal Enfield, which dominate their respective automotive segments but do not exhibit high growth prospects.

Moderate Rank: Non-Annuity, Low Market Share

Businesses with non-annuity revenue models but lower market shares are more attractive. Although these businesses lack recurring revenues, they offer significant growth potential. For example, Godrej Properties and Titan operate in industries where they can expand their market presence substantially over time.

High Rank: Annuity-like Revenue and Cross-Selling Potential

The highest-ranked business models combine annuity-like revenue streams with the ability to cross-sell products to their customers. A company like Nestlé, for instance, benefits from frequent consumption of products like Maggi, creating an annuity-like revenue structure. Additionally, Nestlé has a broad portfolio of brands that can be introduced to new markets, driving further growth.

In comparison, Colgate also enjoys annuity-like revenues from repeat purchases but lacks a sufficiently diverse brand portfolio to drive extensive cross-selling opportunities. Similarly, Zomato benefits from high repeat business and has the potential to cross-sell services, placing it among high-ranking business models.

3. High Switching Costs / Pricing Power

Businesses with low switching costs rank lower as their customers are not captive and can easily switch providers for marginal gains. This dynamic is evident in regional banks, such as DCB, where a customer might switch to another bank offering a loan at a slightly lower interest rate. Such businesses operate in highly competitive environments where products are largely commoditized.

On the other end of the spectrum are businesses with sufficiently high switching costs and significant pricing power, such as Info Edge and Godrej Properties. For instance, Naukri.com, owned by Info Edge, exhibits substantial pricing power. Despite being priced at a premium compared to other job data providers, it is the preferred choice for human resources teams due to its vast database and user familiarity. The value of securing even a single quality hire outweighs the cost of the service. Similarly, Godrej Properties commands a premium in real estate due to its brand reputation. Buyers often prefer the reliability of a large, branded player over the risks of delays and defaults associated with smaller, unbranded competitors.

4. Optionality

Optionality refers to making small investments where many may fail, but the success of a few can outweigh the losses. Essentially, it mirrors a venture capital model. Info Edge exemplifies optionality through its investments in various startups, most notably Zomato and PB Fintech, which have become multibillion-dollar successes. The failures of numerous other ventures are inconsequential compared to the wealth generated by these standout investments.

In contrast, Jio, Reliance Industries' telecom business, does not represent optionality. Reliance's future is heavily tied to Jio's success, meaning its failure would have a significant and lasting impact on the parent company. True optionality involves making a series of small, diversified bets, whereas Reliance has pursued a few concentrated investments.

5. Sidecar Investing

Sidecar investing is a strategic approach where a company acquires or takes a significant stake in another business but refrains from managing its day-to-day operations. This style prevents dilution of management bandwidth, allowing the acquired business's team to operate autonomously while the parent company focuses on capital allocation. This strategy has contributed to Berkshire Hathaway's acquisition success, as research shows that most acquisitions fail. Diversified acquisitions often struggle due to management teams misapplying expertise across industries, but sidecar investing ensures that competent management remains responsible for operational decisions.

The lowest rank is assigned to companies like Motherson Sumi Systems, Piramal, and Suprajit, which acquire businesses and replace management, albeit within the same industry. This approach can stretch management bandwidth. A higher rank is given to businesses like Thomas Cook, Quess Corp, and TeamLease, which retain the acquired company's management but leverage cross-selling opportunities. The highest rank goes to sidecar investors like Info Edge, which allow investee companies to retain full operational control, minimizing the strain on management bandwidth.

6. Market Domination

Market domination is crucial for businesses aiming to achieve superior returns and create wealth for their investors. Dominant companies face limited competitive threats and reduced pressure within the value chain, leading to robust business models. However, the real opportunity lies in identifying companies with the potential to dominate their markets rather than those that are already dominant.

Investors should understand that not every company will exhibit all the desirable attributes discussed. However, this does not mean such companies should be avoided. These attributes should guide position sizing, while the checklist serves as the definitive tool for determining whether a company is investable.

Checkout – Trimming & Selling

A well-constructed portfolio of companies with favourable attributes should not be sold purely on the basis of valuation. Instead, investors often have the option of trimming positions to make room for new investments. Companies that have been part of a portfolio for a substantial period are typically well understood by the investor, who has observed their performance through various cycles and has insight into how the management behaves in different situations. New investments, by contrast, often lack the same level of familiarity. Trimming, therefore, can serve as a prudent alternative to entirely selling positions. High-quality companies at attractive prices are rare, and investors should exercise caution before exiting such holdings.

However, a full sale is warranted in the case of fundamental deterioration in the business. A loss of confidence in critical factors such as management quality, integrity, execution capabilities, or capital allocation decisions often necessitates a complete exit from the position.

Conclusion

Successful investing requires a deep understanding of the companies within a portfolio and a disciplined approach to capital allocation. By focusing on key attributes such as management quality, business longevity, scalability, and a favourable industry structure, investors can identify businesses with strong long-term potential. Tools like reverse DCF analyses, and a keen understanding of competitive advantages—such as switching costs, network effects, and optionality—serve to refine the investment process and guide decisions on position sizing.

Furthermore, the dynamic nature of markets means that new opportunities will inevitably arise, and some positions will need to be trimmed or sold to make room for better prospects. While trimming positions can provide a balanced approach to portfolio management, selling should only occur when there is clear evidence of fundamental deterioration—whether in management, execution, or capital allocation.

Ultimately, building a portfolio with a clear set of guiding principles, focusing on companies that are well-positioned to dominate their markets, and continuously reassessing the potential of each investment will allow investors to optimize returns over time. While no single strategy guarantees success, those who can consistently identify favourable traits in businesses and maintain a disciplined, long-term approach will be better positioned to navigate the complexities of investing.