Every one of us would agree that wealth creators stocks always have been one of the finest businesses. A good business is one that earns a high Return on Capital. This earning power comes from brands or patents, distribution advantage, scale, exclusivity by regulation, etc.
Within that there are two types of business potential:
1) Great : Re-investment opportunity
2) Good : Capital allocator
What does this mean?
Great Business: The highest amount of wealth is generated by a business that earns high returns on capital AND can reinvest those profits at same returns on capital. This means, it might be operating in market that is either under-penetrated, new trends, niche or large unorganised market, etc.
In today’s context Examples: Page Industries, Maruti Suzuki, Eicher Motors, Private sector Banks, Asian Paints, P&G HH
These businesses can earn very high returns on capital and reinvest those returns to grow their revenues without sacrificing profits since there is more demand to cater too. If they earn 25% on capital, they can reinvest the same to grow revenues by 25%. And doing this profitably means, profit also grows 25% every year and hence the stock price. Over 10 years, starting investment can grow 10 times. We can definitely call them Great Businesses.
Compare this with something like Colgate or Bajaj Auto or Castrol. Lot of people are already using their products, so they are fairly penetrated. It is not a lot they can do. Either they can premiumize their products or get into other related products. But they do not have opportunity to grow beyond that. However they still earn very high returns on already deployed capital. They keep some capital for some modest growth and return rest of it through dividends or buyback. By investing/giving away capital, the management is making efficient use of capital, good capital allocation. Assuming 10-12%, growth rate, chances are their dividends could be quite lucrative i.e. 3-4% p.a. This comes to ~15% CAGR, not bad at all. Over 10 years, starting investment can grow to 4 times. So let’s call them Good businesses.
Looking at stark difference between the wealth created by the two, isn’t it wise to always buy a Great business over a Good business? Indeed, but…
It’s not so easy. There are two concerns. One, they are always expensive. Lot of future returns is already earned by early investors/promoters and it gets captured in high price multiples. Second, there is too much uncertainty whether they will be able to grow profitably over long time periods. Will the management be able to execute well not. What if growth happens slower than expectation? Like Air Conditioning market is under-penetrated, agreed but what if A/C volumes reach our expectations over 20 years rather than 10 years? This will lead to fall in annual investor returns. And most profitable and growing businesses always attract more competitors. This leads to risk of deterioration in profitability.
What do we suggest?
We suggest that whenever you get a Great business at sensible prices, buy them heavily and hold them tight for 10-20 years. However, this doesn’t happen very often but only during wide market panic they fall along with it. So we set aside some portion of portfolio for such opportunities. Rest of the time, you can buy a Good business at discount prices. Note that even Good businesses never trade at cheap valuation, but occasionally you may get them cheap due to temporary business problems or during business downcycles.
At MoneyWorks4me, we buy both Good and Great businesses. We don’t keep on waiting for Great business to come to our price. We have to grow our client portfolios to meet their goals. Occasionally when we do get Great business at sensible prices we recommend aggressively buying upto 7-8% of portfolio. Some Great Business we have recommended for our Clients – Asian Paints (2013), Divis Labs (2013 & 2017), Pidilite (2013), Maruti (2013), Titan (2014 & 2016), Sun Pharma (2017)
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