India’s Greatest Cash Generation Machines Keep CompoundingBloombergQuintOpinion
Great companies gain market share in disruptive times.
One of the most striking things about the impact of Covid-19 on India Inc. has been the ability of sector-leading franchises – which we call Consistent Compounders – to gain market share and thereby grow their top line, bottom line, and free cashflows strongly in a tough year like FY21, as seen in the table below. Looking back at the last 20 years, we notice that this happens frequently – i.e. the Consistent Compounders have been able to grow through disruptions like the global financial crisis, demonetisation, the IL&FS crisis, or Covid-19. We explain in this piece that this outperformance is on account of: a) the ability of the Consistent Compounders to offset the adverse impact of macro or micro headwinds either through market share gains or through additional revenue growth drivers over time; and b) the ability of the Consistent Compounders companies to participate in a benign environment which is conducive for growth.
Acceleration In Market Share Gains
The resilience in demand for Consistent Compounders’ products and services over the past 6-9 months has been mainly because of market share gains from both organised as well as unorganised competitors.
For instance, the three lenders mentioned in the table above have delivered stronger loan book growth in Q4FY21 compared to the industry average (see table below). The capital adequacy ratio of the three lenders in Marcellus' Consistent Compounders Portfolio or CCP has been significantly higher than that of the banking industry and also compared to the regulatory requirement.
Remarkably, these differentials between the capital adequacy ratio of CCP lenders and their peers exist despite significantly more aggressive provisioning carried out by CCP lenders over the past 12 months.
Moreover, as shown in the table below, over the past 12 months the drop in cost of funds for CCP lenders has been greater than that of the overall industry. Unsurprisingly, therefore, CCP lenders are likely to continue gaining market share from their peers with improving net interest margins and superior operating efficiencies.
The decorative paints industry in India has faced challenges during the pandemic, both from the demand side as well as the supply side. In larger cities, households have deferred repainting projects due to the worries around the virus, residential societies have not allowed refurbishment activities for several months during the year and contractors faced labour workforce shortage last year due to workers’ migration away from larger cities during the March-July 2020 lockdown.
In an industry where supply chain efficiency in the distribution channel is one of the biggest drivers of competitive advantage, lockdowns have created substantial operational challenges, especially for the smaller unorganised paint players.
Amidst these headwinds, as highlighted in the table below, Asian Paints and Berger Paints have reported resilient revenue and profit growth during the year backed by substantial market share gains both from unorganised as well as organised players like Akzo Nobel and Kansai Nerolac.
Amongst the diagnostic labs, as shown in the table below, Dr. Lal PathLabs has reported far more resilient fundamentals compared to other large listed national chains. Moreover, the revenue growth of organised players is likely to have been significantly higher than that of standalone/unorganised diagnostic labs.
Expected Impact Of The Covid-19 Second Wave And Raw Material Cost Inflation
The Consistent Compounders sell products and services which are small-ticket day-to-day essentials. These firms have also made superior investments in systems and processes compared to their competitors over the past 12 months. Hence, their better preparedness in dealing with the lockdowns related to the Covid-19 second wave over the last few weeks has further accelerated the prospects of market share gains.
As the global economy has entered recovery mode, over the past six months the cost of raw materials has shot up. This again has more positive than negative implications for the Consistent Compounders due to two reasons. Firstly, as the classical textbook definition of pricing power goes – ‘Companies with high pricing power are able to hike their product prices to offset the impact of raw material cost inflation on their margins, without losing market share in the process’.
The Consistent Compounders have repeatedly demonstrated superior pricing power versus competitors. Secondly, the Consistent Compounders avoid hiking product prices meaningfully. These companies focus on deriving incremental operating efficiencies, thereby negating the need to hike product prices, which in turn suffocates their competitors over time. For instance, the MD and CEO of Asian Paints said in the firm’s Q4FY21 results announcement – “The huge inflationary trend in raw material prices has been worrying. However, its impact on profitability has been negated with some path-breaking work on sourcing and cost optimization.”
Investment Implications – ‘Consistent Compounding’ Of Free Cash Flows In An Uncertain World
In addition to healthy earnings growth in the past, the Consistent Compounders have also maintained their returns on capital employed at around 35% on average. Over time, these ROCEs have increased due to an improvement in asset turnover and reduction in working capital cycles, without compromising on the rate at which profits are re-invested back into the business. The combined effect of expansion in ROCEs with healthy earnings growth rates is reflected in the rate at which free cash flows have grown for the Consistent Compounders historically – as highlighted in the table below.
Disruptive events like Covid-19 offer substantial opportunities for high-quality management teams to incrementally strengthen their competitive advantages, to radically disrupt their industries, and to add new growth-drivers. The Consistent Compounders have tried to capitalise on these opportunities over the past 12 months – e.g. Bajaj Finance is planning to launch a new digital offering to its customers; Dr. Lal PathLabs has invested in home collection infrastructure; Asian Paints has invested in home décor services; Pidilite has acquired Araldite and has invested heavily in manufacturing process automation; Berger Paints is massively capitalising on the shift from unorganised to organised products at the economy end; and almost all of the Consistent Compounders have upgraded their systems and process to manage working capital better. We expect such initiatives to keep driving a healthy rate of compounding of their free cash flows in the future.
Note: Asian Paints, Abbott India, Bajaj Finance, Berger Paints, Nestle, HDFC Bank, Kotak Bank, HDFC Life, Dr. Lals PathLabs, Page Industries, Relaxo, Divis Laboratories, Titan, and Pidlite are part of many of Marcellus’ portfolios.
Saurabh Mukherjea, Rakshit Ranjan, and Deven Kulkarni, are part of the Investments team at Marcellus Investment Managers. Saurabh and Rakshit are co-authors of “Coffee Can Investing: the Low Risk Route to Stupendous Wealth”.
The views expressed here are those of the authors, and do not necessarily represent the views of BloombergQuint or its editorial team.