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Diamonds In The Dust (Consistent Compounding For Extraordinary Wealth Creation)

Hello, flocks, After a short break, I'm back. Due to my intense busyness during the past two months, I haven't had much time to read. Today I am going to talk about the book which took me more than one month to read. I would say it's part 2 of Coffee Can Investing written by once again Saurabh Mukherjea, Rashit Ranjan, and Salil Desai.





After coffee can investing. I eagerly want to read this book because that book taught me how to pick consistent compounding stocks, but in this book, the author will teach us how to find good consistent compounding stocks & how to do forensic accounting also. (Note: CCP means consistent compounding).


Author Description: As you may know, Saurabh Mukherjea is the founder and chief investment officer of Marcellus and the author of several excellent books, including Victory Project, Gurus of Chaos, Unusual Billionaires, and Coffee Can Investing. Rakshit Ranjan is a Chartered Financial Analyst and the fund manager of Consistent Compounders PMS in Marcellous. He was also a co-author of the book Coffee Can Investing. Salil Desai is a chartered accountant and MBA working in the Indian equity market for over sixteen years. He also works as an adviser at Marcellus.


Coffee can investing will teach you how to do a capital allocation and that book pointed out that to generate good return equity investing will give you a good return the second thing you will learn about consistent compounder stocks that generate a good return in the long run. I'll bring up a few points from the book here, but if you want to read that book blog, click on the link below.



1) To find a CCP stock, look for sales that have increased by 10% per year. Again, this will tell you to look for a stock whose sales have increased by 10% year after year.


2) Second, it should surpass the cost of capital. That means that in India, a company's cost of capital is around 14 to 15%, so your ROCE should be greater than the cost of capital. Find a company with a ROCE that is always greater than the cost of capital.


The author of this book provides the formula to identify a Consistency Compounding stock. Their strategy is to acquire reputable, well-run Indian businesses with extremely high entry barriers and optimal capital allocation.


  • Clean accounting: Finding such organisations that we can rely 100 per cent on their annual report or quarterly statements


  • Competitive Advantage: Finding an industry or sector with high entry barriers means that other players cannot enter or, if they do, it will be difficult for them to compete.


  • Capital allocation: Find businesses that utilise surplus returns well in order to expand their operations and strengthen their competitive edge.


Now let us know how Marcellus' level of checking in detecting fraud


Level 1: To identify non-financial organizations with accurate accounting, use Marcellu's Forensic Ratio.


As you are aware, clean accounting is the first pillar of Marcellus' CCP stock. In order to rate businesses on their accounting quality, they have created a system of twelve ratings. The classic book on forensic accounting and financial fraud by Howard M. Schill served as an inspiration for the selection of these quantities


"Time in the market is more important rather than timing the market."


Marcellus's Forensic ratios to evaluate accounting quality of non-financial companies

Ratio

Rationale

Remarks

Income statement checks

​A) Cash flow from operations (CFO) as % of EBITDA


B) Year-on year volatility in depreciation rates





C) Change in reserves & surplus explained by the profit/loss for the year & dividends

A) To check aggressive revenue and earning recognition practices


B) Being a non-cash charges, it is easy to manipulate earnings by changing depreciation policy and/ or rates


C) To check direct knock-offs from balance sheet instead of routing through P&L




Balance sheet checks

A) Yield on cash and cash equivalents.



B) Contingent liabilities as % of net worth (for the latest available year)

A) To check cash balance misstatement or cash mis-utilization


B) Indicative of the extent of off-balance sheet risks

Cash theft checks

A) Capital work in progress to gross blocks


B) Free cash flow (cash flow from operations + cashflow from investing) to median revenues



​A) High ratio may indicate unsubstantiated capex


B) To check if cash generated by business is being siphoned off or whether reported revenue/earnings are believable

Auditor objectivity checks

A) Growth in auditors' remuneration to growth in revenues

​A) Faster growth in auditors' remuneration vis-a-via company's operations raises concerns surrounding auditors' objectivity


Level 2: Additional audits of accounting and corporate governance.


These tests, which go beyond the forensics screens, are typically used while conducting their in-depth due diligence on certain organizations. Their forensic investigation enables us to pick out businesses with questionable accounting standards. It also enables us to recognize the main accounting warning signs for a business. Forensic and corporate governance checks beyond the quantitative screens

Advanced accounting checks

​Corporate governance checks

​Comparative common-sized income statement vs peers to analyse any significant divergence in P&L items vs peers

Related-Party transactions and their significance

Comparative Dupont analysis vs peers

Other business interests of promoters (any significant stress in those business, etc.(

R&D capitalization vs charges to P&L

M&A with promoter-owned entities

Goodwill as % of net worth

Significant litigation surrounding promoters

Frequent changes in auditors

Promoter family structure, succession, etc

Any significant adverse comment in the auditor's report

Pledge of promoter shareholding

Any significant portion of company's operations (such as subsidiaries) not audited by the principal statutory auditor

Insider buying & selling

​Quality of audit committee (whether chaired by an independent director)

​Remuneration to promoters

​Frequent changes in accounting periods

Frequency and necessity of equity dilution

The integrity of the company's management and promoter is the main focus of the last level of accounting quality tests. Through thorough discussions with our main data sources, they are determined to be the next level of accounting quality checks. They look for validation of the impressions painted by the company's financials from the primary data sources that are familiar with, have dealt with, and comprehend them. Customers of the company's products, channel partners, raw material suppliers, rivals, and others are examples of these sources. This is crucial, especially for small caps with a short operational history and a strong propensity for falsified accounting.


Level 3: Extensive Diligence through primary data checks.


The integrity of the company's management and promoter is the main focus of the last level of accounting quality tests. Through thorough discussions with our main data sources, they are determined to be the next level of accounting quality checks. They look for validation of the impressions painted by the company's financials from the primary data sources that are familiar with, have dealt with, and comprehend them. Customers of the company's products, channel partners, raw material suppliers, rivals, and others are examples of these sources. This is crucial, especially for small caps with a short operational history and a strong propensity for falsified accounting.


My thoughts on this book: This book focuses on how Marcellus selected a reliable compounding stock and how we may examine the business and conduct our own forensic investigations. Despite the fact that the authors include numerous case studies that might aid us in avoiding fake firms where prompters just make money. If you are investing in equity this book is the one to grab.

 

This month, I read Ichiro Kishimi and Fumitake Koga's Courage to Be Disliked. This book is entirely dedicated to Adlerian Psychology. It imparts the most important life lessons. Everyone should read this book at least once. This book blog is currently under construction. I'm hoping to realise it next month.

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