At the Morningstar Investment Conference held in Mumbai in October 2015, Sanjoy Bhattacharyya, Managing Partner, Fortuna Capital, moderated a session on moats and equity investing. Here is an extract of him in conversation with Raamdeo Agrawal, Joint MD, Motilal Oswal Financial Services.
You practice something which is very close to this franchise approach to investing. How do you verify that it is a genuine franchise? How do you find the truly great moats and how do you measure them?
Warren Buffett talked about the conventional moat of having water around the castle. Somebody sitting inside the castle is minting gold. He is willing to share that gold with the outsiders because his gold making is not under threat.
I understand businesses as input/output machines. You might call it the cement or telecom business, or brand franchise, or whatever. But basically businesses are capital input/output machines, if you simplify at one level. Because we are not specialists in any field - consumer or telecom or online, there are hundreds, thousands of businesses and we can invest in anything.
So, it doesn't mean that we have to be experts. But capital input/output machine as a business is on. This hotel, for instance, is a capital input/output machine. They have spent Rs 1,000 crores. Can they make Rs 100 or 200 crores out of that? So, if you put in Rs 100 crores at the start of the year and it delivers Rs 110 crores after 365 days, it's a very ordinary business because you can put the money in a State Bank of India deposit and earn 10%. So, there is no moat, there is no specialization about that business. But if it delivers 15%, then you might think that this business is good enough. But if it delivers 50-60-70-80-100%......
Today, one very famous company opened its IPO; negative capital employed, so ROE is unlimited. So there are business models and business models…..
What you're really suggesting is that you measure the strength of the moat by its earning power?
Return on equity or earnings power.
That's the first visible sign of existence of moat as far as I'm concerned.
The difference between the cost of capital and how much you earn in a business is a measure of the strength of the moat.
Yes.
What else?
We don't know in 5,000 companies which company has it and which doesn't. You can start from all the 5,000 companies and figure out who is doing special things. That's impossible. So, you got to go to the company which is actually delivering it. It is visibly there financially. So you can run a screener.
Let's say you run a screen and you find 500 companies with return on capital employed in excess of 25%. What next?
The next thing is whether it is the first year of 25%. Is it emerging? It can be emergence, endurance or submergence. Typically companies start and it takes 5-7-10 years for it to break-even and start making money; 99% of the companies die out before they make money. So, that 1% or 0.1% which finally become successful, they emerge.
It's like a rocket being launched into the space, into the corporate world. So, when that launch happens, at that point of time you should be watching. Bharti in 2003, Hero Honda in 1996. Every year 25-30 companies get launched.
So that emergence is defined by exponential growth in profits?
That's one of the signs for sure. But more importantly, they achieve for the first time in life more than 14-15% ROE. So, then you go after that company and figure out what are they doing. Suddenly the company which was not making money till last year or it was making a return on equity of say 10%, 8%, 5% or negative, what has suddenly changed?
Is it just some one-time affair? Has the government given some grant or there is some change in the price which is very temporary? If not, then obviously you go and find out if the change is happening because of internal action of the management. Is the management creating brands? Are they creating products out of their research?
Gujarat Ambuja in 1989-90 innovated on the transportation costs between Veraval and Mumbai and got out Rs 700-800 per ton out of that. It was the most profitable cement company probably in the whole world and their stock was around 15 P/E multiple.
And then they were busted by Shree Cement who became even more profitable?
No, they did not get busted by Shree Cement, but Shree Cement got built because of the same thing again.
And added to it in fact.
Yes. Shree Cement built its own fortune, not at the cost of Gujarat Ambuja.
Not at the cost of Gujarat Ambuja because enough cement can be sold in this country.
Yes. So, industry after industry you keep seeing this kind of emergence. So, that's one level of picking the stocks. When you get one, it can change the entire portfolio profile.
Second is among the running companies where companies mature and year after year they keep making money.
Take Britannia. A new CEO is appointed and he starts doing far better distribution and far better utilization of resources. So suddenly you start seeing the expansion or widening of the moat which already existed. And there again you get hyper growth in the earnings.
Take Maruti. Margins are coming back not because of management action but because of the fall in the commodity prices which busted them earlier. You see on a 15-16% top-line growth they have 40-45% earnings growth. Markets are slaves to earnings power.
Does this happy situation continue from here to ever more? Or does it happen sometimes that the moats that people have built like in the old days of the Roman Empire come under threat from Asterix?
That's active management where you have to keep watching what you have bought. The way I practice it is moat + growth.
Can disruptive change destroy the moat?
Yes. Disruptive change can come from technology. In India it is more because of regulation. Suddenly a regulation could come in and the profits evaporate. So, those things do happen and you suffer at times.
So what do you do?
You got to get out. The moat is gone; you also go out.
You don't wait and hope that the management of the company is smart enough to reinvent itself because in the past they've had 20-25 years of experience? Like Nestle. No one got out of Nestle.
But why get out of Nestle?
The franchise was never at risk. It was regulatory overreach. I never thought Maggi will go out of this action and in fact, they got free publicity for one year. They couldn't have paid for it.
You look for companies with long-term franchise value marked by Q (quality of business), G (growth in earnings), L (longevity of competitive advantage) and P. How do you determine a sensible price?
First is whether I understand the business or not. That's where 90% of the job happens - you understand the next 10-15-20 years of what could be the shape of the business broadly. Is it a predictable management? Is it a predictable business?
Then one looks at the quality of business and quality of management. The difficult part is estimating how long the growth will continue and how long the moat will last. That's a matter of experience and opportunity.
Say it is a global value migration. Infosys came into market in 1993. Over two decades later the moat is very safe even if growth has gone because of the size. It still earns 70-80% return on equity on a reasonably large amount of capital.
When you calculate return on equity, there are many companies which have surplus cash which they refuse to give back to minority shareholders. Do you include that in your calculation of profitability?
When you're looking at a company then obviously you have to. When I'm talking about Infosys, I have to talk about return on equity including treasury. But when I'm talking about the infotech business per se what have I got to do with the treasury of a company?
In company calculation obviously that will come.
A company had an unbelievably high ROE 20 years ago, and from five or seven years it remained unbelievably high. And then in the next 15 years it's actually steadily gone down year after year after year with metronomic precision, but it remains at a high absolute level. Now, is this a sign to you that the moat is breaking down?
No. That moat remains intact because margin is intact.
Question from the audience: What must an individual investor follow in the current situation - growth story, valuation or moats?
We have to invest in companies which are going to make money fundamentally, not in the stock market but actually in their laboratories or factories. The amount of money one is going to make is the amount of money the company is going to make in the next 5-10-15 years. I can't believe that people think that they can make more money in the stock market than what the company actually makes. That's why people keep buying the loss-making companies and they end up making losses.
You have to find those few companies which are making money, which have the earnings power.
