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Company Analysis - The Power of Unknown Unknowns
Being at the right place at the right time
When we do fundamental analysis of a company, we analyse past financial performance of the company and then try to estimate future financial performance. Based on our estimated future performance, we discount these future cash flows and then arrive at the present valuation of the company. If we find that the present valuation arrived by us is higher than the value being given by Mr Market, then we may decide to invest in the company as the company is undervalued. In this post I will try to explain why estimated financial models often fail due to unknown unknowns. I will also explain how to deal with these unknown unknowns and take advantage of them.
At a February 12, 2002, news briefing, United States Secretary of Defense Donald Rumsfeld explained the limitations of intelligence reports:
There are known knowns. There are things we know we know. We also know there are known unknowns. That is to say, we know there are some things we do not know. But there are also unknown unknowns, the ones we don't know we don't know.
We can apply this same logic for analysis of a company. There are known knowns like past financial performance of the company which we can analyse by looking at the past few years financial statements. There are also other known knowns like present management of the company, present business model of the company, present market share, etc. There are also known unknowns like future growth potential of the industry, future market share of the company, succession plan of the management, sustainability of profit margins, etc.
We can arrive at estimated future cash flows of the company based on these known knowns and known unknowns. We can arrive at the present value of the company based on the same. One of the reasons why stock prices fluctuate is due to known unknowns. Mr Market’s opinion on known unknowns keeps changing every often. If our estimate of known unknowns is better than that of Mr Market i.e. if our estimate on the value of the company is more accurate than that of Mr Market, then we tend to beat the Market in the long term. We sometimes find that the value provided by Mr Market is lower than our estimates i.e. we find the company to be undervalued. We can take exposure in such companies and then exit once the company is being overvalued by Mr Market. This is how fundamental analysis works.
What about unknown unknowns and how to deal with them?
Like Mr Donald Rumsfeld said, unknown unknowns are the ones we don’t know we don’t know. If we don’t know that we don’t know them, then how can we deal with them? There is an indirect way of dealing with unknown unknowns.
There are two types of unknown unknowns explained as under:
Negative unknown unknowns i.e. unknown unknowns which have a negative impact on the company
Positive unknown unknowns i.e. unknown unknowns which have a positive impact on the company
To explain the phenomenon better, we can use the present COVID-19 pandemic as an example. The COVID-19 pandemic situation is a negative unknown unknown for few companies like Shopping Malls, multiplexes, amusement parks, tourism, aviation sector, restaurants, etc wherein a few months of revenue has been wiped out. COVID-19 pandemic is also a positive unknown unknown for few companies like food delivery apps, online education, OTT, broadband, sanitizers, etc. No financial model could have predicted this unknown unknown. All valuation models done in 2019/20 could have gone for a toss. In fact, Mr Market was also not sure of how the pandemic situation pans out.
Because of the uncertainty there is a huge spike in volatility in the market. Nifty VIX even reached 70 as against 10 to 20 during normal days.
The idea is to mitigate the impact of negative unknown unknowns and at the same time take exposure to positive unknown unknowns.
How to mitigate the impact of negative unknown unknowns?
We can mitigate the impact of negative unknown unknowns to an extent by looking at margin of safety in everything like as under:
Balance sheet strength link
Gap in actual sales vs breakeven sales link
Surplus cash flows being generated by existing businesses of the company link
Strength of the business model of the company using tools like Porter's five forces model link
Margin of safety in valuation i.e. gap in value arrived by us vs value provided by Mr Market
Comfort from past decisions of management, etc
Apart from all of the above, there should be margin of safety at a portfolio level also which help us avoid impact of negative unknown unknowns to an extent:
Avoiding excessively concentrated portfolios i.e. no single stock having significantly higher share in the portfolio. This will help us in restricting losses in case of a single company not performing due to negative unknown unknowns.
Timing i.e. an investor should not be in a situation wherein he/she is required to withdraw funds from the stock market to meet personal needs at the wrong time. An investor should build enough contingency funds to meet such requirements. Imagine withdrawing funds from the market during March/April 2020 when Mr Market is at its multi year low.
Regularly monitoring the portfolio companies to check whether our fundamental assumptions still hold good. If there is a change in any of our underlying assumptions while arriving at the estimated value of the company, then we will need to exit. While doing such monitoring exercises, we also need to learn to differentiate between short term blips vs long term trends (i.e. signal vs noise). We should not end up exiting a company due to short term blips.
The above mitigating factors at both company level and portfolio level will help us deal with negative unknown unknowns.
How to gain from positive unknown unknowns?
For a company to take advantage of positive unknown unknowns, the company should be at
The right place at the right time
When is the “right time” is not in a company’s hands, it is an external factor. When we are dealing with unknown unknowns we don't know what we are dealing with. Nobody knows when the Right time occurs. Instead what a company can do is to be at the right place “always”. This way, when the “right time” occurs, then the company can take advantage of the opportunity.
Now, how to be at the “right place” always? Following is what a company can do to be at the “right place” always.
The company should have an existing business which is generating surplus cash flows year after year. This existing business should have sustainable competitive advantage (i.e. moat). The company should use this existing surplus cash flows generated every year to maintain a strong balance sheet i.e. having zero or near zero debt and having surplus cash reserves which are not required in existing business. Once the company has a strong balance sheet with adequate surplus cash reserves, then the company can use remaining surplus cash being generated every year to take multiple small bets. This strategy will help the company in two ways:
Surplus cash reserves will help the company grab an opportunity (positive unknown unknown) when it knocks the door.
Surplus cash reserves will also help the company deal with negative unknown unknowns.
One of the multiple small bets can end up being a positive unknown unknown.
Single large leveraged bet will put a company in a situation where it will not be able to deal with negative unknown unknowns. It'll end up ruining the company during a negative unknown unknown event. Instead, unleveraged multiple small bets avoid such situations.
Let us understand this strategy using a few examples.
Info Edge (India) Limited
Info Edge has a very strong existing business i.e. naukri.com which keeps generating surplus cash flows every year. The company uses these surplus cash flows to make multiple small bets. The company over the years made multiple bets in various businesses like 99acres.com which is in real estate sector; jeevansathi.com which is a matrimonial website; Zomato.com which is into restaurant listing and food delivery; siksha.com which is into education space, etc.
One such bet turned out to be a blockbuster hit. It is none other than Zomato. The company first invested in Zomato in 2010 with an amount of Rs 4.7 Crs. The company clocked returns of 1050 times in its Zomato investment. This is one of the primary reasons for appreciation of stock price of Info Edge over the past few years.
During the past 10 years, naukri continued to be a cash generating machine for Info Edge. All its multiple bets are yet to generate sustainable positive cash flows. The positive unknown unknown here is the change in business model of Zomato. Zomato’s business model when Info Edge first invested in 2010 is to provide information on restaurant menus, food reviews and dining options. Zomato in 2015 pivoted into the food delivery business for restaurants. Info Edge or Zomato or anyone could never have imagined this pivot. This is how positive unknown unknowns work.
Reliance Industries Limited
Reliance Industries also has an existing strong sustainable business i.e. petrochemical, refining, oil and gas-related operations which keeps generating surplus cash flows every year. It used these cash flows to take multiple small bets (small when compared to its balance sheet size). One such bet is Jio which is the primary reason for a spike in share price after multiple years of negligible returns. Jio was launched in Sep 2016. Jio’s share in EBITDA is now nearly 35% of that of Reliance Industries Limited.
No one could have imagined the kind of impact Jio would create in the telecom industry back in 2015. That is the reason the stock returns were negligible from 2007 till 2015. Post 2015, the market capitalisation of the company multiplied 4 times which is not a small feat when we consider the fact that Reliance Industries is one of the largest companies in India. This is a positive unknown unknown.
Launch of Jio is however a negative unknown unknown for another company i.e. Vodafone Idea Limited.
Apart from Jio, the company is also suffering from another negative unknown unknown i.e. AGR issue.
Eicher Motors Limited
The company in 2008 had one main business i.e. Trucks and one small business i.e. motorcycles. Its truck business is a cash generating machine.
Motorcycles contributed to a small percentage in revenues and profits back in 2010. Now it is a major contributor to revenue and profits of the company. Motorcycle business is the primary reason for stock price appreciation in the past few years. Whoever analysed the company in 2009 or earlier would not have attributed any value to its motorcycle business. This is another example of positive unknown unknown.
What can an investor do to gain from unknown unknowns?
Invest in companies which are:
undervalued based on analysis of known knowns and known unknowns
having strong balance sheet and surplus cash reserves
atleast one existing cash generating business with strong moat which generates surplus cash every year
management who is willing to take multiple small bets without leveraging their balance sheets