Once in a while, we at Khanal Pradhanang Investment Services (KPIS) go out to the market and interact with retail investors to understand their psychology. I made three key observations about market behavior during my interactions with Nepali investors:
- They prefer companies which give Bonus shares (Stock dividend) to companies which give Cash Dividend
- They think that Rights (Rights issue) & Bonus Shares are similar
- They think any Company which issues Rights/ Bonus are good companies
Through this article, i will try to debunk these misconceptions in the market and in the process also tell you how to identify good companies. I have heard that the Nepali investors get violent when someone gives them a contrary point of view. So putting myself at risk, this is my effort to educate them. Plus, unlike Sir Paul McCartney, there is no Mother Mary speaking words of wisdom – “Let it be”, to stop me. So here I begin.
First part: The (not so) Obvious
Let me start by stating the obvious (though judging by investor behavior it’s doesn’t seem very obvious) that the sole purpose of any company is to earn profits and distribute cash dividend. That’s the sole reason entrepreneurs start a business – They see an opportunity, they invest money into the business to set up infrastructure, sell goods & services, generate profits and distribute cash dividends.
Investors should view the companies listed in the stock market through the same lens. A company which can generate large profits year after year and distribute that money to owners is a good company. A company which generates larger profits each passing year is a great company. And, a company which generates low, zero or negative profit (loss) is a bad company.
But how do we know, how much of profit is good? It’s simple. Imagine you want to start investing in Stock Market but you have 0 savings. So you visit your local bank and request them to loan you Rs 100. They agree to loan you Rs 100 but you must pay 6% interest annually to use their money. You agree to this condition and hence 6% is your “cost of Capital”. It’s the cost on capital you are borrowing.
So when you use this money to invest in a company in the stock market, how much return should it generate? At least 6%, right? Any company which doesn’t generate at least 6% return is a bad company. Keep that in mind as we move to the next part!
Second Part: The Great, the Good and the Gruesome
As an equity investor you must understand that there are three types of companies:
- The Great Company,
- The Good Company, and
- The Gruesome Company.
(If you want to understand this further please read Buffet Letter, 2007 or listen to videos of Ramdeo Agarwal)
The Great Company: Great Companies are rare and they have endurable competitive advantage (moat) which translates into high profitability. What makes them ‘Great’ is their ability to grow their business and profits year after year without any /very less additional capital. For eg. Imagine you invested Rs. 100 into Business-A and in the first year it generated sales of Rs. 100, profit of Rs. 20 and the management distributed the entire Rs. 20 as cash dividend. In Year 2 the management found new customers and increased the sales and profitability of the business by 20%. In Year-2 you have profit and dividend of Rs. 24. If Business-A continued to grow in sales and profit, year after year, without any additional investment, by the end of Year 6, it will have generated total profits of ~Rs. 200 on initial investment of Rs. 100. And that’s not the end of the story; this business will continue to grow further.
Also Business-A generates return on capital way above your cost of capital. For eg: In Year 1 its 20%, in Year 2 its 24% and by Year 6 it’s 49.77%! And this keeps on increasing. If you find such Companies, reach for a canon not a gun!
The Good Business: Good businesses also have competitive advantage which translates into profitability. These businesses generate return on capital well above their cost of capital. So what separates Good Companies from Great Companies? For Good Companies to maintain/ grow their profits, they must continuously re-invest profits into the business.
For eg. Imagine you invested Rs. 100 into a Business-B and in the first year it generated sales of Rs. 100 and profit of Rs. 15. But the management believes that if it re-invests 50% of the profitability, it will be able to set up new equipment and increase its sales & profitability accordingly. Therefore from profit of Rs 15, they distribute cash dividend of Rs. 7.5 and put back Rs. 7.5 into the business. In Year 2 the management meets their sales & profit target and also maintains the return on total capital of Rs 107.5 (original 100 + additional 7.5 reinvested). This continues to happen for foreseeable future.
Good Businesses will continue to grow in sales/profit BUT only through re-investment of profits. However, they will generate return well above your cost of capital.
Occasionally, such businesses, Business–C, might see a large market opportunity and they may require more capital than the profits generated internally by the business. So they ask the existing shareholders for additional capital. Despite asking for more capital, why is this Company still Good? Because of its ability to grow its business and generate return above the cost of capital.
The Gruesome Business: The market is filled with gruesome businesses. They represent 90% of the companies in the market. They do not have any endurable competitive moat therefore they incur losses or generate very low/unsustainable profits. The returns generated by such companies are below your cost of capital. Imagine borrowing Rs 100 from your friend at 6% to invest in this Company, which gives return of only 2%. Your money, and your friendship both are at a risk. If your money is Superman, such companies are Kryptonite (No points for guessing which Company is Lois Lane). Keep your money far away from such companies.
Occasionally, such companies may ask you for additional capital (Rights issue) to expand their businesses. You know what to do then. RUN!
Third part: Correcting the Myths
Now let’s try and correct the myths of naïve Nepali investors.
- Are stock dividends better than cash dividends?
No way! Imagine a Great business which doesn’t require any additional investment, continues to grow its business & profits year after year and distributes incremental dividends annually. What else do you need? Few of such businesses are See’s Candy – USA, Gillette India – India and in Nepal… (If you visit KPIS, we can give you the name for a small research fee).
But let’s not take credit away from those Good Companies who generate profits above cost of capital, re-invest them in the business (Bonus shares) and generate even larger sales & profits in the future. Few of such businesses are BNSF – USA, HDFC Bank – India
But are they a match for a Great Company which gives can grow its business without additional capital and give out large cash dividends? No way!
- Are rights and bonus the same?
Just because they are called ‘rights share’ and ‘bonus share’ in Nepali Investor lingo, you shouldn’t get confused. In Bonus Share, the company earned large profits and wants to re-invest the profits to expand the business. (It’s ‘giving you’ new share certificates instead of cash dividend). In a Rights Issue, the Company sees a market opportunity and needs more capital to grow its business. So it ‘asks you’ for additional money.
You see, the former ‘gives’ and the latter ‘asks’. Are they the same? No
- Should you get excited about either?
Not really, unless you understand the Company’s track record and how they intend to use capital in the future. If they have a track record of good return on capital and you think they can use the new investment (rights or bonus) to expand their business while maintaining good returns on investment, they are good businesses. If they cannot, they are gruesome business and you know what to do when you see one – RUN!
Fourth Part: Implication for Investors
As an analyst or an investor don’t be naïve while investing into a Company. Don’t look at whether the Company is giving rights or bonus shares. Don’t listen to the crowd. Understand the business. Do your own research. Do your homework. It’s time consuming but there are no shortcuts to getting rich! But don’t forget to ask two basic questions we learnt today:
a) Is the company generating return on capital (equity) above your cost of capital?
b) Is the business (Sales & profit) growing and how is it financing its growth?
(If you want to read more on this read The Unusual Billionaires by Saurabh Mukherjea)
In case you don’t have time to do the research yourself, you can always get in touch with us at KPIS. In exchange for a small performance based fee, we will happily help you find Great Companies and help you create wealth.
Happy Investing! 🙂