What drives a Business?
Did you know that only 30% of the businesses are profitable and are able to survive after their first 4 years? The odds of a business survivability have decreased even more in the last decade with the competition increasing multifold and the market becoming increasingly polarised. With such scenarios in place, a fundamental investor must understand what it takes to drive a business. Since most investors are investing for the long term, it is necessary for the investors to understand the dynamics of a business and the characteristics that make a business thrive in the long term.
To understand this, we must first identify the main purpose of the business. The survivability of every business is solely dependent on the value it provides to its customers. The value proposition in comparison to its competitors plays a key aspect in the long term survivability of the business. Examples of companies with such propositions include Nestle (best baby powder) or Asian Paints (best quality of paints) clearly indicate how superior value proposition leads to strong businesses driving growth for really long periods of time. The business models of these companies focus on providing superior value to its customers resulting in longer duration and higher success of these businesses.
Now that value proposition is established, a business needs to protect its offering from the competitors. It needs to maintain its differentiation in the market to keep business growing. As a business one of the key aspects of long term survivability is the lack of competition. If you’ll look at all the greatest businesses in the world, they had a near monopoly status which they maintained for decades to ensure that their businesses continued to perform efficiently. Legendary investors refer this phenomenon as the presence of a “moat”. According to them, the business is the castle and the competitive advantage is the moat which prevents the competitors from taking over the castle. For ex- Asian Paints and Berger Paints have a near monopoly in the paints, which has allowed them to compound capital at 25% for decades. A close look at their business model reveals that their supply and dealership networks are extremely strong thus giving them near monopoly in the market. The strong dealership networks provide the “moat” which allows these companies to protect their businesses from competitors and compound capital for extraordinary periods of time.
The next factor that drives the longevity of the business is capital allocation. Capital allocation refers to allocating the fixed amount of resources a company has to achieve the most profitable proposition that achieves returns over and above the cost of capital. Think of it as having Rs. 100 and figuring out a way to make it 110,120 or 150. The higher the return, the better it is for the business. A business must allocate capital in profitable ventures where they expect to earn a return that is greater than the cost of capital required to generate that return. Over time, these are the businesses that are able to grow exponentially and deliver what we know as “multibaggers”. Capital allocation is the direct consequence of the competency of management and the nature of business. A competent management will be able to identify areas of business where there is a chance of higher profitability and will allocate resources accordingly. The nature of the business depends on the core operations i.e. are the operations capital intensive or not? If the operations are capital intensive the return on capital automatically decreases due to higher capital deployed and hence the higher costs associated with it. On the other hand, an asset-light business (e.g. digital businesses) tend to have lower costs and higher scalability potential which automatically drives the returns on capital higher (e.g. TCS with a return of almost above 50%). Hence, capital allocation and nature of business play a significant role in longevity of a business.
Lastly we have financial health. As a prudent business practice, it is widely believed that the growth of the business must be funded by its own cashflows. Excessive debt taken in hope of superior growth in future typically is an alarming bell which can endanger the longevity of the business. Excessive debt in balance sheet is generally viewed negative and should be avoided by the businesses. The general perception is that interest on debt hurts the bottom line of the company and usually requires an asset-backing. In case of the failure of the business, debt takes a certain part of the assets and hence takes away the earning power of the company. Prudent usage of debt along with equity can lead to superior returns on capital, which is practised by almost every successful business. For ex- The airlines business has always struggled due to frequent bankruptcies that are associated with taking heavy debt. The growth expected to come through debt is never materialised due to heavy competition which drives down revenue, ultimately forcing the company into bankruptcy.
This concludes our topic on business drivers. We clearly see how all the factors interplay with each other in order to create a successful business. In the next module, we will discuss the inference of fundamentals and how they affect the above factors.
Until Next time!