Diamonds In The Dust
What To Buy: Great Franchises
The key questions that the author seeks to answer in this chapter are:
- What are the benefits of high pricing power and strong competitive advantages?
- What are the sources of competitive advantages?
- Which companies in India have demonstrated the rare ability to deliver high returns on capital as well as a high rate of capital redeployment
The virtuous cycle of high ROCEs and high reinvestment rates:
The author's 12-year-old daughter is a budding pastry chef. Early on in her baking foray, she figured that if she wanted to make money from baking, the recipe for generating cash flow was straightforward. She would have to buy the ingredients required to bake a cake for ₹100 or less and sell the cake for ₹150 or more, thus assuring herself a minimum of ₹50 of cash flow. However, once she had the ₹50 in hand, she realized that now she had to make some tricky decisions—should she spend this money at the local ice-cream parlour or should she buy the latest books on baking cakes?
Running a company is simply a scaled-up version of what she is doing at a very basic level. Operating a firm is about using capital to drive a virtuous circle of resource allocation. A firm uses the money to consume and invest in raw materials, utilities, R&D, manpower, technology, manufacturing facilities and logistics. Typically, 'resources consumed' relates to the current requirements of a business and is classified as operating expense on the income statement. On the other hand, 'resources invested' relates to the future requirements of a business and is usually classified as fixed capital (CAPEX) or working capital investment on the balance sheet. Consumption and investment of these resources then help the firm produce products and provide services, which can then be sold to generate capital. This capital can then be reinvested into the business for further 'consumption and investment', and hence future business growth.
The capital (and hence the resources) available with a firm is limited and, like all resources, has a cost attached to it—the cost of capital for most listed firms in India is around 12–15%. Return on capital employed (RoCE) measures the cash flows generated by a firm per unit of money employed. If the RoCE earned by a firm is less than its cost of capital, it cannot pay the capital providers for the use of this limited resource. As a result, the business destroys value for shareholders since the shareholders would have earned a higher return on their capital had they invested it somewhere else. Similarly, a RoCE substantially higher than the cost of capital adds value for shareholders. However, the higher the RoCE of a firm, the greater the number of competitors it will likely attract. Hence, intense competition tends to reduce an incumbent firm's RoCE to as low as possible. This is where the firm's competitive advantages or moats come to the rescue.
Competitive advantage enables a business to outperform its competitors and allows a company to achieve relatively healthy returns for its shareholders. This makes Competitive Advantage the second pillar of Marcellus's investment philosophy for identifying Consistent Compounders.
Firms with strong and sustainable competitive advantages can sustain RoCEs substantially higher than the cost of capital over long periods. This is because the stronger the competitive advantages are, the greater the barriers to entry faced by competition, and hence the more significant the pricing power that the firm possesses.
For instance, in India's innerwear industry, Page Industries (the master franchisee in India of Jockey and Speedo) has delivered an average pre-tax RoCE of 60% over the last ten years, substantially above its cost of capital (which is likely to be around 12–15%), and has thereby generated substantial free cash flows for its shareholders.
However, operating in the same industry, peers like Rupa and Company, Dollar Industries, and VIP Clothing have, over the same period, earned RoCEs of only 23%, 17% and 6%, respectively, generating significantly lower free cash flows than Page Industries. Page's ability to generate and sustain RoCEs substantially higher than its cost of capital is reflective of its being a much stronger business than its peers. Similarly, Maruti Suzuki has delivered a pre-tax RoCE of 22% in India's passenger car industry over the past ten years, while the corresponding RoCE for Tata Motors is only 13%. Whilst' high RoCE' is reflective of strong competitive advantages, it is not sufficient to deliver growth for a business. If all the cash flow generated by a firm with a high RoCE is returned to shareholders, it is difficult for the firm to grow its revenues over time. Firms that can sustain business deliver more elevated and more sustainable earnings growth than firms with high RoCEs but a low rate of capital reinvestment in their business.
Typically, reinvestment of cash flows into the business can be done in two ways. On the one hand, cash flows can be reinvested towards building tangible assets on the balance sheet, like manufacturing plants, machinery and working capital, thereby increasing the firm's overall capital employed, which helps the firm expand faster than the competition. On the other hand, cash flows can also be reinvested on the income statement to build intangible assets like brands (although brands themselves are not sources of sustainable competitive advantages, as explained later in this chapter) and patents, which aid business growth in the future. For instance, in India's pressure cooker market, Hawkins and TTK Prestige possess strong competitive advantages, which are reflected in their average RoCEs over the past ten years, of 69% and 38%, respectively. However, with a capital reinvestment rate of only 26%, Hawkins has delivered a revenue CAGR of only 9% over FY 2010–20, while its competitor TTK Prestige has delivered a revenue CAGR of 14% over the same period, supported by a capital reinvestment rate of 80%.
Hence, to sustain healthy growth in cash flows and earnings over the long term, a firm must first establish sustainable competitive advantages and high pricing power, which help generate high RoCEs. After that, it needs to reinvest future cash flows in areas that deliver high RoCEs.