The 20 most profitable firms in India now generate 70% of the country’s profits, up from 14% thirty years ago. The rise of India’s networked economy (highways, cheap flights, broadband, GST) has allowed large, efficient firms to use superior technology & better access to capital to squash smaller competitors. In line with what is being seen in the US, the growing dominance of a handful of very large companies in India is changing the template of capitalism in India. This has very significant implications for how portfolios are constructed and how valuation techniques are used in India.
“This survival of the fittest, which I have here sought to express in mechanical terms, is that which Mr. Darwin has called ‘natural selection’, or the preservation of favoured races in the struggle for life.” – Herbert Spencer in ‘Principles of Biology’ (1864) after reading Charles Darwin’s book ‘On the Origin of Species’ (1859)
“Since the late 1990s, over 75% of US industries have experienced an increase in concentration levels. We find that firms in industries with the largest increases in product market concentration show higher profit margins and more profitable mergers and acquisitions deals. At the same time, we find no evidence for a significant increase in operational efficiency. Taken together, our results suggest that market power is becoming an important source of value…We also show that the higher profit margins associated with an increase in concentration are reflected in higher returns to shareholders. Overall, our results suggest that the US product markets have undergone a shift that has potentially weakened competition across the majority of industries.” – Gustavo Grullon, Yelena Larkin & Roni Michaely in ‘Are US Industries Becoming More Concentrated?’, Review of Finance, Volume 23, Issue 4, July 2019, Pages 697–743.
“The evidence suggests that there has been a moderate increase in those broad measures of concentration…at least in the US and Japan, though not in European countries….Looking at the evidence on other indicators of competitive intensity, we can see that mark-ups and profits in the US have significantly increased. Data on mark-ups in Europe is unfortunately more limited; however, the picture that is available suggests a more mixed picture on mark-ups across different European countries, though there is a strong trend towards increased profits. Worryingly the rate of churn in the US appears to have fallen, while again in Europe the picture is mixed….there are a broad range of indicators suggesting that, on average, market power is increasing.” – ‘Market Concentration Issues Paper’, OECD, 20th April 2018.
Time to rebuild our mental models of how India functions
Whilst several Western academics have published credible analysis of how their economies have become less equal, we haven’t come across analysis of comparable quality in India. In our January 23rd 2020, blog – How the Nifty will change in the coming decade? we had highlighted how in several sectors in India, one or two companies account for 80% or more of the profits generated:
“India is already an economy with extraordinary levels of profit share concentration in many key sectors. For example, in paints (Asian Paints, Berger Paints), premium cooking oil (Marico, Adani), biscuits (Britannia, Parle), hair oil (Marico, Bajaj Corp), infant milk powder (Nestle), cigarettes (ITC), adhesives (Pidilite), waterproofing (Pidilite again), trucks (Tata Motors, Ashok Leyland), small cars (Maruti, Hyundai) we already have one or two companies accounting for 80% of the profits generated in the sector. Now this trend looks likely to spread to more fragmented sectors where hitherto the unorganised players had greater profit share.”
Since at the core of our investment philosophy lies the notion of investing in firms with dominant positions and high barriers to entry, we decided to examine how the profit share of the top Indian companies has fared in the post-1991 era. What we found took our breath away.
The vertical axis of the chart represents the 3-year moving average of the ratio of the amount of profit generated by 20 most profitable listed companies in India divided by the total profit generated by the entire Indian corporate sector. As the chart above shows, from around 14% when the country was opened up in the early 1990s, India’s top 20 PAT generators now account for nearly 70% of the profits generated in the world’s sixth largest economy.
The churn rate among the top 20 PAT generators is also high at 55-60% implying that there is still a lot to play since the commanding heights of the Indian economy have not yet been locked down firmly. In fact, if you had invested in an equally weighted portfolio in FY09 of the 11 companies which have been added to the top 20 list of FY19, your total shareholder return CAGR would be 26% CAGR (FY09-FY19).
So which companies will be in the top 20 PAT generators list in FY29? Peering into the (murky) crystal ball, we see the following:
- The giant PSUs will continue exiting from the list because of sub-par capital allocation (forced upon it by its largest shareholder) and because of the relentless need of the sovereign to exercise its patronage.
- Companies which are good capital allocators, whose promoters don’t fiddle with the figures and which have high barriers to entry are likely to enter the top 20 list. Here is a list of potential entrants (with their FY19 PAT ranking in brackets): Kotak Bank (21st), Axis Bank (29th), Bajaj Auto (30th), Bajaj Finance (35th), Eicher Motors (57th), Asian Paints (59th).
- Like other developed countries whose economies have formalised, the profit share of the top 20 PAT generators in India will also continue to increase from the current 70% to 80-90% due to the reasons mentioned above. By the time we finish our careers, we would be surprised if more than 20 Indian firms don’t take home 80% of India’s profits. If you care about understanding why this will happen, it is worth reading Thomas Piketty’s magisterial book ‘Capital In the 21st Century’ (2013). In Chapter 10 of this masterpiece he says, “In all known societies, at all times, the least wealthy half of the population own virtually nothing….the top decile of the wealth hierarchy own a clear majority of what is to own (generally 60% of total wealth and sometimes as much as 90%); and the remainder of the population…own from 5-35% of all wealth.”
Implication #3: Investors will need to use DCF models properly
Whilst most investors learn DCF valuation early on their careers, the prevailing tendency is to use a cookie-cutter approach to DCF valuation (of the sort taught in academic courses which were designed in the pre-leviathan era). As explained in our 4th January newsletter: “An investor looking to buy and hold stocks over a long time period, needs to be able to differentiate between businesses which can deliver longevity of consistently healthy free cashflows and those that run a high degree of uncertainty in their fundamental prospects. This differentiation is essential, both, in order to avoid premature exits from investments in great quality franchises due to concerns around expensive valuations (e.g. P/E multiples higher than 30x), and to avoid being tempted into investing in inferior quality franchises just because they are trading at apparently cheap valuations (a 10x P/E multiple might actually be super-expensive).”
The rise of the leviathans will force investors to think more deeply about how they fade ROCE to cost of capital in their DCF models. Given that for many of the firms mentioned so far in this note, ROCE or ROE has not faded to cost of capital over the past 20 years, investors who automatically assume that it will do so over the next 20 years will end up undervaluing the leviathans with potentially adverse consequences for the durability of their portfolios.
Disclosure: Marcellus and/or its advisory clients own HDFC Bank, Asian Paints, Eicher, Bajaj Finance, TCS, Pidilite, Astral Poly, Page Industries, Berger Paints and ITC.
Saurabh Mukherjea and Harsh Shah are CIO and Analyst respectively at Marcellus Investment Managers respectively (www.marcellus.in).
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Marcellus Investment Managers is regulated by the Securities and Exchange Board of India as a provider of Portfolio Management Services and as an Investment Advisor.
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