So you need to ask yourself where this magic is going to happen and for how long will it continue? Surely, the company needs to have a favourable competitive advantage. Think Colgate, Asian Paints or Bosch, Gillette or Parachute (Marico) these are wonderful companies with great moats. Even in a sector like telecom, Bharti Airtel had the first mover advantage in 2003-2004. Then there is the Indian IT sector which has established itself both locally and internationally.
Even in commodities there is Hindustan Zinc with its low cost of raw material or Tata Steel with its low cost coking coal and iron ore. That kind of advantage helps you earn an extra margin over and above your cost of capital. This kind of enormous free cash flow over a period of time can lead to sustainable scale. Given that there are multiple sources of economic moats, the challenge for an investor is to pick the right one and hold on to it. The problem is we do not know which company has an economic moat that will sustain. A company having a RoE above 50% is great but its moat is priced in. So, how do you find the new ones, year after year? You should consider yourself lucky if you can shortlist 2 to 5 moat companies every year.
During their life cycle, most companies struggle for the first 5-7 years and 95% of them die out in this period. Of the 1% that survive, 0.1% emerge to become really large companies. That becomes visible when it crosses the hurdle rate, i.e. a RoE of 17%. That is my benchmark. You can figure that out when you scan through the quarterly or annual results. I have seen company after company whether it is Hero Honda (now Hero Motocorp) or Ajanta Pharma. Companies always start from zero and then go on to 15% RoE and then inch to 17-19% on larger capital employed. This is life. You must keep an eye for those who are emerging. Every company starts with a negative return on capital employed, it then becomes positive RoE and then moat RoE. When the moat is getting built, you should be there to pounce on it.
This is the second of a three-part series. You can read the first part here