Bulk of wealth is created in co's growth advantage period: Raamdeo Agrawal

On the eve of the launch of its 22nd Annual Wealth Creation study, Raamdeo Agrawal, co-founder and joint managing director, Motilal Oswal Financial Services talks to Vishal Chhabria on the learnings from the latest initiative. He also shared his views on the market outlook and why investors shouldn’t worry over the outcome of Gujarat state elections. Edited excerpts:

What are the key learnings from the annual wealth creation study?
 

At the start of this study, we looked at CAP (Competitive Advantage Period) and GAP (earnings’ Growth Advantage Period) of a company, to gauge the power of longevity in wealth creation.

Businesses have a very long life (longevity). TCS, Infosys, HDFC Bank, Marico, etc., were not built in a day but over many years, and their ability to sustain competitive advantage and high earnings growth have helped their market value rise multi-fold. So, identifying a machine with longevity, where you buy and hold, is important.

We do so through our concept, QGLP – Quality, Growth, Longevity and reasonable Price. Q and G mean top quality business, top quality management and growing company. But, how long is it going to grow, at what speed and how long is it going to remain highly profitable, are crucial factors.

There will always be times when competition or external factors bring down the CAP. CAP measures the longevity of competitive advantage. But since CAP alone is not sufficient, measuring longevity of growth is also vital. GAP helps measure how long a company’s earnings could grow faster.

How do you go about identifying the companies?

There are two frameworks. The level of attractiveness of an industry’s structure and the company strategy help determine CAP. ‘The five forces model’ of Michael Porter tells us whether fundamentally an industry structure is profitable or not. For example, today, telecom has a very interesting industry structure, but internal rivalry, the fifth force, is so intense that nobody is making money. So, it is unlikely that investors can make money.

Liquor is an example of a very good industry structure. Only 2-3 large players, none are fighting each other, there is scope to hike prices, and raw materials are easily available. Cigarettes is even better, where regulations are far more supportive especially in terms of pricing and distribution.

Apart from industry structure, the company’s strategy and its mind-set to grow is very important. So that’s at a CAP level.

The more difficult one is GAP. Bulk of the wealth in a stock is created in its GAP. GAP is the time during which a company grows its profits at a faster rate than peers. Equally important, there has to be enough scope for the industry, in which the company operates in, to grow at a high pace. If it is growing by 4-5 per cent, then it is tough for a company to grow at say, 25 per cent. Software services is a recent example.

While this theory is fine, in today’s world you have so much of disruptions—policy, technology, etc. How do you take care of such things?

Yes, you have to keep these things in mind. When technology disruption is coming, is the management aligned to the changes? A big disruption we see coming is the shift from internal combustion engines to electric vehicles. Cars will not disappear. The question is whether existing companies are going to lead the shift. New companies will try to do it, but if the management of existing players is aligned, like Maruti which is the first to put up the battery plant, then there is some comfort. But yes, disruptions are too many. However, nothing happens overnight and investors do get enough time to move from the losers to the winners.

In the context of the speed of change, how relevant does the 5-year period in your studies?

In the lifecycle of an industry or company, you have a phase beginning with start-up, growth, maturity and then decline. We have to capture the start-up or growth phase and stay on. This period could be about 10 to 12 years. In some cases it could be longer, like for HDFC which is running for 40 years. So, you buy a stock after you have seen the initial growth phase and stay on. When growth starts declining, you can take a call to exit or alter your holdings. Barring commodity plays, growth rates don’t come down from high levels of say 80-100 per cent to 10 per cent, in a short period. In secular companies, it happens very slowly.

You mentioned about the life cycle of a company. Do you see this life cycle of the companies and this GAP actually shortening?

Yes, in some businesses, but it is not necessary. Technology is making things faster and better. The delivery channels have become better, customers are well informed. But fundamentally, businesses don’t change. Like, banking is becoming faster because they are using lot of technology, but good banks are making more money than ever. But yes, the GAP is shortening. On an average, the median number of years is about 9 to 10 years for good companies currently. But, it is still more specific to companies, and how they evolve.

Is there a common thread between the winners and losers, which tell you why they have been successful or not?

Yes. Increasingly, what I realised in the last 30-35 years, is that the quality and competence of management is a huge differentiator.

In this entire scheme of things, where does price stand?

It is very important. Investing is not complete unless you buy at a reasonable price. Warren Buffet says, “The strategy is to find a good business and one that I can understand why it’s good, with a durable competitive advantage (CAP), run by able and honest people, and available at a price that makes sense....We need something that will earn more money in 10 and 20 and 30 years from now”. So, longevity (of growth) and CAP, both are addressed. That is the cornerstone of his investing style. We are trying to understand it. But, this study is not focussed on price, but on longevity.

Given the valuations across the board, what is your call on the near-term outlook for markets?

Today, valuations are lofty, which I’ve not seen many years. Everything seems priced in. But, whether there will be correction or not, I don’t know.

But, 2-3 things are clear. One, domestic flow is very sound. Valuations are such that there is a massive supply (of fresh equity paper) also. So, there is a good meeting of supply and demand. Foreigners, issuers, existing promoters, government, many people are selling. It’s a fantastic situation where the real economy and companies are getting money.

The world is watching for earnings and economy to turn around. Once the economy turns around, there will be many companies which will do very well. The companies which grow and don’t issue shares, will grow fast. So, the market may stay here, but such stocks will go up. Companies that don’t perform will suffer. My strategy is to find value and companies doing well. Let’s not bother about what the market is doing.

Are you seeing any kinds of green shoots in economy?

Yes. After the initial GST related issues, some companies we spoke to are saying that business is growing again on higher demand, and registration problems, etc are over now. We expect some capex announcements too though nothing of ground-breaking magnitude. As many companies will fall short of capacity in a year or two, capex should gain momentum.

With Gujarat elections coming up and early surveys showing a close fight, how will markets react should BJP lose?

I think a close fight with BJP winning with little margin is already priced in. But, if BJP loses, still the world doesn’t come to an end. It’s a lesson for them. They have to correct whatever people are not liking. You’ll only get better of Modi. He will become more hard working, focussed, listening to people, and we’ll get a better policy. And businesses are way beyond politics.

Infosys grew by 6,000 times, who was the Prime Minister? Does it really matter? But I’ll be very surprised if BJP loses. What if the results are better than expected?

Also, there are a lot of things happening globally, at the company level, etc. Many people are chasing the stock price. Our effort is to chase the value. And this study is an effort towards understanding of the long-term value.