High RoCE is not enough. Prudent capital allocation is critical
Saurabh Mukherjea, the authority on the doctrine of ‘coffee can investing‘, never misses an opportunity to tutor us about the theoretical aspects of investing.
In his best selling treatise titled Gurus of Chaos: Modern India’s Money Masters, Saurabh has laid bare the modus operandi adopted by stock market wizards to rake in massive gains from stocks.
This was followed by another best seller in which Saurabh explained the core principles of “Coffee Can Investing” and revealed the “Low Risk Road to Stupendous Wealth“.
In his latest piece, Saurabh has explained the importance of “capital allocation“.
“The most sustainable way for a firm to compound profits over the longer term, is to sustain high ROCE alongside a high rate of capital reinvestment,” he has stated.
He has also pointed out that businesses face the challenge of consistently finding avenues for incremental capital redeployment in areas which deliver high ROCE.
Many companies goof up and make several capital allocation mistakes which results in multibagger aspirations disappearing into thin air.
Saurabh has provided a number of examples of companies which have succeeded – such as Pidilite, Asian Paints, Dr. Lal Pathlabs Page Industries and Relaxo Footwears etc, and of those that failed – such as Havells (Sylvania), Tata Steel (Corus), Asian Paints (Berger International, 2001), Bharti Airtel (Africa) etc.
Ultimately, he has advised that the secret to finding “Consistent Compounders” stocks is to find stocks that have a combination of:
(a) high ROCE;
(b) high rate of reinvestment of cash flows and
(c) history of using surplus capital to acquire businesses.
Marico Ltd reaches end of the road
Marico, which is founded by visionary Billionaire Harsh Mariwala, is the stuff of folklore in Dalal Street.
The visionary single-handed created a conglomerate which gave mega MNCs like HUL etc a run for their money.
Years ago, when a multinational conglomerate offered to buy us over, I refused. I wanted to be India's home-grown company. It fills my heart with pride when I see Indians excel. May it inspire many others to work harder & pursue their dreams. #ArvindKrishna
— Harsh Mariwala (@hcmariwala) January 31, 2020
What a Story this is:
1999
HUL called Marico to buy them as their product, Nihar wasn’t gaining share, despite all their might!2006
Marico buys Nihar as HUL fails to break through Marico’s moat. @hcmariwala #FMCGisLife https://t.co/9GWFIaGM85 pic.twitter.com/paLTDCgMhP— Mangalam Maloo (@blitzkreigm) January 31, 2020
The company's union went on a strike in the 80s & I took them on. Though my terms were met, another strike came up just within months!
Since then, I learnt that negotiations have to be a win-win. #FridayFailures
— Harsh Mariwala (@hcmariwala) February 7, 2020
However, unfortunately, the stock has now lost its way and is plunging like a stone.
“Marico’s outlook appears weak across the board but one of our other fears here has more to do with the fact that copra is possibly now facing a scenario of stagnating prices, which may preclude any pricing action or further margin-gains in the Parachute business; in a tepid demand scenario, this could translate into a lower-than-trend level profit growth,” experts at JMFICS have warned.
(Image Credit: LiveMint)
@hcmariwala @SEBI_India And there goes the Marico stock towards creating a new 52 week low that it had just breached this February. 25% down since 52 week high and 15% down in past 1 year….. Marico's stock is truly an investors worst nightmare!! pic.twitter.com/5Avubncx1q
— Nimish Patil (@nimishpatil01) February 14, 2020
What has made the situation intolerable for investors is that Marico’s arch rivals in the FMCG space such as Hindustan Unilever Ltd, Nestlé India Ltd and Britannia Industries Ltd are surging like rockets and coasting at all-time-highs.
In a market where consumption stocks are rallying….Marico is at a 52 week low
— Darshan Mehta (@darshanvmehta1) February 5, 2020
Saurabh has provided a masterful analysis of the state of affairs of Marico and confirmed that it is indeed the end of the road for it.
“In Saffola edible oils, Marico has delivered only 7% volume CAGR over FY12-19 (compared to 12-14% volume growth rates consistently prior to FY12) despite market share gains over this period, and two years ago, the management downgraded their medium-term guidance of volume growth in this product from ‘mid-teens’ to ‘high-single-digit’.
Based on our recent research on this issue, we understand that this moderation in growth is due to the premium edible oils category witnessing reduction in consumption of oil per household because consumers of this product are increasingly becoming health conscious around the quantity of oil consumed in their cooking.
Also, in Value Added Hair Oils, we understand that the low hanging fruits available around market share gains in areas like Amla-Hair-Oils have largely been plucked and hence VAHO segment is unlikely to report volume growth rates higher than 15% in future.”
Saurabh tried to keep a straight face though the emotion was evident from the tone.
“In light of this, we believe that Marico is not likely to deliver earnings growth rates of 18-20% CAGR which we had previously envisaged,” he stated firmly, bidding goodbye to the former favourite stock.
(Saurabh with Billionaire Harsh Mariwala and Ashu Suyash of CRISIL)
Divis laboratories, the new star in the Pharma universe
Saurabh was amongst the few who advised us to aggressively grab Pharma stocks when they were languishing at 52-week lows.
“Pharma is a beaten down sector that has been thrashed badly in the last three years but the fundamentals in terms of ROCs are very strong; cash generation is strong and the last three-four months of channel check that we are doing suggest that an export-driven pharma recovery should be round the corner and this is a sector where at the top of my head, I can think of four of five names where the ROCs are north of 25%,” he had advised in a prophetic tone.
Needless to say, the prediction has come true and Pharma stocks are now the toast of Dalal Street.
Stocks like Ajanta Pharma, JB Chem, Dr Reddy etc are surging at new highs.
Even Abbott India, which was recommended to us by Saurabh as a fail-safe “Cash Machine” stock, is now coasting at all-time-highs (see Saurabh Mukherjea’s Latest Stock Pick Is Blue-Chip MNC With High RoE, Zero Debt & Multibagger Prospects).
The stock has given a return of 100% over the past 12 months, which is quite an achievement given its alleged nose-bleed valuations.
ABBOTT INDIA: New lifetime high, Very less news flow noise. Higher margins. The better CANSLIM candidate from Pharma space. pic.twitter.com/Lm7C2pJOqm
— brahmachary (@brahmachary) April 14, 2018
The void left by the exit of Marico has been plugged by Divi’s Labs, one of Saurabh’s old favourites.
Ekta Batra, a noted expert on the Pharma sector, has provided a brilliant explanation of the trials and tribulations that the Company has faced over the years.
She has explained that China’s environmental woes (now amplified by the deadly Corona virus) has proved to be a blessing for Divi’s Labs.
“The API (active pharmaceutical ingredient) supply disruption in China will also be an opportunity for Divi’s. Currently, China is the lead supplier of APIs globally and in India. China supplies 20 percent API’s globally and 70-80 percent of India’s requirements,” she has noted.
Ekta Batra has also opined that these disruptions provide “multiyear opportunity” for Divis and the company will be able to leverage its long term partnerships to remain a supplier of choice and acquire new clients.
The Company has also received a clean chit from the dreaded USFDA.
Divi's Labs
Co’s Unit II inspected by USFDA
Inspection concluded with no observations
Plant inspected from Jan 27th to Jan 31st
With this – both of Divi’s Units inspected with zero observation (Both Unit 1 & Unit 2)
Unit 1 got zero observations from USFDA in Nov 2019— Ekta Batra (@ekta_batra) February 1, 2020
Divi’s Labs Vying For No. 2 Spot Among India’s Generics-Dominated Pharma Stockshttps://t.co/nzfQuFNDis
— Darshan Mehta (@darshanvmehta1) January 21, 2020
Saurabh has pointed out that Divi’s Labs has numerous virtues which makes it the ideal candidate for the consistent compounders’ portfolio.
Its key strengths are said to be:
(a) outstanding regulatory compliance track record;
(b) deep relationships with big western pharma companies for contract manufacturing (CRAMS) built around trust on IP protection and product quality;
(c) management’s focus on deepening capabilities and increasing capacities only in bulk drugs and CRAMS segments (rather than risking dilution of focus through diversification); and
(d) its highly cost-efficient bulk production of key APIs for global customers.
It is also pointed out that Divi’s is amongst the world’s top 3 API manufacturers. It is a global leader in production of few critical and highly voluminous molecules, and accounts for over 50% of global production of these molecules.
“Considering the business strengths, opportunity from relocation of outsourced manufacturing in pharma away from China and the capacity expansion and backward integration for key raw materials being undertaken by the company (with good track record of sweating assets), we expect Divi’s Labs’ profits to grow at more than 18-20% CAGR,” he has added.
Saurabh provided further commentary about the stock in his latest interview to ET:
“Divi’s has higher return on capital, higher operating margins among Indian companies, which are selling their own medicines in the western world. I would say a CCP-type franchise with strong moat, strong compounding engine and, we reckon, it will potentially stand the test of time“, he has stated.
