Utpal Sheth: Leadership and long-term mega trends: Utpal Sheth on identifying ‘Gorilla’ companies

We have already established that differentiated insights is the root cause towards those components building up the courage, the conviction, the patience, the equanimity and the sell decision, all in terminal value investing.

Today, we will talk about what are the components of that differentiated insight, what are the factors which contribute towards creating that terminal value.

So, as a terminal value investor, one must have the differentiated insights and to have those differentiated insights, one needs to understand what goes into creating terminal value. We have already established that value creation is different from wealth creation. So, in my experience, there are three large components that create terminal value about which the terminal value investor should have differentiated insight on and those three components are intangibles, megatrends and leadership. And let me go into why. Over the years, I have seen that the investing world has evolved in such a way that intangibles now make up bulk of the value in any company. There was once upon a time when bulk of the value was made up by tangibles. I am talking of maybe 80s.
Can you explain that for us?
In the 80s, it was very important for investors to be able to, let us say, see the plant, assess the plant. If that investor was investing in, let us say, the cement sector, then he or she had to understand what was the capacity, what was the EBITDA per tonne and maybe also what was the replacement value.

However, the world has moved away from such tangibles to intangibles. So, rather than giving you the context in Indian examples, let me give you global examples. There is a study which you will see on the screen in which in 1975 in the US about 20% of the value was said to be intangibles and 80% was said to be tangibles.

In 2020, the same study specifies that almost 90% of the value is of intangibles and the balance 10% is of tangibles. So, what really are intangibles? Intangibles are soft factors. They reflect certain qualities which are intrinsic to the company, which do not change easily.

So, I am sure you recollect Charlie Munger talking of franchise businesses. That franchise business is effectively an intangible. But you will also find that the culture that a company creates is also an intangible.

For example, Coke is a brand and Tata is a culture.
Yes, but also let us say there is a culture of innovation at Apple, let us say, or there is a deep customer understanding at Apple.

These are intangibles.
These are intangibles. So, that culture has a lot to do with regard to the terminal value. You will find that all great companies which create a lot of terminal value will have a culture, may be a culture of excellence, may be a culture of innovation, may be a culture of frugality.

There are many frameworks of that, but there is something special about those companies. And as an investor, are you able to assess that something special in that company? Those are intangible. Sometimes the brand could also be an intangible. Sometimes the distribution network is an intangible.

But you have to be able to put your finger on what is special. Sometimes it is not just one thing. Sometimes it is a bundle of a few things. That is fine as well. So, I think terminal value creation without having some intangible is quite difficult. You may create interim value, but that value may not sustain over the really long term. It may sustain for a few years, no doubt about it.

Which means a terminal value investor will never buy a cyclical company, it will never buy commodity companies, it will never buy companies which essentially are exposed to global ups and downs. Is it simple way of putting it?
See, the sector and the cyclicality are incidental. For the terminal value investor, he has to see something special in that company. If hypothetically you find in any sector some player in that sector who can overcome the challenges of that sector, maybe overcome cyclicality by changing his business model, maybe overcoming the perception of it being a commodity by differentiating better, then the terminal value investor should still consider those.

When you are judging intangibles, it is important to look at the track record. So, can I say when you are judging intangibles, this is where it is an art, you need to have a track record of 5 to 10 years of existence of the company, then only a terminal value investor will make up its mind?
Probably true. But I think there are exceptions, especially in new-age companies you have to act differently. Also, certain conventional companies, you are able to see change of the management teams or change of generations which is changing everything about that company.

One more follow up question on intangibles because markets they always tend to focus on who is the CEO, who is the CFO, who is the promoter. A good promoter can turn a bad business into a good business and a bad promoter can mess up a good business into a bad business. In your overall judgment of intangible, what weightage do you give to the promoter and the team who is running it?
I would say very high. To my mind, the promoter and the management team actually determine the culture of the company. They determine the business model of the company. They determine what their team members feel when they are part of that company and they determine how their team members interface with their customers. I think it is very important, I cannot emphasise it more.

For a terminal value investor, it is important to look at sustainability. Sustainability is a function of an intangible. It could be brand, it could be distribution, it really could be cost advantage. But what are the other factors which a terminal value investor looks at apart from intangibles?
Apart from intangibles, as I explained to you, the terminal value investor should also focus on megatrends and leadership. What are megatrends?

First of all, megatrends are not fads. Megatrends persist for decades and they bring about a paradigm shift in the minds of the consumer. The consumer may be a retail consumer or enterprise consumer. Megatrends are typically inevitable and irreversible. Unless you can clear those two filters, you would not focus on megatrends. I mean, then that trend is not a megatrend.

So, as I said, decades, inevitable and irreversible because if something is irreversible, then what kind of a megatrend is it. Now, these megatrends need not always be just applicable to one country or one sector. They could span across sectors, across countries. It could well be global megatrend.

Why are megatrends important? Because if you bet on a sector which does not have secular and structural tailwinds, rising from that megatrend, then the only scope of growth is to take away market share from someone else. Then, you are investing in a company which itself is playing a finite game, whereas as a terminal value investor, you want to play an infinite game.

Therefore, you need an expanding TAM, total addressable market. And what can give you that expanding TAM? It is a megatrend which gives you that expanding TAM. However, just because you bet on a megatrend and that bet was right, the choice of the megatrend was right, does not mean that you will win as an investor with great terminal value.

It is equally important that you are able to assess and partner with the leader in that megatrend. There has to be some element of leadership and these three key components together create that terminal value, but actually speaking they create gorilla companies. They create gorilla companies which create terminal value. Why am I using the word gorilla? Because the confluence of these three factors results in what I call as gorilla companies. In any jungle, there are gorillas and there are monkeys. Gorillas have certain characteristics. What are those characteristics? First and foremost, gorillas are rare. You may find thousands of monkeys in a jungle, but in that jungle, there may not be too many gorillas, a handful of gorillas. Second, gorillas are dominant.

You will find cluster of hundreds of monkeys, but you will not find those monkeys clustering around the gorillas.
The gorillas are dominant, they dominate their space and keep the monkeys away.

And how does that happen? Because the gorillas not only have that personality or character trait, but they can be lethal if required. They create a virtual moat around them which is why the monkeys do not come close to them. Therefore, gorillas you will find always have moats around them, virtual moats, it may not be a physical moat.
And lastly, the average lifespan of a gorilla is far longer than the average lifespan of a monkey.

So, gorillas have longevity. You talked about sustainability. More than sustainability, I think longevity is important because these leaders when they get that longevity, they unleash that flywheel, that power of compounding to keep becoming greater every year.

So, my submission is that when you find intangibles, megatrends and leadership all together, then the probability of a very large terminal value becomes much higher. And you need to understand these three components better than most other investors, which becomes your differentiated insight. Now that we have discussed the concept of gorillas, you will appreciate that it is important not just to hunt in the right jungle, but also hunt for the right animal, which is to find the right jungle and the right animal, you have to have megatrends and leadership together. And they will not be together if the intangibles are not there.

So actually, you have to find the confluence of each of these three key components that create terminal value. Is it that there are no other factors that create terminal value? There are. But these three make up the lion’s share of factors that create terminal value. And in many ways, they are self-reinforcing factors as well. So, there may be some overlap as well. But which is fine, we are not here to dissect, we are here to synthesise all of that together.

To put it very simply, purely from a viewer’s curiosity is that we do hear a lot of comparison about X has happened in China, the same will happen in India. X has happened in US, the same will happen in India. The per capita of India eventually will grow because other developed countries have the same thing. So, can I say that identification of a megatrend should the starting point for the investor here should be look at globally and what has happened globally will happen in India because that is the path on which we are growing?
See, more often than not, you will find that to be true. But there could be megatrends which are specific to India. For example, probably no other country has built the kind of public digital infrastructure backbone that India has built. How will you then extrapolate those learnings here? Second is India could maybe have an urban density which you may not find in most other countries and therefore there may be certain megatrends which evolve out of that. So, one has to keep an open mind and it is not necessary for a terminal value investor to catch every megatrend. Because we are all humans. There is only so much that we can do. You have to catch those megatrends that you understand well and that you have conviction in. Then, find leaders within that megatrend to go back in time. In let us say in the 90s, if one had correctly identified the IT sector megatrend but had bet on certain unscrupulous companies in that sector which were prevalent then and not bet on the true leaders who had the culture and the management quality to navigate every challenge and to keep scaling, then one would not have been a terminal value investor, one would not have created that kind of wealth. So, all three of them are equally important.

First identify the megatrend, badi picture jise hum bolte hain. In that identify the hero of that badi picture and then look at the edge that hero has which is wo comedy achi karta hai, ya phir wo fighting mein acha hai, ya phir martial art mein acha hai. Am I putting it very simply?
Yes, something similar.

Again, with every episode, before we summarise, you also give a sneak peek. So, we have identified megatrends, but give us a sense of one megatrend, which is the obvious megatrend. We all have experienced it, but we have just not acknowledged it.
I think there are many megatrends and we will be talking about some of those megatrends. But if you ask me one, then I would say female labour force participation in India is the megatrend which I feel is least appreciated and has tremendous potential, both for India as a country and for what it can do to Indian businesses.

I just want to use this example again for the benefit of our viewers. If one really looks at the IT companies in 2000, the pecking order was TCS; Infosys; Wipro; Satyam, it is no longer there, unfortunate fact; and it was HCL Tech. And today also, while IT has been a megatrend, the pecking order keeps on changing 1, 2, 3, 4, but 1, 2, 3, 4, they always remain the same, that is the art of identifying the leader.
Yes, but they are leaders for a reason. They are leaders because they have maybe the right culture, maybe the right business model, maybe the execution mindset, maybe the adaptability and so on, the ability to pivot because the IT that you were doing in the 90s, prior to Y2K and the IT that you are doing over the last 25 years is totally different.

When you look at, you look at intangibles. One of them is the promoter quality. Apart from that, what are other intangibles which you think you need to always look at?
I think customer loyalty, brand, distribution network, there are many kinds of intangibles. Of course, promoter quality is very important, it is essential across every company that you look at. But there are all of these as well. And you may not find all the intangibles in every company, you just have to find a few that you can understand and you can bet on those intangibles. You cannot bet on something that you do not understand or do not appreciate. And it does not have to be rocket science. As you know, Peter Lynch talks about in his book, he would look at companies even as a customer of those companies, not just as an investor of those companies. I do not see that as a challenge. The challenge is that these intangibles are soft factors, not always obvious, not always apparent.

I have a personal question for you, which is that how do you keep yourself updated? They say that terminal value investing or any form of investing is just not reading balance sheets, it is just not attending AGMs, it is also understanding different nuances of life and then you connect it. How do you keep yourself updated? What is that you read? What is that you are always, because you are very curious by nature, how do you keep fuelling that curiosity?
See curiosity is surely important, but the ability to connect dots is even more important. Now, somebody can connect thousands of dots, somebody can connect tens of dots and somebody can connect a few dots, does not matter. You focus on those dots that you can connect, but you do need the ability to connect those dots and for that you need both breadth and thereafter depth.

The breadth is important so that you can appreciate a lot of things happening globally, locally, etc, and in different dimensions, could be at a technology level, could be at an economy level, could be at a country level, geopolitical level, whatever, but you also need the depth. So, it is not an easy combination and I am not sure that every terminal value investor has all of it. You have to keep working on it to have more tomorrow than you have today. You have to keep raising the bar for yourself.