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The single most important quality of a true multi-bagger

Nov 20, 2014

In this issue:
» Why is the Fed worried about stock markets?
» What is Marc Faber's view on gold?
» Free float factor is lowest amongst Indian stocks...
» ...and more!

What according to you is the single most important factor when evaluating any business - debt, management quality, corporate governance, RoE? While these 4 factors are pillars and it is difficult to pick one over the other, the root to successful investing lies elsewhere we reckon. And if you choose to ignore it, chances are that you may end up landing in a value trap.

Well, the root which we are talking about and has the potential to build a nest egg for you is - pricing power. In Buffett's own words "If you've got the power to raise prices without losing business to a competitor, you've got a very good business". Such businesses have a moat around them.

In short, pricing power is critical to success of any business. And most companies typically fix their pricing on the two below mentioned approaches:-

  • Cost based pricing
  • Competition based pricing
The first approach is the traditional approach to pricing which most manufacturing firms adopt. Final price depends upon how the cost structure behaves. However, in an inflationary environment, passing on the cost inflation could be fatal. Customers can switch to competing brands if there is no product differentiation and you lose business. In short, cost based pricing fails in an inflationary environment.

Coming to the second approach of competition based pricing. Organizations typically resort to such approach in order to fend competition and re-gain market share. Take the case of BHEL for instance. In order to withstand Chinese competition, it had to re-align its pricing strategy. But the results are for us to see. Such strategy does not work in long term unless you have deep pockets to take a hit on margins just to protect market share. Competition based pricing ensures that weaker players get eliminated. And larger ones like BHEL suffer.

As seen, both the pricing strategies that organizations typically adopt have drawbacks. So, what is the best strategy to pricing then?

Well, it is customer value based pricing. In this strategy, the perceived customer value is the main factor in setting the final selling price. This strategy ignores competitive pricing pressures and makes the cost structure a redundant factor in pricing. Your aim is to just provide better value & consumer satisfaction. This in turn increases the customer willingness to pay. And you price your product accordingly.

Take the case of Apple for example. It has significant pricing power. An Apple IPhone 6 costs anywhere between 60-90K in India. Now we know that mobile manufacturing is extremely competitive industry. Yet Apple is able to charge such kind of a price just because customers appreciate the quality of its products and are ready to pay a premium.

For Apple, the perceived customer value, an intangible factor, is a primary factor in determining the final selling price. Manufacturing cost of the phone is not as relevant. Such a strategy enables the company to have high margins. And makes it a multi-bagger.

But in order to follow value based pricing, a company should know its customer needs and should be able to meet them which is the case with Apple. Very few companies can do that as it requires deep understanding of the customer taste & preferences.

So there you have it. If you are able to locate a business that you think prioritizes customer value above everything else and cares little about what the competition is pricing its products at, you've got a potential multi bagger according to us. So, do keep an eye out for such businesses. And when you come across one which is also valued attractively and has a great management track record, such opportunities should simply be grabbed with both hands!

Which businesses in India do you think price their products based on customer value addition more than anything else? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
We just spoke about pricing power and what are the benefits of buying companies that follow customer value based pricing strategy. However, in order to benefit by buying such companies one needs good liquidity on the bourses. But as can be seen from today's chart below, the BSE Sensex has the lowest float of 45.2% amongst major emerging market indices. Float means the proportion of shareholding of any company that is freely traded on the exchange.

High promoter shareholding has led to lower float in Indian indices. This has a couple of dis-advantages. For one, it lowers the liquidity of any stock. Secondly, since majority of the stock is concentrated with promoters, minority shareholders have limited say in critical matters. Hence, there is a need to increase the float of Indian indices. The fact that many of the Sensex stocks are PSUs and government is looking to divest stake in them to raise money, the float is likely to rise in the future. This shall improve liquidity and attract more investors into stock markets.

Sensex companies have highest promoter holding

As long term fundamental investors, the number one lesson we are taught is how not to look at stock prices frequently and instead, focus on the fundamentals of the business. If the fundamentals are strong, the stock prices will eventually follow. Perhaps no one at the US Federal Reserve has learnt this lesson we believe. For the board members of the Fed just can't seem to take their eyes off the country's stock market. As per a news article, the Fed was in fact planning to make a reference to the stock market's recent volatility. However, better sense prevailed and they dropped the reference fearing it would send across the wrong impression to the readers.

Well, you know what, the damage has already been done as far as we are concerned. And it was done not recently but from the time the Fed started assuming that it can move the economy in the direction it wanted by printing money and keeping rates lower. However, as has been shown in the current crisis or for that matter numerous crises before, the Fed's intervention only makes the matters worse. It no doubt gives the impression of stability but that's only illusory according to us and the crisis returns in a much destructive form than before. Well, we won't be surprised if something similar happens this time as well.

Sticking to the subject of central banks, what do you do when there's not a single central bank in the developed world that you can trust? Well, if Dr Doom Marc Faber is to be believed, everyone should become their own central banker! At least this is what Marc seems to be doing. 'I am my own central banker', he asserted in a recent TV interview. And therefore he owns a lot of gold and is actually happy with where the gold prices are currently so that he can buy more of the yellow metal. He is also urging everyone else to do the same.

So, should everyone pay heed to Faber and start stocking up on gold or wait for prices to correct more? Well, as far as we know, there exists no technique that successfully identifies the top and bottom for any asset class yet. And therefore with the correction it has had, it would certainly be nice to make gold a small portion of one's portfolio if one has not already invested in it.

The Indian stock markets are trading weak today. At the time of writing the BSE-Sensex was trading down by around 58 points, while the NSE-Nifty was down 15 points. Losses were largely seen in realty stocks. Most Asian stock markets were trading in the red. European markets too have opened the day on a weak note.

 Today's investing mantra
"Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things". - Charlie Munger

This edition of The 5 Minute WrapUp is authored by Jinesh Joshi and Rahul Shah.

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3 Responses to "The single most important quality of a true multi-bagger"

mansoor raza

Dec 5, 2014

small cap

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Bhim Raju

Nov 21, 2014

Probably I'm one subscriber who has not invested any money so far for the recommendations made by equitymaster but I reckon subscribing to equitmaster has been one of the best decisions of my life. The wealth of knowlege every research report imparts is invaluable. Kudos to the team equitmaster. One can learn much more regarding investing by going thru the equitmaster research reports then attendng MBA classes:)


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Nov 21, 2014


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