Saurabh Mukherjea's investment mantra to navigate
through a crisis: Part-1 To 5
Saurabh
Mukherjea and his team give tips on investing during tough times
The year 2019 ended on a pretty
strong wicket for equity markets around the world. Most major indices were up
10-25% during the year. The Dow Jones increased investors’ wealth by ~22%, the
FTSE, Hang Seng, and India’s Nifty by ~12% and the Nikkei by 18%.
However, 2020 brought with it the
rumblings of what eventually became a global pandemic, bringing some of the
largest economies of the world to a standstill. As Covid19 spread worldwide,
stock markets crashed globally, with many indices recording their worst-ever
quarter performance and many others seeing the fastest-ever correction in
recent history.
In India, the broader markets were
anyway appearing shaky due to the weak growth in corporate profits for the past
6-7 years. Then came Covid-19 to add to investors’ troubles. And in the middle
of all this came the collapse of Yes Bank. In a matter of weeks, the stock
markets and the larger economy were dealing with a full-fledged crisis.
In five parts, Saurabh Mukherjea, founder of Marcellus Investment Managers,
and his team elaborate on their investment process and emphasise on the
techniques that have helped their fund navigate through tough markets and
a crisis.
Part 1
India is blessed with several companies
that have the unique combination of market dominance and return ratios far in
excess of the cost of capital. The resulting free cash generation enables these
companies to reinvest back into their businesses to keep strengthening their
dominance and return ratios. This cycle gives an opportunity to invest in these
businesses and see your money compound at a steady rate over long periods of
time.
Economic theory dictates that in a
competitive market, no firm can consistently earn a return much higher than its
cost of capital. This is because the excess returns will attract more
competition, which will, in turn, reduce the profitability of all players
operating in that market.
By extension, this means that in a
competitive market, even a business that has a large or dominant market share
in its industry will earn returns on capital employed (ROCE – earnings
generated on each unit of capital employed on the balance sheet) or Returns on
Equity ( RoE – returns on each unit of equity invested in the business) close
to its Cost of Equity or Cost of Capital.
It is not hard to find global
players who dominate their industries – Walmart dominates US grocery retailing,
Carrefour dominates French grocery retailing, Toyota dominates the mid-segment
car market in Japan, Hanes dominates Europe’s innerwear market. However, none
of these companies make ROEs substantially higher than their cost of equity
(see table below).
In India, on the other hand, there
are several industries where one or two companies not only have a dominant
market share, but their RoEs have also remained substantially above the cost of
capital (CoC) for several decades in a row (see Exhibit 2).
The strong pricing power and
competitive advantage of these Indian firms is what sets them apart from their
global counterparts.
The gap between RoCE and CoC is the
free cash flow that a firm generates for its shareholders. Provided these firms
sustain this wide gap whilst also growing their capital employed, they will
generate healthy earnings growth consistently over long periods of time,
regardless of changes in the internal or external operating environment of
these companies. We call these firms ‘Consistent Compounders’.
Once an investor builds a portfolio
of such firms, all that she should do is hold them for long periods of time and
benefit from the power of compounding of healthy returns, with the volatility
in these returns being similar to that of a government bond!
This sounds very simple, but simple
is not always easy! You need to first figure out what exactly is a company’s
competitive advantage that helps it dominate its industry and generate returns
much higher than its cost of capital.
Second you need to assess the
sustainability of the competitive advantage, which will enable the company to
maintain its dominance and free cash generation ability for long periods of
time – keeping in motion a cycle of earning returns much above the cost of
capital, deploying the resulting large free cash flow to grow its business,
profits and market dominance, in turn further strengthening its competitive advantages
leading to higher free cash flow.
For example, it is easy to find
firms like Maruti Suzuki, which has maintained its industry dominance (>50%
market share of cars in India), but its average 10-year ROCE is just 17% – like
that of Toyota and Hanes highlighted above. Or take the example of Hindustan
Unilever (HUL), which sustains a wide gap between RCE and CoC, but does not
find avenues to grow its capital employed and hence, despite maintaining
>80% ROCE over the past 10-15 years, has generated an annualised earnings
growth of only 8% (CAGR) over this period.
Without a thorough understanding of
a company’s core fundamental strengths, one may make an initial investment in a
portfolio of Consistent Compounders, but may have a less than ideal percentage allocation
in the portfolio and/or a shorter than ideal holding period of such stocks in
the portfolio. So let’s use a case study to understand how a company builds
sustainable competitive advantages and becomes a Consistent Compounder.
Case Study of a Consistent
Compounder: Asian
Paints
One of the biggest challenges in
running a decorative paints business in India is that being a chemical, paints
are highly voluminous products. The average realisation of a decorative paint
in India is around Rs 100 per litre – 10-times more voluminous than say FMCG
where the average realisation is around Rs 1000 per litre.
This characteristic makes it
challenging to store and transport 4000+ SKUs of decorative paints to 70,000+
dealers across the country. The easiest way to overcome this challenge is to appoint
various layer in the distribution channel – third-party C&F Agents,
stockists, wholesalers, distributors etc – and let the voluminous product be on
the balance sheets of these channel partners while the supply chain through
these distribution layers. This is exactly how paints used to be distributed
before the 1960s.
However, as Asian Paints became the
market leader, they ended up redefining the supply chain dynamics of the
decorative paints industry in two ways.
Firstly, Asian Paints reached out
directly to the paint dealers on the high-street, without any involvement of a
distributor / wholesaler / stockist etc. This has meant that decorative paints
is perhaps the only mass-market product sold in India directly to 70,000+
dealers on the high-street by the manufacturer.
Secondly, although MRP printed on a
box of decorative paint gives a healthy margin to the dealer, the price at
which these products get sold to customers leaves on average only ~3% margin
for the dealer – one of the thinnest margins available to the last-mile
distribution layer across all B2C categories.
These two changes (direct supply to
paint dealers, and only about 3% average margin of the paint dealers) has
totally changed the competitive advantage framework for this industry. Let’s
delve into this further.
The choice of product manufacturer
(and hence the driver of market shares) in a paint project is not really done
by the homeowner because he chooses products of the company whose shade-card is
brought to him by his trusted contractor / painter (i.e. the influencer).
The painter, in turn, chooses the
shade card based on ready availability of all SKUs on the shade card at all
points of time with the nearest dealer – this is because paint inventory has to
be replenished few times during a paint project and the painter’s team of daily
wage workers cannot afford to sit idle due to stock-outs of one of the 4000+
SKUs at the nearest dealer’s shop. Hence market shares in the industry are
defined by what the paint dealer decides to stock most readily in his shop. Let
us now focus on what drives decision-making of the paint dealer.
The largest element of capital
employed for a paint dealer in India is real estate. On this real estate, the
store economics for the ROCE of a kirana (convenience store) are totally
different from that of a paint dealer.
Firstly, on the same shelf space, a
kirana can stock 10x more value of FMCG products compared to the value of
decorative paint products, given the voluminous nature of paints (as quantified
previously). Secondly, the margin available on each Rupee of sale for a Kirana
is 4x higher than that of a paint dealer (12% for a kirana store vs 3% for a
paint dealer).
Hence, the only way for a paint
dealer to generate ROCE similar to that of a kirana, can be by offsetting the
40x differential (10x multiplied by 4x) through inventory turns which are 40x
faster for a paint dealer vs inventory turns of a kirana store.
If Britannia
and Hindustan
Unilever deliver once in 10 days to a kirana in a city, then the paint
dealer next-door requires delivery of paint products with a frequency of 40
times in 10 days i.e. 4 times in a single day. This is exactly the solution
which Asian Paints provides to paint dealers, unmatched by most other
decorative paint companies in the industry. Why?
Asian Paints has perhaps been the
most pro-active corporate investor in technology across the country over the
past 60 years. One of the many benefits of tech investments has been the
ability of Asian Paints to forecast demand with a high level of accuracy, for
each SKU, each location and for every week of the year.
This ensures that without waiting
for demand from a paint dealer, the firm optimises the type and quantity of raw
material procurement, manufactured products and inventories for each of its
depots and delivery trucks. Asian Paints’ competitors are not capable of this
sort of precise demand forecasting. Furthermore, the firm continues to deepen
this capability over time, since its enormous market share brings to it more
data on current demand from every location, than what is received by its
competitors.
The importance of supply chain
efficiency in helping define winners in the decorative paints industry is so
high that over the past 3 decades several competitors have failed to gain any
market share by offering: a) superior quality of products (e.g. Dulux Velvet
Touch); and b) greater channel margins to paint dealers (e.g. Jotun and Sherwin
Williams – before the latter sold their Indian business to Berger).
Finally, Asian Paints keeps
investing in ways to disrupt the industry rather than waiting for a competitor
to disrupt it. For example, Asian Paints has spent more than a decade in
establishing value-added labour-oriented offerings like Asian Paints Home
solutions, Water Proofing solutions, Color consultancies, etc. These services
benefit from a transition that the sector has undergone over the past few
decades.
Asian Paints has limited product
price hikes to less than 3.0% CAGR because of incremental operating
efficiencies being derived by the firm consistently. This, in turn, has meant
that on average, 65% of the cost of a paint project in India is labour (up from
20-30% two decades ago).
This transition calls for a
possibility to drive market share in the industry by offering a value-added
labour experience to a household in exchange for a labour-intensive composition
of the project cost. Such initiatives increase the longevity of Asian Paints’
powerful franchise.
Part 2
Prudent Capital Allocation is
Critical for Consistent Compounding
Summary: A characteristic feature of
a Consistent Compounder is prudent capital allocation – that is, the
choice of what to do with the free cash generated by the business year after
year. The smartest management teams reinvest a bulk of the free cash in
consolidating their dominance through
sustained business growth, without
compromising on the returns from the incremental capital deployed.
If a firm is consistently generating
large free cash flows, i.e. the excess of RoCE over the CoC, what should
the management do with it? An obvious answer would be to reinvest the free cash
into areas in which the firm already possesses deep-rooted competitive
advantages (i.e. increasing the capital employed). This would keep the
cycle of high RoCE leading to large free cash generation, in turn
leading to higher capital employed and strong returns on that, going.
However, as the firm grows and deepens its competitive advantages, the
quantum of free cash flow available for redeployment tends to far exceed
the amount that the business needs in order to keep growing.
For example, reinvesting to
add manufacturing capacity far in excess of the growth potential of a
product will end up depressing the RoCE as the capital employed rises
without a commensurate increase in the earnings before interest and tax
(EBIT). This then drives the management to explore one of the following two
options.
- Diversification, usually
inorganic: Pursuing growth outside their core business, either
across geographies or product categories, is usually the most common use
of free cash by managements. This can be achieved either organically, or
inorganically, through acquisitions. Many firms prefer the inorganic route
towards diversification, acquiring companies in related or
unrelated businesses, forging joint ventures with other companies,
acquiring minority stakes in other companies, etc.
- Returning the surplus cash
back to shareholders through dividends or buybacks: When surplus cash
cannot be effectively deployed without dragging down the RoCE sharply, it is
prudent to return it to shareholders through special dividends or share
buybacks.
Whilst all this sounds
straightforward, many firms with a great core franchise that consistently
generates high RoCE, have found it difficult to sensibly allocate surplus
capital to diversify their business. Consider these examples highlighted
below.
Creating shareholder value through
M&A and offshore expansion has proved to be difficult for firms that have
sustained high ROCEs in India.
Over the past 3-4 decades,
middle-class household consumption in India has grown substantially across several
essential products of day-to-day consumption. This has meant that over the past
two decades, most dominant firms in these sectors have generated
substantial amounts of surplus capital (i.e. capital after meeting the
core capex requirements of the firm).
Between 1995 and 2005, there have
been various examples of firms deploying their surplus capital towards
M&A to acquire businesses in India. Many of these acquisitions have ended
up generating substantial value for shareholders with RoCEs of the acquired
businesses being well above their cost of capital. Some examples of these
successful acquisitions include Hindustan Unilever’s acquisitions of TOMCO
(Tata Oil Mills Company), Kwality, Brooke Bond, Kissan, Lakme, etc. during the
1990s; Dabur’s acquisition of Balsara (2005); Marico’s acquisition of Nihar
(2006); and Pidilite’s acquisitions of Ranipal (1999), M-Seal (2000), Dr. Fixit
(2000), Steelgrip (2002), Roff (2005), etc. These acquisitions
have successfully added sustainable earnings growth drivers for these
firms with already high RoCEs.
However, after 2005, several
dominant Indian companies have deployed surplus capital
towards international expansion/acquisitions – for example Godrej Consumer
Products Ltd. (GCPL) in Africa, Indonesia, Latin America, Pidilite (Brazil, US,
Middle East), Marico (Middle East, Bangladesh, South Africa), Dabur
(Africa, US, Turkey, Egypt), Havells (Sylvania), Tata Steel (Europe), Asian
Paints (Berger International, 2001), Bharti Airtel (Africa), etc.
Analysing the RoCEs of some of the
overseas acquisitions (RoCE of consolidated entity less RoCE of the standalone
entity, where the India business is housed) shows how these international
acquisitions have fared.
The following points are worth
highlighting from this analysis:
- A substantial part (at times
more than 100%) of operating cash flows generated from the standalone
business has been deployed towards international acquisitions – see the
second column of Exhibit 1
- Domestic (standalone)
businesses of these firms have generated RoCEs substantially higher than the
cost of capital, many at times even higher than 50% - see Exhibit 2. This is
reflective of the strong moats built by these firms in India.
- International
(non-standalone) business ROCEs of these firms have been sub-par, many at
times substantially below the cost of capital – see Exhibit 2. This is
reflective of the weak moats existing in these international businesses.
The analysis above highlights the
fact that an inorganic growth strategy might not always be the right use
of free cash. There might be many reasons for such a strategy to fail. Managing
a business in an unknown (or lesser-known) overseas geography may require
a different organisational structure than what the acquiring company operates
within its home territory. Or, the acquisition might stretch management
bandwidth and the lack of attention reflects in the business’ performance.
Whatever the reason for the poor
RoCEs of the acquired business, it is clear that being a consistent compounder
isn’t just about earnings high RoCEs, but also about the prudent use of the
free cash generated as a result.
This brings us to another aspect of
investment analysis in identifying Consistent Compounders that we have
found useful – and that is on capital allocation. Whilst it is difficult to
precisely forecast future capital allocation decisions of any firm, it
helps to build conviction on the capital allocation approach of our
different companies by analyzing their long term historical track-record of the
same – how / why were certain capital allocation decisions taken in the
past, what were the learnings subsequently and how has the approach towards capital
allocation evolved for the firm?
We have found that Consistent
Compounders usually fall into two categories.
1. Type 1 – Capital redeployed
only in core businesses historically: Firms such as Page Industries
and Relaxo Footwears have reinvested on average, 50% and 90% respectively
of their annual operating to expand manufacturing capacities in their core
operations, enhance IT systems, etc. Moreover, every layer of geographical
(within India) or product category expansion has been carried
out organically in adjacencies which have a significant overlap with their
existing core business. For instance, over two decades, Relaxo expanded
pan-India into sports shoes and various sub-
segments of casual footwear, from being just a north-India player manufacturing
flip-flops. Page started off by offering just men’s innerwear in the 1990s
and has subsequently expanded into leisurewear, sportswear and outerwear
categories for men, women and kids. For such companies,
we focus on building conviction on
the runway of growth available to the firm’s core business, and the
ability of the firm to maintain high RoCE on incremental capital deployment in
existing core businesses.
2. Type 2 – Learnt from
historical experiences around M&A: Firms like Asian Paints and Dr.
Lal Pathlabs are open to doing acquisitions to grow their product
portfolio or geographical presence, respectively. However, the promoter and
management teams of these firms have demonstrated significant caution and
restraint in considering such opportunities in the past. They have
executed bolt-on acquisitions that do not risk a large part of the firm’s
capital employed and have been cautious in deploying incremental capital
into these acquired businesses. One exception though is a firm like Pidilite,
which has had three distinct phases of large-sized M&A transactions in
its history (as summarized below). The firm has acknowledged its mistakes,
and implemented course-correction subsequently, which gives us conviction on
capital allocation discipline likely to be pursued in the future.
Case Study: Pidilite’s capital
allocation
It is worthwhile to look at Pidilite’s capital allocation track record in a little
detail to drive home the point of how crucial prudent capital allocation
is to long-term consistent compounding.
- Phase 1 (1999 to 2005)
– Successful domestic M&A: After having spent five decades in
establishing a monopoly in white glue (Fevicol), Pidilite started
acquiring and building other adhesive and sealant brands to expand its
product portfolio and to extend the firm’s channel presence and intermediary
influence. The acquisitions included: a) Ranipal in 1999 for Rs 4 crores; b)
M-Seal and Dr. Fixit in 2000 for Rs 32 crores; c) Steelgrip in 2002 for Rs
10 crores; and d) Roff in 2005 for an undisclosed amount. Capital deployed
towards acquiring these firms was approx. 11% of the total operating cash
flows generated by Pidilite over this period. Most of these acquisitions have
become monopolies in their respective categories by now and have delivered
RoOCEs substantially higher than the cost of capital for Pidilite. Thanks
to this phase of expansion, Pidilite has one of the most diversified
distribution networks, with its products reaching the customer through multiple channels,
including convenience stores (kiranas), hardware stores, paint shops, modern
retail outlets, e-commerce, paanwalas as well as stationery shops.
- Phase 2 (2006 to 2014)
– Unsuccessful international M&A: Pidilite deployed close to ~Rs
685 crores in international acquisitions (26% of operating cash flows over
this nine-year period) in Brazil, Middle East, USA and in acquiring an
elastomer manufacturing plant in France. Pidilite bought small companies, some
of which were operating in unrelated industries, without any
market leadership. In countries like Brazil, the acquisitions were faced
with economic collapse in the country, and issues with the legacy
management team of the company. Over the past decade,
Pidilite has written off ~Rs 175
crores worth of its investments in subsidiaries in Brazil and the
Middle East, and ~Rs 300 crores of its investments in the elastomer
project. The acquisition made in the USA (Cyclo) has been sold off in 2017 for
~Rs 30 crores.
- Phase 3 (2014 to 2019) –
Successful domestic acquisitions: Having learned from its mistakes made in
the preceding phase of international acquisitions, Pidilite resumed its focus
on frequently acquiring smaller domestic competitors in its core business.
For example, Bluecoat has been acquired for ~Rs 260 crores (6% of FY14-19
operating cash flows) and Suparshva for an undisclosed
consideration. These acquisitions have turned out to be substantially RoCE
accretive for Pidilite. The firm has also deployed ~Rs 300 crores over
FY14-19 (~7% of operating cash flows and ~2-3% of capital employed over
this period) to acquire businesses in adjacent categories (CIPY – floor
coatings; Nina and Percept – waterproofing contractors) and has formed JVs
with MNCs like ICA for niche products like wood finishes. These businesses
have shown significant improvement in financial performance post-acquisition.
In addition to disciplined capital allocation towards M&A in this phase,
Pidilite also announced (and completed) a share buyback of Rs 500 crores in
FY18 at Rs 1,000 per share, a 12-13% premium to the prevailing market price.
This share buyback amounted to 14% of capital employed and 63% of
operating cash flows in FY18.
Part 3
Crushing Risk is More Rewarding than
Chasing Returns
Traditional investing theories can
be detrimental to portfolio returns
The Efficient Markets Hypothesis
(EMH), one of the more popular investing theories, contends that since stock
prices efficiently discount all the available information in the market, it is
impossible to beat the market. On the other hand, there is the Capital Asset
Pricing Model (CAPM), which says that it is possible to increase portfolio
returns is to increase systemic risk – i.e. buying high beta stocks.
Whilst Warren Buffett’s rubbishing
of the EMH is well-known (click here), the CAPM still remains popular, both in
classrooms and in practice.The contention that returns are proportional to risk
makes many investors invest in products without adequately appreciating the
risks involved.
Investors need to minimise four
types of risks if they want to generate steady and healthy investment returns
in the Indian stockmarket:
• Accounting risk: Whilst we all now
know how prominent public and private sector banks in India fudged their NPA
figures for years on end until the RBI’s Asset Quality Review forced them to
come clean, the same problem exists with several housing finance companies (who
don’t come under the RBI’s purview). The accounts of a leading cement
manufacturer don’t stack up. Neither does the annual report of high-flying
retailer make sense. Ditto with a prominent petchem company and a prominent
pharma company. In fact, many companies in the BSE500 have annual reports which
do not pass scrutiny. Using a few accounting ratios and a financial model which
contains time series data on 1300 of India’s largest listed companies, we seek
to identify that 20% of the Indian stockmarket whose books can be readily
relied upon.
• Top-line risk: At USD 2,000,
India’s per capita income is still very low (less than half the level of Sri
Lanka and a quarter of the level of South East Asian countries like Thailand
and Malaysia). As a result, beyond the basic essentials of life – FMCG
products, pharma products, basic apparel – most other products in India are
luxury items for most Indians. As a result, even for small cars or entry-level
two-wheelers, demand in India fluctuates wildly. Eg. Maruti Suzuki typically
experiences 5-6 years of strong demand growth (growth well above 15% per annum)
followed by 3-4 years of famine (growth well below 5% per annum). Whilst its
cross-cycle average growth tends to be around 12%, the stock price volatility
reflects the volatility of Maruti’s topline growth. In contrast, a company
selling essential products like Asian Paints or Marico, tends to see steady
revenue growth – between 10-20% per annum – pretty much every year. Investing
in companies selling essential products in India therefore reduces risk.
• Bottom-line risk: As the cost of
capital is still pretty high for India, it is rare to find Indian companies who
spend heavily on genuine R&D. Understandably therefore, the Indian economy
is characterized by rapid imitation – one company spots a niche (say, gold loan
finance) and within a decade it has a 100 imitators. This rapid new entry squeezes
the profitability of the first mover and thus creates risk for its
shareholders. In order to reduce such risk we look for sectors where over
extended periods of time, 1 or 2 companies cumulatively account for 80% of the
sector’s profit pie. Such monopolies have lower volatility in their profit
margin.
• Liquidity risk: India is the least
liquid of the world’s top ten stock markets largely because promoters own more
than half of the shares outstanding in the Indian market. As a result of this,
beyond the top 30 or so stocks in India, liquidity – measured by average daily
traded volume (ADV) – drops rapidly. By the time you are in the lower reaches
of the BSE100, ADV is well below $5m per day. Such low liquidity creates stock
price gyrations as investors go through their cycles of election induced
euphoria followed by accounting fraud induced panic. Tilting the portfolio
towards liquid stocks reduces this risk.
The advocates of the CAPM argue that
investors who take any of the four risks outlined in the preceding section
should be rewarded by the market for taking that extra risk. That line of
thinking does not work in India.
In the book “Coffee Can Investing:
the Low Risk Route to Stupendous Wealth” (Saurabh Mukherjea, Rakshit Ranjan and
Pranab Uniyal; 2018), it’s been shown that identifying stocks with low
accounting risk, low top-line risk and low bottom-line risk using a simple
quantitative filter (revenue growth should be in double digits and ROCE should
be above 15% every year for ten consecutive years) consistently generates
returns in the vicinity of 20% per annum with share price volatility half that
of the Nifty. Even without adjusting for risk (volatility), you are far better
off investing in this portfolio rather than in the Nifty. In fact, you are far
better off investing in this portfolio – akin to our Consistent Compounder
Portfolio (CCP) – relative to almost every other asset class in India (including
real estate, private equity and government bonds) – see chart above. You do NOT
have to take extra risk in India (or load up on beta) to get healthy returns.
Why does this simple filter-based
approach to creating a CCP work so consistently? Because the CCP basically
seeks to minimise the four risks outlined in the preceding section. If a
company is able to grow revenues at double digits every year for ten
consecutive years, it is almost certainly selling an essential product which
will be in demand in both economic booms and busts. Secondly, if a company is
able to generate ROCE above 15% every year for ten consecutive years, it is
highly likely to be a dominant/moated franchise. (The vast majority of the
Nifty companies have not generated an ROCE of 15% even once in the past ten
years.)
Therefore, it makes imminently more
sense to crush risk rather than embracing unwarranted risk.
Crises expose corporate frauds
The risks highlighted above assume
critical importance during a crisis. The most spectacular accounting frauds
usually come to light when the stock market is tanking and the access to
capital starts drying up. For example, Satyam Computers imploded in January
2009, four months after the Lehman Bros bust triggered a liquidity freeze in
India; the scandal in Enron came to light in October 2001, 15 months after the
dotcom bust and a month after 9/11 had pushed the US stock market further into
the mire; WorldCom filed for bankruptcy in July 2002 after having cooked its
books frenetically in the wake of the dotcom bust; and Bernie Madoff confessed
to his sons in December 2008 – three months after Lehhman went under – that his
wealth management scheme was in reality a massive Ponzi scheme. As night
follows day, when liquidity tightens, big accounting scams come to light.
This happens for three reasons.
Firstly, the central driver of accounting fraud is the promoter’s need/desire
to siphon cash out of the company. When liquidity is easily available, he can
either cover his tracks by borrowing money in his own name and infusing it in
the company (say, through short-term loans) or the company itself can avail of
short-term loans. The surfeit of liquidity sloshing around the company creates
an impression that everything is alright. However, when liquidity tightens,
these short-term loans dry up and staff/suppliers/creditors raise the alarm
that the company is out of cash. By this juncture, typically the Indian
promoter has taken flight.
Secondly, the money that the
promoter borrows is usually collateralised by either his properties or his
shares. A liquidity crunch typically hits the value of both of these asset
classes. That, in turn, leads lenders to issue margin calls to promoters. Thus,
the promoter – who has already pilfered money from his listed entity – now finds
himself being chased by his lenders. It wasn’t a coincidence we think that two
prominent Indian jewellers took flight six months after wholesale money market
rates started rising in India (from August 2017 onwards). Unless a miracle
shores up the value of real estate and shares in India, we should expect more
promoters to take flight rather than taking the trouble to meet margin calls.
Thirdly, in a growing economy,
corporates can show genuine growth in revenues and hence justify the growing
working capital needs. Hence in a booming economy everyone – shareholders,
auditors, lenders – buys the logic of rising short term borrowing to finance
working capital needs (even though the actual driver of higher borrowing might
be the promoter’s pilferage of cash). When the economy then slows – in the wake
of rising interest rates – that fig leaf is removed. The auditors, with their
professional reputation on the line, now become less willing to sign off on
growing pile of receivables. Given that from 2018 onwards, the Ministry of
Corporate Affairs has oversight of the audit profession in India, we expect an
increasing number of auditors to pull the plug on promoters who are cooking the
books.
The importance of accounting quality
“It has been far safer to steal large sums with a pen than small sums with a
gun” – Warren Buffet
The annual churn in the BSE500 Index
is as high as 12% p.a. – meaning 60 new companies become part of the Index
every year, replacing 60 incumbents. This high churn ratio signifies that most existing
incumbents are unable to sustain their place in the index and, over the course
of time, make way for more deserving candidates. A closer analysis of the
stocks exiting the BSE500 over the last 5 to 10 years indicate that most exits
had little to do with business downturns but were mainly due to corporate
governance/accounting lapses and capital misallocations at these firms.
If one were to look at BSE500 as it
stood in December 2009, out of the total 500 member stocks then, only 274
stocks continue to remain in the index. In other words, nearly 45% of the
stocks have exited the index over the last ten years. On their way out, most of
these stocks saw significant erosion in their shareholders’ wealth (on an
average, the companies which exited the index have lost 40% of their December
2009 market cap). Hence, for every Bajaj Finance and Eicher Motors which
significantly enriched their investors, there has been an Educomp and Lanco
Infratech which left their minority shareholders high and dry.
While the number of companies which
have generated enormous wealth for their shareholders are bound to be a
handful, the number of companies which have destroyed shareholders’ wealth
would be much more. Hence, the ability to stay away from dubious names is
equally if not more important than the ability to discover a great company.
Quality may take a backseat
momentarily but always makes a comeback
In the long run, high accounting
quality and efficient capital allocation define investment success. A look at
longer-term stock returns suggests a direct relationship between better
accounting quality and superior stock performance. In the shorter run, however,
markets do have a tendency to test investors’ patience even if the investor is
using the most time tested and rational investment methods. Hence during this
period of irrational exuberance and abundant liquidity, where there is pressure
to chase near terms returns, quality does take a backseat. Take the instance of
the bull market of CY17 which saw speculative excesses being created in
lower-quality stocks.
However, things changed with the
onset of CY18. As the cost of capital rose, liquidity started drying up and equity
markets turned volatile. This, in turn, made investors more selective.
Recurring news flow on auditor resignations further spooked investors through
CY18. All of this, in turn, brought the focus back on accounting quality. This
has resulted in good quality companies outperforming their poor-quality
counterparts by a considerable margin in CY18 and continuing to do so in CY19.
Marcellus’ forensic framework to
evaluate accounting quality
Evaluating the accounting quality of
a company is a cornerstone of the investment at Marcellus. We have developed a
set of 12 financial ratios that help us grade companies on their accounting quality.
The selection of these ratios has been inspired by Howard M. Schilit’s
legendary book on forensic accounting, “Financial Shenanigans’ (first published
in 1993 and currently in its fourth edition). The book draws upon case studies
of accounting frauds, including not just well-known cases such as Enron and
WorldCom but also as numerous lesser-known instances of accounting trickery.
The author then goes to draw lessons from these cases to create techniques for
detecting misreporting and frauds in financial statements.
The 12 forensic accounting ratios we
use cover checks around key financial statement categories like income
statement (revenue/ earnings manipulation), balance sheet (correct
representation of assets/liabilities), cash pilferage and audit quality checks.
Some of these key ratios and rationale are shown in the below exhibit. We look
at the historical consolidated financial statements for the universe of firms.
We first rank stocks on each of the twelve ratios and give a final decile-based
pecking order on accounting quality for stocks – with D1 being the best on
accounting quality and D10 being the worst. The top 5 deciles i.e. D1 to D5 are
generally indicative of a company with good accounting quality/practices – we
call D1 to D5 the ‘Zone of Quality’ whereas the bottom 30% i.e. D8 to D10
generally represent companies with questionable accounting practices – we call
this the ‘Zone of Thuggery’.
Our forensic framework has proven to
be an effective predictive tool
Over the longer term, there has been
a strong correlation between the accounting quality as suggested by our
forensic model and the shareholders returns. For instance, the ‘Zone of quality’
has outperformed the ‘Zone of thuggery’ by a whopping 9% p.a. over CY16-19.
There is another way to understand
the effectiveness of this forensic model – there are around ~53 companies (out
of the BSE 500) which constantly featured in D8 to D10 rankings in our
accounting model for the years FY2015-18. Over CY16-19, these companies have on
an average delivered negative CAGR of 13% compared to benchmark BSE 500’s 10%
i.e. an underperformance of nearly 23% p.a.
Beyond the forensic screens
Our forensic framework helps us to
weed out companies with dubious accounting quality. It also helps us identity
the key accounting red flags for a company. However, our quest for accounting
quality does not end there. There are several qualitative aspects of accounting
and corporate governance which our forensic model may not be able to pick up
due to lack of data uniformity across companies or where there are subjective
judgements involved. Such areas can only be evaluated through a deep dive into
historical financial statements and primary data checks around management
integrity.
We have developed the following
checklist for further accounting and corporate governance checks beyond the
forensic model. This checklist forms an essential part of the qualitative
assessment of stocks.
We produce below our first-hand
experience of analysing Amtek Auto’s financial statements a few years ago. The
stock looked extremely cheap on valuation multiples with very high margin
profile but a very weak balance sheet. Our analysis pointed towards multiple
glaring issues in its financials. We went on to be proved right on most of
these things.
Part 4
Why Consistent Compounders are the
best bet in a crisis?
Summary: A portfolio of Consistent Compounders offers the most
optimised risk-reward for an investor in the Indian markets – healthy returns
with the volatility close to that of a government bond. This makes them an
investment for all seasons, and more so in times of market stress and crisis
where investors are especially worried about large drawdowns in their
portfolios. Consistent Compounders not only fall less in a crisis but also
recover much sooner and sharper.
“Only when the tide goes out, do you
discover who’s been swimming naked’. This insight from Warren Buffett has
repeatedly proven to be correct when it comes to investing in stocks. When the
broader market is undergoing a euphoric or bullish phase, most stocks do well
regardless of the quality of their underlying fundamentals. However, when the
euphoria ends, stocks with poor underlying fundamentals are decimated, leading
to significant capital erosion for investors who did not adequately understand
the weak fundamentals of their portfolio companies.” – from ‘Coffee Can
Investing: The low-risk route to stupendous wealth’ (2018) by Rakshit Ranjan,
Saurabh Mukherjea & Pranab Uniyal.
Investors desire not just healthy
returns on their portfolio, but also for the returns to be steady or
consistent. Most of all, no one likes large drawdowns (declines) in their
portfolios. However, when the broad markets decline during a crisis, it is rare
for a portfolio of stocks not to do so. A sharp fall in stock prices often
leads to panic among investors and they end up selling their holdings at or
near market bottoms. Unless an investor is extremely lucky, it is nearly
impossible to exactly time the market and exit at a pre-crisis peak to avoid
the heartburn of large drawdowns and then enter at a post-crisis bottom to
maximise returns from the rally that follows.
It is here that Consistent
Compounders emerge as the best allies of an investor. Not only does a portfolio
of Consistent Compounders fall less during a crisis it also recovers sooner and
sharper on the other side of the crisis.
Why Consistent Compounders are the
best bet in a crisis?
In simple terms, the share price of
a firm can be expressed as a function of two variables –the P/E valuation
multiple and ‘Earnings’.The P/E multiple is a function of many factors external
to the company (macroeconomic variables, political uncertainty, global commodity
market tends, geopolitical dynamics, etc.) as well as factors internal to a
company (expectations of future earnings growth sustainability). The external
factors are nearly impossible to predict and by extension, so is their impact
on the earnings multiple of a stock. Therefore, at a time when market P/E
multiples compress due to external factors, individual stock prices take a hit
too. But for a company with strong fundamentals, the impact is limited due to
its strong annualised earnings growth (which offsets the P/E compression) as
well as the longevity of these earnings (which restricts the P/E compression).
As we have seen earlier, such strong fundamentals are the essence of consistent
compounders.
Taking the case of Asian Paints as
an example. In FY03 and FY16 (see Exhibit 1 below), Asian Paints managed to
maintain healthy earnings growth even in a disruptive external
environment<what was this environment>. Hence, the ripple effect of a
stressed stock market’s P/E multiple de-rating was more than offset by Asian
Paints’ earnings growth during the same period. In FY12, Asian Paints’ P/E
multiple expanded by 9 percent with an EPS growth of 17 percent, in a year
when the Sensex’s P/E multiple deflated by 16 percent and Sensex’s earnings
grew by 6%.
The observations for Asian Paints
hold true for all Consistent Compounders. As seen in Exhibit 2, Consistent
Compounders not only give returns in absolute terms as well as relative to the
broader market, they do so on a steady basis over long periods of time.
Even during periods of a wider
economic or financial system crisis, Consistent Compounders tend to sustain
their fundamental strengths and their stocks fall less, and recover sooner and
sharper after the stock market crisis. In most cases, these companies emerge
stronger from a crisis. A portfolio of Consistent Compoundersthus addresses the
investor’s worry of large drawdowns in her portfolio in times of a crisis.
During the global financial crisis
of 2008-09, the BSE Sensex declined by 61 percent over the period January 2008
to March 2009. As against this, the average drawdown of all Large-cap CCP
portfolios constructed based on principles laid out in Coffee Can Investing:
The low-risk route to stupendous wealth’ (2018) by Rakshit Ranjan, Saurabh
Mukherjea & Pranab Uniyal (refer to ‘Maximum drawdown’ of ‘Large-cap CCP’
portfolios which were active during the 2008 crash i.e. portfolios shown from
Exhibit 90 and Exhibit 111 of the book) was only 35 percent.
Some of the most common stocks
amongst these active Large-cap CCP portfolios from the book ‘Coffee Can
Investing’ included HDFC Bank, Asian Paints, Cipla, HDFC Ltd, Hero Motocop and
Infosys. An equal-weighted portfolio (let’s call it the Consistent Compounders
portfolio) of these six stocks, for instance, fell by only 25 percent between
January 2008 and March 2009.
Now let’s analyse the data shown in
Exhibit 3 above, to quantify the benefit/futility of timing entry at the bottom
of the stock market crash of 2008, for investment in Sensex vs the Consistent
Compounders portfolio.
Entry into a mediocre quality
stock/portfolio just before the 2008 crash delivered a mere 5 percent CAGR over
the next decade, in-line with the weak earnings growth potential of the
underlying asset as well as compression in the valuation multiples for the
stocks as a reflection of deteriorating fundamentals due to the crisis.
However, if an entry in the mediocre portfolio was timed exactly at the bottom
of the crash, the 10-year CAGR achieved would have increased to 16%! The
difference between 5 percent (without timing) and 16 percent (with perfect
timing) is not only large, it also changes the relevance of compounding for
such a portfolio consisting of mediocre stocks. At a 5 percent CAGR, an
investor is perhaps not even beating inflation in his cost of living. However,
at 16 percent CAGR, the investor would have created substantial wealth over a
ten-year period.
On the other hand, timing entry/exit
from the Consistent Compounders portfolio (as shown in Exhibit 7 above) during
the global financial crisis does not materially change the decadal returns. The
returns for the Consistent Compounders portfolio increase from an already
healthy 17 percent to 20 percent if entry into such a portfolio is perfectly
timed at the bottom of the stock market crash.
Hence, the conclusion that emerges
from Exhibit 3 is that Resilience of the Consistent Compounders portfolio makes
the timing of entry and exit redundant. Meaning that staying invested in a
portfolio of Consistent Compounder stocks eliminates the need to time the
buying or selling of stocks to avoid large drawdowns in a portfolio.
The resilience of companies with
strong fundamentals through a crisis is evident from the performance of
Marcellus’ Consistent Compounders Portfolio through the recent market meltdown
led by the Covid-19 pandemic. As seen in Exhibit 4, the portfolio has delivered
a positive absolute return of 7.6 percent over the past 12 months, unlike the
-25.0 percent return of Nifty50 over the same period. And this holds true when
we back-test returns for a portfolio of CCP companies.
Even on the way up, CCP portfolios
recover much sooner and sharper compared to the broader stock market. After a
14-month long fall in the stock market during the 2008 global financial crisis,
the market bottomed out on March 9, 2009. As shown in Exhibit 4, CCP stocks
recovered back to their pre-crash levels much sooner compared to a long drawn
20-months recovery period for the Nifty50.
As explained earlier, this rapid
recovery in share prices of CCP portfolios after the market has bottomed out is
because of a combination of the following factors:
• CCP companies might strengthen
their fundamentals during such crisis and come out stronger on the other side
of the crisis
• Before the stock market crash,
share price performance of CCP companies is fully supported by their earnings
and fundamentals.
In addition to the challenges
highlighted in Exhibit 7 and Exhibit 9 above, an investor trying to time
entry/exit during a stock market crash will also incur costs involved around a)
risk of getting the timing wrong; b) transaction costs; and c) the intense
focus on share prices rather than on fundamental research (or your day job)
during such times of stock market crash.
What do Consistent Compounders do
differently during a crisis? A look at non-financial companies in the ongoing
COVID-19 crisis
The Consistent Compounder companies
sell products and services which are the small ticket, day-to-day essentials
consumed by Indian middle-class households. Unlike spends on
tourism/entertainment/leisure/luxury categories, demand for products and
services of our portfolio companies is highly utility-oriented and hence cannot
be cancelled easily. For instance: a) you cannot defer the purchase of packaged
foods like baby milk, COVID tests, essential medicines etc; b) you can delay by
few weeks, the purchase of innerwear, footwear, diagnostic tests, etc; and c)
you can delay by few months, the repainting or furniture repair in your home.
Moreover, no matter how our lifestyle changes after such a crisis, habits and
consumption patterns of these products are not likely to change or get
substituted in the foreseeable future.
So, what do Consistent Compounders
do differently?
• Support offered to channel
partners: Addressing the concerns of and managing the interests of the network
of distributors and other partners in the supply chain in mind is a common
trait among Consistent Compounders. For example, during a crisis like
demonetization or the ongoing COVID crisis, Page extends an extra 60 days of
credit to distributors. Such support from Page helps strengthen the firm’s
relationship with their channel over the longer term”. What is so unique about
this? Page’s competitive advantages have allowed it to build a strong balance
sheet, which can support a short-to-medium term pressure on working capital due
to an extended credit period. Most of its competitors cannot as their RoCEs
remain close to their CoC and hence restrict the business’ ability to generate
sufficient free cash to build a resilient balance sheet. Another such example
is of Dr. Lal Pathlabs, where the firm helps their franchisees by trying to
renegotiate downwards rentals for collection centers laboratories.
• Potential benefits of in-house
labour force: Footwear and innerwear are the two most labor-intensive
manufacturing industries. Relaxo and Page not only do their manufacturing
in-house (no outsourced manufacturing), but they do so with a full-time
permanent workforce (no-contract labour). On a normal day, this helps these
companies maintain the quality of their products, but in crisis, it makes it
easier for them to resume normalcy in their manufacturing setups much sooner
than that of their competitors, who rely on contract labour and can take time
in mobilizing the required workforce.
• Benefits of owning/controlling the
supply chain: Once a crisis that affects operations abates, supply chains of
different companies come back to normalcy at different speeds. For instance,
distributor-based supply chains will come back sooner than wholesaler-based
supply chains due to the unorganized/indirect nature and greater stress on the
working capital of a wholesaler vs a distributor. Firms that have fewer layers
in their channel compared to others will get back to normalcy quicker. Firms
like Page Industries and Relaxo are unique relative to their competitors due to
their reliance only on distributors rather than wholesalers. Others like
Pidilite and Nestle have a greater proportion of direct distributors compared
to their competitors who are more dependent on indirect distribution channels.
Firms like Asian Paints and Berger do NOT have any channel partners in their
supply chain barring the paint dealers on the high street. Dr. Lal Pathlabs, with
its B2C business model (direct control on franchisees, lab technicians and
equipment used by these lab technicians) will be better placed than competitors
like Thyrocare which are more B2B in nature and do not such direct control on
their supply chain infrastructure.
• Market share shift from
unorganized to organized players, and from small/weak players to large/stronger
players: Crises bring out the evolutionary equivalent of business, where the
fittest or strongest businesses survive and the weak get weaker. Several
Consistent Compounders have been massive beneficiaries of events like
demonetization and GST implementation due to the shift of market share from
unorganized to organized players after these events. And in all likelihood,
such shifts will continue with every business disruption, be it the COVID-19
pandemic, or other domestic or global calamities that may come in the future.
The opportunity to consolidate market share will be most seen in industries
like footwear, paints, inner-wear, packaged foods, adhesives where the
competition tail is long.
• Utilise benefits from the recent
corporate tax rate cuts to suffocate competition: Consistent Compounders have
been the biggest beneficiaries in their respective industries, of the corporate
tax rate cuts announced in 2019. At a time when competitors struggle due to the
cash flow implications of the ongoing crisis on their balance sheet, the
incremental cash flow available to Consistent Compounders from tax rate cuts is
likely to be used to gain market share through product price cuts, higher
employee benefits, accelerated capex, support to channel partners and vendors,
etc.
