Coffee Can Investing: the low risk road to stupendous wealth

by Saurabh Mukherjea

These three contrasting approaches to equity investing—ETFs for large-caps; a low-cost, conservative strategy like the Coffee Can Portfolio for large and mid-caps; and careful stock selection for small-midcaps—should form the bedrock of any growth-oriented Indian portfolio.

the extent that all of us need to set aside some money for a rainy day, I strongly believe it should be done by investing in government bonds and conservatively managed liquid funds. When it comes to my ‘rainy day’ corpus, life has taught me that I need to focus on liquidity and complete safety of funds.

‘Risk comes from not knowing what you are doing.’ —Warren Buffett1

Firstly, there is an overwhelming dominance of physical investments like gold and real estate in most Indian households’ portfolios. A recent RBI committee opined that 88 per cent of an Indian investor’s wealth is in gold and real estate,3 a dominance not seen in any other large economy of the world.

Thirdly, unlike the stock markets in some developed countries, the Indian stock market has very few great companies that sustain

This point is demonstrated clearly through the following analysis from Ambit Capital’s research—the average probability of a sector leader remaining a sector leader five years later is only 15 per cent, implying that 85 per cent of BSE500 companies slide towards mediocrity.

In fact, the average probability of a ‘great’ company becoming a sector laggard five years later is 25 per cent. Even the Nifty ‘churns’ by around 50 per cent or ...

cent for developed markets and around 30 to 40 per cent in other maj...

‘The best time to plant a tree was twenty years ago. The second best time is now.’ —ancient Chinese saying

As immortalized in the classic 1967 movie The Graduate, relatives and family friends congratulated the young man and told him what they thought he should do with his life. Dustin Hoffman plays the graduate in this super hit movie that made him a star, earned him his first Oscar nomination and captured the spirit of that remarkable decade.

That being said, excessive diversification and exposure to too many stocks/funds can also negatively impact the returns of the portfolio.

Ignoring inflation and taxes: Most investors focus on absolute returns instead of looking at real returns. To arrive at actual returns from your investments, you need to adjust for (or subtract) the impact of inflation and taxes. Mr Talwar was losing most of his equity returns

Also, both these gentlemen held gold believing it to be a great asset. But on an inflation-adjusted basis, gold did not deliver much for them—in the twenty-seven years since he started working in 1990, gold delivered an inflation-adjusted return of just 2 per cent per annum for Mr Talwar.

An investor holding Rs 5000 in equity and Rs 95,000 in debt (assuming 15 per cent and 7.5 per cent compounded annualized returns respectively) will end up with a corpus of Rs 4.85 lakh in twenty years. If, on the other hand, the equity component was 75 per cent (i.e. Rs 75,000 in equity and Rs 25,000 in debt) the same investor would have a corpus of Rs 13.3 lakh in twenty years!

It is important to not adhere to the age-old wisdom of investing heavily in fixed deposits, real estate and gold. These assets have unperformed equity by significant margins over long periods of time. In fact, these assets have often given returns lower than inflation over long periods of time and thus damaged investors’ wealth.

‘For indeed, the investor’s chief problem—and even his worst enemy—is likely to be himself.’ —Benjamin Graham, The Intelligent Investor (1949)

The Intelligent Investor, Jason Zweig included an anecdote about Newton’s adventurous investing in the South Sea Company: Back in the spring of 1720, Sir Isaac Newton owned shares in the South Sea Company, the hottest stock in England. Sensing that the market was getting out of hand, the great physicist muttered that he ‘could calculate the motions of the heavenly bodies, but not the madness of the people’. Newton dumped his South Sea shares, pocketing a 100 per cent profit totalling £7,000. But just months later, swept up in the wild enthusiasm of the market, Newton jumped back in at a much higher price—and lost £20,000 (or more than $3 million in [2002–03’s] money). For the rest of his life, he forbade anyone to speak the words ‘South Sea’ in his presence.

Newton invented calculus and conceptualized the path-breaking laws of motion. But this little episode shows that he wasn’t a smart investor because he let his emotions get the best of him and was swayed by the irrationality of the crowd.

Successful equity investing largely hinges around answering two simple questions: Which stocks should I buy? and For how long should I hold the stocks I bought?

‘An investment in knowledge pays the best interest.’

In Berkshire Hathaway’s 2007 letter to shareholders,2 Warren Buffett explains that the kind of companies he likes to invest in are ‘companies that have a) a business we understand; b) favourable long-term economics; c) able and trustworthy management; and d) a sensible price tag.

Philosophy of warren buffet on investment

Long-term competitive advantage in a stable industry is what we seek in a business’.

On the subject of For how long should an investor hold the shares they buy, Warren Buffett, in 1988’s Berkshire Hathaway’s letters to shareholders stated, ‘When we own portions of outstanding businesses with outstanding managements, our favourite holding period is forever.

Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds.’

‘Our view has always been that we need to invest in companies where we can trust in the people who are running the company. Trust, in turn, is driven by capital allocation.

In an environment like India, where you always have so many “perceived good opportunities”, if you invest in poor capital allocators, you will never get a return. Secondly, our firm belief is that good management teams create optionality for you . . . in an environment like India, smart managers can create a lot of wealth.

Unless a stock reaches an absurd valuation or if something fundamental has changed in the business environment for that company or something critical has changed in the company’s growth outlook, we prefer not to sell stocks that we own. Our view is that there are a limited number of companies in India where everything lines up . . . good business, capable and ethical management, you have access to the management: such combinations do not come that often.’

to consistently generate healthy returns from equity investing, one has to invest in high-quality companies and then sit tight for long (often very long) without losing sleep about where the share price is going.4

Robert Kirby joined Capital in 1965 as the main investment manager in Capital Guardian Trust, where his job involved advising high net worth clients on investments and managing their portfolios. Nearly twenty years later he wrote a remarkable note which introduced to the world the concept of the ‘Coffee Can Portfolio’.

Impressed by this approach of ‘buy and forget’, Kirby coined the term ‘Coffee Can Portfolio’, a term in which the ‘coffee can’ harks back to the Wild West, when Americans, before the widespread advent of banks, saved their valuables in a coffee can and kept it under a mattress.

that in order to truly become rich an investor has to let a sensibly constructed portfolio stay untouched for a long period of time—is as powerful as it is profound. After all, the instinctive thing for a hard-working, intelligent investor is to try and optimize his portfolio periodically, usually once a year.

But Kirby’s counterintuitive insight is that an investor will make way more money if he leaves the portfolio untouched.

we use straightforward investment filters to identify ten to twenty-five high-quality stocks and then leave the portfolio untouched for a decade.

To begin with, of the approximately 5000 listed companies in India, we will limit our search to companies with a minimum market capitalization of Rs 100 crore, as the reliability of data on companies smaller than this is somewhat suspect. There are around 1500 listed companies in India with a market cap above Rs 100 crore. Then, we look for companies that over the preceding decade have grown sales each year by at least 10 per cent alongside generating Return on Capital Employed (pre-tax) of at least 15 per cent.

Approach of searching good companies for the long term investment

A company deploys capital in assets, which in turn generate cash flow and profits. The total capital deployed by the company consists of equity and debt. ROCE is a metric that measures the efficiency of capital deployment for a company, calculated as a ratio of ‘earnings before interest and tax’ (EBIT) in the numerator and capital employed (sum of debt liabilities and shareholder’s equity) in the denominator. The higher the ROCE, the better is the company’s efficiency of capital deployment.

Role of ROCE

We use 15 per cent as a minimum because we believe that is the bare minimum return required to beat the cost of capital. Adding the risk-free rate (8 per cent in India) to the equity risk premium6 of 6.5 to 7 per cent gives a cost of capital broadly in that range.

India’s nominal GDP growth rate has averaged 13.8 per cent over the past ten years. Nominal GDP growth is different from real GDP growth as unlike the latter, nominal GDP growth is not adjusted for inflation.

A credible firm operating in India should, therefore, be able to deliver sales growth of at least that much every year. However, very few listed companies, only nine out of the 1300 firms run under our screen, have managed to achieve this. Therefore, we reduce this filter rate modestly to 10 per cent; i.e. we look for companies that have delivered

revenue growth of 10 per cent every year for ten consecutive years.7

ROE of 15 per cent: We prefer Return on Equity8 over Return on Assets9 because this is a fairer measure of banks’ (and other lenders’) ability to generate higher income efficiently on a given equity capital base over time.10

Loan growth of 15 per cent: Given that nominal GDP growth in India has averaged 13.8 per cent over the past ten years, loan growth of at least 15 per cent is an indication of a bank’s ability to lend over business cycles. Strong lenders ride the down-cycle better, as the competitive advantages surrounding their ability to source lending

opportunities, credit appraisal and collection of outstanding loans ensure that they continue their growth profitably either through market share improvements or by upping the ante...

In simple terms, it means that historical data suggests the Coffee Can Portfolio offers more than a 95 per cent probability of generating a positive return as long as investors hold the portfolio for at least three years. If held for at least five years, there is more than 95 per cent probability of generating a return greater than 9 per cent.

Just to emphasize the importance of 24 to 25 per cent midpoint CAGR portfolio returns, a run rate of 26 per cent return per annum results in the portfolio growing in size to ten times in ten years, 100 times in twenty years and 1000 times in thirty years.

‘The ancient Romans were used to being defeated. Like the rulers of history’s great empires, they could lose battle after battle but still win the war. An empire that cannot sustain a blow and remain standing is not really an empire.’ —Yuval Noah Harari, Sapiens: A Brief History of Humankind (2011)12

Many historians are of the view that the ‘greatness’ of a kingdom or an empire should be measured by its longevity. How long did the empire last? How durable was it? By this measure the first great empire was arguably the Persian Empire. Founded around 550 BC, it lasted for around 200 years until Alexander the Great’s rise in 330 BC after defeating King Darius III.

However, if longevity is the measure of a great empire, then the Roman Empire is possibly the greatest empire the world has ever seen. Whilst the first Roman republic, headquartered in Rome, lasted from 100 BC to 400 AD, the imperial successor to the Republic lasted for a staggering 1400 years before falling to the Ottoman Turks in 1453.

So ubiquitous is the influence of this empire that the language in which we are writing this book, the legal system which underpins the contract between the publisher and the authors of this book, the mathematical concept of compounding which underpins much of th...

The Coffee Can philosophy of investing is built using the twin filters to identify great companies that have the DNA to sustain their competitive advantages over ten to twenty years (or longer). This is because ‘greatness’, which the Coffee Can Portfolio seeks, is not temporary and definitely not a short-term phenomenon.

‘Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns.’ Munger meant that the returns generated by any company’s share price in the long term cannot be significantly more than the return on capital employed generated by the company in its day-to-day business.