Wednesday, July 8, 2015

What Makes Great Companies?

As much as 43% of the Chinese market is currently halted from trading. Chinese markets had crashed again in opening trade, prompting many companies to halt trading in their stocks. China being one of the largest economies in the world, and the very largest manufacturing economy, it has already sent the world metal prices reeling, and the global repercussions are bound to affect India too. The situation has once again brought to fore the need to recognize and stay away from bubbles, and invest in only great companies, which too may correct but with lower impact due to cushions like best Return on Equity, low or zero debt, high tax-free dividend yields that beats even taxable fixed-income yields, and such crucial criteria that get conveniently ignored in bull markets.

That the Chinese stock market was on a bubble was well-known, but what everyone was expecting was that Chinese government would provide a safe landing to the 110%-rally-within-less-than-a-year through its timely interventions. But, as things stand now, destiny of the Chinese market seems to be something else, especially with the kind of large-scale frauds and hyper-inflated Ponzi valuations that are prevailing there. Many less popular Chinese companies had even changed their names or core business activities - only on paper - to benefit from the rally, and valuations for very ordinary businesses were often upward of 80 P/E.

But even without such corporate frauds, and Ponzi grade valuations, a lot can go wrong in a company’s DNA, that makes it next to impossible for it to ever become a great company. Though on an average, good Indian companies are better than good Chinese companies on both Return Ratios and Corporate Governance, they are only a minor portion of the Indian market.    

The first rule of business that beginners in accountancy often struggle to understand is that equity capital comes on the liability side of the balance sheet. To drive home that seeming anomaly, the amused teacher repeats the even deeper underlying principle - that the promoter and the business are different entities.

Business is not its promoter or its shareholders. Business is not the capital they bring in. Business is definitely not the CEO, or managers, or employees. Business is not the lenders or their money, however big has risen the debt-equity ratio.

Business is not even its customers, despite they being put in the highest pedestal with idioms like ‘customer is the king’ and all such lofty ideals. Business is certainly not about other key stakeholders like suppliers and distributors, even when their ecosystem is huge and determines a company’s success or failure.

Business is distinct from all these, is not even an amalgamation of all these, but a distinct standalone entity. And therein lies the secret of what makes a business or a company great.

Analysts will offer you an array of simple looking metrics like P/E, P/BV, RoE or Debt/Equity that are supposed to measure the performance of a company. But all end up making an investor only more bewildered, as it happened in the famed Indian story of blind men feeling and reporting back on the elephant.

A company is as complex if not more complex as an elephant. And just like only experienced mahouts can sense whether the secretion coming from the elephant’s head indicates musth, signalling imminent madly violent behaviour, only experienced analysts can predict whether that famous company which is hogging the limelight today is destined to lose money for its investors in the coming years.

Even tougher to predict than imminent downfalls are emerging positive turnarounds that can last for decades or generations, making millionaires out of ordinary guys and girls.

But think again, does companies need to be that complex to analyze? On first looks everything looks simple to analyze. Whether Sales is growing? Whether Profits are growing? And if these two are there, shouldn’t the stock follow? Nope.

Even while Sales Growth and Profit Growth remain the most crucial fortune-making metrics, they deliver only if at least two dozen other metrics remain in place.

Like, how the Sales Growth is coming? Is it coming at the expense of rising Receivables, or spike in Working Capital Days? Or, like, is the Profit Growth secular? Is the Profit Growth reflected in Operational and Free Cash Flow generation?

Then comes the crucial question of whether the promoters or management are respecting their equity or willing to dilute at the first chance?

Then comes the company’s willingness to share its profits as dividends. Is it paying that namesake 10% dividend or is it distributing one-third to half of its profits as dividends, as great companies practice?

Many investors are also attracted to stocks of large companies that have grossly fallen - some even by 90% plus - thinking that at these sub-3000 crore kind of market caps, these giants are available for dirt cheap. But little do they realize that the Real Market Cap or Enterprise Value = Traded Market Cap + Debt.

And eclipsing all these nitty-gritty arithmetic is all powerful value adders like brand equity. Two companies can operate in the same field with similar kind of products, but with grossly differentiated brand values.

Investors need to focus on all these vital parameters before choosing a firm to invest in, whether it is good times or bad in the stock market.

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