Thread by @ValueEducator

My #investing framework which has the constituents of a #multibagger recipe:

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My journey and investing framework:

I started my initial investing journey by reading the works of Warren Buffet and Benjamin Graham, where I used to buy stocks at cheap valuations. Some of these stocks turned out to be value traps with no potential for growth.

After losing some of my money, I realized that the value investing framework pioneered by Benjamin Graham and Warren Buffet can’t be used as is and has to be tweaked to suit the current times. The framework which will be discussed in this post

below is a work of almost 6-7 years of my investing journey where I learnt to focus first on the quality of the business and buy that business if it is available at attractive valuations. Some of the key elements of my investing framework are:

1)Negative cash conversion cycle
2)High Cash flow conversion(CFO/EBITDA)
3)Asset light model
4)Growth
5)High ROCE+ High growth, dividends don’t matter
6)Increase in margins
7)Branded play
8)Valuation

Let us now discuss each of the elements of this investing framework:

1)Negative cash conversion cycle

The formula of the cash conversion cycle is as shown in the image below:

Inventory days basically means the time needed to convert the entire inventory into finished goods which will be sold in the market.

When you sell your goods in the market, you may sometimes not get the payment immediately and the amount which you don’t get immediately is known as Trade Receivables. The time taken to collect these receivables is known as Receivable days.

Whenever you purchase raw materials from your suppliers, you usually pay them after some time when you have converted your inventory into sales and collected the receivables.

The amount which you have to pay to the suppliers is known as Trade payables and the time you take to pay to your suppliers is known as the Payable days.

In an ideal scenario, you would want your Inventory days & Receivable days to be as low as possible & Payable days to be as high as possible so that you have enough capital in hand which you can reinvest into your business with no worries for immediate payment to your suppliers.

The business with minimum working capital needs is an ideal investment candidate if the business can grow itself without a similar growth in working capital requirements. An example of such a business is the hospital business where the cash is collected upfront from the patients

which leads to low receivable days and with a low probability of bad debts. The image below summarizes the cash conversion cycle in FY22 of some of the players in the hospital business:

As you can see from the image above, all the players in the hospital industry have a negative working capital cycle which shows the general nature of the business.

2)High Cash Flow conversion

Cash flow is an important parameter as compared to profitability. There could be scenarios where the company is having a high profitability but the cash conversion of the company is not good and there could be another scenario

where the company is able to efficiently convert its profitability into cash. Check the Cash Flow from Operations(CFO) even when profitability is good as profit is a book entry, it won’t be realized without cash collection.

Another parameter which determines the effectiveness of cash conversion is the CFO/EBITDA ratio which gives the percentage of profit generated by the business which is converted into cash.

A recommended value for the CFO/EBITDA is >=70%.

An example of a good cash conversion business is Garware Hi-Tech Films. They work on a cash & carry model where they collect money from their customers upfront which results in low receivable days and a high CFO/EBITDA conversion. The details are as summarized in the image below:

As seen in the image above, Garware Hi-Tech films has had a healthy CFO/EBITDA and low debtor days due to their cash and carry model.

It is necessary to check CFO/EBITDA over time period to get a better picture about the business of the company as you can see from the image where Garware has a 6 year CFO/EBITDA average of 98%.

Now let us see example of Kwality Ltd which is an example of poor cash conversion:

As seen from the image above, though Kwality Ltd has posted a good profitability consistently, it had a negative CFO most of the time which reflects some issue in the cash collection of the company.

Therefore, it is necessary to check both the CFO and profitability of the company to get a better understanding and this is where CFO/EBITDA comes in.

3)Asset light model

An asset light model business is one which can grow without much incremental investment i.e. They have minimum working capital requirements. Examples of such models are platform businesses such as IEX and CDSL.

These businesses have generated a high Return on Capital Employed(ROCE) over time and since they do not need much capital to grow their business, they have also paid high dividends historically to their shareholders. These details are summarized in the images below:

4)Growth

Growth is a very important aspect of my investing framework. I focus on quality businesses that are available at low valuations and have future growth prospects.

However, the quality of growth also matters. If a business has grown over time by taking on too much debt, there is a significant risk of capital erosion if things go south. On the other hand, If a company has grown over time by diluting its equity,

even that is not a good sign as equity dilution will lead to the reduction in value of the shares held by the existing shareholders.

You won’t have many opportunities to create wealth in a company which engages in constant equity dilution as it will eventually reduce the value of your shareholding.

I personally prefer businesses which have done their growth without much equity dilution and have minimum to zero debt on their balance sheet. An example of a business which has done its growth without equity dilution and debt is Divis Laboratories.

A)Growth without dilution

Divis has grown its profitability at a CAGR of 19% from ₹429 crore in FY11 to ₹2960 crore in FY22. This growth was completely funded by internal accruals without diluting equity.

B)Growth without debt

Divis has done its growth without diluting its equity and also without taking on much debt. The cash balance of Divis is much higher than the total value of its short-term and long-term debt which makes it virtually a net-debt free company.

The details are summarized in the image below:

Therefore, while looking for growth, I preferably look for companies which are debt-free and have done their growth majorly via internal accruals.

5)High ROCE+ High growth

As discussed earlier, growth is an important parameter to generate long-term wealth. Just buying at cheap valuations won’t matter if there is no growth.

In such a case, even though there is low probability of losing much, you won’t gain if there is no scope for growth. Along with high growth, you should also look for management which is able to redeploy funds generated from the business back into the business at a higher rate.

This rate is called the Return on Capital Employed(ROCE).

An example of High ROCE + High growth business is Divis Laboratories who have consistently generated ROCE in the range of 28-35% and simultaneously have also grown their profitability at a CAGR of 19%,

the details of which are summarized in the image below:

However, there could be some businesses which might have a good ROCE but, there has not been much growth in the business. An example of this case is Swaraj Engines which has generated ROCE in the range of 40-50% consistently however, the CAGR of profitability is only 9.5%.

The details are summarized in the image below:

In businesses like Swaraj Engines, though your capital will be protected, your capital won’t grow. The main idea of investing is to both invest your capital in a way that earns decent returns and to ensure adequate safety of your capital.

You should try to avoid businesses which don’t fulfill either one of them or none of them.

6)Increase in margins

As mentioned earlier, both cash flow and profitability are important parameters before investing.

You should invest in a business where there is a scope of margin expansion which will lead to the growth of the business with possible growth of cash flows as well. Margin expansion happens mainly due to 2 reasons:

A)Increase in capacity utilization(Operating leverage)
B)Change in product mix

Operating leverage basically means a disproportionate change in the profitability of the company with a minimum change in revenues.

Margin expansion can also happen due to Change in product mix where you focus more on high gross margin products/business as compared to low gross margin products/business. An example of margin expansion due to operating leverage and change in product mix is Laurus Labs.

A) Increase in capacity utilization:

Laurus labs consistently kept on doing capex which increased their gross block from almost ₹ 1098 crores to ₹ 3331 crores which is almost a 3x increase in gross block.

The operating leverage however, started to play out post FY18 where the operating margins of the company increased from 16% in FY19 to 33% in FY21 which is almost double. The details are summarized below:

B) Change in product mix

Laurus labs has historically got majority of their revenues from the ARV API segment, the ARV API segment however is a low margin business for the company.

Hence, the company decided to focus more on the CDMO and Finished Dosage Formulation(FDF) businesses which have a higher margin as compared to the ARV. The company was successful in reducing their contribution from the ARV segment from 82% in 2016 to 25% in 2022

and subsequently increasing the share of the CDMO and FDF business in the same time period. As a result, there was a consistent rise in the gross margins of the company from 43% in FY16 to 56% in FY22. These details are summarized in the image below:

7)Branded play

These types of businesses have a strong brand recall and a good pricing power which means they are able to pass on any increase in raw materials to their end customers.

As they are able to pass on price increases to their customers, they don’t have much volatility in their margins. The example of one such business is Nestle which has had operating margins in range of 20-25% even after the Maggi fiasco. Another example we can look at is Parle-G.

In period of 1994 - 2023,they have increased the price of their product from ₹4 to ₹5 with subsequent decrease in grammage which demonstrates the strong brand and pricing power which are the key strengths of a consumer business. The details are summarized in the image below:

8)Valuation:

Suppose you find such a business which ticks most of the parameters if not all, there is a high probability that this business will trade at high valuations. The Market is smarter than us and will already factor these parameters into the valuation of that business.

To take the example of Nestle, it has branded play, good balance sheet, high ROCE and longevity of earnings as a result of which it is trading at almost 80 P/E. You won’t get a 25-30% returns by investing in Nestle right now as it is already trading at high valuations.

The point here is that entry valuations do matter. You should focus on buying a good quality business at low valuations. Buying an excellent business at high valuations won’t create long-term wealth as is the case with Nestle right now.

Comparison of the players:

Now that we have discussed all the parameters of my investing framework, let us compare some businesses in terms of all these parameters. One such comparison is as shown in the image below:

Divis does not have a negative cash conversion cycle as it has to carry a high amount of inventory on its balance sheet so that they can fulfill their customer demands on time without any disruption in operations. As most of their cash is stuck in inventory,

they have a lower CFO/EBITDA as compared to the other companies considered. There is not much scope for margin expansion as most of their plants are multipurpose plants(MPP) which generally have a low-capacity utilization as compared to dedicated plants.

Since, Divis makes generic APIs which are commodity products, Divis does not have any brand power.

HCG has a negative cash conversion cycle, Pricing power due to brand and a high CFO/EBITDA of 90%. However, it is not an asset light model as they had taken a lot of debt for their expansion before COVID-19.

This capex plan backfired during COVID-19 and the Promoter had to sell some of his stake to pay off the debts which led to equity dilution.

Swaraj Engines ticks the first 5 parameters with a decent 60% CFO/EBITDA however, there is no growth in the business in spite of the high ROCE as discussed earlier. Hence, there is not much scope for margin improvement.

There is not much scope for branded play due to the B2B nature of the business of Swaraj Engines.

Conclusion:

In a very rare scenario, you will find a business which will tick all the parameters of my investing framework and will still be undervalued.

Instead, what you should look for is a business which has suppressed margins with some growth triggers which will lead to margin improvement and future growth.

To know more, watch my video on YouTube:

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