One of the concepts which are essential to understanding making an investment and value to the business.
Many of us focus on the story builds for a particular business and make a hope investing rather than focusing on the actual reality. I always quote- “Stories are for kids, not for investors.” We need to focus on the ability of the company for creating access return on invested capital (Access return means higher than the cost of capital) and that should be sustainable for a longer period of time.
Mr.Buffett has always put a huge emphasis on the business which has a moat and earns consistently higher return compared to the cost of capital.
See’s Candy as an example of Great business –
Indian Companies example for Great business
One of the two-wheeler and commercial vehicle manufacturing company
One of the FMCG Company
One of the Assets Management Company
Here, the company does not require to make a huge investment to earn more money. Float itself take care of the major requirement of the invested capital. Many a time float covers working capital as well as fixed assets requirement. Due to such nature, Profit earns from operation majorly gets to the investment and cash so that investment and cash to the company is compound which also provides benefits to the business.
Good Business –
Good business which does not have float available with the business or least float available with business, company has to invest money which they earn from profit, and sometimes little external funding also requires.
Indian Companies example for Good business
One of the company from tableware industry
One of the pharma company
One of the Tea manufacturing company
Gruesome Business –
A gruesome business which does not have float available with the business, company has to invest money which they earn from profit, and also external funding requires to earn little profitability, sustaining the business or further growth. Here, huge capital is required to run a business.
Mr.Buffett has quoted an example of U.S. Air, He acquired a preference share of the company in the year 1989 and sold at the year 1998 with a huge gain. After that company gone for bankruptcy for the twice. The airline business is a cyclical business, huge dependence on the prices of crude oil and during the year 1998-99, crude oil prices were at the bottom (near to the price at the year 1988). So that profitability gets improved for the year 1998-99 and after that crude has never come back to those price level, which has affected to the profitability of the company.
Indian Companies example for gruesome business
One of the telecom company of India
One of the logistics company
One of the steel manufacturing company
We have to use a different valuation matrix for each category of the businesses and cannot provide a similar valuation to each category of businesses. We cannot give the same value to pour water and to dirty water. Yes, it is true that we can make process and pour dirty water but for that, we need to bring more capital and many a times, few qualities of water will be lost during the process of dirty water to pour water.
We have to sell out our position into the cyclical business at the proper time or else we stuck with the business.
Now, for taking an exit from cyclical businesses – When margin approaching towards a previous high margin, we should start to exit from a cyclical business. We need to track the price of the commodities as well as quarterly operating margins.