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Successful equity investing: Understanding business economics

Efforts should be made to understand the company and its prospects for the future. But how do you understand whether a business is successful or not in its endeavors?

Never mind the vision and mission statement of a company, the raison d’etre of an enterprise is to compound the shareholder’s capital at a reasonable rate. Do that and survive, or fail and die.

An equity investor should understand that when buying a stock, she is not buying an entry into her stock account but a piece of a company. Efforts should be made to understand the company and its prospects for the future. But how do you understand whether a business is successful or not in its endeavors?

As a shareholder, the company in which you invest should be able to compound your capital at a healthy rate. To ensure this, the business should operate in an industry where it feels it has an edge over competitors in order to extract a reasonable return for every rupee of shareholder money it puts to work.

The first aspect an investor should then look at when selecting a stock is the attractiveness of the business. This would involve the various competitive edges the company has such as brand, technology, distribution, and so on. There is one more important aspect that needs to be considered—sustainability of this edge.

India has witnessed reforms since the early 1990s. In the initial phase, India opened up its manufacturing sector and this unleashed global competition on Indian companies. When we compare the end of 90s with the beginning of that decade, we would realise that many manufacturing companies did not survive. Even though many had huge advantages, most of those advantages were good only in a closed economy and could not survive the global onslaught. Today, the domestic services sector, which has been protected to a large extent from global competition, is being opened up. One would assume that if you are investing in a company operating in this space, you would need to be sure that the company’s competitive edge would survive in a more open, global environment.

The second aspect of evaluation would be how high the business compounds the capital it employs. Clearly, if one wants high levels of compounding, then it is better to have a small base. The higher the capital employed, the more difficult it is to produce returns sufficient to justify the employment of such a high amount of capital. A good business would be one which can employ low amounts of capital, for it is easy to compound smaller sums of money.

There are various measures used to evaluate this aspect. One such measure is ROCE (return on capital employed). This measure is a reasonable one if the debt levels are low. If debt is a significant component of funding, then as an equity holder, the risk of significant economic losses is high. One should remember that as an equity holder, one gets paid last and hence, if there are more mouths to feed before dividends are paid, the higher is the chance that the leftovers will not be sufficient to take care of the equity holder’s appetite.

Metrics such as EBITDA (earnings before interest, taxes, depreciation and amortisation) are dangerously inaccurate. Sawing off the profit and loss statement needs to be undertaken with discretion. One wonders which right minded businessman will accept that his fixed assets are “cashless". Yet there is no dearth of reports which state that “depreciation" is not a cash expense. I wonder how exactly peddlers of such a theory expect a business to invest in plant and machinery. Strangely, it also ignores interest cost, which is fine if the evaluator is a lender but not if she is the owner.

Another metric used to show attractiveness of a business is “growth rate". Higher growth rates can mask basic business problems for a while but will rarely be able to reverse the basic economics of business. Warren Buffett frequently points out to the two great inventions of the 20th century—air travel and automobiles—which grew phenomenally but were a disaster to the providers of capital to these industries.

An example here would illustrate the uselessness of the above two metrics. There is one investment which any one can make easily. It has 100% EBITDA margins and one can generate as high a growth rate of earnings as one desires. Yet, it probably will not even beat inflation! This investment is a bank deposit.

Since, margins did not consider the capital employed, it had no use in judging the attractiveness of the “investment". And one can easily increase the amount one earns from a bank deposit by increasing the amount of principal that is deposited. It is fairly common to find such businesses that keep increasing the capital employed to produce growth rates even though the return per unit equity capital is low.

Surely, great economics in a business is not possible if it is not run by competent individuals. And hence, evaluation of management is critical for ensuring the continuation of favourable economics. A good manager would be one who keeps enhancing the competitive edge of the business and would also simultaneously respect the equity holders and reward them appropriately.

Huzaifa Husain is head equities, PineBridge Investments India.

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