Continuing Customer Businesses and Stock-picking

We discussed product characteristics of a consumer business, consumption pattern and what role it can play in stock investing in the last post. Taking the theme forward, this time we look at continuing customer businesses and their role in stock-picking. You must have observed that there are many businesses that do not toil that hard to get a large chunk of their customers, those customers are already there, and it’s only for the net incremental customers they focus their energies. Are you wondering what do I mean?

Let’s look at this dimension of assessing business advantage a little more closely.

1.      Housing Finance Companies – These are businesses where customers are continuing y-o-y and generate revenues for the company for a long time. Take example of a Gruh Finance. It gives loans for 10 years or longer. Once a customer is acquired, he/she is a source of income for Gruh for the next decade or so. No more investments needed in retaining this customer, except of course the right customer service & home loan rates. Isn’t it a great business to be in? Theoretically speaking, one can move his loan from one HFC to another, but that number is not so large. Compare this with a Videocon manufacturing TV sets or a Whirlpool doing refrigerators that has to toil hard, against all competitors, to acquire every single customer every year.

2.     OEM suppliers – In businesses like auto ancillaries and other OEM suppliers, we have companies with an assured customer and offtake. Take example of Motherson Sumi, Amtek Auto, Suprajit Engineering etc. In that sense, they have customer continuity with large auto companies or  industrial giant supply chains. The downside is however in their bargaining power. Supplier companies are the price-takers and at times, struggle to protect their margins. Having said that, there can be quite a few that enjoy premium positioning in their supplies, quality control and delivery schedules.

3.      Rating agencies – Here is a business where the companies stick with a particular rating agency (CRISIL, ICRA, CARE, Fitch), and then you have annual surveillance to get the rating refreshed. There are numerous instances when after many years of rating association, a particular rating agency “stopped” understanding their business model in a favourable light and the company goes for a new rating agency. Still, it’s a fairly stable business insofar as continuing customers are concerned with little investment involved in customer retention.

4.     Cable & Telecom operators – In theory, you are a fairly stable revenue generator for your cable TV operator (Dish TV, Tata sky, Sun TV, Hathway or whoever you’re with) or your telecom operator (Airtel, RCom, Idea etc) over a period of time. In reality, however, there is fair bit of switching occurring in these segments due to consumer preferences, cost considerations, service standards, package offerings and so on.

5.     Tollway companies – These sound great from continuing customer perspective. Daily commuters have to pay to cross that road or bridge. It’s a different matter that in Indian markets, two of the better known names in this business are having a rough weather – Noida Tollbridge for uncertainty over its concession agreement terms, PILs filed against toll hike and IRB Infra over corporate governance issues.

6.     Habit forming businesses – I could have done without including these businesses here. The category title I have given is also not very accurate. But customers keep coming back to cigarettes, tobacco & liquor companies, however bad their products may be from health point of view.

There can be many more ideas where customer continuity is far more assured than normal businesses. Obviously, this cannot be the sole criterion of stock-picking. A good combo of business & financial factors coupled with this aspect of investing can make a lot of sense and create enormous shareholder value over a period of time. Do share your stock ideas and themes that look attractive from customer continuity perspective.

Consumer Stocks – Do Product characteristics of business matter?

There is a lot spoken about the boom in consumer stocks, the hyper valuations these consumer stocks are quoting at in the markets, demographics of Indian economy, ever growing middle class, etc.  In all this noise, one aspect that I find generally ignored is that there is very little discussion on the product characteristics of business or consumption patterns from the investing standpoint.

I mean all “consumer facing” businesses cannot be clubbed into one large basket with skyhigh price multiples assigned. After all, they are different breeds and animals which will find their own paths over a longer period of time. Let us analyze this little deeper from view of consumption pattern:

1. Consumables vs Durables – The most obvious distinction to be made when discussing consumer businesses is consumer goods in contrast with consumer durables.  While both the segments are witnessing growth, it’s the consumer goods (FMCG) theme that keeps adding new product categories that were not present before. For instance, we see in the marketplace a host of anti-ageing creams, beauty products, differentiated food supplements, health drinks with a thrust on premiumisation not seen before. FMCG industry in India is projected to become Rs 4 lakh crore industry by the year 2020.
2. Brand stickiness – With rising per capita income and growing rural prosperity (relatively speaking), there is a structural shift in consumer demand towards brands and organized products. Brand play is more evident in consumer products that any other product category one can think of. The chances of your changing your toothpaste or soap brand every single time one purchases is very less. Generally, consumer tend to stick with their brands as they get conscious of the segments and lifestyles.
3. Repeat purchase – To put it simply, the consumables vanish after one use, necessitating repeat purchase. You need a toothpaste, soap, detergent, hair oil (ok, till you have hair on your head) pack after pack all your life. That sounds simplistic, isn’t it? But that’s a fact and the business opportunity these guys are looking at. On the other hand, in durables segment with longer shelf life there is an onslaught from the Koreans & Chinese making life difficult and margins thinner.
4. Fashion & technology trends – Consumer preferences change with the times and need for innovation is a constant. Growing youth population is very conscious of what they consume.  At the minimum, re-packaging in different SKUs and appealing advertising is a must. We have seen even some of the giant companies of yesteryears (like Kodak) getting marginalized due to not keeping pace with ever-changing technology.
5. Target User group – I include it here from the viewpoint of total addressable market and the ultimate growth. If you’re talking about shaving blade & products, half of the population (female folks) is straightaway not the market. Of the remaining, you have below 16s who don’t need to and beard-sporting who don’t prefer to shave. Come to think of it, a toothpaste or soap company has no such limitation on its addressable market – entire country is its market. So the point is, other things being equal, would you like to give a PE multiple to a razor company as high as to a toothpaste company.
6. Staple vs Discretionary – Another important distinction to be made is consumer staples vs consumer discretionary products. Demand for consumer staples doesn’t decline appreciably with seasons and cycles. With increase in inflation and pressure on disposable incomes, discretionary spends are the first to be curtailed by consumers. Jewellery is one such discretionary spend, except for marriage type of purposes. Of course, the recent spurt in jewellery stocks doesn’t seem to support my view, and these are rocketing like no tomorrow.
7. Market positioning – Leadership in market position backed by brand power ensures steady growth. The market leaders have generally the first-mover advantage in introducing new products and break-through technological processes given their superior product portfolios. It imposes high entry barriers for new players.  With competitive intensity in consumer space, market leader companies are constantly looking for volume growth, maintaining their market position and guarding that distance from their next competitor (in market share).
8. Pricing Power – Strong consumer companies are in dominant position in their respective categories and command significant pricing power. For example, tobacco & IMFL (I personally avoid both segments for reasons of socially responsible investing) companies demonstrate that kind of pricing power since their consumers are habit forming and keep coming back. Similarly, baby food is a near monopoly for Nestle that gives them pricing power.

There are a lot many factors however, in financial and management terms, and some of the determinants of PE we discussed in a previous post here and here.

In conclusion, I’d say it’s important for a retail investor to be mindful of the product characteristics of the business and consumption patterns while analyzing a business : the addressable market, the seasonality & cyclicality attached to the products, strong brand or absence of it, market positioning & pricing power, any moat that protects the premium positioning.