#068 Importance Of ROCE VS ROE, Measuring the Operating and Financial Health of the Business, Circle of competence (Metal Sector Case study
Hi, Welcome to the 68h Edition
Brief Overview of What We will cover in this Issue
Detailed Key Takeaways from the book I am reading Currently
Why Competitive Advantages Die
Measuring the Operating and Financial Health of the Business
Best Books Ben Carlson Read In 2022
Importance Of ROCE vs ROE (Video Clip)
Circle of competence (Metal Sector Case study) (Video Clip)
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The Investment Checklist (Part-3)
What type of relationship does the business have with its suppliers?
Does the business have a hostile relationship, in which it is constantly finding ways to pay suppliers lower prices for their goods or services? Or does it have a good relationship, where it helps suppliers innovate new products and services for the benefit of the business’s customers?
Does the business have reliable sources of supply?
Does the business help the suppliers innovate by providing them with customer feedback?
Is the business dependent on only a few suppliers?
Is the business dependent on commodity resources, and to what degree?
Supply Chain Management
If you are evaluating a business, such as a fashion or online retailer (e.g., Amazon.com), it is imperative that you learn how it manages its supply chain. You need to determine if the sources of supply are stable and if the quality is consistent.
You can often find articles written about the supply chain of a business or interviews written about supply chain managers in trade journals.
As you study a business’s supply chain, consider how efficient it is. One way to do this is to calculate inventory turnover, which measures the number of times inventory is sold in a year.
Does the Business Help the Suppliers Innovate by Providing Them with Customer Feedback?
In the 1990s, General Motors’ warranty costs were higher than its profits. One of the reasons for this is that GM was more concerned with driving down its costs than with seeking improvements from its suppliers. In contrast, Chrysler provided customer feedback to its suppliers to help them develop new features that required fewer repairs and less frequent replacements. By seeking new innovations through its supply chain, Chrysler was able to take market share from GM. (You can find such information simply by searching for articles that are written about supplier relationships by combining search terms such as “supplier” and “[ the company in which you are interested].”)
Is the Business Dependent on Commodity Resources, and to What Degree?
If a business depends on certain commodities to manufacture its products, monitor those commodity prices. This will help you to understand whether rising commodity prices may force the business to increase prices, which can decrease profits if a business is not able to pass along price increases to customers.
You need to follow the price of the underlying commodity closely so you can determine whether earnings will increase or decrease. For example, if you are analyzing apparel makers, then you must monitor cotton prices to understand if the costs will increase
Measuring the Operating and Financial Health of the Business
What are the fundamentals of the business?
Determine whether the management team understands what increases the value of the business and whether that shapes their actions.
Larry Page and Sergey Brin, founders of Internet search business Google, focus on “organizing the world’s and making it accessible.”
Michael Bloomberg, the founder of Bloomberg, focused on giving his company’s customers “the information they need— no matter what the information is— where and when they need it, in whatever form is most appropriate.”
You can measure and track each of these: food quality or customer satisfaction, rate of on-time deliveries, employee productivity, graduate employment, or faculty quality. If a fundamental is deteriorating, then the value of the business will as well.
Watch for those managers who chase too many ideas or have continually changing vision statements. This can distract them from focusing on fundamentals.
As an investor, identifying and tracking fundamentals puts you in a position to evaluate a business more quickly.
If you already understand the most critical measures of a company’s operational health, you will be better equipped to evaluate unexpected changes in the business or the outside environment.
Being able to recognize deteriorating fundamentals is equally beneficial, as you can avoid investment mistakes. If a negative news announcement causes the stock price of one of your holdings to drop, always ask, “What impact does the announcement have on the fundamentals of the business?
What are the operating metrics of the business that you need to monitor?
Operating metrics are measures that help you gauge the true performance of the underlying business, similar to taking your blood pressure to monitor your own personal health.
Identify the metrics for a particular industry.
Research the sources of metrics.
Monitor the metrics over time.
Determine if changes in metrics are lasting or temporary.
Compare the metrics of the business you are analyzing to those of competitors and identify the reasons for the differences.
Identify the Metrics for a Particular Industry
To determine which operating metrics are useful, first identify what you are trying to measure. The type of metric you use will depend on the industry or business you are analyzing.
Below are a few of the most commonly used operating metrics in several industries:
Banks use the efficiency ratio, return on assets and the average cost of funds.
Real estate uses occupancy rate, rent per square foot, and cost per square foot.
Airlines use available seat miles, load factor, traffic, and capacity.
Retailers use same-store sales, basket size, sales per square foot, and average ticket.
Internet firms use conversion rates and traffic counts.
Subscription-type firms use a number of subscribers, average revenue per subscriber, average cost per subscriber, and customer churn.
Credit card firms use net charge-offs, delinquencies, and payment rates.
Hotels use occupancy, revenue per available room (RevPAR), and average daily rate (ADR).
Gaming businesses use slot-win percentage, table-win percentage, and average daily win per table per day (WPT).
Research the Sources of Metrics
Transactions per location Industry Primers Useful sources for identifying the operating metrics typically used for an industry are industry primers, such as these:• Reuters Operating Metrics• Standard & Poor’s Industry Surveys• Fisher Investments guides
These are guides written for analysts who are researching specific industries.
Internet Search and Books: A simple Internet search, using terms such as “industry metrics for [insert name of the industry]” will help you begin to identify useful metrics.
Write down all of the reasons for the changes in a particular operating metric for at least a three- to five-year period. By studying the reasons behind the changes in the operating metrics, you will gain deeper insight into what factors have the greatest impact on the value of a business.
For example, if sales drop, identify why they are dropping, instead of focusing on how much they dropped. When you identify which factors have the most impact on a business, those are the operating metrics you want to track most closely.
Determine if Changes in Metrics Are Lasting or Temporary
Comparing Metrics among Competitors: You need to determine the reason for the differences in metrics among competitors.
What are the key risks the business faces?
The first place to start is the 10-K(Annual Report in India Here), in a section titled Risk Factors, where management discloses most of the known risks to the operations of the business.
1. The first part highlights risks that relate to the business or industry. 2. The second part highlights risks that relate to the stock price.
The first set of risks is more useful because it outlines what can go wrong with the operations of the business, whereas the second set of risks tends to be standard legal language found in all 10-Ks: for example, “the stock price may fluctuate.”
Most investors read through this section fairly quickly and do not take the time to understand the potential risks of the business. However, it is important for you to spend some time in this section and investigate whether the business has encountered the risks listed in the past and what the consequences were.
Trade associations will often outline common risks, and many articles are written on how to reduce them. This will help you build a comprehensive collection of risks the business may encounter.
These operational risks might include: Overcapacity• Commoditization• Deregulation• Increased power among suppliers• Shifts in technology• Changes in laws and regulations• Product obsolescence• Patent expirations• Development of new product lines where the business has limited expertise• The emergence of competitors• Brand erosion• Overreliance on too few customers• Limited geographic distribution• Research and development failure• Business-development failure• Merger or acquisition failure• A weak product pipeline• And others
Spend time carefully reviewing each of these risks. As you learn about the different risks a business may encounter, use this information to construct downside scenarios for your valuation of the business.
When Evaluating Operational Risks, Adopt the Mentality of an Insurance Underwriter
Most of us are afraid of risks that are new rather than those we’ve lived with for a while.
For example, when terrorists attacked the World Trade Center on September 11, the relative newness of domestic terrorism decreased the prices of many stocks. Investors believed that there would be many more terrorist attacks and that this was a risk that most businesses now faced. (The recent one is Covid-19)
Just because an event has occurred and the media constantly discusses it does not mean that the actual risk is greater. Therefore, how much people discuss something is a bad indicator of actual risk. In fact, the more people talk about a risk, the more likely that risk will be mitigated.
This is why you should calm in bear market and dont overthink
How Do You Measure Risk?
You have to consider how severe the outcome might be. The more severe the outcome, the higher the risk.
It is very difficult to measure risk because you never know what will happen for sure ahead of time. More than one outcome can occur.
Use appropriate historical data, instead of making subjective estimates. Look to other businesses that have encountered a similar risk
As you consider the risks as presented in the 10-K or other sources, think like an insurance underwriter, making sure that you understand both the risk’s likelihood and potential financial cost. Learn more about these risks by reading articles and looking for examples where the business or competitors encountered a specific risk before. Attempt to understand the financial implications of these risks. Finally, base your evaluation on data and past examples, not noise.
How does inflation affect the business?
Inflation affects most businesses negatively. Most investors think about inflation as prices going up. It is not. It is the value of money going down. To evaluate the effect of inflation on your holdings or potential holdings, ask yourself if the business will be able to maintain its cash flows in real terms. In other words, in order to avoid inflation’s value-destroying effects, cash flows must increase at the same rate as inflation.
If a business is unable to increase prices to offset the effects of inflation, then it will fail to maintain its cash flows in real terms.
The Ability to Pass Along Price Increases: If the business can maintain sales volume, its cash flows will be maintained in real dollars.
The Ability to Reduce Costs: If a business can reduce its cost structure, it can offset the increased cost of labor and materials during an inflationary period.
Low Capital-Expenditure Requirements: On the other hand, businesses that have invested capital at a lower cost might benefit in an inflationary environment as the value of older assets increases.
Long-Term Debt Maturities The common view is that businesses with a lot of debt benefit from inflationary periods as the value of the debt declines. This is true if the business does not have to refinance its debt in the near term, because inflation generally causes borrowing to become more expensive, not less expensive.
There are various types of inflationary risks— such as increasing costs (including wage inflation) and rising interest rates— and you need to develop an understanding of how each of these inflation risks will affect each of your investment holdings.
Rising Interest Rates Most stocks are negatively affected by rising interest rates. In a rising interest-rate environment, the price- to earnings ratios of stocks typically drop. This is why stocks have always tended to perform badly during periods when inflation is rising and corporate earnings are declining.
Real estate would be negatively affected, as capitalization rates in a rising interest rate scenario increase which would then decrease overall asset values.
To evaluate the effects of inflation on potential or current holdings, determine how well the business will be able to maintain cash flows in real terms in scenarios where material costs, wages, or interest rates are rising.
Is the business’s balance sheet strong or weak?
Your primary goal should be to figure out if the cash-flow stream the business generates is predictable enough to assure that debt payment, both on and off the balance sheet, can be made.
Identifying a Business’s Motivation for Debt: Management often attempts to justify its actions by stating that the balance sheet needs a better capital structure and needs leverage to maximize the value of the business.
Considering the Advantages of Low Debt: First, the business has less risk of entering bankruptcy, allowing you, as an investor, to sleep better at night. Second, a strong balance sheet allows the business to be opportunistic.
Case Study of a Company that Uses Debt Conservatively: Brookfield Asset Management
Brookfield also staggers the maturity of its debt repayments so that they don’t all come due at the same time, thus decreasing refinancing risk.
Brookfield will typically finance assets that generate predictable long-term cash flows with long-term fixed-rate debt, instead of variable-rate debt, in order to provide stability in cash flows and protect returns in the event of changes in interest rates.
This way, it is not dependent on any particular segment of the capital markets to finance its operations.
Determining How Much a Business Can Borrow
The more stable the cash flows are for a business, the more debt it can take on.
Factoring in Off-Balance Sheet Debt
These include:• Lease obligations• Warranties• Purchase contracts• Unfunded pension liabilities• Any other contractual obligations
These are typically disclosed in the footnotes to the financial statements
Retailers, ship operators, airlines, and many other types of businesses have large contractual obligations that are off-balance sheet.
The downside to using these ratios is that they only give you a snapshot of the business at a certain point in time. A business can change dramatically from quarter to quarter, so static ratios can be misleading when not analyzed over a longer time frame.
Assessing the Short-Term Financial Strength of a Business
Short-term liquidity is extremely important to lenders because it is the inability to pay short-term liabilities that cause most businesses to enter bankruptcy.
The current assets are things such as cash, accounts receivable, and inventories. Long-term assets include property, plant, and equipment.
Accounts Receivable Next, you need to understand the quality and liquidity of a company’s accounts receivable. This is especially important for those businesses that sell on credit.
Inventory Understanding how long it takes to convert inventory to cash will also help you understand how quickly a business can pay back its short-term liabilities.
Determining the Debt-Maturity Schedule
Refinancing debt represents risk for a business. It is important for you to determine when debt is coming due. You can find the dates when debt is due in the notes to the financial statements under the Debt footnote.
Determining Whether the Business Has Recourse or Non-Recourse Debt
The most benign form of debt is non-recourse debt, which is debt that is secured by a particular asset and not by the overall business.
In a non-recourse situation, if the business defaults on a loan backed by a certain property, then it has the right to turn over the property to the lender, without further losses, in exchange for the forgiveness of the loan.
What is the return on invested capital for the business?
It shows you how well a business is using its assets.
The average ROIC varies from industry to industry and ranges from negative to more than 50 percent; here are some examples of high-end, mid-range, and low-end ROIC industries:• At the high end, with ROIC typically greater than 20 percent, are industries such as software firms, soft drinks, pharmaceuticals, distilled spirits, luxury products, and medical instruments.
Industries with ROIC of 10 to 20 percent include hotels, packaged foods, grocery stores, drug stores, and book publishing.
On the low end, with ROIC from negative to 5 percent, are industries such as airlines.
The reason for this is that the higher the ROIC, the more a business is able to earn.
A business with a high ROIC will deliver more wealth to its shareholders over the long term from higher earnings. Ideally, you want to own a business that over an extended period of time can reinvest excess earnings at high ROIC.
It is important for you to calculate ROIC because ultimately the value of a business is based on the returns a business is able to achieve on its invested capital.
If you pay too high a price for a stock such as a high multiple of book value, then a high ROIC will not help you earn a satisfactory return on your investment.
For example, at discount retailer 99 Cent Only Stores, ROIC averaged 20 percent from 1995 to 1999, but then it began to drop as the cash balance increased. Many analysts were concerned about the drop and believed it was due to deteriorating business conditions, when in fact, it was dropping because of the excess cash on the balance sheet. By removing excess cash, you will understand the ROIC being generated by the operations of the business.
Excerpts and Learning from Articles/Blogs
1) Why Competitive Advantages Die
“Being right is the enemy of staying right because it leads you to forget the way the world works.” – Jason Zweig
Knowing you have a competitive advantage is often the enemy of beginner’s mind, because doing well reduces the incentive to explore other ideas, especially when those ideas conflict with your proven strategy. Which is dangerous
Nothing to lose is a wonderful thing to have.
systems are better than goals, because once you reach a goal you tend to stop doing the thing that made achieving the goal possible. “I’m going to work out every day” is better than “I’m going to lose 10 pounds” because once you lose 10 pounds you’ll probably stop working out. Same thing happens when a successful business or career hits a big goal.
2) How to learn from others
“When the student is ready, the teacher appears, but when the student is truly ready the teacher disappears.”
For a person who is new to investing and having some sense of what they want to learn, this is a mountain of knowledge. A good starting point for many in this field, has been to study the greats and learn from their investing experience. What we pick up from these great investors is that given a set of data points, macroeconomic factors and valuations, how did someone make a decision to buy/hold/sell something.
What we learn from others is not to copy their thought process but how different people process data. What sort of analysis was needed, what sort of information gathering was done & what sort of behavior was demonstrated to reach to a decision? If the investor has a public track record, most of these data points can be verified quite easily.
We also start to believe our superiority when we make a quick profit and start to doubt ourselves hopelessly when we make a loss. Notional or real, all these profits and losses are deeply emotional for us.
With enough iterations over a cycle or two, a period of 5-10 years, one can start seeing their own strengths and weakness
Stop learning from others
This is the tricky part in our learning journey. There is a moment when we need to acknowledge that we are learning and yet we have learnt enough of something to confidently be able to do it at a professional level.
A time comes when the teacher has to disappear and we need to be comfortable in the driving seat without any guidance. At this stage we need to be self aware about our limitations and our style of processing ideas.
The context of investing is not the same as the person you are learning from. The market environment & macroeconomic circumstances are different. The business & the sector dynamics have evolved into something else. The size of the business & nature of competition is different. In many cases if we are learning from investors outside of India, the country specific & geopolitical nature of the sector / business is also different.
Investing is a fundamentally contradictory job. What you learn is valuable and at the same time not valuable because the information & insight can decay over time. We need to constantly update ourselves and yet be fully aware of the parts of our thought process that don’t / shouldn’t change.
We accumulate layers and layers of education, experience and insights which come in handy while building a portfolio. We also believe that while doing so we are learning some fundamental truth about the market or investing.
3) Charlie Munger’s Biggest Investing Mistake
In 1977 a broker offered Charlie 300 shares of Belridge Oil at $115/share. Munger took it.
The next day the broker called and offered him another 1500 shares at the same price. Charlie knew Belridge was super cheap but he needed to sell something to raise the $173,000 to buy Belridge. He passed.
Two years later Belridge was sold for $3665/share to Shell Oil. Charlie made over $1.1 million including dividends on the 300 shares and put the proceeds into Berkshire Which was trading at around $375/share then. Thus $34500 was invested in Belridge in 1977 and then Berkshire in 1979 became $1.45 billion today. The 1500 shares he passed on would be worth over $7 billion today, which may be higher than Charlie’s total networth today.
4) Schrodinger's markets
No matter how crazy markets seem every waking hour, deep down, I believe that markets will eventually sync up with the real world.
Ben Graham recommended intelligent investors entirely ignore mad markets, except for rare occasions when madness led to bargains. Buffett’s $600 billion arose from markets taking his businesses from under-valued to fairly if not unfairly valued. Schizophrenic, yet sensible. Mad, yet fair. Ignored as crazy, yet the basis for how we’re judged. It’s a bit confusing.
Markets are neither efficient nor inefficient. Maybe they are both efficient and inefficient.
Have clear standards to establish what’s sane, preferably based on underlying business, long history and common sense.
On seeing clear insanity, accept it for what it is. Don’t rationalize it merely because sophisticated strangers are doing so.
Base investment decisions and expectations on sanity prevailing, not insanity continuing.
Be mentally prepared for an uncomfortably long periods of insanity, especially of the kind that fosters doubt and regret.
Keep the faith, as Graham did.
5) Best Books Ben Carlson Read In 2022
Small Video Clips
➢ Basant Maheshwari Interview | Kotak Securities
How many stocks are enough in the long-term stock portfolio? (37:28 to 39:47)
Circle of competence (Metal Sector Case study) (39:59 to 42:05)