Dear Fellow Investors,
It was the best of times, it was the worst of times
-Charles Dickens, The Tale of Two Cities
Rising global inflation and resulting tightening of liquidity has pulled global markets including Indian equities lower. While exact causes and future trajectory of inflation are neither easy nor interesting topics to discuss, the impact inflation has on businesses, valuations and investment opportunities is real and therefore deserves your investment attention.
Intrinsic value of a business is present value of its future free-cash-flows (cash profits less investments) discounted at an expected reasonable rate of return. Inflation can adversely affect all the three elements of this value equation – (1) profits, (2) investments in working capital & fixed assets and (3) expected reasonable rate of return (aka cost of capital).
Profits – When revenues fail to increase as fast as costs during inflation, profitability suffers. There are two antidotes to this– (a) raise prices, and/or (b) control costs. There are many nuances to each of them.
Companies that sell unsubstitutable necessities such as staples, utilities etc. can raise prices without material effect on volumes. Inflation raises output prices for commodity producing companies (steel, copper, aluminium, oil etc.), but the benefits are temporary due to cyclicity – higher prices reduce demand and/or attract new supply that cool prices. For lenders, interest rates on loans are reset faster than cost of deposits and supports margins. Industries with low spare capacity can raise prices in near term without materially affecting volumes. On the other side, often regulatory caps on pricing can become a deterrent. If end consumers are seeing strain on their budgets, they will try to delay, substitute or downtrend. However, companies serving higher income consumers may be hit less.
On cost side, companies with high operating margins can maintain absolute profits without large increase in output prices during inflation. Illustration: if revenue is 100, operating cost is 30, then operating profit is 70 (and operating margin 70%). If costs rise by 10% to 33, just a 3% rise in sales price to 103 can protect absolute operating profits of 70. Whereas if the operating margins are 30%, a 7% rise in sales prices will be needed. Continuing on costs, companies with high operating leverage (high fixed costs) can see rise in margins with rise in volumes (rise in fixed costs is slower than rise in volumes and improves margins). Lastly, a lower cost player can breakeven when others in the industry bleed and can get stronger as competition dwindle.
Finally, if inflation leads to rise in interest rates or currency depreciation, companies with high debt or imports can see sharp rise in their interest and forex cost, that can further hurt profits.
Investments – Working capital and capital expenditure (capex) rise with inflation. Rising input prices increase investments in inventory, and rising output prices increase receivables. Some of this is negated by rise in payables. Dominant companies who can keep low inventories, receive dues faster from customers and delay payment to vendors can keep working capital low. Capex heavy businesses are worst hit during inflation. Maintenance or new capex rise in line with inflation. The rise has to be paid out of profits and this reduces free cash that can distributed to shareholders. Capex and working capital light businesses are best saved during inflation. Services are generally less investment intensive than goods. Companies where large capex is already done will also be less affected by inflation.
Discount Rate: Central banks usually raise interest rates to control inflation. This raises the hurdle rate that risky investments like equities should deliver. A higher discount rate reduces present value of future cashflows. There is no running away from this for any company, but loss making companies with back ended cashflows are hit more. Higher discount rates should make us wary of paying high multiples even for strong companies. Keeping other things constant, what was deemed fair at 30x earnings during low inflationary period can become expensive during high inflation.
For a given company, the net effect of inflation on all three variables – profits, investments and discount rate – need to be studied together to understand its investment merit. High points on profitability and/or investments may be nullified by low points due to high valuations. Moreover, short term effects need to be separated from longer term effects. Pricing tailwinds for many commodity producers may be cyclical. Stronger companies may sacrifice margins in near term to capture market share from weaker ones. In short, assessing impact of inflation on intrinsic value is little messy and we need to err on the side of caution. This means accepting that the sub set of companies whose intrinsic values may rise during inflation is very small.
By threatening to adversely impact cashflows and discount rates, inflation has arrested the unidirectional worldwide rise in asset prices. This is the bad part. However after two years, barring a few sector/ companies, valuations in many of our coverage stocks are coming back to reasonable levels. This is the good part. We are changing our stance from cautious to neutral.
A1. Statutory PMS Performance Disclosure
|Portfolio||YTD FY23||FY22||FY 21||FY 20*||Since Inception*||Outper-formance||Avg YTD Cash Bal.|
|CED Long Term Focused Value (PMS)||-8.2%||14.9%||48.5%||-9.5%||41.7%||38.0%|
|NSE Nifty 500 TRI (includes dividends)||-9.7%||22.3%||77.6%||-23.6%||49.8%||-8.1%||NIL|
|NSE Nifty 50 TRI (includes dividends)||-9.1%||20.3%||72.5%||-23.5%||44.3%||-2.6%||NIL|
|*From Jul 24, 2019; Note: As required by SEBI, the returns are calculated on time weighted average (NAV) basis. The returns are NET OF ALL EXPENSES AND FEES. The returns pertain to ENTIRE portfolio of our one and only strategy. Individual investor returns may vary from above owing to different investment dates. Annual returns are audited but not verified by SEBI.|
As shared in recent past letters in the backdrop of high valuations, our efforts have been to fall less. This quarter we have started to see small progress towards that. Versus Nifty500 we have fallen less by 1.7%. What gives us satisfaction is that for capital that was introduced in last twelve months (a period of high valuation), the weighted average marked to market loss is 0.5% versus Nifty 500’s loss of 7.9% in the same period.
Our minimum objective is to beat inflation on every incremental Rupee that we invest. At one stock price this is not possible and we wait. And at another it looks possible or even better and we act. We will continue to be guided by this principle.
A2. Underlying business performance
|Past Twelve Months||Earnings per unit (EPU)2||FY 2023 EPU (expected)|
|Dec 2021 (Previous Quarter)||5.9|
|Mar 2021 (Previous Year)||5.3|
|CAGR since inception (Jun 2019)||10%|
|1 Last four quarters ending Mar 2022. Results of Jun quarter are declared by Aug only. 2 EPU = Total normalised earnings accruing to the aggregate portfolio divided by units outstanding. 3 Please note: the forward earnings per unit (EPU) are conservative estimates of our expectation of future earnings of underlying companies. In past we have been wrong – often by wide margin – in our estimates and there is a risk that we are wrong about the forward EPU reported to you above.|
Trailing Earnings: Trailing twelve months Earnings Per Unit (EPU) of underlying companies, grew by 17% (including effects of cash equivalents that earn ~4-5%). This was in line with our start-of-the-year expectation. In Jun 2021 letter, amid very high uncertainty, we had pegged the FY22 expected EPU at Rs 5.8 per unit. Actual EPU has come at Rs 6.2.
1-Yr Forward Earnings: We introduce estimate for FY 23 earnings per unit at Rs 6.5-7.5 per unit. This wide margin is an acknowledgement of difficulty in predicting earnings during inflationary periods.
A3. Underlying portfolio parameters
|Jun 2022||Trailing P/E||Forward P/E||Portfolio RoE||Portfolio Turnover1|
|CED LTFV (PMS)||22.9x||20.2x||17.4%||1.4%|
|1 ‘sale of equity shares’ divided by ‘average portfolio value’ during the year to date period. 2 Source: NSE. 3Source: Ace Equity. 4Trailing Twelve Months.|
B. DETAILS ON PERFORMANCE
B1. MISTAKES AND LEARNINGS
There were no new mistakes to report this period. We continue to remind ourselves of our past mistakes:
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 added to our existing positions in four companies. Additionally, we trimmed our position in one company in some over-weight portfolios.
B4. FLOWS AND SENTIMENTS
Sentiments and flows continue to remain weak due to fear of monetary tightening and interest rate hikes required to cool down inflation that has crossed 8% in the US and the Euro Zone. Yields of 10 year US government bonds are up from 0.5% in Aug 2020 to 2.9% as of this letter. At 7.04%, India’s inflation has remained above RBI’s target of 6% forcing the RBI to announce out of schedule hike in policy rates of 0.4%.
Suddenly, the world that has been awash with liquidity is finding capital getting costly.
In the US, Tech heavy Nasdaq Composite index is down 32% from its recent highs. Morgan Stanley’s unprofitable Tech Index – an index of loss making tech companies – is down over 60% percent since the start of 2022. Covid darlings like Peleton, Zoom and Robinhood are down 80%-90% from their Covid highs.
IPO pipelines have dried up in the world including India. Private equity and venture capital funds including biggies like Sequoia Capital are advising their investee companies to change their focus from growth to profitability and cashflows. Many startups have been giving ESOPs to attract talent. With stock prices falling sharply, and ESOPs are no longer attractive, hiring cash costs will rise for startups at the time when capital is not easy to raise without downrounds. Startup layoffs are rising.
Total market capitalisation of all crypto currencies is down from peak of 3trn$ to under 1trn$. Bitcoin’s price is down from 60,000$ to 20,000$. Tokens like Terra and Luna have collapsed and Celsius has halted withdrawals (so much for de-centralised currencies).
In India, FPI (foreign portfolio investors) outflows have crossed 33bn$ in last 9 months since Oct 2021, highest ever. Infact, monthly FPI outflows of May 2022 were just 10% lower than Mar 2020 when markets fell over 30% (In May 2022, markets fell 4%). Thanks to continued retail inflows especially through domestic mutual funds the FPI selling has not caused as sharp a selldown as in the past.
In short, while retail enthusiasm remains intact, the general mood has turned from euphoria to caution. We like that.
C. OTHER THOUGHTS
Imagining a different world
If we dial back back a year, US 10 year G-sec were 1.3%, inflation had been below 2% in the rich world for over 11 years and capital was abundant. Tech businesses scaled massively and their stocks galloped at an unprecedented pace. New concepts such as SPAC, Crypto and Unicorns became popular buzz words. Capital was a moat. First mover startups with capital backing kept on growing despite losses. It was difficult to fathom a world of capital scarcity, rising inflation or disciplined valuations. Yet imagining a pause or reversal was an important part of an investor’s toolkit to control risk.
Cut to today, most of those unimaginable things have turned to reality. Inflation is above 8%, US 10 yr bonds are at 2.9%, and capital has become cautious. Tech stock, Crypto, SPAC and Unicorns are looking weak. If capital dries up it will be difficult to see loss making startups commanding multi-billion dollar valuations. Discipline capital spending and sensible valuations are making a comeback. And if this will continue for few quarters more it lead to an exact opposite situation to the one described in previous paragraph. Lower inflation, lower interest rates, growth, will look impossible. Yet imagining them to reverse in some point in future will be an important part of an investor’s toolkit to grab opportunities.
Most things in business including growth, margins, capital availability and valuation multiples turn out to be cyclical. Investment risks can be reduced if (a) we can understand where we are in the cycle and (b) we can position for gradual reversal of the cycle. This involves going slow when bottom up valuations donot makes sense and going fast when they do. We have traversed the first part by being cautious for last 18 months and keeping high levels of cash (often looking foolish). We need to be ready for the second part!
The right discount rate
As we discussed in the opening section, intrinsic value of any asset is the present value of its future free cashflows discounted at an appropriate discount rate. The appropriate discount rate should be the realistic return that one expects from investing in that asset. Such expectation is shaped by returns on risk free instruments of similar maturity. An equity share is a long dated asset, good ones are perpetual. Many great companies are in existence for over 100 years (For eg. Coca Cola, Unilever, P&G etc). In India, the longest dated risk free instrument is the 30 year government bonds. Their current yields are 7.5%. Given that equities are riskier and longer dated than this, we need to add some spread to this. Indian equity discount rates, thus, should be above 7.5% currently, but how much above is a matter of judgement.
Financial theory tries to use past volatility to arrive at this number and involves needless mathematical jugglery. We use a 10% discount rate for quality businesses and keep raising this for lesser ones. Mind you, present values are very sensitive to discount rates. A fall of 1% in discount rates, raises the present value of a 30 year cashflow stream growing at 5% annually by around 11%-13%. Without mathematical acrobatics, our practice is to use a high discount rate. If the business looks fairly valued leave alone cheap at that rate, we become interested.
As always, gratitude for your trust and patience. Kindly do share your thoughts, if any. Your feedback helps us improve our services to you!
Team Compound Everyday Capital
Sumit Sarda, Surbhi Kabra Sarda, Suraj Fatehchandani, Sachin Shrivastava, Sanjana Sukhtankar and Anand Parashar
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.