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March 1 - April 10, 2024
He explained this with an example, ‘If the business earns 6 per cent on capital over forty years and you hold it for those forty years, you’re not going to make much different than a six percent return—even if you originally buy it at a huge discount. Conversely, if a business earns 18 per cent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.’
earnings is the biggest driver of stock market returns in the long run.
Rather than considering earnings growth as an independent metric by itself, it is more useful to see earnings growth to be an outcome of two independent parameters—growth in Capital Employed in a business and the firm’s ability to generate a certain Return on the Capital Employed (ROCE). As a result, ‘earnings growth’ can be achieved either by growing capital employed whilst maintaining ROCE, or by growing ROCE through enhanced operating efficiencies whilst maintaining the firm’s capital employed.
High earnings businesses with low capital requirements: The first example refers to a business like See’s Candies, a chain of candy and chocolate stores in California that Mr Buffett owns. These businesses can’t, for any extended period, reinvest a large portion of their earnings internally at high rates of return. However, in light of the firm’s pricing power, See’s Candies’ earnings keep growing without needing incremental capital, thus steadily delivering a high return on (rather low) capital employed.
Typically, for such companies, two factors help minimize the funds required for operations. First, the product is sold for cash, which eliminates the need to wait for the customer to pay up and thus reduces accounts receivables. Second, the production and distribution cycle is short, which minimizes inventories. Such a business eventually becomes like a cash machine, allowing investors to use that steady stream of cash to buy other attractive businesses.
In the Indian context, Hindustan Unilever is an example of th...
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An example of this type of business is HDFC Bank. As described by Saurabh Mukherjea in his bestselling book The Unusual Billionaires, ‘A rupee invested in HDFC Bank at its IPO in March 1995 is worth Rs 134 now (April 2016), implying a CAGR of 26 per cent. At the heart of this outstanding performance there have been a) a risk-aware culture that focused on generating healthy returns without taking high risks; b) an internal architecture that has consistently allowed the bank to innovatively rethink the core process flows that characterize the central offering of the banking sector in areas like
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Finally, Buffett talks about the worst sort of businesses, which grow rapidly, require significant capital to engender growth and then earn little or no money. The Indian telecom sector over the past decade has been a good example of this, wherein building durable competitive advantages has proven to be elusive for all the players. The telecom industry in India has grown exponentially over the past decade (41 per cent CAGR in the number of telecom subscribers over FY02–17 from seven million subscribers in FY02 to 1200 million in FY17), industry leader Bharti Airtel has maintained its market
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Over FY07–17, Bharti’s standalone business (which largely includes its Indian telecom revenues) had higher ‘cash outflows from investing’ (i.e. capital investments) than its operating cash flows. Despite these investments and exponential growth in its subscriber base, the firm delivered only 13 per cent revenue CAGR for its Indian telecom business, with its earnings declining from Rs 40 billion in FY07 to a loss of Rs 99 billion in FY17. As
Page controls the master franchise of Jockey (innerwear and leisurewear) and Speedo (swimwear) in India. As shown in the exhibit below, over the past fifteen years (FY02–17), the firm has consistently achieved revenue growth in excess of 10 per cent per annum and ROCE in excess of 15 per cent each year. In compounded annualized terms, over the past fifteen years, Page’s revenues have grown at 31 per cent CAGR, earnings have grown at 40 per cent CAGR and ROCE has averaged a staggering 55 per cent.
As per Warren Buffett’s categorization of businesses, Page Industries is a perfect example of a business that requires capital to grow and generates decent ROCE. Over the past ten years, Page has, on an average, reinvested around 50 per cent of its operating cash flows back into the core business via fixed asset investments to expand its manufacturing capacity. Despite this, the firm has either maintained or improved its ROCE over time, implying that it has successfully and consistently generated healthy ROCE on the reinvested capital as well.
Consequently, Page’s share price has compounded at 45 per cent per annum over the past decade (July 2007–July 2017). More
Simply put, Page’s share price performance is largely attributed to its healthy earnings trajectory, rather than the re-rating of its P/E multiple.
One would think that making innerwear isn’t rocket science. And given that innerwear is neither on display (at least not in India as yet) when worn by users or widely spoken about in everyday conversation, the presumption would be that ‘brand’ can’t possibly be that important. But think about this: comfortable innerwear is much more important than the clothes we wear over it. Innerwear also has to be strong and durable. As if all this wasn’t enough, difference in physiques, weather-related factors and consumer preferences of comfort in India are not entirely similar to those abroad.
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Page’s journey with Jockey goes back to 1959. Four generations of the Genomal family (the promoters of Page) have focused on the undergarment business and have no intention of diverting to anything else. As a result, unlike many other promoters in India, who end up diluting their firm’s ROCE by misallocating surplus capital, Page has maintained strict capital allocation discipline over the past two decades.
‘Manufacturing prowess’ is Page’s biggest competitive advantage. Innerwear is a highly labour-intensive industry with limited scope for automation. This calls for astute labour management as the business grows. Whilst several of Page’s competitors have suffered from labour unrest or annual workforce attrition level as high as 100 per cent, Page has maintained this figure at only 12 to 13 per cent. This has been achieved through: a) measured capacity expansion with no more than 1500 labourers in a single factory, which reduces the risk of unionization; b) focus on hiring women (who historically
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Page has also built a very strong front-end with innovative marketing, retail and distribution. Unlike a wholesale-based distribution channel for larger competitors like Rupa, Page has built a strong network of exclusive distributors who are well-incentivized to create a push-based demand13
Page’s approach to advertising has been unique on several fronts—high-impact advertising campaigns, significant emphasis on in-store advertising, consistent use of Caucasian models in its advertisements (which firmly entrenched its brand recall as an ‘international brand’) and strict pricing discipline (no discounts).
We believe that there are very compelling reasons to not touch investment portfolios for long periods of time. In fact, churn in a portfolio goes against the basic philosophy of long-term investing, which is a cornerstone of Robert Kirby’s original Coffee Can construct. Here are four compelling factors that go against churn in a portfolio composed of great companies:
Thus, whilst over longer time horizons, the odds of profiting from equity investments are very high, the same cannot be said of shorter time frames. In his book, More Than You Know,15 celebrated American strategist Michael Mauboussin illustrates this concept using simple maths in the context of US equities. We use that illustration here and apply it in the context of Indian equities.
The probability of generating positive returns goes up to 70 per cent if the time horizon increases to one year; the probability tends towards 100 per cent if the time horizon is increased to ten years (see the exhibit below).
In the exhibit below, we track the progress of this portfolio over a ten-year holding horizon. As time progresses, stock B declines to irrelevance while the portfolio value starts converging to the value of holding in stock A. Even with the assumed 50 per cent strike rate with symmetry around the magnitude of winning and losing returns, the portfolio compounds at a healthy 17.6 per cent per annum over this ten-year period, a pretty healthy rate of return. This example demonstrates how powerful compounding can be for investor portfolios if only sufficient time is allowed for it to work its
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As an example, we highlight how, over the long term, Page’s stock price has withstood short-term disappointments to eventually compound at an impressive 45 per cent CAGR since March 2007 to June 2017 (see the exhibit below).
there is no point trying to be too precise about timing your entry or your exit. As soon as you try to time that entry/exit, you run the risk of ‘noise’ rather than fundamentals driving your investment decisions.
Assume that you invest US$100 million in a hypothetical portfolio on 30 June 2006. Assume further that you churn this portfolio by 50 per cent per annum (implying that a typical position is held for two years) and this portfolio compounds at the rate of Sensex Index.
The lack of correlation between starting-period valuations and long-term holding period returns seems to be specific to India.
Business, defined a term ‘value premium’ in 1992 as the outperformance of value stocks over growth stocks16 when measured using risk-adjusted returns. By this definition, a low P/E multiple stock achieves a higher risk-adjusted return compared to a high P/E multiple stock.
However, our analysis above suggests that in the Indian stock market, a low P/E multiple-based investing approach does NOT improve the return profile of an investor.17 Given this analysis of value investing, it’s clear that investors in Indian stock market should stick with high-quality franchises for the long haul without giving undue importance to valuations.
Specifically, the franchises which featured most often in Coffee Can Portfolios tend to have three common characteristics: a) obsessive focus on the core franchise instead of being distracted by short-term gambles outside the core segment; b) relentless deepening of competitive moats and; c) sensible capital allocation.
More B2C (Business to Consumer) than B2B (Business to Business) sectors: By definition, a B2C firm is one which sells its products or services directly to the end-consumer unlike a B2B firm which sells to another business, which in turn sells it forward after adding more value to it. Most B2C businesses are in sectors like consumption (in the broadest sense of the word), banking and pharma. Within B2C, the Coffee Can portfolio attracts businesses with smaller ticket size and repeat purchase of products and services (i.e. excluding infrequent large ticket consumption areas like residential real
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Due to its proximity with the end-consumer, a great B2C firm is better able to respond to or drive an evolutionary trend of its end-consumer. Hence, a portfolio construct chasing consistency of performance over long periods is likely to end up focusing more on B2C businesses than B2B businesses. Over the past seventeen years, Ambit’s Coffee Can philosophy has seen an average of 75 per cent allocation to sectors like consumption (including autos, home-building materials, staples consumption and discretionary consumption), banking, pharma and IT. More structural
However, we avoid companies which need leverage to grow revenues, e.g. power, steel and real estate sectors. This is because the illiquidity of their asset base reduces the flexibility required to evolve the company over longer periods of time. This illiquidity arises because of the specialized nature of these assets and their specific use; in cases requiring immediate change of business direction, these assets cannot be sold immediately.
Prefer companies with intangible strategic assets: Strategic assets are those that give a firm a platform over which it can build a stack of initiatives like raw material procurement, product development, marketing strengths, great distribution, pricing power, supply chain, etc., and hence sustain competitive advantages. For most good (but not ‘great’) companies, strategic assets are only tangible in nature—access to natural resources, strategically positioned real estate, one good CEO, or surplus capital on the balance sheet.
Such intangible assets can either include intellectual property (patents or proprietary know-how), licences or culture-oriented aspects like: a) hiring, incentivizing, empowering and retaining top-quality talent; b) using IT (technology) investments not just as a support function, but as a backbone of the organization to ensure all aspects of the business are process-oriented and hence efficient; or c) proactively looking after the company’s channel partners, vendors and employees at times when they undergo personal or professional crises.
‘Beware of little expenses. A small leak will sink a great ship.’ —Benjamin Franklin (1706–90)
Had Mr Talwar looked at his portfolio more keenly, he would have realized that his basic purpose of investing money was being defeated by very high expenses. At 1 per cent (or more) brokerage (or fees) per transaction and due to the frequent churn, he ended up paying up to 7 per cent per annum of his stock portfolio as commissions.
ULIPs were even worse. They have three components—insurance, investment and expenses—and their tenors run into decades.
Transaction fees: Also called brokerage, it is the fee you end up paying every time you enter a transaction. More typical to the stock portfolio, these expenses look small in themselves; however they have a devastating effect when the portfolio turnover or the churn goes up. If a broker charges you a 0.5 per cent fee for a stock purchase, it may not seem like much. If, however, in the course of a year you bought and sold five times, your total fee as a percentage of your portfolio becomes 5 per cent!
In insurance products and structured products, it is not easy for investors to understand exactly what fees are being charged. In structured products,2 for example, the investor could be given a formula for the return on his principal but that is really the net return in his hands. He is not told what the actual gross return generated from that product is. The difference between the two is what the manufacturer and the distributor cream from the buyers of structured products. Such hidden charges are also embedded in complex products like ULIPs.
As an illustration, let us compare two mutual funds with the same gross return of 15 per cent per annum. The first has an expense ratio of 2.5 per cent per annum while the second has an expense ratio of 0.1 per cent per annum. Let us now see the impact of these expense ratios on the long-term returns generated from investing Rs 1 lakh in each of these mutual funds (see the exhibit below).
A twenty-year-old who invests Rs 1 lakh when he/she starts working will get Rs 1.11 crore when they retire (at sixty) from the first fund which has a 2.5 per cent expense ratio. From the second fund, which has a 0.1 per cent expense ratio, he/she will get Rs 2.58 crore. That’s more than double the corpus from the first fund!
These are not assumptions which we have plucked from thin air. Presently, most equity mutual funds have an annual management fee of 2.5 per cent. In contrast, in an ETF (Exchange Traded Fund), the fee is approximately 0.1 per cent.
A mutual fund by definition is an investment vehicle made by collecting funds from various investors for the purpose of investing in assets like stocks, bonds, etc. Such funds are managed by an expert manager who seeks to provide returns/gains to the investors.
Mutual funds are believed to have originated in the Netherlands. In 1774, a Dutch merchant named Adriaan van Ketwich pooled money from a number of subscribers to form an investment pool and named it Eendragt Maakt Magt, which means ‘unity creates strength’. By early 1775, the fund was fully subscribed, and the shares became tradable on the Amsterdam Exchange.
The first modern-day mutual fund, Massachusetts Investors Trust, was created in the United States in 1924. It was an open-ended mutual fund and allowed for continuous issue and redemption of shares. By the end of 1929, there were about twenty open-ended mutual funds and more than 500 closed-ended mutual funds in the US.
The mutual fund industry in India was born in 1963 when the Unit Trust of India (UTI) was formed through an Act of Parliament. For almost twenty-five years, the UTI was the only entity offering mutual funds in India, and the first scheme it launched was Unit Scheme 1964.
The year 1993 marked the entry of private sector companies in the sector. Kothari Pioneer (now Franklin Templeton) was the first private sector mutual fund to be registered in 1993.
The Indian mutual fund industry now has more than forty fund houses offering approximately 2500 schemes across various asset classes like equity, debt, hybrid and commodities (gold). The industry now manages more than Rs 20 lakh crore (i.e. Rs 20 trillion or approximately US$ 315 billion) in AUM, of which about Rs 6 lakh crore is in equity.
While SEBI has abolished entry loads in mutual funds, exit loads are still being charged. Most of the equity funds charge a 1 per cent exit load if investors redeem in less than a year.
The American mutual fund industry is around forty years older than ours and, hence, both more mature and more competitive. In the US, fund management fees have come down significantly. In fact, as shown in Exhibit 21, total expenses in the US (expressed as a percentage of assets under management) have fallen cumulatively by 40 per cent in the last two decades (left axis of the chart). In contrast, in India, expenses continue to be high (right axis of the chart). Apart from SEBI abolishing the upfront fees, it would appear that little has changed with respect to fund management charges.
Ind vs us comparison of mutual funds
