Stock Shastra#1: Stock Investing is not Rocket Science.

Stock Shastra #2 – Buy a wonderful business and not just a stock!

We said in Stock Shastra #1 that Investing in stocks is not rocket science, not as difficult as it has been made out to be. You don't need to be an expert to do it. You just need to buy a great business with the mindset of an owner. Let's see why this is important and how you can find this kind of business.

Why do you need to buy a great business?

If you are currently investing in stocks, what is the method you use to select stocks? Is it low P/E, low Price/Book Value, High Dividend yield? Or is it based on charts showing peculiar patterns? These methods are completely inadequate because they over-simplify your investing method. They don't tell you about the earning capacity of a company – the key driver of its stock price in the long term. They may lead you to take a wrong decision. It's much like the story of three blind men who encounter an elephant for the first time and attempt to learn about it by touch alone. The first touches the trunk and thinks the elephant is like a snake; the second touches the ear and thinks the animal is like a fan while the third touches the leg and thinks it is like a tree.

So, what is the best way to avoid making this mistake of over-simplification and at the same time, have a simple but robust way of investing in stocks? The answer is Stock Shastra #2: Buy a wonderful business and not just a stock. The fact is that, in the short run, market sentiments drive the stock prices due to which any stock can go up or down, no matter whether it is wonderful or not. But in the long run the price of any stock is driven by the company's ability to earn profits consistently.  As Benjamin Graham says,

And a company can earn profits consistently only if it has a wonderful business!

How do you find a wonderful business?

A wonderful business is one which has done well and will continue to grow in the future. It mainly has three characteristics:

1. An Excellent Financial Track Record
2. A Sustainable Moat, and
3. Respectable Management

An excellent track record is proof of its successful past whereas a sustainable moat and respectable management will drive the growth in the future. Hence, to find such a wonderful business you need to look for these things.

To find whether a company has an excellent financial track record, you need to see whether it has performed very well over atleast the past 10 years. Why 10 years? Because, over a 10-year period, the company is likely to have experienced one full economic cycle: good & bad times; growth and recession. A business does not do well over a 10—year period just by accident! A question may arise in your mind: Are we saying past performance is a guarantee of future performance? No. But past performance and past behaviour of management give enough clues for the future.

A company which has performed well over a 10-year period will most likely have a moat. A moat is a strong competitive advantage that helps the company survive in tough times and helps earn consistent profits. Consider the example of Colgate. Its moat is its brand, which is known all over the country.

What if a company has an excellent track record, a strong moat but has management who was arrested for a FERA/Excise Duty violation? Would you invest in such a company? The business must have a good, credible leader and management who drive the growth of the company.

Having shortlisted a company that has good financial track record, a strong, sustainable moat and good management, you are on course to find a company that has a high probability of performing well in the future.

The next Stock Shastra will talk about a simple and powerful lens through which we can identify if a business has an excellent financial track record.

Stock Shastra #3: You just need to look at 6 Financial Parameters to shortlist a wonderful company!

We said in Stock Shastra #2 that a wonderful business worth investing in has 3 important characteristics: An Excellent Financial Track Record, A Sustainable Moat and Respectable Management. The first one – An Excellent Financial Track record – is a Go/No-go criterion and hence is critical. It will prevent you from investing in the wrong companies and losing money.

So, what comes to your mind when we talk about company financials?

A big, fat, 100-page Annual Report with reams of data that leave most of us confused!  It seems too difficult, too complex, needing too much time – which you don’t have! However, truth is always simple. Let us now see a simple and powerful lens through which we can identify companies with an Excellent Financial Track record. The answer is Stock Shastra #3:  You just need to look at 6 Financial Parameters to shortlist a wonderful company!

From all the 100+ parameters, all you need are just 5 of them! Earnings per share (EPS); Net operating cash flow; Net Sales; Book Value per share (BVPS); Return on Invested Capital (ROIC); and, Debt-to-Net Profit ratio. Seen together and over 10 years these 6 reveal the truth. Let’s see how!

The truth-revealing 6 Financial parameters

What is the first thing that you will look for in a company before investing? You will check whether it is making Profits, consistently! Since we will be shareholders, we need to look at the profit it earns per share. Hence the first parameter to look for is EPS – Earnings per Share.

However, it is said ‘Cash is king’. Hence, to verify that profits earned by the company are leading to an inflow of cash, you have to look at the second parameter that is, operating cash flows. Net Operating cash flow is the actual cash generated by a company from its business. If a company cannot generate adequate operating cash flow, it may need to rely on outside funding to meet its financial obligations and even to run the day-to-day operations

Now, how can a company continue to earn profits year after year? By selling more and more every year. Hence, the third parameter to look for is Net Sales.

To increase its sales in the long run, a company will need to expand its capacity. Book Value per Share, BVPS tells us how much a company is investing in expanding its capacity. That’s the fourth parameter.

Companies in the most basic sense are money-using and money-making machines.  How do we rate a machine? Simple, we look at what it produces in relation to what it uses i.e. efficiency. Companies produce profits using the capital invested (both equity and debt). Hence to know the efficiency with which a company uses its capital, we need to look at Return on Invested Capital (ROIC). That’s the fifth parameter

Finally, if a company borrows money, it should be able to repay it without serious difficulty over a reasonable period of time. Debt-to-Net Profit ratio tells us the number of years in which the company will be able to repay the debt. Hence the sixth parameter to look for is its Debt-to-Net Profit Ratio.

Apart from these, you can also look at the company’s past performance with regards to its profit margins (OPM & NPM), Return on Equity (ROE), Debt/Equity ratio and the working capital management. These will help you guage the profitability and efficiency of the company.

How can you be absolutely sure if a company’s financial track record is great or not?

We have checked over 1500 companies and arrived at a gold standard that only the best meet: A company that has been growing its EPS, Net Sales and BVPS by 12%+ year-on-year; has a ROIC of over 12% every year; and can pay off its debt in less than 3 years i.e. a Debt-to-Net Profit ratio of 3 or less – has a great Financial Track Record. Companies meeting this gold standard are wonderful companies worth short listing.

Such companies are quite likely to have a moat – a sustainable competitive advantage, which has allowed it to post great numbers. So, now you know how important these 6 parameters are!

We are sure your next question now is ‘Where do I get these 6 Financial Parameters, without wasting any time?’ It was ours too earlier. So we searched high and low and found that it was not available anywhere. And, we chose the road less travelled – we decided to make it available These crucial 6 parameters, over 10 years are now available as a simple and powerful 10 YEAR X-RAY at MoneyWorks4me.com

Write to us for any clarifications. We will be glad to be of help

The next Stock Shastra will outline the importance of sustainable competitive advantage, i.e. moat, for any business.  See you soon with Stock Shastra #4….

Stock Shastra #4: Look for companies with unbreachable moats

We said in Stock Shastra #3 that you need to look at only 5 financial parameters over a 10-year period to shortlist a wonderful company. Once you have identified such a company, you need to determine whether the company has what it takes to remain a winner in the future. So, how do we do this? The answer is Stock Shastra #4:  Look for companies with Unbreachable Moats.

What is a moat?

In olden days, a castle was protected by the moat, a wide channel that was dug around it and filled with water. The wider the moat, the more difficult it was for enemies to enter and capture the castle. For us, the castle is the company we want to invest in. And, the moat is: A sustainable competitive advantage which protects the company from competition and tough economic conditions. Now you know why we use a rarely used word like moat!

So, why is it important to look for a moat?

As discussed in the earlier shastras, a company worthy of our investment must be able to grow its profits consistently, despite competition and tough economic conditions. We emphasize on competition and tough economic conditions because every company has competitors and sooner or later faces tough conditions. During such times, companies fight harder to win customers which usually leads to a fall in prices and thus margins. Only a company with a wide, unbreachable moat – a competitive edge – can maintain and grow its profits even during tough economic conditions. As Warren Buffet said,

What are the moats that can stand the test of time?

While all this may sound a little conceptual to some of you, moats in business are really easy to understand, because it is common-sense. Check out these 5 types of moats!

If you had to buy toothpaste, which name comes to your mind? Most of us would think of Colgate and many of us would buy it. Why? Because this is a name many in India have come to trust over the years. It is quite easy to make toothpaste, maybe even better than Colgate, but without the Colgate brand name, you will sell very little in India. This is the power of the Brand – the first moat. A strong brand helps a business to command a large market share and higher prices, and makes it very difficult for competition to grow.

Wouldn’t we love to own a company that was the only one who could manufacture a particular product and had no direct competition? That is exactly what happens if a company has a patent or a trade secret – the second moat. The most common examples: Pharma companies with patents and food and beverages companies with unique and usually patented recipes like Coca Cola and McDonald’s fries (which are made from specially grown potatoes!).

We travel between cities quite frequently and we always use the expressways/highways, paying a toll. Though the old highways have improved from earlier times, we have never used them since the time the new expressways were inaugurated. The wide empty roads, the time saved and the hassle free driving make the expressway easily the only way to travel between these two cities. Wouldn’t you love to own such a business, that makes money every time someone uses it and people really have no option but to use it. Some companies have exclusive control over particular areas. That gives them the ability to collect a toll – the third moat. For example: If you want to advertise a product in South India on a television network, you would have no real option but to advertise on Sun TV, because of the very high viewership it commands.

We are all creatures of habit. We do not like to change, especially if the change requires a little bit of effort. The fourth moat that a company can have is based on this and is called Switching.  It means a company has a product or service you are so used to, that changing or switching it is either very difficult or not worth it. The most common example of this is Microsoft Windows. We are so used to it, that changing to say Linux is not worth it – even though it is free and offers certain advantages over Windows. IT Companies like Infosys and TCS get around 90% of their business from repeat clientele because of this very moat.

One of the biggest factors on which companies compete is price – the fifth moat. A company which can price its products really low and still make a profit makes it difficult for anyone to compete with it. Consider Future Retail Ltd., which operates in value retailing through Big Bazaar hypermarkets, Food Bazaars and other delivery formats . Its strong retail network and a value retailing format combined with it’s massive scale of operations enables it to offer heavy discounts on products.

So, the five types of moats that a company can have, that can stand the test of time are Brand, Secret, Toll, Switching and Price.

A company can also have other moats like network effects, distribution network, etc.

So, how do you find such a company?

A company which has an excellent financial track record will most likely have at least one moat. Companies without a moat will not usually pass the gold standard of an excellent Financial Track Record, about which you have read in Stock Shastra #3. What we need to check is whether this moat is sustainable in the future. If the company has sustained it for 10 years, it most likely will in future, but check this out before investing.

In the next few Stock Shastras, we will talk more about each of these moats, starting with Brand – the first moat. See you next week with Stock Shastra No. 5….

Stock Shastra #5: Great Brands are an unbreachable moat

In Stock Shastra #4, we said that to invest in a wonderful company, you need to look at a business with an unbreachable moat (a sustainable competitive advantage that helps the company remain a winner, even in tough times). We talked about 5 different moats that a business can have: Brand, Secret, Switching, Toll and Price. But, how does each moat make the company a winner? And what are some good examples of companies in India with these moats? Let start with the first Moat i.e. Brand.

What is a Brand?

Did you know this?

Every Indian consumer uses, interacts or at least comes across 2 Godrej products every day in his/her life. It can be a Godrej cupboard, appliance, furniture, safe or lock.  Right from consumer products like soaps & hair-dyes to equipment parts for spacecrafts, Godrej has a presence in almost every sphere.

This is the power of a Brand. It connects emotionally with consumers and becomes an integral part of their lives.

Brands are represented by a name, phrase, sign, symbol or a combination of these. It is the unique identity, association, emotion; which a product or service creates for itself in the mind of the consumers.

Brands become synonymous with the products & services used by consumers. Take the example of adhesive bandages. When we go to a medical store we ask for Band-Aid. Most of us maybe unaware that Band-Aid is the brand name for Johnson & Johnson’s adhesive bandages. Its popularity across countries has made the brand name synonymous with the product. Examples like Fevicol or Fevistick in the adhesive category, Amul in the Milk & Milk product category; further prove this point.

Companies which have a brand as a moat can generate profits consistently in the long run & emerge a winner during tough times. Let us see how brands become a moat.

Why is Brand a Moat?

When a company creates a successful brand, it creates loyal consumers. When consumers are happy & satisfied with a brand they are unlikely to switch. When happy consumers talk enthusiastically about their favorite brand they help the brand attract more consumers at virtually no marketing cost. This leads to higher profitable market share. Financially, this translates as higher sales & profits for the company.

Brands make the process of taking decisions easier for the consumers & bring peace of mind to them. As consumers love the brand, they do not mind paying a premium for its products & services. Take the example of Asian Paints. It is a classic example of a successful brand which charges a premium in the paints category.

In this age of advertising clutter, successful brands break through the clutter and become a part of the consumer’s consideration set i.e. the shortlist of brands a consumer will consider buying from. Take the example of small cars. Maruti brands will most certainly be a part of every consumer’s shortlist while buying a small car.

A company with a strong & successful brand also has the ability to expand to other product & service categories with ease. Titan is one such brand. It is the largest manufacturer of watches in the organized sector in India. Over the years, Titan has diversified to other categories like Jewellery & Eyewear. It has been quite successful in these product categories too. The company has been able to diversify because of the trust and value that the brand commands. You can refer to our “Company Shastra” to know more about this great brand.

Translating the Brand Moat to outstanding financial track record

While successful brands are a moat, it takes more to translate it into an outstanding financial track record.

First, while brands can earn money, it cannot prevent companies from poor investment decisions, spending disproportionately to achieve short term results, giving away more than required to channel partners, succumbing to price wars etc. Every category has competition. When successful brands do not evolve and maintain the edge over competition, over a period of time they get diluted and the brand ceases to be a moat. This means brands require innovation and investment in the long term. Management that fails to act on this, end up losing an asset that has taken years to build.

When you look at any product category, you would be aware of the top 2 or 3 brands in that category. Find out which company owns these brands. Then look at the 5 critical parameters to know the financial track record of these companies. Such companies with an excellent track record over 10 years clearly own great brands and know how to use this as a moat to keep succeeding. These are stocks you should consider buying, of-course at the right price.

The next Stock Shastra will talk about the second moat i.e. Secret/Patent. See you soon with Stock Shastra#6.

Stock Shastra #6: A company with Patents/Trade Secrets is well protected from competition

Stock Shastra#5 talked about how a great brand can become a competitive advantage (unbreachable moat) for a company. The reason why this happens is because brands are unique and nobody can use or copy your brand name. Once a company creates loyal customers for its brands, and commands a premium, it translates into higher sales and profits. Another powerful moat that can effectively be translated to sales and profits is ‘Patents/Trade Secret’. But how does this moat work?

The answer is Stock Shastra #6: A  company with Patents/Trade Secrets is well protected from competition.

How does a patent or a trade secret work?

What if your company was the only one who was allowed to make a particular product? No other company could produce the same product. If they did, it would be illegal and they would invariably end up facing charges in a court. That is exactly what a patent does. A patent gives an exclusive right to the inventor of a new, innovative and usable product or process to derive benefits from it for a limited period of time. It protects your business as competition cannot copy your product.

With a patent however, you have to disclose all the information related to your unique product. And the life of a patent is usually a maximum of 20 years, after which anyone can produce the product. So, what do you do if you do not want to disclose the way you make your product?

This is where a trade secret comes in. A trade secret can be a formula, recipe or process for making a certain product or providing a particular service. Unlike a patent however, it is not limited for a particular time. Its life depends on how long you can keep it a secret. A famous example of this is Coca-Cola’s formula for the soft drink which has been a closely guarded secret for 122 years. A trade secret confers a slightly different advantage to a company. In Coca-Cola’s case it has given the company a significant business advantage in the ‘carbonated drink’ market, as there is no other cola that tastes the same.

If a product is patented or has a trade secret, the company becomes the only one who can produce it. No other company can compete with it. Consumers who develop a preference for the product continue to buy it, because the other alternatives are not good enough. This leads to higher sales and consequently higher profits.

Which companies fit the bill?

So, which companies have this moat? Obviously the first thought that comes to our mind is that of Pharma companies. Pharma companies like Dr. Reddy’s Labs, Sun Pharma, Cipla, Ranbaxy, Biocon have patents for the new chemical compounds or compositions that they discover. However, companies from other sectors can also have patents.

Bilcare Research, a company that we have covered in Company Shastra is such a company. Belonging to the packaging sector, Bilcare serves the packaging needs of Global Pharma companies. It has patented technologies like Bilcare Optima and Brandpak Building Solutions which alongwith its patented materials and designs have helped the company become a market leader.

IT companies also have patents for their improvements in computer technology. Infosys, for e.g has 5 approved patents and has as many as 216 patents pending approval. Other companies like Wipro and TCS are also research driven companies and file for a large number of patents every year.

One of the leading auto majors of India, Tata Motors has filed more than 400 patents and design applications for its various vehicles and processes.

FMCG companies manufacturing personal care products like Procter and Gamble, Colgate, Hindustan Unilever will usual have trade secrets for their products. Similar is the case with companies producing food products like Brittania, Nestle India etc.

The large number of patents filed by these Indian companies indicate the importance given by them to patents. These companies spend around 6% of their turnover on research and development. Companies like Tata Motors, BHEL, Dr. Reddy’s Labs and Sun Pharma have infact featured amongst the top 1000 largest R&D spenders in the world. This indicates the focus of these companies on the research and development of new and innovative products – a must for remaining successful over the long term.

In Stock Shastra #7 we will look at the next moat that a business can have, Toll.

Stock Shastra #7: A company with Exclusive control can charge a toll

We have been talking about the various competitive advantages (moats) that a business can have. A couple of them are great brands and patents/secrets which we covered earlier. We said in Stock Shastra #6 that Patents/Trade Secrets make a company the only one who can produce a particular product which can lead to higher sales and profits. Another competitive advantage possessed by only a few companies is the exclusive control over a product category or area.

So, how does having an exclusive control help?

The answer to this is Stock Shastra #7: A company with Exclusive control can charge a toll.

If you are 40+ you will remember the days when owning a two-wheeler or a telephone was considered a privilege. If you wanted to buy a two-wheeler you had to buy a Bajaj Scooter and if you wanted a telephone, BSNL was your only option. Forget about product quality or customer centricity. There was a huge waiting list if you wanted to buy either. The license Raj had resulted in these companies getting an exclusive control and becoming the only choice for consumers. However this control was lost after liberalization. These companies had an exclusive control over their product category.

Now, consider Sun TV. If you want to advertise a product in Tamil Nadu on a television network, you would have no real option but to advertise on Sun TV, because of the very high viewership it commands in that state and the absence of a worthwhile second option. Thus, companies can also have an exclusive control of a particular area; much like the ‘dada’ in a Bollywood movie, who controls a particular area in a city..

This exclusive control over a particular product/service or an area gives a company an ability to charge a toll, a premium.

How does this ability to charge a toll translate into higher profits?

If a company has an exclusive control of a product or an area it virtually becomes a monopoly and can charge a premium. The biggest advantage that a company gets is high sales, as there is no substantial competition that it faces. The customers have to come to the company for its products or services. As a result the company can command a premium and not worry about lowering prices due to competitive pressures. This ensures higher margins and high profits. As the company becomes bigger it gets the advantage of economies of scale and the company’s average costs fall. The company can then maintain prices and increase their margin further, which means even higher profits. The ability to charge a toll thus ensures almost secured profits for a company.

Which companies in India have this advantage?

Today, having an exclusive control has become a rarity due to liberalization. However, some companies do get an exclusive control in certain cases e.g.  utility and media companies.

Take for example newspaper companies. Times of India is the most widely read English language newspaper with a readership of around 13.5 million. So, if you had to advertise in an English newspaper, especially in Mumbai, Times of India would be an inevitable option. Likewise, Dainik Jagran (with a Readership of 56 million), commands a position of toll in Hindi Speaking states.

Another similar example is that of credit rating companies like CRISIL or ICRA. If any company wanted to get a rating done for its debt and credit facilities it would have no option but to go these companies. This exclusive control is reflected in the financial track record of these companies especially CRISIL which has managed to post robust growth.

Hindustan Zinc Ltd. is a company which has exclusive mining rights thus collecting a toll for its products. The company has infact made the most of this competitive advantage to record good growth in Sales and EPS. Check this company out in Company Shastra.

In Stock Shastra #8 we will talk about another interesting moat, Switching – Having products that customers have difficulty in switching over from.

Stock Shastra #8: 'High Switching Costs'- a recipe for companies to hold customers for life

Earlier we have spoken about three competitive advantages a company can have: great brands, patents/secrets and exclusive control. Another powerful moat that can translate into higher profits & sales is ‘High Switching Costs’.

So, what do you mean by switching costs?

Almost all of us use computers. And the two software products almost all of us use are Microsoft Windows and Office. If a new alternate, even significantly better in terms of features, ease of use etc is launched, would people use it instead of these. Most people would not. What keeps us from doing this?
The costs involved. Is it only the monetary cost, we are talking about? No. It would definitely require significant amount of money to shift, especially for a company, but what’s more important is the psychological cost. Switching will mean dealing with the unknown – to a software which we don’t know much about. What could be more frightening? Learning it, using it and getting familiar with it will take a lot of time, pain and effort. Add to this the innumerable applications which work well on Windows; we will forever worry whether the new one will work as well. Considering all this you would rather stick with Windows and Office and keep purchasing their latest upgrades, sometimes grudgingly. Microsoft has a big competitive advantage, that of “Switching costs”- the costs that a consumer incurs – monetary, psychological, time and effort-based – which makes switching from the product almost impossible.
Switching as a moat works for complicated products which may take time to learn how to use, as well as for something we all use everyday…the morning newspaper. If you think changing your current morning newspaper, which hardly costs anything, is a simple decision, ask someone who has moved e.g. from Chennai to Mumbai. You just don’t enjoy your morning ritual anymore. The reason, you have got used to your newspaper, its type-setting, layout, what comes on which page etc; changing it throws your mind out of gear.

But, how can this advantage translate into higher profits & sales for the company?

The answer to this is Stock Shastra #8: ‘High Switching Costs’- a recipe for companies to hold customers for life
A company has switching cost as its competitive advantage, when clients find the cost/effort of switching from any of its product/service not worth the trouble. If switching would mean developing a new system, educating employees to use it, investing time with the new vendor, developing capabilities that are not core to the business, or simply changing an entrenched habit, chances are that customers will not switch. Also, if customers are happy with the products and services of their current suppliers, they are inclined to give additional business to the same suppliers than work with new ones. Usually such additional business comes with higher margins. Hence, having the advantage of switching cost ensures repeat business and new business from the same customer. This results in higher sales and profits. Such companies are also able to pass on cost increases to the customer either through price escalation clauses or renegotiations, thereby protecting margins.

Which companies in India have this advantage?

Today, IT systems form the backbone of operations for most companies. Any company would like to have a stable and reliable system. Changing from one service provider to another could lead to serious problems putting the entire business in a tizzy. IT Companies like Infosys and TCS get around 95% of their business as repeat business from the same customers. The costs involved in implementation of the system and training of employees – sometimes across the globe, make it difficult for customers of these companies to shift from them. Check out more about how this advantage works for Infosys in our Company Shastra

Computer education companies like Educomp Solutions which provide digital education to schools also have this advantage with products like Smart Class. These products require hardware, devices & equipment to be installed in the school. It also involves training teachers. Obviously, shifting to any other product will not only require re-installing, but also the effort of learning it again. Educomp is another company which gets a major chunk of its revenues from repeat business, through renewals

Similarly, once you have installed a security system in your house/office, you would prefer to not shift from it. One such company is Micro Technologies. It provides security systems for offices, buildings, computer systems, homes, vehicles etc

Back to our morning newspaper. Deccan Chronicle, Jagran Prakashan (Dainik Jagran), DB Corp (Dainik Bhaskar) and HT Media (Hindustan Times) all have switching cost as a moat.

In Stock Shastra #9 we will talk about another interesting moat, Price – Having products priced so competitively that almost no one can compete

Stock Shastra #9: Only a company with the lowest cost can compete on price and win

In a highly competitive market, companies try to be unique in many ways. While some may emerge as strong brands, some gain exclusive rights by way of patents/trade secrets. Again, there are a few companies that manage to gain exclusive control over an area/product/service and a few who have the advantage of high switching costs. There are also a few companies who stand out by pricing their products/services so competitively that it differentiates it

So what exactly is this advantage?

Consider the example of Nirma. By the 1980s Nirma catapulted to the top-slot over Surf, then a well-established detergent powder by HUL.  So how did Nirma achieve this? It achieved this by pricing its detergent at an unbelievable low-price, compared to Surf. It was the lowest-price detergent powder, then. But was its quality the same as Surf’s? – No, may not be, but the detergent fulfilled the essential job of cleaning, with an acceptable quality that customers were happy with. With indigenous processes, low-cost packaging, low-profiled marketing and attractive pricing, Nirma quickly emerged as dominant market player. This is the power of being able to price competitively.

But this may not hold true always. Ever wondered what Uninor is aiming to do by coming up with such low tariffs? Its tag line – 24 x 7 Badalta Discount Plan clearly indicates that it wants to emerge as a telecom provider that is differentiating on the price front., to attract a large number of users. Though, this may work well as an entry-level strategy, it may/may not be successful for the long-term. Unless the company has some significant cost advantages, this low-pricing strategy is not likely to last in the long-term.

So, to summarize, companies cannot survive only with a price-low strategy. It may work well as an entry-level strategy to grab your first chunk of consumers, but the low-price strategy all by itself, isn’t a long lasting one. The company has to also make money/ profits out of it. Pricing attractively coupled with earning great profits out of it is a long-lasting strategy. But a difficult one!!!

So how do companies make this a winning strategy for the long-term?

The answer is Stock Shastra #9: Only a company with the lowest cost can compete on price and win. Being the lowest-cost producer (having significant cost advantages), when coupled with large volumes helps a company grow its sales & profits, even when it prices its products competitively. With a big chunk of the Indian consumers being highly price sensitive; this advantage helps establish the company as an important/significant player in that segment

1) Working on high-volumes: What happens when a company offers very low & attractive prices for its product/service, so low that nobody can match? Very obviously, it attracts a large number of customers which leads to increased sales volumes. For this the company needs to gear up everything for the large volumes i.e. procurement, manufacturing, selling etc in such a manner that it gives them a cost advantage.

2) Working on a cost-leadership strategy i.e. the lowest-cost producer: This can be achieved by

a) Working on low-costs for everything; procuring raw material, low manufacturing expenses, low selling & marketing expenses etc

b) Having the power to negotiate lower costs with its suppliers. This power usually comes from long-term relations with suppliers, placing orders well in advance (by forecasting demand).

c) If the company’s been lucky enough to get their assets really cheap (maybe while starting up)

d) Inventing a cost-effective process

Two famous text-book examples that have sustained this competitive advantage for years is Wal-Mart and Dell Computers. Wal-Mart’s rise to massive market capitalization from its modest beginnings was largely a result of its aggressive cost controls which enabled it  price lower than competing retail outlets. Dell Computers has been able to offer computers at very low prices mainly due to the JIT model followed by them. This involves not even being in possession of the raw materials needed to fulfill an order until that order is placed and still capable of filling orders in a short period of time. This helps minimize inventory costs. The company can also negotiate favorable component costs due to its size whereas its direct-sales distribution system allows it to sell PCs more efficiently than rivals who use resellers.

An Indian company that exemplifies this advantage is Amul. Amul has been a market leader for the last 4 decades now. It adopted a low-cost strategy for selling its products like ice-cream, butter etc & has since then emerged a winner in this segment. It has a cost advantage as it gets milk directly from a large number of farmers. Amul has always been known for providing value-for-money products, with no compromise on quality.

In a particular industry, you are likely to find only such player existing; who has managed to convert its low cost of operations into attractive pricing & hence earn profits out of it. For example: It is unlikely to have  another Wal-Mart in the same segment

Which companies in India have this advantage?

Consider Big Bazaar a part of Pantaloon Retail (India) Ltd. provides consumers the experience of shopping at a mall/supermarket giving them acceptable quality and service at the lowest prices. Its tag very rightly suggests the same – Is se SASTA aur ACCHA kahin nahi !

Tata Motors (for its cars) is also known to provide good quality cars at very low costs. This started with Tata Indica which provided the public with an affordable alternative to the Maruti 800. Infact just hours before the car was launched, Maruti called for a press conference announcing price cuts across its lineup and introduction of more cheaper variants, fearing its bread and butter model, Maruti 800 was in trouble! And now with the introduction of Tata Nano, they have carried the tradition further.

Meet us next week with Stock Shastra #10, where we will talk about the importance of having a respectable management.

Stock Shastra #10: Look for a trustworthy management, that respects the interests of minority shareholders

A short flashback: In Stock Shastra #2 we stated the 3 important characteristics essential to shortlist a wonderful company. The first two i.e. Excellent Financial Track Record & Sustainable Competitive Advantage were elaborately discussed in Stock Shastra #3 & #4. Now, coming to the 3^rd characteristic; Respectable Management. You need to be sure about the people in charge, i.e. the management of the company.

So, why bother about the management?

Consider this: A company XYZ Ltd. has performed robustly in all its financials over the last few years, has grown its sales ten times and has also grown its EPS at an impressive rate. Also, it has a sustainable competitive advantage that guarantees a future winner. And, how can we forget to mention.. It is currently undervalued, too! So, how tempted are you to invest in this company? Very!!! You’ll probably be tempted enough to put in a big chunk of your savings here….

But, stop!  There’s a small catch here. It has a management which is infamous for a variety of things;  giving false information, arrogance with minority shareholders, known for insider-trading, or paying too much to themselves. Now, think again. Even though, this company may have the capacity to perform and be a winner in future, it has a management that you probably cannot trust to take care of your money. Now, is this the management you would want to stay invested with? Most likely no. You need to stay invested with a management who is trustworthy and respects your interests.

So, how do you check whether the management is trustworthy and respects the interests of minority shareholders?

With no model or framework to differentiate a good one from a bad one, it becomes difficult to judge management. But certainly there are a few clues/signs/factors that can guide you to assess the worthiness of a management and decide whether this is the kind of management you want to stay invested with:

1) Alligned with your interests: Check whether the managements’ interests are aligned with the interests of the shareholders

For this, check for the following clues:

• Vision and plan : Does the management share a vision that appeals to you and a plan to implement it?
• Compensation of top management: Is the compensation they pay to themselves reasonable enough? If the management is paying obscene amounts of money to themselves even when the company’s profits suffer, it is better to stay away from such a management.
• Reducing interest in the company: Is the promoters interest in the company reducing? For this, check whether –

a) the promoters are reducing their stake holding often

b) the CEO and top management are selling/exercising their stock options periodically

c) promoters are pledging their shares;

If promoters are indulging in any of the above (a, b or c) , obviously they have their short-term interests vested with the company. Hence it is better to stay away from such a  management.

• Buy-Back of shares: If the company buys back its shares at a time when the market is undervaluing its stock-price, it usually reflects the management’s confidence in the growth of the company

2) Qualified: Check whether the CEO is qualified to run the company or no? Does he understand the business well-enough to be able to run it well.

3) Transparency: Does the management share the actual threats, concerns the company is facing? If no, this is not the kind of management you should trust your money with. Also, does the management accept that it made a mistake - managements can make mistakes, but a good management is one who admits that it did.

4) Dividend payment in case the management is not able to increase its ROE further: Logically, the company’s net profit should be distributed among shareholders, i.e. the owners of the company, in the form of dividend. But, generally, the company retains a part or the entire profit and re-invests it in the company. What does a good management prefer – paying dividend or retaining the profit? A good manager retains a part of /entire profit only when he thinks he is able to earn a handsome return on it, otherwise he prefers paying dividend.

If there’s one source that can help you with the above points, it is the company’s  annual report; especially the Directors Report, Chairman’s speech & Management Discussion and Analysis

In a nutshell, we are looking for a leader who lives and breathes his company; someone we can trust our hard-earned income with, someone who can call a spade as spade.

So, which Indian management can you look at, as a benchmark?

If you want to have a good benchmark for management look at Infosys. Narayan Murthy (Chairman & Chief Mentor of Infosys) is not only known as the founder of the biggest IT empire in India (read Company Shastra on Infosys), but he is also known for his simplicity. He started with an idea, a vision and pursued it till it became a reality. The management of Infosys has been transparent in its operations and you will find them being very candid about the threats and concerns in management interviews/news items/ annual report. They also disclose the management remuneration in their annual report.

Another great leader is Ratan Tata (Chairman of Tata Group) – one of the most respected business leaders in the world. With his vision and leadership style he has made TATA group one of the leading conglomerates in the world. The Tata group operates on core values of leadership with trust. In fact, Tata Group has emerged as the most trustworthy Indian company on financial reporting in a poll conducted among domestic investors.

See you next week with Stock Shastra #11, where will tell you how to arrive at valuations for a company.

Stock Shastra #11 – Before investing, find the right value of each stock – Its MRP

By now, you must have shortlisted a wonderful company i.e. a company with an excellent financial track record and checked if it has one or more  of the competitive advantages (brand, patent, switching cost, exclusive control or the ability to price competitively). Also, after running a check on the management’s worthiness, you must be now asking yourself the question – below what price is the stock worth buying? Remember finding the right value of a stock is very important as a good stock is not always a good investment. You can lose money even after investing in a good stock if you pay too much for it. So, let’s learn how to find out the right value for the stock i.e.  its MRP or Maximum Retail Price.

So, what is the right value (the MRP) for a stock?

There are many popular methods to calculate the right value of a stock popularly known as Intrinsic Value or Fair Value. Every model be it a Dividend discount valuation model or Discounted cash flow valuation model has its own basis for calculation. But the underlying common theme for all these models is the same:  The value of a stock relates to the returns that investors expect to receive from holding the stock.

So, to arrive at the right value of a stock, we look at the future returns that an investor will get by investing in a stock and discount them to the current period using an appropriate rate of return that we expect from investing in the stock.

So, what are the returns that we can expect from investing in a stock as a minority shareholder?

Suppose you have invested in a stock, keeping a long-term holding period in mind. As a shareholder, the current price of the stock is the investment that you make in the stock. You earn income or returns from this investment in 2 ways i.e.

(a) Future Dividends: The Future Dividends which you will receive every year.
(b) Future Sell Price: The Price that you will receive when you sell the stock in the future.

So, the right value of the stock i.e. MRP can be calculated as

Now that we know how to calculate MRP, let’s look at how to arrive at the 3 individual parameters viz. Future Selling Price, Present value of future Dividends & Expected rate of return.

1)   Future Selling Price: We learned that this is the price that you will receive when you sell the stock in the future. Here, you will benefit if the stock price appreciates., Now, it has been seen that over a long term, a stock’s price is primarily dependant on the long-term future earning capacity of the company. So, as a company’s earnings grow, so should its stock price.

So, how do we calculate the future earnings growth of the company?

The future earnings growth of the company depends on 2 things:

a) The prevailing market conditions i.e. whether the company is present in a growing or stagnant industry, the demand of the company’s product/service

b) The company’s own capability to grow and take opportunity of the market; this can be gauged by looking at its sales, earnings and book value growth rates in the past (y-o-y and CAGR), its average return on equity (ROE), average return on invested capital (ROIC).

2) Present Value of Future Dividends: These are the dividends that you will receive in the future and can be calculated by using the historical dividend per share that is paid by the company and growing it the rate at which you expect the dividends to grow. We calculate the future dividends for each of the years and then discount them to the present year. The summation of these individual present values is taken.

3) Expected rate of return: This is the rate of return that we expect to earn by investing in a stock. At MoneyWorks4me.com, we have taken this as the Cost of Equity of the respective companies. Cost of Equity is the minimum required rate of return that investors expect when they invest in a stock and take up the associated risk.

A holding period of 5 years (n) is taken into consideration to calculate every stock’s right value. This is what we call MRP- the Maximum Retail Price.

To summarize, MRP is the maximum price we should pay for a stock, so as to get a minimum expected rate of return (COE for that stock), every year for the next 5 years.

So, we now know how to calculate MRP, but how is this helpful?

All of us know that the stock market behaves irrationally in the short-term. Most of the time, it doesn’t value the stock at its MRP; sometimes higher/lower. Also, our MRP is based on estimates which can turn out to be different than our expectations. So, how do you protect your investment from this irrational behaviour or your estimates going wrong? The answer is look for a discount or margin or safety.

Logically every smart shopper buys stuff at a discount and the same should apply to stocks. Benjamin Graham – the Guru of Value Investing propagated the idea to buy stocks that were trading at a discount to their full value as this minimizes your risk to a great extent.. Hence, the principle we follow is: always buy much lower than its MRP and sell at when prices cross the MRP.

Now, you must be wondering why is MRP the Sell Price, when we earlier said this is the maximum price that an investor should be willing to pay? … Especially, if  the stock market may value it much higher than its MRP.

Once the stock market stops behaving irrationally (i.e. in the long-term), it is most likely to value the stock at/close to its fair value based on rational expectations i.e. its MRP. As we said earlier, in the long run the stock price is driven by its earnings capability. So, consider MRP as the maximum price that the market is offering for the stock, i.e a benchmark for the ‘Sell Price’. Though there may be times, the market may value it higher, its right value will always be somewhere around the MRP. Remember this is a benchmark for Sell Price, a number somewhere around which the right value is likely to hover.

Having understood the method, you are now probably wondering where you can get the right of for the stock. Moneyworks4me.com is a website, where you can get this right value for around 1300 stocks in the form of the stock’s MRP. So, to know the MRP for your investments, visit www.MoneyWorks4me.com.

So, after telling you that you should buy the stock at a lower price than its MRP,  you are now wondering what is the right price to buy. Hold on. You will have to wait until next week for that. See you next week with Stock Shastra #12.

Stock Shastra #12: Buy at 50% discount to minimize risk and get fantastic returns

In Stock Shastra #11, we told you about the right value of a stock – its MRP. Having already said that you need to buy at a discount to its MRP, you must be now wondering what is this discount %, that will minimize your risk as well as give you great returns? Answering this question, will complete your quest for a great investment.

So, at what level lower than MRP should you buy the stock?

Every smart shopper prefers buying stuff on discount and you can do the same, while shopping for stocks. While calculating MRP, we considered a 15% expected rate of return. But, this is the minimum you should expect. Also, just operating on MRP, may not be the best way to invest as you are not covering any risk. So, while investing in stocks, always demand a margin of safety.

What is this Margin of safety you ask? Margin of Safety is the difference between the current price and the MRP of the stock. So, if the MRP of a stock is Rs.100 and is currently trading at Rs.70, you have a margin of safety of 30%. But is this good enough? Well for the safer stocks for example a large cap company with a trustworthy management, yes, it is probably enough. But, for the small caps where the risk is higher you need to demand a higher MOS.

The Value Investing Guru – Benjamin Graham in fact insisted on a 50% MOS while buying stocks.

Discount Price = MRP *(1- margin of safety/100)

But the rule of 50% may not be applicable for all stocks and at all times. If you always insist on a 50% discount, you may miss out on a buying opportunity in the case of at least the large caps, the popular brands and the market leaders. Very rarely will these kind of stocks be available at a 50% discount. Hence, we at MoneyWorks4me.com have come up with our in-house model which helps us ascertain a MOS% for each stock.

This model consists of 8 parameters/componenets that help us ascertain the risk associated with the stock and hence guides us wrt to the % of MOS the stock deserves. Buying the stock at/below this MOS% will help you negate this risk. Let’s have a look at these 8 parameters and understand them with the help of a few companies:

So, why look for a margin of safety?

You must be wondering why do you need to wait for a margin of safety. A couple of reasons for this are:
•    Minimize risk: Compared to other traditional investment options like bank FDs, bonds, etc stock investing comes with an additional risk. This is because of the irrational behavior of the market which drives the short-term fluctuations in the price of a share. The market almost doesn’t need a reason to react and fluctuates due to news, sentiments, baseless rumors and just about everything else.

•    Great Returns: The other advantage by buying low is that you increase your returns. The lower you buy the stock, the higher return you get on the investment.

So, does the market give you such opportunities that you can buy the stock at a very low price? Yes, it does! In reality, there are many times, the market tends to over-react and undervalues a fundamentally strong company, probably because it is facing tough times right now or maybe due to some negative rumor, news etc. But in the long-term, its stock price will appreciate rationally based on its earning capacity. So, while investing always keep a long-term perspective in mind and make sure you take advantage of such opportunities.

Hence, to protect yourself from risk and get great returns, buy your stock at/below Discount Price i.e. at a 50% discount to MRP

Having understood the Margin of Safety concept, you must be eagerly wanting to know where can you find the Discount Price of your stocks. For this, visit Moneyworks4me.com, where we have given you the Discount Price of around 1000 stocks.

So, now you know when to buy a stock. To know when to sell and what considerations to keep in mind while selling, wait till the next week for Stock Shastra #13.

Stock Shastra #13: 3 Signs that tell you "Sell your Stock"

In Stock Shastra #12, we told you that the right price to buy a stock at a reasonable discount to its MRP. We also said that we need to sell, once it crosses MRP. Since no one can time the market, knowing when to sell is one of the toughest decisions, especially since greed usually takes over and you always hope for a higher price.

In theory, the perfect business to buy is, one we never have to sell. That’s our ultimate objective: To buy a company so wonderful and at a price so attractive, that we never sell it. Of course, this rarely happens in reality. Wondering why? Because not all companies stay wonderful forever. Also, the market at some point tends to grossly overvalue these companies, giving a sell opportunity.

At Moneyworks4me, we buy and sell on the following guideline –  Buy at/close to Discount Price and sell once it crosses its MRP. But, what if the company ceases to be wonderful before the stock price crosses its MRP. Or the market has grossly overvalued the company! There are many such considerations you need to keep in mind, and they will guide you to figure out the right time to sell the stock. Let’s see them:

While taking a decision to retire from your stock, you can be in 2 situations. Either the stock price is

1) Well above MRP – If the current stock price is well above its current MRP i.e. 20%+ above MRP – consider selling the stock, as the market is overvaluing the stock irrationally above its earning capacity.

Considering that the market has overvalued the company right now, there are chances that it will correct in the future. In such a case it would be a great opportunity to sell the stock now, book great profits and later, wait till it is available at a good discount again. This time you can wait for a slightly lower MOS than before, considering by now you have confidence that the company is a sure-shot winner in the future.

 2) Just above MRP – If the current stock price is just above the stock’s current MRP ( 0-20% above), you need to ask yourself –

a) Has the company ceased to be wonderful? : If the company’s MRP is stagnating and it is not a short-term trouble, most likely the company has ceased to be wonderful. In such a situation consider selling. This means that the company has ceased to have the sustainable competitive advantage, that earlier guaranteed great growth and is no longer attractive with a long-term perspective.

This will usually show up in the form of a poor performance in  its financial track record. If the financial track record is no longer good enough to warrant holding on to the company/business, sell it.  In such a case this will reflect in a stagnant or reducing MRP, due to our reduction in expectations of earnings capacity.

 However, if the company is wonderful with an increasing MRP, consider holding the company till the market grpslly overvalues it i.e. (20%+ above MRP)

b)       Is there a better opportunity available?: If you have found a better company, where the probability of growth and returns is higher and this company is available at an attractive discount. In such a case consider selling of your earlier investment, if you are sure there is a better opportunity available.

c)       Are you are in requirement of funds? – If you are in need of funds, it is always better to sell off a stock that has crossed its right value (MRP), rather than selling one which yet has scope for appreciation in stock price

3) The company has ceased to be wonderful, before reaching its MRP – If there has been a sudden change in circumstance or you have received new information, that changes your opinion about the company that you once believed was wonderful, consider selling the stock; even though its current price may not have touched its MRP.

If the stop loss has been reached: When you buy a stock, it is usually with the expectation that the stock will go up and we will make a handsome profit. But what if the stock goes plummeting down! This is where a stop loss comes in. As the name suggests, it is the price level at which one should stop/limit the losses in a trade. The purpose is to define the maximum loss you are willing to take on your investment. One should not take unlimited risks in any investment, because if the stock starts going down, you may even face the risk of capital erosion.

Deciding the stop loss level will depend on a few factors like how much loss are you willing to take on a trade, how risky and volatile is the position, how is the market trending, etc. The trailing stop loss method seems to work the best amongst the different known methods.

Let’s understand how this method works with the help of an example. Suppose you bought a stock for Rs. 1000 and decide to set a trailing stop loss at 15% i.e. a stop loss will be triggered at Rs. 850 (You can also set a stop loss in absolute terms, say Rs. 150). If the stock moves up, the trailing stop loss goes up too. So, at Rs. 1100, the trailing stop loss will have moved to Rs. 935; at Rs 1300 the trailing stop loss will be Rs. 1105 and so on. However, if the stock turns south and comes down Rs. 1200 from Rs. 1300, the trailing stop loss remains at Rs. 1105. If the stock reaches Rs. 1105, the trailing stop loss is triggered and a sell trade will be executed, thus protecting a profit of Rs. 105 or 10.5% on your initial trade of Rs. 1000.

The discipline of following a stop loss will help you to not only minimize your losses but also protect your profits to a great extent!

At MoneyWorks4me.com we provide our subscribers with a feature- 5 Companies Above MRP , every month. These are 5 well-researched stocks, which are right now overvalued in the market and should be considered for selling.