Intelligent investing

The following question was posed to me by Prem sagar on my previous post. The question made me think and I am posting my thoughts on what I think is a fairly important issue in investing (earlier post on pricing )

But what would u say for an industry like say auto ancillaries or retail-proxies like Bartronics, control print, etc where the opportunity is huge, but they have little or no pricing power?

According to me, pricing is an important variable to evaluate the presence of a competitive advantage or strength. A company with strong pricing power, will be able to sustain high returns for a long time and can increase its intrinsic value over time too. So if one were to buy a company with strong pricing power (with other factors in favour), then it is likely that the investment would work out well with passage of time as the company increases its intrinsic value. So such companies can be long term holdings in a portfolio

That said, it does not mean that companies without pricing power would not be good investments. If one can find a company with low pricing power (commodity business), but with some kind of competitive advantage and selling below its intrinsic value, then such a company can be good investment. I would however not hold such an investment too long, once the stock price is close to the intrinsic value as the likelyhood of an increase in the intrinsic value is less.

I do not have much insight into retail-proxies. However as far as auto-ancillaries are concerned, I have done a bit of analysis ( see here, and here) and have not found too many companies to invest in (mainly due to valuation issues). By the very nature of the industry, these companies have poor pricing power (except for retail), have a few large buyers (OEM) and not many have achieved economies of scale in their operation (this industry is still fairly fragmented). However some auto-ancillaries do posses a few competitive advantages such as a low cost position due to focus on specific segment (fasteners for sundaram clayton?) and good growth opportunities. However as I have written earlier, I would invest in these companies only at a fair discount to intrinsic value and sell once the stock reaches the intrinsic value. I would really not hold the stock for a long term.

I have always thought that a strong brand equates to a strong franchise (profitable businesses). However over the course of time, I think I have started to understand that both are necessarily not the same

For ex: Brands like Starbucks, Tiffany, coke etc are strong brands and good franchise (earning huge profits for the companies). But at the same time there are strong brands such as Mercedes, Taj (?), titan etc which are not very profitable franchises for their companies.

I am still not absolutely sure of the reason behind it. Maybe each case is different.

Please share your thoughts with me on this

I have been working on various permutations of ROE and CAP (period for which the company can earn over cost of capital) using the DCF model to see the PE ratios which are thrown up by the model.

Its fairly intuitive that a company with a high CAP and high ROE should have a high PE. But these permutations have thrown a few insights

• For similar CAP and growth rates a company having an ROE of 20 % should have a PE which is 1.3-1.4 times that of a company with an ROE of 10%. Similar ratios come up for every 10% increase of ROE
• Companies with moderate ROE ( 10-15 %) need CAP of more than 10 years to justify a PE of 20 or higher
• Companies with PE of 30 or higher need a CAP of 10 + years with a growth of 15% and ROE of 25% or higher

So any time I see a company with PE of 20 or higher (which is high these days), the first question I ask is – Given the ROE of the company, does the company have substantial duration of CAP ( 10 years or higher ).

A company with a PE of 30 or higher must have a great return on capital, very strong growth and 10 years or higher CAP. A point worth thinking about when looking at such high valuation companies.

This way of think is detailed in the book ‘expectations investing’ by micheal maubossin and is definitely worth a read.