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What are the filters used by Marcellus to select stocks? CIO Saurabh Mukherjea explains in exclusive interview

Lokeshwarri SK | Updated on July 26, 2020 Published on July 26, 2020

Stock market activities will normalise from FY22 onwards: Founder of Marcellus Investment Managers

Investors need to do nothing different as they navigate the current patch, says Saurabh Mukherjea, founder and Chief Investment Officer, Marcellus Investment Managers. All they need to do is to pick clean companies with strong franchises, which will automatically compound investor returns. As Marcellus gets ready to launch its financial sector fund, he explains the filters used by him to select stocks and the pitfalls to avoid, in this exclusive interaction with BusinessLine.

What are your thoughts on the current market scenario? The Nifty 50 is soaring above 11,000 despite the picture being so bleak on the economy and earnings…

There is enough data now to question this narrative of things being bleak. Electricity and diesel demand has normalised. We are hearing from many FMCG and auto makers that demand has revived significantly. Banks such as HDFC Bank registered , credit growth of 7-8 per cent, even in the June quarter. The wheels of the Indian economy did not come off even in the darkest days of the lockdown. A similar trend is witnessed in other countries in Europe and in the US too.

If you a take 2-3 year view, the picture is quite positive. In the last 40 years, every single economic boom in our country was preceded by a recession in the US. This is due to two reasons. One, a US recession makes oil prices fall by 60-70 per cent, and that is conducive for an oil-importing nation like ours. The fall in oil prices is equivalent to a stimulus amounting to 3 per cent of our GDP. The second reason is that a US recession brings down the US treasury yields by 2- 3 per cent that eventually brings down interest rates India, too. So, over the next 2-3 year period, we can have a period of accelerated economic growth, similar to 2009-2011.

But we have lost the entire month of April, with no economic activity. So, the growth for FY21 will shrink to that extent, right?

Look at it this way, any stock price reflects 20 years of profits discounted. Assume that a company makes ₹5 of discounted profit every year, so its price is ₹100 (₹ 20*5). Even if this year’s profits are wiped out, the stock price should be ₹ 95 and that is what the stock market is reflecting now. Thankfully, after the hysteria in March, sanity has prevailed and the Nifty50 is 7-8 per cent below its January peak. So the Indian stock market is saying that this year’s profits are gone but from FY22 onwards, activity will normalise.

There is another more optimistic way to look at this. Say a good company that is a market leader gains 10 per cent market share because of the way Covid-19 has hit weaker companies. So, instead of ₹5 for the next 19 years, if they generate ₹5.50 for the next 19 years, then the price of the stock should actually be ₹105.

In your handbook, ‘Investing Through a Crisis’, you say that choosing companies with good governance is critical. Can you talk about the Marcellus forensic framework that you use to filter companies?

What we were trying to highlight in the book, ‘Investing Through a Crisis’, is that irrespective of Covid-19, the biggest risk in the Indian stock market comes from accounting fraud. Our analysis suggests that 80 per cent of companies in the Indian stock market fabricate their accounts to a greater or lesser extent. Focusing on the other 20 per cent that have clean account is extremely important for all investors in our country, whether investing in debt or equity.

In Marcellus forensic framework, we use 10 accounting traps over previous six years of financial statements to filter companies. A simple trap is growth in audit fee divided by growth in revenues. If audit fee grow faster than revenue over 4-6 years, it is a powerful indicator to show that the auditor is fabricating the accounts and the company would get a negative score in our framework.

Another test we do is to see if a company that generates hefty profits over many years generates commensurate free cash-flow. Almost 70 per cent of Nifty 50 companies fail in this test, they have not been able to generate any free cash-flow in the last decade.

The cash conversion ratio is quite important. This shows how much cash flow the company generates for every ₹100 of operating profit. The company’s ratio has to be compared to the industry norm. For instance, in the pharma industry, this ratio is 85 per cent. Many of the Indian pharma companies, however, fail in this test. The reasons could be due to debtor days being unusually long. The longer collection period is, in most instances, due to most of the invoices being fabricated that results in bloated receivables. This in turn results in fabricated profits and inflated networth, based on which the companies go and borrow money from banks and mutual funds.

These safeguards are useful in normal times too. But during Covid-19, the pandemic itself can be used as a pretext by many companies to steal investors’ money.

Do you think that going for companies audited by the Big Four or the top audit firms can help investors?

Everybody is human. I haven’t found any difference between companies audited by the prestigious and not-so prestigious auditors. What is interesting is to see the name of the audit partners on financial statements. Some audit partners keep popping up in several dubious sets of accounts. The same people keep signing on accounts that test the limits of human rationality.

Can you give me a brief description of the stocks that you call -- consistent compounders? What are the features of these stocks?

The way we have gone about building our portfolio across large-, mid- and small-caps and the financial sector fund is to look for a) companies with clean accounts, b) companies that sell essential products, which the vast population needs to use in their daily lives. Since we are a poor country, if we take manufacturers of essentials such as dairy products, pharmaceuticals, under-garments, foot-wear etc, the demand can be far more robust. c) Companies with barriers of entry higher than Mt Everest. d) Companies that are able to generate return on capital between 35 to 50 per cent. We find that such companies are sector monopolists. Because the return on capital employed is high, such companies are able to generate free cash flows equaling 30 per cent of capital employed every year. Free cash-flow is return on capital minus cost of capital (45% - 15% = 30%). e) Most of these consistent compounders dividend out a third of their free cash flow and re-invest two-third of it, and they grow the business by 20 per cent per annum. If you grow your capital employed by 20 per cent every year, on a ten-year period, your profits will grow anywhere between 20 to 25 per cent every year.

These are the criteria we use to pick stocks for all our portfolios – consistent compounders, little champs (which is currently closed for inflows) and our financial sector fund, Kings of Capital that consists of clean dominant financial franchises such as HDFC Bank, Kotak Bank, HDFC Life.

Companies such as Britannia, Marico, Pidilite, Asian Paints and Berger Paints, Nestle etc are a few that pass all these tests. To put it in cricketing parlance, these companies not only have a high batting average, they also have a high strike rate.

What do you mean by entry barrier higher than Mt Everest?

A book called ‘The Myth of Capitalism’ by American economist Jonathan Tepper describes this well. So, we have two types of barriers, the first is around regulation. The ability to get the regulations to be in your favour or tilting it towards you. The second is the ability to use technology and big data in a weaponised manner, where your competitors can see what you are doing, but they can not do the same because they don’t have the data or the kind of data scientists that you have on board. Increasingly, the largest monopolies in our country are marrying these two pillars of monopoly strength.

As a results of this, the top 20 profit generators account for nearly 70 per cent of India’s corporate profits. Twenty years ago, the top 20 companies accounted for only 15 per cent of corporate profits. This is because adept companies have built high entry barriers, As long as they don’t get complacent these companies can keep compounding investor wealth.

What are your views on timing the market?

Practically it is hard to time the market and also this exercise is futile. Let’s take Asian Paints, over the last 10 years, if you bought ₹ 100 worth of the stock in January, your 10-year XIRR will be 26 per cent. Then Marcellus comes and says that they can time the stock. Every year they buy the stock at the year’s low, the XIRR over 10-years is 27.5 per cent. These are numbers worked out by us. In a company like Asian Paints, timing does not matter because the underlying earnings compounding is so powerful that you will anyway make good returns.

Let’s take the polar opposite of Asian Paints, where the companies have no entry barrier, return on capital does not exceed cost of capital and there is no free cash- flow. Most companies in the Indian market fall in this category. In these companies, volumes grows at an impressive rate. But there is hardly any earnings growth. This is due to low-entry barriers leading to lower pricing power, leading to lower profits. Airlines and telecom industry are good examples. The underlying business does not allow automatic compounding of returns here.

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Published on July 26, 2020
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