What they tell you versus What they dont (Part II)

This post got inspired by something I read on the internet last week. I follow a website on the internet https://25iq.com/
where the author has written a beautiful post on attributes of a scalable business. You can go and read the post from the following link A dozen attributes of a scalable business
One facet from that post caught my attention and i am presenting it here. Please read through the extract (emphasis mine)

1. Customer acquisition cost (CAC) is low in a scalable business since positive word of mouth is strong (i.e., the business benefits from organic customer acquisition) 

Andy Rachleff believes: “If you don’t have exponential word of mouth growth, you don’t have product/market fit.” In terms of staging a successful startup, product/market fit (which is central to the value hypothesis) should precede scaling (which is central to the growth hypothesis). Spending capital on growth before you have a product that people want to buy is essentially a giant bonfire of cash. Steve Blank talks about why scalability is so important in business: “Success isn’t about size – of team or funding. It turns out premature scaling is the leading cause of hemorrhaging cash in a startup – and death. In fact: (1) The team size of startups that scale prematurely is 3 times bigger than the consistent startups at the same stage; (2) 74% of high growth Internet startups fail due to premature scaling; (3) Startups that scale properly grow about 20 times faster than startups that scale prematurely; and (4) 93% of startups that scale prematurely never break the $100k revenue per month threshold.” Ryan Smith the founder of Qualtrics describes this objective simply: “Nail It, Then Scale It.” Too often people try to scale a start-up before they nail it.
The positive customer word of mouth that Rachleff describes is important for a business since it enables a lower customer acquisition cost (CAC). In other words, scalable businesses generating organic growth do not need massive spending on marketing and sales. Every business will have some customer acquisition costs but in the best and most scalable business that cost is relatively low. Bill Gurley agrees with Rachleff: “With great companies the consumers buy because the product is so good. They aren’t spending [tens of millions] on marketing.” Gurley also believes that customers quality if higher is they are organically acquired: “Organic users typically have a higher NPV, a higher conversion rate, a lower churn, and more satisfied than customers acquired through marketing spend.”
It is important to understand that growth is not always organic from the start of a business. Sometimes critical mass must be achieved in non-scalable ways before a business becomes scalable via organic customer acquisition. Paul Graham points out that sometimes doing what does not scale is essential to enabling critical mass which does allow a business to scale: “One of the most common types of advice we give at Y Combinator is to do things that don’t scale. In Airbnb’s case, these consisted of going door to door in New York, recruiting new users and helping existing ones improve their listings.”



After reading the above post the first thing that came into my mind was the innerwear industry in India and the leader in that sector "Page Industries", the franchisee for Jockey. Now in a consumer facing industry one of the biggest expenses is Customer Acquisition Cost termed as Selling & Distribution Expenses.

One would assume that the leader in the sector would be spending the highest amount on direct selling expenses, both as a percentage of sales and also absolute amounts. Also selling expenses are of three types:

• Advertisment Expenses (Directly help to build company's brand)
• Sales Commission & Incentives (Money spent on distributors to push sales)
• Other Selling Expenses (Indirect/Miscellaneous Selling Expenses)

From the above, one can clearly differentiate between companies having a good brand recall in public versus a company not enjoying a good brand recall. A company spending money on sales commission and incentives implies spending to push sales through distribution channel. A strong brand does not need to give incentives to the distribution channel because products enjoy a recall in the customer's mind.


The following exercise was performed to find how the leading companies stand in the inner wear and leisurewear industry

 

 

 

The figures for Lux Industries are for 2016

 

We can note following points from the above:

1. Page Industries is the market leader with net sales of over rs 2100 crores as on FY17
2. The two closest competitors viz Rupa & Page do less than half of the revenues of the market leader
3. Page Industries spent 5.79% of its revenues on Selling & Distribution (S&D) while the same figure for  Rupa & Lux Industries stood at 12.60% & 13.13% respectively.
4. The  S&D expenses for Page Industries have remained in the range of 5-6% of sales over the last six years while the same for RUPA & Lux has been over in the range of (10-13%) over the same time period
5. The cumulative amount spent on S&D expenses by the companies over the last 5 years is as under:

• Page Industries: Rs 415 crores
• Rupa & Company: Rs 567 crores
• Lux Industries: Rs 507 crores

As we can see Rupa & Lux over the last five years have spent more on S&D than their competitor Page Industries which  still sells 2 times more than either of these companies, is growing sales at a rate double than these two and has a much better brand recall evident by zero incentives given.

I also tried to see how much each of these companies ell purely on advertisment and the figures are as under

• Page Industries: Rs 318 crores
• Rupa & Company Ltd.: Rs 359 crores
• Lux Industries: Rs 303 crores

All the three companies spend nearly the same amount on advertisement of brand while Rupa still outspends Page Industries by more than 10 percent. However have a look at the next figure and you will know why even after 20 years of page Industries running in the market its competitors still haven't got their strategies right

• Page Industries: Rs 0.85 crores
• Rupa & Company: Rs 78.62 crores
• Lux Industries: Rs 39 crores

The above bullet points show the amounts spent by companies for incentives and commission to distributors. Now what's interesting is that Rupa even after outspending Page Industries on advertisements costs, still pays 8% of its Sales as incentives to distributors.

Its enlightening to know that how good is the S&D strategy for Page Industries versus its competitors where it is able to target its brand effectively, spend lesser amount than its competitors and still keep making the brand stronger year after year. While the strategy that Rupa& Lux follow tells you why the innerwear & leisurewear market has been dominated so effectively by this one brand JOCKEY.

My purpose of this exercise was to show some facts on companies which do simple things everyday that go a long way in creating a sustainable franchisee. Many people would outline the PE of Page Industries or other valuation ratios showing how it is so very expensive versus the other relatively cheaper competitors. However, some time spent in knowing how a company is built, rather than always focusing on price tells you more than what the price of the company on the stock exchanges will show.

Remember the value of a company is the outcome of the work being done behind the scenes. If you focus only on the price you will miss out on a lot...

What they tell you versus what they don't

This post have been inspired by a recent conundrum which has intrigued many investors. Often people find it difficult to navigate the cycles of stock market and in lack of experience fall prey to following prices.
The individual investor in stock markets will often find people advocating purchase of "lower priced companies".  They wouldn't also be wrong as undervaluation is a big source of long term out performance.
However the idea of purchasing companies with a passionate and ethical management, running a business with a long runway of growth has always intrigued me. I have always seen companies like HDFC Bank, Page Industries, ITC etc delivering returns year after year and what surprises me is that the valuations have always looked expensive.
Thus I thought to study a few of these companies and see whether "undervaluation", which we want while purchasing common stocks have persisted in these companies or not. The first company which I have used while doing this is HDFC Bank. I went through data, annual reports and prices for HDFC Bank since 1996. Below I present you the facts for the bank

Over the last 21 years of its trading history,

Median year end Price to Earnings ratio (1996-2017): 24
Median year end Price to Book ratio (1996-2017): 4.1

I tried to work further with the data to find out if investors could have taken the opportunity of mid year volatility to get better prices. Below are the findings

Median Lowest Price to Earnings ratio from (1996-2017): 16.8
Median Highest Price to Earnings ratio from (1996-2017): 27.5

The lowest valuations experienced by HDFC Bank was in the year 2000 when the mid year Price to Earnings ratio fell to 9.8 times.

Now, I would presume only people who were lucky enough to have insights into business evaluation and also the stomach to buy when price are low could have been able to buy in the year 2000 when valuations were cheap. However, that would have only been a small minority as mere mortals we can hope to make more use of averages than extremes.

For the sake of studying I also wanted to see what If someone bought at the most extreme valuations. How would they have fared? Below I present the facts:

Highest Price to Book ratio (Year 2000): 8.1 times
Stock price as on 31st march 2000: Rs 51.44
Stock prices as on 31st march 2017:  Rs 1442.55

Annual Return over 17 years: 22%

Not bad eh. Even when you would have bought the company at the times when valuations were at historic highs, the returns would have been decent.

The idea of the post is to check whether its always better to look for undervaluation or that every case should be evaluated separately.
In the case of HDFC Bank, even if one would have bought at the extremes they would have generated handsome return. Simultaneously the idea is to look at multiple companies and check whether this idea persists in other companies as well. I would be continuing this practice and would post my findings for the other companies as well.

I have attached the excel sheet if one wants to look at the data. The data prior to 2012 has been adjusted for splits.