Dear Fellow Investors,

High expectations (valuations) steal the joys of life (investing) 

Stock prices reflect future expectations. The higher the expectations, the lower the room for positive surprise—both in life and investing. When valuations are stretched, the risk of disappointment rises, making aggressive investments at elevated prices a potential recipe for regret.

As of 31^st March, about 50% of the top 700 companies (market cap > Rs 5,000cr) traded at or above 40x trailing price to earnings (P/E) ratio (including loss making companies). This is after some moderation from Sep 2024 highs when that count was over 60%.  Average P/E of BSE 500 index has been around 22x for past two decades.

A 40x P/E roughly builds in an expectation of an 18% annual free cash flows growth for a decade, followed by 5% growth for the next 90 years. At 100x P/E, those expectations rise to 25% and 8%, respectively—expectations that nearly 10% of these companies are pricing in today! 

Of these 40x+ P/E companies having listing history of 10+ years, only 20% have been able to grow their earnings at or over 18% for last 10 years. The median 10-year earnings growth of these companies has been 15%. A caveat here – many sectors are at their cyclical top – for example PSU banks, railways, defence, capital goods, real estate, power, oil & gas, hospitals, hotels, capital market facing firms etc. There are high chances that the median future 10-year earnings growth for this cohort will be lower than 15%.

Sustaining high growth for decades requires two ingredients—moat and demand. Moat or competitive advantage refers to entry barrier(s) that provides protection against competition, while demand determines the size of the opportunity. Of the two, moat is essential. Without a moat, rapid growth attracts competitors, squeezing margins and returns. Even if this is temporary, picking ultimate winner becomes difficult.

Today, Indian companies trading at or above 40x P/E span diverse sectors – auto and auto-ancillary, paints, wires and cables, quick commerce, airlines, hospitals, hotels, footwear, clothing, retail, luggage, solar, wind, jewellery, FMCG, QSR (quick service restaurants), electrical appliances, salty snacks, writing pens, plastic products, commodity chemicals etc.

Many of these sectors have no, narrow, or weakening moats. Two broad factors are driving such high valuations:

1. Overestimating fundamentals:

• Misjudging growth: Cyclical/ temporary growth is misjudged as structural tailwind (e.g., the Indian chemical sector post-2014, COVID-driven demand spikes in healthcare, capital goods due to government capex etc.).
• Overestimating market size: Many consumer categories in India have a smaller actual market than initial optimism suggests. Also, a part of consumption is fuelled by unsustainable debt.
• Weakening competitive advantages: Technological shifts and new distribution models (e-commerce, quick commerce) have weakened moats in many sectors including FMCG, retail, consumer durables, and quick service restaurants (QSRs). Artificial Intelligence may also disrupt moats in future.
• Growth attracting competition: High-growth sectors such as telecom, paints, wires, airlines, retail, and diagnostics have seen new entrants dilute profitability.
• Overestimating management quality– Great managements protect and/ or strengthen the moat through culture, capital allocation and efficient execution. Without moat, however, their abilities to protect growth and profitability is reduced (passenger vehicles for example). The subset of businesses, where management is the moat (banking and general insurance for example) is small. Outside of this set, giving high multiples for business lacking strong moat only because of quality management may lead to overvaluation.
• Regulatory tailwinds – Regulations or government protection can give temporary bouts of growth (eg, public capex, license etc); however, regulations and governments can change. Price curbs or caps can be introduced in consumer interests (eg telecom, real estate, micro finance, city gas distribution etc.).

2. Flows driving prices: Often non-fundamental reasons like global and local flows (due to momentum, index inclusion, or lack of alternative opportunities) can drive prices. The current episode of buoyant prices in India can partly be attributed to unprecedented flows from retail investors further supported by ease of trading and positive narratives painted by media and fund managers. In such an environment, price movements become shorthand for quality, and the belief that “rising prices equal strong fundamentals” can take hold. This creates a self-fulfilling prophecy where valuation metrics and underlying business fundamentals are overshadowed by the prevailing market sentiments.

In the short run, imaginations can continue to run wild and valuations can stretch beyond reason. However, the maths ultimately needs to add up. Time ultimately acts as a reality check. If growth, profitability or capital intensity turns out weaker than lofty expectations, price resets can be sharp.

Investing involves looking into the future and many times it is not that easy to judge the nature of moat and future growth. These are all the more reasons to demand margin of safety.

Markets fell from their Sep’24 highs and they recovered some ground in the month of March. As of writing of this letter, US tariffs have led to fall across markets including India. While valuations in many pockets continue to imply unreasonably high expectations, some entry points have emerged. Changing the stance from Cautious to Neutral.

A. PERFORMANCE

A1. Statutory PMS Performance Disclosure

Risk is under our control, not returns

The above statutory performance table captures returns but not risks. That’s because risk isn’t a neatly quantifiable number that can be benchmarked periodically. Yet, managing risk—not predicting returns—is the one aspect of investing firmly within our control. A simple but difficult way to do so is by focusing on the quality of the businesses we own and the price we pay for them. And, in absence of either, waiting for them by parking the cash in liquid and safe instruments.

The secret in equities is that in long term, low risk can lead to moderate to high returns for most investors, but high risks lead to lower returns for most investors. Operating word is “most”. A few may achieve extraordinary short-term success through sheer luck or randomness, but for the vast majority, the only dependable way to earn satisfactory returns is through consistent risk management.

However, much like vaccines or insurance, risk control often feels unnecessary in investing. As long as things are going well, all three seem like an avoidable cost, a needless drag. But their true value becomes clear when uncertainty strikes. The prudent approach is to spread this cost over time, rather than defer it, because risks, when ignored, can compound and strike with fatal force.

Investors got a glimpse of this in the latter half of FY 2024-25. For many newer participants, the market correction may have been a shock. But for experienced investors, it was not unexpected. We had been preparing—not by making dramatic market calls, but by being cautious and accepting smaller, more manageable doses of discomfort: the pain of underperforming and looking out of sync when euphoria prevailed. Our higher cash equivalents amid lack of meaningful opportunities over last few years was a result of this caution. It took its toll in terms of lesser relative returns. But that’s a far better price to pay than the alternative—finding oneself out of money, conviction, or emotional strength when the tide turns.

A2. Underlying business performance

Trailing Earnings: So long as we do not overpay, our returns will track or exceed the earnings growth of our underlying companies. We track the earnings available to per unit of PMS through Earnings per Unit (EPU) metric. This is calculated by taking normalised earnings accrued to our portfolio divided by PMS units. For the trailing twelve months ended Dec 2024, our EPU came in at Rs 9.2 per unit, higher by 15% year on year.

1-Yr Forward Earnings: We retain our EPU guidance for FY25 at the range of Rs 8.5-9.5 per unit.

A3. Underlying portfolio parameters

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

There were no mistakes to report in this period.

B2. MAJOR PORTFOLIO CHANGES

Bought: We added to two existing positions. 

Sold: We have completely exited from CDSL at 8x gain from our average cost.

CDSL Exit (8x gains) and Learnings

In our past letters, we’ve shared our approach to selling—while we tolerate some overvaluation as long as fundamentals remain stable, we reassess when they weaken. In the case of CDSL, we believe the fundamentals are now weakening.

CDSL’s revenue is significantly tied to equity market activity, including cash market deliveries, IPO applications, corporate actions (rights issues, bonuses, buybacks, etc.), and KYC transactions. A bull market of last four years has helped CDSL increase its profits by 3.3x. However, as markets declined 7-9% in the December quarter, CDSL’s revenue growth slowed. Given CDSL’s high fixed-cost base, profit after tax (PAT) grew even more slowly than revenue.

Looking ahead, we expect India’s exceptionally high retail participation—up 3-10x over the past four years—to moderate as market valuations remain elevated and volatility increases. Meanwhile, fixed costs like employee and technology expenses will remain sticky, putting further pressure on profitability. At the price we exited, forward valuation multiples looked demanding in this context.

We have exited our CDSL position with an 8x gain over five years. CDSL allowed us to experience, first hand, the power of duopoly, capital-light businesses and impact of mega trends—surge in retail investor participation in this case. Hopefully, we will over allocate to such cases next time. For now, it goes back to our watchlist.

B4. FLOWS AND SENTIMENTS

Smallcap and midcap equity indices fell 16 and 11% respectively last quarter, despite continued positive inflows into smallcap and midcap mutual funds. The decline was driven by selling from foreign and high-net-worth investors on thin volumes rather than a slowdown in domestic fund flows.

This correction has tempered excessive bullishness in riskier market segments—a welcome development. However, if retail investors start redeeming from mutual funds, liquidity constraints could amplify the downturn. On the other hand, sustained inflows might mark a bottom. As always, timing is uncertain, and with valuations still elevated, caution remains key.

Globally, trade tensions are back in focus, with the return of US tariffs under President Donald Trump. Trade policies are unpredictable, and history suggests that protectionism often leads to economic inefficiencies and, in extreme cases, geopolitical instability. While growth slowdown and inflation concerns in the US may limit aggressive escalation, the risk of negative surprises has risen.

Meanwhile, artificial intelligence (AI) is reshaping the technology landscape. US tech giants are investing heavily in AI infrastructure, while Chinese firms like DeepSeek and Baidu are emerging contenders. As with past technological revolutions—railways, radio, automobiles, and the internet—the winners remain uncertain. AI’s impact on healthcare, mobility, security, and automation presents both opportunities and disruption risks.

Both tariffs and AI add to global uncertainty, reinforcing that we remain demanding of multiples we pay for equities.

C. OTHER THOUGHTS

Market Eras and Investment Beliefs

Beliefs are shaped by direct and vicarious experiences – both in life and investing. Market regime/ era that investors live through influence their risk appetite, valuation frameworks, and core investment beliefs. Here are some of the historical investing eras:

• The 1930s and the Great Depression: The 1929 crash in the US led to prolonged stagnation, with U.S. stocks not recovering for 25 years. Investors from this era viewed equities as risky, favouring bonds, dividends, and capital preservation.
• The Inflationary 1970s: High inflation during 1970s in the US compressed valuations and led to negative real returns. Bonds and commodities became preferred investments, reinforcing inflation sensitivity among investors of that era.
• The Great Bull Market (1980–2020): 40 years of falling interest rates fuelled a multi-decade bull market, driving valuations higher and benefiting long-duration assets like technology stocks. Passive investing and private equity thrived, while ‘buying the dip’, became a reliable strategy.
• The Japanese Equity Winter (1990–2020): Japan’s post-real-estate-bubble stagnation left investors conservative, prioritizing cash preservation. Even decades later, Japanese households remain underweight equities despite global market strength.
• India’s ‘Lost Decade’ (1992–2001): After the Harshad Mehta crash, the Sensex remained flat for nearly a decade, fostering scepticism toward equities. Many Indian investors turned to fixed deposits (FD rates were over 12%), real estate, and gold, delaying the cultural shift toward equity investing until the mid-2000s.

Those who have lived in declining or stagnant markets develop cautious attitude and those having lived through bullish times develop a carefree attitude to investing. Much like Plato’s allegory of cavemen, these attitudes are so strong that it is difficult to convince them that other eras exist. In The Republic, Plato shares a story about a group of people who lived their entire lives chained inside dark cave facing a wall. Behind them was a fire, and between the fire and the prisoners was a walkway. On this walkway, others carried objects, puppets, and shapes, casting shadows on the wall in front of the prisoners. When one of the cavemen escaped and discovered the real world, his attempts to enlighten the others were met with disbelief and resistance.

India’s Post-Pandemic Boom (2020–2024): Of the 20 crores demat accounts live today in India, 15 crores (75%) were opened in the last four years. Many of these investors have only seen a rising market, believing 20% annual returns are the norm. Veteran investors, who have experienced multiple cycles, warn against such high expectations. But much like the cave prisoners dismissing the freed man, such advice falls on deaf ears.

Common themes and thinking about current Era

While it is nearly impossible to predict start or end of an era, one commonality is that like night following day, bullish eras have been followed by bearish ones and vice versa. The duration of either of them is unpredictable. However, aspects like peace, free markets, capitalism, technological progress elongate a bullish era. India has a great future if we look at these factors barring the high valuations. While this in itself does imply an era of falling or stagnant prices, past does warn us not to take good times for granted.

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As always, gratitude for your trust and patience. Kindly do share your thoughts, if any. Your feedback helps us improve our services to you!

Kind regards

Sumit Sarda

Partner and Portfolio Manager

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Disclaimer: Compound Everyday Capital Management LLP is SEBI registered Portfolio Manager with registration number INP 000006633. Past performance is not necessarily indicative of future results. All information provided herein is for informational purposes only and should not be deemed as a recommendation to buy or sell securities. This transmission is confidential and may not be redistributed without the express written consent of Compound Everyday Capital Management LLP and does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product. Reference to an index does not imply that the firm will achieve returns, volatility, or other results similar to the index.

Dear Fellow Investors,

Value investing is simple, but not easy

Value investing, at its core, is a pursuit of buying assets below their worth. And, resisting buying if that’s not the case. This is the simple stuff! Just to clarify, we are referring to value investing in the widest sense including growth/ quality at reasonable price. History shows that, if done properly, value investing works over longer run. Here’s why:

Because, it doesn’t work in the short run.

Due to liquidity, emotions, and incentives prices often rise above rational levels. Choosing not to overpay – the right investment behaviour – can cause interim underperformance and mental agony if the irrationality continues – wrong interim outcome. Not every individual or institutional investor is wired/ incentivised to endure this dichotomy.

While value investing is simple (buying below worth); it’s not easy (tolerating emotional pain). And that’s why it works.

We have been practicing caution since last nine months, and markets have gone up ~25% in one direction. While we have not lost money, we have grown less. In hindsight, nonetheless, we are looking foolish and this is emotionally painful. We, thankfully, take strength to persist from the fact that we are not alone. Many legendary investors have endured this before:

Between 1994 and 1999, the Nasdaq went up 40% per year. Many respectful investors including Ray Dalio, Seth Klarman, Howard Marks, Warrant Buffet, and Peter Lynch cautioned “bubble!, bubble!” in 1995, 1996, 1997 and 1998. They underperformed the roaring markets and looked ‘out of touch’ till March 2000. And then the tech bubble burst. By October 2002, the Nasdaq had fallen 75% from its peak, giving up most of its gains.

Or, take the case of 2003-2007. S&P 500 went up over 18% p.a. for 4 years. Value oriented investors lagged indices, until sub-prime bubble burst in 2008 and the S&P 500 fell 56%, giving away all the gains of those four years.

Something similar is happening today. Yes, Covid-19 has lifted earnings of some companies permanently, but for the rest, the earnings jump is cyclical/ temporary. Still, Nifty 50 and Nifty 500 are up 43% and 49% respectively from their pre-Covid highs – in a rare straight line. Form fundamentals point of view, it doesnot make sense. Only liquidity, emotions and incentives can explain this peculiarity. When people think they are making money, rarely will they say that it doesn’t make sense.

To clarify, we are not predicting that markets will fall tomorrow. Last nine months have shown you that we are bad at market prediction. But like the judicious ant, we are trying to prepare for the rainy day while the grasshopper revels in the balmy summer. For, finding an umbrella/ food in a rain storm might be impossible or very costly. We are enduring with our cautious stance.

In case you are tempted by offers to invest in the next shiny thing – that’s normal in heady times – please keep in mind that you have the option of sending the money to us to be kept safely as a stand by fund. We will use them to buy liquid instruments in your demat account, won’t charge any fees till a hurdle of 5%, and wait. Wait for better prices and lower risks. Out of sight, out of mind, out of risk!

A. PERFORMANCE

A1. Statutory PMS Performance Disclosure

For the half year ended September 30, 2021 our NAV was up 16.3%. During the period we were invested in equities, on monthly average basis, to the extent of 62%. The balance 38% was parked in liquid funds/ liquid ETFs in your demat accounts. NSE Nifty 500 and Nifty 50 were up 23.0% and 20.8% respectively including dividends.

Return is visible. Risk is not

Unlike investment return, there are no full proof quantitative measures of investment risk. Risk can only be qualitatively judged. It’s like driving a vehicle. One can choose between safe and rash driving. Driving at 100 kmph can be both rash and safe depending on type of vehicle, road and traffic. Similarly, a 20% return can be both safe and risky depending on the buying price. An expensive buy can get more expensive and generate that 20% return. At the same time a cheaper stock can get reasonably priced and generate 20% return. Former is risky, latter is less so.

Assessment of investment performance is incomplete if the focus is only on returns and not risks. The best way to reduce investment risk is to invest within one’s circle of competence and not to overpay.  Our job in these letters is to help you assess that.

A2. Underlying business performance

Trailing Earnings: Trailing twelve months Earnings Per Unit (EPU) of underlying companies, excluding one position where the losses are temporary, grew by 26% (including effects of cash equivalents that earn 5% net of tax). 

1-Yr Forward Earnings: We expect that TTM earnings for FY 22 to come at Rs 5.8 per unit, higher by 21% over FY21.

A3. Underlying portfolio parameters

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

In hindsight, our cautious stance can be termed as a mistake. However if we go back nine months, today’s outcome would have been a very low probability outcome. Given that we are dealing with your hard earned money, if conditions were to repeat, we will take the same conservative stand again. Our intent is to beat inflation first and then index.

From our two past mistakes- “Cera Sanitaryware” and “2015-16” – we learnt that unless fundamentals are extremely compelling, it is better to be gradual in selling and buying respectively. From our past mistake on “Treehouse Education” we have learnt that bad management deserves a low price, it’s seldom a bargain. In Dish TV we underestimated the competitive disruption but thankfully sold at breakeven. Tata Motors DVR taught us that cyclical investing requires a different mindset to moat investing and one needs to be quick to act when external environment turns adverse. In Talwalkars, we learnt that assessing promoter quality is a difficult job and we should err on the side of caution irrespective of how cheap quantitative valuations look. From DB Corp we learned that industries in structural decline will fail to get high multiples even if the industry is consolidated, competition limited and free cash flows healthy. 

B2. MAJOR PORTFOLIO CHANGES

We halved our position in one company, mainly due to 7x rise in share price in last eighteen months. There were no other changes to our aggregate portfolio.

Meanwhile, we continue to do what we like best – study, research, and keep adding more companies to our coverage list. We are ready with the work. And waiting.

B4. FLOWS AND SENTIMENTS

Amid rising global inflation and gradual economic recovery, the US Federal Reserve – the fountainhead of global liquidity raising all asset classes – indicated that it will reduce its bond buying (a tool to inject liquidity in economy) by November 2021. There is also a growing inclination among Fed officials to raise interest rates (near zero currently) from 2022. All this, however, is dependent on continued economic recovery. In absence of express roadmap for raising interest rates and continued benign Fed stance, markets continued to rally.

As per an Economist article, it’s raining unicorns (companies valued over 1bn$) this year. Their count has grown from a dozen eight years ago to more than 750, worth a combined $2.4trn. In the first six months of 2021 technology startups raised nearly $300bn globally, almost as much as in the whole of 2020. That money helped add 136 new unicorns between April and June alone, a quarterly record. Those that went public in 2021 made a combined loss of $25bn in their latest financial year.

Back in India, IPO and retail interest continue to soar to worrying levels.

FY 22 so far has seen 26 IPOs raising Rs. 58,000cr. While the year is yet to close and total raisings excluding LIC will pass Rs. 120,000 cr., this half yearly number is itself highest in last 9 out of 10 years.  FY 2018 is the only year that saw raisings of 67,500cr through IPO. And that year in hindsight was an interim top.

Record IPO subscriptions and listing pops continued. IPO offering of Paras Defense was subscribed over 300x (highest ever), Tatva Chintan 182x, Devyani International 117x, Clean Science 93x, GR Infra 72x, and Zomato 38x. Paras Defense opened 185% up on listing, highest ever (Govt. of India is its biggest client), GR Infra 100% up, Clean Science 70% up, Zomato 80% up and Tatva Chintan 100% up. All these companies are trading above 80 times trailing earnings. Few are yet to report a profit.

Equity oriented mutual funds have seen net inflows of Rs 60,000 cr since Mar 2021.  Noteworthy is that two new fund offers (NFOs) – ICICI Flexicap and SBI Balanced Advantage collected Rs 10,000cr and 13,000cr respectively – highest ever in equity and hybrid schemes respectively. Please note that an NFO offers nothing that existing schemes donot. Moreover, there is no listing pop in NFOs – they are yet to invest the monies into securities. Such crazy response cannot be possible without distributors pushing/ switching customers for earning higher commissions (trail commissions on NFOs are higher by 30-35bp vs existing funds) at a time when valuations are not cheap.

C. OTHER THOUGHTS

AVERSION TO LIFE INSURANCE COMPANIES

Some of you have asked us about our view on life insurance companies and our aversion to investing in them. Here’s our take in brief:

Despite selling mutual fund/ Bank-FD like but less efficient products, life insurance companies are valued at 2x-4x of the most expensive mutual fund / bank.

We take a moment to elaborate on this (caution: this is going to be a long and technical read):

Mutual-Fund/Bank FD-like Products

Life insurance products can be broadly classified into two categories – (a) Protection and (b) Savings.

Protection products are the plain vanilla life insurance products that pay money (sum assured) to dependents of the policyholder on latter’s demise in return for annual payments (premiums). When we use the term life insurance we generally mean these products. Term Insurance and Whole Life Insurance are examples of protection products.

For FY21, protection products formed only 10%-20% of premiums of life insurance companies. The figures are shared in the below table. The largest public company – LIC doesnot share it’s product mix. However we gather from LIC agents that protection’s share is lesser than 10% of its premiums.

Thus, protection (or plain vanilla insurance) products form 10%-20% of life insurance industry’s premiums.

Savings products, on other hand are products where the element of protection is minimal and the policyholder gets assured, assured+, or market linked returns at the end of the policy period. These three categories of savings products are briefly described below:

1. Assured return products are called non-participating savings The returns to policyholders are fixed. Any spread that life insurance earns over that assured return is retained by the life insurance company. These products are just like bank FDs. Bank retains all the spreads over FD interest that they pay to FD holder.
2. ‘Assured+’ return products are called participating savings Here too, the base returns to policyholders are fixed. In addition, 90% of spreads over guaranteed returns are shared with policyholders in form of bonus. Only 10% is enjoyed by the life insurance company. These products are like low risk mutual fund products, where fee earned by a life insurance company is not a fixed % of AUM but 10% of spreads.
3. Market linked returns products are called as Unit Linked Insurance Policy or ULIPs. Here the premiums are invested in debt and equity instruments and returns to policyholders are not assured but depend on market behaviour. ULIPs are similar to debt/ equity mutual funds.

Thus, 80%-90% of life insurance products are similar to mutual funds or bank FDs.

Less Efficient Products

As per FY 20 disclosures of IRDA (Life Insurance sector’s regulator) , life insurance industry incurred commissions and operating expenses of Rs 0.91 trn on an average AUM (asset under management) of Rs 36 trn. This means an expense to AUM ratio of 2.5% (0.91 divided by 36). These numbers include figures for LIC.

For top five private life insurance companies this ratio is 3.4% for FY 21 (see below).

Life insurance companies account customers’ investments as revenue and then ship back a portion of it to liabilities using actuarial assumptions. This makes accounting profits an incomplete measure of a life insurer’s profitability. Despite this limitation of accounting, we can safely assume that to remain profitable, the top 5 private life insurance companies should earn a spread (excess over guaranteed return) of 3.4% on savings products and/or they should charge at least 3.4% on market linked products (ULIPs).

These are higher than 0.05-2.0% that large mutual fund houses charge.

Assured FD-like returns with tax benefits is the main reason that investors choose life insurance savings products over mutual funds. However tax benefits come with a lock-in of 5 years. Surprisingly, over a third of policyholders surrender their policies in less than 5 years losing tax benefits as well as incurring surrender charges. Many end up earning below FD taxable returns.

Over time with investor education, there will be competition to savings products of life insurance companies.

Valued at 2x-4x of the most expensive Mutual Fund company/ Private Sector Bank

We argue that Embedded Value method that is currently being used to value life insurance companies is inadequate given the unique situation of Indian Life Insurance sector. In plain-speak, Embedded Value means the net present value of life insurance policies sold upto the valuation date (without accounting for future business) plus networth. Today, life insurance companies are valued at 2x-6x of their declared Embedded Value (interestingly, Embedded Values are declared by life insurance companies themselves).

We believe, Embedded Value method is more appropriate for protection based products. Given that 80%-90% of business of life insurance companies comes from mutual funds/ bank like savings products, it makes sense to value life insurance companies as mutual funds/ banks.

Valuation of mutual fund companies

There are two broad methods to value mutual fund companies:

1. As % of Assets under Management (% of AUM)
2. Discounted Cash Flow (DCF) or Earnings multiple

Due to complicated and assumptions based accounting that does not reflect true profits or operating cash flows, DCF, price to earnings or price to operating cash flows are not reliable valuation methods for life insurance companies. That leaves us with % of AUM method.

Three listed mutual funds companies are valued today between 7%-15% of their assets under management (AUMs):

Valuation of banks

Banks are mostly valued on price to book multiples (P/Bx). Banks with better spreads, loan-book granularity, and asset quality command higher multiples. Large private sector banks are valued between 2x-5x on Price-to-book basis:

Life Insurance multiples

If we use the similar methods for the three independently listed life insurance companies, we find they are being valued at 55%-85% of their June 2021 AUMs or 11x-17x of their book values:

A combined reading of above three tables tells us:

• HDFCAMC, the most expensive mutual fund, trades at 14.5% of it’s AUM. Life insurance companies trade at 55%-85% of their AUMs (3x-6x).
• Kotak Mahindra Bank, the most expensive bank, trades at 4.7x its book value. Life insurance companies trade at 11.5x-16.9x of their book values (2.4x-3.6x).

Thus, despite 80%-90% of products similar to mutual funds or banks, life insurance companies trade at 3x-6x of the most expensive mutual fund and 2x-4x the most expensive private sector bank.

What will change our view?

Life insurance companies state that pure protections and non-participating savings products enjoy VNB margins (proxy for profitability on new premiums) of 10%-100%. However these products form only a third of total premiums currently.

At the end, these are commodity products. Given most of the larger companies have banking or trusted corporate parentage, trust is not an issue. And like all commodities, they remain susceptible to price competition. We, therefore, donot believe that all the excess value that life insurance companies are commanding over banks and mutual funds can be attributed to pure protection/ Non-participating savings products.

Nonetheless, if pure protection and non-participating savings products gains penetration and competition remains sane, we are open to change our mind.

What will further strengthen our view?

Any entity that is providing bank or mutual fund like products should be regulated like them. Life insurance sector, however, enjoys two preferential external supports:

1. High distribution commissions – For roughly same AUMs (around INR 35 trn), life insurance companies paid over 4x commissions to their distribution partners last year versus mutual funds. This is due to the fact that SEBI has imposed a lower cap on maximum commissions that a MFs can give versus IRDA’s similar dictate for life insurance companies.

In fact, life insurance companies can pay commissions as high as 35% on first year premiums on savings products whereas upfront commissions are banned for mutual fund companies. If you are a distributor and your client is ambivalent (or ignorant), it’s a no brainer to push savings products of insurance companies over similar products from mutual funds. Over half of policyholders surrender their insurance policies in their 6^th year –this suggests that most of the insurance products are miss-sold.

2. Income Tax benefits – Currently, maturity value of an insurance policy is tax free in the hands of investors if they remain invested for at least 5 years. Similar benefit is not available to mutual fund units or bank deposits. The benefit was given to promote protection based life insurance products, but has led to proliferation of savings based ones. The last union budget took away this tax benefit for policies with premiums above Rs 2.5 lacs. It still remains for others.

Banks/ mutual funds can claim that they lack a level playing field versus life insurance savings products. If the advantages of higher distribution commissions and tax benefits are taken away or further diluted, it remains to be seen if life insurance savings products can compete with equivalent mutual fund products or Bank FDs.

Summary: Thus despite selling bank/ mutual fund like but less efficient products, life insurance companies trade at 2x-4x of the most expensive bank or mutual fund. We find them overvalued.

Disclosure: We own one of the mutual fund companies and two of the banks mentioned above. And we donot have any direct or indirect short interest in any life insurance company.

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Your trust and patience is the secret ingredient that allows our value philosophy to work. We judge our performance against only one true benchmark – giving you the best risk adjusted returns that markets allow during your investment journey. We are steadfast by that today more than ever!

Kind regards,

Team Compound Everyday Capital

Sumit Sarda, Surbhi Kabra Sarda, Suraj Fatehchandani, Sachin Shrivastava, Sanjana Sukhtankar and Anand Parashar

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Disclaimer: Compound Everyday Capital Management LLP is SEBI registered Portfolio Manager with registration number INP 000006633. Past performance is not necessarily indicative of future results. All information provided herein is for informational purposes only and should not be deemed as a recommendation to buy or sell securities. This transmission is confidential and may not be redistributed without the express written consent of Compound Everyday Capital Management LLP and does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product. Reference to an index does not imply that the firm will achieve returns, volatility, or other results similar to the index.