BSE's bhav copy for 9 January 2009 lists 2,532 traded companies. So why is it that the largest investors (mutual funds, FIIs and the like) have less than 50 companies in the top 90% of their holdings? That's roughly one out of every 50 companies that were traded. One reason is that most firms are not even moderately worthy of investment. After the Satyam scam, it's tempting to say this about some widely-owned companies as well!
So what do investors want? It's fairly simple to figure this out, but a word of caution: this list can prove very difficult for many companies to deliver. Not convinced? Read on.
Integrity and credibility: Investors want to buy into a business that is run by a capable and credible management high on integrity. Boards and top management must realise that they need to think and behave in a way that tells the shareholders: we are squeaky clean and we play no games with any of our stakeholders. We are good at our business and can negotiate hard, but we will not cross the line when it comes to following the law and fairness in our dealings.
An institutional investor can nominate a representative on the board. But this option is not available to small investors, who end up depending on the likes of Ramalinga Raju (Satyam), Dinesh Dalmia (DSQ Software) and countless others who have committed frauds on the very people whose interests they were supposed to protect.
The Infosys stock rose about 4%, while Satyam's stock tanked on that fateful Friday (9 Jan). This is because Nandan Nilekani inspires as much confidence in Infosys' clean ways as N.R. Narayan Murthy did. Some companies where the management's perceived integrity is a big driver of investor popularity include HDFC, Tata group, NTPC, ITC, L&T and Wipro.
Profitability and sustainability: Investors want a business that is inherently profitable and owns some unique, or nearly unique, franchise that makes it sustainable. Today, nobody wants to invest in a jute mill in India or an automobile manufacturer in the United States. These are businesses that have driven themselves to the ground over a period of time and there is little probability that anything can turn them around with the present set of dynamics. I fail to understand why all our analysts and fund managers chase the PSU refining giants (IOC, BPCL and HPCL) when all it takes is a turn of the populist mood with a minister or bureaucrat to render them unviable.
Today, investors are willing to pay about 25 times the annual profits to own a brand-rich company like Hindustan Unilever. There's no rocket science involved in making products like Lux, Liril or Surf. But nobody can do branding, positioning and distribution better than HUL. Nestle, ITC, Castrol and Titan are good examples of strong brands which make their companies more valuable. Some terrific brands in services are Bharti Airtel, HDFC and LIC.
Sometimes the capability reflects in the performance. Look at the above average profit margins enjoyed by Sun Pharma and Divi's Labs in the healthcare space, or Maruti in auto. How does NTPC manage to report such high plant load factors? And why does L&T earn the best gross margins in construction? Their managements can teach us a few things. That's why they quote at such premium valuations compared with their peers.
Growth: The third thing that investors want is growth, especially in emerging economies like India, which offer gigantic opportunities to create, nurture and build businesses for several years. There's no point being clean, capable and uniquely positioned if you can't use these virtues to grow.
Reliance is the Indian patron saint of the investing religion called growth. If you think that the late Dhirubhai Ambani delivered growth, consider the record of his sons: from the time they split, they have more than tripled the value of the shares held by the original shareholders. And this, after the market's downturn in 2008 has brought most of the R-stocks down to a third of their peak value. The promise of growth, coupled with the ability to deliver, is behind the other poster boys of the stock market . L&T, Bhel, Bharti Airtel , HDFC, HDFC Bank, SBI and many more companies stand out for the sheer pace at which they have revved up their operations and delivered stable, and often, improving profit margins.
I also look for a few other things in companies. One is the ability to generate a positive cash flow. If a company is just posting higher profits but is bloating up its balance sheet, you should avoid it like the plague. Sometimes, growth takes its toll on cash flows as the enterprise has to pump back profits into the business just to sustain the growth. This is what happened to many construction companies which were growing very quickly. Many of them did not have unique capabilities, nor did they have credible managements operating in a clean environment. When the tide turned, as it has now, these stocks crashed as investors fled to the safety of cash-generating firms.
Two indicators of genuine cash generation are tax outgo and dividend distribution. Dividend is a solid indicator that profits and cash generation are for real. Especially when the promoter group's holding is below a threshold, say 60-70 %, so that an appreciable part of dividend outgo would accrue to ‘outsiders'. Similarly, any company that is paying taxes to the tune of at least 10-15% of its declared PBT, not just incurring deferred tax liability, is probably earning genuine profits and cash flows, otherwise it would not pay the government in a hurry.
Another thing that I do is to size up the business opportunity. The business needs a leading market share or at least some promise of market share. Again, Bharti comes out tops, but there are many others like ICICI, HDFC, Reliance and Bhel who have garnered leading positions in their markets in spite of the tough competition.
Dipen Sheth is Head of Research, Wealth Management Advisory Services. He can be reached at email@example.com