Cracking The Code: Three ways alpha seekers can uncover hidden moats

As investors become more sophisticated, it becomes more difficult to search for alpha. Initially, investors used to have simple toolkits. Around 80-100 years back, during legendary investor Warren Buffett’s guru Ben Graham’s time, one could see if the net cash or networth was greater than the market cap,  and create an alpha-generating portfolio.

For a long time, investors could look for low price-earnings (PE) ratio, low PCF (price-to-cash-flow ratio) or low price-to-book value (PBV), and generate alpha. Then came investors who looked for companies with average PE, but which were growing and could generate alpha. Some would even accept higher-than-average PE for very high growth and generate alpha.

Buffett’s partner Charlie Munger taught Buffett that one could buy companies with average PE but with moats, and still generate alpha. He explained that companies with moats could generate a higher return on capital compared to the cost of capital, and hence a higher price multiple was fair.

Over the last decade, most sophisticated investors have learnt to look for companies with a high return on capital. This has led to a bubble in most such companies, with PE multiples ranging from 50 to more than 100. This is true even for companies with growth rates below the nominal GDP growth rate, and which practically have only price increases and hardly any volume growth in a high-growth economy such as India. Such companies have become huge “quality traps” and are eventually likely to destroy huge amounts of investor wealth because of over-valuation.

There are three relatively simple ways to search for alpha.

Look for companies with high capital-work-in-progress. These companies will have seemingly low returns on capital. This would be the case since a lot of their assets are not yet generating profits. These assets, which are still being set up, will generate revenues and earnings eventually. If one can estimate the return on capital with these assets generating revenues, then one would get a better picture of the return on capital.

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For example, assume there's a company with no debt and capital work in progress equal to the value of the plant, property, and equipment. One could also assume that the true ROC of the company would be nearly twice of what it was. So, a single digit ROC of, say, 9 percent, could actually be an ROC of nearly 18 percent. Or one could estimate the additional profits generated by the currently non-operating assets  which might become operational in the next two-three years. This, too, would lead to a higher estimate of ROC.

The power sector is one such area, where there are companies which have capital work in progress of 50 to 250 percent of their current fixed assets. Thus, these companies have low RoE and are also available at low PE multiples.

Another way to search for alpha is to look for companies with high net cash. If the companies have high net cash compared to their equity, then the true RoC will be very high once the equity is adjusted for the non-operating cash assets. Currently, one can find such companies in the information technology (IT) sector. However, these companies might not be  cheap on the PE front.

A third way to search for alpha is to look for companies with under-utilised capacity. One could look for manufacturing companies with unutilised production capacity,  and hence with low RoE. As the idle production capacity is increasingly utilised, the revenues go up, profits accelerate, and the true RoE becomes visible. This is because of operating leverage coming into play. There is at least one such company which contributes to defence, railways, and the power sector, and is about to show its true RoE after a long time.

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Within this strategy, there is a similar play currently hiding in plain sight. Most of the banks have huge, underutilised lending capacity. The typical capital-to-risk weighted assets ratio (CRAR) for banks ranges from 12-16 percent or so, while the RBI norm is 9 percent. This means that the banks have huge lending capacity. Like with the manufacturing company example above, the banks would have accelerating profits and thus accelerating RoEs as more of their lending capacity is utilised and their CRAR tends towards RBI norms. Interestingly, a lot of these banks are available at significantly low price multiples, whether PE or PBV, compared to what their intrinsic values would justify.

Keep in mind that none of the above is a recommendation to buy, sell, or hold any stocks or sectors.

It is likely this alpha is already in our portfolio, but we could be looking to buy, sell, or hold stocks depending on various factors. One should make such decisions only after understanding the risk and return of asset classes and specific investment opportunities, and after assessing and planning their finances properly and consulting their advisor.

We have tried to provide three unconventional ways of looking for companies with hidden moats that do not show up on the typical high RoE screens. Further, the idea is to demonstrate that even today there are a large number of companies which have moats and are still available at a significant discount to their intrinsic values, or at least at fair value.

One can use this way of thinking to come up with more unconventional ways to search for alpha.