Alpha Moguls | Three Filters Saurabh Mukherjea Uses To Identify Companies To Invest In

Saurabh Mukherjea uses three filters to narrow down on the companies worth having in his stock portfolios. Be it large cap, small cap, FMCG or pharma, the companies must satisfy this basic philosophy.First, the books must be clean, that’s the 10-15 years of forensics, the founder and chief investment officer at Marcellus Investment Managers, which managed Rs 2,131.9 crore assets as of August, said in BloombergQuint’s latest episode of the special series Alpha Moguls. “If the promoters are stealing then we have no interest regardless of how the sector or the stock might be,” he said. “We’re going to be running away as far as possible from the company.”The second criteria, Mukherjea said, is to focus on companies that are selling essential products or services. “We try to avoid commoditised sectors, in the sense of metals, cement, real estate, infrastructure and cyclical sectors with heavy commodity orientation,” he said, while adding luxury sectors to the list.The final filter is to look for monopolies or companies with a near dominant position in the market, irrespective of its market value. “Whether your market cap is half a billion or a $100 billion, we need you to be as close to being a perfect monopolist for us to take a large position,” Mukherjea said, citing the examples of Pidilite Industries Ltd. in the paints and Nestle India Ltd. in the baby milk powder segment.According to Mukherjea, to gauge how clean a company is, the portfolio management firm’s analysts dig deep into 10-15 years of annual reports, and discuss with the various stakeholders, including dealers, former employees, distributors and consultants.“The natural manifestation of essentiality would be steady revenue growth,” he said while explaining the application of the second filter. “And then the natural manifestation of dominance will be the return on capital well above the cost of capital every single year.”Applying these metrics—a double-digit revenue growth every year and return on capital above cost of capital every single year—there will barely be 15 companies in India passing through this funnel, the portfolio manager said. “If you then apply forensics, the 15 might become more like 12 and unsurprisingly our flagship portfolio only has 13 stocks in it.”Mukherjea cautions against investing in cheap Indian companies as they often come with faults—shoddy accounting or a broken business model. He said 90% of Indian companies have no competitive advantage, with a return on capital never exceeding the cost of capital and no growth in earnings. “By the time the retail investor or even the professional investor figures that out, the money has already gone into the gutter.”.Watch the full interview here:.Here are the edited excerpts from the interview:.My first question to you would be when I look at how you’re going about your investing style versus a lot of other investing styles and there are a thousand ways to skin a cat but you are noticeably different. You have no qualms of taking exposures to companies which might be perceived to be expensive incurrent valuations. You have no qualms in buying companies which might not be trading at very high volumes as compared to what normal people look at as well. What sets your theory apart from what is largely the popular parlance?I would say, it’s not just me but there’s a group of us who work together. This co-group has been together for the best part of 15 years now. So, for most of our lives, we’ve been working with each other. As a result, what’s happened is whatever we do is an amalgamation of our skill sets. I have some strengths, I have some weaknesses. Pramod has strengths, he also has weaknesses. Rakshit has strengths and weaknesses. So, if you put the group together, and not surprisingly, I’ve talked in the victory project about this part that collaboration is the essence of success in highly creative and competitive industries. Therefore by working together for over 15 years, we’ve been able to build a unit where each of our strengths comes together and creates a sum which is greater than the sum of the parts. So two plus two is five, not because of anything great I am doing but because all of us have come together and pooled our strengths together which makes for a unique style of investing.The second thing is all of us, I suppose to some extent are birds of a feather who flock together. So all of us are more bent towards reading, more bent towards a slightly intellectual turn of mind and it so happens in this job that orientation actually is quite helpful. So just like if you want to be a great basketball player, it helps to be six feet five or above. Similarly, if you want to be a successful fund manager, it helps to be a person who likes reading endlessly because what the stock market across the world does is; the stock market over emphasizes short-term factors and under emphasises longer-term factors. If you’re therefore someone who naturally cuts out noise, if you’re someone who’s naturally introverted who just likes reading and thinking, you’re able to play to your strengths and the stock market’s weaknesses..'The stock market’s weakness is that it does not emphasise the longer term enough.'.If you’re able to do that because of your personality bent, you end up with slightly better outcomes than others. So I would say, those are the main things that set us apart. The fact that we’ve been together for so long and that we’ve built a cohesive unit which amalgamates many different types of personalities. The second is most of us are oriented towards heavy-duty reading. I might like reading books on Psychology and English literature, some of my colleagues like reading 15 years of annual reports on companies, to each his own but that collection of heavy duty readers coming together into one group and we just finished our weekly research call. The weekly research call is basically over the last seven days who has read how much, what have you read and what have we learned. We pool it together every week and then we agree that over the next seven days, we decide who reads what, then off we go again. That style of investing I think works very well in a stock market context..Just taking a leaf out of your previous answer. Is the reading leading you to be able to identify businesses in a different fashion because you are kind of underplaying a role that each of your strengths collectively brings to figuring out which are the companies that will do really well over a period of time due to a variety of factors.Let’s just use that prism of reading to sort of think through why reading is so powerful. So, let’s start with this observation, Charlie Munger made this observation famously. Charlie Munger says that he has never met a smart person in his life who does not read non-stop. Now, why does he say that? So reading does three very powerful things from the context of an investor. Firstly, it develops your neural networks and the development of the neural network allows you to think deeper. So for example, if I take my colleague Tej Shah, the depth at which Tej is able to think through forensic accounting of Indian lenders arises from not just the fact that he’s a chartered accountant, but also from the fact that is a chartered accountant who reads decade or more of annual reports of lenders before Marcellus takes positions in those lenders. So, it’s a combination of someone doing the reading, doing it over long periods of time over several years, the neural networks and the brain strengthening allowing my colleague to go deeper and to think deeper about accounting of the lenders in whom we might take stakes. So, that’s the first benefit of reading. It forces you to develop your mental muscles, so to speak. Just as a gymnast who sort of goes to the gym and works out for decades on and ends up with an exaggerated upper body, similarly a reader who reads non-stop, the brain expands, thankfully you and I can’t see the expansion of the neural networks.The second benefit of reading is, if you’re going to be allocating a heavy duty part of your time to reading, necessarily you’ll have less time for the noise. You’ll have less time to sort of ponder over the P/E multiple and say P/E is less or more, you have less time to figure out what is the latest Covid death count in India and how do we compare to Brazil and China and so on. You’ll have less time to figure out what is the latest from the RBI or the Federal Reserve. So, by focusing on reading you’re de-emphasising noise and by de-emphasising noise, you’re reducing portfolio. We are all human beings right? If I sit in front of a trading terminal all day long and I keep looking at prices and P/E multiples and the latest news flash from central banks and latest earnings announcements, obviously my mind will get more inclined to trade and go with the market opinion. By reading you’re cutting yourself off and not only is your brain getting stronger and your neural network is getting deeper but you’re also focusing less on the news flow which is driving the herd. That’s the second benefit.I think the third benefit of reading is if you’re able to see a company’s numbers or its annual report over 10-15 years, if you’re able to see long cuts of data, the world reveals itself to you in ways that others can’t see and I’ll give you a simple example of this in the context of cricket. So when I was a 17-18, 19-20 year old I used to work in a betting shop over the weekends to earn some money for my college education and I used to notice that there was a small group of betters who would come first thing in the morning at 9 o’clock. They would come into the shop and place their bets for the day and then they would go home. Then, I won’t see them and the next morning they would come to collect their winnings. I used to notice that there were a couple of these guys who used to win every day at a very high hit rate. They would bet once and have a very high hit rate. The rest of the fellows would be standing there all day in the betting shop but would not get money. So I asked one of these British guys I remember I was 17 or 18, I asked him how do you do it? How come you know which bet to put on in the morning and you win with a high degree of certainty. So he taught me something I’ll never forget. He said, I follow the same routine every day. I wake up at five or six in the morning, sit down with a big cup of coffee and I read the sports pages of newspapers. I’ve been doing this for 20 years. So as a result I’m able to see simple patterns that others can’t see. So, one pattern he taught me was, he said whenever India plays England at Lord’s in a test match, if Dilip Vengsarkar plays, you should always bet on him getting a century. So the logic was simple. I’ve seen him play for the last for the last 10 years. This conversation took place around 1992-1993. He said, I’ve seen Vengsarkar come to England over the last 10-11 years. Whenever India plays England in Lord’s and Vengsarkar plays, he gets a 100 and it’s actually true. I checked on Cricinfo, it is true. That taught me that just the simple fact that this guy’s been reading the sports pages for 20 years allows him to make money. Similarly, if we read or your viewers read the same company’s annual reports for 10-15 years, they will spot stories and patterns that even the most seasoned fund manager can’t see. That is the benefit of long cuts or long sweeps of reading..You told me what you do differently is that you research companies 6 to 24 months before you buy their shares. It gives you time to read about 10-15 years of annual reports and meet 20 to 40 people who know the company and the promoter really well. That’s the other intrinsic part, sort of scuttlebutt and I’m guessing you kind of dwell on that a lot while either choosing or monitoring the performance?So there are two ways to do channel checks, right. The industry euphemism is channel checks. One is to say, “Dhanda kaise chal raha hai?” (how’s the business going?), what will happen this quarter, that’s the typical channel check most fund managers do. Our preference is to do a different type of channel check. So, let’s take an example of a stock we have in some portfolios – Maruti. To do Maruti channel checks, we would not be that interested to know what will happen to Maruti this quarter or indeed this year. That has very little value but we’re more interested in, over the last 3, 5-10 years, what systems and process improvements has Maruti put in place which you as a dealer are benefitting from. Compared to what say Hyundai is doing, has Maruti done some things fundamentally better or worse over the last three or five years. In terms of the quality of Maruti staff who come to engage with you Mr. dealer, what have you seen? Has the quality of staff improved or has the quality of staff deteriorated? In terms of the degree of support you get from Maruti – whether it’s tech support or financial support or support for the rental cost of the dealership –has there been a fundamental change in view over the last three or four years. Those are far deeper insights into Maruti’s competitive advantages than knowing what will be the sales number for Maruti in October–November or indeed this year..'So the channel checks are hard work, to talk to a dealer, engage him and it takes hard work because most dealers naturally don’t have time as they’re busy running their businesses.'.So when you have these conversations, it’s a waste to ask them “Kitna maal bikega iss mahine ya iss quarter meh?” (How much inventory will be sold in this month or in this quarter?). The discussion is around what actually fundamentally defines the quality of the company vis-à-vis the competition..Surely, you don’t ignore the other part right, because even if the company is generally doing everything right, what if the products are not selling?One another interesting thing is we don’t ask about “maal bika hai ki nahi” (if the inventory is sold or not) but we make a note of which companies’ dealers are really focused on telling us that maal bik raha hai ya nahi bik raha because that itself tells you a big part of the mindset. A company which is just focused on showing the numbers and running the stock is something that our channel checks tell us to get wary about.'One of the most interesting things about living in India and investing in companies over long periods of time is, you realise that some companies end up with incredibly good dealer networks. Talking to the dealer is almost like talking to the CEO of a BSE small cap company.'The quality of the dealer is so good in some companies’ cases and actually Maruti is a good example. Some of the Maruti dealers are so evolved in their thinking that it’s almost like talking to the CEO of a small cap company. That tells you far more about the company than that quarter’s sales number will tell you..Is this approach common for almost all the companies? You have a small-cap portfolio called the little champs but that has got all small names and then if the kings of capital portfolio is an offering, that necessarily would also have some of the highest market cap companies, even though the nature of the businesses are different. So, is this approach similar across sizes, nature of business, etc.?Let’s just step back a bit. I don’t think anybody can, you can’t go to one shop and say, sell me completely different types of investment products right. In our case, our investment philosophy is identical across all products, which is look for companies – whether they are large-cap, small-cap, financials, FMCG, pharma – that satisfy three broad criteria.The first criteria is the books have got to be clean. That’s the 10-15 years of forensics.If the promoters are stealing money then we have no interest regardless of how hot the sector or the stock might be. If the promoters are stealing money as per our forensics, then we’re going to be running away as far as possible from the company.The second is we try to, as much as possible, focus on investing in companies which are selling products or services which are essential for life in our country.We try to avoid sectors which are commoditised in the sense of metals, cement, real estate, infrastructure and cyclical sectors with heavy commodity orientation. We also try to avoid luxury oriented sectors. So, as much as possible, essential products and services.And the third criteria is that we look for monopolies. Whether your market cap is half a billion or 100 billion, we need you to be as close to being a perfect monopolist for us to take a large position.So, we find that, that if you apply this philosophy, you can do this in large-cap, small-cap and mid-cap. For instance, in Aliphatic Amines, Alkyl Amines is as much of a dominant position as say a Pidilite or Asian Paints has in the context of paints. Similarly, in glass line vessels, GMM Pfaudler has as much of a dominant position as Nestlé has in baby milk powder. Now yes, Nestlé’s market cap is $23 billion and GMM Pfaudler is a billion dollars, but they are fundamentally the same franchises and therefore the investment philosophy is consistent.'Now, if the investment philosophy is cleanliness, essentiality and dominance, therefore it stands to reason that the checking which is the primary data work, the discussions with distributors, dealers, ex-employees, competitors and management consultants will also be very similar. 'That actually allows us to underpin a common investment culture across the whole portfolio, across all our analysts and fund managers..Would it therefore also eliminate a few themes completely? I mean some stocks may be really strong in certain cycles but would they get eliminated completely?So most things get eliminated in our country. So, like I said, we are looking for essentiality products which are essential in day-to-day life and we’re also looking for dominant franchises..The natural manifestation of essentiality would be steady revenue growth and then the natural manifestation of dominance will be return on capital well above cost of capital every single year..If you just apply these two metrics – a double digit revenue growth every year and return on capital above cost to capital every single year – you find barely 15 companies in India pass this filter. I didn’t use any forensics, I just used a double-digit revenue growth and I used return on capital above cost of capital; and barely 15 companies passed this test on a 10-year look back. Now if you then applied forensics, the 15 might become more like 12 and unsurprisingly our flagship portfolio only has 13 stocks in it. If I add up our flagship portfolio, our financials portfolio Kings of Capital, and our small-cap portfolio Little Champs together, we have around 30 stocks which we came about to after a team of 12 analysts worked full time over two years. That tells you a lot about how much gets excluded in our country. We’re comfortable with that, we are not here to create an index fund which is all singing and all dancing. The other people who produce very good index funds – that is their strength; our strength is this sort of fundamentally oriented long term research and we enjoy doing it. It’s so happens that it also makes money for our clients..Just thinking out loud that if there is a real sharp downtick in a cyclical space, let’s say steel, for example and by virtue of the kind of reading that you’re doing, and other knowledge that you guys have, you might be able to identify say an uptick in a cycle coming up but the company would not meet the criteria that you laid out.No, we still would not be interested. There can be as many upticks as they want in a sector. Let’s take three sectors where upticks can be non-stop but it’s not going to be of interest for us – airlines, steel and telecom.None of these sectors have produced companies which can generate a return on capital above cost of capital on a steady basis. So it’s entirely possible that there will be an uptick in the airline sector as we come out of Covid, but it’s not in our skill set to second guess that. There might be really smart people out there who can second guess the airline sector but we can’t; and similarly with steel and telecom. So, we’ll stay away and we’ll focus on our strengths. You play to your strengths right, while other people have other strengths, let them play to theirs..The other questions is, in the previous books that you’ve written and the companies that you’ve highlighted as having moved from good to great so to say, would all of these businesses also have satisfied these characteristics because a good business need not be a good stock, right?So, that distinction is very specious. So that’s a devastating distinction and I think it destroys a lot of people in our country. So the good business-bad stock distinction only applies to people who don’t really figure out what is a good business. Let’s take two examples. Let’s take an extremely simple business – Nestle. The bulk of their cash flows, we estimate that 80-85% of their cash flows come from selling infant milk powder. The infant milk powder business in our country grows at around 15 to 20% per annum, has done so for a long period of time and looking at other countries that are twice as rich as us or thrice as rich as us saw some per capita income is also very tangible evidence. They are all the way up to $10,000 per capita income – 5X of where we are. This baby milk power market continues to grow twice or thrice as fast as GDP. So the growth runway is clear. One company has 95-96% share, Nestle derives 85% of their cash flow. So clearly, it is good business. Even at 220 times P/E multiple, Nestle is a good stock and it’s quite easy to actually show that math. So, let’s assume that Nestle continues gunning out dividend yield plus earnings growth. Let’s assume it stays in the vicinity of 20-22%, been like that for a long time. Even if the P/E multiple halves on Nestle, so if dividend yield plus earnings growth is say 20-22%, then even if the P/E multiple halves on Nestle in the next 10 years, we will still take home 15-16% returns on Nestle, which is higher than my cost of capital for a typical client.So, this is one example where a good business is a good stock even at P/E multiples significantly north of where we are today.Where a lot of people get stuck in our country is on names like Maruti Suzuki. Maruti Suzuki while it’s dominant in the small car market, if you take market share they have 50-55% of the small car market. In a 10-year cycle, Maruti will have four rough years. It’s an auto company and can’t help it. In those four rough years, obviously the P/E multiple halves in those four, five, six years and then in those four rough years, the earnings growth also disappears. So obviously if you buy Maruti in the sixth year of its six-year bull run or the seventh year of the seven-year bull run, in the next three-four years the earnings will tank off and the P/E will half.Then you will turn around and say, I told you it is a good business but not good stock. So, as this takes us back to what we were discussing five minutes ago, there’s around 20-25 companies in our country whose dominance of their industries is such that even if you buy these companies at a substantially higher P/E multiples than they are today, we still make money. Unfortunately, the rest of the stock market 90-odd percent of the stock market is such that, you can buy them at any P/E multiple you want, it’s close to impossible to make money for any return because for the vast majority of listed companies, 80-90%, return on capital will never exceed cost to capital.So investing in these stocks is like putting petrol in a car without an engine because there’s a kind of a hood over it you don’t realise and you just keep pumping life savings into these stocks.It’s like putting petrol in the car with no engine and the money is going into a gutter. That’s the most devastating aspect of investing in our country. A lot of people and a lot of pundits go and hog this value investing dogma taken from Benjamin Graham and taken from the American stock market but it works over there. What Ben Graham did, works especially in the Great Depression era in America at work. Warren Buffett amended it for the more prosperous America of the 80s-90s and made his name on it. What a lot of people in our country have done is, taken that and implemented it without understanding that in our country the economic landscape is fundamentally different..You invest in cheap companies in India and often you run into companies with account shoddy accounting. If the accounting is not shoddy, the business model is broken, the return on capital never exceeds cost of capital but by the time the retail investor or even the professional investor figures that out, the money has already gone into the gutter..This is the most lethal trap I find, because MBA and being a Chartered Financial Analyst, all our training is on Western literature, you end up learning the wrong paradigms at a very important stage of your life — 18-22 — where you build the wrong mental models and they then damage you for the rest of your working life which is one of the reasons I keep writing books based on India for the Indian market because the Indian reality of investing is very different from the U.S. paradigm..A two part question and I would love that every time we speak on a show and if we have time, you tell us about your theory about why P/E multiples used in Indian context are bunkum because you’ve explained that in past but I think every time it’s a learning for whoever is listening to it, that is part one of my question. A follow up to that question is, companies – whatever valuation parameter you use – are well priced or maybe expensive at certain times and at times egregiously priced too. My question is this that if you buy a really solid company, but you are paying in traditional valuation parameters a higher price at a wrong year; let’s say in the case of Maruti at the seventh year of its thing and then in the next three or four or five years it doesn’t quite do as well. Now, even though you’ve invested in a good company hasn’t the price that you paid ensure that your returns don’t come maybe for the foreseeable future and therefore how important would be a valuation parameter and what would be that valuation parameter?So let’s start by focusing more generally on life. Whether you’re buying a shirt, a car, a stock or a house; whenever you find yourself obsessing about price, that’s an immediate sign that you don’t actually understand what you’re buying. Now, why does the human mind look at price as a determinant of what to buy, because the human mind is implicitly telling the buyer that you don’t quite understand any other inherent characteristic of the shirt or the car or the house or the stock you’re buying and hence, you’re defaulting. You’re defaulting to use the price for the heuristic. So, whoever is out there, you’re investing or you’re buying a house or a car or a shirt – remember this, this has served me great – whenever I find myself thinking too much about the price of whatever I’m buying whether it’s a stock or a shirt, it’s a signal to me that I don’t know how to buy shirts. Now, I agree and I confess I don’t know, but my wife does and therefore she does the shirt shopping. Neither of us know how to buy cars so we don’t buy cars and we have the same clapped out car for the last 12 years. So, that’s the first thing to sort of realise..'Why do you look at price? You look at price because you’re unable to appreciate other aspects which drive the purchase decision.'.Now, let’s come to this point about what drives share prices.So I’ll just use a simple mental model to explain why focusing on price leads people down the garden path. So the price of any stock can be re-expressed as the P/E multiple of the company multiplied by earnings. It’s just a basic mathematical manoeuvre. So, the share price is equal to P times E and E & E cancels out, so P is equal to E. Now, class 10 or class 11 differentiation depending on which school you went to is a change in share price therefore is change in P/E multiple plus change in earnings. So, the money you make on a stock can be driven by two factors. The P/E multiple goes up and/or the earnings go up. If they both go up then obviously you’re on the way to a nice party. You can now in this context quickly see how the Indian market sorts itself out in your head.As I said 90% of companies in our country have no competitive advantage. Their return on capital never exceeds their cost of capital. As a result, these companies simply can’t grow earnings.There are hundreds of examples we could take. Let’s take the simplest example possible, take any of our airlines which are still flying in the sky. So let’s take probably the best-run carrier in our country, IndiGo. If you look at IndiGo over the last decade, the growth in passenger volumes has been pretty consistently around the 20% mark per annum, but earnings growth has been closer to the 0% mark. Now, why is that? IndiGo is a well-run carrier and has a dominant 55% market share. The reason is, there is no barrier to entry into this industry. So, as a result whenever IndiGo’s volumes go up, they typically cut their tariffs to maintain their competitive standing. Your high volume and your tariff cut cancels out and you end up with a zero EPS growth business.So if you look at IndiGo over the last 10 years, earnings growth is closer to zero, passenger volume growth is closer to 20%. The result is the earnings compounding engine in IndiGo doesn’t quite fire.Now, you come to the traditional Indian country domains. On your show you interview some people who will say, God came to me in a dream, he has now assured me that the P/E multiple for the said stock will go up and it gives you some cock and bull story as to why the P/E multiple will go up and let’s assume it indeed does that. Your guest team has done a stellar job – they get this incredibly farsighted fund manager and he’s able to call it right that IndiGo’s P/E multiple goes up. If IndiGo’s P/E multiple doubles in the next 10 years, let’s do what brokers call a structural re-rating – P/E multiple doubles, that means you’ll get 7% compounding from IndiGo’s P/E doubling. The earnings engine unfortunately is not firing so overall your return from IndiGo is therefore 7%. I’m not going to do the P/E halving scenario, the math is obvious so let’s get to the optimistic outcome right. We’re in a bull market after all so one should be optimistic.So 7% is the best you will get on these 90% of stocks in our country and this is the typical Sensex-Nifty stock.A big company, return on capital never exceeds cost to capital. If they go through one of these structural re-ratings, you end up making 7% over a decade. This is 90% of our market. The next 8-9% of our market are good companies and companies with competitive advantages. Maruti is a classic example. They’ve got extensive sales and service network, each factory I think there are 500 suppliers who supply these extremely precise parts in one month intervals; they clearly have competitive advantages. In a 10 year cycle, 6 years out of 10, Maruti’s return on capital will be 26-27% well above cost of capital. That gives Maruti free cash flow, they put that into new factories and new products and over a 10-year cycle Maruti’s earnings typically grow at around 12% which I think is extremely creditable given that they have a majority of the small car market and yet they consistently go faster than GDP. 12% earnings growth is a big credit to Maruti. Then we bring this farsighted fund manager into the picture; somebody with great ability to time the Maruti stock. So let’s assume this guy buys Maruti at 13 P/E and sells at 26 P/E; basically holds Maruti through a long period of time over which the P/E doubles. That should add another 7% to your return. Now, 12 +7 =19, and we are all celebrating Warren Buffett style investing. Good company and bought at a good price - this is the Indian fantasy. Now, the problem with this sort of stock is, we’re all human beings. So, when for three-four years in a row, you are saying on a show Maruti is the way to go and auto is the sector to be in. By the sixth year of Maruti’s bull run, everybody in Bombay, Bangalore, Pune, Kolkata has bought Maruti and Hero and Bajaj and so on but if you buy Maruti, or Bajaj or Hero in the sixth or seventh year of their bull run, the odds are very high, you will not make 12+7, you will make 12-7. The earnings growth will still hold up broadly, but the P/E will de-rate on you because you’ve bought into the wrong part of the cycle and you’ll end up with 5-6% return and you’re back to the IndiGo scenario.So, paradoxically, two very different franchises – Maruti and an IndiGo – a lot of people end up not being able to distinguish between them, although they’re fundamentally different franchises. Maruti does have barriers to entry and IndiGo struggles with the barriers to entry point but optically, they look very similar because Maruti or Bajaj bought at the wrong part of the cycle and generate single digit returns or negative returns and make it look as if there’s something wrong with the company when there actually isn’t. Now, this is typically the Indian context in which the investing takes place.90% is the IndiGo-type situation and 7, 8-9% of our market is the Maruti-type situation.What we have tried to do through reading, through using fundamental analysis is to identify around that 1% of the Indian market which defies both of these norms. So, we’re looking for companies with return on capital in the vicinity of 45%. This is where most of our portfolio holdings come in as Asian Paints, Nestle, Pidilite etc.So let’s take a simple example, let’s take Nestle. Nestle’s return on capital is close to 50%, ROC is close to 50%. That means Nestle's free cash flow is three times that of a Maruti. That means, in the IndiGo-type companies, there is no free cash flow. Maruti-type companies six to seven years out of 10 there is free cash flow, Nestle type companies every year there’s a mountain of free cashflow; so much so that one third of it is dividend out, that means Nestle gives you a 2% dividend. Even after that Nestle has twice as much as free cash flow as a Maruti. So, Nestle reinvests in new factories, products and Nestle’s earnings growth typically tends to be twice as Maruti’s. So, Maruti’s is 12% very creditable, Nestle’s earnings growth is between 20-25%.Now, you bring into the equation the farsighted fund manager who will time it right, the Indian fantasy of a good company-good stock. So, this far sighted fund manager buys Nestle cheap and doubles the P/E in 10 years. So he gets 25% from earnings compounding, doubles P/E and adds the dividend yield, while partying all around the investors house. The fund manager becomes celebrated and becomes an Alpha Mogul or an Alpha Superstar because this guy is generating 35%. Now let’s assume that this person doesn’t actually exist and instead you have people from Marcellus who honestly don’t look at P/E multiples. So the result, let’s go through this scenario that a lot of people fear. Let’s assume Nestle’s P/E multiple structurally de-rates. Indians dread-structural de-rating. Even if Nestle’s multiple halves in the next 10 years, because babies start drinking orange or carrot juice and the P/E multiple halves, you’ll end up with 25-7=18; add the dividend, 20%. So even with a P/E multiple halving, a Nestle or Asian Paints or a Pidilite kind of a situation, you’ll make more money than doing the Warren Buffett type of investing in Maruti.But, the human mind struggles to understand the basic math of this and as a result, both in our books and in our slides; this is freely available on the Marcellus website. We’ve laid it out in a simple slide. So, it’s really important to do this to break down price movement into P and E and if you do that you realise how irrelevant this P/E multiple becomes..The irrelevance of P/E is one of hardest things to understand in investing. It’s the hardest thing to learn, partly because market noise tends to be so overwhelming and it makes you convinced; partly because this is the easiest thing to look at..To understand what will drive earnings growth is far harder. Even the local chai wala has a view on the P/E multiples of Nestle or Maruti or IndiGo and hence the whole world opines on this and the lazy heuristic is to invest on the back of this. There is no money to be made by investing on the back of this. This further challenge is that our finance education system over emphasizes this to everybody’s detriment I think..If indeed the sample size of companies which are investable in India is so low, do you get tempted to invest outside India?So there’s two ways to look at it. One way is to say that diversification is a good thing we should all do it and I have a degree of sympathy with that view, especially if, like me, you are at a stage in life, when you might have children going abroad to study and so on. So it might make sense to have, depending on your corpus and your stage of life, say perhaps, 10-15% of your portfolio in overseas stocks. So, that’s the sort of the financial planner in me. I’m no great financial planner but if I was one maybe on that basis maybe I’d have 10-15% but I certainly wouldn’t do it myself. I don’t think anybody in India should be going and punting on these stocks themselves.You’re out of your mind if you think you can sit in India and punt on global stocks and make money.Find a really high quality global fund. In our office we found a couple of funds outside India which are very similar to what we do in India; which are clean companies, monopoly franchises, essential products and we and some of our colleagues are getting our money to these fund managers..I don’t think any of us in Marcellus believes that they can read Elon Musk’s tweets and invest in Tesla. I don’t think we've got that degree of faith in our stock hunting abilities..But another way to think about it is how much money you make from a company which actually is driven by two factors. What is the spread between ROCE and cost of capital because that is free cash flow and secondly, how much of that free cash flow goes back into the franchise? How much of it gets reinvested - so the investment ratios.So in our country we are the only large country in the world, America comes nowhere close to us in this regard. We are the only large country in the world where ROCE (Return on Capital Employed) minus WACC (Weighted Average Cost of Capital) is around 30% for 20-25 companies and secondly, most of these 20-25 companies are reinvesting 60-70% of the free cash flow. Right now, I haven’t seen this combination anywhere else in the world. If any of your viewers had I would love to hear from them.Google doesn’t do, this Microsoft doesn’t do this, Amazon doesn’t do this and Apple doesn’t do this. A, they don’t have ROCE minus WACC running at 30%, B, they had it as a part of their existence, Google had it but they did they couldn’t figure out how to invest 60-70% of the free cash flow. They couldn’t figure out what to do with the free cash flow. Now, this combination is your engine of wealth- ROCE minus WACC gives you the cashflow. Reinvestment of that free cash flow, 60-70% of it going back into the franchise, funds future growth.We are the only country in the world with this combination. Very honestly one of the reasons we choose to live, work and spend our time investing in India is because of this unique combination. This is very powerful and it convinces me that the vast majority of my wealth and of my colleagues' wealth as well should be invested in India. A small part can go into equivalent franchises like Nestle, Asian Paints, Pidilite, HDFC Bank and Bajaj stocks. There are many similar franchises elsewhere in the world and there are very smart fund managers based out of India who can identify them but a small part can go there but 80-85% should be invested in these powerhouse franchises. We get this combination very rarely..There is a great deal of interest about your views on ITC.We think ITC is an incredibly powerful franchise. Not just because of cigarettes, which is probably one of the greatest monopolies ever built in India, but also because of the way that ITC has scaled up FMCG in the last six-seven years reflects very well on the company and their execution competence..The main reason why we exited ITC is because we couldn't convince ourselves on how this company will generate 20% EPS growth on a steady basis..To be part of our any of our portfolios, we want to see with a high degree of certainty 20% earnings compounding. In ITC's case, we could see with a high degree of certainty, dividend yields plus earnings growth taking us to 15-16% maybe even 17%. We couldn't quite get to the 20% number. Hence after a year of reflection and extensive dialogue with the management, we decided that we needed to exit.But that doesn't take anything away from one of the greatest franchises existing today. It's a double-barreled franchise built around a cigarette monopoly and a thriving FMCG business. Mid-teens earnings compounding is a tremendous asset in our country, especially when we realize that Nifty EPS growth over one, three and five and ten years is close to zilch. So a company that gives mid-teens dividend yield plus earnings growth is a tremendous outcome.

Alpha Moguls | Three Filters Saurabh Mukherjea Uses To Identify Companies To Invest In

Be it a large cap, small cap, FMCG or pharma, the companies have to satisfy this basic investment philosophy.

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