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Show me the Margins!


Greetings from Team Carnelian!!


Wealth creation and compounding are a function of three things - Quality of Business, Quality of Management and Reasonable price. If you even get one of these wrong, it either brings you an undesired risk or impacts the desired returns. In the past, we have shared with you our detailed frameworks around each of them.


This time around, we thought of sharing one specific insight, we use, on the Quality part of business. Quality of businesses are usually reflected in them consistently generating superior ROCE. While the key driver of wealth creation – superior ROCE (capital efficiency) is undisputed and widely known, however, it is important to understand the path to ROCE, which is a result of “Gross Margins” and “Asset Turnover.” Same ROCEs can be achieved through “low margin and high turnover” or “high margin and a low asset turnover” or “a great balance of two.” The table below attempts to depict a broad categorisation of companies using these metrices:

From the above, we clearly prefer businesses within the first two categories and keep looking for good businesses in the third one. We love businesses which generate higher gross margins. Let us discuss on why ‘Gross Margins’?


Gross margins demonstrate the value addition component by an enterprise and thereby indicates a high probability of business MOAT. Higher gross margin is usually an outcome of (any or all below):

  • IP/Technology

  • Lower availability / threat of substitutes

  • Superior branding power

  • Access to raw material / bargaining power with suppliers

  • Market structure – Regulated, monopolized setup, lower competitive intensity

  • Better operational efficiency

A combination of any / all the above, brings a distinct competitive advantage to a business vs peers / other industry. Moreover, businesses with high Gross Margins have far more leeway to withstand the impact of any short-term volatility in the business environment without any permanent damage.


We back tested data for the last 20 years – interestingly, we found that there are ~ 80 non BFSI companies out of the total sample base of ~ 850 non BFSI companies which have multiplied more than 50 times in the last 20 years (>20% CAGR) having consistent return on capital employed greater than 15% and in those companies one of the few things among many other things which were common were high gross margins (relative to peers in the same sector). The table below further gives break up of companies.

How do higher gross margins lead to a superior competitive strength and further strengthen it?

David George and Alex Immerman, partners at venture capital firm highlighted, “A high gross margin is a preferred business feature. Higher gross margins allow for more percentage points of revenue to be spent on growth and product development.”

Having high gross margins in a business has its own distinct advantages:


More cash for spending on R&D/branding etc: Having high gross margins allows the management to plough back the money earned on advertisements, Research & Development, increasing distribution reach, etc. This helps companies to increase market share which in turn leads to more cash generation and thus, further enhancing the competitive advantage. This is what is the “Virtuous circle of Healthy gross margins.”


Ability to invest in innovation & customer, thereby staying ahead of competition: While there are lots of benefits of a higher gross margins, higher gross margins and higher ROCE tends to invite competition from fresh players as they look to

take a pie of this superior profitability. Higher gross margins businesses, however, will have the capability to compete with peers as they will be better equipped to do product innovation/expand distribution, branding spend and more.


Ability to invest in future growth drivers: Companies with higher gross margins always tend to invest not only in current products and services but also potential future growth drivers / trends. This way they keep reinventing and staying ahead of the curve.


Pidilite, over the years has been known for its famous advertisements of their flagship product Fevicol. Over the years it has faced competition from enormous players trying to capture the market share, it has faced raw material volatility and many other disruptions, despite all this the company has been able to strengthen its Fevicol brand, continuously innovate and introduce new products (Fevikwik one can resonate with). Advertising cost as a % of sales has come down over the years but absolute amount has increased manifold, all while maintaining its operating margins coupled with growth.

Surviving difficult times/mistakes: Higher gross margin enables companies with lower breakeven points in comparison to their peers in the same industry. We have observed over the years that low gross margin businesses despite having good returns on capital employed at times find it difficult to sustain in the times of crisis. Historically, crisis like loss of a large customer, disruption (recent times – covid), escalation in raw material costs etc. have impacted profitability of these companies as there is no room to accommodate shocks.


3PL Logistics company: One of the 3PL logistics companies of a large industrial house, which was consistently clocking ~25% ROE albeit with low single digit gross margin, found it difficult to sustain its business operations during covid it and its profitability dropped by more than 70%.


Staffing Companies: The nature of this business is such that gross margins are in single digit, thereby leaving little room for businesses to absorb downturns in business cycle, business mistakes etc, leave aside investing in future growth.


Businesses with low gross margins will have a low capacity to manage uncertain events in comparison to high gross margins businesses. Needless to say, no business can remain unexposed to uncertainties of environment.


Now one can argue that if it were easy to get high Gross Margins, everybody would tend to get it. So, what are the factors that lead to building a company with high margins:


Founder’s mindset and organisation culture:

This is the most important aspect which contributes to high gross margins, the best example here being Apple – The Company is synonymous with brilliant products, creativity, and customer experience. Allowing creativity within the organisation has been the bedrock of Apple which over the years has reflected in the products of the company. In the Indian context, the same can be said for


Siddhartha Lal who has created a whole new market segment for bikes greater than 250 cc which never existed in India before. He has been successful in building a completely new community of riders and cult belonginess amongst them. Another great example can be Vedant Fashion who is creating a new category of ethnic wear “Manyavaar” in an organised format and expanded the market size through an innovative approach.


Amazon CEO Jeff Bezos calls failure and innovation as “inseparable twins” and says failure is “necessary for invention.”


We thus believe that it is the founder’s mindset and the organisational culture which sets it apart from peers in any industry. The culture to offer the best innovative products/service at the best possible cost to maximise customer satisfaction sets the initial stage towards healthy gross margins for any company.


The resultant advantages could be in form of any one or a combination of the following strengths:


Pricing power with customers

Companies having a brand value can charge premium to its customers for their products in comparison to their peers. Apple is the classic case in point, over the years company has been able to build a reputation for quality and design which has enabled it to charge a premium for its products. In the Indian context, Eicher can charge a premium for its bikes because of its differentiated product/the rider community it has built over the years. The company has created a differentiated offering of customised bikes (make your own bikes) which resulted into a significant increase in the sale of spare parts/accessories further expanding margins. Titan can charge a premium for its product and making charges because of the trust that consumers have in its brand.

All the above companies’ pricing power has helped them garner better margins, better cash flows which in turn has led to more investments in distribution expansion, innovation and foraying into newer categories.

Bargaining power with suppliers

Companies who have advantage of scale get advantage of cost as well, which their peers may not be able to get thereby leading to higher selling prices for them. We have seen companies having better gross margins in comparison to peers on account of cost advantage due to scale, have been able to sustain and grow well vs peers.


Value addition which may be on account of differentiated work, intangibles like trademarks, know-hows, etc.

Engineering Research and Design Companies (ERD) in the IT sector, a niche contract manufacturing company in the pharma space, niche API companies are a few examples of companies which have high gross margins on account of niche expertise that they have built over the years which is difficult to be replicated by others.


Higher gross margins lead to higher valuations?

Over time as a company demonstrates the ability to generate sustainable higher gross margins for a long period, eventually leads to an expansion in the PE multiples. Of the above companies which generated returns greater than 50 times in the last 20 years, companies on an average started with a PE multiple of ~9x which gradually kept on expanding with average PEs going as high as ~42x. (as mentioned above other factors like growth, ROCE etc. also matter along with high gross margins).


Conclusion

In the hindsight, things always look easy but obviously that is not the case in an ever evolving and dynamic world as ours currently and therefore one can only take a leaf from the past.


While higher gross margins do not necessarily lead to a Moat, they are often a reflection of Moats. Thus, looking at higher gross margin companies help narrows down the selection universe. For lower gross margin companies, one needs to focus even more on moats as without those extra points of revenue to invest in sales and marketing, R&D, etc – the business needs other ways to keep generating such cash flows over time.


We use this as a very important point to look for future wealth creators while building our portfolio. Average gross margins of our shift portfolio stand at ~50% with ROE of 18% having generated 45.3% CAGR since inception in October 2020 and that of non BFSI companies in our compounder fund gross margins stand at ~ 48% with ROE of 17% having generated 20.3% CAGR since inception of May 2019.


Hope this has given you some insights into our thinking and approach.


Happy Investing and wealth creation with Carnelian.

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