This is an excerpt from the book ‘Coffee Can Investing: The Low-Risk Road to Stupendous Wealth’ by Saurabh Mukherjea. Bestselling author of Gurus of Chaos and The Unusual Billionaires, Saurabh Mukherjea has spent most of the past decade trying to construct and implement systematic methods for analysing Indian companies in the midst of the chaos that surrounds the Indian stock market. A London School of Economics alumnus, Mukherjea is also a CFA charter holder.
This excerpt has been taken from the chapter, ‘The Coffee Can Portfolio: Robust Returns with a Low Degree of Uncertainty’. This is an introduction to an investment concept of Coffee Can Portfolio and it’s significance in Indian Context.
Headquartered in Los Angeles, Capital Group is one of the world’s largest asset management firms with assets under management in excess of US$1.4 trillion. In the late 1960s, Capital Group set up an entity called Capital Guardian Trust Company whose aim was to provide traditional investment counselling services to wealthy individuals. Robert Kirby joined Capital in 1965 as the main investment manager in Capital Guardian Trust, where his job involved advising high net worth clients on investments and managing their portfolios. Nearly twenty years later he wrote a remarkable note which introduced to the world the concept of the ‘Coffee Can Portfolio’.
Kirby, in a note written in 1984, narrated an incident involving his client’s husband. The gentleman had purchased stocks recommended by Kirby in denominations of US$5000 each but, unlike Kirby, did not sell anything from the portfolio. This process (of buying when Kirby bought but not selling thereafter) led to enormous wealth creation for the client over a period of about ten years. The wealth creation was mainly on account of one position transforming to a jumbo holding worth over US$8,00,000 which came from ‘a zillion shares of Xerox’. Impressed by this approach of ‘buy and forget’, Kirby coined the term ‘Coffee Can Portfolio’, a term in which the ‘coffee can’ harks back to the Wild West, when Americans, before the widespread advent of banks, saved their valuables in a coffee can and kept it under a mattress.
Although Kirby made the discovery of the Coffee Can Portfolio sound serendipitous, the central insight behind this construct—that in order to truly become rich an investor has to let a sensibly constructed portfolio stay untouched for a long period of time—is as powerful as it is profound. After all, the instinctive thing for a hard-working, intelligent investor is to try and optimize his portfolio periodically, usually once a year. It is very, very hard for investors to leave a portfolio untouched for ten years. A retail investor will be tempted to intervene whenever he sees stocks in the portfolio sag in price. A professional investor will feel that he has a fiduciary responsibility to intervene if parts of the portfolio are underperforming. But Kirby’s counterintuitive insight is that an investor will make way more money if he leaves the portfolio untouched.
Five years ago, inspired by Kirby’s 1984 note on ‘Coffee Can Portfolio’, analysts at Ambit decided to recreate the Coffee Can Portfolio for Indian equity investors.
The Coffee Can Portfolio comes to India
In the Indian context, we have built the Coffee Can Portfolio using a simple construct: we use straightforward investment filters to identify ten to twenty-five high-quality stocks and then leave the portfolio untouched for a decade. Both in back-testing and in the live portfolios that we manage for our clients, we have found that this simple approach delivers consistently impressive results. In particular, the portfolio not only outperforms the benchmark consistently, it also delivers healthy absolute returns and, more specifically, it performs extremely well when the broader market is experiencing stress.
Before we detail the returns delivered by the Coffee Can Portfolio, let’s explain the simple investment filters that we employ. To begin with, of the approximately 5000 listed companies in India, we will limit our search to companies with a minimum market capitalization of Rs 100 crore, as the reliability of data on companies smaller than this is somewhat suspect. There are around 1500 listed companies in India with a market cap above Rs 100 crore. Then, we look for companies that over the preceding decade have grown sales each year by at least 10 per cent alongside generating Return on Capital Employed (pre-tax) of at least 15 per cent.
Why Return on Capital Employed (ROCE)?
A company deploys capital in assets, which in turn generate cash flow and profits. The total capital deployed by the company consists of equity and debt. ROCE is a metric that measures the efficiency of capital deployment for a company, calculated as a ratio of ‘earnings before interest and tax’ (EBIT) in the numerator and capital employed (sum of debt liabilities and shareholder’s equity) in the denominator. The higher the ROCE, the better is the company’s efficiency of capital deployment.
Why use a ROCE filter of 15 per cent?
We use 15 per cent as a minimum because we believe that is the bare minimum return required to beat the cost of capital. Adding the risk- free rate (8 per cent in India) to the equity risk premium of 6.5 to 7 per cent gives a cost of capital broadly in that range. The equity risk premium, in turn, is calculated as 4 per cent (the long-term US equity risk premium) plus 2.5 per cent to account for India’s credit rating (BBB-as per S&P). A country’s credit rating affects the risk premium as a higher rating (e.g. AAA, AA) indicates greater economic stability in the country which lowers the risk premium for investing in that country and vice versa.
Why use a revenue growth filter of 10 per cent every year?
India’s nominal GDP growth rate has averaged 13.8 per cent over the past ten years. Nominal GDP growth is different from real GDP growth as unlike the latter, nominal GDP growth is not adjusted for inflation. In simple terms, it is (GDP) evaluated at current market prices (GDP being the monetary value of all the finished goods and services produced within a country’s borders in a specific time period). A credible firm operating in India should, therefore, be able to deliver sales growth of at least that much every year. However, very few listed companies, only nine out of the 1300 firms run under our screen, have managed to achieve this. Therefore, we reduce this filter rate modestly to 10 per cent; i.e. we look for companies that have delivered revenue growth of 10 per cent every year for ten consecutive years.
Following the Coffee Can Portfolio approach can lead to high-quality, low-risk investing. Coffee Can Investing is a great book if you want to learn how to go about low-risk investments that generate great returns.
Where did this term “Coffee Can Investing” come from?
Coffee Can Investing is a concept that originated in the US. This term was first coined by an American investment manager, Robert G. Kirby, in 1984. The name came about because of the old practice in old West America of people hiding their valuables in coffee cans and then placing them under the mattresses, where they stayed for decades. This way, such an investing strategy is known and famous for provisioning high returns in future.
What is something a beginner should keep in mind while investing?
The first and foremost thing to consider for a beginner is what goal you want to achieve by investing and the length of time you have to invest before reaching that goal. It is also important for you to understand your personal risk tolerance as all investments have some level of risk, and the market is volatile. You have to consider how comfortable you are with risk or how much volatility you can handle. When investing, one thing an investor should keep in mind is to not put all of the eggs in one basket. Diversification is the key. Consider an appropriate mix of investments and beware of frauds.
What is the difference between investing and trading?
Investing takes a long-term approach to the markets. The goal of investing is to gradually build wealth over an extended period of time through the buying and holding of a portfolio of stocks, basket of stocks, mutual funds, and other investment instruments. On the other hand, trading involves short-term strategies with the motive of maximising returns in the short run. Trading involves more frequent transactions and has high risk associated with it. Traders sell the stocks if the price goes higher. Trading is a skill of timing the market, whereas investing is the art of creating wealth by compounding interest and dividends over the years.