18th Annual Wealth Creation Study

2008-2013

Uncommon Profits

By Raamdeo Agrawal

13 December 2013

18th Annual Wealth Creation Study www.motilaloswal.com

 Uncommon Profits

Theme Study
18th Annual Wealth Creation Study www.motilaloswal.com
Theme Discussion Points

Uncommon Profits: What & why

Emergence & Endurance: What & why

Framework to identify Emerging Value Creators

Methodology to shortlist Emerging Value Creators

Why Enduring Value Creators?

Methodology to shortlist Enduring Value Creators

2
 A simple mantra for Wealth Creation

Uncommon Profits in companies

=
Uncommon Wealth Creation in markets

18th Annual Wealth Creation Study www.motilaloswal.com

 Uncommon Wealth Creation #1
250
Ambuja Cement Sensex - Rebased
200

150

Ambuja up 420x in 25 years; 27% CAGR

100
Sensex up 45x; 16% CAGR
50

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18th Annual Wealth Creation Study www.motilaloswal.com
 Uncommon Wealth Creation #2
750
HDFC Bank Sensex - Re-based
600

450

HDFC Bank up 64x in 15 years; 32% CAGR

300
Sensex up 7x; 14% CAGR
150

0
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18th Annual Wealth Creation Study www.motilaloswal.com
 What leads to Uncommon Wealth Creation?

Over the long term, its hard for a stock to earn a

much better return than the business which
underlies it earns. If the business earns 6% on
capital over forty years and you hold it for that forty
years, youre not going to make much different than
6% return even if you originally buy it at a huge
discount. Conversely, if a business earns 18% on
capital over 20 or 30 years, even if you pay an
expensive looking price, youll end up with one hell
of a result.
Charlie Munger, VC, Berkshire Hathaway

18th Annual Wealth Creation Study www.motilaloswal.com

 In simple words

Uncommon Profits in companies

=
Uncommon Wealth Creation in markets

18th Annual Wealth Creation Study www.motilaloswal.com

What is Uncommon Profit?

Uncommon Profitability (%) = RoE > Cost of Equity

Uncommon Profit (abs) = (RoE CoE) x Equity employed

where RoE = Return on Equity
Cost of equity = Opportunity cost of equity or
Risk free rate + Equity risk premium

In Indian context, Cost of Equity = 15%

Consistent Uncommon Profit earning companies

are Value Creators

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What is Emergence & Endurance?

Emergence is first entry of a company into

the Uncommon Profit zone i.e. RoE > 15%

The next challenge is Endurance i.e.

sustaining RoE > 15% for several years ahead

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Uncommon Profit & Company Lifecycle

PAT
(a) Renewal
Post-Emergence struggle
for Endurance

(b) Decline

POINT OF
EMERGENCE

Pre-Emergence
struggle for survival

Introduction Growth Maturity Time

10
Uncommon Profit Case Study #1

Titan Industries (YoE: 2003)

Uncommon Profit generation

Uncommon Wealth Creation

26x in 5 years (85% CAGR),

130x in 10 years (59% CAGR)

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Uncommon Profit Case Study #2

Gruh Finance (YoE: 2003)

Uncommon Profit generation

Uncommon Wealth Creation

10x in 5 years (60% CAGR),

70x in 10 years (54% CAGR)

12
Uncommon Profit Case Study #3

Bharti Airtel (YoE: 2005)

Uncommon Profit generation

Uncommon Wealth Creation

4x in 3 years (59% CAGR)

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Framework to identify Value Creators
Contribution of various factors to abnormal profits
Contributing factor High Performers Low Performers
Emergence Sustainability Emergence Sustainability
Year 2% 3% -7% -5%
Industry 37% 44% 12% 13%
Corporate-parent 18% 19% -4% 2%
Segment-specific 43% 34% 99% 90%
Source: Paper by Anita McGahan & Michael Porter

Year Economic cycle

Industry Industry-level factors like size of profit pool,
competition, stability, strategic opportunity, etc
Corporate Parent Promoter or majority owner
Segment-specific Company-specific factors like quality of
management, strategy/unique value proposition, etc
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Value Creators: Industry-level factors

#1 Size of profit pool

10 highest PAT sectors (2013)
Sector Rs crores % share
Financials - Banks 84,154 21
Energy - Oil & Natural Gas 39,963 10
Technology - Software 34,702 9
Financials - NBFCs 32,376 8
Mining & Minerals 27,261 7
Energy - Refineries 22,774 6
Utilities 22,349 6
Automobiles 21,931 6
Healthcare 16,518 4
Metals - Non-Ferrous 10,520 3
Total of above 312,547 79
Grand Total 394,786 100
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Value Creators: Industry-level factors

#1 Size of profit pool (contd)

10 lowest PAT sectors (2013)
Sector Rs crores
Aviation -5,695
Telecom - Service & Eqpmt -3,972
Shipbuilding -410
Sugar -212
Shipping -203
Glass & Glass Products -166
Ceramic Products -163
Paper -18
Printing & Stationery -10
Electronics 1
Total of above -10,846
Total Profit Pool 394,786
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Value Creators: Industry-level factors

#1 Size of profit pool (contd)

Highest PAT CAGR (03-13) with minimum PAT of Rs 2,000 crores in 2013
Sector 03-13 PAT PAT Sector 03-13 PAT PAT
CAGR (%) Delta CAGR (%) Delta
Textiles L to P 5,653 Infra Developers 28 6,233
Realty L to P 3,799 Metals - Steel 28 3,006
Fertilizers L to P 2,821 Metals - Non-ferrous 27 9,556
Cement 57 7,825 Healthcare 20 13,843
Tech - Software 54 34,239 Capital Goods 19 5,413
Gems & Jewelry 46 3,176 Tobacco Products 18 6,275
Financials - NBFC 46 31,647 Banks 18 67,998
Mining & Minerals 46 26,627 Auto Ancillaries 17 2,917
Automobiles 39 21,101
Chemicals 29 3,115 TOTAL CORP. SECTOR 20 331,719

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Value Creators: Industry-level factors

#1 Size of profit pool (contd)

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Value Creators: Industry-level factors

#1 Size of profit pool (contd)

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Value Creators: Industry-level factors

#2 Competitive landscape & bargaining power

Porters 5 forces
framework to
assess competition
& bargaining power

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Value Creators: Industry-level factors

#3 Value Migration

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Value Creators: Industry-level factors

#4 Stability of industry
12000
11440
Baltic Freight Index
10000
Cyclicality makes industries risky
8000
5551
6000
4078
4000
2337
2000
1804
715
0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

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Value Creators: Industry-level factors

#5 Emergence of new industry /strategic opportunity

1,500
Jubilant Foodworks Sensex - Rebased
1,200
Jubilant up 6x in under 4 years;
CAGR of 65% v/s 7% for Sensex
900

600
Uncommon Wealth Creation

300

0
Feb-10

May-10

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Feb-11

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Aug-13
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Aug-12

Feb-13

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Nov-10

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Nov-13
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Value Creators: Corporate-parent factors

3Is Integrity + Intelligence + Initiative

#1 Value system
#2 Processes
#3 Capital allocation
#4 Management skill v/s Luck

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Value Creators: Company-specific factors

#1 Unique value proposition / Strategy

#2 Nature of business:
Consumer Adv v/s Production Adv
#3 Market leadership or pioneering

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Pitfalls to avoid in Emergence

#1 Pre-empting emergence
#2 Emergence during peak of good times

the risk of paying too high a price for good-quality

stocks while a real one is not the chief hazard
confronting the average buyer of securities.
Observation over many years has taught us that the
chief losses to investors come from the purchase of
low-quality securities at times of favorable business conditions.

Benjamin Graham in his book The Intelligent Investor

26
Methodology for Emerging Value Creators
#1 Age criterion
Select listed companies below 25 years of age

#2 Meaningful Emergence
15% RoE for first time with minimum PAT size, say, Rs 10 crores

#3 View on corporate-parent/management
based on group performance, Annual Reports, payout policy, etc

#4 Avoid cyclicals
Incorporating stability of industry

#5 Valuation check considering risk of non-Endurance

P/E typically not exceeding 20x

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Backtesting during 2001 to 2008
Emerging Value Creators financial & stock market performance
Company Year of P/E (x) 5-year post emergence (%)
Emerg. in YoE PAT CAGR Price CAGR Rel Perf.
Shriram Transport 2001 1 56 85 60
Accelya Kale 2008 3 36 60 56
Shriram City Union 2004 3 45 70 58
GRUH Finance 2003 4 33 60 22
Plastiblends (I) 2004 4 1 4 -8
Manappuram Finance 2007 4 123 70 64
Havells India 2004 7 P to L 39 27
Cera Sanitaryware 2008 7 36 29 17
KPIT Tech 2004 8 36 4 -7
Blue Dart Express 2001 9 22 45 20
Titan Industries 2003 12 53 85 46
Hitachi Home 2006 12 14 22 11
Tata Elxsi 2001 16 20 23 -3
Emami 2007 18 31 33 27
Suprajit Engg. 2006 18 21 0 -12
IL&FS Invt Managers 2007 18 32 9 3
Asahi India Glass 2002 19 25 51 21
AVERAGE 10 24 41 24

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Backtesting during 2001 to 2008

Applying Value Creator checklist items (amplifiers)

Industry Profit pool size
Nature of business
Leadership
Amplifier No. of 5 years post-emergence (%)
cos. PAT CAGR Avg RoE Price CAGR Rel. Perf.
Industry Profit Pool
High 10 26 29 55 37
Low 7 21 37 20 4

Nature of business advantage

Consumer 9 21 34 46 31
Production 8 27 30 34 16

Leadership i.e. among top 3 players

Yes 10 19 32 45 28
No 7 31 32 34 18

Portfolio avg 17 24 32 41 24

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Backtesting during 2001 to 2008

Optimized portfolio with Amplifiers

Company P/E (x) 5-year post emergence (%)
in YoE PAT CAGR Price CAGR Rel. Perf.
Manappuram Finance 4 123 70 64
Shriram Transport 1 56 85 60
Titan Industries 12 53 85 46
Havells India 7 P to L 39 27
Blue Dart Express 9 22 45 20
AVERAGE 7 65 43

30
Emerging Value Creators to bet on now
Potential Value Creators by applying methodology for years 2009-13
(Rs crores) FY13 1HFY14 Nov-13
PAT PAT Gr. % RoE % PAT Gr. % Price Mkt Cap P/E (x)
With amplifiers
Bajaj Finserv 1,574 18 24 36 739 11,760 7
Bajaj Corp 161 38 35 15 231 3,410 19
Zydus Wellness 97 43 44 29 544 2,127 20
Symphony 59 11 29 27 408 1,427 23
Others
Cairn India 11,882 49 25 6 324 61,868 5

31
Why Enduring Value Creators

Emerging Value Creators are rare

(we could get only 17 in 8 years 2001-08)
Enduring Value Creators too
outperform despite being fully discovered
and fairly discounted
A suitable methodology may help
to shortlist Enduring Value Creators

32
Methodology for Enduring Value Creators
#1 Quality & Longevity criteria
RoE >= 15% for each of the last 10 consecutive years

#2 View on corporate-parent/management
based on group performance, Annual Reports, payout policy, etc

#3 Growth
Last 3-year CAGR of at least 15%

#4 Value-enhancing growth
Postive delta RoE over the last 5 years

#5 Reasonable valuation
Not more than 50% premium to market
i.e. P/E typically not exceeding 30x

33
Backtesting during 1999 to 2008
2008 Enduring Value Creators financial & stock market performance

Company 2008-13 P/E

PAT Price Rel.
2008 2013
CAGR CAGR Perf.
Berger Paints 19 40 36 12 31
Torrent Pharma 28 38 34 9 13
Asian Paints 22 33 29 28 43
Castrol India 15 27 23 20 33
Colgate-Palmolive 16 27 23 22 34
Marico 18 26 22 26 37
City Union Bank 26 25 21 7 8
HDFC 20 12 8 25 19
Wipro 13 11 7 19 18
Glenmark Pharma -1 -1 -5 19 20
AVERAGE 16 24 20 21 20

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Enduring Value Creators to bet on now
Applying methodology for years 2004 to 2013; preferred bets highlighted
Company 2010-13 2003-13 P/E Price Return CAGR
PAT CAGR % Avg RoE % (x) (INR) 08-13 (%)
City Union Bank 28 23 7 49 25
Axis Bank 28 20 10 1,155 11
Suprajit Engg 24 31 11 39 34
Torrent Pharma 27 26 15 462 38
HCL Technologies 47 26 16 1,087 25
M & M Financial 36 22 17 296 28
Zydus Wellness 28 37 20 544 38
VST Industries 25 31 20 1,664 37
HDFC Bank 32 18 23 661 19
Astral Poly Technik 29 30 24 250 35
GRUH Finance 28 27 26 233 47
ITC 21 29 34 320 25
Hindustan Unilever 16 77 40 594 17
Page Industries 42 62 44 5,265 51

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 Thank You !
&
Happy Investing For

Uncommon Profits