Business Growth (Part 1 of 3)

Once the quality of business is established, the second most important criteria to select an investment is its growth history & potential. Growth is critical for sustenance. However, not all growth are good for the business, especially when it comes at the cost of margins.

Any analyst report you pick, you will find that future growth assumptions drive the valuation; I do not believe such valuations. DCF valuation mandates forecasting future cash flows. Predictions inherently bring in a lot of biases which obscure our view on the company. What we believe the company can, takes over the reality of what the company actually can.

Rather, a detailed study of how has the company achieved growth in the past provides a good measure for how its performance will be in the future (unless there is a disruption in the markets). All we need to workout as analysts is probability of the company achieving the the same type (not the numbers, just the type) of growth in the next 1-3 years.

For a company to pass our growth test, it should have historically grown at a rate higher than nominal GDP growth (nominal = real + inflation) and its growth type should give us the confidence that similar growth can be achieved in the near future (1-3 years).

We measure growth as growth in operating earnings.

Companies can grow by increasing their service or product offerings (like Reliance industries; from petrochemical to retail to telecom to digital content provider) or in their market reach (like HULs ever increasing supply chain, Reliance Jio’s increasing subscriber base, DMART’s store count) or by simply raising prices (Like Eicher, Page, Hawkins). Most of the times it is a combination of the above.

We try to analyze what types of growth has the company achieved and what type of future growth its financial statements indicate. Remember, we will not try to predict the growth numbers but rather the type of the growth a company can potentially achieve in the future.

Lets try to identify the types of growth and how do we determine each of them using financial statements:

1) Inflation driven growth
Even if a company sells the same number of products as last year, increase in cost of raw material due to inflation will force the company to raise prices correspondingly to maintain its margins. This growth is inflation induced growth.

Assume a company sells product worth 100 with raw material costing 80. If the raw material price increases to 90 (12.5%), new selling price of the product will be 112.5 to maintain the same profit percentage. Profit will increase from 20 to 22.5.

All companies have this default growth. If a company is growing at a pace less than inflation induced growth rate consistently, it is surely on a down trend.

2) Commodity price driven growth
All commodity companies have their moments in sunlight. Commodity cycles will push earnings of such companies to astronomical levels for a couple of years only for them to fall down as a rock in the next few years. Typical examples of such companies will be from:

  • Sugar industry
  • Basmati Rice Industry
  • Chemical Industry
  • Alloys and Metals Industry
  • Graphite & Carbon Industry
  • Paper & Packaging Industry
  • Petrochem & Allied Industry
  • Textiles
Commodity prices can go up for any number of reasons, recently chemical & graphite companies hit a gold pot since China decided to shutdown its factories citing environmental concerns. Floods or famine in South America raise sugar prices, World GDP pushes metal prices and so forth. To succeed in investing in commodity companies, tracking these cycles is of utmost importance.

3) Consumption driven growth

Consumption is as cyclical as commodities. Consumption tends to go up in spurts, settle down, drop and then catch up again on its next cycle. The key difference is that the same products rarely participate in multiple cycles, technology and change in preferences mean that a new kind of product replaces the one in the previous cycle, albeit the services offered by the products remain similar.

Consumption cycles impact financial companies in a big way. Financial companies hence are also cyclical in nature.

Typical examples of such companies include:

  • FMCG companies
  • Banks & Financial Institutions
  • Vehicle Manufacturers
  • Gold & Jewellery Companies
  • Transportation
  • Hotels & Restaurants
  • Paint Companies
  • Hospitals (forced consumption)
For a country like India, consumption as a story is here to stay. As the middle class population expands, consumption is bound to increase. You will find the most expensive valuations for companies in this category. Innovative companies with good brands fetch even premium valuation, for e.g. 3M, Nestle, Titan, HDFC Bank, Indigo, Eicher, Asian Paints

The challenge in this category is to keep the operations cost in limit during the growth phase. Many Hotels & Restaurants and Hospitals fail and hence falter in their cash flows.

….Continued in the next post.

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