A white paper titled ‘Looking Beyond The Obvious’ released by PineBridge provides interesting insights on what make good companies.
Large companies are not necessarily good companies to invest in, reveals a white paper titled ‘Looking Beyond The Obvious’ released by PineBridge AMC. Good companies are the ones which generate high cash flows in a sustainable fashion where the management plays the role of an efficient asset allocator.
The report states an example of a duopoly industry, manufacturers of global passenger aircrafts having great brands, high technology, high entry barriers, and so on. One would assume that these could be great companies which highly reward its shareholders. However, these companies don’t necessarily make supernormal profits.
The white paper throws a fresh perspective on how to go about identifying good companies, which are as follows:
Cash flows: The first step is to determine if the existing business is generating good cash flows. Typically, one would use standard accounting measures such as return on capital to determine the same. However, Instead of relying on return on capital, which may not give an accurate picture of cash flows, one may look at the number of years it takes to get back a rupee invested in the business.
Sustainable business model: The second step is to determine which of the potential investment targets have a sustainable business model whereby the longevity of cash flows is maintained. This is determined by studying the dynamics of the industry it operates in, the strength of the brand, the uniqueness of the business franchise to name a few. The key is in determining the competitive advantage and the durability of that advantage.
Management’s mindset: The third step is to understand whether the actions of the management are in sync with maximizing returns to the shareholders. The report highlights the need to go beyond the reported numbers and look at the history of the management to understand the nature of the people who are running the business.
Companies which report less profit are not necessarily bad companies. To drive this point, the report cites an example of a mid-sized cement manufacturing company which doesn’t enjoy the same brand advantage and technology its peers enjoy. Yet, the company is better in generating good cash flows because of its operational efficiencies. Moreover, its reported quarterly profit has historically been volatile. because it depreciated its equipment at a rapid rate which reduced profits and thus the tax outgo. This is essentially a cash preservation strategy. In another example, PineBridge noticed a bank which provisioned 180% for its bad loans when typically other banks provisioned for 60-80% of the bad loan amount. This caused the profits and book value to be understated.
Challenge of investing at attractive valuations
The trick here is to be constantly prepared:
- Monitor a large and increasing number of companies and keep track of better ones very closely to be able to capture any valuation anomalies.
- Use a bottom up focus to invest meaningfully in a name as and when required.
- Continuously analyse mistakes and build an investing discipline.
The level of preparedness is the key to spotting great investing opportunities which are always present.
