Article

Investing in Businesses that Record Highs – Tackling Qualitative Issues

16 Dec 2019

The starting point to track the performance of any business is obviously the hard numbers. You need to look at volume growth, pricing power, operating margins, efficiency ratios, leverage risk etc. While these form the hard facts to evaluating any business, the real decision is taken on a number of soft factors too. For example, Hindustan Lever’s product brand or Bharti’s network effect or HDFC Bank’s reliability are not about hard facts alone. In all these cases, it is the softer aspects or the qualitative aspects that gives these businesses an edge. Let us look at 7 such qualitative factors that make a big difference to value.

What is the Business Strategy of the company?

How the company makes its money is as important as how much money the company makes. That is where strategy comes in. Many successful businesses have a strategy that is focused on a handful of clients or on a set of circumstances. They often do not have a Plan-B in place. That is bad strategy. For example, in the financial services business, a strategy to extract more revenue per customer is always more successful in the long term.

On what basis does the business compete?

When a company is a leader in a particular business, it is how they compete and what makes them competitive that really matters. A company that purely competes on price cannot sustain for too long. Similarly, service standards are more sustainable but even they can only take you up to a point. It is the companies that compete by being ahead of the business disruption that really thrive in the long run. Warren Buffett called that a moat but it basically defines how well you can maintain the lead over competition.

Quality of intangible assets in the business

Intangible Assets are not found in the balance sheet nor are they assigned any numerical value. But they do translate in a big way into business advantage and hence give higher valuations to the business. Intangible assets could be in the form of business monopoly, patents or even brands. For example, the Tata group has the brand of quality while the Godrej group has the brand of sturdiness as their approach to business. These factors give an edge in valuation. Similarly, patents can matter a lot in sectors like pharma, chemicals, biotechnology etc.

How steep is the customer switching cost?

Switching cost is what it costs the consumer to switch to a competitor’s product. Companies with high switching costs are unlikely to lose customers so easily. For example, Microsoft Windows has a high switching cost, which is why it is the most valuable company in the world. The effort and cost of switching is so high that the customer just does not have any incentive to switch.

How strong is the network effect?

If you have used Facebook or Twitter, you will realise that as the network expands, it automatically becomes more valuable because at some point the on-boarding of new customers is automatic. Such a network effect applies to telecom sector in India. That explains why Bharti Airtel managed to create tremendous wealth between 2002 and 2006 when the network effect really worked in favour of the company. Reliance Jio has now been using the network effect in creating a digital ecosystem at a reasonable cost.

Competent and honest management

Good management is critical for any company’s success. The difference between the way Indigo Airlines thrived and Kingfisher went out of business was the way the management handled the business. That is one of the reasons large businesses like the Tatas, Hindustan Unilever and Infosys give a lot of importance to management bandwidth. The reason IT companies like Infosys and TCS always commanded a premium valuation over Satyam was due to the doubts over the quality of management in the case of Satyam.

Corporate governance standards

Transparency and disclosure practices are an integral part of corporate governance. You are looking at a stock as the owner of a business. Hence, when you evaluate management, you look for managers who act like owners. Corporate governance is enhanced when the management and the owners of the business act in the larger interests of the minority shareholders. That is why, at the core of corporate governance it is all about aligning the goals of the business with the goals of capital providers. As Narayana Murthy famously said, “When in doubt, disclose”. Transparency can do wonders for corporate governance and also for the valuation of the business.

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    This article claims RJio was given a "Backdoor Entry" into the 4G Based Voice Routing. The peculiar aspect is without the Voice License, Rjio would have been a mere ISP. With the license, it is now a holistic communications service provider, with ability to exponentially scale the bouquet of products. The events indicate it was meticulously planned way before the auctions because the auctions were clear on the agenda: 4G for internet only.

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Investing in Businesses that Record Highs – Tackling Qualitative Issues

16 Dec 2019

The starting point to track the performance of any business is obviously the hard numbers. You need to look at volume growth, pricing power, operating margins, efficiency ratios, leverage risk etc. While these form the hard facts to evaluating any business, the real decision is taken on a number of soft factors too. For example, Hindustan Lever’s product brand or Bharti’s network effect or HDFC Bank’s reliability are not about hard facts alone. In all these cases, it is the softer aspects or the qualitative aspects that gives these businesses an edge. Let us look at 7 such qualitative factors that make a big difference to value.

What is the Business Strategy of the company?

How the company makes its money is as important as how much money the company makes. That is where strategy comes in. Many successful businesses have a strategy that is focused on a handful of clients or on a set of circumstances. They often do not have a Plan-B in place. That is bad strategy. For example, in the financial services business, a strategy to extract more revenue per customer is always more successful in the long term.

On what basis does the business compete?

When a company is a leader in a particular business, it is how they compete and what makes them competitive that really matters. A company that purely competes on price cannot sustain for too long. Similarly, service standards are more sustainable but even they can only take you up to a point. It is the companies that compete by being ahead of the business disruption that really thrive in the long run. Warren Buffett called that a moat but it basically defines how well you can maintain the lead over competition.

Quality of intangible assets in the business

Intangible Assets are not found in the balance sheet nor are they assigned any numerical value. But they do translate in a big way into business advantage and hence give higher valuations to the business. Intangible assets could be in the form of business monopoly, patents or even brands. For example, the Tata group has the brand of quality while the Godrej group has the brand of sturdiness as their approach to business. These factors give an edge in valuation. Similarly, patents can matter a lot in sectors like pharma, chemicals, biotechnology etc.

How steep is the customer switching cost?

Switching cost is what it costs the consumer to switch to a competitor’s product. Companies with high switching costs are unlikely to lose customers so easily. For example, Microsoft Windows has a high switching cost, which is why it is the most valuable company in the world. The effort and cost of switching is so high that the customer just does not have any incentive to switch.

How strong is the network effect?

If you have used Facebook or Twitter, you will realise that as the network expands, it automatically becomes more valuable because at some point the on-boarding of new customers is automatic. Such a network effect applies to telecom sector in India. That explains why Bharti Airtel managed to create tremendous wealth between 2002 and 2006 when the network effect really worked in favour of the company. Reliance Jio has now been using the network effect in creating a digital ecosystem at a reasonable cost.

Competent and honest management

Good management is critical for any company’s success. The difference between the way Indigo Airlines thrived and Kingfisher went out of business was the way the management handled the business. That is one of the reasons large businesses like the Tatas, Hindustan Unilever and Infosys give a lot of importance to management bandwidth. The reason IT companies like Infosys and TCS always commanded a premium valuation over Satyam was due to the doubts over the quality of management in the case of Satyam.

Corporate governance standards

Transparency and disclosure practices are an integral part of corporate governance. You are looking at a stock as the owner of a business. Hence, when you evaluate management, you look for managers who act like owners. Corporate governance is enhanced when the management and the owners of the business act in the larger interests of the minority shareholders. That is why, at the core of corporate governance it is all about aligning the goals of the business with the goals of capital providers. As Narayana Murthy famously said, “When in doubt, disclose”. Transparency can do wonders for corporate governance and also for the valuation of the business.