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The Path To Consistent Compounding

Why the search for compounding stocks requires a greater depth of research & patience about a business’ operating efficiencies.

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(Image: pxhere)

There are four key drivers of free cashflow in a business – revenue growth, profit margins, working capital efficiency, and asset turnover. The order of importance across these four drivers differs across businesses. As our investee companies invest in technology to improve operational efficiencies, compress working capital cycles and expand their asset turnover, these companies are able to scale their franchises whilst avoiding price hikes. For such companies, growth in free cashflows can remain higher than growth in profits over long periods of time. Hence, investment in such companies purely by building expectations around their profit growth is an incomplete exercise.

The Path To Consistent Compounding

Investors Need To Evolve As Nature Of Business Changes

The valuation of any business is the net present value of all expected free cashflows in the future. As a result, for every business, an investor needs to build their expectation of the quantum of growth and the longevity of growth in free cashflows. This is a universal concept that applies to every business.

However, what is not common across businesses is the primary driver of free cashflows, which particularly affects the quantum of growth in free cashflows. Consider the following examples.

Type 1 - Book value as the primary driver of free cashflows: Let’s assume that there is a business that has a unique manufacturing process in a factory that produces a product that meets an essential demand of a large customer base. Furthermore, let’s assume that no competitor can produce a substitute product to meet this customer demand. As the business reinvests capital to expand its manufacturing capacity (plant and machinery), it delivers growth in free cashflows. To invest in such a business, investors must focus on growth in its asset base as the primary driver of its moat and hence free cashflows in the long term. Until half a century ago, investment in many great businesses was carried out on this basis, when the price-to-book multiple was a commonly followed metric.

Type 2 - Profits as the primary driver of free cashflows: Let’s say there is a business that has an exceptionally strong brand recall that cannot be replicated by a competitor. Since there is nothing differentiated about its product quality, the business outsources the entire manufacturing process, and hence it is an ‘asset-light’ business. The primary moat of such a business is its ‘brand’. At the simplest level, the more this business advertises its brand across various media channels, the more it delivers volume growth, revenue growth, and hence profits growth. Investing in such a business requires focus on only the ‘profit and loss’ statement – how much of profits from a given year get reinvested in advertising next year. Over the last 40 years, as penetration of mass media increased across countries, there were several such great businesses.

It is not worth considering the P/B multiple for such a business – its P/B multiple will keep rising as the business grows because the business is outsourcing its ‘B’. Instead, the price-to-earnings multiple is more relevant for such a business.

Here is an interesting comparison of two different businesses from the same industry on P/B multiples – Proctor and Gamble (the parent listed in the United States) and Colgate Palmolive (the parent listed in the U.S). P&G has grown its business through numerous acquisitions. These acquisitions have brought significant goodwill onto its balance sheet. On the other hand, Colgate-Palmolive has a negative accounting book value because its most valuable assets are the brands it has developed in-house over its hundred-plus years of existence. Hence, P&G looks cheaper based on a P/B multiple compared to Colgate because the denominator is much bigger in the case of P&G. The two companies are in the same industry, but given the differences in their capital allocation approach, one looks significantly cheaper than the other on P/B multiple and that highlights the irrelevance of P/B.

Let’s now move forward another step to see businesses that have evolved even further and thus made the P/E multiple irrelevant. Let’s understand this more through a third type of business.

Type 3 – Operating efficiencies as a key driver of free cashflows: What if a business significantly reduces its working capital cycle and increases its asset turnover through a variety of initiatives, consistently over the next 20 years? Let’s assume that such a business also sustains high pricing power (and hence profitability on the income statement) and a healthy rate of capital reinvestment. In such a case, the rate of growth in free cashflow will far exceed, both the rate of growth in its profits, as well as the rate increase in its net assets, due to the reduction in working capital cycles and increase in asset turnover. Investing in such a business requires focus on free cashflows rather than just growth in net assets or growth in profits.

If the rate of growth in free cashflows of such a business remains higher than the rate of growth in earnings, then the comparison of this business with a Type 2 competitor, as described above, on P/E multiple is flawed. In other words, the P/E of such a business will keep rising as long as the free cashflow growth of the business remains above earnings growth.

Hence, in equity investing, it is worth understanding the source of free cashflow growth of your investee company (metrics on balance sheet vs income statement vs cashflow statement) in order to focus on the most relevant financial metric and hence a valuation approach.

Why Investors Should Focus Only On Free Cashflows Of Consistent Compounders

In Marcellus’ Consistent Compounders Portfolio, there are several companies whose growth in free cashflows tends to be far greater than the growth in their profits. As shown in the table below, free cashflow to the firm CAGR of our portfolio companies (ex-financials) has been 11%-12% points higher than the earnings CAGR consistently over the past 5/10/15 years.

As a result, investors focusing on only the income statement or profits of these companies often get an incomplete understanding of their competitive advantages and hence valuations.
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A combination of the following three reasons makes most companies in Marcellus’ Consistent Compounders portfolio akin to Type 3 companies defined above.

1. Focus on in-house manufacturing and distribution of products and services which are of day-to-day essentials: Our portfolio companies sell essential products and services such as pathology diagnostics, infant milk powder, undergarments for daily wear, over-the-counter medication for daily consumption, etc. The small ticket sizes of these essential offerings orient their businesses towards large volumes of sales. Distribution of small-ticket high-volume products to every nook and corner of India gives rise to complexities around the management of inventory, receivables as well as payables in the supply chain.

Additionally, even though these companies have the option to outsource manufacturing at the back end and distribution at the front end, most of them have chosen to keep these functions in-house. For example, Nestle manufactures most of its products at its own factories. Page Industries is the only apparel manufacturer which employs its entire labour workforce on their payrolls, does not rely on wholesale-oriented distribution, and also owns all fixed assets related to their manufacturing plants. Asian Paints directly sells its products to paint dealers on the high street, without any involvement of distributors or wholesalers, and also manufactures all its products at its own manufacturing plants.

Due to in-house manufacturing and distribution of small-ticket high-volume products and services, our portfolio companies have a massive opportunity for deriving operating efficiencies around working capital cycles and asset turns.

2. Lack of price hikes to suffocate competition: In our June 1, 2020, note we had highlighted that firms in Marcellus’ CCP Portfolio — like Asian Paints, Abbott India, Dr. Lal Pathlabs — have historically avoided hiking product prices meaningfully. This is because by focusing more on the volume of sales (rather than value), these companies do not intend to leave any room for their competitors to start any price wars to gain market share. Such firms consistently derive incremental operating efficiencies through investments in technology, systems, and processes. These operating efficiencies help offset the adverse effect of inflation in raw material and operating cost, and hence negate the basic need to hike product prices.

If competitors cannot match the quantum of such incremental operating efficiencies, they get suffocated because of a lack of price hikes from the market-leading player.

3. Investments in technology to derive operating efficiencies that further strengthen their moats: There are several technology-based ingredients of competitive advantages of our portfolio companies that drive a greater rate of free cashflow growth compared to profit growth. For example, a superior understanding of the end consumers’ demand and preferences helps the manufacturer reduce dead inventory in its supply chain and distribution channel and convert working capital into cash much quicker compared to the competition. A faster cash conversion cycle then helps the manufacturer to carry out activities such as making quicker payments to raw material vendors and avoiding price hikes despite generating high returns on capital employed. Moreover, there exists immense scope for deriving operating efficiencies through initiatives such as the use of technology to automate manufacturing processes, reduce cycle times, derive raw material procurement efficiencies, to sweat the fixed assets harder.

Most of the tech investment-related competitive advantages are difficult for competitors to replicate, either because they are based on proprietary data, or because they were done over a period of time as part of the DNA of the organisation, rather than investments that were done at a single point of time in the past.

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How Some Companies Have Consistently Focused On Free Cashflow-Oriented Initiatives

Here are some examples of how Marcellus’ CCP companies have compounded their free cashflows faster than profit growth through improvement in operating margins, compression of working capital cycles, and improvement in asset turns.

Asian Paints

Asian Paints has consistently used demand forecasting and data analytics to improve its supply chain efficiencies. As a result, the firm saw a reduction in its working capital cycle from over 100 days in FY95 to around 10 days by FY10. Moreover, Asian Paints’ annual reports over the past 20 years have consistently talked about its focus improve fixed asset turns by sweating its assets harder before it decides to expand its manufacturing capacity. For example, the FY04 annual report states “Company's last greenfield paints manufacturing facility was set up in 1990. Over the last few years, Asian Paints has been following a deliberate strategy of postponing capital expenditure for primary production facilities. This has been possible, as we have focused on enhancing productivity of existing assets and improving plant efficiencies to realise higher production levels from existing plant and machinery, quick and effective standardization of processes, implementation of the concept ‘Right First Time (RFT)’, 5S and RCA (problem solving through Root Cause Analysis) are some initiatives undertaken by the company that have allowed existing manufacturing facilities to produce more from the same assets”.

As the complexity of manufacturing increased with increasing number of SKUs, plants and warehouses set up after FY09 were fully automated leading to better scalability, lower wastage, and stronger environmental compliance.

As a result, Asian Paints’ asset turns (measured by gross profit divided by gross block) improved from ~1.4x in FY00 to ~1.8x in FY07, and to ~2.1x in FY17.
The Path To Consistent Compounding

Titan

In India, all jewellers outsource manufacturing of gold jewellery to the karigar (goldsmith) community which is highly unorganised and marked with outdated practices/technologies of manufacturing along with poor work conditions. The resulting challenge is an inefficient supply chain in the form of higher wastage, high manufacturing lead times leading to high investment in raw material / work-in-progress inventory of a high-value commodity like gold. Titan radically disrupted the status quo starting with basics by engaging with karigars to upgrade their working conditions by providing health benefits, financing procurement of modern equipment, and investing in land and building for four ‘karigar centers’ designed to improve the lifestyle of karigars. Moreover, once the basics were addressed, Titan worked with karigars to train them around efficient practices like Theory of Constraints and Lean Manufacturing, resulting in significant improvements in manufacturing efficiency.

As a result, over a period of FY05-FY11, manufacturing lead time at vendors reduced from ~35 days to ~6 days, effectively reducing WIP inventory at vendors by one-sixth and improved Titan’s ability to offer faster turnaround times and improved stock availability to its customers.

While most of the plain gold jewellery manufacturing is outsourced to karigars, the bulk of Titan’s diamond jewellery products are manufactured in-house where Titan used robotics to automate manual processes which have improved capacity by 10x over FY05-11 and has freed up hundreds of man-days of its workers.

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Page Industries

On the manufacturing front, Page’s moats include product differentiation in the form of quality, consistency and comfort derived from in-house manufacturing. Executing in-house manufacturing of Page’s products at scale is challenging because the process is highly labour-intensive.

Page’s approach to improve and sustain higher asset turns has been three-fold:

  • Managing labour relations better than competitors to improve retention rates of a well-trained workforce;

  • Use of automated machines for processes such as fabric inspection, fabric cutting, etc. to improve productivity;

  • Use of technology to monitor labour efficiency (e.g. use of RFID/proximity cards to capture real-time data).

As a result, over FY08-18, Page’s asset turns improved from ~3.8x to ~6.5x. Also, over FY13-18, Page reported a 6% CAGR in the volume of products sold per unit of labour workforce. On the working capital front, the ready availability of a large number of SKUs across around 80,000 points of sale across the country is another key moat of Page’s business.

However, the key challenge here is managing the complexity in the supply chain due to a large number of SKUs, without compromising on inventory turns, thereby avoiding loss of sales.

Moreover, the complexity of Page’s supply chain has increased over time due to the launch of new SKUs and increasing focus on adjacencies like women’s innerwear (which has by itself has a wider range of SKUs versus men’s innerwear), athleisure/outerwear, and more recently kidswear. To overcome this challenge, Page has made significant tech investments around sales force automation to capture granular sales data, data analytics for demand forecasting, and supply chain tools like ‘BlueYonder’ for better planning. As a result, despite increasing complexity due to more SKUs, Page’s inventory days have reduced from around 100 days to ~85-90 days over the last 10 years.

The Path To Consistent Compounding

Investment Implications

Free cashflows forecasting requires far more research versus profits or book value forecasting.

There are four possible drivers of free cashflows of a firm:

  1. Volume growth or revenue growth;

  2. Operating margins or profit growth;

  3. Reduction in working capital cycles or operating cashflow growth; or

  4. Increase in asset turnover or free cashflow growth.

When it comes to high-quality companies, investors who have focused only on volume growth and profit growth (or only P/E multiples) and have ignored the other two factors, have only partially been able to understand the long-term compounding ability of these companies. Having said that, building an understanding around working capital cycles and asset turnover prospects is far harder than understanding a company’s earnings growth prospect for two key reasons. Firstly, it requires a greater depth of research around the business’ operating efficiencies. And secondly, it requires a greater degree of patience from an investor, because free cashflow can be far more volatile in the short term compared to profits or book value per share.

Note: All the firms named in all the tables and charts shown above are part of Marcellus Investment Managers’ portfolios.

Saurabh Mukherjea, Rakshit Ranjan, and Deven Kulkarni are part of the Investments team at Marcellus Investment Managers. Saurabh Mukherjea and Rakshit Ranjan are the authors of ‘Diamonds in the Dust: Consistent Compounding for Extraordinary Wealth Creation’.

The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.