In this month’s newsletter, we disclose the stock specific holdings in Marcellus Little Champs strategy. Besides the obvious requirements of clean accounting and prudent capital allocation, common traits across Little Champs are dominant positions in respective niches, high RoCEs & high reinvestment rates and consequent high earnings growth alongside a healthy balance sheet. In this newsletter, we place the spotlight on Garware Technical Fibres, a long-standing leader in the domestic fishing nets space, which has successfully built world leadership in the supply of nets to Salmon aquaculture. The key success factor has been its unflinching focus on product innovations that address customer needs and enable Garware to earn premium pricing and healthy profits on such products.

Performance update of the live Little Champs Portfolio

At Marcellus, the key objective of our Little Champs Portfolio is to own a portfolio of about 15 sector leading franchises with a stellar track record of capital allocation, clean accounts & corporate governance and at the same time high growth potential. While we intend to fill our portfolio with winners, we want to be sure of staying away from dubious names where we are not convinced about the cleanliness of accounts or the integrity of the promoters (even though business potential may sound promising) as the fruits of company’s performance may not get shared with minority shareholders. We intend to keep the portfolio churn low (not more than 25-30% per annum) to reap the benefits of compounding as well as minimize trading costs.

The Little Champs Portfolio went live on August 29, 2019. The performance so far is shown in the below table:

 

Performance composition and brief description
As announced last month, thanks to the faith reposed in us by investors, our Little Champs PMS reached its full capacity and we have now closed the portfolio to fresh inflows. We have also almost completed the deployment of the funds. The portfolio composition is as shown in exhibit 2 below. All investors in the PMS can now view their live portfolios on our portal using their login details. Furthermore, we would also be sharing the investment rationale for each one of our portfolio stocks once every 2-3 weeks. In this month’s newsletter, we start with Garware Technical Fibres (see the section on ‘Stock in the spotlight’).

 

As we have highlighted in our previous newsletters, some common traits across most of our portfolio companies’ fundamentals besides the obvious requirements of clean accounts, corporate governance and prudent capital allocation are:

  1. Well moated market leading franchises with high RoCEs: As we have discussed in our earlier newsletters, almost all of our Little Champs portfolio companies are the leaders in their respective niches. This leadership has been backed by strong competitive advantages surrounding their products, people and processes. We will discuss the competitive advantages of each of our portfolio companies in great detail on a regular basis (we start with Garware Technical Fibres in this newsletter – see the section on ‘stock in the spotlight’). These competitive advantages help the Little Champs earn significantly higher RoCE than their peers (see our July 2020 newsletter  where we compare and contrast Little Champs portfolio companies with their respective peers). But more importantly, it helps in generating healthy absolute levels of RoCE which are well above the cost of capital thus resulting in healthy free cash generation.
  1. Companies with high reinvestments of capital: High RoCE by itself would not be of great use if the company is not able to find avenues to redeploy the surplus cash flows at the current high level of RoCE. On the other hand, companies which are able to maintain a combination of high re-investment rates amidst high RoCEs typically deliver the highest share price returns. There is an extremely small set of small cap companies in India which are able to achieve the above combination of high RoCEs and high reinvestment rates over the longer term. However, this is one of the key traits we look for while shortlisting the stocks for our Little Champs portfolio. It goes without saying that achieving this requires: (a) the work ethic to grow the Organisation by instilling a process oriented culture, by devolving power & responsibilities to divisional heads and by creating a transparent & fair reward structure for employees; (b) the capital allocation skills to rationally and patiently invest in building long term competitive advantages; and (c) the skill and the drive to run efficient manufacturing operations such as keeping working capital cycles tight and being cost conscious. More details on this aspect of Little Champs can also be found in our March 2020 newsletter.
  1. Strong balance sheets place the Little Champs in an enviable position in the current environment: Most of the Little Champs portfolio companies have net cash on their balance sheets. This is the result of their healthy RoCE (well above the cost of capital); hence much of the reinvestment needs of these firms are being met out of internal accruals rather than through external borrowing. The strong balance sheets of the Little Champs provides opportunities to Little Champs to gain market share : (i) enable them to not only survive the short-term stress but also to continue to invest for future growth unlike their cash starved smaller peers for whom survival will be the key focus in the near term; (ii) opportunity to acquire weaker peers (we have already seen this playing out in case of some of our portfolio stocks like GMM Pfaudler – see our blog 18th July 2020)

Stock in the Spotlight: Garware Technical Fibres
As stated above we will be communicating our detail investment rationale on each one of our portfolio stocks every 2-3 weeks. We start with our detailed investment rationale for Garware Technical Fibres.

Company background: Formed in 1976 through a technical collaboration with Wall Industries Inc (USA), Garware Technical Fibres (earlier known as Garware Wall Ropes) is a leading Indian as well as a global player in the field of synthetic cordage and fibres. Whilst initially strong in the fishing nets and ropes sector (~60% of revenue in 1997 came from the fishing sector and the company still commands >50% market share in domestic fishing nets for trawls), it has over the years diversified into other applications like aquaculture (now ~1/3rd of revenues), agriculture, sports, infrastructure and other segments. Exports’ share in revenues has risen to 58% in FY20 (from 32% in FY10) thanks to breakthrough success in the Salmon aquaculture market where Garware has emerged as leading net (cage) supplier in key geographies like Canada, Scotland, Norway and Chile.

Financial snapshot: The company has witnessed healthy net earnings growth of 27% & 22% over the last 5 & 10 years respectively. The revenue growth has been relatively muted due to rising focus on value added products (which now constitutes nearly 65% of revenues), focus on commoditised products, impact from pass-throughs of correction in crude oil prices and a weak demand environment in the domestic market. On the other hand, rising share of value-added products has led to significant improvement in EBITDA margin and consequent growth in net earnings. Furthermore, the net fixed asset turnover and working capital days have also improved thus resulting in sharp RoCE improvement in the recent years.

Key success factors for Garware:

  • Low cost but highly critical nature of Garware’s products: Garware’s products like nets and ropes typically do not form a significant portion of the overall operating costs for the end-user. For instance, our channel checks suggest that in the case of aquaculture, fish feed accounts for nearly 50% of total operating costs whereas net cages constitute under 10% of the total cost. Similarly, for fishing trawlers, diesel which is used to power the motor accounts for >50% of the total operating cost. However, at the same time, the resultant impact on business can be significant if these nets/ropes do not measure upto expectations. For instance, (i) great reputational damage from use of faulty nets in marquee sporting events; (ii) aquaculture cages where any defect in nets can be devastating not only in terms of loss of fish but also time involved in replacement; (iii) similarly for agriculture where there can be substantial damage to the crops in case of any defect in protective nets.
  • Product innovation – cornerstone of Garware’s success: Coming up with innovative products has been the cornerstone of Garware’s success in the recent years particularly in aquaculture. While as discussed above, the cost of failure of nets is high, Garware’s innovative value-added products (through priced higher) can in fact help bring down the overall cost of operations for the user (see the next section) and hence customers are more than willing to pay a premium price for the same.

Some examples of the breakthrough innovations by Garware in the recent years:

  1. V2 nets for anti-fouling properties: Fouling is a common problem in aquaculture where marine organisms settle on the surface of the net and lead to occlusion of mesh openings. There are two impacts of this: (i) increased pressure on cage structures and (ii) reduced water exchange across nets. The traditional solution was to clean the nets at regular intervals and apply a copper solution on the nets to avoid the accumulation of fouling. However, the drawback of this was frequent cleaning cycles (and hence higher cost of maintenance) and high release of copper which, in turn, raises environmental concerns. Around couple of years back, Garware came out with V2 nets with in-built anti fouling technology. Almost at the nano particle level, Garware was able to infuse the melted plastic with copper particles and the company then made the nets with this material. Using V2 nets helps the customer reduce cleaning costs by almost half with significantly faster cleaning cycles. Although the product is priced at a premium, significant savings on maintenance costs and longer product life results in a much shorter payback period for the end-users.
  1. X12 nets for sea-lice solutions: Another common problem in the salmon aquaculture industry is of sea lice infestation. Sea lice are external parasites which feed on its host, in this case the salmon fish. This prevents the growth of the salmon fish. One of the more recent solutions used for this problem is wrapping the cage with “Lice Skirts” or “Shields” at depths ranging from 5-10 meters. The major drawback of using shielding skirts is the blocking of water exchange which is again detrimental to the health of the salmon. Garware has come up with an innovative patented product called X12 Lice Shield, a special fabric which not only blocks sea lice but at the same time allows high water flow. In a normal lice skirt, one litre of water flows in 7.5 minutes whereas in X12 Lice Shield, it flows in 6 seconds. In Chile, in an experiment, 2 cages were covered with X12 nets whereas 9 cages were treated only using special solutions to get rid of sea lice. After a full 13-month cycle, there were 55-60% less sea lice in the cages with the X12 skirts (source: Fish Farmer magazine December 2019).

The key enablers for innovation by Garware have been:

  1. Strong understanding and experience in polymer engineering. The Garware group was one of the earliest entrants in the fields of polymers. Group companies Garware Polyester and Garware Synthetics were formed in 1957 and 1958 respectively although now the ownership/management of these companies are completely separate from Garware Technical. This helped company gain a headstart in the field of polymers.
  1. The Company has also been proactive on focussing on R&D with a separate in-house R&D unit set up as far back as the early 1990s. The management had realised that it would compete primarily by offering innovative products (see the annual reports of the 1990s). The firm’s technical team is headed by Mr Sanjay Raut who has been associated with the company for >25 years. The company’s R&D spend has also been on the rising trend with 1.6% of sales in FY18/FY19 compared to an average of 0.96% over FY13-17. The company now has close to 43 patents filed across various geographies.
  1. Our discussions with the industry sources also indicate strong in-house manufacturing capabilities in the areas of extrusion, knitting, wet processing, fabric weaving etc.

 

  • ‘Application’ focussed innovation: Any product, however innovative, needs to address the customer needs to be successful. Annual reports of Garware consistently mention that the starting point of any new product development within the company is understanding the customers’ business needs and how Garware’s products can help address needs like reducing costs, improving productivity and more specific needs like addressing environmental concerns/high cost of maintenance (V2 nets) and attacks by sea creatures like Seals (Sealpro nets). Industry sources indicate strong involvement with customers right from the top management who personally oversee key client accounts to regional managers responsible for customer connects and relationships. Garware was also early in setting up regional branch offices in key geographies like USA (a branch in North Carolina was set up in 1998). Besides USA, there are now 5 overseas offices in key countries like UK, Norway, Canada, Chile and Australia which has helped improve customer interactions and servicing. While Garware has direct presence in markets like Canada and Chile, it also has strong distribution partners like Knox in Scotland and Selstad in Norway which provides them the critical customer feedback loop.

 

Growth runway:  As discussed in a preceding section, company’s revenue growth has been relatively muted (4% CAGR over FY15-20) in contrast to very healthy growth in earnings (27% CAGR for the same period) due to rising focus on value rather than volumes. We expect his trend of improving product mix to continue in the coming years. Some of the imminent growth in revenue/earnings for Garware are: (i) continued market share gains in global aquaculture industry on the back of innovative products; (ii) newer segments like geo-synthetics, agricultural nets and coated fabrics which currently contribute somewhat little to the revenues but have potential to evolve and contribute meaningfully in the coming years as awareness of the benefits of these products growth and hence find increased adoption.
Regards
Team Marcellus