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Hi guys. Welcome to School of Intrinsic compounding. So, in today’s video we will be talking about a very important mental model and a very interesting mental model too. So, the name of the mental model is California Goldrush and what happened with it? A famous technique was introduced of Peter Lynch by the name of Shovels and pans technique.
Let’s understand this before stock picking that how can we apply the mental model in this stock picking in Indian stock markets. Let’s have a look at the history. So, California gold rush took place in 1848. When nearly 3 lakh Americans left their jobs, left their homes, left their livelihoods just to go to California to mine for gold.
And what happened as a result was yes even though the gold was found but very few people made money in the California gold rush. Whereas most of the miners were left empty handed. Basically, they were earning only enough money to sustain themselves. But guys a very important mental model to understand over here is based on this trend a different class of people got rich altogether.
Who were just different class of people? These were the general store owners near California. It was a grocery shop. What were these grocery shops doing? Basically, they were selling shovels, pans and jeans to the people, to the miners. There is an uncertainty in mining that you may or may not get the gold but in eating and drinking, there is a certainty.
You have the demand for this, there is an annuity demand over here always. If you are using a shovel so much than its obvious that it will break someday and you will need to replace the shovel with a new one otherwise you cannot do business. Moreover, you will eat food daily, you will wear jeans and it may tear off as you are doing mining so guys you will be very surprised to know the name of the company is Levi’s jeans which was born due to this trend.
The material of denim jeans was only made considering the miners so that it won’t get torn off easily as compared to other trousers which used to get torn off easily. So, material of denim jeans was totally inspired by the miners and made considering them. So, as a result very few people in miners got rich but the ones who were providing services to the miners, they kind of became service providers and annuity came into place.
They got even richer than the miners. General store owners on an average were better of after the gold rush in California as compared to the miners. So, guys similarly there is a similar trend in investing right now. Let’s start with couple of companies which are listed abroad then we will come to the Indian companies and we will discuss about some 10 to 15 Indian companies and will see in their financial business where does the number reflects.
So, guys starting with abroad. I will give 2 examples of abroad. 1st company name is Verisign which is very interesting according to me. What Verisign does is that they basically own the domain name of .com It is a regulatory body of .com Whenever you open facebook.com or google.com or you open anything with .com than the website has to pay Verisign close to 3 to 4 dollars every year for using the .com domain name.
Guys just think about it. You are making a website, right. And you have to keep a name of .com. So, if you make a website with the name of .com than there is a toll tax of someone else, your growth has a toll tax of someone else. So, you have to take a .com name. 2nd such example is the platform on which you are watching this video.
YouTube, basically. What happens in YouTube is that there are many content generators but very few content generators earn money. Due to content generators, there are many publics coming on YouTube to watch the videos. So, what is happening right now is that content generators are earning less money.
Public is giving attention to YouTube platform. As a result, what is happening that the content generator growth is like miners out which very few are able to make money but YouTube platform will surely keep on earning money always because YouTube is getting advertisement business because people are giving attention to YouTube.
Why we are giving attention to YouTube? Because content generators are generating content and uploading on YouTube. So, YouTube is a sure short bet. Before we proceed to Indian examples there is another example which is listed in abroad which we can talk about, the name of the company is Christian Hansen.
So, what does Christian Hansen does? Basically, they develop enzymes. We eat Nestle yoghurt, right. We eat particular yoghurt of Nestle. Suppose, if we eat Greek yoghurt of any particular flavor than that flavor, we have been liking from last 10 years. In that flavor, a particular enzyme has been used so that company will be supplying Nestle with that enzyme.
Due to this that company makes higher returns on capital than Nestle itself. Because you are taking enzymes from that company so you won’t want that enzyme to change. As enzyme didn’t changed, taste didn’t change and customer didn’t leave. I hope everyone remembers the new coke fiasco, right. There is a very big feedback of taste here.
Now guys coming to the Indian examples. In Indian examples there are lot of companies which we can use as a strategy to get the benefit out of it. So, one of my favorite industries in last 3 to 4 years have been very bullish on that industry is the amines industry. So, what are amines? Basically, it is used in your bulk drugs.
What are bulk drugs? Bulk drugs are your APIs – active pharmaceuticals ingredients. So, amines are used in the production of active pharmaceutical ingredients. As I don’t go in depth, there is a complexity in API, sometimes US FDA observations arrive to indirectly play the API industry, I bet on amines industry through alkyl amines and Balaji amines.
You will make medicines and put salt in those medicines. In salt there can be a regulatory risk. Moreover, it’s a very capital-intensive business. Even though amine is also capital-intensive business but I will come to that part later. Here, there is a regulatory risk too. So, through amines industry you can indirectly play in API industry as amines is used in APIs.
In 2020 numbers, alkyl amines ROCE that is the return on capital employed is more than 30%. If I keep aside their hotel business and CFL business than Balaji amines ROCE that is the return on capital employed is even better than alkyl amines. It is close to 32 to 33 percent. Even though these are at very historically high level and it may come down but across the cycle these guys have made 20 to 25 percent return on capital employed.
Because what is happening is if I take an API player then what is the risk that if US FDA observation arrives then my stock will collapse by 30 to 40 percent overnight. As it happened in Divi’s labs case. Even though it’s a brilliant company means whatever they have built, every Indian should be proud of such companies.
But the problem was in 2017 the moment regulatory issue arrived; stock went down by 50%. Very few people can hold such stocks when they go down by 50%. Whereas in amines industries what happened that if you are giving it to Devi’s then you will not be impacted much as you are already supplying to the entire bulk drug industry.
So, guys this was one trend. You can look for Alkyl amines and Balaji amines, I have personally liked Alkyl amines may be not at these valuations because margins are also really high. So, coming to the 2nd company which we can play this trend out of is the industry of Crams, CMO and CRO. Basically, your contract research and manufacturing services and contract research organization and contracts manufacturing organization.
So, if CRO and CMO is a part of any company then we call that as Crams. So, suppose there is one company in which there is a lot of expenditure in R&D, I was recently reading a report and I got to know that the outside companies spent close to 17% of their sales in R&D for new molecule. Now, you suppose you are spending 17% on R&D and the molecule is not succeeded than it is such a big risk on your P&L, right.
If you have capitalized those assets than there is such a big risk on balance sheet as well. I think expense is a better strategy. But what happens is that there are few crams players like if we talk about Suven Lifesciences. Sorry, its not Suven Lifesciences, it is Suven pharmaceuticals. Then we talk about Divi’s laboratories.
Then we can also talk about Syngene. So, what are these players doing basically these players are acting as service providers. Sir, do R&D of your molecule. Whatever is its manufacturing or whatever are the services, molecule development or molecule discovery services so we can come and help you out with it.
Syngene is totally an integrated model. Syngene basically, will work from molecule discovery to molecule manufacturing. Syngene basically reminds me of a very good company in China by the name of Wuxi Apptec which is a company of 200 billion dollars market capitalization and they are still growing at 30 to 33 percent in biologics business.
All this is not important to understand but you need to understand that these guys are service players. So, their valuation should be higher than the upstream guys valuation. Because upstream says that they are doing R&D and making molecules. And downstream or the one basically which is moving with you in side cart they are your service providers.
These are basically coming to you with a platform that Sir, there is everything for you in this plate to eat. You can have your choice. But you need to pay us for it. There is hardly any risk in service providers as compared to the risk in doing R&D. There is a lot of risk in R&D and we are afraid of it.
Guys, 3rd category of business which we can look at is basically glass lining equipment providers. Now, what is the problem with glass lining equipment providers is that here the replacement cycle is 10 to 12 years. So, they earn a lot of money when there is a new capex in the industry means when there is new capacity expenditure or capital expenditure.
So, there is some risk here as it is not an annuity driven business model as compared to the earlier ones we talked about. Syngene and other companies have a lot of annuity driven business. Here, GMM Pfaudler and HLE Glascoat are the examples. We are going to create very in-depth videos for these 2 companies.
They have informed about GMM Pfaudler but nobody has notice HLE Glascoat yet. HLE Glascoat can be similarly a very interesting company as GMM Pfaudler, right. GMM Pfaudler have been one of the best performing stocks in last decade. One of the reasons is that there is so much capex happening in chemical industry that GMM Pfaudler is indirectly benefitting out of that capex because 10% capex cost is received by these players who are your GLE equity providers.
Again, an interesting trend to watch out for and these guys are also making 25 to 30 percent plus return on capital employed numbers, right. As compared to your chemical companies, some make extraordinary level of numbers like Vinati organics but most of them make 15 to 20 percent return on capital employed.
Coming to the 4th category of companies, these are your railway companies. It is a PSU sector. I personally don’t like PSU sector so much nor I will suggest investors to see PSU sector as there is a risk of capital misallocation in it. But there are still 2 companies present over here which are similarly beneficially of a similar trend.
Name of the 1st company is Rites. Rites is basically providing consultancies services, right. You set up railway, make capex in railway, if you set up airport than Rites will give you consultancy services and their return on capital employed is more than 20 to 25 percent and second category is IRCTC which is a platform company.
So, whenever you book a ticket, you do it through IRCTC. Indian railway which is a capital heavy business, someone else is taking advantage of the Indian railway business that is IRCTC as they are bring a platform. Platform economics would always be superior than the upstream economy. Always remember this point.
Link to platform business is info edge. When we talk about platforms in India, we cannot ignore info edge. So, Info edge is a platform in itself. Info edge is indirectly taking an advantage of a lot of industries so Info edge have already invested in policy bazar. Info edge has already invested in Zomato.
They also want shoe connect. Shoe connect is a very great business. Shoe manufacturers must be aware of it. Except this Info edge owns Naukri.com. They want 99 acres. They want Jeevansathi. They want Shiksha.com I have a friend who have a business of career counselling and of admissions so he got all the leads from Shiksha.com.
I can see that and tell that Shiksha.com is indirectly growing through his business, right. Even though that business might not be profitable right now. But in Info edge case if someone is actually looking at Info edge so what you have to look at is not what they are today, you need to focus on what it can become in future.
Because platform economics is such an economics where you make a lot of money. If Shiksha.com owns all the leads than where will all the counselors go? They will all got to Shiksha.com, right. And over a period of time, it will be easy for Shiksha.com to increase the prices slowly. Same goes for Naukri.com.
If today, India wants to grow than job creation needs to be done, right. If job creation will happen than directlyNauri.com will benefit out of it. Because 70 to 80 percent today, you have made a monopoly. You have markets share. Monster.com is nothing in front of them. Moreover, Indeed.com is nothing.
I think Times and shine jobs is also very behind. So, this is another interesting company to watch out for. One more company you can talk about is Honeywell automation. Automation is going to be a very big theme after this coronavirus. It has already been a very big theme in the last decade. Guys, people keep telling me that capex is not done in 2003 to 2008 Guys, you are looking at a wrong thing.
Opex is done vastly. So, what is opex? It is an operating expenditure as compared to capacity expenditure. So, what happens in opex is that basically you upgrade the factory slowly. So, the current factories have upgraded the automation power a lot and moreover what Honeywell automation is taking advantage of is that Honeywell automation in India is using as a low-cost manufacturer to export to other countries.
If I remove the excess cash on the balance sheet of Honeywell automation. They are making close to 70 to 80 percent on return on invested capital which is just mindboggling. As earnings growth is high and 70 to 80 percent return on capital they are earning so these are not numbers which have to be scarfed at so it is a very nice number.
Similarly, there is one more company where similar trend can play out. I am not saying it will play out but it can play out. Name of the company is Orient refractories so we can see steel players like TATA steel, GSW steel. TATA steel over the cycles only makes 10 to 15 percent ROCE in numbers and sometimes it is negative whereas your Orient refractories have made the return on capital employed of more than 40% for the last 6 to 7 years.
It was 60% at one time. I think there was excess cash on balance sheet due to which we can see the number is inflated. Just think about it, 40% ROC. In last 5 years, if you compare what was happening to steel cycle and their profitability then you will find that probability wasn’t budging much. And very interesting trend that can play out in this company is RHI Magnesita which is the world market leader in refractory products has recently acquired Orient refractories.
What they are going to do? They will merge their subsidiaries with Orient refractories. Like MNC used Honeywell automation as a low-cost exporter, similarly, RHI Magnesita can use Orient refractories as an exporter. So, guys it is an important trend and interesting company. It should be on your radar.
If anyone wants to study then you guys should study. And guys, there is one more company who can take advantage of FMCG capex and the company name is Axtel industries. They make FMCG machineries and they also make good numbers but guys important to realize in all of these trends is that you need to take care here that which is annuity driven business and which is capex driven business.
If you come in capex driven business and end user capex is collapsed, like for example if you take a company like Sterlite technology and the end user – 4g and 5g telecom companies if their capex defers and their capex collapse than what will happen with you is that your stock will drop like anything in 80 to 90 percent.
Because their growth is dependent on the end users which are capex oriented. So, we feel the same in GMM Pfaudler and HLE Glascoat. So, in next video or next to next video we will going in depth about these business modules which includes HLE. Whereas the 2nd type of business we have is the annuity driven business where replacement cycles are very less.
Replacement cycles are of 2 to 3 months and in some cases, it can be 2 to 3 days too. So, we like these kinds of businesses. As you are at least assured of the demand that the demand won’t fall off the cliff. Moreover, if it is supplier side concentrated and there are only 1, 2 or 3 players in competition than guys you are potentially sitting on a gold mine, if you buy at the right valuations.
So, guys before ending the video, I would like to draw your attention towards the description where we have mentioned all the companies who are taking advantage of different trends. Along with the return on capital employed numbers and you just compare these ROC numbers with other companies and I think 2 companies which I completely forgot during the video is another interesting trend that is AI engineering and another one is your Abrasive manufacturers.
You can check these two also. So, guys thank you for joining in the video. If you have any suggestions, if you have any feedback, if you have any recommendation for any new company you want to study, do mention it in the comment box. See you in the next video. Thank you guys.
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