All about CAP – Competitive advantage period
I am sure value investors would detest the idea of listening to What Mr Market is telling , however I think sometimes it does help to understand what Mr Market is telling us
All of last fortnight I have been engrossed in understanding few concepts ,this is my attempt to pen thoughts on them any meaningful consumption of them would require some work on your side so let’s start
Note this work is largely based on reading and understanding of this paper by Michael Mauboussin & Paul Johnson
First up is
CAP – Competitive advantage period
Competitive advantage period (CAP) is the time during which a company is expected to generate returns on incremental investment that exceed its cost of capital
To understand a company’s competitive advantages go through this
Now coming back to CAP.
A company’s CAP is determined by a multitude of factors, both internal and external.On a company-specific basis, considerations such as industry structure, the company’s competitive position within that industry, and management strategies define the length of CAP
What interested us was the use of CAP for security analysis , Michael Mauboussin & Paul Johnson slightly modified it and called it as market-implied CAP (MICAP)
Determination of the MICAP has a few steps. First, the analyst needs a proxy for unbiased market expectations as the key input into a discounted cash flow model (we use Value Line long-term estimates). Since, by definition, there is no value creation assumed after CAP, the model uses a perpetuity assumption (NOPATCAP/WACC) for the terminal value. Next, the length of the forecast horizon is stretched as many years as necessary to achieve the current stock price. This period is the company’s MICAP
In simpler terms, by breaking the current market price using the reverse DCF technique we can compute how many years market is assigning as CAP to the company. This is in built in the price, savvy investor would love to catch companies with expanding CAPs
Now let’s work through an example to understand this concept better , we will use ASTRAL POLY TECHNIK for our study
Current Market Price INR 385
EPS (Proxy for FCF) – INR 6
Return on Capital employed – 25% (Current)
WACC – 11% (Assumed value)
MICAP – No of years it take to make Present Value of future cash flows (A) and PV of terminal value period* (B) equal to Current Market Price (C)
Terminal value is the number when the company stops earning returns above WACC
Now both of the above running values can be easily calculated using excel
For ASTRAL the current market price has an embedded assumption that it is going to earn current incremental rates of return over cost of capital for next 17-18 years, MICAP for ASTRAL is 18 years as reflected in current market price
Now let me throw some more numbers for you
With above projection after 18 years how ASTRAL would look like this
Net profit – INR 3700 Crore ( Calculated at 18th year EPS * No of shares outstanding) FY 2014 number was 77 crore
Net sales – INR 37000 Crore (at 10% margin) FY 2014 number was roughly 1000 crore
As an investor this is what market is telling you, you have to make a subjective judgement and that will help you in buy and sell decision
Few tough questions you have to answer as an investor who will go long
- Can ASTRAL continue to earn 25% return on capital remember ?
- Can ASTRAL earn incremental rates of return over cost of capital for next 17-18 years or even more ? Is market under estimating or over estimating growth ?
- Can we really take EPS as proxy of FCF ?
A second important concept is that if the CAP for a value-creating company remains constant, an investor can expect to generate excess returns over time. Note that a constant CAP is contrary to economic theory, but it may be achieved through outstanding management (i.e., resource allocation, acquisitions)
In Indian context ITC has been a gleaming example of this.
As the investor purchased the shares expecting above-cost-of-capital returns for the implied period, the additional year of value creation represents a “bonus,” or excess returns.
As we see in above picture for ASTRAL if the eventual CAP is 20 years, the current discounted value should be 536 which is 40% above current market price, this is the excess return for investor when ASTRAL continues to earn incremental years even after 18 years
It appears that Warren Buffett has used this concept for years in his investment process. He buys businesses with “high returns on capital” (returns in excess of the cost of capital) that have “deep and wide moats” (sustainable CAPs) and holds them “forever” (hoping that the CAPs stay constant). Although this technique seems fairly straightforward, finding businesses with enduring CAPs is not simple
Using CAP to base your decision would need a very keen understanding of company and industry
Some Interesting CAP numbers at current market prices
Page Industries – 13 years
TCS – 10 years
Asian Paints – 20+ years
Symphony – 17 years
BHEL – 14 years
Suven Life Sciences – 6 years
MM Forgings – 15 years
Kitex garments – 11 years
ITC – 20 years