Know these structural breaks while investing for long term

Gaurav MehtaWe keep hearing stock recommendations and there are a multitude of reasons, often quite varied, that form the basis of these recommendations. These may range from attractive valuations to cyclical turnaround to positive industry dynamics and so on amongst several others. In itself no reason is right or wrong, but one critical thing to keep in mind while evaluating a stock is that the purchase decision is intertwined into and in fact inseparable from the exit decision. For example, a speculator may buy a stock on a quarterly result announcement and get out within days, even within the day sometimes. Similarly a fund manager may buy a mediocre cyclical stock just because it is cheap and because he or she foresees an economic recovery and then sell out when the recovery crystallizes. Not everyone, however, and especially those who are preoccupied with other things, like a job outside of stock markets, has the time or resources or both to make well informed decisions on precise entry and exit timings. For this group, as much for any group for that matter, the most suited strategy would be to buy well run, structurally sound businesses that once bought can be held for the long run and perhaps forever without the need for active monitoring, such that the investment keeps on compounding and creating wealth for the investor. As the legendary investor Warren Buffett himself maintains, “Our favourite holding period is forever.”On similar lines ‘Good & Clean’ approach to investing works, where focus on ‘clean’ accounts and governance and ‘good’ capital allocation helps to identify good businesses for the long run. A combination of consistent growth (as measured by revenue growth), sustained profitability (as measured by RoE and RoCE) and healthy cash generation emerge as the common threads between these firms.Once invested in a good business, there is a great chance that one may not need to do anything and just stay invested for years, decades, and virtually forever. However, in certain cases, the business may witness a ‘structural break’, such that the future is rendered disconnected with the successful past. While what sets good firms apart is their ability to better manage risks versus an ordinary company, these are situations that long term investors need to carefully evaluate once faced with, as they have the potential to derail the long term story and hence the merit of continued investment.Some examples of situations that constitute a structural break are discussed hereafter. 1.    Succession planning: This problem is especially pronounced in family owned businesses, more so in firms run by first generation promoters. The promoter may have been the driving force in creating a well-run, successful franchise. Lack of proper succession planning, however, may threaten the continued business success that investors have been taking for granted..2.    Capital misallocation: Prudent capital allocation focused on profitable growth is the cornerstone of any successful business. Driven usually by limited growth opportunities in the core business in some cases, and by over confidence in many others, signs of capital misallocation should be treated as red flags. Outsized acquisitions, recurring high capital expenditure and unrelated diversifications need to be carefully evaluated.3.    Regulation: Firms making supernormal profits, especially in industries which rank high on social or political sensitivity may attract adverse regulation. Necessity items, luxury or sin goods, natural resources etc. are some pockets that have been prone to adverse regulation in the past. What has happened to the cigarettes sector over the past few years is a classic example of this type of break.4.    Competition: While competition is omnipresent and good companies usually survive and may even thrive in the wake of competitive onslaughts, there are situations where a large challenger may completely alter the rules of the game. Telecom is a case in point currently, where the entry of a large challenger is likely to put a dent on profitability and balance sheets of incumbents. The sector also happens to be regulated that makes matters worse.5.    Disruptions: Disruptions to existing incumbents may come due to newer technologies or innovative business models. Good organizations are nimble and will adapt quickly to newer technologies and models. However, some will not and will falter. With the advent of ‘e’ and ‘m’ commerce and given the broader digital revolution underway currently, this threatens to be as big a structural break today as it has ever been in the past.6.    Growth normalization: Many businesses face long periods of high growth rates which eventually give way to more sustainable, lower growth phases. This is very likely if the industry size is limited and becomes a constraint, while the firm fails to generate newer engines of growth. The markets however, in their optimism, may have priced in the high growth phase to sustain and the growth drop off may lead to a structural derating for the stock.7.    Shifts in megatrends: Some businesses appear good just because they are beneficiaries of large trends underway at the given point in time. These firms may not necessarily be strong intrinsically and may falter as soon as the underlying trend reverses. Many lenders looked good in the credit boom of the last decade only for the subsequent slowdown to separate men from boys.This by no means is an exhaustive list. In any case, investing is more art than science. But having a framework beforehand may facilitate better decision making when faced with issues in real world.Author is vice president of Ambit Investment Advisors