Technology combined with ease of raising capital is resulting in rapid disruptions in many existing businesses. We lay strong emphasis on the economic moat of any business i.e. ability of a business to maintain its competitive advantage in order to protect/grow its markets share and earnings over long periods of time. The wide economic moat should result in significant value creation as measured by the difference between ROIC (Return on invested capital) and WACC (Weighted average cost of capital) as well as strong free cash flow generation.
We will be biased towards businesses where promoter holding is more than 33%. Promoter integrity, leadership team & corporate culture are important factors in creating a sustainably strong business. A unique leadership and corporate environment may contribute significantly to a corporation’s prolonged economic success. Corporate governance becomes even more important in India as many companies have large promoter shareholdings with less reliance on professional management. Owing to the same, the independence of board to ensure oversight may be less reliable.
We believe that as the industry/product cycles are getting shorter with increased competitiveness, the companies with low leverage are much better placed in most businesses. The preferred businesses for investment are those that have lower debt compared to its immediate competitors as well as the industry average.
Our stock selection hinges primarily on the ability of businesses to generate consistent and superior earnings growth. We rely more on structural changes in the industry, business franchise and new market entry as the drivers for earning growth and stay away from global cyclical driven earnings growth. The business growth enablers could be market share gains, shift towards organized as well as growth in the opportunity size itself. Besides earnings growth, even quality of earnings has to be emphasized which gets impacted by various factors like accounting, conservatism in asset impairment recognition, depreciation rate, tax rate, capitalization of expenses, etc.
Free Cash to the Firm is an important factor to generate value for businesses. However, some businesses may not be able to generate significant free cash flow if they are enhancing their operating capacities significantly, in which case operating cash flows become important. Pressure on operating cash flows is one of the early signs of increasing pressures in the business. Businesses that demonstrate growth in earnings without commensurate cash flow generation are avoided.
The focus will be to identify companies where there is evidence of trigger points which will lead to expansion of capital return ratios like RoCE and RoE. These are the periods when the equity value of a business shows multiplier effect and generate super normal returns, as was witnessed during the period 2003-2008 in Indian equities market.
In arriving at the value of a security, we look at a variety of factors. Key focus is on cash flow, economic value added and also analyse trends in capital efficiency. We also examine valuation multiples like EV/EBITDA multiple, P/E multiple, Price to book and PEG ratio on an absolute as well as relative basis for determining the fair (intrinsic) value of the business. We believe in keeping significant margin of safety while evaluating an investment. The price value gap should be higher than the expected return to justify Entry Target Price. More often than not, good businesses going through a bad patch will provide the required price value gap.
We continuously monitor investments to validate our investment hypothesis. When the Exit Target Price, which is equal to or higher than the intrinsic value, is reached or when there has been fundamental deterioration in business models or market conditions in contrast to what was earlier envisaged, we will exit the investment.