Thursday, 13 December 2012

Playing Second Fiddle: Possibility of First Rate Returns

It is human mind's innate tendency to seek patterns from the past experiences and extend this patterns to predict the future. Even though this innate human trait is very handy on number of occasions,  many a times it leads to visualizing patterns where there exist none! In my opinion, a key differentiator in identifying a useful pattern is the causal relationship or lack of it! In simple words, if our mind visualizes some pattern but there is no logical/rational explanation for why particular pattern exist, more likely than not, pattern may turn out to be misleading. Idea behind discussing this trait of human mind is that this post is related to a pattern that I have observed in some of my investments and there is a common thread binding success of these investments. My personal take is that this pattern can have high predictive value as there are enough logical reasons to explain for the pattern deciphered here.

There is a very interesting thread going on on valupickr forum on identifying success patterns in investment. Donald has done an excellent summary of various patterns discussed on this thread. Do read this thread as some of the patterns there are indeed very interesting.

Let me start the discussion with a question. What is common between Amara Raja Batteries, Cera Sanitaryware and Oriental Carbon & Chemicals? Let me define characteristics which bind them together..

  • All these companies operate in duopoly/oligopoly: Organized sanitaryware industry catering to mass market is dominated by three players i.e. HSIL, Parryware and Cera in that order. Similarly, battery industry is dominated by Exide, Amara Raja and to a limited extent Tata. In insoluble sulfur space, there only few suppliers garner more than 95% market share in insluble sulfur supply to all tyre majors across the world.

  • They are not leaders in their industry but are second/third largest players in their industry: Cera is the third largest player in organized sanitaryware industry catering to mass market. Amara Raja is the second largest player in battery market (both industrial and automotive combined) and OCCL is third largest player in insoluble sulfur market.

  • All three companies have been discussed on this blog based on fundamental and business analysis. (though due to some management actions, I have exited OCCL as I was not comfortable with management quality, however, on quantitative basis, it still looks very good for longer term)

So once I noticed the commonality among these three companies, I sensed that there may be some pattern emerging which may have causal/logical links.

So here is the hypothesis

" Second or third largest players, operating in a consumer-centric industry and increasing/retaining their market shares are good investment candidates if it is acquired before market picks up the thread"

Now the hypothesis seems slightly complicated (may be verbose!), but i put it like that to ensure none of the attribute is left out from the hypothesis!  So what are the attributes one should be looking for in second/third largest players in order to qualify it as good investment candidate?

  • Industry should be consumer centric or product should be used in consumer centric industry to ensure steady demand
  • Industry should be growing at reasonable pace
  • Industry shall have duopoly/oligopoly with market leader enjoying pricing power.
  • overall business economics (return ratios and margins) for industry is good  and consistent while second/third largest players enjoy similar economics as that of industry leader (or may be better!)
  • Second/third largest players should ideally be increasing its market presence/share
  • Second/third largest players trade at significant discount to market leaders.
This may sound like a wish list but the fact that such opportunities existed in the past does build confidence as an investor that one may come across such opportunities from time to time. If one is able to spot such opportunities and invest, it is likely to give first rate returns!

So let me dwell into logical link as to why this pattern makes sense as investment opportunity.

  • Typically in an industry, with duopoly/oligopoly, market leaders enjoy pricing power and hence their margins are generally decent and protected. This ensures that second/third largest players also can take advantage of this dynamics and enjoy protected margins. Thus any major fluctuations on RM price is typically passed on to the end user (though some times with lag). This attribute can be very handy as company's bottom line is predictable as long as company is able to sell same/more of its products.
  • Another advantage second/third largest players have is that they have to grow from much lower base than market leaders.As we all know it is much easier to grow at faster pace from lower base than higher base. Moreover, since company is growing from lower base, it is possible to maintain growth momentum (of course with right products and strategy) for longer. Thus if company is operating in an industry with reasonable  growth it shall be able to grow at pace comparable to industry growth. Now if we combine these two attributes of reasonable growth in top line and protected margins, it will lead to predictable earning growth for some years. 
  • Another interesting fact is that market typically focuses on industry leaders and assigns discount to companies which play second fiddle to leaders. Many a times, this means that one can get opportunity to buy a business which has as good economics as industry leader, higher growth than  industry average (due to lower base) at much lower valuations. It thus may present an opportunity to buy growth companies with superior economics at very reasonable price giving some margin of safety to the investor. 
So apparently, there is some logical link that can explain why investing in second/third largest players in oligopoly/duopoly makes sense. However the moot question here is, does it always work? There may be contrary evidences where in spite of this pattern, playing second fiddle did not work as investment  opportunity. Hence, it is important to recognize that, just spotting an opportunity which fits the pattern is not the end, but the beginning. It shall never be a proxy for fundamental/business analysis that one should perform before making investment decision. Limited point here is that, pattern may be useful in identifying investment opportunities which have higher probability of giving superior returns over a long period of time.

Food for thought: A few other opportunities which can fit in this pattern are Atul Auto, Narmada Gelatines and Fluidomat as all three of them operate in an industry with oligopoly/limited competition. 

Please share your ideas on which other businesses you think can fit into this category.