The secret to that lies in the answer to this question: What makes successful businesses? Of course, successful businesses are those that can earn money. The following factors may shed some light on whether the business in question is making money.
Business continuity
First, look at continuity of business. Take the instance of a company in the electronics sector. The Indian government-owned ECTV closed down operations when it failed to take advantage of other business opportunities. It was once the largest seller of television sets in the country. Another example in this industry was Videocon VCR, which was set up as a stand-alone manufacturer of VCRs. The company failed to be alert to technological advancements, which sounded the death knell for the outdated VCR and obviously for the company too!
Adequate capacity
Second, look at capacity. How big is beautiful? Size brings in economies of scale all right—cost is spread over a larger output, bringing down the overall cost. But bigger isn't necessarily better in this case. Companies can grow out of control. Arvind Mills built 10% of the global denim capacity, creating an oversupply situation. When these capacities went on stream, prices of denim dropped and the infrastructure costs just killed the company. Arvind Mills couldn't go close to achieving full capacity in its manufacturing, which it needed to do to be viable.
Something
similar happened to Core Healthcare. The company scaled up its
capacities to 60% of India's IV fluids capacity. The market just could
not absorb this capacity and its quality was found wanting in the
international market. The obvious happened: losses mounted and the
company completely eroded its net worth. Big could also mean small, but dominant in its area. Small companies in niche segments which nevertheless rule their sectors. Like Himatsingka Siede, a designer house that made it big in the international silk furnishing business, catering to a select market and never going in for the overkill.
Capacity as much as the market needs,
not how much the company can make
not how much the company can make
Survival ability
Competition kills and this is one major cause of failure. Hindustan Unilever has over the years taken the competition to its rivals and expanded its portfolio. When growth from its bread and butter business of detergents and soap was plateauing, the company found new outlets to grow. In the last three decades, this survival skill transformed the company into an FMCG conglomerate with powerful cash flows. The survival factors here are more to do with the ability of the management to see future trends in their business.
Subsidies and barriers to entry
In numerous cases, to encourage the development of a business or of society, governments resort to subsidising services and equipment in order to make it viable for manufacturers to develop infrastructure. But such sops-dependent businesses may not make for wise long-term investments. Once such benefits are withdrawn, as they must eventually be, companies are exposed to the cold chill of ruthless competition, which may squeeze margins and reduce cash flows. Monopolies also bring with them inefficiencies that are hard to scale back in a free regime.
Talking
about subsidised businesses, Renewable Energy Systems and NEPC Micon
are two companies that actually thrived on subsidies to grow their
profits. That's all they did. In a crunch, when subsidies were
withdrawn, they found themselves uneconomical and unviable because their
products weren't as efficient as alternatives available in the market.
The markets have recognised these factors at the earlier stages and
valued these companies at a meagre ten times their earnings.
Monopolies
and subsidised business come with a disclaimer: Though cash flows are
strong, returns will exist only as long as the happy situation does
Minor points to watch, from the company's viewpointAppropriate infrastructure: The infrastructure should complement the market where it sells its product or where it procures its raw material. You can't have a cement plant in Karnataka and try to service the Delhi market. It would be far more expensive just to transport goods that far, thus spiralling costs.
Watch competition
New capacity creations: Most capacities in any business come in at the peak of the business cycle. This generally leads to a drop in selling prices as new capacities mean more supply. And a demand drop would hurt the players in that field.
Increase in capacities usually comes at the crest of the product cycle
Cost management: The company should have a suitable cost structure for the business. Lower costs enable the company to survive in a down phase well. In an upward business cycle, good cost management implies higher profitability.
Efficient companies go the distance. In an industry revival, these are the first to rebound
Products with stamina: Look out for opportunistic businesses. There have been small niche players who have tried to identify and milk insubstantial opportunities. For instance, a small company, India Food Fermentations, tried to market the concept of dosas as fast food through a vending machine, Dosa King. This company went bankrupt.
Novelties don't make lasting businesses
The above factors were about as comprehensive as we could cover them. These are, broadly, the most common factors one encounters as an analyst in the process of sieving out companies eligible for investment. Sharekhan’s Stock Ideas are well-researched companies with sound fundamentals. In order to get healthy returns on your portfolio over a longer term, invest in Sharekhan’s Stock Ideas, which presents our best stock picks in today’s market.
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