- Date : 03/06/2022
- Read: 5 mins
Investors have chased supernatural profits and also settled for reasonable returns. Let's figure out what is the best investment strategy as a long-term investor.
Investors want their money to grow. It remains their primary goal. To meet their expectations on return on investment, they invest in quality companies. Here, quality means companies with a sustainable business model, healthy cash flow, a strong team and robust planning. They read and decide based on the company's balance sheet and financials. Over the years, investors have adopted different investment techniques to filter out companies that fall into these criteria.
As a test of time, techniques have failed abruptly, and many gave multiple fold returns. Though market conditions are an influential factor, the investor risks their money with proper management skills and places their bets. The sustainability of businesses reflects the investor sentiment in the company.
Investors run behind two such techniques today. Super Natural Profits and Reasonable returns. Both are two different sides of the same coin. Let's understand the differences, pros and cons in this article and as an investor what you could do.
Super Natural Profits
A business will have Normal profits and Supernatural profits.
Normal profits1 is the basic level of profits to keep the company afloat in the business. This helps the company to meet the salary compensation of employees and gives a little reward to the owner.
By now, you could have guessed what supernatural profit is:
Super Natural profit is the excess profit that keeps the company in business. The surplus profit, after all the variable and fixed costs plus the minimum income for the owner to be happy in the business, is supernatural profits.
Supernatural profit = Total revenue - Total costs - Normal Profit.
It is the excess profit over normal profits and is also known as Abnormal profits.
Imagine yourself as an investor. Don't these supernatural profits look lucrative?
You might think that any investor who denies investment opportunity with supernatural profit is stupid enough. But there is a little catch to it. We will discuss and settle on a debate at the end of the article. Now let us understand reasonable returns.
For comparison, let's consider the simple yet most efficient metric, Return on Investment (ROI)2 which measures the value of your investments. It shells out how well or how badly your investment has performed regarding your initial investment in a year. It is mathematically expressed in percentages. So let's assume you invest a sum of Rs.1,00,000 and it grows at 15% at the end of one year. Now the value of your investment is Rs. 1,15,000/-.
This value at the end of one year is unrealized and can move up or down depending on the business performance.
So measuring your investments based on ROI is a powerful concept. To put into perspective, if your investments made 15% per annum, you belong to the top 1% of the investing population in India.
Now that you have understood both concepts as an investor, what is your approach? Let's break it down.
1. The Theory of Perfect Competition suggests that supernatural profits can be made only in the short term. In the long-run normal profits alone will be made.
But in the modern era, with tech companies that are into the profitable phase are giving extra supernatural returns to investors. As there is demand and price rise, tech companies can make supernatural returns for quite a good time now. It remains a question mark in the long run. We will leave it to time for an answer.
Take the example of Zerodha, India's largest broking platform, their PAT3 for 2021-2022 was Rs. 1000 crore, as their profits doubled over the previous year. With demand, a High barrier of entry for other players into the market and sustainable business, they made a staggering supernatural profit.
But not all companies in a similar line of business could make it like Zerodha. There is a lesson in there. Supernatural profits are an outcome of operating as a monopoly. So as an investor, if you are on the dire quest to invest in companies for supernatural profits, you might end up losing the increase in value of your investments in the same period.
2. Investors are playing the valuation game. Coal India, the largest owner of coal mines in Asia, has multiple tangible assets under its name, and operates at an enormous scale that we can't dare to imagine is valued less than Nykaa, an e-commerce store that runs on a website and ships beauty products across India.
But Nykaa, during its listing, gave 10× returns to its early investors. But as with PayTM, over-valuation played spoilsport to investors after it lost 60% of its market cap since listing.
End of Debate
Why are we talking about the downsides here?
Because as an investor, it is the risk that you should consider first, rewards are an outcome. There is unlimited potential upside.
Reasonable returns are enough to create generational wealth with prudent investing and impeccable patience over decades. Yes, supernatural profits are lucrative, but it is a long shot. In the end, all that matters is survival, not dismay in the chase of high profits as minister Piyush Goyal says.4