Adwait's Investment Approach and Journey

Adwait_Deshpande · April 25, 2024, 9:13am

Hello everyone,

As clichéd as it may sound, I too have been a long time lurker in this community, which I have browsed in search of informed opinions with respect to my own stock picks, diverse investment philosophies, and approaches to investing in general. I would like to thank the many contributors to this forum which make it a goldmine of learning for newbie investors like myself. After dabbling in publicly listed equities for almost a decade, I think it’s time for me to share my own investment approach and receive feedback from the wider public.

Why do I invest in equities?

It is an asset class which is the least risky in the long term, because it enables real wealth creation through value addition to society and civilization. What helps additionally is that it also liquid, capital gains are conservatively taxed (till now), and there is no minimum ticket size required for me to participate. This makes it the best asset class for me in my unique life situation for wealth creation.

What is my investment philosophy?

I wish to be a permanent owner of a high quality business.

I believe that picking individual stocks and creating a portfolio is an exercise of stacking odds in your favour, so that a desirable outcome maybe achieved in due time (measured in decades).

Stock Screening Filters - (These filters ensure the long term survival and prosperity of minority shareholders is NOT in jeopardy)

Clean Promoters and Management
Avoiding Leverage
Avoiding M&A Junkies
Avoiding Turnaround Situations
Avoiding unaligned owners (PSUs, Large Corporate Houses, MNCs with unlisted subsidiaries)
Avoiding unpredictable, fast changing industries

The checklist has been borrowed from Pulak Prasad’s book. He has articulated the why’s far better than I can. But essentially, avoiding these risks reduces errors of commission at the expense of increasing errors of omission (which means we live to fight another day.)

Adding to pt 6. I also avoid all industries/sectors where the historical ROIC - WACC spread is insufficient. This indicates that industry dynamics are brutal, and do not allow even it’s dominant players to consistently earn a ROCE above the COC.

Therefore, I only stick to these sectors (where the long term ROIC - WACC spead is tilted in my favour) -

Consumer Staples
Consumer Discretionary
Pharma, Healthcare, Diagnostics
IT Services

Incidently, this idea is borrowed from Terry Smith. (All my ideas are borrowed from investors I admire.)

After I have filtered out the potential candidates for errors of commission (pt. 1 to 6), and candidates not belonging to the aforementioned sectors, I apply my next set of financial filters.

TRIGGER WARNING - I am an admirer of Saurabh Mukherjea and Marcellus Investment Managers (including their books and newsletters). Those who do not subscribe to his views will not agree with the following approach. So be it.

Financial Filters -

ROCEs above 18% consistently for the past 10 - 15 years (with exceptions for COVID and other such calamities)
Operating Revenue Growth of above 10% for the past 10 - 15 years
FCF Growth - General Upward Trend
Cash Reinvestment rates - (Increase in WC + Increase in CAPEX/CFO) between 50 - 80% - 3 or 5 year average annualized

After applying the following filters, I am left with very few businesses that would interest me. I now try to answer the whys?

Why consistently high ROCEs?
Why consistently high Revenue Growth?
Profitablity, Leverage, Operating ratios - do they make sense wrt the industry and do they sync together?
Risks to survival/existence 20 - 30 years from today
Porters 5 forces model, Cost Leadership vs Product Differentiation, Big Fish in the value chain, Niches, Sir John Kay’s IBAS framework.

The next pertinent question that I ask myself is with respect to valuations - What is a price that I am willing to pay for them?

I anchor my price to the median TTM P/E of the market index, and do not pay for any multiple above that price. I will also look at the median TTM P/Es of the sectoral indexes to fine-tune this anchor. I might occasionally overspend a little bit for a franchise that I truly appreciate. But that is it when it comes to valuations.

I do not indulge in forecasting (DCF valuations) or any other excel wizardry for valuating a business.

Selling - I never sell a business until the business has obviously lost the plot (like DHFL or Vodafone India) or if the inital investing hypothesis does not hold true anymore (management makes a large unrelated acquisition, leverage, etc.).

I hope that I have been able to illustrate my investment philosophy adequately. I invite everyone to poke holes in it, or ask for further clarity on any of the topics.

I think there’s been more than enough gyaan in this next post. In the next post, I will try to argue the case for a particular stock that I own in my portfolio and do so for each stock in the weeks to come.

Happy Investing, and all the best.

rajat1973 · April 30, 2024, 2:19am

Do share your list of investements too for the benefit of all

Adwait_Deshpande · April 30, 2024, 7:35am

Having laid out my investment approach in the 1st post, let me argue the case for the 1st stock in my portfolio (in alphabetical order).

Abbott India Ltd

At the outset you will point out that it violates pt.5 - Avoiding Unaligned Owners - MNCs (especially when they have an unlisted entity). In the case of AIL however, the evidence suggests that the consequences of this arrangment have not harmed minority shareholders (yet.)

The unlisted business does not step on the toes of the listed entity in terms of cannibalization of products, markets or management bandwidth.

Quantitative Analysis

Ratios - Profitability, Leverage, Operations

Free Cashflows

I can infer from the numbers above that -

AIL has maintained high ROCEs consistently in the past 10 years
It has also grown operating revenues consistently in the past 10 years
Healthy and improving gross, operating and PAT margins - Profitability Check
Leverage is not an issue - Leverage Check
Healthy Fixed Asset + WC + Inventory + Receivable turnovers in the past 10 years Ops Check
Resulting in a growing stack of FCFs YOY

Qualitative Analysis (Go from answering easy to hard questions - helps save effort in the process of elimination - via negativa)

Management Quality

Does the management have a track record of good governance and clean accounting?

Yes. There have been no corporate governance issues in AIL in it’s history and has clean accounting.

Do the owners of the company have connections to political parties?

No, they stay out of the limelight.

Does the company have a strong track record of efficient capital allocation?

Yes, they have maintained high ROCEs in the past. The large part of the net income has been dividended out to shareholders in the last 3 years as it can’t be absorbed into the business.

Do the promoters have a track record of remaining focused on their core operations?

Yes. They have not invested in unrelated businesses.

Industry Attractiveness & Company Positioning

High historical long term ROIC - WACC spread in the industry. It allows dominant players to earn and keep a profit.

Is the company’s business heavily dependent on government regulation?

AIL’s business can be affected if a majority of the product protfolio in included in the NLEM which is price capped. Currently, almost 26% of AIL’s business by value comes from NLEM products, the rest is from non-NLEM. There is scope to increase prices inline with WPI even within the NLEM list.

How many competitors are present in the industry and how strong is the competitive intensity?

If the molecule has had a LOE, then a lot of players will jump into the fray and drive down market share and profitability - {Duphaston}. However, if there is an active patent for the molecule, there is exclusivity and high margins + monopolistic market share. There are plenty of competitors present in the industry, however, there are 2 - 3 players which dominate each molecule in terms of market share.

What is the overall size of the industry and its growth potential?

India’s domestic pharmaceuticals market (IPM) is estimated at 2,21,922 Crores in 2023 and the market is expected to grow at a CAGR of 8.8% between 2022-2027 reaching 3,08,329 Crores by 2027. It will be driven by economic growth, increasing penetration of health insurance and increased private sector investment. AIL can positively maintain a topline inline with industry growth CAGR +1 or 2%. AIL has demonstratred a ~ 10% operating revenue growth YOY for the past 10 years.

Is the company in an industry where the proportion of value addition is high?

Yes, there is value addition in terms of product efficacy, administration of the drug, packaging, innovative SKUs (pill, gels, liquids), availability online and offline, and doctor trust and recommendation. All this is determined by AIL and is under the ambit of AIL. Value addition is high (except for the Novo Nordisk portfolio)

What is the capital intensity and capital efficiency of the industry?

Once the licensing rights are obtained, AIL’s business requires low capital reinvestment (<5% of capital employed) and is able to convert around 80-95% of net income to free cash flow. AIL typically earns 80-90% of incoming cash from business operations and balance from interest income (Exceptions are seen in the FY where there is a major sale of business assets or loan repaid by subsidiaries). Its average cash conversion ratio (net CFO/net income ratio) over the last ten years is 85%. It holds a large reserve of term deposits to maintain liquidity and finance its working capital. Over the last 10 years, Abbott India has reduced costs, improved gross, operating and net margins, decreased cash conversion cycle by 85% and maintained ROCE>30% and ROE > 20 % without resorting to external debt. It has maintained leadership position in most of the categories it operated in the last decade.

Is the industry’s business dependent on India’s broader economic cycle?

Abbott India Ltd’s business may be influenced by India’s broader economic cycle to some extent.
Its dependence is moderated by factors such as the essential nature of healthcare products, government policies which are always going to be pro-healthcare spending, and positive demographics. The therapy sectors chosen by Abbott India generally require long term medication to manage the symptoms of the disease.

Does the business generate excess returns for shareholders?

Yes. ROCE is 2x COC for decades. This results in free cash flow growth and excess returns for shareholders.

Sir John Kay’s IBAS framework

What is the company’s track record on innovation?

AIL focuses on new launches, which is fairly consistent (+100 launches and line extensions in the last 10 years). Target for the next five years ~75 launches. They try to extend the lifecycle of each megabrand molecule through innovations like introducing a gel, topical lotion, spray as well different SKUs depending on use cases. They also have a strategy of looking at molecules which will experience LOE in their relevant sectors - women’s health, GI, CNS, Metabolics, Vaccines, Etc. AIL is investing in creating new categories related to the aforementioned sectors, hoping to scale them in the future.

What is the company’s investment in brands and reputation?

AIL has 15 brands which are market leaders in their respective segments, accounting for over 80% of our revenue. Their reputation is better than other generic pharma companies with competing products.
Doctors trust prescribing Abbott brands over competition. Duphaston is still the leading pill recommended by IVF clinics, where the stakes are high, although the brand may have lost market share in the gynac division (with comparitively low stakes for patients).

How strong is the company’s architecture?

1/3rd of the manufacturing is in house, 2/3rds it outsourced, leaving AIL with an asset light model and a high fixed assets turnover ratio. It has excellent parentage which supplies AIL with new and innovative products for India which AIL doesn’t have to spend a dime (of royalty) giving it superior ROCEs in a growth market. It has good penetration in urban areas (esp metros) but reach into tier 2, 3, 4 towns is still lacking. It has also adopted the e-pharmacies channels in India. AIL can be thought of as a sales and distribution arm of Abbott Ltd. (USA) for India. It does not incur any PD/R&D costs and has a ready pipeline of products.

Does the company own any strategic assets?

The key strategic assets for AIL are - Leading brands in categories they play in, excellent parentage resulting in a long product pipeline, doctor + pharmacist trust, category creating abilities. They also stay away from parts of the industry which are very heavily regulated.

Does the company have ROCEs that are higher than the industry average?

Yes, AIL has ROCEs 2x that of the industry, consistenly well above its COC.

Miscellaneous

End consumers (patients) are dependent on doctor’s prescription or pharmacist’s recommendation in the selection of medication. Concerns about quality control and manufacturing practices at local generic manufacturers in India has led to the perception that only well known brands generally sold by MNCs are safe/ trustworthy to use. This allows branded generic pharma companies to charge premium prices on off patent/ generic drugs.

Lindy Effect - The Lindy effect (also known as Lindy’s Law) is a theorized phenomenon by which the future life expectancy of some non-perishable things, like a technology or an idea, is proportional to their current age.

Abbott India Ltd. was incorporated on August 22, 1944, so it has stood the test of time and most likely will be around for another 80 years or so. (It was called Boots Pure Drug Company then, but it has had operations in India from 1910 throught a pvt ltd. company.) I am long on the longevity of the business.

Disc - Bought in March 2017 at ~ Rs. 4500 at a PE of about 33x. Holding.

Surender · April 30, 2024, 8:32am

Appreciate your detailed post.I keep thinking about the points below, sharing with the hope that you may share your thinking around these aspects:

B/S drowns with cash [Sep 2023: 70% of Tot. Assets], but mgmt. does not act to grow the topline at a better rate. In a time frame of up to 5Yrs., OPM expansion has covered for the anaemic (single digit) sales growth.
How long earnings growth can sustain in this fashion?
How do they intend to solve the problem of too much cash?

Adwait_Deshpande · April 30, 2024, 8:58am

Hi Surender,

Too much cash: This is actually a positive trait as far as I am concerned.

I think they will dividend out excess cash to shareholders in the future while keeping a lot of it on hand too. This works for me as I can allocate that cash to an alternate investment.
The excess cash on the B/S will be used for inorganic acquisitions in the future if any make sense (wrt to adjacencies and valuations) when a competitor might be going through a tough time
Excess cash provides antifragility during black swan events, it can be a strategic asset when there are headwinds (you need to survive in order to thrive)

Sales growth will remain around 10%, earnings growth will remain at around 15% in the long term, and I am fine with both.

Higher topline (vanity) will result in poorer PAT margins, ROCEs and cashflows (sanity) in the future
I am looking for share price compounding at no more than 12.5% CAGR and for that, an exit PE of 40 and earnings growth of 15% CAGR is enough (mathematically). This seems realistic for the next decade.
Expecting 10 - 12% PA compounding from this franchise over the next 10 years. With this context, I think the explanation will make sense.

Adwait_Deshpande · May 4, 2024, 11:46am

Here is the 2nd stock in my portfolio that I own -

Dr Lal Pathlabs Ltd

I have always been keen on investing in the diagnostics sector in India. This is because of the large unorganized segment present in the market, and the high CAGR of the industry itself.

These twin tailwinds of size of the pie growing, along with the opportunity to grab of a larger slice of the pie for oneself, has the potential for outsized rewards in the long-term. (Demonstrated by PE/VC investments in the space, looking for abnormal returns.)

However, one must be wary of key risks, especially pertaining to Dr. Lal, which are -

Acquisition Risk (Inorganic Growth)
Evolving Business models (which makes the industry somewhat unpredictable)

Quantitative Analysis

Ratios - Profitability, Leverage, Operations

Free Cashflows

I can infer from the numbers above that -

Dr. Lal has maintained high ROCEs consistently in the past 10 years (adjusting for COVID)
It has also grown operating revenues consistently in the past 10 years (adjusting for COVID)
Healthy and improving gross, operating and PAT margins - Profitability Check (adjusting for COVID)
Leverage is not an issue - Leverage Check
Healthy Fixed Asset + WC + Inventory + Receivable turnovers in the past 10 years - Ops Check
Resulting in a growing stack of FCFs YOY - (adjusting for COVID)

Qualitative Analysis

Management Quality

Does the management have a track record of good governance and clean accounting?

Yes. There have been no corporate governance issues in Dr. Lal in it’s history and has clean accounting.

Do the owners of the company have connections to political parties?

No, they stay out of the limelight.

Does the company have a strong track record of efficient capital allocation?

Yes, they have maintained high ROCEs in the past. A decent part of the net income has been invested back into the business for acquisitions and capex. Fingers crossed on the Suburban brand turnaround and scaling.

Do the promoters have a track record of remaining focused on their core operations?

Yes. They have not invested in unrelated businesses.

Industry Attractiveness & Company Positioning

High historical long term ROIC - WACC spread in the industry. It allows dominant players to earn and keep a profit.

Is the company’s business heavily dependent on government regulation?

Until now, the industry has been unregulated. Only 1% of the labs in India have NABL accredition. Majority of the labs do not even have qualified pathologists running operations. Any regulation in terms of QC or minimum standards will hit the fragmented 47% of the industry first, with the organized players already having the checks and QC is place. The ICMR has published a National Essential Diagnostics List (NEDL) which does not talk about price caps, but more about procedures and QC. There have been price caps for endemic seasonal diseases like dengue, malaria and COVID 19 in the past, but they do not erode margins significantly for the business in any time period.

How many competitors are present in the industry and how strong is the competitive intensity?

The market is divided into the unorganized & standalone labs (47%) who mostly do high volume/low cost testing as a service. There is little value add for the customers here. The next segment is hospital based labs (37%) who cater to the patients who are admitted there. The last segment is the organized sector which is dominated by 4 players - Dr Lal, SRL, Metropolis and Thyrocare (which is now acquired by Pharmeasy). Dr Lal has dominated the north and east market (2%), while metropolis is strong in the south and west (1%). The sector is very price competitive (also because of PE/VC funded labs) and the only way to grow the topline is by volume growth. Price hikes have been rare in the diagnostics space.

What is the overall size of the industry and its growth potential?

Diagnostics in India today offers a huge market opportunity at ~Rs. 70k-80k crores which is growing in double digits. This is led by faster growth in elder population, increase in evidence-based treatment, and increase in health awareness (especially post covid). Rising incomes which will lead to higher per capita spending on healthcare, increase in lifestyle diseases, and adoption of health insurance also help.

Is the company in an industry where the proportion of value addition is high?

Yes, the diagnostics industry is essential for the treatment of patients and to assess the overall health (in case of wellness testing). It is the 1st step on the way to getting better if unwell, or preventing any health risks before hand. The value addition depends upon faster + accurate test results which are consistent & fairly priced. The continued demonstration of these attributes lead to an increase in trust with doctors who recommend patients use a particular lab for diagnosis.

What is the capital intensity and capital efficiency of the industry?

The industry has high capital efficiency. Organized players use an asset-light model for organic expansion which generates high ROCEs and FCFs consistently for the 4 players. Cash on the B/S enables acquisition of fragmented labs where there is no prior geographical presence. This makes sense as it takes decades to build trust with customers and doctors in a geography. On the whole, the capital intensity of the industry is low, with the fixed assets turnover being 4 - 5x. Imaging and Radiology are capex intensive. (Dr. Lal has stayed away from them). However, the FA turnover deteriorates temporarily with acquisitions and setting up of reference labs (hub for the spokes). The spokes are all franchise driven.

Is the industry’s business dependent on India’s broader economic cycle?

The diagnostics space is secular and does not depend on the India’s broader economic cycle. As people fall sick and need to be diagnosed to identify the disease or deficiencies, they will require diagnostics. It has nothing to do with economic cycles. There is a 10% revenue contribution from wellness diagnostics, which might be impacted during recessions, but in the long term it will go up due to a multitude of other factors (D2C marketing, lifestyle diseases, rise in disposible incomes).

Does the business generate excess returns for shareholders?

Yes. ROCE is 2x COC for decades. This results in free cash flow growth and excess returns for shareholders.

Sir John Kay’s IBAS framework

What is the company’s track record on innovation?

Dr. Lal has been implementing automation in sample testing with intelligence fed from in-house data analytics to enable faster & less variable TAT and further improving accuracy of results. For example, the firm’s ‘control tower’ initiative which enables monitoring of a sample lifecycle and identification/ correction of bottlenecks has allowed Dr. Lal to meet the ETR (Estimated Time for Report) more than 90% of the time vs. 80% earlier. Additionally, the scope for real time tracking of samples by hospitals has also been increased substantially allowing for better management of the doctor’s time, further building the stickiness of the firm with these doctors. Dr. Lal has also introduced high end speciality tests to India, where samples had to be sent abroad earlier.

What is the company’s investment in brands and reputation?

Dr. Lal enjoys immense brand equity and has a very good reputation in North India (NCR region) from where it began it’s journey approx 75 years ago. It is trusted by doctors and the public alike, and has also acquired labs with good reputations in their localities. (Hence it is leveraging the Suburban brand to expand in MH). It takes a long gestation period to build trust in the medical fraternity, and Dr. Lal being the oldest has an advantage here.

How strong is the company’s architecture?

In the B2C segment (60% of revenues), diagnostic charges are borne by the patient; so, the industry has evolved into a service industry competing on consumer convenience (rather than being focussed on the clinical or medical side). Dr. Lal has the largest network of franchise PUPs, PSCs and clinical labs for home collection and walk-ins. This enhanced reach results in customer acquisition and market share gains by solving for customer convenience. Digitization of the user journey from booking appointments for home collection, to providing online reports has enabled Dr. Lal to compete with other tech based diagnostics startups. In the B2B segment (40%) - 36% of revenues are derived from high end speciality testing from hospital and standalone clinical establishments. The hospital lab management has a 4% contribution (where Dr. Lal manages hospital labs).

Does the company own any strategic assets?

Strategic Assets: Expansive network and reach, brand equity and reputation, economies of scale and operating leverage, digitization of operations and customer interface, and a legacy of 75+ years.

Does the company have ROCEs that are higher than the industry average?

Yes, Dr. Lal has ROCEs 2x that of the industry, consistenly well above its COC.

Miscellaneous

Things to watch out for -

Entry into tier 2/3 towns - Accretive contribution to the topline
Suburban Acquistion Turnaround and Scale Up
Replicating the success in the NCR region to other geographies (market share wise)

Lindy Effect - The Lindy effect (also known as Lindy’s Law) is a theorized phenomenon by which the future life expectancy of some non-perishable things, like a technology or an idea, is proportional to their current age.

Dr. Lal has a legacy of 75 years, and has started expanding seriously since 2005, with 20 years of solid performance with Dr. Om Manchanda at the helm.

I think there is tremendous longevity and robustness in the business with the potential to grow. They are at 2% market share (market leader) in a rapidly growing industry, with all the systems and processes in place, cash on the b/s for acquisitions, and a large, fragmented, unorganized segment of the industry to prey upon.