Trading Rule – “Always focus on the winners in a group”…

One of the basic rules of investing in the markets is that normally it is the sectoral leaders or the thematic leaders who actually give you outperformance. The focus should not be on existing leaders but companies with the potential to emerge as future leaders. Classic examples are hero honda and bharti in the indian context. They not only disrupted an entire industry but ended up dominating the industry for many years!

WHAT DO WE REALLY UNDERSTAND BY WINNERS IN A GROUP?

One of the basic rules of the business is that only the fittest and the most adaptable survive and thrive in the long run. Winners are those who identify a niche in the market and focus all their energies on that niche. In the process, they not only disrupt an existing industry but end up reinventing the industry and creating new and larger markets in the process. Hero Honda not only overtook Bajaj Auto but also created an entirely new private transport industry with focus on fuel efficiency, youth and style. Bharti not only ended the MTNL/BSNL dominance but also created a market for over 1 billion mobile connections across India. Private Banks are another case of disrupters emerging as winners.

NOT ALL DISRUPTERS EMERGE AS WINNERS…

This is a very important and subtle distinction that you need to understand. Disruption of an industry alone is not sufficient for a company to emerge as a winner. The Indian corporate landscape abounds with examples of companies which disrupted, showed promise and then fizzled away as they could not get their business model right. Take the case of Deccan Airways. With their low cost model, they did manage to disrupt airlines and helped millions fly. But the real benefits were reaped by Indigo Airlines which managed to get its business model right. Tata Motors did disrupt the passenger auto segment with its fuel efficient Indica but it could never fully capitalize on the domestic market, which was eventually done by Maruti. Gujarat Ambuja is another example of disrupting the cement industry with its innovative cost structures. Again, the company could never create enough wealth for shareholders in the long run as it could never really emerge as a sectoral winner.

In the stock markets you not only gamble on an idea but also on the practicality and viability of that idea” – Jeremy Renner

6 SIGNALS THAT A DISRUPTER CAN EMERGE AS A STOCK MARKET WINNER…

  1. Is the disrupter’s model actually scalable? This is the fundamental question that you need to ask yourself before selecting a company. In the case of Hero Honda and Bharti, the big advantage was that they could actually scale the model up rapidly without compromising the financial position too much. Same was the case with Eicher, which not only disrupted the higher end of the two-wheeler market but also managed to scale up its business. HDFC Bank has successfully done that in the banking industry. That is the key to a disrupter emerging as a winner.
  1. Can the business model be executed with minimal leverage? Financial risk is one of the biggest risks that hold back disrupters from becoming value creators in the long run. Take the case of the infrastructure sector in India. The companies that got into that space had big plans for the trillion dollar opportunity. But what happened during that period was that the liquidity tightened, demand went down and companies started postponing investments. By then these companies had taken on too much debt and just did not have the requisite revenues to sustain that kind of debt. Same is the case with telecom and power. A billion dollar opportunity in both these cases was wasted because the companies were just too leveraged to be able to sustain in the long run. More often than not, it is debt that stops disrupters from becoming winners.
  1. Does the company have a viable and sustainable pricing model? Building market share by loading discounts upfront is the easiest thing too. Take the case of airlines 10 years back. Easy financing meant that companies could afford to beat down prices to unsustainable levels even as costs were going up. When the tide turned, most of the models turned out to be absolutely unviable. Air Deccan, Paramount and Kingfisher are classic examples. Most internet ecommerce players today are in the same boat!
  1. Is the company able to perform in a lacklustre market? This is an acid test. A company like Eicher not only disrupted the two-wheeler industry but managed to give its best outperformance between 2009 and 2014 when the overall markets were simply going nowhere. If the company can manage that, then you have a winner in front of you!
  1. Is the company getting overcapitalized? Debt is one side of the story; the more important story is equity which has a higher cost of servicing than debt. Tata Tele entered the telecom market in India at the right time. But the company had such a huge capital base that it was impossible for the company to really offer worthwhile returns to shareholders. Be cautious of a huge capital to be serviced.
  1. Is the company maintaining higher standards of corporate governance? This is subjective but there is enough evidence in the market. A Satyam versus an Infosys or an Axis Bank versus HDFC Bank is cases in point. At the end of the day, it is companies with higher standards of corporate governance, transparency and disclosure that will not only create but also sustain wealth in the long run!

THAT IS WHERE THE REAL CREAM LIES…

As an investor you actually make big money in the market when you are able to identify winners well before the market sees them. Such disrupters are all around you and you just need to keep your eyes and ears open to catch signals. Of course, you need to apply the above rules to identify which of the disrupters can become winners. That is easier said than done, but nobody ever said that making big money in the markets was simple!

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