How stock investors can spot hidden gems

By Morningstar |  22-12-21 | 
 

GAUTAM BAID is the founder of Stellar Wealth Partners, author of The Joys of Compounding, a book every investor should read. Here he goes beyond the technicalities of investing and share his insights with senior editor Larissa Fernand.

Watch the video here

When it comes to picking stocks, you advocate being on the lookout for undervalued or mispriced products or services simply because they have untapped pricing power. Can you explain what it is and where you are finding such opportunities today?

Real pricing power or untapped pricing power refers to an inefficiently priced product or service. And this undervaluation is a source of great potential value over time as the business starts to price its product or service more efficiently.

In India, Hester Biosciences is a low-cost producer with significant untapped pricing power. Hester is one of India’s leading animal healthcare companies and second largest poultry vaccine manufacturer. The company is planning to sell its animal PPR vaccine at 3 cents/dose, compared to its global competitors who plan to sell the same at 10 cents/dose. Hester’s earnings and margins are expected to get a big boost in the future if and when they decide to increase the price, even if by a modest amount. The flow through margins on such price increases is very high.

In the U.S., Netflix sells its monthly subscription package at $14-15. A traditional cable TV company would sell their monthly subscription packages at multiple times the price that of Netflix. The value a Netflix subscriber gets is far more than the value he derives from a traditional cable television network. If and when Netflix decides to increase its price, even slightly, the flow through margins will be very high and the valuations will come down sharply. Because the entire price increase flows down to the bottom line.

This is how to spot hidden gems. Find companies that have a lot of demand from their customers and which are not fully deriving the producer surplus, in fact delivering consumer surplus at the moment and opting for delayed gratification. If you play the long-term game, you can get very good compounding returns over time.

Are you finding a lot of such opportunities in today’s inflationary environment?

Yes. I gave you two examples. This principle applies to any company that opts for delayed gratification. In the form of not extracting the full juice from the customers right away, but focusing on delivering a lot of consumer surplus. Many tech companies are incurring customer acquisition costs upfront. The opex is actually capex but they are having to debit all that opex in their P&L statement. Hence, their reported earnings looks low. But if you look at the total lifetime value from each customer for these businesses, they are actually very valuable. The intrinsic value of these businesses is very very high. They are opting to go for growth and getting as many customers on their platform today in the hope and promise of a far greater value many years down the line.

Frequency of correctness does not matter; it is the magnitude of correctness that matters. I know you agree with this, so can you flesh it out?

The average success rate of even the best investors in the world is less than 50%. What matters is that when you win, you make it count. Anyone can identify a winning stock. Great investors differentiate themselves through superior individual position sizing. A truly great idea should make a big difference to your life and your portfolio.

Successful investing is not just being right per se. Far from it. It boils down to how great ideas are executed. The art of execution lies in the initial allocation and the subsequent pyramiding or averaging up.

It is important to make the great ideas count. It is not the frequency of winning that matters in investing. It is not about the batting average in investing, but the slugging percentage.

This is what George Soros referred to when he said it is not whether you are right or wrong. What matters is how much money you make when you are right, and how much you lose when you are wrong. Investors need to inculcate this expected value principle in our thinking.

Does any stock come to mind that has played out in the way you have just described?

During 2018, the Indian auto industry was undergoing a downcycle. Investor attention on this sector was low. Rajratan Global, in the auto ancillary space, was undergoing huge capacity expansion.  From 2018 till 2020, almost 27 months, the stock was completely neglected and available at a depressed valuation and market cap. Visibility went up, in terms of earnings, post completion of capex and uptick in the auto cycle last year. The return has been more than 1,100% since April 2020.

Morningstar is a strong believer in economic moats, which are competitive advantages. You have often said that you see culture as a moat. What does that really entail? Does ethics form culture? Does innovation form culture?

We often talk about the traditional sources of competitive advantage, but a much underappreciated and difficult to replicate competitive advantage is that of corporate culture. Between 1957 and 1969, when Warren Buffett was running his private partnership, he never mentioned the word “culture” even once in his letters to investors. From 1979 to 2020, he mentioned it more than 35 times.

Culture matters to long-term investors because it empowers the company’s employees to do their daily tasks slightly better than the way their competitors do. Over time, these little advantages compound into much larger advantages which persist for far longer. It is best exemplified by companies such as Berkshire Hathaway, Constellation Software, Costco, Nebraska Furniture Mart, and Amazon.

As investors, we look for companies that are fanatically obsessed with the wellbeing of their customers and empathize with their customers more than their competitors do.

What will widen the company’s moat? Management strategy and corporate culture. For Facebook it is about improving user engagement on its various social media platforms like Facebook, Instagram and WhatsApp. For Amazon, it is all about improving the customer experience in terms of flexibility, options, convenience, speed of delivery, and making life for the customer seamless on its platform. For Nebraska Furniture Mart and Costco it’s all about sharing the economies of scale in the form of lower prices and creating good will.

When we invest in companies that are widening their moat cause of an emphasis on culture, over time, these businesses invariably turn out to be much cheaper than the results from our initial valuation work. This is how you can get an advantage, by focusing on the long-term intangible and softer aspects of businesses like the culture.

Are they difficult to narrow down on? Difficult to spot?

Not really. The best way to understand a company’s culture is to see how they focus on stakeholder value maximization. A company that focuses on all its different constituencies – employees, customers, suppliers, environment, society at large. Those that play the long-term game end up maximizing long-term shareholder value.

Shareholder value maximization is just a byproduct of the stakeholder value maximization.

You talk about emerging moats, but what about crumbling castles? A moat without a castle defeats the entire purpose.

An Emerging Moat is a company in the process of building its competitive advantage. For example, a B2B company transitioning to a B2C company with improving terms of trade. During this transition, there will be disruption in earnings, and investors who want instant gratification will dump their shares. If you have the long-term view, and are able to hold on to such companies which are in the process of building their moat, you can make handsome returns.

Crumbling Castles are very important in today’s world. They refer to companies where the primary business segment is in decline and are losing relevance with their customers. In such cases, the present moats carry little or no meaning. High market share in itself is not a moat. Think of General Motors in the U.S. In India, Maruti has the dominant market share in passenger vehicles. But, if it does not make the transition to electric vehicles, it may lose its relevance with consumers 10 years down the line. The longevity of growth, the sustainability of growth, is becoming increasingly scarce in today’s world characterized by rapid pace of change.

In 1969, the average time a company spent in the S&P 500 was around 60 years. Today the average age of a S&P constituent is just 10 years. If you were on the Fortune 500 list in 1955, in 2020 it would reveal that more than 90% of them would either be bankrupt or acquired by some other companies or fallen off the list as ranked by total revenue. The moats in such cases are illusionary.

So buy-and-hold should not be buy-and-forget.

Never.

Exercise active patience. Diligently verify your original investment thesis all the time. Proactively look out for disconfirming evidence. Do nothing till something materially adverse emerges.

Watch the above interaction on video

Larissa Fernand is Senior Editor at Morningstar India. You can follow her on Twitter.

Add a Comment
Please login or register to post a comment.
Arjun V M
Jan 18 2022 11:09 AM
 Very informative content. Heard about Finprov Learning..? one of the best platforms for learning finance and accounting certification courses. The Finprov team has an experience of more than 38 years in the industry. Creates world-standard solutions for learners and organizations with the right mix of theoretical and practical learning.

Visit website for more info: https://finprov.com/
1<>
Top
Mutual Fund Tools
Ask Morningstar
Feedback