Why Does Coffee Can Portfolio Perform Well?
- The coffee can portfolio is built using twin filters, which are used to identify great companies that have the DNA to sustain their competitive advantages over 10 to 20 years or even longer.
- Greatness is not a temporary phenomenon and definitely not a short-term phenomenon. It does not change from one quarterly result to another. Great companies can endure difficult economic conditions and that's why they also thrive in economic downturns.
- Great companies do not get distracted by evolution in their customer’s preferences or competitors or any operational aspect of their business. Their management has various strategies that can deliver results better than their competitors can.
- Often such companies appear conservative. However, do not confuse conservatism with complacency. They simply bide their time before making the right move.
Why choose revenue growth and ROCE as the financial metrics to measure 'greatness' of a Company?
According to Charlie Munger,
Earnings growth is not an independent metric, instead, it is the outcome of 2 independent metrics:
1. Growth in capital employed, and
2. The Firm’s ability to generate ROCE.
Revenue earnings growth can be achieved either by growing capital employed while maintaining ROCE or by growing ROCE through enhanced operating efficiencies while maintaining the firm's capital employed.
There are 3 categories of businesses based on ROC:
1.High earnings with low Capital requirement:
These businesses can't reinvest a large portion of their earnings internally at high rates of return for a longer period of time.
But in light of firms’ pricing power, earnings keep growing without needing incremental capital. Hence they steadily keep delivering a high rate of capital employed.
Typically for such companies, 2 factors help minimise the funds required for operations:
- The product is sold for cash which eliminates the need to wait for customers to pay up and thus, reduces accounts receivable.
- The production and distribution cycle is short which minimises the inventory.
Such a business eventually becomes a cash machine, allowing investors to use a steady stream of cash to buy other attractive businesses.
Hindustan Unilever is an example of this kind of business.
2.Businesses that require capital to grow and generate a decent ROCE:
Such businesses are extremely difficult to find.
Typically, companies require additional capital to keep growing their earnings because growing businesses have both working capital needs, which increases in proportion to sales growth, and significant requirements for fixed asset investments.
Such businesses are also decent investment options as long as they enjoy durable competitive advantages that can lead to attractive returns on the incremental capital employed.
An example of this type of business is HDFC Bank
HDFC Bank’s outstanding performance:
A.A risk-aware culture that focuses on generating healthy returns without taking risks,
B.An internal architecture that consistently allows the bank to innovate, and rethink the core process flows that characterize the central offering of the banking sector,
C.The strength of the iconic HDFC brand.
3.Businesses that require capital but generate low returns on capital:
This is the worst kind of business that grows rapidly but requires significant capital to engender growth and then earns little or no money.
A very classic example of this kind is the Indian telecom sector.
Such businesses’ demand for capital is insatiable and investors who have chased growth of such companies end up destroying wealth over long periods of time.
Example- Bharti Airtel’s share price in August 2017 was 2% lower than what it was 10 years ago.