Normally, investing in stocks is based on valuation models. The approach is to project the cash flows of the stock for the next five years and then discount it back to the current value based on a hurdle rate. This is later ratified with practical factors like the Price to Earning (P/E) ratio, the Price to Book Value (P/BV) ratio, sectoral benchmarks etc. Even after these efforts, what you get is a financial valuation of the stock. There are still qualitative factors that you need to consider and that may not reflect in your financial projections and your valuation models. What exactly are these qualitative factors that go into deciding on an investment.
Robustness of business model
This is something that is hard to quantify but we can illustrate with an example. For example, let us look at what happened to Nokia. When Apple introduced the smart phones in 2007, people suddenly found the Nokia Symbian operating system wanting. The Nokia business model was based on the assumption that phones would continue to be voice instruments and data would still gravitate towards PCs and laptops. That was a gross miscalculation. Over the next few years, consumer preference shifted rapidly towards use of data on mobile phones and that is where the operating systems like Apple IOS and the Google Android went on to dominate. In short, the business model of Nokia was just not robust enough. Focus on whether the business model of the company is robust enough. Take the case of the pharma industry in India. For 25 years, these pharma companies rarely invested in IP and focused on producing generics at a much cheaper cost through reverse engineering. When competition from low-cost countries built up and the customers in the US became more demanding, most pharma companies started losing value and margins. Business model was just not robust enough.
Quite often markets
are willing to pay premium for management pedigree. The reason why the MNCs have garnered a better premium is due to greater management quality and performance integrity. Even within India, business groups like the Tatas, Birlas, Mahindra and even newer businesses like Infosys and Wipro have always commanded a premium due to much better management quality. All these groups have made efforts to build a strong management bench so that growth and strategy becomes more of a sustainable model over a period of time.
Corporate governance is a much wider term compared to the simpler topic of management integrity. Corporate governance basically measures if the top management of the company is acting in the larger interests of the shareholders; especially the minority shareholders. Issues like disclosure, transparency, management principles and consistency matter a lot. In the recent past, companies have taken deep cuts when corporate governance was not adhered to. Look at some instances. Zee Group took a major price hit after instances of opaque inter group transactions came to light. Stocks like Manpasand Beverages lost over 80% value after the auditors not only raised objections but also resigned under questionable circumstances. Infibeam lost nearly 90% of its value after it was found to be routing funds as loans to group companies. Sun Pharma had a similar problem of channelling its pharma profits into real estate. When you invest in a company, these corporate governance issues matter a lot.
Michael Porter had pointed out more than 25 years back that the future of business lay in creating competitive advantages. This normally came in the form of entry barriers. For example, Reliance Jio created a virtual entry barrier into the Indian telecom story by bombarding the data market with its low cost offering. With its huge war chest, it is an advantage that is hard to replicate even for large business houses. Let us look at Maruti that is another prime example. With its wide range of offerings and a service network to boot, Maruti has virtually swept the consumer car segment across grades. This is again, very hard to replicate. In the world of investments, such competitive advantages are also called moats; representing the protection that companies have from competition.
Brands and other intangibles
One can argue that brands are a kind of a moat but we are treating it separately as it has been around long before the concept of moats and competitive advantages came about. Brands are the name or customer association that represents quality, service and reach. Companies like Hindustan Lever, Nestle and Britannia have created a brand that represents quality; something highly essential when it comes to food items. Similarly, HDFC Bank and Kotak Bank have created a brand that is associated with growth without compromising asset quality. At a time when most PSUs and some private banks are under stress, this is an important brand representation for investors.
Qualitative factors may be hard to value but they are critical in taking your final investment decision. Ignore these at your own peril!
The author heads advisory department at Angel Broking. Views expressed are his own.