There are several business models which are seem to be inherently more risky and then there are some businesses which may not be risky to begin with, but changes in industry dynamics can make them risky for some time.
The indian pharma industry seems (atleast to me) to be one such industry. This industry is one of the few industries which is in the process to globalizing. A few years back companies like ranbaxy, Dr reddy’s lab etc got into the mode of releasing generics of blockbuster drugs which were going off patents. I remember distinctly that some of these companies were selling at fairly high PE. The analyst’s could see only a bright future and market was pricing accordingly. To be fair, there were murmurs of litigation risks etc, but somehow that was not visible in the price (with PE of 40 and more).
Later some of these companies had high profile clashes with pharma giants and lost some of the law suits. As a result the stock crashed when the expected payoffs did not materialise. I would look at this strategy of the pharma companies akin to bets in a casino, but where the odds in your favor. What I mean is that the expected payoff is positive in the companies favor, but often some of these bets could fail. So if the market values these companies as if all the bets are going to succeed, then there is a distinct over-valuation. But at the same time, every time a bet fails, if the market prices the company based on the latest failure, then there could be underpricing happening.
The problem (for me only) with the above business model is that I am not able to project the cash flow for such companies as I am not competent to evaluate the odds of success for such bets (investor who can could and should profit from it).
The business risk in the other globalizing star ‘IT services’ seems to be lower as these companies have used mainly labor arbitrage in the initial phases which is a lower risk strategy. However the market recognises that and has bid the stock prices up and so we have a lot of stock related investment risk.
I was have started analysing the textile industry recently. This industry seems to be globalising with the quotas gone. My initial thoughts on the business risk are
- execution risk for some companies. Not all managements have the capability to manage ‘hyper’ (50%+) growth. Look at arvind mills track record in mid to late 90’s. They invested heavily in denim using debt. The denim cycle turned south and this company was left saddled with huge debt
- Commodity nature of the product could result in pricing pressure on an ongoing basis
- Limited leverage with customers – Being a supplier to one of the major retailers will constantly expose these companies to pricing pressure and stiff competiton
Indian pharma companies are desirous of making money in the post-patent periods of successful drugs.But, from an investment point of view – it indeed is like placing your trust on the roll of the dice. I read somewhere that one should avoid investment whose success depends on the outcome of some binary/digital events.i have a hunch that the real options methodology can be used to tackle such situations. But then – should the small, individual investor summon enough courage to play Hiesenberg? i.e be the observer AND have an intimate stake in the experiment itself.The Hiesenberg tangent is just to bring out the notion that, usu. in such “fuzzy” situations, one fashions the analysis results to what he/she would like to hear.But Mr. Hyde in me is going after Orchid Pharma!
Business risk for some industry- The media company, technology and pharma companies have one thing in common, they all rely on the next big blockbuster product.For pharma it is the drug, for technolgy it is the software ( product) or the next big project (consulting/outsourcing IT ), for media it next big movie or program ( i.e. content).From the point of view of recurring revenue, in pharama you cannot predict the next blockbuster drug with any relaibility. It will probably rely on existing drug sales untill patents run out and genric hit the market while researching on the next drug.For media it is similar problem, difficult to predict the next big content leading to advertising dollars.For IT , the similar situation exist but risks are reduce because of recurring revenues through services and labor arbitrage as explained in the article.It doensot mean they are not worth investing, making a investment decision on the stock of companies in these industries is more of matter of timing and what cycle the industry is in. Overall I feel one has to make carfeul decision when coems to making investments in these stocks because the predictbilty of cahs flow is difficult. Investing in these companies is more like trying to hit jackpot on the slot machine, if you get it right you could make a lot of money.