Saurabh Mukherjea | ITC: Saurabh Mukherjea explains what will make Marcellus consider buying ITC
We have explained in the past why the Indian markets will be dominated by master franchises and the more I think about it, the more it becomes evident with the way the economy evolves. How will some of the master franchises evolve in the great economic recovery we envision, which is currently fueled by commodity prices and low liquidity?
The whole theme of the Indian market over the past decade has been this set
Diamonds in the dust story and that’s what we wrote in the book. Just to put in some numbers, over the past 10 years the Indian stock market has created $ 1 trillion in wealth. It’s a big deal, but 80% of that trillion is from 16 stocks. Another way of looking at it is that today we have come to a situation in India where 10 master franchises or 10 diamonds represent 90-95% of the nation’s profits. The stock market creates a lot of wealth in India and that’s the good news, but for people who think they’ll have a punt here and another there and make money in the market, the idea should be to focus on the country’s dozen and a half franchises that make huge sums of money and create a lot of wealth.
The stock market has 6,000 stocks, but 15 to 16 companies will make just about all the money in the market. In this recovery too, we see that in the banking sector, the industry leaders are increasing their loan portfolios to 15-16% while according to the RBI, the overall loan portfolio of the sector is increasing by 5%. In IT departments, giants like TCS are able to keep attrition single-digit while everyone struggles to keep attrition even at 15%. So we see this story unfolding in India where in each sector one or two franchises take away 90% of the profits, 90% of the wealth and it is imperative that our clients lock themselves in this dynamic.
So if 16 companies created the lion’s share of the wealth and a large part of the profit pool is now concentrated with 15-20 companies, are you saying that these companies will continue to build wealth for Investors ?
It’s true. Obviously there will be churn. The 15-20 companies have delivered just about all the wealth in the market over the past 10 years and most of them will shine in the next 10 years. My estimate is that about a third of those 15 to 20 names will have an approximate decade between 2020 and 2030 and there will be four-five new names. But the basic construction of the Indian market will be a bundling of value creation around super powerful franchises, strong competitive advantages, high class corporate governance and superior use of technology.
Thus, the basic market construction will remain these 15 to 20 names and despite a limited churn rate, these names will be the engine of wealth creation in the market. Our book tries to help people identify them. For example, TCS is above any other IT service company. Its main competitive advantage is the way it recruits, trains and retains around two lakhs each year.
It is the largest training and retention program in the world that allows them to keep attrition low and grow rapidly while keeping wage inflation under control. They have 25% free cash flow compounded over the past 10 to 15 years. It’s a monster franchise, a global leader that we can all benefit from by investing.
Let’s start by adding a few actions that may apply to your filter criteria, but that are not part of the portfolio. One of them is. Some would say this is a great franchise and it generates cash flow and the FMCG business is not losing money and yet the stock is cheap. Why and why don’t you have it?
There are sort of three prongs to building wealth in our country, I’ve said this before but I’m repeating it quickly today and it’s also in the book – step 1, accounting and governance. must be top notch. ITC ticks the box there. Step 2, you must have deep competitive advantages, without a doubt ITC ticks the box. Its cigarette franchise is unmatched in the country. But in step 3, you need to take the surplus generated by the business and reinvest it so that the business grows 20-25% – this is where they had a little challenge. The cigarette franchise generates a lot of money – almost Rs 10,000 crore comes from the cigarette franchise that the ITC has in its wallet. Reinvesting that money to generate roughly 20% compound EPS has been a bit of a challenge for the company over the past decade and that is why it is not part of Marcellus’ portfolio.
I think ITC executives are aware of the problem, they are aware of the scale of the problem and the day the company starts redeploying its Rs 35,000 crore on the balance sheet to generate an EPS dialing machine at 20%, will obviously be very happy if you look at this stock.
If you look at the main franchise or champion franchise shares that you own – whether it’s Asian Paints or a combination of HDFC Life or Dr Lal Path, whether you invest or stay invested in those shares of September 2021 to September 2025 or 2026, can they give double-digit returns or at these levels shouldn’t you expect that kind of return?
In our discussions with our clients, we keep telling people not to watch the stock price. The share price won’t tell you anything. The multiple PE does not give you any information about a company. Things to consider when deciding to invest – whether it’s Asian Paints, Pidilite, or any other company – is to look at the gap between return on capital and cost of capital. Typically for a champion franchise, the diamond franchise, there will be a spread of around 30%. Typically, you will find that the majority of this money is reinvested in the business. So if you reinvest, say two-thirds of 30%, you are reinvesting in the business 20% more capital each year. It is then very difficult for the business not to grow at odd 20%.
If your business grows odd 20% year over year, it doesn’t matter if the stock is trading at 60 EP or 30 EP. If the business grows 20% year over year and the business doubles every three and a half years, it will achieve double-digit returns consistently for a very long time. And it’s a very simple philosophy. We tried to articulate it as best we could and tried to tell people not to watch the multiples of EPs. They won’t tell us if you make money with a stock or not. If you want to look at the numbers, look at the return on capital, look at the free cash flow and the reinvestment of that. This will give a pretty good idea whether or not there will be double digit returns.
You say don’t look at stock prices and try not to time compounders. Can you tell us a little more?
Related to this theme of not looking at multiple EPs, this is what we showed in Chapter 6 of the book Diamond in the Rust. In fact, I was stunned by it. Suppose we had perfect foresight and bought a composing champion like Asian Paints at the low of the year, every year for the past 10 years. If we had done that we would have made up the return around 27-28% which is a great result and we are perfect timekeepers. But suppose we are not that smart and mechanically buy Asian paintings every year on a random basis, say January 1st of every year. If we did this every year for 10 consecutive years, we would get about 26%, which is still a very good result. And then, most astonishingly, we found out that if we buy Asian paintings at the highest level of the year 10 years in a row, we will continue to compose at 19%!
Therefore, what we are saying is that if you go for a champion franchise where the underlying activity consists of 20 to 25%, it does not matter whether you buy it at the highest or at the lowest of the year. We will compose globally at these 25%, as we say in the book. There are 15-20 such companies in the country and one of them is expected to engage in these master franchises. They will be the core, the key to wealth creation in India over the next decade.