• The London Finance Journal

The Equity Market in India is quite extraordinary




The most generalised metric used to understand any equity is its Market Share i.e. the ratio of total sales of the equity to total sales of the industry/product. Simply, it gives you the portion of the market controlled by that particular franchise. This metric has indicated massive growing competition among various companies across all sectors in India. Sadly, the goodwill of the Market Share formula has been widely successful to mislead investors, and thus hide the real crux of the Indian Equity Market.

If the Market Share was based on profit instead of revenue i.e. the ratio of total profit of the equity to total profit of the sector/product, it is fascinating to note that for every product that is essential for day to day life in India, there are either 1 or 2 equities who account for 85% of the profits generated from that industry/product. Despite the herd mentality of growing competition, India has 25 monopolists who have an average ROCE (Return on Capital Employed) of 45%.


For example, Britannia and Parle account for 85% of the profits generated from biscuits. Britannia is the high- end monopolist and Parle is the low-end monopolist creating hammer lock on the biscuit market.

As an investor, I was curious to understand the reasons behind this level of market penetration of monopolists. Until the 1960s, paint was sold just like a normal FMCG product i.e. from the factory the product would go to the wholesaler, then the distributor and finally to the dealer. In the late 1960s, Champaklal Choksey, the dominant founder-promoter of Asian Paints turned this paradigm on its head. He decided to buy a supercomputer and was the first one in India to do so. He bought it 10 years before ISRO(Indian Space Research Organisation). Through this, he developed a money machine that is unparalleled even today.

Mr Choksey got rid of the wholesalers and the distributors of Asian Paints and started selling direct to the firms 50,000 dealers. The remarkable distribution network that Asian Paints built in the late 1960s means that even today, paint is a unique sector in four different ways:

(1) Only sector in India where the product goes straight from the manufacturer to the dealer.

(2) Only sector where the dealer’s shop is replenished multiple times in the same day

(3) Only sector where the manufacturer (Asian Paints) earns 97% of the retail price of the product [in all other products the channel accounts for 30-40% of the retail price]

(4) Asian Paints’ distribution logistics are still unmatched.

So, whilst HUL, India’s largest FMCG company, has 7000 distributors to whom it delivers once a week, Asian Paints delivers to nearly 50,000 dealers four times a day!

Behind this remarkable network architected by Champaklal Choksey, is 50 years of proprietary data on paint demand for each neighbourhood in India, for every hour of the day, for every day of the year. That allows Asian Paints to forecast the paint demand just like Amazon can second guess what you will buy when you visit their website next. Asian Paints’ proprietary data, its forecasting ability and its distribution network give it a working capital cycle of 8 days. Nobody else in the paint sector comes remotely close to Asian Paints on this metric. As a result, Asian Paints ROCE (usually at around 30%) and free cash flows are head and shoulders above its rivals.


The above case study of Asian Paints and other equities like HDFC show how their innovative money machines developed high barriers for entry in the market providing them deep market penetration.

I realised that at the heart of all great money machines of India, exists a non-linear insight which at early stages appear to be absolute madness but eventually is undiluted genius. Now, as an investor, I look for high barriers of entry for every large cap stock I fundamentally analyse.

Before I look to question the standard of the business model of an equity, I look for companies with clean accounts using forensic accounting. I use the following forensic ratios that are accounting traps - more the failure more the fraud.


Following are the Forensic Accounting ratios:


I look at over six years of consolidated financials and rank stocks on each of the 10 ratios individually. These ranks are then cumulated across parameters to give a final pecking order on accounting quality for stocks.

I filter companies with Revenue YoY of 10% and 15% ROCE for 10 years continuously. These equities have compounded 20% with less volatility than a Government of India Bond. Finally, I skew my likes on equities that have monopolistic features. This process has indicated that 80% of listed companies in India are suspects of accounting fraud. 70% of Nifty companies have no free cash flow although the promoter has no shortage of cash. Minority shareholders don’t have cash, but promoters have it in their own life. In the long run, high accounting quality and efficient capital allocation define investment success. A look at longer-term stock returns suggests a direct relationship between better accounting quality and superior stock performance. In the shorter run, however, markets do have a tendency to test investors’ patience even if the investor is using the most time tested and rational investment methods. Hence during this period of irrational exuberance and abundant liquidity, where there is a pressure to chase near terms returns, quality does take a backseat.


As the above chart shows, over the longer term, there has been a strong correlation between the accounting quality and the shareholders returns.


After finding clean and monopolistic equities, another fascinating trait of the best stocks is the hunger to compound growth consistently by conservative capital allocation.

Stocks with deep-rooted competitive advantages deliver ROCE substantially higher than their cost of capital (CoC). The gap between ROCE and CoC is surplus cash flow generated by the firm, which can either be returned to shareholders through dividends / share buybacks, or it can be redeployed on the balance sheet. For a firm to consistently grow its profits over the longer term, it must sensibly allocate cash flows from operations. The best stocks that are clean and hungry invest in the core business. They redeploy capital back into areas in which the firm already possesses deep-rooted competitive advantages (which have led to the existing high ROCEs and hence free cash generation in the first place). Although this sounds obvious, as the firm grows and deepens its competitive advantages, the quantum of free cash flow available for redeployment tends to far exceed the amount that can be reinvested to grow the core business further.

Companies such as Page Industries and Relaxo Footwears have redeployed on average 50% and 90% of their annual operating cash flows, respectively. This entire capital has been reinvested to expand manufacturing capacities in their core operations, enhance IT systems etc. Moreover, every layer of geographical, within India, or product category expansion has been carried out organically in adjacencies which have a significant overlap with their existing core business. For instance, Relaxo has expanded pan-India into sports shoes, various sub- segments of casual footwear, from being just a north-India focused flip-flops oriented firm 2 decades ago. Page started offering only men’s inner-wear in the 1990s, and has subsequently expanded into leisurewear, sportswear and outerwear categories for men, women and kids. This enables growth of the company’s core business and leads to high ROCE. The strengths provided by the above methodology -

  1. Unique DNA of these companies – By ‘filtering in’ companies with a history of very consistent fundamentals over very long time periods, the portfolio is skewed towards companies with a DNA built around relentlessly deepening their competitive moats despite disruptive changes taking place both inside as well as outside the organisation. More often than not, such DNA sustains over the subsequent 5-10 years investment horizon of the filter-based approach.

  2. Power of Compounding – Holding a portfolio of stocks untouched for 10 years allows the power of compounding to play out such that the portfolio becomes dominated by the winning stocks while losing stocks keep declining to eventually become inconsequential.

  3. Avoiding the pitfalls of psychology and reducing transaction costs – Being patient with the portfolio helps cut out the noise of trying to time entry and exit decisions.

This also proves that Large Cap investing is not as safe as it is assumed in the Indian population due to high accounting frauds.

Almost 50 equities are listed and delisted from BSE 500 every year indicating high degree of churn. When a new stock enters, it trades at book value. When it compounds, it is discovered by large PMSs and Mutual funds which three folds the market price of the new entrant. This difference is called discovery premium. To successfully find a small cap stock which is clean, hungry and have high barriers to entry can give huge returns with the discovery premium. To find such equities, I look for small companies that are essential to Large Caps. This essential relationship gives the small cap stock enormous bargaining power to generate consistent ROCE and returns.


Following are the checkboxes to find a small cap equity that is clean, has conservative capital allocation and have high barriers to entry-

  1. SMEs, often family owned, producing inconspicuous products but ranked top for that product.

  2. Normally work in niche markets for which they design unique products often using proprietary process.

  3. Operate extremely close to their customers who depend on their products and cannot change their source.

  4. Competitive advantages of such firms are rarely because of cost leadership but more quality, total cost of ownership, high performance, and closeness to the customer.

  5. Large caps are dependent on them giving them bargaining power.

  6. Sector leading franchise with stellar track record of capital allocation. Clean accounts and corporate governance and high growth potential.

‘Survival of the Fittest’ – Charles Darwin

The current recession which can potentially be a Depression is an event-driven recession as it is mainly a Health crisis. As no human is immune to this disease, the ones who have the strongest quality of immune system will survive and evolve. This whole period of crisis can be thought off as a phase of Evolution. Thus, it all comes down to surviving this through to individually and collectively evolve and defeat this health crisis.

Likewise, ‘Survival of the Fittest’ is not only applicable to humans but is also applicable to the Equity markets around the globe. Thus, following the above methodology will develop a high-quality portfolio of equities that will not only survive through this phase of evolution, but also bring enormous returns.



By Divyansh Agrawal

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