Buy the business


Director, Banyan Tree Advisors

December 20, 2011

If the companies in your portfolio generate healthy cash flows, that’s good. But if they also invest the cash flow sensibly into high-growth areas, they’re almost perfect. Found one of these paragons?

THE CHOICE of business to invest in is perhaps more important than any other decision an investor must make. Year after year, some businesses are just more likely to produce superior returns than others. Many believe that the choice of
management is the most important factor in an investment decision, but even a competent management can do little if the company happens to be in the wrong business, possibly for historical reasons.

Business should not be confused with sector. Within a sector, there can be a multitude of business models. For instance, within the telecom sector, you could have three companies — one operating basic and cellular services, another in the
networking equipment space, while a third could be making a commodity product such as jelly-filled telecom cables. To club all these together as part of the high-growth telecom sector, and therefore competing investments for an investor’s
portfolio, would not only be inappropriate, it could be disastrous.

Free cash flows… So what makes for a good business? Perhaps the most important factor is the company’s ability to generate free cash flows on a sustainable basis over a long period. Free cash flow is the net profit plus depreciation less the capital expenditure required to maintain a minimal unit volume growth for the company. This is simply the cash that flows annually into a company after it has paid for all regular capital expenditure.

The best businesses generate lots of free cash flow — a very good example is Hindustan Lever, which has a history of using these cash flows to make strategic acquisitions, which have strengthened the company significantly over the years.
Another sector with a consistent track record of free cash flows is pharmaceuticals. Here again, the bulk drugs business is more of a commodity business and cash flow generation is erratic compared to formulations, especially OTC drugs, which are good cash flow generators.

Even in the high-growth technology sector, there are many different kinds of business models. Most Indian software companies, including Infosys and Wipro, are significant free cash flow generators, as opposed to companies such as Zee’
s Siticable which need to invest large sums of money to generate sizeable profits. Since commensurate revenue and profit flows are likely only with a lag, free cash flows are likely to remain deeply mired in the red for the next few years.

One of the main reasons why the dotcom revolution was doomed from the very beginning was the inability of these companies to generate free cash flows. While venture capitalists were eager to meet the cash flow demands of these
companies when the IPO market was strong, their inability to move to a revenue and cash flow generating model has led to their predictable demise. The commodity sectors typically go through a cycle where they make significant cash
flows during the boom years but are usually forced to spend this money in capacity expansion, modernisation and fending off competition. As a result, years of strong free cash flows are few and inconsistent.

The sustainability of free cash flows is also important. In certain cases, this may be in doubt — for instance, the cigarette companies’ future is a forecaster’s nightmare. On the one hand, you have a huge bidi-smoking population, which should normally move towards cigarettes. And yet, if the trend in the West and the increasing concern about tobacco are anything to go by, one hesitates to predict growing free cash flows far into the future.

… and where they go. Generating free cash flow is not enough. The ability to utilise it wisely is just as important. This is where management comes in. A good management puts the cash flows either back into the business or into acquisitions
or gives it to the shareholders as dividends and buybacks.

A very interesting case here is Bajaj Auto. In 1997, Bajaj Auto was the darling of teh stock market. It was a market leader in a high-growth segment of the automobile market, generating substantial free cash flows, which it found difficult to invest back into the business. Part of this was due to the bad management decision not to invest sufficiently in R&D. So much so, the cash pile in Bajaj Auto grew almost alarmingly, helped along by the company’s GDR issue of $110 million a few years ago. It is only recently that the company has used a buyback to reduce some of this cash pile. But even after returning almost Rs 700 crore to shareholders, it is still sitting on a mammoth Rs 2,000 crore (worth almost Rs 180
per share). It is no surprise that Bajaj Auto’s stock price has gone nowhere in the last few years. It is currently quoting at half the offer price of its GDR (Rs 540 per share, adjusted for the 1:2 bonus).

The ideal company for investment is one that’s able to invest these cash flows profitably in growth areas, preferably within the business itself. Indian Shaving Products and Birla 3M are good examples. While some managers have been
smart enough to handle diversification well, the best businesses are those where the potential for growth is large enough for the management to avoid the effort of trying to be jack of all trades. One struggles to find Indian managers who have
done a brilliant job at capital allocation — Azim Premji and Aditya Birla are the shining examples here. However, most of Indian corporate history is full of ill-advised, poorly managed diversifications, which explains why of the 20 largest
weighted Indian companies, only two (Reliance Industries and L&T) are diversified. To its credit, Bajaj Auto has at least not used its cash reserves for diversifications.

Other clues. What other attributes should an investor look out for? Warren Buffett advises investors to buy into a business that is so simple even a fool can run it — for, as he says, eventually some fool will. If you need to be a rocket scientist to understand it, you should probably give it a pass. This is how a great investor like Peter Lynch found a large number of brilliant stock tips in his wife’s shopping basket. (For more on how you can use the Peter Lynch principle to pick stocks, see A housewife’s guide to stock-picking.)

Predictability is another characteristic to be preferred. Change, though good from a social point of view, is often the investor’s enemy. This is one reason why the fast-moving consumer goods sector is one of the surest places to find good
investment opportunities. People are loath to change their bathing, cleaning and eating habits. Companies that can capture a good share of mind of the customer find their revenues growing at a predictable pace for years to come.

Similarly, the Indian software services sector is part of the powerful global trend of outsourcing, and hence one can be reasonably sure of high growth for the next four-five years. However, being part of the technology sector exposes this sector to a degree of unpredictability that can take a heavy toll on valuations.

So, when you go about building your ideal portfolio, take a long, hard look at the businesses your companies are engaged in. If the business is easy to understand, reasonably predictable and generates free cash flows consistently, go ahead and invest. If the management allocates the free cash flows sensibly in growth areas, you may have found the perfect pick for your long-term portfolio.