Tuesday, February 19, 2019

Companies need to qualify a rigorous screening process

Nalanda adopts a rigorous screening process to select potential portfolio companies. The four screens are: high return on capital, attractive industry, clean and outstanding entrepreneur, and an asymmetric risk-reward trade-off.

  • High return on capital - Nalanda invests in only those companies that have, or have had a consistently high return on capital. This includes companies that may have had a temporary decline of returns. Being a long term (and not momentum) investor, Nalanda’s approach is to invest only in high quality businesses, and return on capital is a very good indicator of the quality of the management team and the competitive advantage of the business of the portfolio companies.
  • Attractive industry - Nalanda analyzes the industry structure, conduct of industry participants and performance of key companies in the industry to assess if the industry is attractive from the point of view of long term value creation. Industry analysis in India is made quite difficult by the high growth rates of companies and changing dynamics of the competitive environment. Also, many Indian industries are not likely to follow the path of industries in the west (e.g. information technology services), and so, a bottoms up analysis and independent thinking is required to develop a point of view.
  • Clean and outstanding entrepreneur - Nalanda’s focus has been and will be to back entrepreneurs who are clean and transparent, and have an outstanding track record. This assessment involves doing a lot of reference checks on the entrepreneur and the management team. Nalanda needs to be convinced that the company is a “leader”. It need not be a leader in market share or volume, but the management team needs to demonstrate its leadership in some area(s) that could potentially create significant value in the future. For example, the company may be a leader in profitability, it may be a leader in a fast growing and potentially large niche segment of the market, it may be a leader on cost structure, or in creating and spotting opportunities that competitors have not been able to match.
  • Asymmetric risk-reward trade-off - Ultimately, Nalanda will perform well only if it ends up getting disproportionately rewarded for the level of risk it assumes. In other words, it seeks situations where there is an asymmetry in the risk and reward. This involves assessing the probability and quantum of various outcomes through a rigorous financial modeling process, and a thoughtful qualitative analysis of the industry and the management team.