So Charlie, Should We?- Part 2

As far as the public market is concerned, traditionally, Indian arms of multinational companies have been considered to have the best moats: Nestle India, P&G Hygiene, Castrol, Colgate, Glaxo, Bosch, 3M, Unilever, to name a few. But the problem with consumer companies in India is two-fold. Buffett can and has invested in their parent or in the case of Unilever tried to buy them outright. Instead of buying P&G here, he might as well play white knight to the parent, which is being pushed by activists. It makes more sense given the exuberance reflected in the relative valuations of the Indian arms compared with the parent. Suzuki’s Indian arm, Maruti, is a fine example: the company is on a roll with stellar growth and has a deep moat where both supply-side and demand-side economics are at play. But today Maruti trades at a market cap of $32 billion, reflecting a multiple of 25, compared to Suzuki, whose market cap is $20 billion or that of Honda at $50 billion. 

The second problem with big brand companies in India is that they face intense competitive pressure from low-cost single-product or nimble-footed regional players. Pabrai says, “Wal-Mart & Costco in the US and V-Mart in India sell store brands that are clones of the established brands. Packaging is similar, it is placed right next to the branded product and pricing is lower. Look at V-Mart’s store version of Parachute Coconut oil. As retailing concentrates in the hands of fewer players, it will put pressure on the brand guys.” Additional competitive pressure comes in the form of larger companies for whom profit may not be the prime objective. A classic example of the latter is GCMMF, a co-operative whose main objective is to maximise the price offered to members of the co-operatives i.e. its farmers. It operates under the Amul brand and its supply chain is an unbeatable moat, but it is not run for profit. Then there’s Ayurveda-powered Patanjali that has sprung up and is targeting doubling its sales in the next two years, through aggressive pricing. “When your competitors are not profit-focused, they will damage the industry. They can be disruptive,” says Soumendra Nath Lahiri, CIO, L&T Mutual Fund. “HUL took 58 years to reach a turnover of Rs.29,000 crore but Patanjali claims to have reached Rs.10,500 crore in five years,” he adds.  

Another global trend that threatens to alter the supply-side drivers for brand creation is the decline of television as a medium of advertising. If you wanted to build a national brand in the ‘80s or ‘90s, you got a bigger bang for your spend by advertising on television. Today, you can put up a YouTube video or you can buy targeted ads on Facebook. Start-ups can now build consumer awareness at vastly lower costs than 10 years ago. “Dollar Shave Club, a California-based start-up founded by Michael Dubin that sold cheap razors and blades went from zero to being bought by Unilever for $1 billion in seven years. Chobani is another billion-dollar brand that didn’t exist 10 years ago and it has taken share from Yoplait. Buffett calls brand companies, ‘The Inevitables’. I think that is a pretty dangerous word,” says Dorsey. For more than a 100 years Gillette (now owned by P&G) had pricing power but the entry of start-ups such as Dollar Shave and Harry’s has forced the venerable brand to play the price game.

In India, too, traditional consumer brands are getting challenged because it’s become much easier and faster to build brands powered by cheap private equity money and digital marketing. Snack-maker Balaji and beverage brand Paper Boat are examples of fledgling brands that are making their presence felt. 

That apart, a new dimension to business risk was introduced when Nestle’s Maggi noodles was banned. The Maggi story was one of horrific brand destruction and is estimated to have cost Nestle $500 million. “If the country is prepared to let that kind of thing go on because of improper allegations that at some level is intended to re-orient consumer preferences and availability, it’s a dangerous game. I can own Nestle, secure that we have a good business around the world, but not in India,” says Tom Russo, partner, Gardner, Russo & Gardner and for whom Nestle is his biggest holding. Competition can test a moat from time to time but regulatory interference could destroy it. “If you spend tens of millions of dollars only to find your position being taken away on the basis of some report that alleges more harm than is proven, that reduces your willingness to make investments and increases the odds of local players doing better,” feels Russo. 

It is not only a storied foods company like Nestle that has to go through the regulatory pincer, liquor and tobacco companies are perceived as perennial sinners. But that does not prevent them from being fancied by investors. United Spirits and United Breweries are a bunch whose potential could be finally unleashed as they pass into foreign hands. Diageo already controls United Spirits while Heineken is working on obtaining control over United Breweries. Russo holds Heineken as well as Diageo and feels that the growth runway for both is promising. But what makes earnings unpredictable is that governments have a love-hate relationship with alcohol. They love it for the taxes and hate it (or pretend to) for its ill-effects on society. “Cigarette and liquor companies have a good moat but the fact that we do not have a fix on taxes brings in a sense of unpredictability. Globally though, they have delivered decent returns,” says S Naren, CIO, ICICI Prudential AMC.  Five states in India have prohibition and the latest Supreme Court diktat to ban selling of liquor alongside highways has been a major dampener. The complexity of the business in India is compounded by the fact that liquor companies have to individually get pricing approved by the state governments every year. “An attempt to outlaw alcohol doesn’t work. The borders are too porous and the counterfeits are lethal. Per capita consumption of beer in China has moved from 2 to 32 litres, India is at 2 and the game is too early,” claims Russo. 

Mr. Buffett, India’s calling
Apart from the multinationals, India has several companies that have built strong moats around them across segments from paints and hair oil to batteries and tyres (see: Moats of India). From Buffett’s perspective, while both the public and private market may be fertile hunting ground, the fact remains that in India, most promoters sell their businesses when the going gets tough, not as part of succession planning or with the intent to preserve its culture. Companies don’t last forever either and once the moat is tested and recognised, the market quickly discounts it. Yet, several companies tend to deliver a superior return for long periods as they are able to ‘rollover’ their competitive advantage period by defending their moat continuously, according to Mauboussin. That’s the reason Buffett believes in paying a fair price for such companies rather than wistfully waiting for them to get cheap. 

Seen from this prism, can India’s moat companies make the cut at their prevailing price? Pabrai thinks strong consumer brands such as Patanjali or strong capital allocators like Piramal could interest Buffett. Historically, Buffett has kept the capital allocation role for himself but Pabrai says, “At his size, Buffett needs to be flexible and he’s given capital allocation to 3G as well with Kraft Heinz. As for Patanjali, it is the challenger and at the core, as long as it promotes great natural/organic products at great prices, it will continue to put pressure on P&G, Unilever, etc.”

The best large-sized moats available in India are family-run businesses such as Asian Paints, Marico, Godrej Consumer, Pidilite and MRF to name a few. The beauty is that apart from a moat they also have a long runway of growth given India’s demographics. For Buffett to buy, the owners must be willing to sell their businesses and also run them — that’s Buffett’s buy-out model for family-run businesses. Going by prevailing multiples, these stocks seem richly priced — most valued around 40x earnings. Is the multiple justified? So if you pay 40x for a stock that is expected to compound earnings at 20%, you’ll take a little over 20 years to recover the price paid. Simply put, if the company continues to compound earnings at 20% year-on-year for the next 10 years and you get an exit at 25x, you will make a compounded return of 14.49% on the stock; if you held it for 15-years and sold it at a similar valuation, you would have compounded at 16.29%.  However, if earnings were to compound at 15%, your returns for 10-year and 15-year periods would be 9.72% and 11.45% respectively, assuming exit at similar valuations. For the record, Pidilite has grown earnings at 24.11% over the past 10 years, Asian Paints at 23.32%, Marico at 22.32% and Godrej at 20% (see: India’s Economic Moats).  “Brand companies are expensive. India is a cyclical destination at this point in time – that’s where one can find value today,” says Naren.

Barring infrastructure which is reeling under a debt overhang and commodities that may appear cheap, high return on capital sectors such as software services and pharmaceutical companies are also trading at relatively low multiples. Buffett has refrained from investing in pharmaceuticals perhaps because he thinks the rate of change in this industry is unfavourable for value creation. It could also be because despite the research efforts, profits of companies may be capped by public clamour/government push for affordable medicines. Significantly, even generic players lack pricing power beyond the exclusivity period, which forces them to continuously replenish their launch pipeline, something that necessitates an outstanding manager at all times, quite contrary to Buffett’s liking. 

Again, software services firms such as Infosys and its peers have seen a dip in both growth and valuation. Infosys was once perceived to have a strong moat given its large workforce and execution capability, which created client stickiness. That client equity is coming unstuck as the dynamics of the business are changing in favour of specialised, product-based solution providers. “There may be a number of large growth companies but not necessarily companies that have very deep moats like in the US; that may be one of the reasons Buffett may not be interested in India,” says Naren. “Mega return requires innovation; it does not look like we are going to see a Google or Tesla in India. You cannot have an $800-billion market cap company like Apple without a moat,” he adds. As Buffett told Outlook Business in 2014 and also re-iterated this year, size is a key constraint that has kept him from investing in the Indian market. Agrawal however says, “Our markets are not mature – America offers companies of all size and shapes with several different business models. We have to adapt to our markets.”

Here’s the pitch, Mr. Buffett
A good bet for Buffett in the Indian market could be the financial services space. He isn’t particularly fond of banks as their leverage amplifies the downside. Still, Buffett did buy Wells Fargo in 1990 during the banking panic and has held it since. He only recently sold about 9 million shares to get back below the Fed’s 10% threshold. A retail bank, Wells Fargo currently trades at a price-book of 1.5x. The moat in a bank is really about making it easy for a customer to transact and “switching costs” — it’s a hassle for customers to switch services. The Indian version of Wells Fargo could well be HDFC Bank, with low-cost deposits constituting 48%. The other bank that enjoys a strong moat here is Kotak Bank and where low-cost deposits account for 44%. Uday Kotak has been a cautious banker keeping wholesale lending to the minimum and focusing on the retail book where delinquencies tend to be low. Kotak Bank also has more room to increase foreign holding compared to HDFC Bank, where the 74% ceiling has almost been breached.

The question again is how much should one pay up for quality? Ordinarily, value investors will shy away from investing in a bank that trades at 4x book value — banks are best bought at less than book value. The case for investing would be that the growth rates in India are far superior compared to growth rates in the US. Samir Arora, founder, Helios Capital maintains that state-owned banks still hold 60% market share, and that will keep declining over time as these banks have very little by way of technology (except SBI) and if the government does not change its stance of reducing its stake, they’ll starve for capital. That means the top four private banks will gobble their market share.

If one believes the economy will experience 7% real growth and 12% nominal growth, then a private sector bank like HDFC could likely grow at 1.5x. Because it’ll not only penetrate newer markets but also take market share from public sector rivals, it could grow at 18%. Assuming an annual currency depreciation of 3% (average over the past 15 years) the growth in earnings for HDFC Bank can be very conservatively around 15%. The bank earned a RoE of 18.65% in FY17 and a RoA of 1.92%. Wells Fargo earns a RoE of 11.01% and RoA of 1.16%, with negligible growth but then it hands out stable income by way of dividends.  

In one of the earlier interviews, Munger commented on a deal that was offered to Buffett. “There is this company in an emerging market that was presented to Warren. His response was, ‘I don’t feel more comfortable buying that than I do of adding to Wells Fargo.’” Despite its super franchise, Wells Fargo delivered a 9% annual stock return since 2000, while HDFC Bank’s stock gained 20% annually because the latter has delivered a 24.56% compounded growth in earnings over the past 10 years, and an even higher rate if you take a longer period. How much premium should one pay for this superior earnings power? That really depends on your take on growth. The fact remains that HDFC Bank has rarely traded at a price below 3.5-4x book. This takes us back to the point made by Mauboussin on ‘rollover’ of competitive advantage period, which can perpetuate high returns from moat companies.

The other significant play for Buffett in the Indian market might be the National Stock Exchange (NSE), which is planning an IPO. The NSE enjoys a near monopoly in the cash and derivatives markets and it is reasonable to assume that economic growth will increasingly reflect in trading volume. NSE’s FY17 revenue and profit was Rs. 2,318 crore and Rs.1,033 crore, respectively. It also doled out Rs.1,000 crore as dividend and is expected to list at a valuation of at least Rs. 40,000 crore. In comparison, the Bombay Stock Exchange is valued at Rs. 5,500 crore. 

The best value opportunities today in India come with a host of imponderables. Be it prices of global commodities or the future of India’s software services companies or banks, it requires either a leap of faith or contrarian thinking to take a bet on these stocks. There are, as at all times, pockets of temporary mispricing that may offer opportunities to make superior returns. But stocks whose fortunes seem predictable do not have any margin of safety. “The question to ask is if Buffett will buy anything in India at 45x. If the P/E shrinks despite the earnings coming in, he is going to lose money. Everything is opportunity cost for him. He will make 15% or the rate at which earnings compound. Buffett is not coming here to earn 10 or 15%,” points out Lahiri. The contrast in valuation is even more striking when you look at US stocks — Google trades at 21x, clocking revenue and earnings growth of 15% and RoE of 15% last year; Apple trades at 15x current year earnings with a revenue growth of 8% and RoE of 35% and Disney trades at 15x with an earnings growth of 15x and RoE of 21. Investing in India at the moment is far from shooting fish in a barrel.

This is the second of a two-part series. Read the first part here.