Spot the winners early

Imagine if former Barcelona coach Carles Rexach had never discovered the wunderkind Lionel Messi at the age of 13. The world, as we know it, would have missed out on the greatest football champion to walk the planet. Musical virtuoso Mozart was only five when he composed his first piece and six when he performed before European royalty. It was his father Leopold who recognised and nurtured the young musical genius, giving us a pioneer of the classical era. One could argue these prodigies were simply destined for greatness. But had it not been for the people who spotted their gifts early on, their stories may have turned out differently. 'Catch them young', as the saying goes, holds true for achieving greatness in the stock market too. A sum of Rs 10,000 in Cera Sanitaryware 20 years ago, for instance, would have made you a crorepati today! But it's impossible to have known this back then. After all, not every 13-year old could be one Messi. Early performers may not always succeed unless they are creating a solid foundation. Thus, besides growth, a company needs a moat to thrive. It is a unique advantage that sets it apart from the crowd. So, how to spot the champions of tomorrow that are building moats today? One way is by evaluating company life cycles. This issue of Wealth Insight draws upon Columbia Business School adjunct professor Michael Mauboussin's article - 'Trading stages in the company life cycle' - to detail a company's different growth phases and identify when it builds a moat. The story also packs case studies of winners and losers. Lastly, you will find a framework to spot the big shots of tomorrow and profiles of 20 stocks that might be just that. Dive in! Quest for tomorrow's titans: Walking you through the process of finding young budding stocks Every master was once a beginner. However, not every juvenile company can be a future trailblazer. So, how do we identify student companies with the potential to be a master? Broadly, spotting such companies boils down to two steps: Identifying companies building a solid foundation. You must look for quality companies that are building strong moats. More on this later. Getting the timing right. To pocket big gains, you need to detect the future big shots well ahead in the present. You cannot do it too early when it's still finding its footing, nor too late when it is already established. But beware! We are not asking you to time the market. Rather, we are asking you to identify the right time to invest in a company. For that, you must understand the concept of life cycle. Like a caterpillar's metamorphosis that gives it the final form of a butterfly, a business goes through various stages in its life before reaching the end. To generate maximum returns, investors must know which stage is ideal to invest at. How do you know which stage is ideal? For that, we need to take a quick tour back in time to understand how the concept of the business life cycle came to life. The theory of business life cycle is loosely based on Raymond Vernon's product life cycle theory devised in 1961, which divides every product's life in five stages - 'introduction, growth, maturity, and finally decline or withdrawal'. Over the years, the concept was eventually applied to businesses. Among many who adopted the theory was Victoria Dickinson. She named these stages and created a quantitative framework by linking them to a company's cash flow statement. See the framework in the graph 'In the roundabout.' Michael Mauboussin's article that we mentioned earlier also discusses the life cycle of a business and categorises its stages based on its cash flow patterns. In the next pages, we have used Mauboussin's quantitative classification to explain how one can determine a particular life stage of a business from its cash flows. Later, we have detailed some qualitative checks to identify moat-building companies. The merry-go-round of life Like humans, businesses are also transient. They go through their own aggressive teenage years, twenties, stable forties, and so on. These years are spread across introductory, growth, maturity, shake-out, and decline stages. The cash flow patterns, as can be seen in the 'The hits and misses' table, are uniquely different at each of these stages and help one gauge how the business behaves at each level. We trace this correlation below. 1. Introductory This is the initial phase of the company after its birth. Its revenue streams are not solid and neither does it have any track records. It is still trying to figure out a stable business model. Due to high expenses to establish itself, it is likely to be loss-making. At this stage, companies incur operating cash outflows but have positive cash flows from financing as they raise funds for capex. Nearly all startups belong to this stage. For example, after raising Rs 9,000 crore from its IPO, Zomato continues to burn cash to this day. 2. Growth The company is still new, but has a financial track record by this stage. It knows what it is doing and begins to carve a small presence in the industry. It is able to generate a positive operating cash flow. But this is not enough to fuel the capex, so it continues to raise capital. As a result, its cash flows from financing remain positive. The goal is clear; strengthen position, expand the scale of operations and establish dominance. Most IPO companies fall in this category as they seek external capital to accelerate growth. 3. Maturity At this stage, the company has finally established itself in the industry, achieving stability. The growth is not as exponential as before but it's steady. The profits are stable, too. Healthy cash flows and return on capital helps the company generate free cash flows. It starts repaying debt (if any) and giving out dividends. TCS and Asian Paints are good examples. 4. Shake-out This is the company's mid-life crisis. At this stage, its growth could slow down or even decline. This could happen due to company or industry-specific reasons. Some pick up and go back to the previous stages. Others hit the wall. For instance, Jagran Prakashan, owner of the daily Dainik Jagran, is still trying to claw its way out from the slump in the print media industry. 5. Decline The company bites the dust in this stage. It begins reporting operating cash outflows and the profits start waning. It often begins selling off its assets. The poor decisions during the shake-out stage generally lead to this phase. Jet Airways is one example. It went bankrupt on failing to survive intense competition and adverse industry headwinds. Dialling it down: What is the ideal life-cycle stage for investors to pool their money in? We have understood the different sequences of a company's life cycle and the typical behaviour it exhibits at every stage. Next we have to narrow down to the life stage, which is most ideal for investors to pool their money in. It needs no explanation why we would eliminate the last two stages: shake-out and decline. Even though the company in the shake-out stage has possibilities of a turnaround, it seldom does. Those in decline are a definite lost cause. The third stage, i.e., maturity is an old race horse. Here, the company has already tasted success and is a stable profit generator. Investing in a company at this stage would not yield lucrative returns as the moat is already established. That means that it's the introductory and growth phases where the moat is created. The introductory stage could generate the most attractive returns given you would be participating in the foundational chapter of the company. No wonder venture capitalists (VCs) are always on a lookout for young startups. But most investors can not be VCs. For good reason, too. Companies in the initial phase have the highest risk of failure and many times investments do not pay off. This leaves us with companies in the growth stage that have lived their teenage years but are yet to pull into the stable late thirties. This is the goldilocks stage to pool money in since the business is off the ground but not in orbit yet. 'Finding Nemo': Tracing out qualitative traits needed to find the next moat builder Now that we have deduced the right stage to invest, the next step is to figure out how to go about it. The growth stage is ideal not only from a quantitative perspective (as concluded above) but also from a qualitative point of view. This is because it is also the moat building stage-where companies attempt to create a unique and sustainable long-term advantage. For example, in their younger years, Astral created a moat by building rapport with its plumbers, while Asian Paints did it by closely focusing on its distribution channels. But before you hurry and pick companies in the growth stage, know that the number of fish in the sea is actually not plenty. Not all growth-oriented companies that raise capital and incur high capex necessarily build moats. Many focus on growth alone. Therefore, it becomes crucial to distinguish a growth stage 'Nemo' or the next moat builder from among the ordinary fish (growth companies without moats). You can identify one if it has any one or all of the below given traits. Does it have intangible assets? Intangible assets are for branding and strategic purposes, and provide an edge to the company. Consumer facing companies generally use branding assets to create a brand recall among customers. For instance, Nestle's 'Maggi' became synonymous with instant noodles in India, giving the FMCG giant a unique advantage. Licences and patents are strategic intangible assets. These give the company exclusivity in producing or marketing its products for a time period. For example, Page Industries' pact with Jockey allowed it to exclusively sell the latter's products in India. Other intangible assets can be strong distribution channels and client relationships. One example is Divi's Laboratories' three-decades-old association with many of its clients. Is there a high switching cost? The more difficult it is for customers to switch products, the higher their stickiness. For example, switching from Microsoft Windows to Linux OS would entail high switching cost for users given the familiarity and ease in using the former. Thus, most users stick with Windows. An irreplaceable product or service creates a loyal customer base, becoming an effective moat. Does it have a strong network effect? Besides ad spending, a significant edge for a company could be its popularity among customers on account of word of mouth. For instance, a key advantage Meta (formerly Facebook) has over other platforms is the large number of users it managed to acquire due to peer-to-peer acceptance. Does it have a cost advantage? Cost advantages over peers can be another moat. Having lower costs than competitors is crucial in industries where products are commoditised. A common way to achieve lower costs is through scaling up. Cement players are good examples of this strategy. Other ways to reduce costs are backward integration and constant debottlenecking. Coromandel International, for instance, maintains attractive returns on capital and margins against its peers, thanks to its consistent backward integration. Even one of the above stated traits can result in a significant competitive advantage for a company depending on the industry it operates in. If the company successfully builds a moat, it gradually transitions to becoming a free cash flow compounder. Power Grid is one example. As seen in the graph 'Winds of change', the company's free cash generating ability has improved over the years, thanks to its early investments aimed at having India's largest power transmission network. To recap, here's what we have learnt so far. When looking for next-gen wealth creators, first ensure that the company is in the growth stage of its life cycle, as moat building happens in this phase. Secondly, assess if the company is investing money in itself to simply grow or to actually build a moat through any of the strategies explained above. In the next section, we have featured case studies of two companies that successfully navigated through their growth stages, created solid moats and became free cash flow compounders. 1. Kajaria Ceramics: The growth tryst with tiles Kajaria Ceramics is the world's eighth-largest and India's largest tile manufacturer with an annual capacity of 86.5 million square metres (MSM). Ceramic tiles segment is its biggest revenue generator, which contributed 38 per cent to its FY24 revenue, followed by glazed vitrified tiles at 36 per cent and polished vitrified tiles at 26 per cent. Kajaria's market leadership is a result of its three moats: scale, branding, and most importantly, the right product mix. Recognising the growing demand for vitrified tiles in India during the late 2000s, Kajaria capitalised on this opportunity. Since India was predominantly meeting its requirements through imports, Kajaria sought to bridge that gap. Between FY07-13, the company invested Rs 572 crore in capex, which was 125 per cent of its cumulative operating cash flow during the period! This increased its capacity from 26.4 MSM to 43.6 MSM, with the majority directed toward the vitrified tiles segment. The company even converted certain ceramic tile lines to produce vitrified tiles. With the product strategy in place, Kajaria then invested in marketing and distribution to reach customers. It spent over Rs 100 crore on marketing. On the distribution side, it not only increased the number of dealers but also rewarded them to enhance loyalty and assisted them with skill development. With new products and strong distribution in place, it witnessed explosive growth. The company has been free cash flow positive since FY16, generating Rs 1,629 crore till date. As a result, its 10-year annual share price return is 14 per cent. 2. Astral: The prosperity pipeline Founded by Sandeep Engineer, Astral is India's second-largest plastic pipe manufacturer by market cap. It operates 22 manufacturing facilities with a total capaci

This article was originally published on July 01, 2024.