Value addition from every initiative undertaken by a company follows an ‘S-curve’ with three parts to it – the investment phase, the growth phase and the fade period. The fundamentals of the overall company are a consolidation of ‘S-curves’ of all initiatives. There are several limiting factors to every initiative such as addressable market size, diseconomies of scale, competitive forces and the disruptive evolution of the industry. Marcellus’ CCP companies use several tools to periodically add new ‘S-curves’ in the business (i.e. new initiatives) and increase the durability of value addition from each initiative. This provides greater longevity to CCP companies’ overall fundamentals. Longevity of fundamental growth is the most undervalued component in valuation of these companies and that gives us significant opportunities for consistent compounding.
Performance update – as on 30th November 2021
We have a coverage universe of around 25 stocks, which have historically delivered a high degree of consistency in ROCE and revenue growth rates. Our research team of eleven analysts focuses on understanding the reasons why companies in our coverage universe have consistently delivered superior financial performance. Based on this understanding, we construct a concentrated portfolio of companies with an intended average holding period of stocks of 8-10 years or longer. The latest performance of our PMS and offshore fund (USD denominated) portfolios is shown in the charts below
The S-curve of every fundamental initiative taken by a company
Every successful fundamental initiative that a company undertakes broadly consists of three stages – ‘initial investment’, ‘growth’, and ‘fade’, as depicted by the exhibit below. The longevity and pace of growth of an initiative is defined by the slope of its overall S-curve, the height of the overall S-curve, and shape of the fade of its overall S-curve.
The fundamentals of the overall business can be treated as an overall S-curve, which is nothing but the consolidation of all individual S-curves pertaining to each initiative the business undertakes. For instance, the exhibit on the above right shows how several initiatives with their respective S-curves consolidate together to deliver the overall S-curve for the business.
The challenges organisations face as they grow bigger in scale (size) and scope (variety)
A 2012 study by Richard Foster at the Yale School of Management suggested that the average lifespan of an S&P 500 company in the US has fallen from 67 years in the 1920s to just 15 years today. This is a global phenomenon. Of the 100 companies in the FTSE 100 in 1984, only 24 were still operating in 2012.
However, there are also few companies in every country which continue to survive and grow their fundamentals at a healthy rate consistently over several decades. Effectively, as shown in the exhibit below, these companies (curve ‘C’ in the exhibit below) deliver greater longevity of growth.
There are several factors which limit the longevity of growth for a company. For example:
Limited size of the addressable market:
Growth drivers for companies in several industries include penetration of consumption, frequency of consumption and increase in market share. There are limits to all three of these factors. For instance, three decades ago, India’s toothpaste industry was underpenetrated (a large part of the population was not a consumer off toothpastes), with low frequency of consumption (several consumers of toothpastes used the product only once a day), and fragmented market shares. This offered a massive growth opportunity for a company like Colgate in India. However, with 90% penetration of oral care, 60% market share of Colgate, and rising frequency of consumption, the saturation of the addressable market now offers limited growth potential in the toothpaste industry.
Diseconomies of scale and scope:
As organisations grow, they suffer from diseconomies of scale because the business becomes too complex to manage and grow further. Authors Marco Iansiti and and Karim Lakhani summarised this in their book ‘Competing in the Age of AI’ (2020) – “When organizations expand, they become increasingly complex and difficult to manage, so they build bureaucracies and inefficiencies, and they embed norms, incentives, and rewards—and each of these fosters inertia. With too much scale, too much scope (variety), or too much demand for learning and innovation, any managerial process will eventually stop working well, leading to inefficiency and even failure. Plants reach an optimal size and then become unwieldy to organize and manage. Restaurants reach a maximum size and scope, as their customers and menus begin to overwhelm the staff’s capabilities and systems. Even R&D organizations and product development teams can grow too big, and their productivity and innovativeness are known to suffer as a result. These considerations shape the maximum efficient scale of an organization and impose overall limits to its growth.”
The more successful a company becomes, the more competitors it attracts who attempt to eat into the profit pool created by the successful incumbent. As a result, companies with weak pricing power either undergo a deterioration in their profitability or loss of market share in the wake of rising competitive intensity. For instance, a firm like Colgate has frequently faced price wars from new entrants like Patanjali (2015) and incumbents like Hindustan Unilever (Pepsodent and CloseUp) and Dabur (Red and Meswak).
Disruptive and evolutionary changes:
Innovative technologies / digitisation / automation / machine learning / artificial intelligence – all these themes have been a significant source of disruption over the last decade. Evolution in the economic landscape has consistently brought changes to the way companies have added value to customers in an industry. For instance, in the global automotive industry, Ford established its dominance by introducing mass production with the first moving chassis assembly line in 1913 that transformed manufacturing by increasing scale. However, through the 1950s and 1960s, General Motors won market share from Ford by increasing the scope of offerings through product-specific assembly lines. This was followed by market share gains by Japanese carmakers like Toyota. The next phase of evolution is underway as electric vehicles, autonomous vehicles and ride sharing apps see increased adoption.
Tools used by Marcellus’ CCP PMS portfolio companies to increase the longevity of existence and growth in their overall S-curves
Several of Marcellus’ CCP portfolio companies have historically delivered exceptional longevity in their S-curves without undergoing fade in their growth rates – e.g. 6-8 decades of consistent growth for Asian Paints, Berger and Pidilite; and 2-3 decades of growth for HDFC Bank, Titan and Page Industries.
We expect significant longevity of our portfolio companies in future due to the following factors:
Macro factors – Polarisation of the Indian economy
Various industries in India are undergoing consolidation of market shares due to rapid networking of the Indian economy, improving availability of technology to drive scalability, Government initiatives such as GST introduction and black swan events like Covid-19 pandemic (read our blog Three Distinct Layers of Polarization in the Indian Stock Market on this subject). These factors help increase the slope of the S-curve for CCP companies by enabling faster market share gains from both unorganised as well as organised competitors.
Company specific factors around pricing power, operational efficiencies and capital allocation
Strong pricing power
avoids limitations to growth posed by competitive forces and hence increases the height of the S-curves for their businesses.
Superior operating efficiencies
using technology, systems and processes not only increase the slope of the S-curves (i.e. drive faster rate of cash generation), but also generate cashflows for consistent reinvestments into newer S-curves to the overall business. Read more about this in our 1st November 2021 newsletter.
Prudent capital allocation to consistently add new S-curves –
Consistent deepening of moats, addition of new revenue growth drivers and radical disruption of the industry (rather than waiting for a competitor to drive the disruption). Our lethargy tests proactively aim to understand how our portfolio companies are deepening their competitive advantages, strengthening ties with various stakeholders, and refreshing their offerings so as to leave no room for a competitor to take away market share through such actions. Read more about this in our 1st Aug 2020 newsletter.
Softer aspects around management quality and succession planning – provides continuity and scalability to business initiatives:
All businesses face the event of succession of key management personnel, whether it be promoters or professionals. However, succession planning is a process that is not adequately engrained in the DNA of most organizations due to the variety of challenges involved in this process. As a result, many great businesses with strong competitive advantages fail to sustain in the long run. Our proprietary succession planning framework assesses all our portfolio companies around parameters such as the decentralization of power, the relevance of independent directors on the Board, and the grooming and empowerment of high quality CXOs in the organization. This assessment is one of the key inputs which drive our conviction around the longevity of a franchise. Read more about this in our 1st September 2020 newsletters.
Investment implications – Longevity of business fundamentals is the most undervalued aspect of valuations of CCP companies
An investor looking to buy and hold high quality stocks (e.g. CCPs) 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.
As highlighted in the exhibit above, even if two companies have the same slope of the S-curve (i.e. rate of growth of fundamentals), greater longevity of the business has a disproportionate impact on the company’s fair value (25x P/E multiple vs 250x P/E multiple). Inadequate understanding of the longevity of S-curve of a business’ fundamentals thus becomes the biggest source of undervaluation for an equity investor to benefit from.
Hence, 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).
At Marcellus, we assess and quantify the longevity of S-curves of a business using our proprietary ‘longevity framework’ – summarised in the exhibit below [click here for our 1st Sept’21 CCP newsletter which gives you more details about our Longevity Framework].
If you want to read our other published material, please visit https://marcellus.in/