Invest in the Best, Forget the Rest
(Oct 23, 2015)
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In this issue:
» Default rated debt of India Inc
» IMF's dire warnings to oil economies
» Update on the markets
» ...and more!
Do you remember the second person to land on the moon?
Do you remember the second person to climb Mount Everest?
Or the second book or movie you ever watched?
The human mind is wired so that we remember the most significant things the longest. This is true in business. Coming in second or third often isn’t good enough.
Now it isn’t just the companies with the biggest brands that we remember the longest and recollect the fastest, but the ones that have a 'network effect'.
For internet and tech companies, a network effect can be their most important moat.
Think Google, Facebook, and Amazon. Or for that matter, Just Dial and Indian ecommerce companies Flipkart, Quickr, and Make My Trip?. The reason huge numbers of users converge on these sites is because their networks grow by the day.
Companies with wide economic moats tend to safeguard shareholder wealth over a long time. And companies with ‘network effect’ can grow their moats widest over time. Network growth means robust returns for shareholders. Therefore, venture capitalists and angel investors are keen to invest to see the network multiply.
A reader recently asked whether all technology companies backed by venture capitalists will leverage the network effect.
It is true that, unlike other moats, the network effect is a self-driven growth catalyst. A truly strong and growing network can help a company get bigger and better over time. If a company can build such a network, it has a fair chance of trading at premium valuations for years.
But don’t invest in a company based on the network effect alone.
Very few companies have managed to ride their network effect to huge success. Even among the ones that have, it is usually only the top player in a market segment that can truly deliver handsome returns. The rest spend too much time and money trying to catch up and outbid the competition.
It is easy for tech companies to spend the venture capital they fetch under the pretext of growing their network effect. But only the top player will generate the desired return on the investment. And unless you have the biggest network, you’ll have to fight over the leftovers.
But the network effect moat may not last with the biggest company forever. With technological obsolescence, even the network effect may be passed on to another player. EBay, which was arguably the first company to ever leverage the network effect, has seen its moat degenerate, losing users at a faster rate than it’s gained them.
So do look for companies with network effect. But you may want to invest in the one that ranks first and forget the rest. And as long as it’s in your portfolio, make sure the company remains numero uno.
What are the criteria you look for in companies with network effect moat? Let us know your comments or share your views in the Equitymaster Club.
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India Inc continues to be stumped by piling debt. As per a report by Credit Suisse published by Mint, the debt levels of the top 10 business groups in India has risen seven folds in the past eight years. These conglomerates include the likes of Lanco Group, Jaypee Group, GMR Group, Videocon Group, GVK Group, Essar Group, Adani Group, Reliance Group, JSW Group and Vedanta Group.
The business groups have been hit badly by the economic recession and the delay in acquiring requisite government approvals for land acquisition and fuel procurement. This in turn has put a large number of their infrastructure projects on the backburner constraining cash flows and impeding their debt servicing abilities. As a result their combined interest coverage ratio has slumped to 0.8 times in FY15.
The combined loans of these business groups constitute 12% of the total loans in the banking system. Although some business groups have reduced capital expenditure and are also selling assets to raise funds but this has not helped in bringing down debt levels due to ongoing projects as well as operating losses from cost overruns. Therefore, debt of these business groups is being increasingly downgraded by rating agencies. Four of the business groups, Jaypee, Lanco, Essar and GMR have around 40-65% of their group debt downgraded to default category by rating agencies.
As large business groups struggle with stressed balance sheets coupled with growing incidence of downgrades, banks are also likely to face the heat of increased slippages into bad loans. As per the report, the share of stressed loans of the top ten highly leveraged business groups constitutes 4.5% of system loans. State owned banks that have huge exposure to corporate lending will be the worst affected as they continue to battle poor capital adequacy and falling profitability.
Growing debt woes for conglomerates
Crude oil prices plunged to record lows this year. While this has been a blessing in disguise for emerging economies such as India, fuel producing nations have been caught on the wrong side of the fence. As per the International Monetary Fund, countries such as Saudi Arabia, Bahrain and Oman in the six-member Gulf Co-operation Council are likely to exhaust their buffer of financial assets within five years as they run huge fiscal deficits on account of large spending.
Cashing in on the black gold crude, Saudi Arabia has in the past decade built large dollar reserves with its debt falling to less than 2% of GDP in 2014. However, the slump in crude price to below USD$ 50 a barrel and continued spending by the Arab nation is expected to push its budget deficit to over 20% of the GDP in 2015.
Factors such as fighting a war in Yemen and measures for avoiding stringent economic policies to ward off political or social unrest have added on to its woes. Moreover in a bid to protect market share, Saudi Arabia has been boosting production even in the face of weak crude prices that have further strained its cash flows. If reports are to be believed then Saudi Arabia’s net foreign assets fell to the lowest level in August 2015.
Smaller oil producing nations such as Oman and Bahrain are likely to be more severely impacted by the rout in crude price with their fiscal deficits swelling to more than 14% of the GDP in 2015. Therefore the empire built on the riches from crude oil faces a threat of crumbling much sooner unless adequate steps are taken to curtail on huge spending by the oil nations.
At the time of writing, the Indian markets were trading in the green. The BSE Sensex was up by about 235 points or 0.9%. Gains were seen in energy and banking stocks while commodity, engineering and IT stocks were trading weak. The Midcap and smallcap indices were also trading firm.
"In a bull market, one must avoid the error of the preening duck that quacks boastfully after a torrential rainstorm, thinking that its paddling skills have caused it to rise in the world. A right-thinking duck would instead compare its position after the downpour to that of the other ducks on the pond." - Warren Buffett
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|This edition of The 5 Minute WrapUp is authored by Tanushree Banerjee (Research Analyst) and Madhu Gupta (Research Analyst).
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