The Hindu Business Line : Due diligence, by the dozen

Prudent cash flow management is what separates a well-run company from the mediocre ones. As it is said, it’s not profit that matters, but what you do with it that counts.

Mr Sandeep Shenoy, Strategist, PINC Research, Mumbai.

D. Murali

Before you invest in a company, there are at least a dozen factors to consider, says Mr Sandeep Shenoy, Strategist, PINC Research, Mumbai. “Whenever an investor forays into stock markets, he is faced with more questions than answers, and feels intimidated by the sheer scale and dynamics of data around him,” he adds.

To help arrive at a proper decision, he emphasises the need to take into account aspects about a company’s working, the financial and business environment. The 12 factors, according to Mr Shenoy, are as follows: Addressable markets, business model, promoter ability, operating margins, growth or scaling up, operating leverage, asset sweating, debt equity ratio, cash flows, dividend and taxes, value proposition, and cyclicality and dependency.

Excerpts from the interview.

You address the investing issue by putting addressable markets right at the start.

That’s right. Addressable markets are those markets in which the company operates or caters to. These should be clearly defined, lucrative and preferably growing, so as to ensure a high predictability in revenues, assuming that all operational issues are addressed.

Won’t the market be yet in the making, as for example, in the case of a new product/service?

Taking a call on a market evolving or emerging and then proving to be an addressable market is frankly a game which VC (venture capital) funds would be adept at. Not lay investors.

For example, a company manufacturing 100cc two-wheelers has clear addressable markets, while it is difficult to ascertain the same for a portal selling second-hand two-wheelers.

Why the need to study a company’s business model?

A company may have a strong addressable market for itself, but it becomes imperative for it to have an efficient business model to tap/exploit the same for profitable means. This would translate into multiple advantages, such as pricing power, lowered selling cost, increased margins, etc, and offer a clear advantage over peers in the longer term.

At times, we find the model undergoing changes…

True. Changes in business model are inevitable, and companies should be fleet-footed to evolve and fine-tune their business models to tap changing opportunities. The IT (information technology) majors of India offer the best example. While Y2K (year 2000) was a huge addressable market, which many tapped efficiently by offshoring and garnered scale, only a few were able to evolve and survive the meltdown in year 2000. Those who did so went on to achieve greater recognition.

How important is promoter ability?

Highly important, I’d say. Because many companies have vibrant markets and good business models, but they fail to tap the same efficiently due to the inability of promoters to efficiently execute and implement the planned strategy and capex (capital expenditure).

Improper execution of plans, and suffering time and cost overruns can ruin a company’s prospects. Thus it is important to take cognisance of the promoters’ or key management’s ability to execute company plans. Reliance Industries is probably one of the best examples of companies not only drawing big business plans but also implementing world-scale projects in a tight schedule; and its impact on the valuation front is discernible.

On margins.

Operating margins convey the efficiency of operation of the company and thereby influence its profitability. During the growth stage, operating margins could dip, but upon maturity, margins should improve and exhibit stability.

Aren’t margins and growth potential related?

Yes, they are. While predictable margins are highly desired, the fear of compromising the same can deter the growth of the company. Stock prices reflect promise and potential. Low-growth companies, therefore, hold little attraction for investors despite stable margins.

A strong successful scale-up in operations (organic or inorganic) would definitely ensure premium valuations, as, despite the ensuing margin squeeze, investors would sense better days ahead. They would also overlook short-term pressure and bestow a valuation premium for the company.

Why is operating leverage key?

Many a time, companies have historical, depreciated assets, with high replacement cost, acting as an effective deterrent or barrier to entry for newcomers. This offers high operating leverage for the company as its fixed costs would be low and any degree of production beyond breakeven level would result in supernormal profits and thereby be profitable investment opportunity for investors.

That’s the same as asset sweating?

There’s a difference. When a company embarks on a growth path, its asset block would definitely increase. A desirable scale-up would be the one where the asset-turnover ratio on the incremental asset is higher than on the existing asset base.

A company that reports higher asset sweating in its peer group would report higher return on capital employed, and thus automatically command premium valuations.

Does debt-equity ratio continue to be relevant? It’s one of the traditional measures.

An old measure, but debt-equity ratio continues to be important. While debt is an advisable form of capital resource for companies embarking on a growth path, leverage ratio has to be under a strict watch.

Taking on debt for an ambitious project that has a long-drawn implementation and gestation would definitely impair the valuation of a company in the early stages as stock markets hate uncertainty. Again, within an industry sector, companies with low gearing ratio always manage to be on the shopping list of investors.

When profits are good, why look at cash?

Wrong. Cash flows are vital. A company may be exhibiting strong profitability; still, the key indicator to watch out would be its cash flows (preferably free cash flow). The principle assumption is that while it is easy to ‘manage’ profit and loss accounts, it is difficult to tinker around with cash flows.

It is understandable that high-growth companies would be guzzling cash more than what they generate. However, prudent cash flow management is what separates a well-run company from the mediocre ones. As it is said, it’s not profit that matters, but what you do with it that counts.

On the role of analysing dividend and taxes.

Any company that claims to be operating fine and cruising on the growth path but not paying dividends and taxes should evoke scepticism and rightly so. Dividend yield usually lends some support to the price discovery on the markets, and tax payouts many a time reiterate the quality of earnings of the company.

Some companies may not come within all these 10 parameters…

Which is where ‘value proposition’ becomes relevant. Many companies, despite not fitting within many of the above parameters, can still garner investor interest. The simple reason is that there would be value proposition in them waiting to be encashed or unlocked. Prime examples would be companies with holding in other listed entities, land or other such assets that can be enchased; and there have been scores of instances where investors have been handsomely rewarded.

Can you give examples of cyclicality and dependency, the twelfth factor on your list?

Many companies operate in cyclical business or dependent business. Steel and cement are the best examples of cyclicals, while iron ore, bauxite, and auto ancillaries are examples of dependent business, because their fortunes usually depend on other sectors such as steel, aluminium and auto.

It is always a sensible proposition to buy into cyclicals when there is all-round pessimism, as you would be getting strong companies at a bargain price. These companies give phenomenal returns when the cycle turns and becomes benign.

The fortunes of dependent companies also undergo a dramatic change once the sectors they depend upon embark on an upward path.

However, identifying cycles and dependency entails a lot of study from investors and rewards, though bountiful, would emerge after a long wait.

Now, isn't studying the 12 factors a tough exercise?

Analysing companies, using the publicly available and filed information such as annual reports, quarterly numbers, balance sheets, industry data, etc, is not an arduous task. Anyone with a reasonable grasp of accounting and business logic can draw a short list of investible stocks for himself. A prospective investor has to lay down the yardsticks based on which he can evaluate companies to invest in; and upon ascertaining the facts, he can draw up his conclusions.

What, according to you, is the secret of successful investing?

Successful investing can be said to be a science. However, there is a huge amount of subjectivity that makes it a bit of an art also. While these appear to be simplistic on paper, there are two other critical factors, i.e. patience and discipline, which sometimes emerge as a differentiating factor of a successful investor from a not so successful investor.

Using the above yardstick to study investment options would certainly make the investment process a bit easier for investors; however, they have to be consistently evaluating their investments so as encash the same at appropriate times.

Brilliant stock pickers make money on a short term, but it is the patient and the disciplined investor who laughs his way to the bank on a longer term.

Hence it is paramount for any investor to identify his analytical strengths, i.e. circle of competence, and stay well within it. Happy investing!

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