Posted on 09 May, 2020
Pankaj Raina, Managing Director, Zephyr Peacock writes for
Inc42 Media on how to identify resilient businesses.
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Investors will sharpen focus on value
creation as a result of Covid-19.
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A useful checklist comprises of both
quantifiable and non-quantifiable parameters.
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No investment checklist is complete without
considering qualitative metrics
With the wreckage of Covid-19 led recession smoldering and
slow economic growth expected for the foreseeable future, it is not surprising
to note that many companies are turning inward and hunkering down. Growth,
profits, capital efficiency, and value creation seem to be stretch goals rather
than baseline investor expectations.
Over the past decade, privately funded companies were
praised for shareholder valuation growth (measured as price per share increase)
over shareholder value creation (measured as revenue growth, profit growth,
free cash growth, dividend, and capital gains).
One of the critical measures of shareholder value creation
and business resilience is capital efficiency, which, if maintained over time,
can lead to significant real wealth creation. However, the myopic view on
raising share price in the short term has led to difficult times for most
businesses – focus on growing revenues/market share at the cost of profits,
high debt, no capitalization plan once customers are willing to spend again.
Several public and private companies are currently operating
in a challenging environment. Some of these companies will continue to grow
revenues and profits, gain market share, in contrast to their competitors’
intense focus on cost cuts to ensure survival. These are companies that may not
have been the fastest to grow in terms of valuations but have found a way to
build value over the long term. These businesses are successful because they
have built what I call a ‘durable competitive advantage’.
“The key to
investing is not assessing how much an industry is going to affect society, or
how much it will grow, but rather determining the competitive advantage of any
given company and, above all, the durability of that advantage” – Warren Buffet
A combination of qualitative and quantitative factors allows
most companies to build a competitive advantage in the industries in which
these firms operate. A robust investment checklist can help generate
high-quality resilient investment ideas.
The checklist makes use of qualitative (management
strengths, culture) and quantitative (profitability and operating indicators)
to identify sound business models. While the list of quantifiable parameters is
never-ending, the below items summarize the most crucial indicators to identify
sustainable business models:
"No wise pilot, no matter how great his talent and
experience,
fails to use a checklist" – Charlie Munger
The
investment checklist would be incomplete without considering the qualitative
parameters that define a resilient business. A business is only as good as its
leaders, its culture and it is important to ascertain certain qualitative
parameters that could help separate a resilient business from others.
Quality
Of Management
Reviewing
management and founding teams before the investment is crucial. Companies are
only as good as the management teams driving the business. Management teams and
founders are vital to the creation and establishment of company values and
culture. In most cases, an investor is testing capability and
credibility, which in early-stage start-ups could be difficult, as information
availability is limited. Past track record, if available, would be helpful.
As an
investor, I recommend we find answers to the passion of driving the founders.
Skin in the game, an important tool to measure what percentage of owner’s
assets are invested in the company, is also an important determinant. I am
interested in owners who are fully invested and don’t leave the business in
economic downturns.
It is only during difficult times do we see wheat
easily separate from the chaff. As the business matures, I favor management
teams who efficiently allocate capital to high RoI initiatives.
Governance
An
independent Board is one of the most important factors to identify a
well-governed company. A well-structured Board can offer expertise to run a
business efficiently and sustainably for the long run while keeping in place
checks and balances for the short term. You may not get the most desirable
Board; however, as investors, we can insist on revising the composition.
Business
Agility
It is
important to note that agile businesses could also be fragile businesses, but
in the current times, business agility is synonymous with the ability to adapt;
e.g., can your business move from offline to online? Do you lose customers in
the process? What is the cost of moving entirely online? Is the supply chain
flexible to help achieve this? Business agility also helps companies quickly
adapt and respond to changing competitive environments. Was Nokia agile and
able to respond to the threat from Android and IOS?
The
fundamental test of resilient businesses has not evolved much over time.
Qualitative parameters have gained prominence, given the emphasis on
early-stage investing. However, after the current crisis and the lock-down, I
expect investors to be more cautious and invest more time in studying
quantitative parameters. Most investors would use quantitative metrics to
correct portfolio companies to help them survive.
There will be funds keen on making new investments,
and these funds will test new businesses for their ability to generate profits
and cash flows.
The epoch of
private investments driven by purely revenue growth at the cost of profits will
come to an end. Investors will sharpen investment frameworks to identify unique
businesses and use a far superior risk weighted investment approach in the
immediate future.
This post first appeared on Inc42
Media and has been published with permission. Click
here to read the article on ‘Inc42 Media.
Zephyr Management is a global emerging markets investment manager, specializing in the creation and management of highly focused private equity funds
Since its inception in 1994, Zephyr has sponsored and/or managed 26 investment funds in both public and private securities markets representing approximately $1.2 billion in combined commitments and assets under management
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The firm has initiated several private equity funds investing in several African countries, South Korea, Mexico, India, and Sri Lanka since its founding. Zephyr's funds serve medium size enterprises that are often ignored by larger private equity players. Zephyr funds provide growth capital to established companies with proven business models and sustainable competitive advantages.
Investment activities are currently focused on India, Sri Lanka and Africa.
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Zephyr Acorn provides equity financing and business support to innovative early-stage companies in East Africa.
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