Of Long-term Value & Wealth Creation from Equity Investing by Bharat Shah is an insightful book to understand long-term value & wealth creation from equity investing.
The book is about identifying stocks of long-term value & wealth creation and provides various tools to understand the quality of business & valuation. What differentiates and makes the book even more interesting is that the context i.e., businesses discussed in the book are from India.
Price is What You Pay, Value is What You Get
Understanding the value of an underlying asset of equity investing i.e., valuation of equity/stocks is critical for long term wealth creation from equity investing. Price is known to everyone, but value of an underlying asset in equity investing is known to very few.
Price is known and upfront, whereas value will unravel over time in future. What makes equity investing interesting/mystical is the difference between price and perceived value.
Successful investing is all about judgment to rightly value the business, buying at a good discount and getting more in return for what you have already paid.
It is all about collating, assimilating, and using all the insights available about a business at a time, and using it to probabilistically forecast the future of the business. When that process is done with integrity, intensity, and intellect, the outcome is normally good.
Size of Opportunity
“Size of the opportunity is the foundation for continual growth (of profits) and creating a compounding machine, foundation on which large value creation rests.”
Size of opportunity is the most important factor for long-term value & wealth creation. The size of the opportunity is not about what the size is at the point of observation, but it is more about potential the opportunity size can be in the future.
“Size of opportunity is a very fundamental point. It really is the foundation of investment edifice, on which the large value creation rests. Simply put, it describes the opportunity for and constraints on the size and duration of growth (of earnings) of a business.
Whether it will hit a glass ceiling soon or can soar freely for long will be decided by this idea. Nothing keeps expanding forever (except the universe). If trees keep growing tall, they should touch skies. But that does not happen. Practically speaking, it is about the notion of whether a business can grow at a meaningfully high rate for a meaningfully long duration.”
The idea of size of opportunity is very well explained through analogy of size of fish and the size of pond.
- Large fish in a large pond
- Small fish in a small pond
- Large fish struggling in a shallow pond
- Small fish growing in a large pond
Large fish in a large pond is the most desirable opportunity. The fish is large and has acquired strength, and has potential to get even bigger over time.
Small fish in a small pond is the most vulnerable one. The small fish in a small pond with shallow waters cannot grow due to inadequate food and nourishment to grow big.
Large fish in a small pond looks very interesting and acceptable/lucrative for investment, but if the fish is already large, it means in the past it has been successful and as it is in small pond i.e., industry in which it operates has limited size, the future growth is constrained and challenged.
Small fish in a large pond is the most interesting. The large pond (~large opportunity/new sector/sunrise sector) implies that the headroom for growth is very favorable. The conditions with plenty of availability of nourishment are very much favorable for explosive growth.
Identifying large fish in a large pond, small fish in a large pond are the best options for value creation.
Earnings Growth (Quantum, Consistency, Predictability, Duration)
“Stock price is a slave of earnings growth.”
Over a period of time, market value creation is usually aligned to the underlying profit compounding. There is umbilical cord of a relationship between earnings growth and investment returns.
The investment return will track the earnings compounding over a long enough period of time. Short term aberrations get evened out over a period of time.
Positive exceptions (earnings growth overshoots investment return) can happen during early stage, when the businesses are undiscovered and undervalued.
Negative exceptions (investment return overshoots earnings growth) can happen when the business generates too much hype (beyond its potential) and it results into overvaluation. The overvaluation will usually get corrected over a period of time. It results into lower investment returns as compared to earnings growth.
Quality of Business (CapitalIntensity and Capital Efficiency)
The two most vital characteristics of business are Capital Intensity and Capital Efficiency. Capital Intensity means whether a business fundamentally requires high amount of capital.
Capital Efficiency signifies whatever be the amount of capital required in the business, whether it generates a superior return or not.
“Quality of business, in simple terms, is its ability to generate superior, consistent, predictable, and durable ROCE. It essentially stems from the pricing power of a business, whether a business is a price taker or a price marker in its competitive space.
The ability of a business to be a price maker is likely to stem from an economic moat. Sources of the moat can be, but not confined to, protected intellectual advantage, legally sanctioned monopoly, a valuable brand, an exclusive technology, favorable consumer goodwill, lasting cost advantage, and the like.
Absence of moat, or breaching of the moat, implies the weak quality of business, and in turn, threatened or impaired value creation or investment returns.”
Certain businesses, by their nature are capital intensive in nature, with heavy investment frontloaded or recurring capital investment for expansion.
During capital expenditure, ROCE of such businesses gets adversely impacted. Airlines, hotels, theater screens, retailing, metals, oil exploration and many such business are capital intensive in nature.
The business scenario between capex & future cash inflows can alter adversely, impacting the business and resulting into losses or less return as expected.
Businesses with high capital intake have usually low ROCE. High Capital intensity may result into lower value creation through increased operational risk and reduced capital efficiency. Quality of business and demand shall remain intact for value creation in capital intensive business.
The capital intensity can come from two elements i.e., the need for fixed assets (fixed capital) and working capital.
A business that requires both high capital as well as working capital may not be very favorable for investment. Ideally for a business to create value, it needs to have low capital intensity on account of the fixed capital and working capital.
But if there is a choice, it is better to have capital intensity due to working capital rather than due to fixed assets, as capex is upfront whereas value creation depends on possible future cash inflows.
In businesses with heavy capex owing to fixed assets, for investment to generate return the quality of business and demand shall remain intact.
Earnings Growth and Quality of Earnings
Rise in profits does not necessarily translate into increase in market value. Profits can rise even by injecting more capital in the business, through discounts etc. Rise in profit with decreasing capital inefficiency can diminish market value creation.
“Earnings growth is necessary but not a sufficient condition for value creation”
Therefore, growth of earnings is a necessary condition but not a sufficient of for investment returns. Growth to create market value has to be capital efficient growth i.e., growth backed by superior ROCE.
“Persistent and superior capital efficiency is the single most important evidence of quality.”
“Fusion of the two vital aggregators, rate of earnings growth and quality of earnings determine the investment returns.”
Quality of Management
Ethics, vision and execution capability of a management have a significant impact on investment returns. Market rewards good corporate governance and ethics. Companies associated with good corporate governance and ethics are usually trades at premium valuation as compared to peers.
“A good head and a good heart are always a formidable combination” Nelson Mandela
Quality of management is revealed by capital allocation and capital distribution decisions of the management. Capital allocation i.e., capability and prudence of the management in allocating surplus capital. ‘
Capital distribution i.e., whether management has shown wisdom not to hoard unnecessary cash on the balance sheet which is not required in the business, rather giving it back to investors through dividend/buyback.
Of long-term Value & Wealth Creation from Equity Investing by Bharat Shah is one of the finest books to understand the art & science of equity investing & valuation.
This is a guest post by Vikash Anand who is Senior Manager, Tribal Development Department, Government of Gujarat. Catch him on LinkedIn.