by RAVISHANKAR
Director, Banyan Tree Advisors
December 20, 2011
You can make exceptional returns over a time-frame of three to five years by investing in companies that are increasing market share within their industry.
RECENTLY, A friend of mine, who is a portfolio manager by profession, posed an interesting problem to me. He had this new client, who wanted investment advice on his portfolio. Infosys alone accounted for 85 per cent of the client’s portfolio, while 12 per cent of it was invested in Hindustan Lever. Over 30 stocks made up the balance 3 per cent. Apparently, the client had bought Infosys and Lever at the time of their respective IPOs (initial public offerings), and simply held on to them. His investment in Infosys had appreciated 2,000 times. Now, he wanted to know what to do with his portfolio?
My friendly advice to my friend was to give his money to his client to manage. The client seemed to have taken a smarter decision than any portfolio manager I have seen: he placed most of his chips on one potentially good stock, and patiently watched it appreciate steadily over a period of time.
Sounds simple: invest Rs 10,000 in one stock, and see it go through the roof over the next decade.
Infosys might be an extreme example. Still, fact remains, the stock market does throw up such opportunities time and again. Lever, Hero Honda, Punjab Tractors, Castrol, Wipro, Zee are some illustrious names that have given phenomenal returns over the past decade. Such outperformers exist in every market, even mature ones like the US. There, stocks like Dell, EMC, Wal-Mart, Home Depot have also done extremely well over the past decade or so.
So, just what is common to all these stocks? How does one identify such stocks? Well, here are some pointers:
The company should be gaining market share. Probably, the first important sign of an excellent performer is that the company constantly proves its ability to increase market share. So, when the industry in which it operates is growing at around, say, 10 per cent, our company grows at over 25 per cent. As a rule of thumb, look for companies that beat their average industry growth by at least 10-20 percentage points.
This happened with two-wheeler major Hero Honda. Around a decade ago, it had a market share of less than 10 per cent — in other words, potentially, it had plenty of opportunity to grow. And it did. For many years, it consistently grew at an annual rate of over 25 per cent. Today, its market share is close to 50 per cent, and its becoming more difficult for it to add incremental market share. And though it still throws up growth rates in excess of 40 per cent in a market growing at less than 15 per cent, I can’t see the company sustaining this above-par performance.
Stocks of companies on the fast path in the market share sweepstakes exhibit some standard patterns. The best time to buy such stocks is when the company’s market share is in the region of 1-4 per cent. During this phase, the company would have shown sufficient proof of its ability to grow at a pace faster than the industry. In other words, you are making more than an informed guess. At the same time, the valuation given by the market to the stock would be reasonable – so, the appreciation potential is immense.
Stress starts to develop in a stock when the company’s market share nears the 20 per cent (in some industries, 35 per cent) level. Castrol and Punjab Tractors were excellent performers, with steady growth, till about the time they hit a market share of about 20 per cent. That’s when the stock started to peter out. Globally too, high-growth companies have shown similar trends. EMC, for instance, started moving down when its market share approached 35 per cent.
As a corollary, any company whose market share is in excess of 50 per cent will face serious resistance. It happened to Colgate over the past decade. The company lost market share, from being in excess of 65 per cent to below 50 per cent. It’s difficult for companies to sustain market share well over this threshold level in a free market, as competition eventually tends to find ways to breach your defences (unless they are a utility or a monopoly).
The company should operate in a reasonably fragmented market. A fragmented market makes it easier for a company to increase market share. Ideally, the combined market share of the top five players should not exceed 60 per cent. Such industries enable a company to increase market share without seriously affecting industry dynamics.
This happened to PC (personal computers) manufacturer Dell in the US. The company has increased its market share from below 3 per cent a decade ago to around 15 per cent today in the PC industry (an extremely fragmented industry). However, don’t expect serious changes in market share in an industry like oil refining in India, which is dominated by essentially three players.
The market for the company’s product(s) should be growing at a decent clip. Besides being fragmented, the market itself should be growing at a reasonable pace. Multi-baggers abound when the underlying market itself is growing at an extraordinary pace. Like Nokia in mobile telephony devices. The company has gained market share steadily over the past decade, to around 35 per cent today – the stock’s performance too has been exceptional. At the same time, the market for mobile devices has grown at a brisk pace, much better than the average growth rates in most other industries.
The ability to log above-industry average growth is one of the reasons I like Infosys. The company has consistently grown at a pace faster than the average industry rate. Its share in the Indian IT industry is less than 8 per cent. The IT industry is still growing at a healthy rate. Given the above hypothesis, Infosys still has a few years of above-average growth to show before stress starts developing.
Single-product companies offer high returns, but keep a look out for multi product companies. When it comes to growth, single-product companies and multi-product companies have different risk-reward equations. A fast-growing single-product company will give better stock performance, as it is not weighed down by slow-growth products. But the risk associated with it is higher, as everything depends on that one single product.
For lower risk, look at multi-product companies that have many sub-product categories gaining market share.
Take Lever. Over the past decade, it has held on to its dominant position in the soap segment, while increasing market share at a dramatic pace in various other product categories like shampoo, toothpaste and other personal product niches. It is also trying to replicate the same magic in the foods segment in the coming years.
The company should be available at a reasonable valuation. I have high regard for a pure value-driven approach to investing. One major problem with this approach (of buying companies very cheap), though, is that many of the exceptional-performing stocks over long periods of time will be missed, for chances are you will never really get them at rock-bottom prices attractive to value investors. Home Depot is one such example. It has increased its market share from scratch to about 15 per cent in the past 15 years. At no point during this time has the stock been available at a PE (price-to-earnings) ratio of less than 22 – valuation levels that just don’t entice value investors.
The best measure to buy into these companies is the PEG (PE to projected earnings growth) ratio. To explain, if a company is growing at 25 per cent and you get it at a PE of 25, then its PEG ratio is 1. A PEG ratio of less than 0.7 is ideal to buy into growing companies – in other words, a company whose earnings are growing at 20 per cent a year can be bought at a PE of less than 14. So, assuming Infosys can grow at over 30 per cent a year, the best price to buy it would be at a PE of around 22.
Get into the practice of finding out market shares. As an equity investor, it is probably most important to get into the habit of finding out the total addressable market opportunity. Even a rough estimate should help you go a long way, and save you from making major errors. It helps to find out whether the industry is at a nascent stage, or whether most of the growth opportunity is over?
So long as you stick with companies that are increasing market share within their respective industries, chances of you making exceptional returns over a time-frame of three to five years are high.