“Our job is to look for companies where the barriers to entry are absolute. There is very little competition to these companies and therefore their ROCEs (return on capital employed) are high because competition has been crushed by using a combination of clever business process and technology. The ROCEs are 45 per cent on an average, which means free cash flows are very high, and 20 per cent extra capital is reinvested every year,” Mukherjea said at a conference organised recently by the Singapore chapter of the Institute of Chartered Accountants of India (ICAI).
As a result, free cash flows grow at 25 per cent and we and our 10,000 clients compound our wealth at that rate with volatility lower than a government bond, he explained.
Here’s Saurabh Mukherjea’s 3-step formula to identify consistent compounders:
1) Use forensic accounting to avoid most common pitfalls
Mukherjea’s stock picking journey begins from the universe of BSE 500 companies. Using 10 forensic tests and 12 accounting ratios, he shortlists around 100-150 companies where the books of accounts are believable. “It is something very similar to a health check-up where your doctor looks at your triglycerides, blood pressure, white blood cells and so on. They have a range of observations which is normal, and if you’re on the wrong side of normal, they put up a red flag.”
One of the most reliable tests is to compare the growth rate of the company’s revenue with the compensation given to the auditors. If the latter is growing faster than the former, it indicates that the auditor may be getting incentives to manipulate the books.
2) Identify companies with superior capital allocation
Once Mukherjea and his team figures out that the company’s numbers are real, then they try to understand how smart the management is in doing business. “Unfortunately, most of the promoters whose books are clean don’t have the greatest business acumen,” he said adding that he uses a simple metric which is to find out whether the business is delivering a return on capital in excess of the cost of capital. “90 per cent of Indian promoters fail this simple test. They are unable to deliver pre-tax ROCE of 15 per cent,” the fund manager said.
Mukherjea said share price follows free cash flow and not earnings. “Share price does not follow GDP. Share price is not driven by PE multiples, Ukraine war or UP elections. Share price is driven by free cash flow,” he said.
3) Invest in franchises with high pricing power and high reinvestment rates
Mukherjea said he never ever invests in a company where there is price based competition. “No airline, telecom company, real estate developer, power and infrastructure company, metals and mining company can generate sustainable wealth because they’re competing on price.”
Stocks in his consistent compounder portfolio includes bluechips like Asian Paints, Titan, HDFC Bank, Bajaj Finance, Nestle India and HDFC Life.