MARCELLUS Consistent Compounders

As discussed, please find below a brief write-up on Marcellus Portfolio. The portfolio will typically have 12-15stocks.

One of the strategies that we have recently launched is Marcellus’ Portfolio – this strategy has a minimum ticket size of Rs. 15 crores and has been specifically created for investors who want a customised portfolio. Marcellus’ portfolio is a multi-cap strategy and consists of Marcellus’ most high conviction bets which have been selected using the following steps:

• Forensic accounting: Identify companies with clean accounts using Marcellus’ proprietary forensic model. At Marcellus, the first step across all its strategies is to eliminate companies with poor quality accounting – this eliminates a large universe of listed stocks (please click here for our newsletter on the importance of accounting quality).
• Capital allocation: Identify companies with a track record of superior capital allocation using Marcellus’ proprietary capital allocation framework (please click here for our newsletter on the criticality of prudent capital allocation for consistent compounding).
• High barriers to entry: Out of companies which pass the above two steps, identify companies which have high barriers to entry.

The Marcellus Portfolio will consist of stocks which meet with the above three criteria irrespective of whether these are small cap companies or large cap companies.

Fee Options:

Option 1:Fixed fee: 2.50%

Option2:

Fixed fee: 1.50%

Hurdle Rate: 10%

Performance fee: 15% (without catchup)

Consistent Compounders PMS by Marcellus invests in an intense portfolio of heavily moated companies that can generate healthy earnings growth over long periods. Portfolio creation is a two-stage process technique.

• A filter-based method for generating a spend universe of 25-30 stocks.
• In-depth, bottom-up research of such enterprises in the universe to assess long-term competitive moats and build a portfolio of 10-15 stocks that improve healthy compounded acquirement over time.

While the filters are implemented annually, companies in the portfolio and coverage universe are continuously monitored for moat sustainability through comprehensive primary and secondary research. You can find their newsletters for a more detailed discussion of some frameworks used in their ongoing research process.

Let’s discuss it briefly. Marcellus PMS has three core investment pillars. They hold business enterprises for long periods with little or no churn, allowing them to capture the long-term compounding magic and deliver superior returns.

• Clean Accounts:Their investible universe is defined by our quantitative frameworks, which use a fusion of forensic accounting and capital allocation assessment.
• Capital Allocation:They seek companies with a strong track record of capital allocation. They admire businesses that create free cash flows and reinvest them in the business to fuel future growth.
• Competitive Advantage:Their experienced investment team builds a portfolio of companies with significant competitive moats using in-depth primary research.

Before being included in their investment basket, each company in their portfolio is subjected to a stringent and uncompromising filter.

The PMS from Consistent Compounders has ZERO entry/exit load and no lock-in. Our clients have the option of selecting from one of the following fee structures:

1. A fixed fees model (2% p.a. fixed fees + zero performance fees)
2. A hybrid model (1% p.a. fixed fees + performance fees of 15% profit share above a hurdle of 12%, no catch-up).

Performance fees are subject to a high water mark; the minimum investment is INR 50 lacs.

Area of engagement

• Corporate governance

Analysts utilize forensic accounting to keep a watch on cash diversion by our investee firms’ “promoters.”

• Succession planning

Many of India’s prominent ‘promoters’ are now 70 or older, thirty years after the 1991 reforms that freed up the Indian economy. As a result, they are passing the baton to the next generation.

• Capital allocation

• 1. Our investment approach, which entails investing in dominating franchises with a ROCE of over 40%, naturally leads us to businesses that produce a lot of free cash flow.
  2. The compounding of the franchise suffers if this Free Cash Flow is not intelligently reinvested.
• Regulatory constructs

India’s regulatory framework, particularly in terms of corporation law and securities market legislation, is still developing. This exposes the unsuspecting to danger.

Desired Outcome

• They leave if They notice diversion on a significant scale.
• If They notice the beginnings of what appears to be a small-scale diversion, They engage with the ‘Promoter’ and explain why her wealth production might be jeopardized.
• They keep a careful check on whether the ‘promoter’ is on top of his game through our talks with suppliers, customers, and rivals of the firm.
• If his successors do not exist or have not been properly trained, They examine the situation and its implications with him.
• They interact with the ‘promoter’ to understand her capital allocation thinking if They notice a firm hoarding cash or going into an unrelated industry.
• They convey our point of view if They are not satisfied that what she is doing is appropriate (arguing in favor of a different capital allocation strategy)
• If our engagement has made no effect after six months, They will consider terminating.
• They have worked to promote openness in the Indian fund management business by serving on several regulatory panels, writing in the press, and speaking out on regulatory change on social and broadcast media.

Use Forensic Accounting To Avoid Most Common PitfallsThe income statement (revenue/earnings manipulation), the balance sheet (accurate portrayal of assets/liabilities), cash pilferage, and audit quality checks are all covered by 12 accounting ratios. Financial data from the previous six years have been combined. To begin, rank stocks based on each of the 12 ratios separately (some examples are outlined in the table on the right). These rankings were then averaged across characteristics to get a final ranking of stock accounting quality, with D1 being the highest and D10 being the worst.Identify Companies With Superior Capital Allocation

If one creates a list of stocks using twin-filter criteria* of double-digit YoY revenue growth and return on capital exceeding the cost of capital each year for ten years in a row, and then builds a portfolio of these stocks each year and holds each of these annual iterations of portfolios for the next ten years (without churn), the bar chart on the right shows the performance of such portfolios.

There Are Two Conclusions From This Exercise:

• This filter-based portfolio generates annual returns of 20-30 percent (in INR) and outperforms the Sensex by 8-12 percent.
• For holding durations longer than three years, the volatility of such portfolios’ returns is comparable to that of a Government of India Bond.

The returns above (for both the filter-based portfolio and the Sensex) are calculated on a Total Shareholder Return basis, which means that all dividends are included.

Invest In Franchises With High Pricing Power And High Reinvestment Rates Using Marcellus’ Longevity Framework

Free Cash Flow growth rate

• Revenue growth, return on capital employed, and capital reinvestment rate
• Calculate the increase of industry demand, as well as its drivers and resiliency.
• Calculate revenue growth in relation to anticipated market share increases.
• Are profit margins and asset turns projected to improve significantly?

Moat score

Strength of today’s pricing power

Can a rival provide a product that is a third cheaper and have no effect on our investee firm’s profitability or market share?

Lethargy score

Analysis based on efforts made in the last 3 years

Three aspects of lethargy tests:

1)Deepening of existing moats on a piecemeal basis
2) Experimentation/investment in new revenue growth drivers that are moated
3) Attempts to completely destabilize the industry’s future

Succession planning score

Softer aspects to help build an ‘institution’. Four aspects of the succession test:

1) Execution that is decentralized
2) The quality and duration of the firm’s CXOs
3) Evidence of CXO succession implementation in the past.
4) The Board of Directors Independence

Factors driving SELL decision at Marcellus

• Complete withdrawal from a stock owing to a worsening in Marcellus research analysts’ perceptions of the company’s strength and competitive advantage sustainability (longevity).
• Optimizing portfolio concentration by exiting when new stock is added to the portfolio – owing to a rise in conviction levels about the strength and sustainability of the new company’s competitive advantages (which was hitherto not in the portfolio)
• Partially selling stock as part of a portfolio rebalancing to bring it in line with the relative belief in the stock’s fundamentals versus other equities in the portfolio.