Introduction

About the book:

The book begins with an analogy between test cricket and investing.

Peak performance in Test cricket requires technical proficiency and intelligence, and immense powers of concentration. In that regard, Test cricket and investing in Indian equities have interesting parallels, an appreciation of which can help newcomers understand the process of investing and the toolkits required to build a durably successful investment portfolio.

Why Equity Investing In India Parallels Test Cricket?

As a group of cricket lovers, the author and his team are not just crazy followers of the sport, but they also find inspiration from it from time to time. And, given that ours is an entire nation of cricket lovers, they have also found cricketing analogies to be the most effective in communicating our investing approach.

Many people perceive investing as something involving constant action, including monitoring the share prices and reacting quickly to news flow and market movements. The general belief is that such 'active investing yields results in the immediate future. However, it seldom works like that. Investing is not like a T20 match where you attempt to hit every ball out of the park. It is more like Test cricket, where you do not even attempt to play every ball, let alone try to hit it to the boundary. Therefore, the key to successful investing is to leave the risky stocks alone, then identify the ones that can grow earnings and cash flows steadily, and once you find such stocks, bet big on them. Also, as in Test cricket, investing requires the player to possess the relevant skills and training and the mental conditioning and discipline to apply those skills and training consistently. More crucially, investing requires the patience to play long innings, which, as in Test cricket, is the assured way to victory. The difference between successful and unsuccessful investing is, in many ways, the difference between Test cricket and T20.

The skill-building process for an investor starts ten years later compared to that of a budding batter. Most investors are in their early twenties when they first learn the analysis of financial statements and valuation techniques. While these are the foundational concepts of investing, the young investor tends to understand only the superficial aspects of these concepts. And, if investing is akin to Test cricket, who better to emulate than Rahul Dravid, the most excellent Test batsman to play for India and one of the greats of the game across all eras and all countries. Unfortunately, his skill-set, which looks simple on its face, is very hard to acquire.

Similarly, acquiring the right skills for investing is not an easy task. It requires a lot of effort to identify the right companies to invest in, which are expected to become multi-baggers. This book will help you identify such companies and answer the two most difficult questions that arise in every investor's mind. They are:

• What to buy?
• When to buy?

About the author:

Saurabh Mukherjea is a bestselling author and the founder and CIO of Marcellus Investment Managers. Previously, he was the CEO of Ambit Capital, an Indian investment bank. He was rated the leading equity strategist in India in polls conducted by Asiamoney in 2014, 2015 and 2016. A London School of Economics alumnus, Mukherjea, is also a CFA charter holder. He has authored five books now.

But the book:

The book teaches you how to identify a few good stocks for investments that can provide multi-bagger returns consistently over a long period. We highly recommend you read the entire book.

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Four Myths About Investing In India

So, in this section, the author will discuss the four myths about Investing here in India. 

MYTH 1: Gold will help me protect my wealth

According to an RBI report, the author found that next to real estate, gold, at 11%, accounts for the largest share of the wealth of Indian households. An 11% allocation to any asset is a reasonably large chunk by any standard. So how has such a material asset allocation worked for Indian households? Over the last ten/twenty/thirty years, the price of gold (in rupee terms) has compounded at an annualized return of 9.2%/12.7%/9.3%, respectively.

Over the same periods, an investment in the equity markets, represented by an investment in the BSE Sensex index, returned 10.4%/15.0%/14.8%, respectively, higher than gold. However, if the author considers returns from gold in each of the three decades separately over the last thirty years, he sees that gold has underperformed the Sensex by a wide margin. In 1990–2000, gold prices grew at an annualized return of just 2.8%, not even beating inflation. The narrowest margin by which gold underperformed was in 2010–2020, when gold prices compounded at 9.2% per annum, against 10.4% of the Sensex. However, in this decade, gold prices were more volatile (measured by the standard deviation) than equities, suggesting that there wasn't a compelling reason to own gold on a volatility-adjusted basis.

Even though gold does not fetch returns superior to equity, it could improve the portfolio's risk-adjusted returns if it were negatively correlated to equities (thus allowing you to diversify your returns). The widespread public perception is that gold is negatively related to equities. However, the data on this is mixed. While gold has been negatively correlated to the Sensex over the past ten years, over more extended periods, namely twenty and thirty years, the negative correlation drops away and becomes a mild positive correlation. This means that the prices of gold and the BSE Sensex have moved more or less in tandem over the last twenty-year and thirty-year periods.

Further, if the author breaks down the last thirty years into three decades, he sees that gold has, for the most period, been positively correlated to equities. This means that using gold as a diversifier of wealth also does not work consistently. On the whole, it is difficult to make a case for gold forming a significant part of the portfolio of an Indian investor.

MYTH 2: Real Estate will help me grow my wealth

Over the last five years, if one were to look at the return rate from real estate in metropolitan cities in India such as Mumbai, Delhi and Bengaluru, one would see that returns have been around 3–4% per annum; i.e., house prices have at best-kept pace with consumer inflation. Real estate in major markets like the National Capital Region has not even accomplished that. However, a school of thought in India says that because residential real estate returns have been weak over the last five years, they will be better going forward. However, this point of view cannot be sustained when one compares Indian house prices with the prices prevalent in other markets. The first problem is affordability. As shown in the chart below, Indian residential house prices, expressed as a proportion of GDP, are 6– 10x the prices prevalent in some comparable Asian economies.

Secondly, Indian residential rental yields are around 2–3% in most Indian cities, whereas the cost of a home loan for prime residential real estate customers is about 7%. The disparity between these numbers suggests that Indian residential real estate still has room to correct from its highs before it becomes an attractive asset class.

Thirdly, comparing Indian residential rental yields with yields in other countries suggests that the Indian residential property market is significantly overvalued. For example, other markets whose rental yields are comparable with India’s—say, Singapore and the USA—have borrowing costs of 2–3%. In contrast, as mentioned above, in India, the price of a home loan for even a prime customer is much higher, around 7%.

The cost of a home loan in India is significantly higher than in Indonesia (7% vs 5%), even though rental yields in Indonesia are much higher than in India. Therefore, investing in real estate in India does not make much economic sense. Add to it other factors—such as high transaction costs (broking, stamp duty, etc.), illiquidity (your property is pretty useless in funding emergency cash calls) and the lack of transparency in finding the actual value or price—and investing in real estate becomes cumbersome and risky.

MYTH 3: Debt mutual funds offer decent returns with low volatility

Salespeople who earn a living by selling mutual funds have popularized the idea that HNIs should invest in debt funds, which give industry-beating returns. Despite the repeated high-profile reverses suffered by prominent mutual fund houses with high-risk, low-quality paper in their debt funds, the intermediary community continues to sell such products. So, why are debt funds far riskier to invest in than many investors believe (and many intermediaries let on)? Personal finance guru Monika Halan has provided an excellent explanation for this:

Remember, when you lend money, the interest is the reward you get for postponing your consumption, taking care of the effects of inflation on the money you get back. The risk of the borrower not returning your money. The government is considered to have no risk of default, and therefore the rate at which the government borrows is called the risk-free rate. As the creditworthiness of firms falls, the interest they offer rises. When you invest in a debt fund, the scheme buys bonds and other fixed return instruments. The risk in debt funds comes from several sources. The author will discuss the three most important aspects of this conversation.

The first is interest rate changes, or an interest rate risk. This is the risk of your fund manager’s interest rate call going wrong.

The second is the risk of default by the borrower—or credit risk. Funds can invest in debt papers rated investment grade by credit rating agencies. But within this band of investment-grade, fund houses can invest in lower-rated papers than the safest paper in the market. As a result, when things go wrong for the firm that borrowed money from the mutual fund, the credit ratings can drop sharply, and the fund's value suffers. When such an event happens, there is a significant redemption pressure. 

The third risk kicks in lack of liquidity—or the lack of a market when you want to exit.
The non-government Indian bond market is not very liquid; that is, fund managers may not find buyers if they need to sell in distress.

A debt mutual fund’s return is a function of: 

1) Yield to Maturity or YTM, 
2) Mark to Market or MTM, 
3) Expense Ratio. 

Let’s delve into these: MTM and the expense ratio should not differ markedly between debt mutual funds. That brings us to the YTM, which refers to the total return earned on a bond held until maturity with interest reinvested at the same rate. The YTM of a debt fund is the weighted average yield of all its investments. The yield of a debt fund depends on the credit quality of its portfolio.

All corporate debts are ‘rated’ based on the probability of the corporation defaulting on its debt obligations. These ratings are provided by credit rating agencies that, the world over, are conflicted because the issuer of the debt pays the credit rating agency its fees. The debt issuers with the strongest balance sheets get a rating of ‘AAA’, implying that their probability of default is similar to that of the government.

In contrast, companies with poor debt management may get a rating of ‘B’.

There tends to be an inverse correlation between the rating enjoyed by the debt issuer and the YTM on the issuer’s bonds, i.e., companies with the strongest ratings enjoy the lowest YTMs. That, in turn, means that a fund manager who stuffs his debt fund full of highly-rated bonds will have a fund with a low YTM, and hence the debt fund will give low returns. However, that will make the fund unpopular with the army of salespeople who sell such products. So, fund managers who want to earn significant bonuses tend to stuff their debt funds full of bonds with low credit ratings.

Such funds deliver high returns for a few years, but when defaults occur (low-rated bonds have high default risk), the whole thing blows up, and millions of investors find that their savings in debt funds are worth much less than they thought they would be. 

MYTH 4: GDP growth drives the stock market. So, if I can time the economic cycle, I can time the stock market 

In a blog post published by Marcellus in November 2019, they have shown that the relationship between Nifty50 EPS growth and GDP growth seems to have completely broken down in the last five years.

 Do note two things in the chart above:

(1) the growing gap between the two lines;
(2) the fact that the lines often go in opposite directions.

To understand why the Nifty50 no longer captures the dynamism of the Indian economy, an excellent place to start is the index as it stood ten years ago. The ten-year (2011–2020) share price return from investing in the Nifty50 is 9% (on a total return basis), i.e., significantly lower than India’s nominal GDP growth, which, over the same decade, has been around 12% per annum.

More generally, there tends to be low or no correlation between stock markets and GDP growth across the world, implying that timing the stock market is not possible on a systematic basis. For example, Ben Inker of the fund management house GMO, in an article in 2012, concluded that ‘Stock market returns do not require a particular level of GDP growth, nor does a particular level of GDP growth imply anything about stock market returns.’

The valuation guru Aswath Damodaran says that instead of running from GDP growth to the stock market, the causal relationship runs the other way round, i.e., stock markets are predictors of GDP growth (rather than being ‘reflectors of GDP growth’). So, for example, he highlights a 30% correlation between stock market returns in the US in the period 1961–2019 and GDP growth four quarters hence.

Reality: Equities are a better way to build wealth

Suppose gold, real estate, bank deposits and corporate debt (through mutual funds) do not optimally balance risk, returns, diversification and financial objectives for Indian savers. What other options do they have to invest in and build their wealth? Are equities the answer? Let’s find out in the next section.

How CAPM Has Hurt A Generation Of Indian Investors?

Over the last twenty years, equities have generated a 13%% compounded return (measured by the returns on the Nifty50 Total Return Index). And some selected portfolios, such as the ones shown in the book Coffee Can Investing: The Low-Risk Route to Stupendous Wealth, has generated compounded annual returns in excess of 20% over twenty years. However, investments in equities also suffer from some of the same problems discussed above, the main being the lack of access to sound and trusted advice. This leads to investors taking on undue risk while building their equity portfolios. Chasing stocks in sectors that are in favour, buying cyclical stocks without appreciating the underlying drivers of cyclicality, and trading in and out of stocks based on punts on the outcome of short-term events, are some of the ways these risks manifest in investors’ portfolios. A key reason for this is the reliance on conventional financial theory, particularly the capital asset pricing model (CAPM), which has shaped the world view of many investment advisors.

But how has CAPM hurt a generation of Indian investors?

There are many delusional theories in finance. One of these is the Efficient Markets Hypothesis (EMH), which contends that since stock prices efficiently discount all the available information, it is impossible to beat the market. Another is the Capital Asset Pricing Model (CAPM), which claims that the returns from stock will be directly proportional to the systematic risk (or beta) represented by the stock.

Whilst Warren Buffett’s rubbishing of the EMH in a famous speech delivered in 1984 at Columbia University is well-known, CAPM is still taught in classrooms worldwide—thanks to the pseudo-science peddled by business schools—including in India. But unfortunately, CAPM is even less applicable in this country than in America.

So, what is CAPM and just why is it so damaging? Investopedia explains CAPM this way:

The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for assets, particularly stocks.

CAPM is widely used throughout finance for pricing risky securities and generating expected returns for assets, given the risk of those assets and the cost of capital.

The formula for calculating the expected return of an asset given its risk is as follows:

ER i = R f + β i (ER m − R f)

where,

ER i =expected return of investment
R f =risk-free rate
β i =beta of the investment
(ER m − R f) =market risk premium

Investors expect to be compensated for risk and the time value of money.

The risk-free rate in the CAPM formula accounts for the time value of money. The other components of the CAPM formula account for the investor taking on additional risk.

The beta of a potential investment measures how much risk the investment will add to a portfolio that looks like the market. If a stock is riskier than the market, it will have a beta greater than one.

Conversely, if a stock has a beta of less than one, the formula assumes it will reduce the risk of a portfolio.

A stock’s beta is then multiplied by the market risk premium, which is the return expected from the market above the risk-free rate. The risk-free rate is then added to the product of the stock’s beta and the market risk premium. The result should give an investor the required return or discount rate they can use to find the value of an asset.

Following CAPM in India leads investors to cause self-damage. The investor believes that higher returns are proportional to higher risk (measured in CAPM by higher beta).

In short, not only is there NO POSITIVE relationship between beta and stock-level returns, there seems to be strong evidence that lower beta leads to higher returns. This finding also holds if, rather than using beta as a proxy for risk, one uses share price volatility (as measured by the standard deviation of monthly returns divided by the compounded annual returns over the corresponding period). Specifically, there is a STRONG NEGATIVE correlation between share price volatility and returns, i.e., companies whose share prices are less volatile give significantly better returns over twenty, ten, five, and even three years.

Therefore, the data shows that CAPM is completely useless in India—not only do the highest-risk stocks (high-beta stocks) NOT deliver the highest returns, but the stocks that deliver the best returns are low-risk stocks (i.e., low-beta stocks with low share price volatility). So, why doesn’t CAPM work in India? Because the assumptions underlying CAPM is unrealistic, even in a developed market like the US.

In an emerging market like India, these assumptions are on the verge of being delusional. For example, CAPM assumes that all investors have free access to all information at no cost. This makes no sense in a market like India, where even institutional investors have little or no idea of the accounting fraud that most companies engage in.

Another example of an absurd assumption embedded in CAPM is that there are no taxes and no transaction costs. In reality, short-term capital gains tax is 15%, and even for Nifty50 stocks, brokerage costs plus price-impact costs are around 0.5% for institutional investors. So, if CAPM does not work in India, what does? Crushing risk works in India. Let us dig deep into the concept in the next section. 

Crushing Risk Is The Key To Generating Higher Returns In India

You need to minimize four types of risks if you want to generate steady and healthy investment returns in the Indian stock market:

Accounting risk: Whilst you all now know how prominent public and private sector banks in India fudged their bad-debt figures for years until the RBI's Asset Quality Review in 2015 forced them to come clean, the same problem still exists with several housing finance companies. The accounts of a leading cement manufacturer don't stack up. Neither does the annual report of a high-flying retailer make sense—ditto with a prominent petrochemical company and a prominent pharma company. The majority of the companies in the BSE500 have annual reports that don't pass scrutiny. Using twelve forensic accounting ratios and a financial model which contains time-series data on 1,300 of India's largest listed companies, they seek to identify that 20% of the Indian stock market whose books are believable. The next chapter of the book focuses on this subject in more detail.

Revenue risk: At around US$2100, India's per capita income is still meagre (nearly half the level of Sri Lanka's, less than one-fifth of Malaysia's and about one-fourth of Thailand's). As a result, beyond the essentials of life—FMCG products, medicines, basic apparel and basic financial services products—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. For example, suppose you consider the sales volumes reported by Maruti Suzuki. In that case, you see that the company typically experiences six to seven years of solid demand growth (growth well above 15% per annum—for example, 15.2% CAGR in volumes over FY 2004–11) followed by three to four years of famine (growth well below 5% per annum—example, 0.4% CAGR in volumes over FY 2011–15). Whilst its cross-cycle average growth tends to be around 12%, the stock price volatility reflects the volatility of Maruti's top-line growth. In contrast, a company selling essential products, like Asian Paints or Marico, tends to see steady revenue growth—between 10% and 20% per annum—pretty much every year. Investing in companies selling essential products in India, therefore, reduces risk.

Profit risk: As the cost of capital is still pretty high for India, it is rare to find Indian companies that spend heavily on genuine R&D.
Understandably, the Indian economy is characterized by rapid imitation—one company spots a niche (say, gold loan finance), and within a decade, it has dozens of imitators. This rapid entry of new companies into a business squeezes the profitability of the first mover and thus creates risk for its shareholders. To reduce such risk, they look for sectors where, over extended periods, one or two companies cumulatively account for 80% of the sector's profit pie. Such monopolies have lower volatility in their profit margin.

Liquidity risk: Liquidity measures how easily an asset or security (like stocks) can be bought or sold in its markets. Liquidity is usually measured in terms of a stock's average daily traded volume (ADV). The higher the ADV, the easier it is to buy or sell the stock without materially impacting its price. Unfortunately, India is one of the least liquid of the world's top eight stock markets, mainly because promoters own more than half of the shares outstanding in the Indian market. As a result, beyond the top thirty or so stocks in India, liquidity drops rapidly. By the time you are in the lower reaches of the BSE100, the ADV tends to fall to as low as Rs 10 crore per day. Such low liquidity creates stock-price gyrations as investors go through election-induced euphoria cycles and accounting fraud-induced panic. Tilting the portfolio towards liquid stocks reduces this risk.

The Consistent Compounding Formula

In this book, the author elaborates on the key elements necessary for crushing risk to generate steady and healthy returns from equities in India. Their approach is to buy clean, well-managed Indian companies selling essential products behind very high barriers to entry. They call this approach to investing Consistent Compounding, and have seen, both in theory and in practice, that it works. This approach has three key elements—

• Credible Accounting
• Competitive Advantage 
• Capital Allocation

They are the foundational pillars of Marcellus’s investment philosophy, which will help investors generate healthy returns without taking additional risk (or loading up on beta).

The first pillar, Credible Accounting, uses a set of forensic accounting ratios and techniques to identify companies with the least accounting risk and the highest reliability of reported financial statements. 

The second pillar, Competitive Advantage, is the search for companies that possess strong and durable pricing power, enabling them to be leaders in their markets and consistently earn returns higher than their cost of capital. This mitigates their revenue and profit risk. 

The third pillar, Capital Allocation, is about finding companies that make the best use of their excess returns (the difference between the return on capital and cost of capital, akin to free cash flow) to grow their business and deepen their competitive advantages. 

Knowing what stocks to buy using the three pillars is the ‘Consistent Compounding Formula’

In the first part of the book, the author discusses the Consistent Compounding Formula to understand ‘what to buy'. Then, in the later part, they discuss ‘when to buy' and focus on two key areas that regularly confound investors—the timing of stock purchases (or sales) and the valuations at which to buy (or sell) them. But, before they dive into these topics, let us also understand what this book is not about in the next section.

The ABC Of Indian Stocks

As they will see in subsequent chapters, the Consistent Compounding approach to investing is simple to understand but not easy to practice. The critical challenge investors face at the very outset is that ‘consistent compounder’ stocks are few and far between in the Indian stock market. This book is not about the vast majority of stocks that do not possess the three foundational pillars of consistent compounding mentioned earlier. Instead, this section discusses the kind of stocks that make up this vast majority of the Indian stock market and the kind of stocks that are the small minority of ‘consistent compounders’.

Given how price multiples have expanded for high-quality companies over the last decade, should investors be concerned about the sustainability of stock returns from such companies if they buy at current levels? Their answer is a resounding NO . . . whether they look at bull market phases of the Indian stock market or bear market phases, all the evidence points in one direction—starting-period valuations have minimal impact on long-medium-run investment returns in India. Moreover, the lack of correlation between starting period valuations and long-term holding period returns seems specific to India. 

Eighty years ago, Benjamin Graham and David Dodd introduced to the investing world the then-revolutionary and interlinked concepts of ‘value investing’ and ‘margin of safety' in their book Security Analysis. In an era ravaged by the Great Depression, the two men pointed out that the way to make money in the stock market with a high degree of certainty is to buy companies with low P/B, low P/E multiples and low debt. In addition, such investments meant that your purchase price would be significantly below the fair value of the stock, thus providing a ‘margin of safety for the investor.

Since the publication of Security Analysis, numerous academics have shown that value investing does generate superior results in the US market and elsewhere. Even more famously, Warren Buffett, in his famous 1984 speech at Columbia University—which they referenced earlier in this chapter—reaffirmed the superiority of value investing to other investing approaches:

The common intellectual theme of the investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in the market. Essentially, they exploit those discrepancies without the efficient market theorist’s concern about whether the stocks are bought on Monday or Thursday, whether it is January or July, etc. Incidentally, when businessmen buy businesses, which is just what our Graham & Dodd investors are doing through the medium of marketable stocks . . . Our Graham & Dodd investors, needless to say, do not discuss beta, the capital asset pricing model, or covariance in returns among securities.

These are not subjects of any interest to them . . . So instead, investors focus on two variables: price and value.

In India, too, one could argue that value investing (i.e., buying companies when they are inexpensive on P/E) makes sense for most stocks. One can divide the Indian stock market into broadly three sets of companies:

TYPE A stocks comprise around 80–90% of the Indian market. Such companies find it difficult to grow earnings over extended periods. This is because they have no sustainable competitive advantages and hence no ability to generate a Return on Capital Employed (RoCE) in excess of the Cost of Capital (CoC). Lacking sustainable free cash flows, such companies struggle to invest in growing their businesses. 

Examples of such companies are India’s telecom providers and its airlines, with never-ending volume growth but with no sustainable competitive advantages and hence no earnings growth.

If you assume that you make returns from investing in any company from two sources—either the P/E expands or the earnings expand—with Type A stocks, your only hope of making money is that the P/E grows (since the earnings are unlikely to expand). If you find a fund manager who can double the Type A company’s P/E over a decade, your returns will compound at 7% CAGR. If the fund manager you found mistimed his investment, i.e., he entered when the P/E was high (he wasn’t a value investor) and exited when the P/E had halved, your return will be -7% CAGR.

TYPE B  stocks account for a further 5–10% of the Indian market, and this segment includes good franchises like Maruti or HUL, which have meaningful competitive advantages. As a result, these companies will have a RoCE higher than the CoC in most years. Moreover, reinvestment of the free cash flow will allow these companies to grow their business at around 10–12% CAGR, i.e., the same rate as nominal GDP growth on a cross-cycle basis.

Here too, value investing works. If you can find a fund manager who enters Maruti Suzuki at 13x P/E and exits a decade later at 26x P/E, the stock would give you returns of around 18–19% (10–12% from earnings growth and 7% from P/E doubling). If, on the other hand, your fund manager has mistimed your investment, i.e., he entered when the P/E was high (he wasn’t a value investor) and exited when the P/E had halved, your return will be 3–5% CAGR (10–12% from earnings minus 7% from P/E compression). A committed value investor like Warren Buffett can generate high-teen returns with Type B stocks if he times his entry point well. This is exactly what Buffett’s legend is built around.

If we were living in America (or in any other large economy, barring India), Type A & B stocks would form the entire investment universe. However, there is a third subset of stocks in the Indian stock market— Type C.

This book is all about Type C stocks. However, such stocks constitute less than 1% of the Indian stock market (if measured by the number of stocks). So, why did the author write a book about a handful of companies which make up less than 1% of the Indian stock market?

India is perhaps the only large economy where one or two players dominate several industries, and these dominant players make returns on capital employed (RoCE—earnings generated on each unit of capital employed on the balance sheet) that are significantly higher than the cost of capital (CoC) for several decades. For instance, 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, and Hanes dominates Europe’s innerwear market. However, none of these companies makes RoEs substantially higher than their cost of equity. On the other hand, India has several industries where one or two companies have a dominant market share. Still, their RoCEs have also remained substantially above the cost of equity for decades in a row.

We can call these Indian companies—whose RoCEs are a million miles above their CoC for decades on end—Type C. The vast free cash flows that these firms generate decade after decade allow them to pay generous dividends (dividend yields for such firms tend to be 2–3%) and reinvest in growing the business. As a result, earnings growth for such firms tends to be around 25% per annum.

With a Type C firm, if the fund manager can get the timing of his entry and exit right, the results are spectacular: 25% earnings growth + 7% from doubling of P/E + 2% from dividend yield = 34% per annum return. However, since many of these firms are trading at optically high P/Es, let’s assume that their P/Es halve over the next decade. These Type C firms produce a return of 20% (25% earnings growth—7% for P/E halving + 2% dividend yield). Interestingly, even with P/Es halving over ten years, Type C firms produce returns similar to Type B firms with P/E doubling (20% vs 17–19%]. For 99% of Indian stocks, value investing provides the only route to decent returns (in the mid-high teens). The challenge that India’s Type C firms pose to Graham & Dodd’s value investment paradigm can be understood in the context of the investment framework that these legends had laid out in Security Analysis.

The value of a firm is nothing more than its future cash flows (discounted appropriately). These future cash flows are nothing more than the gap between RoCE and CoC. When a firm or firms in any industry are earning a return on capital far higher than their cost of capital, they attract new players into the industry who also wish to make attractive returns. The more the number of players, the greater the competitive intensity in the industry, putting pressure on profitability and returns for all players, including the incumbents. As a result, the gap between the RoCE and CoC keeps narrowing. However, if the gap between the RoCE and CoC does not close (say, because the Indian economy is not as competitive as the US economy or the Chinese economy)—as often happens with Type C companies in India—the future cash flows of such firms remain healthy. Hence, they drive a high value for the firm.

Such firms can therefore command very high P/E multiples. But, as they have said before, less than 1% of the stocks in the Indian market fall in this category! For the remainder of the investment universe in India—as in America—the rules of Graham and Doddsville can be successfully applied.

In this book, the author discusses why Type C firms exist in India, how you can spot them, and how much money you can make from them. The table below summarizes the taxonomy of Types A, B, and C outlined above.

Key Takeaways Till Now

Most investors in India who follow the common myths around investment in asset classes like real estate, gold and debt mutual funds fail to beat the inflation rate in their wealth-compounding.

While equities as an asset class are better wealth compounders than real estate, gold and debt and real estate, investment in equities is also plagued with similar problems as the other asset classes, in the context of investors taking on undue risk building their equity portfolios. An equity investor in India needs to minimize four types of risks if she wants to generate steady and healthy investment returns— Accounting risk, Revenue risk, Profit risk and Liquidity risk. The ‘Consistent Compounding’ approach to investing in equities in India has three key elements—Credible Accounting, Competitive Advantage and Capital Allocation, which help investors generate healthy returns without taking additional risk (or loading up on beta).

What To Buy: Accounting Quality

The key points that we will discuss in this chapter are: 

• Why evaluating account quality should be a central part of investment research and analysis?
• How to identify the key traits of fraudulent companies/management? 
• What is Marcellus’s forensic framework for avoiding dubious companies?

First, let us discuss why evaluating accounting quality is central to investing? 

1. Financial statements form the foundation of the Investor’s efforts to evaluate and value companies

Financial statements provide the critical window to understanding and evaluating the company's operating performance, competitive strengths, and health. Financial statements also form the basis for making future company projections and valuing them. Hence, if the financial statements themselves are inaccurate, the whole edifice of the analysis can come crumbling down. Therefore, building confidence in the sanctity of the financial statements and the broader corporate governance of the company should be the starting point for any stock analysis.

2. The majority of listed companies in India give a raw deal to the minority shareholders

Given that greed is a common human trait, financial misreporting has been occurring in companies worldwide for decades. However, given the high proportion of Indian companies manipulating their financial statements, evaluating accounting quality is the single most important component of researching Indian stocks. This is amply demonstrated in the quantum of churn in the BSE500 Index—a premier index representing the top 500 companies by market capitalization in India.

Between June 2003 and June 2020, the annual churn in the BSE500 was close to 12%, which means, on average, nearly sixty companies exited the index every year. The high churn ratio implies that most incumbents cannot sustain their place in the index, making way for more deserving candidates.

A closer analysis of the stocks exiting the BSE500 over the last five to ten years indicates that most of these exits had little to do with business downturns but were mainly on corporate governance/accounting lapses and capital misallocation at these firms. If one were to look at the BSE500 as it stood in end-December 2009, of the 500 member stocks, only 267 remained in the index by end-December 2019. Nearly 40% of the stocks have exited the index over the last ten calendar years for reasons other than corporate action (delisting, acquisition, etc.). Most of these stocks saw significant erosion in their shareholders' wealth on their way out. On average, the companies which exited the index in 2019 had lost 30% of their December 2009 market capitalization.

While the number of companies that have generated enormous wealth for their shareholders is bound to be a handful, the number of companies that have destroyed shareholder wealth is perturbingly high in India. For example, only 18% of the December 2009 BSE constituents generated compounded annual returns in excess of 15% over December 2010–to December 2019. On the other hand, 51% of the constituents generated negative returns for the same period. Hence, an investor's ability to avoid dubious names is equally important as her ability to discover a great company.

3. Corporate frauds often leave the investor with little time to react and to exit the stock without material financial loss

As discussed earlier, when a fraud starts unravelling, the stock in question sees significant erosion in price. While the absolute destruction in the market cap is enormous, the pace of destruction is equally devastating in most cases. 

When the fraud gets unearthed, the share prices decline sharply in most cases. However, a similar or even more painful scenario is when the complete picture of the fraud is not yet out in the open. Still, the accounting quality and practices of the company appear to be questionable. A typical feature of such stocks is that they seem to be significantly cheaper than their historical valuation multiples and relative to their peers. Gullible investors who cannot recognize that such stocks are value traps keep buying the stock every fall. However, the share price slide never stopped, and what was perceived to be value hunting turned out to be a falling knife.

Key traits of a fraudulent company/management 

To build a practical fraud detection framework, the investor must understand the modus operandi of fraudulent companies. Based on the collective experience of analyzing the financial statements of thousands of companies over the last twelve years, the author and his team at Marcellus believe that the following are the most common traits of companies/managements engaging in accounting malpractices:

Marcellus’s 3-Level Check To Detect Accounting Frauds

In this section, we will see how the author explained the process of detecting accounting fraud in his book. 

Evaluating accounting quality and corporate governance is the cornerstone of Marcellus's investment process. Their research covers this evaluation in three ways: Level 1 checks, where they use their quantitative forensic screens to rank companies on their accounting quality. Their quantitative screens reject nearly 40% of companies from broad-based stock exchange indices that they analyse. The companies which make it through their quantitative forensic screens are the ones on which they conduct in-depth research and diligence. These companies are subject to two different levels of forensic checks: Level 2 checks, where they conduct an in-depth reading of the financial statements to identify some of the traits mentioned in the preceding section; and finally, Level 3 checks, where the author also tries to gauge promoter/management integrity by doing primary data checks on the companies, wherein the author speaks with former employees, customers and suppliers of the company.

Level 1 Checks: Marcellus's Clean Accounting Model

The first line of defence is the author's proprietary forensic accounting model. They have developed a model using a set of twelve ratios that helps us grade companies on their accounting quality. The selection of these ratios has been inspired by Howard M. Schilt's legendary book on forensic accounting, Financial Shenanigans. 

This book draws upon case studies of accounting frauds (involving well-known frauds like Enron and WorldCom and numerous lesser-known cases of accounting trickery) and, from the lessons learnt, creates techniques for detecting frauds in financial statements.

Their twelve forensic accounting ratios cover checks across the critical components of financial statements, including the profit and loss account (for revenue or earnings manipulation), balance sheet (for false representation of assets and liabilities), cash pilferage and audit quality. Some of the key ratios and their rationale are shown below.

The Forensic Framework has proven to be an effective predictive tool

There is a strong correlation between accounting quality, as indicated by their forensic model, and shareholder returns. 

Level 2 Check: Further Accounting and Corporate Governance checks

These checks are over and above the forensic screens and are usually employed during their deep-dive diligence on individual companies. Their forensic framework helps us weed out companies with dubious accounting quality. It also helps us identify the key accounting red flags for a company. However, their forensic model may not be able to pick up several qualitative aspects of accounting and corporate governance due to a lack of uniformity in data across companies or where there is subjective judgment involved. Such areas can only be evaluated through a deep dive into historical financial statements and primary data checks around management integrity. They have developed the following checklist for deeper accounting and corporate governance checks beyond the forensic model.

This checklist should form an essential part of qualitative assessment of any stock.

Level 3 Checks: Extensive Diligence through Primary Data Checks

The integrity of a company's promoters and management is assessed as the next level of accounting quality checks through detailed discussions with our primary data sources. The author seeks confirmation of the picture painted by the company's financials from primary data sources familiar with the company and who have worked with or dealt with it. Consumers of the company's products, channel partners, raw material suppliers, competitors, and so on are examples of such sources. This is especially important in the case of small caps, which have a shorter operating history and a high propensity to fudge accounts. Similarly, visiting the company's branches, factories, or even a plant under construction helps build confidence in the company's financials.

Accounting Quality: Spotting the Naughty Lenders

The key questions the author seeks to answer in this chapter are:

• How can minority investors differentiate between companies with poor accounting quality and well-run financial services companies with high quality accounting?
• What is the relationship between share price returns and accounting quality, and what are the benefits of investing in companies with high quality accounting?
• Why is accounting quality central to investing in financial companies?

Why is Accounting Quality central to investing in Financial Companies?

For a lending business, capital is its raw material. A lender raises equity capital and then raises debt, which is as high as five to ten times the equity and lends it out.

The profits generated from this increase the bank's net worth, allowing it to raise more debt and increase the quantum of loans it can give out. For some exceptionally able Indian lenders, this dynamic has created a virtuous cycle and has generated extraordinary returns for their shareholders. However, poor accounting quality and dishonest promoters are an existential threat to a bank or NBFC.

Stage 1: When Investors do not know which companies have a poor quality of accounting

There is a strong correlation between accounting quality and shareholder returns, irrespective of whether the sub-par accounting practices of companies are common knowledge or not. Therefore, in this chapter, the author has given details of Marcellus's proprietary forensic accounting model to identify financial services companies whose accounting quality is poor.

This framework will help investors demarcate financial services companies with high-quality accounting from those with poor accounting.

Stage 2: When Investors know which companies have poor quality accounting but their accounting fraud is not public knowledge yet. 

In some cases, shareholders decide to invest in financial services companies despite being aware of their sub-par accounting quality. Such investors are of the view that either:

1. The fraud won't come to light.
2. They will be able to exit the stock before the fraud becomes public knowledge.
3. They will have enough time to exit the stock once the fraud is public knowledge.

None of these arguments holds. For instance, Yes Bank and DHFL saw a 40% crash in their share prices within a month of their accounting issues becoming public knowledge. Even their credit ratings saw accelerated downgrades once their accounting issues started emerging. For example, it took just six months for DHFL's AAA rating (in January 2019) to be downgraded to D, which is the default grade.

Stage 3: When accounting fraud is public knowledge 

Even after a fraud is  public knowledge, retail shareholders have a tendency to go bottom fishing, i.e., investing in fraudulent companies at low prices in the hope of witnessing a miraculous turnaround story. For example, the retail shareholding in Yes Bank and DHFL more than doubled once their frauds became public knowledge and share prices declined. Many investors fall prey to the anchoring bias—their attraction towards such companies is stoked because shares of these companies can be bought at a fraction of the price they had earlier traded at. However, turnaround stories in the case of financial services companies are rare, and even when such miracles happen, the minority shareholders get substantially diluted before the new management can achieve the turnaround.

Therefore, the most prudent approach for investors would be to not invest in companies with poor quality accounting, irrespective of whether such accounting malpractices are public knowledge.

How to identify naughty financial services companies? 

The author introduces us to the forensic accounting model used to identify fraudulent companies. 
Forensic accounting means the use of accounting skills to investigate potential fraud. A forensic accounting model uses a combination of financial analysis tools to flag off risks in the reported financial statements of banks and financial services companies. Marcellus has developed a model using a set of eleven accounting ratios specifically for conducting forensic checks on the numbers of financial services companies. These ratios, covering the balance sheet, profit and loss statement and cash flow statements, grade financial services companies based on the quality of their accounting. Some of the key ratios and their rationale are shown below.

The methodology evaluates eleven accounting ratios covering income statement (for revenue/earnings manipulation), balance sheet (for false representation of assets/liabilities), NPA recognition and audit-quality checks using at least six years of historical financial statements. The financial services companies are then ranked on each of these eleven ratios individually and slotted into ten deciles, from D1 to D10 (D1 being the best score and D10 the worst). These ranks are then cumulated across parameters to give a final pecking order on accounting quality. The author has termed the top three deciles as the ‘Zone of Quality’, the following three as the ‘Zone of Opacity’ and the bottom four as the ‘Zone of Thuggery’. 

There are several qualitative aspects of accounting and corporate governance which the forensic model may not be able to pick up due to a lack of data uniformity across companies or where there is subjective judgment involved. Such areas can only be evaluated through a deep dive into historical financial statements and primary data checks around management integrity. Some of the aspects that are checked to determine include loan sourcing strategies, underwriting processes, risk management practices, the quality of the board of directors, the nature and significance of related-party transactions and the governance culture within the bank/NBFC.

What To Buy: Great Franchises

The key questions that the author seeks to answer in this chapter are:

• What are the benefits of high pricing power and strong competitive advantages?
• What are the sources of competitive advantages?
• Which companies in India have demonstrated the rare ability to deliver high returns on capital as well as a high rate of capital redeployment

The virtuous cycle of high ROCEs and high reinvestment rates:

The author's 12-year-old daughter is a budding pastry chef. Early on in her baking foray, she figured that if she wanted to make money from baking, the recipe for generating cash flow was straightforward. She would have to buy the ingredients required to bake a cake for ₹100 or less and sell the cake for ₹150 or more, thus assuring herself a minimum of ₹50 of cash flow. However, once she had the ₹50 in hand, she realized that now she had to make some tricky decisions—should she spend this money at the local ice-cream parlour or should she buy the latest books on baking cakes?

Running a company is simply a scaled-up version of what she is doing at a very basic level. Operating a firm is about using capital to drive a virtuous circle of resource allocation. A firm uses the money to consume and invest in raw materials, utilities, R&D, manpower, technology, manufacturing facilities and logistics. Typically, 'resources consumed' relates to the current requirements of a business and is classified as operating expense on the income statement. On the other hand, 'resources invested' relates to the future requirements of a business and is usually classified as fixed capital (CAPEX) or working capital investment on the balance sheet. Consumption and investment of these resources then help the firm produce products and provide services, which can then be sold to generate capital. This capital can then be reinvested into the business for further 'consumption and investment', and hence future business growth.

The capital (and hence the resources) available with a firm is limited and, like all resources, has a cost attached to it—the cost of capital for most listed firms in India is around 12–15%. Return on capital employed (RoCE) measures the cash flows generated by a firm per unit of money employed. If the RoCE earned by a firm is less than its cost of capital, it cannot pay the capital providers for the use of this limited resource. As a result, the business destroys value for shareholders since the shareholders would have earned a higher return on their capital had they invested it somewhere else. Similarly, a RoCE substantially higher than the cost of capital adds value for shareholders. However, the higher the RoCE of a firm, the greater the number of competitors it will likely attract. Hence, intense competition tends to reduce an incumbent firm's RoCE to as low as possible. This is where the firm's competitive advantages or moats come to the rescue. 

Competitive advantage enables a business to outperform its competitors and allows a company to achieve relatively healthy returns for its shareholders. This makes Competitive Advantage the second pillar of Marcellus's investment philosophy for identifying Consistent Compounders.

Firms with strong and sustainable competitive advantages can sustain RoCEs substantially higher than the cost of capital over long periods. This is because the stronger the competitive advantages are, the greater the barriers to entry faced by competition, and hence the more significant the pricing power that the firm possesses. 

For instance, in India's innerwear industry, Page Industries (the master franchisee in India of Jockey and Speedo) has delivered an average pre-tax RoCE of 60% over the last ten years, substantially above its cost of capital (which is likely to be around 12–15%), and has thereby generated substantial free cash flows for its shareholders.

However, operating in the same industry, peers like Rupa and Company, Dollar Industries, and VIP Clothing have, over the same period, earned RoCEs of only 23%, 17% and 6%, respectively, generating significantly lower free cash flows than Page Industries. Page's ability to generate and sustain RoCEs substantially higher than its cost of capital is reflective of its being a much stronger business than its peers. Similarly, Maruti Suzuki has delivered a pre-tax RoCE of 22% in India's passenger car industry over the past ten years, while the corresponding RoCE for Tata Motors is only 13%. Whilst' high RoCE' is reflective of strong competitive advantages, it is not sufficient to deliver growth for a business. If all the cash flow generated by a firm with a high RoCE is returned to shareholders, it is difficult for the firm to grow its revenues over time. Firms that can sustain business deliver more elevated and more sustainable earnings growth than firms with high RoCEs but a low rate of capital reinvestment in their business.

Typically, reinvestment of cash flows into the business can be done in two ways. On the one hand, cash flows can be reinvested towards building tangible assets on the balance sheet, like manufacturing plants, machinery and working capital, thereby increasing the firm's overall capital employed, which helps the firm expand faster than the competition. On the other hand, cash flows can also be reinvested on the income statement to build intangible assets like brands (although brands themselves are not sources of sustainable competitive advantages, as explained later in this chapter) and patents, which aid business growth in the future. For instance, in India's pressure cooker market, Hawkins and TTK Prestige possess strong competitive advantages, which are reflected in their average RoCEs over the past ten years, of 69% and 38%, respectively. However, with a capital reinvestment rate of only 26%, Hawkins has delivered a revenue CAGR of only 9% over FY 2010–20, while its competitor TTK Prestige has delivered a revenue CAGR of 14% over the same period, supported by a capital reinvestment rate of 80%.

Hence, to sustain healthy growth in cash flows and earnings over the long term, a firm must first establish sustainable competitive advantages and high pricing power, which help generate high RoCEs. After that, it needs to reinvest future cash flows in areas that deliver high RoCEs.

Sources Of Competitive Advantages

• Where do competitive advantages arise from?
• What are the sources from which a firm derives and sustains its edge over competition, allowing it to sustainably generate RoCEs higher than its peers? 

Bruce Greenwald and Judd Kahn, in their book Competition Demystified, said that there are three kinds of genuine competitive advantages.

• Supply: Strictly cost advantages that allow a company to produce and deliver its products or services more cheaply than its competitors.
• Demand: Access to market demand that competitors cannot match.
• Economies of scale: If cost per unit declines as volume increases, then even with the same basic technology, an incumbent firm operating at a large scale will enjoy lower costs than its competitors.

Beyond these three primary sources, Greenwald and Kahn point out that government protection or superior access to information could also be a competitive advantage for a business.
But what are the sources of such competitive advantages that allow the firm to demonstrate high pricing power around either supply/demand/economies of scale?

The business guru who has answered this question most clearly is Sir John Kay. Sir John’s IBAS framework includes four broad sources of competitive advantages—Innovation, Brand, Architecture and Strategic Assets. Here are some examples of Indian firms with competitive advantages across these four categories.

Innovation:

Asian Paints, HDFC Bank and Garware Technical Fibers are great examples of firms repeatedly excelling as the first mover, thinking differently and being several steps ahead of the competition.

Asian Paints: Given the voluminous nature of the Indian paint sector’s product, its low margins for dealers, the seasonality of demand and a large number of stock-keeping units (SKUs), innovation in supply chain management is a key differentiator and a critical success factor in the industry. Asian Paints has a track record of running the most efficient supply chain network in India, making three to four deliveries every day to more than 70,000 dealers in over 600 cities. This ensures high inventory turns for a dealer, for whom the thin margins from a voluminous product are a key challenge in earning a reasonable return on capital. Some of the initiatives that Asian Paints has taken to strengthen its supply chain include being the first company to (a) use mainframes in the early 1970s to forecast demand for better inventory management; (b) start branch billing on computers in the late 1970s; (c) import a colour computer in 1979, which helped reduce tinting time from five or six days down to four hours; and (d) use a global positioning system (GPS) for tracking movement of trucks carrying finished goods in the channel (implemented between 2010 and 2015).

HDFC Bank: One feature that distinguishes HDFC Bank from its competitors is the management’s ability to use technology in the broadest sense of the word—including hardware, software systems, and processes—to create a unique offering. 

In the late 1990s and for much of the noughties, ICICI Bank was often the bank to develop the most stylish of technology-driven banking products (e.g., it was the first to provide internet banking and the first to introduce mobile ATMs). However, HDFC Bank’s strength rests not so much in the uniqueness of its technologies but in how it has lined up technology in a clever process flow that other banks did not envisage.

In the mid-and late 1990s, when most banks opted for Infosys’s technology platform, HDFC Bank chose Iflex’s Microbanker. This proved to be a masterstroke, as the bank’s management had sensed that real-time online banking was the future. 

Microbanker subsequently allowed HDFC Bank to garner large quantities of low-cost deposits by providing payment solutions to capital market players. HDFC Bank pulled in all the players of the capital markets in the supply chain— buyers, sellers, brokers and exchanges—and got them into an automated settlement system. It offered a solution to both brokers and exchanges. If brokers had an account with HDFC Bank, exchanges could see in real-time whether brokers had the money to settle pay-outs and, if there was a shortfall, there was enough time before the actual settlement to ask the broker to meet this shortfall. Such reduced settlement risk for exchanges drove all significant exchanges to sign up with HDFC Bank. The incentive for brokers to sign up with HDFC Bank was that pay-in money was credited immediately to the broker’s account, reducing his working capital requirement. This led all the brokers to open their accounts with HDFC Bank for settlements.

Moreover, since brokers needed bank guarantees for exchanges, the bank also provided credit lines to these brokers. So the bank earned a free float on money kept by brokers for their settlement; it also earned fees by providing credit lines to brokers. Starting with the NSE in 1998, the bank became a clearing bank for all major exchanges by FY2000. Eight hundred brokers and most custodians used HDFC Bank’s services by FY2000.

The bank had captured 80% of the market share in the settlement business by the mid-noughties. Buoyed by the success of its capital markets initiative, HDFC Bank implemented similar initiatives in retail banking. This created the foundation of its formidable low-cost deposits platform.

Brand:

A firm’s ability to create and sustain strong brand recall requires dealing with challenges around the changing definition of aspirational consumption in every category over time. Hence, the brand recall of category leaders need to evolve according to price points, type and mode of branding initiatives, and product characteristics.

There have been several instances of brands that were once significantly dominant in India in their respective product categories but saw a reduction in their market share with a dilution in their aspirational value. These brands once had an allure because customers desired or aspired to own and use them. Some key examples include brands like Titan in watches (2005–12), VIP Frenchie (1995– 2005) in men’s innerwear, and Bata in footwear (2000–10). This loss of aspirational value is a big risk for any brand. On the other hand, firms such as Page Industries (brand: Jockey) and HDFC Asset Management Company (HDFC AMC) have overcome the challenges of brand dilution over the past twenty-five years.

Page Industries: Page’s approach toward advertising has been unique on several fronts. Firstly, its advertising campaigns have consistently been high-impact affairs, like ‘Just Jockeying’ in FY2010–14 and ‘Jockey or Nothing’ launched in FY2015. Secondly, Page has placed significant emphasis on in-store advertising, to the extent that Jockey advertisements cover the bulk of in-store advertising space at most multi-brand outlets (MBOs). Thirdly, in a neat play on the world view of Indians, Page has made consistent use of Caucasian models in its advertisements and thus firmly entrenched its brand recall as an international brand. This unique approach in advertising has helped Jockey emerge as the only aspirational brand in the mid-premium innerwear segment over the past two decades.

Architecture:

Tata Consultancy Services (TCS) is a prime example of a ‘system of relationships within the firm’. In contrast to other leading Indian IT Services firms, all TCS CEOs are groomed internally and spend decades working within TCS before rising to the CEO role.

The fact that leadership changes in TCS are organic allows the firm to retain its most prominent clients for longer. As a result, TCS’s most significant clients are larger than other Indian IT services firms. For example, TCS’s implementation of a core banking platform for State Bank of India (SBI) in 2003–04 remains the largest such project implemented anywhere globally. Successful implementation of colossal projects has helped TCS become the only Indian IT services firm to consistently rank among the world’s three largest IT services firms by revenues since 2015.

Moreover, employees at TCS are aligned to organizational goals as part of a routine process. Unlike many IT companies that first-generation entrepreneurs started, TCS came from the Tata Group, and therefore institution and organization building was in their DNA. As a result, hiring and training practices are institutionalized, ensuring that employees are aligned to common goals. Every year, TCS trains or re-trains 2,00,000 employees. It is highly unlikely that any other firm in India trains even half as many people in a given year.And thirdly, TCS has standardized processes to a very large extent and captured their application development life cycle in an institutional knowledge base. This gives the firm the ability to have the largest scale of implementation among peers and in a much shorter time frame than others.

These processes result from collaboration and processes laid down by top management over the years.

Strategic Assets: 

The strategic assets of a firm could be around intellectual property (i.e., patents or proprietary know-how), licenses, or other such means of access to resources which are not easy for a competitor to replicate. Some examples from Indian companies include Page Industries’ relationship with Jockey International, GMM Pfaudler’s access to the R&D capabilities of Pfaudler, or Divi’s Laboratories’ thirty-year relationship with global pharma giants for their contract research and manufacturing services (CRAMS) business.

The relationship of Genomics, promoters of Page Industries, with Jockey International, USA, is Page’s biggest strategic asset. Jockey renewed its license with Page in 2010 for twenty-one years instead of five years, which was the earlier practice. Thus, until 2030, Page will remain Jockey’s exclusive franchise in India and the UAE. For Jockey USA, Page Industries is now its biggest franchisee. For Genomics, India remains a large market, growing in size (more consumers aspiring to buy Jockey products) and expanding in-depth (new segments like leggings for women and underwear for children). Accessing Jockey’s innovations in the US and bringing them to a steadily growing market like India is a formula that has worked since 1995 for Page and should continue in the foreseeable future.

GMM Pfaudler started as an Indian joint venture between Gujarat Machinery Manufacturers (GMM) and Pfaudler Inc. GMM’s promoters continue to run the company daily. Pfaudler Inc. is a 130- year-old multinational giant founded by the inventor of the process of glass-lining of steel. Glass-lined equipment is necessary for industries such as chemicals, pharmaceuticals and food and beverages, where the production process requires equipment with corrosion resistance or cleanliness properties. As manufacturing processes evolve, glass-lined vessels also have to evolve through significant R&D investments. Over its long history, Pfaudler Inc. has pioneered multiple other innovations in glass-lined vessels, reactors and related equipment, and it is today a global leader in the space. GMM has leveraged Pfaudler Inc.’s capabilities to establish a clear edge in India, and its access to Pfaudler’s product development pipeline enables GMM to maintain the technology leadership.

GMM has bolstered the technology edge with its manufacturing capabilities, building a production capacity that exceeds the aggregate of all other players in the industry.

GMM has also recently acquired the manufacturing facilities of De Dietrich Process and Systems, the other MNC operating in India’s glass-lined equipment sector, thus consolidating its market position even further.

This was followed by GMM acquiring its parent entity Pfaudler Inc., which makes GMM now the largest glass-lined equipment manufacturer globally. These strategic assets of technology access and manufacturing scale, combined with its long-standing customer relationships, have proven to be potent, driving healthy Roces for the company (five-year average, FY2016-20, of 26.6%).

How To Identify Dominant Firms In India?

A framework to identify dominant firms in India that have sustained high pricing power:

Just like it is hard to build pricing power, it is equally hard to sustain pricing power over time. In a dynamic world, the evolution of both demand (i.e Customer behavior) and supply of a product or service can disrupt monopolies overnight, the way firms like Polaroid, Kodak and Xerox got disrupted, despite being great companies with strong competitive advantages.

Some of the reasons for the destruction of great Indian firms include: 

• disruption of the product/service due to evolving technology or changing consumer habits;
• disruption of the distribution channel/marketing/supply chains;
• capital misallocation decisions by the company; 
• change in the management team or ownership of the firm; and 
• drop in focus/rigor of the management team due to complacency or lethargy.

Therefore, a creative monopolist or a dominant company reinvests the monopoly profits to innovate new products, improve existing products and figure out better ways of meeting evolving customer preferences. The above flowchart shows the most common framework adopted by Indian monopolies/dominant firms that have sustained their dominance over decades despite several disruptions and evolutions. First, they approach a challenging aspect of the industry. Then, instead of resolving the challenge adopted by the firm's incumbent competitors, the monopolist further deepens the challenge to change the industry's structure in its favour. And then brings out a solution to this challenging construct, which competitors cannot easily replicate.

Over the long term, these firms keep evolving the challenge and the solution to make it difficult for competitors to catch up.

It is difficult to foresee exactly how industry, business, or customers will evolve in the future due to disruptions and evolutions.

However, specific characteristics are common to existing leaders who are likely to disrupt/innovate in their businesses to ensure that a competitor cannot challenge their leadership. The most important one includes a single-minded focus on the company's business and its capital allocation without any signs of complacency, lethargy, fatigue or boredom. 

Disruptions

Over the past few years, event-based disruptions like the introduction of GST, demonetization, financial crises (e.g., those at IL&FS, GFC), and the COVID-19 crisis, have become very frequent. On the other hand, several disruptions are caused by new technologies or new infrastructure (digital or physical) to meet customer requirements. 

Consistent Compounders typically use such disruptions to consolidate the dominance of their franchise by benefiting from the challenges faced by their competitors through such disruptions. Therefore, Marcellus's Lethargy Tests need to keep close track of the attempts made by portfolio companies during periods of turmoil.

Evolution

As time progresses, there will be changes in customer preferences, market demographics, the scale of operations and penetration levels of the relevant products and services in existing geographies, etc. Therefore, lethargy Tests need to measure how alive, awake and adaptive the business models of an investor's portfolio companies are to such evolutionary changes, to ensure that they sustain earnings growth over long periods.

Risk of Capital Misallocation

As Consistent Compounders grow and deepen their competitive advantages, the quantum of free cash flows available for redeployment tends to exceed the amount that can be reinvested to develop the core business further.

Promoters with aspirations of 'empire building' or those who want to add new revenue growth drivers to their business for the long term tend to use surplus capital to diversify across geographies or product categories. This could be either organic or inorganic diversification. Many firms prefer the inorganic route towards diversification, acquiring companies in related or unrelated businesses, forging joint ventures, acquiring minority stakes in other companies, etc. Whilst all this sounds straightforward, many firms with a great core franchise that consistently generates high RoCE have found it challenging to allocate surplus capital to diversify their business sensibly. Hence, the Lethargy Tests need to focus substantially on capital allocation decisions taken by a firm on an ongoing basis.

These Lethargy Tests need to combine secondary data research (annual reports, quarterly management commentaries) with primary data checks (e.g., extensive discussions with channel partners, vendors, customers, IT and HR consultants, former employees, etc.)

What To Buy: Masters Of Capital Allocation

The key questions the author will address in this chapter include: 

• How to review the capital allocation decisions of companies?
• What risks to look out for when analyzing capital allocation decisions?

What is Free Cash Flow? 

As the author has discussed earlier, a business creates value only when it earns more on the total fixed and working capital invested in the business than what it has to pay the providers of this capital. He also discussed that the difference between the RoCE and the CoC is the free cash flow of the business. But how is the RoCE linked to free cash? A simple way to understand the link between RoCE and free cash flow is to break down the calculations of these metrics into their key components. RoCE is expressed as:

POST TAX ROCE= EBIT-TAX/CAPITAL EMPLOYED (NET FIXED ASSETS +NET CURRENT ASSETS)

Earnings before interest and tax (EBIT) measure the operating profit or return that the business has earned or generated. In this instance, the author considers EBIT and not EBITDA (earnings before interest, depreciation, amortization and tax), which is a better measure of cash flows. This is because the amount charged to depreciation can be used as a proxy for maintenance capital expenditure—that is, the minimum amount of CAPEX the business needs to undertake to maintain the current scale of operations. EBIT is the cash profit earned without any growth CAPEX (i.e., from capacity additions). From this cash profit, the business must be able to pay the providers of capital—i.e., the lenders (debt holders) and equity shareholders. And only if the EBIT is higher than the amounts due to the providers of capital will the business generate a surplus or free cash. And only if the company generates surplus cash will it have the ability to invest in capacity expansion and grow revenues and earnings further.

A key responsibility of a company’s management is deciding on the best use of the free cash flow the business generates. If a company sees sufficient growth opportunities in its business, it will prioritize the allocation of free cash for reinvesting in the business. Such reinvestment is done both to expand capacity (which drives future growth) and to deepen competitive advantages (which helps sustain RoCE higher than CoC). 

Another way of thinking about the situation is that if a company is consistently reinvesting cash flows at a rate of return higher than the cost of capital, it reflects both its competitive advantages and the management’s ability to redeploy surplus capital successfully. Therefore, the objective of the company’s management must be to keep the cycle going, building solid competitive advantages to earn high Roces, which leads to sizeable free cash generation, which in turn is invested in increasing the capital employed and deepening competitive advantages.

It follows growth that generates a RoCE less than the CoC, which is not a sensible use of free cash. Therefore, the role of the company’s management in identifying suitable investments and allocating capital toward those projects is critical. However, most businesses, even the ones with deep moats, will be eventually constrained by the size of the market they operate in. Beyond a point, the quantum of free cash flow available for redeployment will exceed the amount the business needs to keep growing. Therefore, in the absence of investment opportunities that cover the cost of capital, it is prudent for the management to return the free cash to shareholders as dividends or through buybacks. 

However, intelligent management teams and Consistent Compounders do not allow themselves to be constrained by the lack of prevailing market opportunities; they expand the business to find growth in newer avenues without diluting returns or increasing the business risk. For investors, identifying such management teams is crucial for long-term wealth creation, making Capital Allocation the third pillar of Marcellus’s investment framework.

Inorganic Product or Market Expansions are risky

Product or market extensions can be done either organically or inorganically. Organic expansions are undertaken internally, like expanding manufacturing capacity or increasing the number of retail stores, etc. Inorganic expansions are achieved by mergers, acquisitions, and takeovers—buying out a manufacturing capacity. In sectors with fragmented market shares, inorganic expansion becomes a relatively higher contributor to growth. Over time, players with strong competitive advantages in such fragmented industries tend to acquire the weaker players who struggle to cover their cost of capital on a sustainable basis. Intelligent management teams also use their strong free cash generation to buy out players in adjacent products, thereby gaining an immediate foothold in a new segment, which would have otherwise taken years to build organically.

However, market or product extensions are tricky when a company tries to enter an unfamiliar overseas market, and that too by acquiring a local player.

Unrelated Diversification poses the biggest risk:

It is evident from the Ansoff Matrix that the riskiest strategy is 'new products in new markets and the one that investors should be most wary about. Such diversification requires large capital commitments and demands a disproportionate share of management bandwidth. Moreover, as highlighted, the split focus could hurt even the core business, as competitors will exploit the opportunity to weaken the barriers to entry built-in that business. 

In pursuing an unrelated diversification, a company starts with what the author can call a double handicap—it lacks competitive advantages in the new product and the new market. More often than not, it is challenging to build sustainable advantages that allow the company to earn justifiable returns in the new business areas. And even if it is not complex to create a new business (in the sense that it is not rocket science to build a competitive advantage), it can take several years. Comparing conglomerates with companies focused on a single product/market and its adjacencies drives this point.

Timing Equity Capital raises sensibly 

Smart capital raising is also, in a way, smart capital allocation. Typically, fast-growing lenders need to raise capital every three years since a growth rate higher than RoE puts pressure on regulatory capital. KMB (Kotak Mahindra Bank) has also raised capital at intervals of three to four years, but what has set this bank apart is its ability to raise money from the capital markets while restricting the extent of equity dilution. KMB has raised equity capital through the qualified institutional placement (QIP) route twice—in 2007 and 2017—and on both occasions, at or near the market peak, which meant lower equity dilution and the resultant impact on RoE. KMB's remarkably effective capital allocation has created enormous wealth for its shareholders. Re one invested in the company on 31 December, 2000 would have become Rs 532.2 by 31 December 2020 (excluding dividends), a CAGR of 36.9%. In contrast, Re one invested in the Sensex on the same day would have grown to only Rs 12.0 by 31 December 2020, implying that KMB has outperformed the Sensex by nearly 43x over the intervening twenty years.

The Dark Side of Capital Allocation 

So far, the authors have discussed capital allocation decisions taken by the management of companies. However, in some cases, it is also very important to assess capital allocation decisions made by the promoters of companies— that is, the way they decide to deploy funds between the different businesses they own. When promoters control more than one business, there could be a risk of them trying to 'allocate' capital from a company that is doing well and generating cash flows to another business that needs funds. Such transfer of funds, even if done transparently, is seldom in the interests of minority shareholders. Usually, the board of directors would object to and block such support to other businesses of the promoter. But a desperate promoter could find means of bypassing the board too. Therefore, it makes sense for investors in any company to be cautious when the promoter has multiple businesses housed in different companies; more so if the promoters' shareholding varies from company to company and there is an incentive for them to favour a company where their shareholding is higher relative to others.

When evaluating capital allocation decisions, investors should consider the allocations made at the promoter and company levels.

Human Capital- The most critical allocation decision 

Human capital is the most precious capital of a Consistent Compounder since it helps the firm nurture a DNA of deepening competitive advantages over the long term. However, as time progresses, individuals who are part of a firm's human capital could retire, resign or get supplemented by a widening team that shares key responsibilities. Hence, a Consistent Compounder needs succession planning to help sustain its competitive advantages. However, succession planning is not an event. It is a process that must be embedded in an organization's DNA. Implementation of a succession plan is challenging at multiple levels for most organizations. For example, when a business is small, it might be run by a leader (the promoter, CEO or MD) who is omnipotent—someone who can do anything and can solve all problems. As such organizations grow bigger, the 'omnipotent' leader might feel insecure about letting go of control, which becomes particularly difficult when the firm has built strong competitive advantages under the same leader.

Moreover, if the leader builds a layer of CXOs and trains them as potential successors, then there is a risk that the trained CXOs who don't get the top job will leave the firm to assume leadership roles in other organizations. Such exits can then leave a massive void in the organization. Optimal timing for identifying a successor is also important. If the successor is identified too soon, then there is the risk of increasing attrition amongst other capable CXOs as they see themselves having hit the ceiling in their career progression. If the successor is identified too late, she might be underprepared for the role and other leadership capabilities. Promoter families run many businesses in India. 
Such promoters might think about their sons and daughters as the natural successors to head the business. However, unlike some professionals who might have worked in the organization for twenty or thirty years, successors from the next generation of the promoter family might not have spent enough time at the ground level to learn about the strengths and weaknesses of the business and may not have built trust and relationships with various stakeholders. Furthermore, there might also be more than one candidate from the next generation of the promoter family, which could create friction amongst family members.

If not appropriately addressed through a standardized and meritocratic succession planning process, such challenges can lead to strategic mistakes, deterioration in employee culture or lethargy and complacency in ground-level execution and capital allocation.

An investor's understanding of the quality of succession planning in a Consistent Compounder has to include the following four components:

1. Evidence of decentralization of power and authority—both in day-to-day business execution as well as in implementing capital allocation decisions; 
2. Quality and tenure of CXOs in the organization; 
3. Involvement and independence of the board of directors—both for decentralizing capital allocation decision making, as well as for recruitment of CXOs in the firm; and 
4. Historical evidence of the execution of succession at the CXO level without adverse impact on the organization. 

Asian Paints is one the best examples of a company that covers all aspects of its succession planning framework reasonably well. For over a decade now, the execution of operations has been controlled by empowered professionals from the CEO level down to the middle management level in the firm's hierarchy. Over the last fifty years, the firm has been hiring talent from the best universities as management trainees and has had an outstanding track record of training and retaining this talent pool for more than twenty to twenty-five years. As a result, most of its CXOs and key management personnel have spent more than twenty years at Asian Paints across several functions. Tech investments and data analytics, which also drive decentralization of execution of operations, are a large part of Asian Paints' competitive advantage. All seven independent directors on the board of Asian Paints have highly reputed and relevant professional backgrounds. And last but not least, the firm's historical track record has been healthy and consistent despite: 

a) three instances of professional CEO changes over the last fifteen years,

b) three generations of Asian Paints' promoter families having come and gone in the last seventy years,

c) one of the founding promoter families having exited in 1997, and 

d) several CXOs have changed hands regularly.

Key Takeaways of the Chapter: 

Prudent use of free cash flows is a key driver of shareholder value, and hence investors need to assess risks in capital allocation decisions.

Growth outside core products and markets must be evaluated in the context of the quantum of capital being allocated. Incremental steps towards the market and product development are less likely to destroy shareholder value than large capital commitments towards diversification. Promoters with multiple business interests call for special attention when evaluating the capital allocation decisions of any entity within a group.

A robust succession planning process and framework is the key to extracting the best returns from the most critical source of capital— human resources.

When To Buy?

The key questions addressed in this chapter include:

• Is there any merit in trying to time the market for buying and selling stocks?
• What does a relative valuation multiple tell you about the intrinsic value of a business? And,
• To what extent, and in what cases, can you rely on PE multiples to drive your buying and selling of stocks?

In this book so far, the author has discussed the question of what stocks to buy. The Marcellus framework of identifying companies with clean accounts, a track record of prudent capital allocation and presence of strong and sustainable competitive advantages are helpful guides to answer this question. Once you know what you need to buy, one common question investors have is—when to buy? As soon as investors come to this juncture, they tend to get mentally submerged in a sea of questions, like: 

‘There are elections in the US this year. Should I wait until we know who the next US President is going to be, before buying this pharma company that gets 80% of its revenues from the US?’

‘This bank reported good results for this quarter and the stock price has gone up by 10%. Should I wait for it to correct before buying?’ 

‘This consumer goods stock is trading at a PE multiple of 30x, while its competitor is trading at a multiple of 20x. Should I sell the ‘expensive’ stock and buy the ‘cheaper’ one?’ 

Such questions broadly cover two aspects of when to buy or sell a stock. The time and the price. In this chapter the author tries to answer these questions.

Timing the market

Between January and March of 2020, as the COVID-19 pandemic began spreading across India and local authorities in some cities started limiting economic activity, the Sensex index fell from its then lifetime high of 41,953 on 14 January 2020 to 25,891 on 23 March 2020—a decline of 38% in just a little over two months. Then came the announcement of a 21-day nationwide lockdown starting on 24 March 2020. A few investors in Marcellus's PMS portfolios expressed worry about the economic impact of the lockdown on nearly all economic activities across the country and a desire to redeem their investments and shift out of equity to perceived safer investment avenues. At that point in time, amid an unprecedented crisis, it would have been natural to expect the markets to decline further, causing more significant wealth erosion, right? No. 

23 March 2020 turned out to be the bottom of the Index. It took forty-nine trading sessions for the 38% fall from peak to bottom, and in the following forty-nine sessions, the Sensex had already recovered by 32%. And by the end of 2020, Sensex had scaled a new all-time high.

The above example indicates how the market typically behaves, not just during periods of crisis but also in normal times. Unfortunately, the example also shows how most investors react to market behaviour and, in panic, tend to sell at the worst possible time. The futility of trying to time the market has been proven repeatedly in scores of studies.

It is practically impossible to identify the lowest stock point for executing your buys and identifying the highest significance to selling them. It would be nothing but incredible luck for anyone to achieve this consistently.

Why is timing not relevant for consistent compounders?

Stock prices should ideally reflect the present value of the business's underlying cash flows, and in the long term, they tend to do so. However, in the short term, stock prices fluctuate depending on market participants' assessment of multiple factors, most of them external to the company. For example, stock prices of export-oriented companies might react to every small change in the exchange rate up or down, even though over the long term, it might depreciate steadily. As a result, provided the underlying asset (company or an index) delivers a modest or healthy growth in earnings and cash flows, it does not matter how the near-term stock price moves. And in turn, this means that for such stocks, it does not matter whether the entry point of one investor was 20% higher or lower than another's.

In the case of companies in cyclical businesses, earnings tend to be volatile over a period, with a few years of strong growth followed by a few years of weak or even negative growth. As a result, it matters when they are bought or sold for such stocks. However, the challenge with these stocks is in knowing what the right time to buy or sell them would be.

Since the volatility in earnings is driven more by external factors, including macroeconomic variables, and less by the fundamental strength or weakness of a company, it becomes much more difficult to time the right cycle. For example, the earnings of a metals company depend not just on the producer's efficiency but also on the price of metals in international markets, which is determined by multiple global demand-supply factors. 

Do P/E valuations matter?

The other aspect of when to buy (or sell) a stock is centered on its pricing or valuation. For example, should you buy a stock if its price and earnings multiple is 'low' or 'cheap' compared with peers or the broader market? And should you sell a stock with an earnings multiple higher than its peers or its sector average?

As noted earlier, the intrinsic value of a stock reflects the present value of the company's cash flows. However, to assess the stock's value, investors more intuitively use relative measures, such as price-to-earnings (PE) multiple or price-to-book value (P/BV) multiple. As a rule of thumb, a company trading at a relatively lower PE than its peers is considered to be more attractively valued. 

The comparison, however, ignores a number of factors that drive the value of a business—the return on capital and the reinvestment rate being the chief amongst them. It is like saying a plot of land should be valued at a certain price per acre because someone acquired the neighbouring plot of the same size at the same price. What if the neighbouring plot had fruiting trees or an oil well while the other did not?

However, it isn't easy to forecast the cash flow for each year, especially for periods in the distant future. As a result, most practitioners forecast cash flows for the foreseeable future of the next five, seven or ten years and then assign a terminal value to the remaining cash flows. The terminal value is the present value of all cash flows beyond the first five, seven or ten years, as the case may be. While calculating the terminal value, the cash flows of a business are assumed to keep growing at a constant rate for perpetuity.

Key Takeaways:

Remaining invested for the long-term is the key to steady and healthy stock price returns. It is practically impossible, and not worth the time and effort it takes, to time short-term buys and sells and hope of making consistent returns.

The value of a stock is driven by two key elements of its underlying cash flows—growth in these cash flows and, more importantly, the longevity of the cash flows.

Most valuation methodologies, including absolute methods like the discounted cash flow and relative methods like P/E, EV/EBITDA, etc., ignore or undervalue the longevity of cash flows. This makes investors overlook stocks that appear 'expensively valued' but could be priced much below their intrinsic value. Investing in Consistent Compounders addresses the two key aspects of an investor's dilemma about when to invest—the timing and the pricing.

Preparing An Investment Plan

Financial planning is essential for an investor to ascertain their financial objectives and allocate savings across various types of investment instruments.

An investor’s first allocation of savings should relate to the quantum of funds required in the near term/for emergency purposes —also called rainy-day money. Since capital preservation is the only objective of this allocation, this investment should be in instruments such as tax-free government bonds.

The equity allocation of an investor, regardless of whether it is in small caps or large caps, should be in a portfolio which has been thoroughly researched for:

a) clean accounts; 
b) prudent and efficient capital allocation with strong free cash generation; and
c) massive barriers to entry against competition.

Conclusion

Diamonds in the Dust makes a compelling case for why equities are one of the best financial instruments for generating long-term wealth instead of real estate and fixed deposit schemes, which are value drains in retrospect.

The fundamental difficulty that plagues newcomers is what happens if the stock falls and the company fails. While this is still a possibility, the authors show how specific hygiene measures can significantly reduce the likelihood of such a loss.

The book demonstrates three principles: credible accounting, competitive advantage, and capital reallocation, which help sift through the market to identify the companies worth investing your hard-earned money in.

The book summary contains eye-opening case studies on various companies  whose promoters engaged in accounting fraud to siphon investor funds. The highlight of this book is their proprietary 'Forensic Analysis' tool, which the authors have generously shared in extensive detail to assist us in deciphering flawed accounting practices before they are brought to the regulator's attention.

The authors get granular in this book, describing the steps taken by companies like Asian Paints, Garware Technical Fibers, and Page Industries to institutionalize the practice of sustaining competitive advantage.

The third principle which the authors have demonstrated is reinvesting earned capital back into the core business to widen competitive moats. This is another essential aspect of the book. They have shown how these market leaders have identified a challenge in a sector, provided a solution that is difficult to replicate, intensified the challenge over time by adding extra layers of difficulty around it, found newer solutions, and evolved, creating a monopolistic advantage in their core area through the cited business models.