For those interested in the discussion on brands and how strong, and powerful brands add value to a business, there is an article in fortune which discusses the top ten brands across the globe.
How to Build a Breakaway BrandHow ten companies, making products from drills to waffles, took good brands and made them much, much better.By Al Ehrbar
What do Gerber, Google, and Eggo have in common? They're all selling familiarity, trust, and quality—those intangible traits summed up by the word "brand." Right now that word is more important than ever before, because competitors are more instantly reactive and consumers more sophisticated than ever before. The Model T Ford was in production for 18 long years with little change; Sony's Cyber-shot digital cameras go out of production while the packaging is still crisp. And once upon a time shoppers pretty much believed the hype; these days Internet-powered bargain hunters are armed with accurate pricing and product information—and brutal in their search for value.
In this cutthroat marketplace, which brands have been most successful? To find out, FORTUNE turned to Landor Associates, a brand and design consultant in San Francisco. Landor mined a huge database of brand perceptions called the BrandAsset Valuator, or BAV, to identify ten products that scored the largest increases in brand strength from 2001 to 2004. (Landor is part of WPP Group's Young & Rubicam division, which owns the BAV.) Landor's partner, the New York consultancy BrandEconomics, then calculated the pop in economic value each of these breakaway brands gave their parent companies.
Here's how it works. First, Landor and BrandEconomics asked consumers—9,000 of them—what they thought of 2,500 U.S. brands. Then they looked at brand strength. This is a combination of two properties: differentiation and relevance. Differentiation is the degree to which a brand stands out. Relevance is the degree to which consumers believe a brand meets their needs. That all sounds rather obvious, but what's surprising is that the two factors don't necessarily go together. Rolls-Royce has stellar differentiation but hardly any relevance, since few people can pay $300,000 for four wheels. Kleenex is highly relevant but undifferentiated: Most tissues feel alike. The brands that do best are those that deliver on both counts.
In addition, the BAV measures a brand's stature, which can also be broken down into two components—esteem and knowledge. Esteem is how well regarded the brand is, while knowledge refers to whether the consumer understands it. And once again, those two qualities don't operate in lockstep. A high-esteem, low-knowledge profile may be a sign of a brand on the rise—the consumer's curiosity is piqued. A high-knowledge, low-esteem profile, on the other hand, is the consumer's way of dissing a brand: We know it, and it's nothing special (think Dodge or Coor's Lite).
Weakening brands tend to depend more on coupons and discounts; muscular ones can command a premium. How much does that matter? A lot. The intangible value of a company is its market value minus its tangible capital (i.e., property, plant, equipment, and net working capital). A BrandEconomics analysis found that companies with strong, well-regarded brands had an intangible value of 250% of annual sales; companies with listless brands had one of only 70%.
In important ways, though, the value of a brand is incalculable. A rising brand secures more customer loyalty, higher margins, greater pricing flexibility, and new opportunities for growth. And brands on the way up, BrandEconomics research shows, ride through economic downturns with less trauma. "The combination of faster growth with less risk," says Hayes Roth, vice president for global marketing at Landor, "is business nirvana." Here's a look at ten brands that are pretty close to paradise right now.
Thursday, October 27, 2005
A good article on brands in fortune
For those interested in the discussion on brands and how strong, and powerful brands add value to a business, there is an article in fortune which discusses the top ten brands across the globe.
How to Build a Breakaway BrandHow ten companies, making products from drills to waffles, took good brands and made them much, much better.By Al Ehrbar
What do Gerber, Google, and Eggo have in common? They're all selling familiarity, trust, and quality—those intangible traits summed up by the word "brand." Right now that word is more important than ever before, because competitors are more instantly reactive and consumers more sophisticated than ever before. The Model T Ford was in production for 18 long years with little change; Sony's Cyber-shot digital cameras go out of production while the packaging is still crisp. And once upon a time shoppers pretty much believed the hype; these days Internet-powered bargain hunters are armed with accurate pricing and product information—and brutal in their search for value.
In this cutthroat marketplace, which brands have been most successful? To find out, FORTUNE turned to Landor Associates, a brand and design consultant in San Francisco. Landor mined a huge database of brand perceptions called the BrandAsset Valuator, or BAV, to identify ten products that scored the largest increases in brand strength from 2001 to 2004. (Landor is part of WPP Group's Young & Rubicam division, which owns the BAV.) Landor's partner, the New York consultancy BrandEconomics, then calculated the pop in economic value each of these breakaway brands gave their parent companies.
Here's how it works. First, Landor and BrandEconomics asked consumers—9,000 of them—what they thought of 2,500 U.S. brands. Then they looked at brand strength. This is a combination of two properties: differentiation and relevance. Differentiation is the degree to which a brand stands out. Relevance is the degree to which consumers believe a brand meets their needs. That all sounds rather obvious, but what's surprising is that the two factors don't necessarily go together. Rolls-Royce has stellar differentiation but hardly any relevance, since few people can pay $300,000 for four wheels. Kleenex is highly relevant but undifferentiated: Most tissues feel alike. The brands that do best are those that deliver on both counts.
In addition, the BAV measures a brand's stature, which can also be broken down into two components—esteem and knowledge. Esteem is how well regarded the brand is, while knowledge refers to whether the consumer understands it. And once again, those two qualities don't operate in lockstep. A high-esteem, low-knowledge profile may be a sign of a brand on the rise—the consumer's curiosity is piqued. A high-knowledge, low-esteem profile, on the other hand, is the consumer's way of dissing a brand: We know it, and it's nothing special (think Dodge or Coor's Lite).
Weakening brands tend to depend more on coupons and discounts; muscular ones can command a premium. How much does that matter? A lot. The intangible value of a company is its market value minus its tangible capital (i.e., property, plant, equipment, and net working capital). A BrandEconomics analysis found that companies with strong, well-regarded brands had an intangible value of 250% of annual sales; companies with listless brands had one of only 70%.
In important ways, though, the value of a brand is incalculable. A rising brand secures more customer loyalty, higher margins, greater pricing flexibility, and new opportunities for growth. And brands on the way up, BrandEconomics research shows, ride through economic downturns with less trauma. "The combination of faster growth with less risk," says Hayes Roth, vice president for global marketing at Landor, "is business nirvana." Here's a look at ten brands that are pretty close to paradise right now.
How to Build a Breakaway BrandHow ten companies, making products from drills to waffles, took good brands and made them much, much better.By Al Ehrbar
What do Gerber, Google, and Eggo have in common? They're all selling familiarity, trust, and quality—those intangible traits summed up by the word "brand." Right now that word is more important than ever before, because competitors are more instantly reactive and consumers more sophisticated than ever before. The Model T Ford was in production for 18 long years with little change; Sony's Cyber-shot digital cameras go out of production while the packaging is still crisp. And once upon a time shoppers pretty much believed the hype; these days Internet-powered bargain hunters are armed with accurate pricing and product information—and brutal in their search for value.
In this cutthroat marketplace, which brands have been most successful? To find out, FORTUNE turned to Landor Associates, a brand and design consultant in San Francisco. Landor mined a huge database of brand perceptions called the BrandAsset Valuator, or BAV, to identify ten products that scored the largest increases in brand strength from 2001 to 2004. (Landor is part of WPP Group's Young & Rubicam division, which owns the BAV.) Landor's partner, the New York consultancy BrandEconomics, then calculated the pop in economic value each of these breakaway brands gave their parent companies.
Here's how it works. First, Landor and BrandEconomics asked consumers—9,000 of them—what they thought of 2,500 U.S. brands. Then they looked at brand strength. This is a combination of two properties: differentiation and relevance. Differentiation is the degree to which a brand stands out. Relevance is the degree to which consumers believe a brand meets their needs. That all sounds rather obvious, but what's surprising is that the two factors don't necessarily go together. Rolls-Royce has stellar differentiation but hardly any relevance, since few people can pay $300,000 for four wheels. Kleenex is highly relevant but undifferentiated: Most tissues feel alike. The brands that do best are those that deliver on both counts.
In addition, the BAV measures a brand's stature, which can also be broken down into two components—esteem and knowledge. Esteem is how well regarded the brand is, while knowledge refers to whether the consumer understands it. And once again, those two qualities don't operate in lockstep. A high-esteem, low-knowledge profile may be a sign of a brand on the rise—the consumer's curiosity is piqued. A high-knowledge, low-esteem profile, on the other hand, is the consumer's way of dissing a brand: We know it, and it's nothing special (think Dodge or Coor's Lite).
Weakening brands tend to depend more on coupons and discounts; muscular ones can command a premium. How much does that matter? A lot. The intangible value of a company is its market value minus its tangible capital (i.e., property, plant, equipment, and net working capital). A BrandEconomics analysis found that companies with strong, well-regarded brands had an intangible value of 250% of annual sales; companies with listless brands had one of only 70%.
In important ways, though, the value of a brand is incalculable. A rising brand secures more customer loyalty, higher margins, greater pricing flexibility, and new opportunities for growth. And brands on the way up, BrandEconomics research shows, ride through economic downturns with less trauma. "The combination of faster growth with less risk," says Hayes Roth, vice president for global marketing at Landor, "is business nirvana." Here's a look at ten brands that are pretty close to paradise right now.
It is easy to know what will happen in the market, but difficult to know when
The above comment is from warren buffet. He has also written in the annual letters that he prices the market, rather than time the market. The difference is substantial between the two approaches. The first one, is based on valuation and understanding when the market price is way above the intrinsic value and then going ahead and selling the overvalued security.
The second approach of timing the market is based on psychology of the market and is very difficult (at least for me) to do consistently. People try technical analysis, charts etc to time the market and there could some investors out there who could be good at it. But I have never tried it, as it is too difficult and not really productive for me.
The approach in ‘pricing’ the market works in areas beyond the stock market too. Let me give a personal example
Interest rates in India have fallen for quite some time. From a 10% in 2001 to around 6-7 % by 2004. This was the time to be an investor in debt as debt funds gave good returns. In 2004 I was looking at a housing loan and had an offer of 7.75 % fixed versus 7.25 % Variable. The loan officer ofcourse was very enthusiastic about the variable loan and kept pushing it. I however was keen on the fixed loan and had worked the following math (with assumptions)
Long-term inflation – 5-6 % (assumption on the lower end, can be higher)
NPA – 0.5-1 %
Cost of loan servicing for an HFC – 0.25 – 0.5 %
Return on asset – 1.5 % (for an HFC to earn a reasonable return on equity)
The effective cost (rate an HFC should charge me) should be around 7.5 % - 9 %. So with all the optimistic assumptions built into the ‘value’ of the funds, it should not be priced below 7.5%.
As the bank was offering 7.75 % fixed for a tenure of 20 years, I felt the loan was underpriced and opted for a fixed rate loan.
I could be wrong in my decision if
But the odds are that over a 20-year period, we could have periods of high inflation and high NPA. So I went ahead with the fixed rate loan. At the same time I moved out of debt funds and into floating rate funds.
I found the approach of pricing (and working on odds) the market much more productive. I am not right immediately and so there is no instant gratification (all my friends in 2004 kept saying that floating rate is the way to go). But if my logic is correct and I make a rational, informed decision, it has worked out for me.
Please share any such experiences you would have had
The second approach of timing the market is based on psychology of the market and is very difficult (at least for me) to do consistently. People try technical analysis, charts etc to time the market and there could some investors out there who could be good at it. But I have never tried it, as it is too difficult and not really productive for me.
The approach in ‘pricing’ the market works in areas beyond the stock market too. Let me give a personal example
Interest rates in India have fallen for quite some time. From a 10% in 2001 to around 6-7 % by 2004. This was the time to be an investor in debt as debt funds gave good returns. In 2004 I was looking at a housing loan and had an offer of 7.75 % fixed versus 7.25 % Variable. The loan officer ofcourse was very enthusiastic about the variable loan and kept pushing it. I however was keen on the fixed loan and had worked the following math (with assumptions)
Long-term inflation – 5-6 % (assumption on the lower end, can be higher)
NPA – 0.5-1 %
Cost of loan servicing for an HFC – 0.25 – 0.5 %
Return on asset – 1.5 % (for an HFC to earn a reasonable return on equity)
The effective cost (rate an HFC should charge me) should be around 7.5 % - 9 %. So with all the optimistic assumptions built into the ‘value’ of the funds, it should not be priced below 7.5%.
As the bank was offering 7.75 % fixed for a tenure of 20 years, I felt the loan was underpriced and opted for a fixed rate loan.
I could be wrong in my decision if
- Inflation for next 20 years remains below 5 %
- NPA for most of the HFC are below 0.5 %
But the odds are that over a 20-year period, we could have periods of high inflation and high NPA. So I went ahead with the fixed rate loan. At the same time I moved out of debt funds and into floating rate funds.
I found the approach of pricing (and working on odds) the market much more productive. I am not right immediately and so there is no instant gratification (all my friends in 2004 kept saying that floating rate is the way to go). But if my logic is correct and I make a rational, informed decision, it has worked out for me.
Please share any such experiences you would have had
It is easy to know what will happen in the market, but difficult to know when
The above comment is from warren buffet. He has also written in the annual letters that he prices the market, rather than time the market. The difference is substantial between the two approaches. The first one, is based on valuation and understanding when the market price is way above the intrinsic value and then going ahead and selling the overvalued security.
The second approach of timing the market is based on psychology of the market and is very difficult (at least for me) to do consistently. People try technical analysis, charts etc to time the market and there could some investors out there who could be good at it. But I have never tried it, as it is too difficult and not really productive for me.
The approach in ‘pricing’ the market works in areas beyond the stock market too. Let me give a personal example
Interest rates in India have fallen for quite some time. From a 10% in 2001 to around 6-7 % by 2004. This was the time to be an investor in debt as debt funds gave good returns. In 2004 I was looking at a housing loan and had an offer of 7.75 % fixed versus 7.25 % Variable. The loan officer ofcourse was very enthusiastic about the variable loan and kept pushing it. I however was keen on the fixed loan and had worked the following math (with assumptions)
Long-term inflation – 5-6 % (assumption on the lower end, can be higher)
NPA – 0.5-1 %
Cost of loan servicing for an HFC – 0.25 – 0.5 %
Return on asset – 1.5 % (for an HFC to earn a reasonable return on equity)
The effective cost (rate an HFC should charge me) should be around 7.5 % - 9 %. So with all the optimistic assumptions built into the ‘value’ of the funds, it should not be priced below 7.5%.
As the bank was offering 7.75 % fixed for a tenure of 20 years, I felt the loan was underpriced and opted for a fixed rate loan.
I could be wrong in my decision if
But the odds are that over a 20-year period, we could have periods of high inflation and high NPA. So I went ahead with the fixed rate loan. At the same time I moved out of debt funds and into floating rate funds.
I found the approach of pricing (and working on odds) the market much more productive. I am not right immediately and so there is no instant gratification (all my friends in 2004 kept saying that floating rate is the way to go). But if my logic is correct and I make a rational, informed decision, it has worked out for me.
Please share any such experiences you would have had
The second approach of timing the market is based on psychology of the market and is very difficult (at least for me) to do consistently. People try technical analysis, charts etc to time the market and there could some investors out there who could be good at it. But I have never tried it, as it is too difficult and not really productive for me.
The approach in ‘pricing’ the market works in areas beyond the stock market too. Let me give a personal example
Interest rates in India have fallen for quite some time. From a 10% in 2001 to around 6-7 % by 2004. This was the time to be an investor in debt as debt funds gave good returns. In 2004 I was looking at a housing loan and had an offer of 7.75 % fixed versus 7.25 % Variable. The loan officer ofcourse was very enthusiastic about the variable loan and kept pushing it. I however was keen on the fixed loan and had worked the following math (with assumptions)
Long-term inflation – 5-6 % (assumption on the lower end, can be higher)
NPA – 0.5-1 %
Cost of loan servicing for an HFC – 0.25 – 0.5 %
Return on asset – 1.5 % (for an HFC to earn a reasonable return on equity)
The effective cost (rate an HFC should charge me) should be around 7.5 % - 9 %. So with all the optimistic assumptions built into the ‘value’ of the funds, it should not be priced below 7.5%.
As the bank was offering 7.75 % fixed for a tenure of 20 years, I felt the loan was underpriced and opted for a fixed rate loan.
I could be wrong in my decision if
- Inflation for next 20 years remains below 5 %
- NPA for most of the HFC are below 0.5 %
But the odds are that over a 20-year period, we could have periods of high inflation and high NPA. So I went ahead with the fixed rate loan. At the same time I moved out of debt funds and into floating rate funds.
I found the approach of pricing (and working on odds) the market much more productive. I am not right immediately and so there is no instant gratification (all my friends in 2004 kept saying that floating rate is the way to go). But if my logic is correct and I make a rational, informed decision, it has worked out for me.
Please share any such experiences you would have had
Wednesday, October 26, 2005
Pidilite industries - results and a change of opinion
Pidilite industries is one of the leading companies involved in adhesives, sealants and construction chemicals business. It has several top brands like fevicol, Fixit, M-seal etc.
I had looked at this company in 2001 and had made a small investment based on the following points
- Good ROC of 20 % +
- Sustaniable competitive advantage due to strong brands, extensive distribution network and high market share/ mindshare
- Consistent revenue and profit growth for last 10 years
What stopped me from committing myself more was the tendency of the management to do strange, under-related commitment of capital to businesses like windmills !. In addition they had some IT disputes. All this made me uncomfortable.
A few weeks back I looked at their latest annual report and liked what I saw. A few notable point
- Capital allocation has been rational and has added to the core business. Management has acquired brands like Mr Fixit, M-seal etc and have grown these brands after acquiring them
- No funny diversifications into stuff like windmills !!
- An increasing dividend flow indicating a willingness to return excess capital back to shareholders
- Focus on EVA / Return on capital ( The management discussion talks about these points which kind of indicates the managements commitment to it)
- Impressive growth in the core business of adhesives, sealants, construction chemicals
- Growth of the business to international markets
All in all, I am ready to re-think on the capital allocation attitude of management, which I feel is fairly pro-shareholder and rational. But the price is a bit higher than what I would like. So I guess, I would wait and watch for the price to be in happy zone before I take a swing
Pidilite industries - results and a change of opinion
Pidilite industries is one of the leading companies involved in adhesives, sealants and construction chemicals business. It has several top brands like fevicol, Fixit, M-seal etc.
I had looked at this company in 2001 and had made a small investment based on the following points
- Good ROC of 20 % +
- Sustaniable competitive advantage due to strong brands, extensive distribution network and high market share/ mindshare
- Consistent revenue and profit growth for last 10 years
What stopped me from committing myself more was the tendency of the management to do strange, under-related commitment of capital to businesses like windmills !. In addition they had some IT disputes. All this made me uncomfortable.
A few weeks back I looked at their latest annual report and liked what I saw. A few notable point
- Capital allocation has been rational and has added to the core business. Management has acquired brands like Mr Fixit, M-seal etc and have grown these brands after acquiring them
- No funny diversifications into stuff like windmills !!
- An increasing dividend flow indicating a willingness to return excess capital back to shareholders
- Focus on EVA / Return on capital ( The management discussion talks about these points which kind of indicates the managements commitment to it)
- Impressive growth in the core business of adhesives, sealants, construction chemicals
- Growth of the business to international markets
All in all, I am ready to re-think on the capital allocation attitude of management, which I feel is fairly pro-shareholder and rational. But the price is a bit higher than what I would like. So I guess, I would wait and watch for the price to be in happy zone before I take a swing
Monday, October 24, 2005
Is a strong brand a profitable franchise ? - comments / thoughts/ cases
I had posted my thoughts on the difference between a brand and franchise. Initially my understanding was that they are the same and a strong brand equates to a good franchise (franchise can be defined as a business which earns more than its cost of capital and has a sustainable competitive advantage).
However I have seen cases where the two are not the same ( ex : titan, Mercedes etc, general motor brands etc).
I put out a question asking for comments and got replies from bruce (see below) and from george who has put his thoughts on his website Fat Pitch Financials.
I am listing a few criteria which came to my mind after I got the comments from bruce and george
So here goes
A strong brand would equate to profitable franchise if price is not the key differentiator or is not key factor in the purchase decision. I can think of the following cases
Ofcourse the above are not sufficient for a strong brand to be a profitable franchise. Cost structures and other factors would also be important for the business to be a profitable franchise.
Now why go through all this in trying to distinguish between a franchise and good business (with or without a brand). If I remember correctly, warren buffett in his annual report has written about newspapers as very strong franchise with a kind of a toll bridge business model. Later with internet and other media, he commented that newspapers were still good businesses, but not bullet proof franchise. In the same section he also did a rough valuation exercise of a good franchise v/s good business and showed how strong franchises are worth more than good businesses.
Please share your thoughts on the above topic.
Comments :
Bruce said...
Here's my abstract opinion (there are a LOT of ways of looking at this one question). A brand/franchise/whatever is something which signals a contract with the customer. It's a popular solution to the prisoner's dilemma problem that plagues all economic transactions to some extent. Game theory deals with this subject very well.A vendor spends a great deal of time and money developing an easily recognizable public image that is protected by law (from having other vendors use the same image). That image slowly becomes a reputation, but it also signals a commitment from the vendor not to cheat the customer quickly and then run away. The average consumer must keep track of a very large and growing number of brands and franchises. They don't want to have to do the enormous work to validate a vendor every time they want to make an economic purchase. A brand/franchise allows them to make quick decisions, often in unknown places. So in a sense, a brand/franchise becomes a contract between the buyer and the vendor. The cost in establishing the brand (and also the value in not destroying it) is a fuzzy guarantee placed into the public by the vendor.When you have a comodity product or service, that brand becomes less important. Someone stands by the side of the road with a rock that you want to buy. They have no brand, but all you want is a rock which is easily verified during the purchase. Anyone spending lots of money to establish a brand is at a cost disadvantage to someone who just gathers rocks and stands at the side of the road. For that reason, comodity markets are won by whoever has the lowest cost. If the market demands 10,000 rocks, then you essentially line up the vendors from lowest cost to highest cost. You start with the lowest cost and work your way up until you buy 10,000 rocks (well, it's more complicated than that due to the supply/demand curve). The market price essentially becomes the highest cost rock among the 10,000.So call it a brand or franchise or whatever, it's really a sort of contract. It's very important that the law upholds the property rights of the brand or everything breaks down. In fact, it's always important for property rights to be upheld for economic activity to be efficient and effective. India has come a long way over the years and I suspect it will become a very major economic superpower so long as it continues on the path of free markets and property rights.
7:02 PM
Bruce said...
What makes a strong brand? Well, one view is covered very well in The 22 Immutable Laws of Marketing. But a better answer is to look at your own behavior and where you rely on brand. Buffett made some comments about Coca Cola that make a lot of sense. One type of very good brand is small, repeat purchases that are almost habit.When you look at what a brand is all about (a contract), then you can ask yourself when is that contract valuable from the vendor's perspective. One good thing is lots of confusion and doubt in the minds of customers. Another is a long delay before the customer finds out whether what they bought was good quality vs poor quality.
9:47 AM
George said...
This is a very interesting topic. I posted my comments about it over at my blog, Fat Pitch Financials. It would be nice to put together a set of criteria by which to gage how likely a brand will lead to a franchise.
8:04 PM
However I have seen cases where the two are not the same ( ex : titan, Mercedes etc, general motor brands etc).
I put out a question asking for comments and got replies from bruce (see below) and from george who has put his thoughts on his website Fat Pitch Financials.
I am listing a few criteria which came to my mind after I got the comments from bruce and george
So here goes
A strong brand would equate to profitable franchise if price is not the key differentiator or is not key factor in the purchase decision. I can think of the following cases
- Low value purchase v/s high value purchase (borrowed from george’s post on his website). I cannot think of anyone putting as much effort in buying a cola v/s buying a car. As a result a strong brand can charge more for a product
- A complex purchase decision requiring substantial information to asess the true price of a product. For ex: high end electronic products – A bose system ?
- Emotional association with the product – Disney products / Barbie dolls – try giving a child a regular lower price but equally good doll and you will understand what I mean
- Social proof / Association tendency – High prestige product which confer a social status on the owner . Ex : tiffany’s
Ofcourse the above are not sufficient for a strong brand to be a profitable franchise. Cost structures and other factors would also be important for the business to be a profitable franchise.
Now why go through all this in trying to distinguish between a franchise and good business (with or without a brand). If I remember correctly, warren buffett in his annual report has written about newspapers as very strong franchise with a kind of a toll bridge business model. Later with internet and other media, he commented that newspapers were still good businesses, but not bullet proof franchise. In the same section he also did a rough valuation exercise of a good franchise v/s good business and showed how strong franchises are worth more than good businesses.
Please share your thoughts on the above topic.
Comments :
Bruce said...
Here's my abstract opinion (there are a LOT of ways of looking at this one question). A brand/franchise/whatever is something which signals a contract with the customer. It's a popular solution to the prisoner's dilemma problem that plagues all economic transactions to some extent. Game theory deals with this subject very well.A vendor spends a great deal of time and money developing an easily recognizable public image that is protected by law (from having other vendors use the same image). That image slowly becomes a reputation, but it also signals a commitment from the vendor not to cheat the customer quickly and then run away. The average consumer must keep track of a very large and growing number of brands and franchises. They don't want to have to do the enormous work to validate a vendor every time they want to make an economic purchase. A brand/franchise allows them to make quick decisions, often in unknown places. So in a sense, a brand/franchise becomes a contract between the buyer and the vendor. The cost in establishing the brand (and also the value in not destroying it) is a fuzzy guarantee placed into the public by the vendor.When you have a comodity product or service, that brand becomes less important. Someone stands by the side of the road with a rock that you want to buy. They have no brand, but all you want is a rock which is easily verified during the purchase. Anyone spending lots of money to establish a brand is at a cost disadvantage to someone who just gathers rocks and stands at the side of the road. For that reason, comodity markets are won by whoever has the lowest cost. If the market demands 10,000 rocks, then you essentially line up the vendors from lowest cost to highest cost. You start with the lowest cost and work your way up until you buy 10,000 rocks (well, it's more complicated than that due to the supply/demand curve). The market price essentially becomes the highest cost rock among the 10,000.So call it a brand or franchise or whatever, it's really a sort of contract. It's very important that the law upholds the property rights of the brand or everything breaks down. In fact, it's always important for property rights to be upheld for economic activity to be efficient and effective. India has come a long way over the years and I suspect it will become a very major economic superpower so long as it continues on the path of free markets and property rights.
7:02 PM
Bruce said...
What makes a strong brand? Well, one view is covered very well in The 22 Immutable Laws of Marketing. But a better answer is to look at your own behavior and where you rely on brand. Buffett made some comments about Coca Cola that make a lot of sense. One type of very good brand is small, repeat purchases that are almost habit.When you look at what a brand is all about (a contract), then you can ask yourself when is that contract valuable from the vendor's perspective. One good thing is lots of confusion and doubt in the minds of customers. Another is a long delay before the customer finds out whether what they bought was good quality vs poor quality.
9:47 AM
George said...
This is a very interesting topic. I posted my comments about it over at my blog, Fat Pitch Financials. It would be nice to put together a set of criteria by which to gage how likely a brand will lead to a franchise.
8:04 PM
Is a strong brand a profitable franchise ? - comments / thoughts/ cases
I had posted my thoughts on the difference between a brand and franchise. Initially my understanding was that they are the same and a strong brand equates to a good franchise (franchise can be defined as a business which earns more than its cost of capital and has a sustainable competitive advantage).
However I have seen cases where the two are not the same ( ex : titan, Mercedes etc, general motor brands etc).
I put out a question asking for comments and got replies from bruce (see below) and from george who has put his thoughts on his website Fat Pitch Financials.
I am listing a few criteria which came to my mind after I got the comments from bruce and george
So here goes
A strong brand would equate to profitable franchise if price is not the key differentiator or is not key factor in the purchase decision. I can think of the following cases
Ofcourse the above are not sufficient for a strong brand to be a profitable franchise. Cost structures and other factors would also be important for the business to be a profitable franchise.
Now why go through all this in trying to distinguish between a franchise and good business (with or without a brand). If I remember correctly, warren buffett in his annual report has written about newspapers as very strong franchise with a kind of a toll bridge business model. Later with internet and other media, he commented that newspapers were still good businesses, but not bullet proof franchise. In the same section he also did a rough valuation exercise of a good franchise v/s good business and showed how strong franchises are worth more than good businesses.
Please share your thoughts on the above topic.
Comments :
Bruce said...
Here's my abstract opinion (there are a LOT of ways of looking at this one question). A brand/franchise/whatever is something which signals a contract with the customer. It's a popular solution to the prisoner's dilemma problem that plagues all economic transactions to some extent. Game theory deals with this subject very well.A vendor spends a great deal of time and money developing an easily recognizable public image that is protected by law (from having other vendors use the same image). That image slowly becomes a reputation, but it also signals a commitment from the vendor not to cheat the customer quickly and then run away. The average consumer must keep track of a very large and growing number of brands and franchises. They don't want to have to do the enormous work to validate a vendor every time they want to make an economic purchase. A brand/franchise allows them to make quick decisions, often in unknown places. So in a sense, a brand/franchise becomes a contract between the buyer and the vendor. The cost in establishing the brand (and also the value in not destroying it) is a fuzzy guarantee placed into the public by the vendor.When you have a comodity product or service, that brand becomes less important. Someone stands by the side of the road with a rock that you want to buy. They have no brand, but all you want is a rock which is easily verified during the purchase. Anyone spending lots of money to establish a brand is at a cost disadvantage to someone who just gathers rocks and stands at the side of the road. For that reason, comodity markets are won by whoever has the lowest cost. If the market demands 10,000 rocks, then you essentially line up the vendors from lowest cost to highest cost. You start with the lowest cost and work your way up until you buy 10,000 rocks (well, it's more complicated than that due to the supply/demand curve). The market price essentially becomes the highest cost rock among the 10,000.So call it a brand or franchise or whatever, it's really a sort of contract. It's very important that the law upholds the property rights of the brand or everything breaks down. In fact, it's always important for property rights to be upheld for economic activity to be efficient and effective. India has come a long way over the years and I suspect it will become a very major economic superpower so long as it continues on the path of free markets and property rights.
7:02 PM
Bruce said...
What makes a strong brand? Well, one view is covered very well in The 22 Immutable Laws of Marketing. But a better answer is to look at your own behavior and where you rely on brand. Buffett made some comments about Coca Cola that make a lot of sense. One type of very good brand is small, repeat purchases that are almost habit.When you look at what a brand is all about (a contract), then you can ask yourself when is that contract valuable from the vendor's perspective. One good thing is lots of confusion and doubt in the minds of customers. Another is a long delay before the customer finds out whether what they bought was good quality vs poor quality.
9:47 AM
George said...
This is a very interesting topic. I posted my comments about it over at my blog, Fat Pitch Financials. It would be nice to put together a set of criteria by which to gage how likely a brand will lead to a franchise.
8:04 PM
However I have seen cases where the two are not the same ( ex : titan, Mercedes etc, general motor brands etc).
I put out a question asking for comments and got replies from bruce (see below) and from george who has put his thoughts on his website Fat Pitch Financials.
I am listing a few criteria which came to my mind after I got the comments from bruce and george
So here goes
A strong brand would equate to profitable franchise if price is not the key differentiator or is not key factor in the purchase decision. I can think of the following cases
- Low value purchase v/s high value purchase (borrowed from george’s post on his website). I cannot think of anyone putting as much effort in buying a cola v/s buying a car. As a result a strong brand can charge more for a product
- A complex purchase decision requiring substantial information to asess the true price of a product. For ex: high end electronic products – A bose system ?
- Emotional association with the product – Disney products / Barbie dolls – try giving a child a regular lower price but equally good doll and you will understand what I mean
- Social proof / Association tendency – High prestige product which confer a social status on the owner . Ex : tiffany’s
Ofcourse the above are not sufficient for a strong brand to be a profitable franchise. Cost structures and other factors would also be important for the business to be a profitable franchise.
Now why go through all this in trying to distinguish between a franchise and good business (with or without a brand). If I remember correctly, warren buffett in his annual report has written about newspapers as very strong franchise with a kind of a toll bridge business model. Later with internet and other media, he commented that newspapers were still good businesses, but not bullet proof franchise. In the same section he also did a rough valuation exercise of a good franchise v/s good business and showed how strong franchises are worth more than good businesses.
Please share your thoughts on the above topic.
Comments :
Bruce said...
Here's my abstract opinion (there are a LOT of ways of looking at this one question). A brand/franchise/whatever is something which signals a contract with the customer. It's a popular solution to the prisoner's dilemma problem that plagues all economic transactions to some extent. Game theory deals with this subject very well.A vendor spends a great deal of time and money developing an easily recognizable public image that is protected by law (from having other vendors use the same image). That image slowly becomes a reputation, but it also signals a commitment from the vendor not to cheat the customer quickly and then run away. The average consumer must keep track of a very large and growing number of brands and franchises. They don't want to have to do the enormous work to validate a vendor every time they want to make an economic purchase. A brand/franchise allows them to make quick decisions, often in unknown places. So in a sense, a brand/franchise becomes a contract between the buyer and the vendor. The cost in establishing the brand (and also the value in not destroying it) is a fuzzy guarantee placed into the public by the vendor.When you have a comodity product or service, that brand becomes less important. Someone stands by the side of the road with a rock that you want to buy. They have no brand, but all you want is a rock which is easily verified during the purchase. Anyone spending lots of money to establish a brand is at a cost disadvantage to someone who just gathers rocks and stands at the side of the road. For that reason, comodity markets are won by whoever has the lowest cost. If the market demands 10,000 rocks, then you essentially line up the vendors from lowest cost to highest cost. You start with the lowest cost and work your way up until you buy 10,000 rocks (well, it's more complicated than that due to the supply/demand curve). The market price essentially becomes the highest cost rock among the 10,000.So call it a brand or franchise or whatever, it's really a sort of contract. It's very important that the law upholds the property rights of the brand or everything breaks down. In fact, it's always important for property rights to be upheld for economic activity to be efficient and effective. India has come a long way over the years and I suspect it will become a very major economic superpower so long as it continues on the path of free markets and property rights.
7:02 PM
Bruce said...
What makes a strong brand? Well, one view is covered very well in The 22 Immutable Laws of Marketing. But a better answer is to look at your own behavior and where you rely on brand. Buffett made some comments about Coca Cola that make a lot of sense. One type of very good brand is small, repeat purchases that are almost habit.When you look at what a brand is all about (a contract), then you can ask yourself when is that contract valuable from the vendor's perspective. One good thing is lots of confusion and doubt in the minds of customers. Another is a long delay before the customer finds out whether what they bought was good quality vs poor quality.
9:47 AM
George said...
This is a very interesting topic. I posted my comments about it over at my blog, Fat Pitch Financials. It would be nice to put together a set of criteria by which to gage how likely a brand will lead to a franchise.
8:04 PM
Q&A with Warren buffett (Tuck school of business)
http://mba.tuck.dartmouth.edu/pages/clubs/investment/WarrenBuffett.html
Some excerpts from the Q&A
Q: In your letters you speak frequently of the importance of not over-complicating things. What are your secrets to keeping your life simple?A: When making investments, pretend in life you have a punch-card with only 20 boxes, and every time you make an investment you punch a slot. It will discipline you to only make investments you have extreme confidence in. Big money is made by obvious things. If using a discount rate of 8% vs. 10% is going to make or break an investment idea, it's probably not a good idea. Back in 1951 Moody's published thick handbooks by industry of every stock in circulation. I went through all of them, thousands of pages, motivated by the hope that a great idea was just on the next page. I found companies like National American Insurance and Western Insurance Securities Company that nobody was paying attention to that were trading for far less than their intrinsic values. Last year we found a steel company on the Korean Stock Exchange that had no analyst coverage, no research, but was the most profitable steel company in the world
Q: I have worked in various technologies businesses, but I understand that you do not typically invest in the technology sector. Why is that? How do you view technology as an individual and as an investor?A: Technology is clearly a boost to business productivity and a driver of better consumer products and the like, so as an individual I have a high appreciation for the power of technology. I have avoided technology sectors as an investor because in general I don't have a solid grasp of what differentiates many technology companies. I don't know how to spot durable competitive advantage in technology. To get rich, you find businesses with durable competitive advantage and you don't overpay for them. Technology is based on change; and change is really the enemy of the investor. Change is more rapid and unpredictable in technology relative to the broader economy. To me, all technology sectors look like 7-foot hurdles
Q: In many of your letters you speak about the importance of looking through the windshield and not the rearview mirror. What issues do you think people today are mistakenly looking at through the rearview mirror?A: Investors are always looking for the holy grail, the next great idea that will carry performance and pension returns for the several years. Right now its 'alternative investments' - private equity, hedge funds, the assets that have outperformed public equities for the past five years since the tech bubble burst. There's so much money chasing these ideas now that the returns in the future will probably not be as good. At some point, public equities will become good investments again and fewer people will be looking at them. At Berkshire, we look at a lot of "super-cat" (super catastrophe) insurance business that few firms will write. The challenge is determining when there's a paradigm shift, when the future will no longer look like the past. It's probable that the next hundred years of hurricane activity will not look like the past hundred years. Another example, we write a lot of D and O insurance, Directors and Officers liability. Post Enron, I feel strongly that juries will award much harsher penalties to victims of corporate fraud, etc. than they would have five years ago before the average juror watched hours of news stories about all the scandals. There's no model that can quantify that added risk, but it's a risk that won't be captured looking at historical data.
My thought - The last Q&A throws up an interesting question for Indian investors. After 3 years of great returns, are we as investors also operating with a rear mirror view? Any thoughts ?
Some excerpts from the Q&A
Q: In your letters you speak frequently of the importance of not over-complicating things. What are your secrets to keeping your life simple?A: When making investments, pretend in life you have a punch-card with only 20 boxes, and every time you make an investment you punch a slot. It will discipline you to only make investments you have extreme confidence in. Big money is made by obvious things. If using a discount rate of 8% vs. 10% is going to make or break an investment idea, it's probably not a good idea. Back in 1951 Moody's published thick handbooks by industry of every stock in circulation. I went through all of them, thousands of pages, motivated by the hope that a great idea was just on the next page. I found companies like National American Insurance and Western Insurance Securities Company that nobody was paying attention to that were trading for far less than their intrinsic values. Last year we found a steel company on the Korean Stock Exchange that had no analyst coverage, no research, but was the most profitable steel company in the world
Q: I have worked in various technologies businesses, but I understand that you do not typically invest in the technology sector. Why is that? How do you view technology as an individual and as an investor?A: Technology is clearly a boost to business productivity and a driver of better consumer products and the like, so as an individual I have a high appreciation for the power of technology. I have avoided technology sectors as an investor because in general I don't have a solid grasp of what differentiates many technology companies. I don't know how to spot durable competitive advantage in technology. To get rich, you find businesses with durable competitive advantage and you don't overpay for them. Technology is based on change; and change is really the enemy of the investor. Change is more rapid and unpredictable in technology relative to the broader economy. To me, all technology sectors look like 7-foot hurdles
Q: In many of your letters you speak about the importance of looking through the windshield and not the rearview mirror. What issues do you think people today are mistakenly looking at through the rearview mirror?A: Investors are always looking for the holy grail, the next great idea that will carry performance and pension returns for the several years. Right now its 'alternative investments' - private equity, hedge funds, the assets that have outperformed public equities for the past five years since the tech bubble burst. There's so much money chasing these ideas now that the returns in the future will probably not be as good. At some point, public equities will become good investments again and fewer people will be looking at them. At Berkshire, we look at a lot of "super-cat" (super catastrophe) insurance business that few firms will write. The challenge is determining when there's a paradigm shift, when the future will no longer look like the past. It's probable that the next hundred years of hurricane activity will not look like the past hundred years. Another example, we write a lot of D and O insurance, Directors and Officers liability. Post Enron, I feel strongly that juries will award much harsher penalties to victims of corporate fraud, etc. than they would have five years ago before the average juror watched hours of news stories about all the scandals. There's no model that can quantify that added risk, but it's a risk that won't be captured looking at historical data.
My thought - The last Q&A throws up an interesting question for Indian investors. After 3 years of great returns, are we as investors also operating with a rear mirror view? Any thoughts ?
Q&A with Warren buffett (Tuck school of business)
http://mba.tuck.dartmouth.edu/pages/clubs/investment/WarrenBuffett.html
Some excerpts from the Q&A
Q: In your letters you speak frequently of the importance of not over-complicating things. What are your secrets to keeping your life simple?A: When making investments, pretend in life you have a punch-card with only 20 boxes, and every time you make an investment you punch a slot. It will discipline you to only make investments you have extreme confidence in. Big money is made by obvious things. If using a discount rate of 8% vs. 10% is going to make or break an investment idea, it's probably not a good idea. Back in 1951 Moody's published thick handbooks by industry of every stock in circulation. I went through all of them, thousands of pages, motivated by the hope that a great idea was just on the next page. I found companies like National American Insurance and Western Insurance Securities Company that nobody was paying attention to that were trading for far less than their intrinsic values. Last year we found a steel company on the Korean Stock Exchange that had no analyst coverage, no research, but was the most profitable steel company in the world
Q: I have worked in various technologies businesses, but I understand that you do not typically invest in the technology sector. Why is that? How do you view technology as an individual and as an investor?A: Technology is clearly a boost to business productivity and a driver of better consumer products and the like, so as an individual I have a high appreciation for the power of technology. I have avoided technology sectors as an investor because in general I don't have a solid grasp of what differentiates many technology companies. I don't know how to spot durable competitive advantage in technology. To get rich, you find businesses with durable competitive advantage and you don't overpay for them. Technology is based on change; and change is really the enemy of the investor. Change is more rapid and unpredictable in technology relative to the broader economy. To me, all technology sectors look like 7-foot hurdles
Q: In many of your letters you speak about the importance of looking through the windshield and not the rearview mirror. What issues do you think people today are mistakenly looking at through the rearview mirror?A: Investors are always looking for the holy grail, the next great idea that will carry performance and pension returns for the several years. Right now its 'alternative investments' - private equity, hedge funds, the assets that have outperformed public equities for the past five years since the tech bubble burst. There's so much money chasing these ideas now that the returns in the future will probably not be as good. At some point, public equities will become good investments again and fewer people will be looking at them. At Berkshire, we look at a lot of "super-cat" (super catastrophe) insurance business that few firms will write. The challenge is determining when there's a paradigm shift, when the future will no longer look like the past. It's probable that the next hundred years of hurricane activity will not look like the past hundred years. Another example, we write a lot of D and O insurance, Directors and Officers liability. Post Enron, I feel strongly that juries will award much harsher penalties to victims of corporate fraud, etc. than they would have five years ago before the average juror watched hours of news stories about all the scandals. There's no model that can quantify that added risk, but it's a risk that won't be captured looking at historical data.
My thought - The last Q&A throws up an interesting question for Indian investors. After 3 years of great returns, are we as investors also operating with a rear mirror view? Any thoughts ?
Some excerpts from the Q&A
Q: In your letters you speak frequently of the importance of not over-complicating things. What are your secrets to keeping your life simple?A: When making investments, pretend in life you have a punch-card with only 20 boxes, and every time you make an investment you punch a slot. It will discipline you to only make investments you have extreme confidence in. Big money is made by obvious things. If using a discount rate of 8% vs. 10% is going to make or break an investment idea, it's probably not a good idea. Back in 1951 Moody's published thick handbooks by industry of every stock in circulation. I went through all of them, thousands of pages, motivated by the hope that a great idea was just on the next page. I found companies like National American Insurance and Western Insurance Securities Company that nobody was paying attention to that were trading for far less than their intrinsic values. Last year we found a steel company on the Korean Stock Exchange that had no analyst coverage, no research, but was the most profitable steel company in the world
Q: I have worked in various technologies businesses, but I understand that you do not typically invest in the technology sector. Why is that? How do you view technology as an individual and as an investor?A: Technology is clearly a boost to business productivity and a driver of better consumer products and the like, so as an individual I have a high appreciation for the power of technology. I have avoided technology sectors as an investor because in general I don't have a solid grasp of what differentiates many technology companies. I don't know how to spot durable competitive advantage in technology. To get rich, you find businesses with durable competitive advantage and you don't overpay for them. Technology is based on change; and change is really the enemy of the investor. Change is more rapid and unpredictable in technology relative to the broader economy. To me, all technology sectors look like 7-foot hurdles
Q: In many of your letters you speak about the importance of looking through the windshield and not the rearview mirror. What issues do you think people today are mistakenly looking at through the rearview mirror?A: Investors are always looking for the holy grail, the next great idea that will carry performance and pension returns for the several years. Right now its 'alternative investments' - private equity, hedge funds, the assets that have outperformed public equities for the past five years since the tech bubble burst. There's so much money chasing these ideas now that the returns in the future will probably not be as good. At some point, public equities will become good investments again and fewer people will be looking at them. At Berkshire, we look at a lot of "super-cat" (super catastrophe) insurance business that few firms will write. The challenge is determining when there's a paradigm shift, when the future will no longer look like the past. It's probable that the next hundred years of hurricane activity will not look like the past hundred years. Another example, we write a lot of D and O insurance, Directors and Officers liability. Post Enron, I feel strongly that juries will award much harsher penalties to victims of corporate fraud, etc. than they would have five years ago before the average juror watched hours of news stories about all the scandals. There's no model that can quantify that added risk, but it's a risk that won't be captured looking at historical data.
My thought - The last Q&A throws up an interesting question for Indian investors. After 3 years of great returns, are we as investors also operating with a rear mirror view? Any thoughts ?
Friday, October 21, 2005
Spreadsheet Link keeps breaking
I have uploaded the files in yahoo briefcase and provided the links here. However the link keeps breaking. Unfortunately I do not have better way of loading the files.
So if anyone wishes to have a look at the files please email me @ rohitc99@indiatimes.com. I will be glad to share the files.
So if anyone wishes to have a look at the files please email me @ rohitc99@indiatimes.com. I will be glad to share the files.
Spreadsheet Link keeps breaking
I have uploaded the files in yahoo briefcase and provided the links here. However the link keeps breaking. Unfortunately I do not have better way of loading the files.
So if anyone wishes to have a look at the files please email me @ rohitc99@indiatimes.com. I will be glad to share the files.
So if anyone wishes to have a look at the files please email me @ rohitc99@indiatimes.com. I will be glad to share the files.
Why do i blog ?
I have put this question to myself and have come up with two main reasons
I don’t think this blog is going to make me money directly (although it would not hurt), but hopefully would make me a better investor.
And what the heck ! , I am having fun putting my thoughts out and getting feedback/ suggestions/ clarifications from other. For me that is good enough.
- My blog is more like an online dairy. I try to put my thoughts on a regular basis. I try to read what I have posted in the past and try to see what I was thinking then and how has my thinking changed. Typically if something works out, I tend to think that it was my foresight (given time I will be become the new warren buffett !!) and luck had nothing to do with it. My blog ensures that when I look at my posts, I would be able to ‘recall’ what I was thinking and see if I can improve/ change it. At the same time if something does not work out, my earlier posts may prevent me from attributing my failure to bad luck.
- The second reason is to learn from others. Bruce, value architects and a few other visitors have commented or written personally to me in the past. It is good to have a different opinion or to get some inputs from others as it makes me rethink my assumptions or helps me in resolving some of my doubts.
I don’t think this blog is going to make me money directly (although it would not hurt), but hopefully would make me a better investor.
And what the heck ! , I am having fun putting my thoughts out and getting feedback/ suggestions/ clarifications from other. For me that is good enough.
Why do i blog ?
I have put this question to myself and have come up with two main reasons
I don’t think this blog is going to make me money directly (although it would not hurt), but hopefully would make me a better investor.
And what the heck ! , I am having fun putting my thoughts out and getting feedback/ suggestions/ clarifications from other. For me that is good enough.
- My blog is more like an online dairy. I try to put my thoughts on a regular basis. I try to read what I have posted in the past and try to see what I was thinking then and how has my thinking changed. Typically if something works out, I tend to think that it was my foresight (given time I will be become the new warren buffett !!) and luck had nothing to do with it. My blog ensures that when I look at my posts, I would be able to ‘recall’ what I was thinking and see if I can improve/ change it. At the same time if something does not work out, my earlier posts may prevent me from attributing my failure to bad luck.
- The second reason is to learn from others. Bruce, value architects and a few other visitors have commented or written personally to me in the past. It is good to have a different opinion or to get some inputs from others as it makes me rethink my assumptions or helps me in resolving some of my doubts.
I don’t think this blog is going to make me money directly (although it would not hurt), but hopefully would make me a better investor.
And what the heck ! , I am having fun putting my thoughts out and getting feedback/ suggestions/ clarifications from other. For me that is good enough.
Wednesday, October 19, 2005
Difference between a brand and a franchise
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
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
Difference between a brand and a franchise
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
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
Warren Buffett on 'Dividend Policy'
Dividend policy is often reported to shareholders, but seldom explained. A company will say something like, "Our goal is to pay out 40% to 50% of earnings and to increase dividends at a rate at least equal to the rise in the CPI". And that's it - no analysis will be supplied as to why that particular policy is best for the owners of the business. Yet, allocation of capital is crucial to business and investment management. Because it is, we believe managers and owners should think hard about the circumstances under which earnings should be retained and under which they should be distributed.
The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios - inflation causes some or all of the reported earnings to become ersatz. The ersatz portion - let's call these earnings "restricted" - cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.
Restricted earnings are seldom valueless to owners, but they often must be discounted heavily. In effect, they are conscripted by the business, no matter how poor its economic potential. (This retention-no-matter-how-unattractive-the-return situation was communicated unwittingly in a marvelously ironic way by Consolidated Edison a decade ago. At the time, a punitive regulatory policy was a major factor causing the company's stock to sell as low as one-fourth of book value; i.e., every time a dollar of earnings was retained for reinvestment in the business, that dollar was transformed into only 25 cents of market value. But, despite this gold-into-lead process, most earnings were reinvested in the business rather than paid to owners. Restricted earnings need not concern us further in this dividend discussion.
Let's turn to the much-more-valued unrestricted variety. These earnings may, with equal feasibility, be retained or distributed. In our opinion, management should choose whichever course makes greater sense for the owners of the business. This principle is not universally accepted. For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders - to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect - backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future - that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.
To illustrate, let's assume that an investor owns a risk-free 10% perpetual bond with one very unusual feature. Each year the investor can elect either to take his 10% coupon in cash, or to reinvest the coupon in more 10% bonds with identical terms; i.e., a perpetual life and coupons offering the same cash-or-reinvest option. If, in any given year, the prevailing interest rate on long-term, risk-free bonds is 5%, it would be foolish for the investor to take his coupon in cash since the 10% bonds he could instead choose would be worth considerably more than 100 cents on the dollar. Under these circumstances, the investor wanting to get his hands on cash should take his coupon in additional bonds and then immediately sell them. By doing that, he would realize more cash than if he had taken his coupon directly in cash. Assuming all bonds were held by rational investors, no one would opt for cash in an era of 5% interest rates, not even those bondholders needing cash for living purposes.
If, however, interest rates were 15%, no rational investor would want his money invested for him at 10%. Instead, the investor would choose to take his coupon in cash, even if his personal cash needs were nil. The opposite course - reinvestment of the coupon - would give an investor additional bonds with market value far less than the cash he could have elected. If he should want 10% bonds, he can simply take the cash received and buy them in the market, where they will be available at a large discount.
Think about whether a company's unrestricted earnings should be retained or paid out. The analysis is much more difficult and subject to error because the rate earned on reinvested earnings is not a contractual figure, as in our bond case, but rather a fluctuating figure. Owners must guess as to what the rate will average over the intermediate future. However, once an informed guess is made, the rest of the analysis is simple: you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment.
Many corporate managers reason very much along these lines in determining whether subsidiaries should distribute earnings to their parent company. At that level,. the managers have no trouble thinking like intelligent owners. But payout decisions at the parent company level often are a different story. Here managers frequently have trouble putting themselves in the shoes of their shareholder-owners.
With this schizoid approach, the CEO of a multi-divisional company will instruct Subsidiary A, whose earnings on incremental capital may be expected to average 5%, to distribute all available earnings in order that they may be invested in Subsidiary B, whose earnings on incremental capital are expected to be 15%. The CEO's business school oath will allow no lesser behavior. But if his own long-term record with incremental capital is 5% - and market rates are 10% - he is likely to impose a dividend policy on shareholders of the parent company that merely follows some historical or industry-wide payout pattern. Furthermore, he will expect managers of subsidiaries to give him a full account as to why it makes sense for earnings to be retained in their operations rather than distributed to the parent-owner. But seldom will he supply his owners with a similar analysis pertaining to the whole company.
In judging whether managers should retain earnings, shareholders should not simply compare total incremental earnings in recent years to total incremental capital because that relationship may be distorted by what is going on in a core business. During an inflationary period, companies with a core business characterized by extraordinary economics can use small amounts of incremental capital in that business at very high rates of return. But, unless they are experiencing tremendous unit growth, outstanding businesses by definition generate large amounts of excess cash. If a company sinks most of this money in other businesses that earn low returns, the company's overall return on retained capital may nevertheless appear excellent because of the extraordinary returns being earned by the portion of earnings incrementally invested in the core business. The situation is analogous to a Pro-Am golf event: even if all of the amateurs are hopeless duffers, the team's best-ball score will be respectable because of the dominating skills of the professional.
Many corporations that consistently show good returns both on equity and on overall incremental capital have, indeed, employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis. Their marvelous core businesses, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere (usually involving high-priced acquisitions of businesses that have inherently mediocre economics). The managers at fault periodically report on the lessons they have learned from the latest disappointment. They then usually seek out future lessons. (Failure seems to go to their heads.)
In such cases, shareholders would be far better off if earnings were retained only to expand the high-return business, with the balance paid in dividends or used to repurchase stock (an action that increases the owners' interest in the exceptional business while sparing them participation in subpar businesses). Managers of high-return businesses who consistently employ much of the cash thrown off by those businesses in other ventures with low returns should be held to account for those allocation decisions, regardless of how profitable the overall enterprise is.
Nothing in this discussion is intended to argue for dividends that bounce around from quarter to quarter with each wiggle in earnings or in investment opportunities. Shareholders of public corporations understandably prefer that dividends be consistent and predictable. Payments, therefore, should reflect long-term expectations for both earnings and returns on incremental capital. Since the long-term corporate outlook changes only infrequently, dividend patterns should change no more often. But over time distributable earnings that have been withheld by managers should earn their keep. If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained.
Historically, Berkshire has earned well over market rates on retained earnings, thereby creating over one dollar of market value for every dollar retained. Under such circumstances, any distribution would have been contrary to the financial interest of shareholders, large or small.
The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios - inflation causes some or all of the reported earnings to become ersatz. The ersatz portion - let's call these earnings "restricted" - cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.
Restricted earnings are seldom valueless to owners, but they often must be discounted heavily. In effect, they are conscripted by the business, no matter how poor its economic potential. (This retention-no-matter-how-unattractive-the-return situation was communicated unwittingly in a marvelously ironic way by Consolidated Edison a decade ago. At the time, a punitive regulatory policy was a major factor causing the company's stock to sell as low as one-fourth of book value; i.e., every time a dollar of earnings was retained for reinvestment in the business, that dollar was transformed into only 25 cents of market value. But, despite this gold-into-lead process, most earnings were reinvested in the business rather than paid to owners. Restricted earnings need not concern us further in this dividend discussion.
Let's turn to the much-more-valued unrestricted variety. These earnings may, with equal feasibility, be retained or distributed. In our opinion, management should choose whichever course makes greater sense for the owners of the business. This principle is not universally accepted. For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders - to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect - backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future - that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.
To illustrate, let's assume that an investor owns a risk-free 10% perpetual bond with one very unusual feature. Each year the investor can elect either to take his 10% coupon in cash, or to reinvest the coupon in more 10% bonds with identical terms; i.e., a perpetual life and coupons offering the same cash-or-reinvest option. If, in any given year, the prevailing interest rate on long-term, risk-free bonds is 5%, it would be foolish for the investor to take his coupon in cash since the 10% bonds he could instead choose would be worth considerably more than 100 cents on the dollar. Under these circumstances, the investor wanting to get his hands on cash should take his coupon in additional bonds and then immediately sell them. By doing that, he would realize more cash than if he had taken his coupon directly in cash. Assuming all bonds were held by rational investors, no one would opt for cash in an era of 5% interest rates, not even those bondholders needing cash for living purposes.
If, however, interest rates were 15%, no rational investor would want his money invested for him at 10%. Instead, the investor would choose to take his coupon in cash, even if his personal cash needs were nil. The opposite course - reinvestment of the coupon - would give an investor additional bonds with market value far less than the cash he could have elected. If he should want 10% bonds, he can simply take the cash received and buy them in the market, where they will be available at a large discount.
Think about whether a company's unrestricted earnings should be retained or paid out. The analysis is much more difficult and subject to error because the rate earned on reinvested earnings is not a contractual figure, as in our bond case, but rather a fluctuating figure. Owners must guess as to what the rate will average over the intermediate future. However, once an informed guess is made, the rest of the analysis is simple: you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment.
Many corporate managers reason very much along these lines in determining whether subsidiaries should distribute earnings to their parent company. At that level,. the managers have no trouble thinking like intelligent owners. But payout decisions at the parent company level often are a different story. Here managers frequently have trouble putting themselves in the shoes of their shareholder-owners.
With this schizoid approach, the CEO of a multi-divisional company will instruct Subsidiary A, whose earnings on incremental capital may be expected to average 5%, to distribute all available earnings in order that they may be invested in Subsidiary B, whose earnings on incremental capital are expected to be 15%. The CEO's business school oath will allow no lesser behavior. But if his own long-term record with incremental capital is 5% - and market rates are 10% - he is likely to impose a dividend policy on shareholders of the parent company that merely follows some historical or industry-wide payout pattern. Furthermore, he will expect managers of subsidiaries to give him a full account as to why it makes sense for earnings to be retained in their operations rather than distributed to the parent-owner. But seldom will he supply his owners with a similar analysis pertaining to the whole company.
In judging whether managers should retain earnings, shareholders should not simply compare total incremental earnings in recent years to total incremental capital because that relationship may be distorted by what is going on in a core business. During an inflationary period, companies with a core business characterized by extraordinary economics can use small amounts of incremental capital in that business at very high rates of return. But, unless they are experiencing tremendous unit growth, outstanding businesses by definition generate large amounts of excess cash. If a company sinks most of this money in other businesses that earn low returns, the company's overall return on retained capital may nevertheless appear excellent because of the extraordinary returns being earned by the portion of earnings incrementally invested in the core business. The situation is analogous to a Pro-Am golf event: even if all of the amateurs are hopeless duffers, the team's best-ball score will be respectable because of the dominating skills of the professional.
Many corporations that consistently show good returns both on equity and on overall incremental capital have, indeed, employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis. Their marvelous core businesses, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere (usually involving high-priced acquisitions of businesses that have inherently mediocre economics). The managers at fault periodically report on the lessons they have learned from the latest disappointment. They then usually seek out future lessons. (Failure seems to go to their heads.)
In such cases, shareholders would be far better off if earnings were retained only to expand the high-return business, with the balance paid in dividends or used to repurchase stock (an action that increases the owners' interest in the exceptional business while sparing them participation in subpar businesses). Managers of high-return businesses who consistently employ much of the cash thrown off by those businesses in other ventures with low returns should be held to account for those allocation decisions, regardless of how profitable the overall enterprise is.
Nothing in this discussion is intended to argue for dividends that bounce around from quarter to quarter with each wiggle in earnings or in investment opportunities. Shareholders of public corporations understandably prefer that dividends be consistent and predictable. Payments, therefore, should reflect long-term expectations for both earnings and returns on incremental capital. Since the long-term corporate outlook changes only infrequently, dividend patterns should change no more often. But over time distributable earnings that have been withheld by managers should earn their keep. If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained.
Historically, Berkshire has earned well over market rates on retained earnings, thereby creating over one dollar of market value for every dollar retained. Under such circumstances, any distribution would have been contrary to the financial interest of shareholders, large or small.
Warren Buffett on 'Dividend Policy'
Dividend policy is often reported to shareholders, but seldom explained. A company will say something like, "Our goal is to pay out 40% to 50% of earnings and to increase dividends at a rate at least equal to the rise in the CPI". And that's it - no analysis will be supplied as to why that particular policy is best for the owners of the business. Yet, allocation of capital is crucial to business and investment management. Because it is, we believe managers and owners should think hard about the circumstances under which earnings should be retained and under which they should be distributed.
The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios - inflation causes some or all of the reported earnings to become ersatz. The ersatz portion - let's call these earnings "restricted" - cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.
Restricted earnings are seldom valueless to owners, but they often must be discounted heavily. In effect, they are conscripted by the business, no matter how poor its economic potential. (This retention-no-matter-how-unattractive-the-return situation was communicated unwittingly in a marvelously ironic way by Consolidated Edison a decade ago. At the time, a punitive regulatory policy was a major factor causing the company's stock to sell as low as one-fourth of book value; i.e., every time a dollar of earnings was retained for reinvestment in the business, that dollar was transformed into only 25 cents of market value. But, despite this gold-into-lead process, most earnings were reinvested in the business rather than paid to owners. Restricted earnings need not concern us further in this dividend discussion.
Let's turn to the much-more-valued unrestricted variety. These earnings may, with equal feasibility, be retained or distributed. In our opinion, management should choose whichever course makes greater sense for the owners of the business. This principle is not universally accepted. For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders - to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect - backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future - that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.
To illustrate, let's assume that an investor owns a risk-free 10% perpetual bond with one very unusual feature. Each year the investor can elect either to take his 10% coupon in cash, or to reinvest the coupon in more 10% bonds with identical terms; i.e., a perpetual life and coupons offering the same cash-or-reinvest option. If, in any given year, the prevailing interest rate on long-term, risk-free bonds is 5%, it would be foolish for the investor to take his coupon in cash since the 10% bonds he could instead choose would be worth considerably more than 100 cents on the dollar. Under these circumstances, the investor wanting to get his hands on cash should take his coupon in additional bonds and then immediately sell them. By doing that, he would realize more cash than if he had taken his coupon directly in cash. Assuming all bonds were held by rational investors, no one would opt for cash in an era of 5% interest rates, not even those bondholders needing cash for living purposes.
If, however, interest rates were 15%, no rational investor would want his money invested for him at 10%. Instead, the investor would choose to take his coupon in cash, even if his personal cash needs were nil. The opposite course - reinvestment of the coupon - would give an investor additional bonds with market value far less than the cash he could have elected. If he should want 10% bonds, he can simply take the cash received and buy them in the market, where they will be available at a large discount.
Think about whether a company's unrestricted earnings should be retained or paid out. The analysis is much more difficult and subject to error because the rate earned on reinvested earnings is not a contractual figure, as in our bond case, but rather a fluctuating figure. Owners must guess as to what the rate will average over the intermediate future. However, once an informed guess is made, the rest of the analysis is simple: you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment.
Many corporate managers reason very much along these lines in determining whether subsidiaries should distribute earnings to their parent company. At that level,. the managers have no trouble thinking like intelligent owners. But payout decisions at the parent company level often are a different story. Here managers frequently have trouble putting themselves in the shoes of their shareholder-owners.
With this schizoid approach, the CEO of a multi-divisional company will instruct Subsidiary A, whose earnings on incremental capital may be expected to average 5%, to distribute all available earnings in order that they may be invested in Subsidiary B, whose earnings on incremental capital are expected to be 15%. The CEO's business school oath will allow no lesser behavior. But if his own long-term record with incremental capital is 5% - and market rates are 10% - he is likely to impose a dividend policy on shareholders of the parent company that merely follows some historical or industry-wide payout pattern. Furthermore, he will expect managers of subsidiaries to give him a full account as to why it makes sense for earnings to be retained in their operations rather than distributed to the parent-owner. But seldom will he supply his owners with a similar analysis pertaining to the whole company.
In judging whether managers should retain earnings, shareholders should not simply compare total incremental earnings in recent years to total incremental capital because that relationship may be distorted by what is going on in a core business. During an inflationary period, companies with a core business characterized by extraordinary economics can use small amounts of incremental capital in that business at very high rates of return. But, unless they are experiencing tremendous unit growth, outstanding businesses by definition generate large amounts of excess cash. If a company sinks most of this money in other businesses that earn low returns, the company's overall return on retained capital may nevertheless appear excellent because of the extraordinary returns being earned by the portion of earnings incrementally invested in the core business. The situation is analogous to a Pro-Am golf event: even if all of the amateurs are hopeless duffers, the team's best-ball score will be respectable because of the dominating skills of the professional.
Many corporations that consistently show good returns both on equity and on overall incremental capital have, indeed, employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis. Their marvelous core businesses, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere (usually involving high-priced acquisitions of businesses that have inherently mediocre economics). The managers at fault periodically report on the lessons they have learned from the latest disappointment. They then usually seek out future lessons. (Failure seems to go to their heads.)
In such cases, shareholders would be far better off if earnings were retained only to expand the high-return business, with the balance paid in dividends or used to repurchase stock (an action that increases the owners' interest in the exceptional business while sparing them participation in subpar businesses). Managers of high-return businesses who consistently employ much of the cash thrown off by those businesses in other ventures with low returns should be held to account for those allocation decisions, regardless of how profitable the overall enterprise is.
Nothing in this discussion is intended to argue for dividends that bounce around from quarter to quarter with each wiggle in earnings or in investment opportunities. Shareholders of public corporations understandably prefer that dividends be consistent and predictable. Payments, therefore, should reflect long-term expectations for both earnings and returns on incremental capital. Since the long-term corporate outlook changes only infrequently, dividend patterns should change no more often. But over time distributable earnings that have been withheld by managers should earn their keep. If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained.
Historically, Berkshire has earned well over market rates on retained earnings, thereby creating over one dollar of market value for every dollar retained. Under such circumstances, any distribution would have been contrary to the financial interest of shareholders, large or small.
The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios - inflation causes some or all of the reported earnings to become ersatz. The ersatz portion - let's call these earnings "restricted" - cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.
Restricted earnings are seldom valueless to owners, but they often must be discounted heavily. In effect, they are conscripted by the business, no matter how poor its economic potential. (This retention-no-matter-how-unattractive-the-return situation was communicated unwittingly in a marvelously ironic way by Consolidated Edison a decade ago. At the time, a punitive regulatory policy was a major factor causing the company's stock to sell as low as one-fourth of book value; i.e., every time a dollar of earnings was retained for reinvestment in the business, that dollar was transformed into only 25 cents of market value. But, despite this gold-into-lead process, most earnings were reinvested in the business rather than paid to owners. Restricted earnings need not concern us further in this dividend discussion.
Let's turn to the much-more-valued unrestricted variety. These earnings may, with equal feasibility, be retained or distributed. In our opinion, management should choose whichever course makes greater sense for the owners of the business. This principle is not universally accepted. For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders - to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect - backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future - that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.
To illustrate, let's assume that an investor owns a risk-free 10% perpetual bond with one very unusual feature. Each year the investor can elect either to take his 10% coupon in cash, or to reinvest the coupon in more 10% bonds with identical terms; i.e., a perpetual life and coupons offering the same cash-or-reinvest option. If, in any given year, the prevailing interest rate on long-term, risk-free bonds is 5%, it would be foolish for the investor to take his coupon in cash since the 10% bonds he could instead choose would be worth considerably more than 100 cents on the dollar. Under these circumstances, the investor wanting to get his hands on cash should take his coupon in additional bonds and then immediately sell them. By doing that, he would realize more cash than if he had taken his coupon directly in cash. Assuming all bonds were held by rational investors, no one would opt for cash in an era of 5% interest rates, not even those bondholders needing cash for living purposes.
If, however, interest rates were 15%, no rational investor would want his money invested for him at 10%. Instead, the investor would choose to take his coupon in cash, even if his personal cash needs were nil. The opposite course - reinvestment of the coupon - would give an investor additional bonds with market value far less than the cash he could have elected. If he should want 10% bonds, he can simply take the cash received and buy them in the market, where they will be available at a large discount.
Think about whether a company's unrestricted earnings should be retained or paid out. The analysis is much more difficult and subject to error because the rate earned on reinvested earnings is not a contractual figure, as in our bond case, but rather a fluctuating figure. Owners must guess as to what the rate will average over the intermediate future. However, once an informed guess is made, the rest of the analysis is simple: you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment.
Many corporate managers reason very much along these lines in determining whether subsidiaries should distribute earnings to their parent company. At that level,. the managers have no trouble thinking like intelligent owners. But payout decisions at the parent company level often are a different story. Here managers frequently have trouble putting themselves in the shoes of their shareholder-owners.
With this schizoid approach, the CEO of a multi-divisional company will instruct Subsidiary A, whose earnings on incremental capital may be expected to average 5%, to distribute all available earnings in order that they may be invested in Subsidiary B, whose earnings on incremental capital are expected to be 15%. The CEO's business school oath will allow no lesser behavior. But if his own long-term record with incremental capital is 5% - and market rates are 10% - he is likely to impose a dividend policy on shareholders of the parent company that merely follows some historical or industry-wide payout pattern. Furthermore, he will expect managers of subsidiaries to give him a full account as to why it makes sense for earnings to be retained in their operations rather than distributed to the parent-owner. But seldom will he supply his owners with a similar analysis pertaining to the whole company.
In judging whether managers should retain earnings, shareholders should not simply compare total incremental earnings in recent years to total incremental capital because that relationship may be distorted by what is going on in a core business. During an inflationary period, companies with a core business characterized by extraordinary economics can use small amounts of incremental capital in that business at very high rates of return. But, unless they are experiencing tremendous unit growth, outstanding businesses by definition generate large amounts of excess cash. If a company sinks most of this money in other businesses that earn low returns, the company's overall return on retained capital may nevertheless appear excellent because of the extraordinary returns being earned by the portion of earnings incrementally invested in the core business. The situation is analogous to a Pro-Am golf event: even if all of the amateurs are hopeless duffers, the team's best-ball score will be respectable because of the dominating skills of the professional.
Many corporations that consistently show good returns both on equity and on overall incremental capital have, indeed, employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis. Their marvelous core businesses, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere (usually involving high-priced acquisitions of businesses that have inherently mediocre economics). The managers at fault periodically report on the lessons they have learned from the latest disappointment. They then usually seek out future lessons. (Failure seems to go to their heads.)
In such cases, shareholders would be far better off if earnings were retained only to expand the high-return business, with the balance paid in dividends or used to repurchase stock (an action that increases the owners' interest in the exceptional business while sparing them participation in subpar businesses). Managers of high-return businesses who consistently employ much of the cash thrown off by those businesses in other ventures with low returns should be held to account for those allocation decisions, regardless of how profitable the overall enterprise is.
Nothing in this discussion is intended to argue for dividends that bounce around from quarter to quarter with each wiggle in earnings or in investment opportunities. Shareholders of public corporations understandably prefer that dividends be consistent and predictable. Payments, therefore, should reflect long-term expectations for both earnings and returns on incremental capital. Since the long-term corporate outlook changes only infrequently, dividend patterns should change no more often. But over time distributable earnings that have been withheld by managers should earn their keep. If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained.
Historically, Berkshire has earned well over market rates on retained earnings, thereby creating over one dollar of market value for every dollar retained. Under such circumstances, any distribution would have been contrary to the financial interest of shareholders, large or small.
Sunday, October 16, 2005
The wisdom of warren buffett
I am reading the annual letters to shareholder from warren buffet again. Anyone wanting an education on investing should read and re-read these letters. Found several great quotes/ ideas which I will be sharing over a few posts.
On Temperament
“Our advantage, was attitude: we learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values. We have no idea how long the excesses will last, nor do we know what will change the attitudes of government, lender and buyer that fuel them. We do know that the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs”
On buying businesses
“ I've said many times that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact. After many years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers.”
On Capital allocation
“And, despite the age of the equipment, much of it was functionally similar to new equipment being installed by the industry. Despite this “bargain cost” of fixed assets, capital turnover was relatively low reflecting required high investment levels in receivables and inventory compared to sales. Slow capital turnover, coupled with low profit margins on sales, inevitably produces inadequate returns on capital. Obvious approaches to improved profit margins involve differentiation of product, lowered manufacturing costs through more efficient equipment or better utilization of people, redirection toward fabrics enjoying stronger market trends, etc. Our management was diligent in pursuing such objectives. The problem was that our competitors were just as diligently doing the same thing.
Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable. This is precisely the choice that often faces us since entire businesses (whose earnings will be fully reportable) frequently sell for double the pro-rata price of small portions (whose earnings will be largely unreportable). In aggregate and over time, we expect the unreported earnings to be fully reflected in our intrinsic business value through capital gains”
On Intelligent Investing
1. that you should look at stocks as part Ownership of a business,
2. that you should look at market fluctuations in terms of his "Mr. Market" example and make them your friend rather than your enemy by essentially profiting from folly rather than participating in it, and finally,
3. the three most important words in investing are "Margin of safety" - which Ben talked about in his last chapter of The Intelligent Investor - always building a 15,000 pound bridge if you're going to be driving 10,000 pound trucks across it.
On Investing strategy
“ Our equity-investing strategy remains little changed from what it was years ago: "We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety. We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price." We have seen cause to make only one change in this creed: Because of both market conditions and our size, we now substitute "an attractive price" for "a very attractive price."
But how, you will ask, does one decide what's "attractive"? In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition:
"value" and "growth." Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing. We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.
Whether appropriate or not, the term "value investing" is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics - a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield - are in no way inconsistent with a "value" purchase.
Similarly, business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.
Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor. “
On Temperament
“Our advantage, was attitude: we learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values. We have no idea how long the excesses will last, nor do we know what will change the attitudes of government, lender and buyer that fuel them. We do know that the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs”
On buying businesses
“ I've said many times that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact. After many years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers.”
On Capital allocation
“And, despite the age of the equipment, much of it was functionally similar to new equipment being installed by the industry. Despite this “bargain cost” of fixed assets, capital turnover was relatively low reflecting required high investment levels in receivables and inventory compared to sales. Slow capital turnover, coupled with low profit margins on sales, inevitably produces inadequate returns on capital. Obvious approaches to improved profit margins involve differentiation of product, lowered manufacturing costs through more efficient equipment or better utilization of people, redirection toward fabrics enjoying stronger market trends, etc. Our management was diligent in pursuing such objectives. The problem was that our competitors were just as diligently doing the same thing.
Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable. This is precisely the choice that often faces us since entire businesses (whose earnings will be fully reportable) frequently sell for double the pro-rata price of small portions (whose earnings will be largely unreportable). In aggregate and over time, we expect the unreported earnings to be fully reflected in our intrinsic business value through capital gains”
On Intelligent Investing
1. that you should look at stocks as part Ownership of a business,
2. that you should look at market fluctuations in terms of his "Mr. Market" example and make them your friend rather than your enemy by essentially profiting from folly rather than participating in it, and finally,
3. the three most important words in investing are "Margin of safety" - which Ben talked about in his last chapter of The Intelligent Investor - always building a 15,000 pound bridge if you're going to be driving 10,000 pound trucks across it.
On Investing strategy
“ Our equity-investing strategy remains little changed from what it was years ago: "We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety. We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price." We have seen cause to make only one change in this creed: Because of both market conditions and our size, we now substitute "an attractive price" for "a very attractive price."
But how, you will ask, does one decide what's "attractive"? In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition:
"value" and "growth." Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing. We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.
Whether appropriate or not, the term "value investing" is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics - a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield - are in no way inconsistent with a "value" purchase.
Similarly, business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.
Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor. “
The wisdom of warren buffett
I am reading the annual letters to shareholder from warren buffet again. Anyone wanting an education on investing should read and re-read these letters. Found several great quotes/ ideas which I will be sharing over a few posts.
On Temperament
“Our advantage, was attitude: we learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values. We have no idea how long the excesses will last, nor do we know what will change the attitudes of government, lender and buyer that fuel them. We do know that the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs”
On buying businesses
“ I've said many times that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact. After many years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers.”
On Capital allocation
“And, despite the age of the equipment, much of it was functionally similar to new equipment being installed by the industry. Despite this “bargain cost” of fixed assets, capital turnover was relatively low reflecting required high investment levels in receivables and inventory compared to sales. Slow capital turnover, coupled with low profit margins on sales, inevitably produces inadequate returns on capital. Obvious approaches to improved profit margins involve differentiation of product, lowered manufacturing costs through more efficient equipment or better utilization of people, redirection toward fabrics enjoying stronger market trends, etc. Our management was diligent in pursuing such objectives. The problem was that our competitors were just as diligently doing the same thing.
Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable. This is precisely the choice that often faces us since entire businesses (whose earnings will be fully reportable) frequently sell for double the pro-rata price of small portions (whose earnings will be largely unreportable). In aggregate and over time, we expect the unreported earnings to be fully reflected in our intrinsic business value through capital gains”
On Intelligent Investing
1. that you should look at stocks as part Ownership of a business,
2. that you should look at market fluctuations in terms of his "Mr. Market" example and make them your friend rather than your enemy by essentially profiting from folly rather than participating in it, and finally,
3. the three most important words in investing are "Margin of safety" - which Ben talked about in his last chapter of The Intelligent Investor - always building a 15,000 pound bridge if you're going to be driving 10,000 pound trucks across it.
On Investing strategy
“ Our equity-investing strategy remains little changed from what it was years ago: "We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety. We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price." We have seen cause to make only one change in this creed: Because of both market conditions and our size, we now substitute "an attractive price" for "a very attractive price."
But how, you will ask, does one decide what's "attractive"? In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition:
"value" and "growth." Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing. We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.
Whether appropriate or not, the term "value investing" is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics - a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield - are in no way inconsistent with a "value" purchase.
Similarly, business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.
Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor. “
On Temperament
“Our advantage, was attitude: we learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values. We have no idea how long the excesses will last, nor do we know what will change the attitudes of government, lender and buyer that fuel them. We do know that the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs”
On buying businesses
“ I've said many times that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact. After many years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers.”
On Capital allocation
“And, despite the age of the equipment, much of it was functionally similar to new equipment being installed by the industry. Despite this “bargain cost” of fixed assets, capital turnover was relatively low reflecting required high investment levels in receivables and inventory compared to sales. Slow capital turnover, coupled with low profit margins on sales, inevitably produces inadequate returns on capital. Obvious approaches to improved profit margins involve differentiation of product, lowered manufacturing costs through more efficient equipment or better utilization of people, redirection toward fabrics enjoying stronger market trends, etc. Our management was diligent in pursuing such objectives. The problem was that our competitors were just as diligently doing the same thing.
Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable. This is precisely the choice that often faces us since entire businesses (whose earnings will be fully reportable) frequently sell for double the pro-rata price of small portions (whose earnings will be largely unreportable). In aggregate and over time, we expect the unreported earnings to be fully reflected in our intrinsic business value through capital gains”
On Intelligent Investing
1. that you should look at stocks as part Ownership of a business,
2. that you should look at market fluctuations in terms of his "Mr. Market" example and make them your friend rather than your enemy by essentially profiting from folly rather than participating in it, and finally,
3. the three most important words in investing are "Margin of safety" - which Ben talked about in his last chapter of The Intelligent Investor - always building a 15,000 pound bridge if you're going to be driving 10,000 pound trucks across it.
On Investing strategy
“ Our equity-investing strategy remains little changed from what it was years ago: "We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety. We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price." We have seen cause to make only one change in this creed: Because of both market conditions and our size, we now substitute "an attractive price" for "a very attractive price."
But how, you will ask, does one decide what's "attractive"? In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition:
"value" and "growth." Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing. We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.
Whether appropriate or not, the term "value investing" is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics - a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield - are in no way inconsistent with a "value" purchase.
Similarly, business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.
Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor. “
Friday, October 14, 2005
Trying to develop a mental model to value cyclical / Commodity businesses
I have always had a mental block against low return commodity / cyclical businesses (highly influenced by warren buffett’s writings).
Other than the fact that investing in such businesses requires being tuned to the business cycle and overall requires more work in tracking such businesses, I have found it difficult to value such businesses. It would be naïve to use PE or such simplistic ratios because these ratios would mislead you completely. During the peak of cycle, due to operating leverage the earnings shoot up and the PE drops to single digit, making the stock appear cheap. The reverse happens when the business cycle turns.
Developing a DCF model also has been difficult, because I have found it difficult to predict future free cash flows for such companies (I assume that would require having a reasonable grasp of the business cycle in terms of demand supply picture, inventory levels, pricing etc).
In contrast businesses like FMCG, paints, pharma have good returns, low or non-existent cyclicality. I have found such businesses easy to understand, project for some years out and value them. In addition, for the past few years such business were available at throwaway prices. As warren buffet says (I like to quote him a lot), “degree of difficulty does not count in investing, being right counts more. Better to invest in a simple business with a single knowable variable, than a complex business which have multiple complex factors driving it” (I have paraphrased from memory).
So why this change of heart. For one, it is an intellectual challenge. I would like to understand and value such businesses, even if do not invest in them. In addition, it increases the investible universe for me.
It could a long time for me to confidently value such businesses. The ‘business analysis’ excel is an effort in that direction. I also have a detailed valuation file (which I will post shortly), which I use to value an individual company. Hopefully towards the end of this effort I should be able to use it to value a commodity/ cyclical business.
Other than the fact that investing in such businesses requires being tuned to the business cycle and overall requires more work in tracking such businesses, I have found it difficult to value such businesses. It would be naïve to use PE or such simplistic ratios because these ratios would mislead you completely. During the peak of cycle, due to operating leverage the earnings shoot up and the PE drops to single digit, making the stock appear cheap. The reverse happens when the business cycle turns.
Developing a DCF model also has been difficult, because I have found it difficult to predict future free cash flows for such companies (I assume that would require having a reasonable grasp of the business cycle in terms of demand supply picture, inventory levels, pricing etc).
In contrast businesses like FMCG, paints, pharma have good returns, low or non-existent cyclicality. I have found such businesses easy to understand, project for some years out and value them. In addition, for the past few years such business were available at throwaway prices. As warren buffet says (I like to quote him a lot), “degree of difficulty does not count in investing, being right counts more. Better to invest in a simple business with a single knowable variable, than a complex business which have multiple complex factors driving it” (I have paraphrased from memory).
So why this change of heart. For one, it is an intellectual challenge. I would like to understand and value such businesses, even if do not invest in them. In addition, it increases the investible universe for me.
It could a long time for me to confidently value such businesses. The ‘business analysis’ excel is an effort in that direction. I also have a detailed valuation file (which I will post shortly), which I use to value an individual company. Hopefully towards the end of this effort I should be able to use it to value a commodity/ cyclical business.
Trying to develop a mental model to value cyclical / Commodity businesses
I have always had a mental block against low return commodity / cyclical businesses (highly influenced by warren buffett’s writings).
Other than the fact that investing in such businesses requires being tuned to the business cycle and overall requires more work in tracking such businesses, I have found it difficult to value such businesses. It would be naïve to use PE or such simplistic ratios because these ratios would mislead you completely. During the peak of cycle, due to operating leverage the earnings shoot up and the PE drops to single digit, making the stock appear cheap. The reverse happens when the business cycle turns.
Developing a DCF model also has been difficult, because I have found it difficult to predict future free cash flows for such companies (I assume that would require having a reasonable grasp of the business cycle in terms of demand supply picture, inventory levels, pricing etc).
In contrast businesses like FMCG, paints, pharma have good returns, low or non-existent cyclicality. I have found such businesses easy to understand, project for some years out and value them. In addition, for the past few years such business were available at throwaway prices. As warren buffet says (I like to quote him a lot), “degree of difficulty does not count in investing, being right counts more. Better to invest in a simple business with a single knowable variable, than a complex business which have multiple complex factors driving it” (I have paraphrased from memory).
So why this change of heart. For one, it is an intellectual challenge. I would like to understand and value such businesses, even if do not invest in them. In addition, it increases the investible universe for me.
It could a long time for me to confidently value such businesses. The ‘business analysis’ excel is an effort in that direction. I also have a detailed valuation file (which I will post shortly), which I use to value an individual company. Hopefully towards the end of this effort I should be able to use it to value a commodity/ cyclical business.
Other than the fact that investing in such businesses requires being tuned to the business cycle and overall requires more work in tracking such businesses, I have found it difficult to value such businesses. It would be naïve to use PE or such simplistic ratios because these ratios would mislead you completely. During the peak of cycle, due to operating leverage the earnings shoot up and the PE drops to single digit, making the stock appear cheap. The reverse happens when the business cycle turns.
Developing a DCF model also has been difficult, because I have found it difficult to predict future free cash flows for such companies (I assume that would require having a reasonable grasp of the business cycle in terms of demand supply picture, inventory levels, pricing etc).
In contrast businesses like FMCG, paints, pharma have good returns, low or non-existent cyclicality. I have found such businesses easy to understand, project for some years out and value them. In addition, for the past few years such business were available at throwaway prices. As warren buffet says (I like to quote him a lot), “degree of difficulty does not count in investing, being right counts more. Better to invest in a simple business with a single knowable variable, than a complex business which have multiple complex factors driving it” (I have paraphrased from memory).
So why this change of heart. For one, it is an intellectual challenge. I would like to understand and value such businesses, even if do not invest in them. In addition, it increases the investible universe for me.
It could a long time for me to confidently value such businesses. The ‘business analysis’ excel is an effort in that direction. I also have a detailed valuation file (which I will post shortly), which I use to value an individual company. Hopefully towards the end of this effort I should be able to use it to value a commodity/ cyclical business.
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