Saurabh Mukherjea, author of the book 'The Unusual Billionaires' feels the buy-and-hold approach to investing holds true even as volatile financial markets and disruptive changes across sectors are questioning its validity
Consistent revenue growth combined with a consistent return on capital employed: if a company has been delivering on these two parameters for over ten years, then look no further. That, in effect, is the theme of Saurabh Mukherjea’s second book 'The Unusual Billionaires'. The book says that a portfolio of companies which satisfies both these criteria will invariably beat the market over the next decade and more.
Mukherjea, whose day job is CEO, Institutional Equities at Ambit Capital, feels the buy-and-hold strategy for stock investing holds true even as volatile financial markets and disruptive changes across sectors are questioning its validity.
However, the two filters recommended by Mukherjea are not easy to get past; less than 20 companies have managed that over the past decade. Mukherjea feels the bar is not too high; it is just that most promoters lack the discipline that could have helped their firms go from being good companies to great companies. Through the journeys of seven companies which made the leap, Mukherjea narrates the qualities and strategies that helped them get there.
Edited excerpts from an interview:
Q: Your definition of a great company is one that has delivered a compounded revenue growth of 10 percent and an average return on capital employed of 15 percent over a decade. Your analysis shows that only 18 out of the couple of thousand traded companies on the bourses made the cut over the past decade. What does that tell you?
A: Growing a business at a steady pace (10 percent topline growth or better) whilst maintaining healthy levels of profitability (15 percent ROCE or better) over long periods of time is very very hard. I think most people don’t understand how difficult it is to pull this off. As a result companies which are able to achieve this rare feat -18 odd companies out of the 1500 largest companies in India – don’t get the recognition they deserve. That in turn opens up opportunities for the discerning investor who understand how challenging the 10 percent revenue growth plus 15 percent ROCE combination is.
If you ask me why is it so hard to pull off this combination? My answer is that most promoters struggle to find a balance between growth and profitability. Balance in business is just as hard to achieve as it is in other spheres of life. As Rama Bijapurkar says in the book, most companies tend to focus on short-term results and hence that makes them frequently do things that deviate away from their articulated strategy. The willingness to resist the temptation of short-term ‘off-strategy’ profits for long-term sustainable gain is not there in most Indian companies.
Q: You say that if an investor were to simply buy the stocks that met the two parameters over the last decade and stays put, he can beat the market over the next decade. Is that not making investing a bit too simplistic?
A: Buying high quality stocks and holding them for an extended period of time is a well-known mantra in the world of investing. Several legends including Buffett, Bolton and Peter Lynch have espoused such a strategy. What I have done is boil such a long term buy-and-hold strategy down to its very essentials – a simple formula of revenue growth and ROCE to identify high quality stocks – and quantified the market beating investment returns that such a strategy can generate. Just because such a strategy is simple does not mean it is easy. Why is such a strategy not easy to follow? Because it requires patience to buy and hold stocks for a decade. Effectively, the investor has to eschew excitement now for returns ten years from now.
Secondly, it requires character to hold on to those stocks whose share prices begin to slip in the second, third, fourth or fifth year of the ten year period. Thirdly, it requires a deeper of understanding of what exactly a great company is i.e. great companies are not those who are lionized by the media; they are the anonymous promoters who slog away quietly decade after decade persistently improving their franchises and delivering the 10 percent revenue growth and 15 percent ROCE combination. Great companies are the Rahul Dravids of the stockmarket (as opposed to the more exciting players like Yuvraj Singh or Sehwag).
Q: In a rapidly changing world where business models are getting disrupted frequently, does a buy and hold approach work over the long term?
A: It is fashionable for all of us to believe that “change is the only constant”. That may or may not be true but its relevance to the investment style espoused in the book is relatively limited for two reasons: (a) Most focused promoters are able to make technology work for them rather than being disrupted by technology eg. The extensive use of Enterprise Resource Planning tools and software is a trend that Asian Paints, Berger Paints, Marico and Astral Poly have capitalized on and the book explains how each of these companies use ERP to reduce their working capital cycle. (b) The biggest source of disruption for Indian promoters is neither technology, nor the external business environment; it is the promoter himself/herself.
99 percent of promoters that I meet struggle to focus on the same activity beyond 4 or 5 years. After that they tend to get bored and their attention drifts it to the next flavor-of-the-month idea. As a result, the 'change' that takes place is usually triggered by the promoter himself who uses the fig leaf of technological change and/or the external environment as reasons for his change in tack.
Q: To quote Buffet, it is important to buy good businesses at the right price. Even after you have identified the stocks with a consistent revenue growth and ROCE, you still need to buy it at a reasonable price. So how does an investor approach these stocks?
A: Over the past six years my colleagues at Ambit have shown repeatedly in the research for our clients that for horizons longer than a year valuations do not play a role in generating investment outperformance. I show in the book that over the long run the biggest driver of share prices is ROCE followed by revenue growth. There is zero correlation between valuation multiples and share price returns over long run time periods. In fact, our research shows that investors who try to buy cheaper stocks almost always end up with lower quality portfolio which generates inferior growth in cashflow and earnings. Secondly, Buffett over the past 20 years has brought great franchises at what look like expensive multiples eg. his recent acquisition of Apple shares; my reading is that he too is focused on the underlying drivers of ROCE and growth rather than valuations per se. Thirdly, most of us neither have the acumen nor the resources of a Buffett; hence we need simpler methods to identify outstanding companies.
Q: You have mentioned Asian Paints, Page Industries, HDFC Bank, Astral Poly, Axis Bank, Berger Paints and Marico as great companies. Do you see these stocks delivering market beating returns over the next decade?
A: One point I repeatedly make in the book is that we have to learn to think of investment in the context of portfolios rather than of stock picks. Even more specifically, the investment style that seems to work in all countries and in all eras is to buy 15-20 high quality companies and hold them for a long period of time, at least a decade. Harking back to the term coined by the late Rob Kirby, I call this style the Coffee Can Portfolio and I show using 16 separate Coffee Can Portfolios that in a typical portfolio you have 2-3 stars (who compound at 35 percent or more over ten years), 2-3 dogs (who go to zero over ten years) and around 8-10 stocks which deliver solid returns (around 15 percent). The blend of these 15 stocks typically gives you 20-30 percent per annum compounded over ten years which is significantly better than the 16 percent that the Sensex gives you on average. I highlight in the book that Peter Thiel, the founder of PayPal, has explained in his book Zero to One why such portfolio constructs are central to Silicon Valley’s success.
Q: If an investor were to take a shorter track record of a company, say five years, do the revenue and ROCE parameters still hold good. As in, what are the filters an investor could use to identify great companies in the making?
A: The shorter the track record that you use, the greater the scope for error. So, yes you can use a five year revenue growth and ROCE track record but I reckon that you will make more mistakes. In the book I have used a ten year track record and I find that even then 2-3 out of 15 stocks in a portfolio misfire. With a shorter track record, the error rate could be 6 out of 15. That will in turn drag down the return you get from the portfolio and reduce the outperformance that you get from the portfolio vis a vis the Sensex.
Q: At a time when valuations seem to be completely disconnected from fundamentals and the market is willing to pay an outsized premium for quality stocks, what is your advice to investors?
A: If you are short term trader then you should worry out valuations quite a lot. Valuations matter hugely for short term traders. For long term investors, today’s P/E or P/B multiple or tomorrow’s P/E or P/B multiple is of little relevance; their focus is the fundamental quality of the franchise. To use another cricketing analogy (which is very apt in the context of Rahul Dravid), ‘Form is temporary whereas class is permanent’.