Motilal oswal 17th wealth creation study presentation economic moat - dec 2012

www.motilaloswal.com17th Annual Wealth Creation Study

Economic Moat

By Raamdeo Agrawal

12 December 2012

17th Annual Wealth Creation Study2007-2012

www.motilaloswal.com17th Annual Wealth Creation Study 2

Discussion Points

• 17th Wealth Creation Study Findings

• Theme 2013: Fountainhead of Wealth Creation

• Market Outlook

• Conclusions


Wealth Creation 2007-12Study Findings


Concept of Wealth CreationThe process by which a company enhances market value of the capital entrusted to it by its shareholders

Net Wealth CreatedChange in Market Cap over the study period (2007-12),adjusted for corporate actions like dilutions

Study Methodology


Fastest Wealth CreatorsThe top 100 wealth creators are sorted by fastest rise in their adjusted stock price

Most Consistent Wealth CreatorsBased on no. of times a company appeared in the last 10 studies

Study Methodology (contd)


Biggest Wealth CreatorsTop 100 Wealth Creators subject to a new condition that stock performance beats the benchmark (Sensex)

Who missed the bus because of the market outperformance filter

Study Methodology (contd)

Company NWC (Rs cr)

Price CAGR

O N G C 40,863 4.0Wipro 26,602 5.6I O C L 15,839 5.6NTPC 10,678 1.7

Company NWC (Rs cr)

Price CAGR

Hindalco 8,838 1.8B H E L 7,557 2.6Cipla 5,463 5.3Oracle Finl 4,594 4.7

NOTE: 5-time topper Reliance Industries did not make it on both counts –absolute wealth created and market outperformance


Rank,Company

NWC (Rs cr)

Price CAGR

1. ITC 118,681 262. TCS 108,186 143. HDFC Bank 74,425 324. MMTC 67,110 485. H D F C 55,793 21

Rank,Company

NWC (Rs cr)

Price CAGR

6. SBI 55,595 217. Infosys 51,573 88. Tata Motors 49,946 269. Hind Unilever 45,746 1510. Jindal Steel 43,647 47

Top 10 Biggest Wealth Creators

ITC largest wealth creator for the first time ever, beating RIL

Total wealth created during 2007-12: Rs16+ lakh crores

HUL has made it to the top 10 after a long time


Rank,Company

Mult.(x)

Price CAGR

1. TTK Prestige 24 89

2. LIC Housing 10 57

3. Coromandel Inter 9 54

4. Eicher Motors 8 52

5. IndusInd Bank 8 50

Rank,Company

Mult.(x)

Price CAGR

6. MMTC 7 48

7. Jindal Steel 7 47

8. Bata India 6 41

9. Titan Inds 5 40

10. GSK Consumer 5 39

Top 10 Fastest Wealth Creators

TTK Prestige is the Top 10 fastest wealth creator

4 Consumer companies in Top 10 fastest wealth creators;sector hitherto associated with steady growth seems to be enjoying tailwind of India’s NTD era


Rank,Company

WCS (x)

Price CAGR

1. Kotak Mahindra 10 48

2. Siemens 10 44

3. Sun Pharma 10 40

4. Asian Paints 10 35

5. HDFC Bank 10 31

Rank,Company

WCS (x)

Price CAGR

6. Hero Motocorp 10 30

7. H D F C 10 29

8. ACC 10 29

9. Ambuja Cement 10 26

10. Infosys 10 21

Most Consistent Wealth Creators

Kotak Mahindra Most Consistent for 2nd year in a row

Holcim Group is getting its act together in India – both ACC and Ambuja among Most Consistent Wealth Creators


Wealth Creators v/s Sensex

Wealth-creating companies’ financial and stock market performance is above benchmark.

Mar-07 Mar-12 5-yr CAGRBSE Sensex 13,072 17,404 6

Wealthex – re-based 13,072 32,884 20

Sensex EPS (Rs) 718 1,125 9

Sensex PE (x) 18 15

Wealthex EPS (Rs) 809 2,102 21

Wealthex PE (x) 16 16


Wealth Creation by Industry

Financials the biggest wealth creating sector for 2nd year in a row. Absence of new banks has led to widespread profitability and stock performance.

Consumer sector a very close second.

Industry(No of cos.)

WC(Rs cr)

2012 (%)

2007 (%)

Financials (21) 367,223 22 13Consumer (21) 335,845 21 5Metals / Mining (8) 209,492 13 9Technology (3) 173,419 11 10Auto (11) 163,007 10 6Healthcare (11) 121,480 7 4

Industry(No of cos.)

WC(Rs cr)

2012 (%)

2007 (%)

Oil & Gas (7) 99,634 6 24Cement (5) 66,842 4 3Cap Goods(6) 60,902 4 10

Ultility (3) 23,549 1 2Others (4) 16,629 1 15Total 1,638,021 100 100


Wealth Creation by PAT growth

Markets can neither price hyper-growth or high quality growth, resulting in huge wealth creation at a rapid pace.

Price CAGR (%)

2007-12 PAT growth range (%)


Wealth Creation by base RoE

High RoE alone does not guarantee superior Wealth Creation.Profit growth is equally important. Economic Moat (or compe-titive advantage) protects profits and ensures Wealth Creation.

Avg PriceCAGR: 20%


Wealth Creation & Valuation Metrics

Unlike most past studies, low P/E alone did not ensure high speed of wealth creation during 2007-12.

PAT CAGR was a key determinant of Price CAGR.

P/E (x) No. of Cos.

% Wealth Created

Price CAGR %

PAT CAGR %

<10 18 17 20 1810-15 21 18 22 2415-20 19 10 21 20

20-25 13 18 25 2425-30 13 28 16 21>30 16 10 25 24

Total 100 100 20 21



P/B below 1x did deliver high returns, but returns from higher P/B stocks were also comparable (except when P/B > 6)

P/B (x) No. of Cos.

% Wealth Created

Price CAGR %

PAT CAGR %

<1 6 6 25 281-2 20 12 20 192-3 10 7 24 213-4 11 13 20 20

4-5 13 14 22 245-6 11 14 26 21>6 29 34 17 19

Total 100 100 20 21



Payback ratio (Mkt Cap / 5-years forward PAT) of less than 1x in 2007 did ensure superior wealth creation. Also, again here, correlation of PAT and Price CAGR is high.

Economic Moats help sustain PAT and PAT growth.

Payback Ratio (x)

No. ofCos.

% Wealth Created

Price CAGR %

PAT CAGR %

<1 19 14 26 251-2 37 33 23 242-3 26 29 20 15>3 18 23 15 16

Total 100 100 20 21


Wealth Destruction

4 of top 10 wealth destroyers are telecoms.Breach of Economic Moat causes massive wealth destruction.

Company Wealth Destroyed PriceRs crores % Share CAGR (%)

Reliance Communication 67,698 12 -28Unitech 29,399 5 -32Suzlon Energy 27,558 5 -34Satyam Computer 24,948 5 -30Bharti Airtel 16,918 3 -2S A I L 8,280 2 -4Tech Mahindra 8,161 2 -13M T N L 7,519 1 -29Himachal Futuristic 7,367 1 -12B F Utilities 7,315 1 -30Total of Above 190,482 35Total Wealth Destroyed 542,546 100


Theme Study


"(Great companies to invest are like) wonderful castles, surrounded by deep, dangerous moatswhere the leader inside is an honest and decent person. Preferably, the castle gets its strength from the genius inside; the moat is permanent and acts as a powerful deterrent to those considering an attack; and inside, the leader makes gold but doesn't keep it all for himself. Roughly translated, we like great companies with dominant positions, whose franchise is hard to duplicate and has tremendous staying power or some permanence to it.” – Warren Buffett

Moat Quote


The concept of 'Economic Moat' has its roots in the idea of a traditional moatA moat is a deep, wide trench filled with water, that surrounds the rampart of a castle or fortified place.

An Economic Moat protects a company's profits from being attacked by business forcesTraditional management theory terms: "Sustainable Competitive Advantage" or "Entry Barriers"

What is an Economic Moat?


Without Economic Moat, competition from rivals will ensure that high returns of a company are lowered to the level of economic cost of capital … or even belowWhat is happening in the Indian Telecom sector is a classic example of this

Moat QuoteThe dynamics of capitalism guarantee that competitors will repeatedly assault any business "castle" that is earning high returns … Business history is filled with "Roman Candles," companies whose moats proved illusory and were soon crossed.” – Warren Buffett

Why Economic Moat?


Economic Moat helps sustain superior profitability multiple pulls and pressuresCompanies do not compete only with rivals for profit, but also with customers, suppliers, potential entrants and substitute products

Why Economic Moat?

Porter's Five Forces of IndustryEconomic Moat protects profits

being eroded by such forces


Much like companies, equity investors too chase high returns on their investmentsIn the long run, equity investors can only make as much money and return as the company itself makes

Investing in companies with Economic Moats is the only way to enjoy a share of their high profits and create wealth

Moat Quote“A truly great business must have an enduring moat that protects excellent returns on invested capital.” – Buffett

Economic Moat & investing


Companies with "deep, dangerous moats“ outperform those without, both in terms of financial performance and stock returns.Markets worldwide are replete with examples similar to cross-sector cases given below in India

1. Hero MotoCorp v/s TVS Motors

2. Bharti Airtel v/s Tata Teleservices

3. L&T v/s HCC

4. HDFC Bank v/s Central Bank

Economic Moat & investing


Hero MotoCorp v/s TVS Motors

The facts … Both started business around the same time in the 1980s

Both were Indo-Japanese JVs –Hero Group with Honda and TVS Group with Suzuki

MOAT IMPACT: Hero MotoCorp: World’s

largest two-wheeler company TVS Motor: Struggling to retain

its hitherto No 3 spot in India


Bharti Airtel v/s Tata Teleservices

The facts … Both incorporated in 1995 on the eve of India’s telecom

boom. In fact, Tata Tele had the rich Tata legacy Both journeyed India’s wireless

explosion – massive value migration from wired telephony.

MOAT IMPACT: Bharti: India’s No1 telecom co

with global aspirations Tata Tele: Yet to report a

single quarter of profit


L&T v/s HCCThe facts … Both long standing construction players in India. In fact,

HCC was incorporated in 1926, earlier than L&T (1946) Both have benefited from

India’s exponential growth in infra, construction, real estate

MOAT IMPACT: L&T: Arguably India’s answer

to General Electric HCC: Struggling to make profit

plus issues like BOTs, Lavasa


HDFC Bank v/s Central BankThe facts … Central Bank has recently completed 100 years. HDFC

Bank, in contrast, is less than 20 years old. Central Bank’s has 60% more

branches than HDFC Bank (4,000+ v/s 2,500)

MOAT IMPACT: HDFC Bank: FY12 PAT 10x of

Central Bank, Mkt Cap 24x Central Bank: Lagging on most

metrics – NPA, RoE, RoTA, etc


1. INDUSTRY STRUCTUREInterplay of Buyer power, Supplier Power, Threat of new entrants/substitutes, etc

2. COMPANY STRATEGY5 elements – (1) Distinct value proposition (2) Tailored value chain (3) Trade-offs (4) Fit (5) Continuity over time

Economic Moat: Two factors

Moat Quote“Why are some companies more profitable than others? … First, companies benefit from (or are hurt by) the structure of their industry. Second, a company’s relative position within its industry can account for even more of the difference.”

– Joan Magretta, in her book Understanding Porter


1. The Economic Moat hypothesisInvesting in a portfolio of EMCs (Economic Moat Companies) should lead to sustained outperformance over benchmark indices across years, irrespective of market conditions.

2. Backtesting the hypothesis

Step 1: The backtesting framework 1. Arrive at a list of EMCs as on March 2002 and

invest in them2. Monitor price performance from March 2002 to

March 2012

Economic Moat:Applying in equity investing


Backtesting the Economic Moat hypothesis (contd)

Step 2: Deciding Economic Moat criteria2A. The principles:1. Economic Moat ultimately reflects in financials, with

RoI significantly superior to peers2. Competitive advantage is relevant only within sectors2B. The practice:1. For each of the last 8 years, calculate for all sectors

RoE of companies and sector average RoE2. A company is an EMC if for at least 6 years, its RoE

exceeds industry average3. Discretionary adjustment to the final list based on

then known facts and figures




Step 3: The findings#1 – EMCs handsomely outperform#2 – EMCs’ outperformance is earnings and valuations

agnostic#3 – EMCs’ outperformance is sector agnostic#4 – Future not too meaningful for EMCs,

but critical for non-EMCs




Finding #1: EMCs handsomely outperform Over 2003-12, overall return of 177 companies was 18% EMCs returned 25% whereas non-EMCs returned 12% Sensex return was 18%, implying 7% Alpha for EMCs and

negative 6% Alpha for non-EMCs


EMCs Non-EMCs Overall

Return 25% 12% 18%

Sensex 18% 18% 18%

Alpha +7% -6% 0%

2003-12 Avg Price CAGR (%)



Finding #1: EMCs handsomely outperform (contd) Besides point-to-point outperformance, EMCs outperformed

the Sensex in every year over the 10 years Also, after 3 years, EMCs outperformed even non-EMCs


Payoffprofile



Finding #2: EMCs’ outperformance is earnings and valuations agnostic

The most plausible explanation for this:

Earnings agnosticismEMCs’ strong competitive advantage which ensures that they enjoy a more-than-fair share of the growth inherent in most sectors in India

Valuation agnosticismContinuous rollover of EMCs’ competitive advantage period (CAP)




Explaining EMCs’ valuation agnosticism: CAP Competitive advantage period (CAP) is the time

during which a company is expected to generate returns on incremental investment that exceed its cost of capital.

Markets do assign premium valuations to EMCs, given their reasonably accurate assessment that such companies enjoy a very long CAP.

Where the markets fail is in recognizing that barring a low mortality rate of less than 15%, EMCs leverage their moat and sustain high return even with passage of time.

The CAP of EMCs simply rolls over with each passing year, creating incremental excess return for investors.




CAP rollover plausibly explains EMCs’ valuation agnosticism


Return=WACC

CAP in Year 0 CAP rolls over by 1 year



Finding #3: EMCs’ outperformance is sector agnostic EMCs are likely to outperform benchmarks across sectors,

even if the sector itself is out of market favor. Thus, out of our 22 homogenous sector groupings, EMCs

underperformed the Sensex in only two sectors – Oil Refining and Textiles.





Finding #4: Future not too meaningful for EMCs, critical for non-EMCs Mortality rate of EMCs is likely to be low. By 2012 only 11 of 74 turned into

non-EMCs (mortality<15%). But even these companies beat the Sensex EMCs which remained so did not do much better than initial performance Non-EMCs who upgraded into EMCs delivered the highest return at 27%,

albeit with a mortality rate of 75% Worse of all, non-EMCs which remained so delivered only 8% return.

Payoff Matrix2003-12 Yes 27% 26%

EMCs No 8% 20%No Yes1995-02 EMCs2003-12 Sensex return was 18%




Applying the methodology to Nifty constituents in year 2002We applied our backtesting methodology to 38 constituents of Nifty in 2002. The results were similar to that of the broader universe – EMCs outperform both non-EMCs and overall Nifty Non-EMCs underperform Nifty EMCs which maintain status quo do not report materially high returns But non-EMCs which upgrade to EMCs deliver high returns Non-EMCs which stay so perform the worst

Stock returns on 2002 NiftyPrice CAGR No. of cos.

EMC 22% 29

Non-EMC 16% 9

Nifty payoff matrix

2003-12 Yes 21% 22%

EMCs No 4% 14%

No Yes

1995-02 EMCs38 stocks return: 20%Nifty return: 16%


Applying the methodology to current NiftyWe have bifurcated current Nifty stocks into EMCs and non-EMCs using the backtesting methodology –1. Company and sector average RoE data 2005 to 2012, and2. In some cases, discretion based on currently known

information and subjective opinion

Prognosis based on past experience1. In our view, there are 27 EMCs and 23 non-EMCs in the

current Nifty2. Expect EMC basket to outperform non-EMCs and Nifty itself3. Expect about 6 non-EMCs (25% of 23) to upgrade to EMCs

and deliver handsome returns4. Non-EMCs which maintain status quo will eventually be

replaced in the Nifty



Nifty: The Economic Moat classification



Market OutlookSeems poised for new highs


Corporate Profit to GDP should be around 5% for 2013

Market Outlook


Interest rates have softened to 8.2%; expect further fall

Market Outlook


Earnings Yield to Bond Yield at 0.9x is just below parity

Market Outlook


Sensex forward P/E is currently at 14.4x around LPA

Market Outlook


Sensex EPS is expected to grow 11% over FY12-14

Market Outlook


Consumer sector has bounced back into wealth creationITC is the largest wealth creator, TTK Prestige the fastest, HUL back in top 10.

Financials has emerged the largest wealth creating sector for the second time in a row. Absence of new entrants is leading to widespread profitability and stock performance.

Economic Moat protects the profit and profitability of companies from competitive attack.

Extended CAP of EMCs drives superior profits and stock returns.Over 2002-2012, EMCs in India have meaningfully outperformed benchmarks.

Breach of Economic Moat causes massive wealth destruction.The Telecom sector is a classis case.

Markets seem poised to touch new highs in the next 12 months.On the back of earnings growth of 10-11%, imminent moderation in interest rate, and reasonable current valuation.

In Conclusion

Thank You !&

Happy Investing In

Economic Moats

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