Letter to Investors – Mar’24 – Extracts

 

EXECUTIVE SUMMARY

    • Trailing twelve months’ earnings of underlying portfolio companies grew by 45%.
    • FY24 NAV grew by 29.2% with 74% funds invested in equity positions. Balance 26% is parked in liquid funds.
    • We share takeaways from studying performance of 1000 monkey portfolios.
    • We added to few existing positions, and started a new toehold position. We exited from a minor position at >25% IRR.
    • Impact of elections on stock returns.
    • Stance: Cautious

Dear Fellow Investors,

From Beginner’s Luck to Winner’s Curse?

Consider this: If 1000 monkeys had constructed portfolios of Indian stocks in the calendar year 2021, how many of those 1000 portfolios would have beaten the BSE 500 index after 3 years?

The surprising answer: ALMOST ALL OF THEM (997 of 1000).

No, these aren’t specially gifted/ trained primates; they’re random monkeys with random portfolios. We conducted a simulation with 1000 random portfolios. Each portfolio picked 100 equal weighted stocks at random from the BSE 500 universe in calendar year 2021. To remove starting period bias, we excluded period from May 2020 to December 2020 (marked by a sharp recovery from Covid-19 lows). Additionally, we assumed that stocks were added on a monthly basis throughout calendar year 2021. Then, on March 31, 2024, we compared the performance of these 1000 portfolios with that of the BSE 500 index, assuming a similar monthly purchases of the index. Remarkably, almost all monkey portfolios outperformed BSE 500’s 15% annualised returns from 2021 to March 2024, recording a median return of 22% p.a.

The secret behind this superlative performance lies in the starting point and market’s direction during the study period. Stocks have been on a relentless ascent since Covid-19 lows in May 2020. Many small and midcap BSE 500 stocks with less than 1% weight in the index have surged 3x to 12x. An equally weighted portfolio of random 100 stocks would allocate 1% weight to these stocks. Just a few such stocks are sufficient to improve the portfolio performance materially. Moreover, hardly any stock experienced significant declines to drag down the overall performance. If these portfolios were allowed to include micro caps, IPOs and SME IPO stocks (currently excluded) or reduce the number of stocks from 100 to say 50 or even 30, their performance would have risen further (100% outperformance; over 22% median return).

This outcome – call it beginner’s luck – mirrors the experience of many new investors who entered equity markets post Covid-19. Consistently beating the index is challenging even for seasoned investors. So, after outperforming the index over 3 years, many novice investors may start to believe that they possess a Midas touch for stock picking. However, in reality, the past 3 years’ success is largely attributable to luck. Worryingly, nothing sets up someone for financial and/or emotional ruin more than luck mistaken as skill and/ or an imprudent approach rewarded handsomely. Emboldened by their riches, many investors will raise their bets (trade in options, dabble in stocks of questionable companies etc.) precisely at the wrong time, and fall victim to the winner’s curse.

We also conducted a reality check: we made those 1000 monkeys repeat the same exercise in calendar year 2018. How many of them would have beaten the BSE 500 by June 2020? Only 200 out of 1000, with a median return of -6%. The reason? The markets were in decline from 2018 to June 2020.

Liquidity can propel stock prices to any level in the short term. However, fundamentals and valuations ultimately serve as anchors. Until then, ironically, a thoughtful investing approach may seem foolish, while a foolish investing approach may appear thoughtful. It’s therefore difficult to correctly evaluate performance in a uni-directionally rising market. The true test of investment skill lies in a falling market. Correct evaluation period should encompass a full market cycle, not just one phase as is the case with last three years. A full cycle is when margins and multiples both mean revert. A strong performance across full cycle results from being mindful of risks in a rising market and maintaining the price and quality discipline consistently.

 

A. PERFORMANCE

 

A1. Statutory PMS Performance Disclosure

Portfolio FY24 FY23  FY22 FY 21  FY 20* Since Inception* Outper-formance Cash Bal.
CED Long Term Focused Value (PMS) 29.2% -4.3% 14.9% 48.5% -9.5% 14.8% 26.1%
S&P BSE 500 TRI (includes dividends) 40.2% -0.9% 22.3% 78.6% -23.4% 19.7% -4.9% NIL
*From Jul 24, 2019; Since inception performance is annualised; 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. W.e.f. April 01, 2023 SEBI requires use of any one from Nifty50, BSE500 or MSEI SX40 as a benchmark. We have chosen BSE500 as our benchmark as it best captures our multi-cap stance.

 

Discipline or Delusion?

Our commitment to ‘protection first, returns later’ remains the guiding light behind our investment decision. This means we aim to acquire assets at prices below their conservatively assessed values. However, in today’s market, this criterion is often not met. As a result, our prudent course of action remains one of patience and continued study.

We understand the frustration that comes with our cautious approach, especially as it has led to underperformance compared to broader market indices like the BSE 500, which have surged due to rally in midcap and smallcap stocks. It is useful to question whether our stance reflects discipline or delusion, particularly when markets continue to rise, defying any caution.

While short-term market movements can be unpredictable, they cannot defy the fundamental principles of valuation. The mathematics of valuations dictate that the present value of future free cash flows, not current prices, should serve as the anchor for asset prices. Just as trees cannot grow infinitely towards the sky, stock prices cannot indefinitely surpass their intrinsic values. Eventually, the gravity of fundamental factors realigns stock prices with their true worth.

It’s crucial to recognise that enduring the disciplinary pain during lofty markets is precisely what safeguards and fortifies longer term investment returns. Investing is a marathon and tallying scores after every lap is of no use if we fail to complete the marathon. Stance: Cautious.

 

A2. Underlying business performance

 

Past Twelve Months Earnings per unit (EPU)2 FY 2024 EPU (expected)
Dec 2023 8.01 7.5-8.53
Sep 2023 (Previous Quarter) 8.6 8.0-9.03
Dec 2022 (Previous Year) 5.5
Annual Change 45%
CAGR since inception (Jun 2019) 12%
1 Last four quarters ending Dec 2023. Results of Mar quarter are declared by May 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 45% (including effects of cash equivalents that earn ~6% post tax currently).

1-Yr Forward Earnings: We downgrade the expected earnings per share range for FY24 from 8.0-9.0 to 7.5-8.5. This is because we exited from two positions where the earnings were at cyclical high and lifted base period’s earnings.

 

A3. Underlying portfolio parameters

 

Mar 2024 Trailing P/E Forward P/E Portfolio RoIC Portfolio Turnover1
CED LTFV (PMS) 23.8x 22.5x-25.5x 30.0%3 8.4%
BSE 500 26.0x2 16.2%2 3.4%2
1 ‘sale of equity shares’ divided by ‘average portfolio value’ during the year to date period. 2Source: BSE. 3Portfolio Return on Invested Capital (RoIC) is on core equity positions.

 

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

Music Broadcast (Radio City): You will remember we had initiated an arbitrage position in equity and preference shares of Music Broadcast (aka Radio City) some time ago. From -30% this position broke-even last quarter. We had guided that we will sell the equity end of the position soon. We failed to sell the 2.3% Music Broadcast equity position in time. Music Broadcast equity share price went up by 50% i.e. from 16 to 24 last quarter. We sold just 10% of the position at that price. The price is down to 18. At this price our combined yield to maturity of equity and preference shares is at 7%. We are waiting for government’s decision on TRAI’s recommendations involving lowering of radio license fee and allowing news broadcast for 10min/hour on FM radio. These if accepted, shall support the stock. Nonetheless, it was a mistake to not sell at 24.

 

B2. MAJOR PORTFOLIO CHANGES

Bought: We further added to a major position in all accounts to take it from 5% to 9% of the portfolio. Since Oct’23, we have increased its weight from 3% to 9% We also added to two other positions in underweight accounts. We also initiated a toe hold position in a new stock. Including this, we now have 4 toehold positions, not scaled up yet. See these long tail of small positions as experiments, where we have cleared off the red flags, but are either waiting for more confidence in our ability to see their future or better price. They say, we should try to position ourselves to get lucky. This is one of the ways. We will either scale them up and share detailed rationale or in absence, exit them fully.

Sold: We fully exited from one minor position giving an internal rate of return (IRR) over 25% p.a.

 

B4. FLOWS AND SENTIMENTS

Smallcap’s Abhimanyu Moment?

Smallcap mutual fund schemes invest atleast 65% of their funds in companies ranking below 250 by market capitalisation (smallcaps). Most of these companies have low liquidity. Unprecedented flows have led to one way rise in smallcaps creating an illusion of safe asset class with high returns. Entering into smallcaps may have been the easy part for retail investors. Will they be able to timely exit during the next crisis or will they get stuck like Mahabharat’s Abhimanyu ?

As per latest liquidity stress test, top 5 smallcap mutual funds schemes (70% share) will take 22-60 days to liquidate 50% of their smallcap schemes. This is after assuming that liquidity will be 3x of last 90 days average daily trading volume.

This may be an optimistic assumption and therefore an optimistic timeline. The liquidity present in a buoyant market like current one, can vanish during a crash when everyone including mutual funds and other alternative investment vehicles like PMS & AIF look to exit at the same time. Circuit breakers of 10%/ 5%/ 2% will further scare away buyers. The Franklin debt fiasco of 2020 reminds us that when everyone wants to exit no one can exit. A part of smallcap schemes is parked in largecaps and we think that they will be sold first in the event of redemptions from smallcap schemes. Exit in smallcaps may lead to pressure on largecaps too even if they are not as frothy. Everything is connected to everything else!

 

C. OTHER THOUGHTS

Investing during elections

Government policies and regulations have a material impact on business growth and profitability. Research has shown that business/ capitalism friendly policies add to general national prosperity. Take for instance the 1991 Economic Liberalisation in India. That single decision has altered the trajectory of wealth creation by Indian businesses. Respect for trade, commerce, enterprise and property rights has been a common source of wealth creation across multiple countries including Switzerland, Singapore, America, Japan, and to a limited extent, even China.

It is not surprising that Indian markets are cheering the expectation of the Modi government’s relection in the forthcoming elections. Over last 10 years, the Modi government has spearheaded many notable reforms including GST, reduction of corporate income taxes, speeding up infrastructure spends, fostering digitalisation through JAM – Jandhan, Aadhar and Mobile – trinity and promoting Make in India to name a few.

While the impact of policies on business growth is clear, the near term impact on the markets is less so. Two key challenges are (a) double counting and (b) impact of other factors:

Often, expected election outcomes already get baked into prices. Expecting a further rise when markets have already risen can be a double counting error.

Also, politics is not the only factor that affects markets. Global interest rates (falling interest rates since 2008 to 2022), global economic cycle (Chinese commodity boom in 2003-2007), geo political issues (Kargil war, 9/11, Ukraine-Russia war), technological changes (internet in 2010s and AI currently), demographics etc. all can have multiplicative or countervailing effect on markets.

Here are few examples of how correlation between elections and stock market is messy:

After rising 3x post Economic Liberalisation of July 1991, (partly due to the Harshad Mehta scam), the BSE Sensex remained flat for next 11 years even as the benefits of Liberalisation continued. There were the Asian crisis, Pokhran nuclear test (leading to global sanctions), and the Kargil War all in between.

In the 2004 elections, there were high expectations of the BJP-led government’s re-election under Mr. Atal Bihari Vajpayee. We all remember the optimistic “India Shining” campaign. Contrary to expectations, the Congress-led United Progressive Alliance (UPA) won, initially leading to a 14% drop in the Nifty Index over the month following the election. However, the market was up 24% next year due to the Chinese commodity boom.

Or, take the 2009 elections, when Sensex was up 81% for the full year on re-election of The UPA’s government with a stronger coalition. How much of this was due to UPA re-election and how much a recovery from steep fall the previous year due to the Global Financial Crisis, is difficult to segregate.

In summary, it is not very easy to pinpoint election outcome’s exact and solitary impact on stock markets both in near term and longer term. This is because not only do prices bake in expectations, but there are other factors at play too.

Our approach is taking election outcomes as one of the many inputs into assessment of a company’s economic worth and comparing that worth with prices. Election outcomes stack lower than many other more important inputs like size of opportunity, competitive advantage, management quality etc in the pecking order. While there may be some businesses that directly benefit from who is in the power (infra, mining, defence, capital goods etc), economic cadence of businesses that we like (not many in the above list) are not materially affected by who’s in charge of the country so long as capitalism and free enterprise flourish.

***

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,

Team Compound Everyday Capital

Sumit Sarda, Surbhi Kabra Sarda, Punit Patni, Arpit Parmar, 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.

 

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Letter to Investors – Jun’23 – Extracts

 

EXECUTIVE SUMMARY

    • Trailing twelve months’ and quarterly earnings of underlying portfolio companies grew by 16% and 32% respectively.
    • NAV grew by 9.9% YTD with 73% funds invested. BSE 500 grew by 13.2% including dividends in the same period.
    • Understanding, opportunity size, competitive advantage, management quality and valuation are our five investment filters.
    • Barring a few pockets, markets are expensive. There is bubble in quality
    • Stance: Neutral

Dear Fellow Investors,

 

Five hurdle checklist that reduces risks and improves returns

Surgeons, pilots and many critical professionals have saved lives using checklists. In last 12 years, our investment checklist has evolved after being battle tested with real life wins and losses. Here’s that checklist summarised into five key hurdles/ questions that every company we own or wish to own has to pass:

First and the biggest hurdle is that we must be able to independently understand the business. This involves understanding how the business makes money and why do consumers demand its product/ services. Due to complexity of the business or our own ignorance, many businesses are not able to pass through this screen. No understanding, no conviction, no investment case. Time, reading and thinking help us improve understanding of new or existing businesses.

The second key question that we ask is how large is the opportunity size. A company that is serving an essential product/ service with no threat of substitution and has low penetration can be said to have a long runway (for example demat accounts, air conditioners, health insurance etc). A definite disruption threat is a key risk to avoid.

Long runway, however, in itself is not enough. The business should have some inherent competitive advantage that allows it to tap the runway profitably. Competitive advantage allows the company to protect profits from competition or regulations. Low cost, network effects, patent/ license/ copyright, switching costs, consumer habits, culture etc. can be some of the sources of competitive advantage. Without competitive advantage, growth does not create shareholder value. This is an area where we spend a lot of time. High returns on capital hints presence of an advantage in the past. We probe the causes and durability of such high returns. It is important not to mistake cyclical tailwind/ headwind as competitive advantage/ disadvantage.

The fourth and the most difficult filter is management quality. We look at the past actions of management around three areas. First is execution track record i.e. ability to create distribution, human resource, and supply chain capabilities that allows it to maintain or grow its market share. Second is capital allocation i.e. investing incremental earnings on return accretive projects or in absence, returning them back to shareholders in best possible way. Last is treatment of minority shareholders as evident from accounting quality, embezzlement, remuneration and skin in the game.

The last but important hurdle is valuation. For core equity positions, valuation alone is useless unless the company passes all the four hurdles above. Our preferred method to value is to see what growth and margin assumptions are built into current price versus (a) past and (b) our conservative imagination of its future. Often a company that passes the above four tests does not come cheap. While quality demands paying up, paying any price can be a mistake. We need to wait for temporary hardships or size discount (smaller companies can remain mispriced due to lack of attention from larger investors) that can create mispricings.

**

Despite failing to pass one or more of the above five hurdles, a company’s stock may do temporarily well. An 80 P/E stock may go to 100P/E; stock of a company in a new long runway sector but no entry barrier may rise in initial euphoria; temporary tailwinds may be mistaken for enduring advantage etc. But if the truth around the five steps hold, weak thesis gets its due punishment. Conversely, a company passing through all the five hurdles sooner or later gets it due reward. Keeping the investing bar high and executing all five of them with discipline and margin of safety is the key to minimise investment mistakes and improve long term returns. Funnily, the five hurdle process eventually works because it does not always work.

 

A. PERFORMANCE

 

A1. Statutory PMS Performance Disclosure

Portfolio YTD FY24 FY23  FY22 FY 21  FY 20* Since Inception* Outper-formance Cash Bal.
CED Long Term Focused Value (PMS) 9.9% -4.3% 14.9% 48.5% -9.5% 13.1% 27.0%
S&P BSE 500 TRI (includes dividends) 13.2% -0.9% 22.3% 78.6% -23.4% 17.3% -4.2% NIL
*From Jul 24, 2019; Since inception performance is annualised; 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. W.e.f. April 01, 2023 SEBI requires use of any one from Nifty50, BSE500 or MSEI SX40 as a benchmark. We have chosen BSE500 as our benchmark as it best captures our multi-cap stance.

 

What are we waiting for?

Our cash levels (invested in liquid funds) have been high at 25-30% in last few quarters. The only thing that we are waiting for is better entry prices. For, a high entry price can lead to subpar future returns.

At surface, the price to earnings (P/E) ratio of BSE 500 companies is 24.4x, moderately high if not exorbitant. But if we exclude financials, LIC, and GIC-RE where earnings are at cyclical highs, the P/E of remaining BSE 442 companies jumps to 30.4x P/E, one of the highest since inception in 1999. The effect is similar if we use other valuation metrics like price to book (3.7x to 4.4x) and enterprise value to ebitda (15.3x to 16.3x).

Within the above set, if we look only at quality stocks (high returns on invested capital, low debt and high sales growth), their P/E is over 40x. Many are pricing in earnings growth that are 1.2x-2.0x of their past 10 year run rate. This is despite their larger size today and higher interest rates (that pull stock prices down). We believe, there is bubble in quality.

Only a subset of our coverage stocks pass all the five hurdles (understanding, opportunity size, competitive advantage, management, and valuation) currently. We have made full allocations towards them. For rest, the valuations (fifth filter) are high and we are waiting. Nonetheless, we continue to actively track them as if they are part of the portfolio. When price will be right, we will be ready.

The spare cash is the dry powder which will be valuable at those times. We donot want to take any capital risk on that. Hence our preference to park it in liquid funds.

Underperformance of a Style

Practicing a sensible investment style consistently is important for investment performance. There will be periods when a style will be out of favour. And with each year of underperformance, one will wonder if the style works (Warren Buffet in 1998-2000; Prashant Jain in 2015-2019). The tendency to dump the out of favour style and hug the popular style is highest at the time when the out of favour style starts working again (both Warren and Prashant came out on top as cycle reversed). So if the style makes economic and rational sense, there is need to endure especially when confidence is low. We might be at that point today. Not overpaying for quality has been tested before (Nifty Fifty bubble in US) and it will work.

 

A2. Underlying business performance

 

Past Twelve Months Earnings per unit (EPU)2 FY 2024 EPU (expected)
Mar 2023 5.91 6.5-7.53
Dec 2022 (Previous Quarter) 5.5
Mar 2022 (Previous Year) 6.2
Annual Change 16%4
CAGR since inception (Jun 2019) 10%
1 Last four quarters ending Jun 2022. Results of Jun quarter are declared by Nov 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. 4 Adjusted earnings.

 

Trailing Earnings: As against our lowered expectation of 5.2-6.2, trailing twelve months Earnings Per Unit (EPU) of underlying companies came in at Rs 5.9. Excluding two companies with temporary and reversible losses, this is a growth of 16% over last year (including effects of cash equivalents that earn ~4-5%).  Due to Covid related one offs and higher cash balance our earnings growth since inception (2019) has been lower than our minimum target of 15%. However, we are set to reach there gradually.

 

1-Yr Forward Earnings: We expect FY 24 earnings per unit to be between Rs 6.5-7.5 per unit, an annual growth of around 18%.

 

A3. Underlying portfolio parameters

 

Jun 2023 Trailing P/E Forward P/E Portfolio RoE Portfolio Turnover1
CED LTFV (PMS) 27.5x 21.6x-24.9x 16.8%3 0.7%
BSE 500 24.4x2 15.0%2
1 ‘sale of equity shares’ divided by ‘average portfolio value’ during the year to date period. 2Source: Ace Equity. 3Excluding cash equivalents. 

 

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

There were no mistakes in this quarter.

 

B2. MAJOR PORTFOLIO CHANGES

We increased our position in one existing company. At ~9%, it is now our largest position.

 

B3. UNDERLYING FUNDAMENTAL PERFORMANCE

Earnings per unit (earnings of our portfolio companies accruing to us divided by units outstanding) of our portfolio grew by 32% in the last quarter (no exclusions) and 16% in last year (excluding two companies companies due to temporary reasons). Prices of most companies in the portfolio are cheap or reasonable given the expected strong earnings performance.

 

B4. FLOWS AND SENTIMENTS

 

Going back to Zero Interest Rates?

Buoyant flows: Both domestic and foreign flows have been strong in last few months providing liquidity to the market. Gross SIP flows into Indian mutual funds continue to remain robust crossing Rs 14,000cr in last month. Foreign investment flows crossed $12bn in last 4 months. It is surmised that China has become less investible due to slowing growth and political issues and that is making India attractive to foreign flows.

Insiders selling: Insiders and promoters are using high valuations as an opportunity to sell their stakes either through market sale or IPOs. In last three months, promoters/ investors have sold stakes over $4bn (highest since 2020) through block deals and offer for sale in over 30 companies. Not to mention stake sale in open market by many promoters. IPO/ QIP/ FPO pipeline that had dried up is full again with some IPOs being oversubscribed by 85x-106x. All this indicates that promoters/ insiders find these times opportune to exit.

Zero interest rates?: US markets are back to their 52 week highs. The breadth has been narrow with a few tech stocks accounting for all the gains in US S&P 500 index and remaining stocks being flat. This is thanks to new bubble in town – Artificial Intelligence (AI). Not to undermine the power of this technology (we are using in our research and writing this letter too), but winners are hard to predict and prices often get ahead of reality. When markets were at similar level last time, US interest rates were near zero. Now they are 4%-5%. US core inflation too continues to remain high at 5% even at higher base. If exit from zero interest regime was the reason for fall in stocks globally, and stocks are back to where they were before fall, are markets assuming that we will go back to zero interest rates again?

 

C. OTHER THOUGHTS

Emperor has no clothes

You might wonder why we are so worried when most around us are not so alarmed by high valuations in general and in some pockets in particular. We will try to answer this through a popular kindergarten story:

Once upon a time an emperor was miss-sold an empty dress hanger claiming that it had a special dress which only clever people could see. While the emperor could not actually see the dress – as there was none- he pretended that he was wearing one just to look clever. He then paraded around naked, while his subjects, advisors and courtiers, feared speaking the truth due to their incentives or fear of looking foolish. It took the innocence and honesty of a child to point out that the emperor had no clothes.

Similarly, in the financial world, conflicting incentives or biases prevent market participants from openly acknowledging certain realities, such as overvalued markets. Various participants, such as stock brokers, investment bankers, mutual funds, mutual fund distributors, finfluencers and financial press may have a vested interest in promoting positive market sentiment and encouraging investments. For, that allows them to earn commissions or fees based on trading volumes or assets under management or eyeballs or page visits.

If these market participants were to openly express concerns about overvalued markets or caution against excessive risk-taking, it could potentially deter clients from investing or trading actively, leading to a decrease in their own revenues. Hence, there can be an inherent conflict of interest that discourages them from highlighting the potential risks or warning about market frothiness.

This mal-incentive when combined with human fallacies of trend extrapolation (rising prices will keep on rising), envy (those around getting rich), greed and FOMO (fear of missing out) create a powerful force that tricks investors to fall for the narrative of investing at any price.

Only antidote against this force is to pay attention to the incentives of one’s financial advisor and remind oneself that focus on risk (and not return) should become the most important consideration while investing in a heated market.

***

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,

Team Compound Everyday Capital

Sumit Sarda, Surbhi Kabra Sarda, Punit Patni, Arpit Parmar, Sanjana Sukhtankar, 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.

 

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Letter to Investors – Dec’22 – Extracts

 

EXECUTIVE SUMMARY

  • Adjusted trailing twelve months’ earnings of underlying portfolio companies grew by 2%.
  • NAV grew by 0.5% YTD with 64% funds invested. NSE Nifty 50 and Nifty 500 grew by 4.8% and 4.7% respectively.
  • Amid growing noise on inflation and interest rates, we need to continue focusing on intrinsic values.
  • Rise in interest rates is a creating pressure on expensive/ risky assets like growth stocks and crypto.
  • Stance: Neutral

Dear Fellow Investors,

 

“What do you see, son”? Asked Guru Dronacharya. “Only the bird’s eye, Sir”, replied Arjun.

-the Mahabharat

We all have grown up listening to this Mahabharat  story on importance of focus. Whether its archery or investing, great achievements demand undivided focus. The bird’s eye equivalent in long term investing that demands undivided focus is company’s intrinsic value (or economic worth, in simpler terms). For, only that can help us decide if a company is undervalued or overvalued versus its stock price. Everything else, is noise.

To recall, a company’s intrinsic value is the present value of its future free cash flows. Two broad components of intrinsic value calculation are (1) future free cash flows (i.e. cash earnings less investments) and (2) future interest rates to discount those cashflows to their present values (aka discount rates).

Assessing intrinsic value, thus, requires looking into the future – for both cash flows and discount rates. Unlike Arjun’s bird in the Mahabharat that is still and clearly visible, intrinsic value is therefore a moving and hazy bird.

Future cashflows: Either due to their nature or our current ignorance, we cannot imagine future cash flows of most of the companies. It’s futile to even attempt their intrinsic value calculations. For, in archery parlance, we cannot even see the bird. Nonetheless, there is a sub set of companies where we can. Mostly these companies provide essential, under-penetrated or non-substitutable products/ services competitively and are run by able and honest management. They are expected to see reasonable revenue growth and high returns on capital. Here is where we limit ourselves looking.

Future interest rates: For intrinsic value purposes we are concerned, not with interest rates of next quarter or year, but with long term future interest rates. Just as assuming very low long term future interest rates is mistaken (last 10 years), so is assuming very high long term interest rates (temptation today). We need to assume moderate interest rates over long term in our intrinsic value assessment. Given that 30-yr Indian government securities are yielding around 7.5% today, 4% is too low, and 15% too high for discount rate. Anywhere between 10%-12% sounds okay, today.

We need to place all incoming information including the current inflation and interest rate scare in the above backdrop. As detailed in the June’22 letter, yes, by adversely affecting cash flows and interest rates, inflation does lower intrinsic value of most companies. However for minority of companies, it does not. Or not at least commensurate with price erosion that happens due to near term unfounded inflation fears. Discipline to limit ourselves to such companies and focus on their intrinsic values that correctly embeds future cashflows and long term future interest rates, therefore, offers opportunity to take advantage that this dislocation triggers.

***

While the world markets were down 10%-30% for the calendar year 2022, India’s Nifty50 index ended in green. This is one of the biggest outperformances in history versus many countries including the US. Though index is near its peak, broader market is not. Within our coverage too, there are a few companies that are still down 10%-30% from their previous highs without material change in their intrinsic values. We are deploying capital here and retain neutral stance.

A. PERFORMANCE

 

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) 0.5% 14.9% 48.5% -9.5% 13.6% 36.0%
NSE Nifty 500 TRI (includes dividends) 4.7% 22.3% 77.6% -23.6% 17.4% -3.8% NIL
NSE Nifty 50 TRI (includes dividends) 4.8% 20.3% 72.5% -23.5% 15.9% -2.3% NIL
*From Jul 24, 2019; Since inception performance is annualised; 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.

 

Care while Benchmarking Performance

Regulations require us to benchmark our performance with an index every quarter. While over a full cycle such comparison is useful, we argue that it is dangerous during a one way rising and expensive market like the one of last 2 years. This is because all indices including Nifty50 or Nifty500 are value agnostic indices. In other words, this means that they will increase the weight of constituent stocks that have done well and vice versa irrespective of their intrinsic values (Eg: Adani group stocks). In a rising market, expensive stocks – which a prudent investment approach would normally avoid –will get higher weight in indices helping indices to post higher returns in near term albeit at a higher risk.

Over 3-5 years, falling 5% when indices fall 10% is not a desirable outcome even if we beat indices, for we would have lost even more after accounting for inflation. Investing aggressively in an expensive market like today has higher chances of above outcome. The only antidote to safeguard from this malady is not to overpay and wait for correct prices. Hence our higher than usual cash balance. Problem with this approach is that in short run expensive stocks can get more expensive, propel indices, and make a cautious approach like ours look foolish when compared quarterly with these indices. It is like comparing a marathoner with a sprinter. Both are running different races.

Thus, while looking at the above statutory table every quarter, you should remind yourselves that our race is against inflation first and indices later; absolute returns first and relative returns later. You should therefore prefer checking whether on absolute basis we are able to beat inflation over 3-5 year period. That’s the minimum benchmark we need to beat. Given that our incentives are linked to performance and not AUMs, and we understand what we are doing, we will do better than that.

 

A2. Underlying business performance

 

Past Twelve Months Earnings per unit (EPU)2 FY 2023 EPU (expected)
Sep 2022 5.41 5.2-6.23
Jun 2022 (Previous Quarter) 6.0 6.2-7.23
Sep 2021 (Previous Year) 5.7
Annual Change 2%4
CAGR since inception (Jun 2019) 9%
1 Last four quarters ending Jun 2022. Results of Jun quarter are declared by Nov 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. 4 Adjusted earnings.

 

Trailing Earnings: Adjusted trailing twelve months Earnings Per Unit (EPU) of underlying companies grew by 2% (including effects of cash equivalents that earn ~4%). 

 

1-Yr Forward Earnings: Against our start of the year expectation of earnings per unit of Rs 6.2-7.2 for FY23, we are trimming the estimate to Rs 5.2-6.

 

A3. Underlying portfolio parameters

 

Dec 2022 Trailing P/E Forward P/E Portfolio RoE Portfolio Turnover1
CED LTFV (PMS) 28.7x 24.6x-29.8x 17.9%4 5.6%
NSE 50 21.8x2 15.0%3
NSE 500 22.9x2 13.7%3
1 ‘sale of equity shares’ divided by ‘average portfolio value’ during the year to date period. 2 Source: NSE. 3Source: Ace Equity. 4Excluding cash equivalents. 

 

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

We continue to retain higher than usual cash balance due to lack of abundant opportunities. Our incentives and objectives encourage us to act only when it makes sense. In hindsight of rising markets, this might feel like folly, however that’s the cost of running a conservative investment operation. It, nonetheless, pays out over longer term.

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 five companies in underweight accounts. Additionally, we shifted liquid funds from Nippon Liquid ETFs to ICICI Pru Liquid ETFs. While both have similar risk-return profile, the latter has 44bp (Rs 440 per lac) lower expense ratio. The reason we shifted now and not before was liquidity. We were waiting for average daily liquidity to reach adequate amount, which has reached now. Transaction cost for this switch was 0.0042% (or Rs 4 per lac). There was no brokerage or STT paid.  Getting Rs 440 p.a. by paying Rs 4 onetime (per Rs 1 lac), and ensuring liquidity, was a good deal.

Liquid Funds Management

We park all our cash in liquid ETFs. You may ask why we choose liquid ETFs and not liquid mutual funds which give slightly higher returns. As of writing of the letter, last one year return of liquid ETFs were around 4% and liquid mutual funds were around 4.3%. Secondly you may also ask is there a merit in investing these funds in other debt products like short term funds or PSU funds to improve the returns.

We keep cash to capitalise on equity opportunities that volatile markets often throw. Liquid mutual fund money is available on T+1 to T+3 days (holidays of mutual funds are difference from equity markets). Whereas liquid ETFs are immediately available. If we have to buy an equity position today, we can buy that stock and sell liquid ETF on exchange on the same date. This flexibility is important as many times opportunities are available only for limited time.

Secondly on return part, we donot want to take any credit or duration risk on the surplus cash that we hold. For, when calamity strikes and opportunities rise in equities, riskier or long duration debt instruments can entail capital loss at the very time when we want cash to be intact. We want to protect the dry powder that will be useful to buy equities during trouble. Consider liquid ETFs as current accounts yielding 4%.

So while ETFs deliver lower returns, they provide better flexibility and safety.

B4. FLOWS AND SENTIMENTS

 

From TINA to TANIA

The low interest rate and abundant capital regime of 2010-2021 was like a rising tide that lifted all asset prices. As safe investment alternatives were not remunerative, money chased riskier asset classes like growth equities, private equities, venture capital and even cryptos in search for yields. In those 11 years, Nasdaq Composite index (proxy for tech stocks) rose 7x, private equity AUM size grew 4x and crypto went from nothing to 3trn$. This regime has been popularly called TINA – there is no alternative.

Today with rapidly rising interest rates and cautious capital, that rising tide has gone out. TINA is giving way to TANIA – there are new investment alternatives. US treasuries that used to yield 0% few years ago yield 4% today. In India too, fixed deposit rates are rising and now offering 7% risk free returns. Those seeking risk free returns have more alternatives than just risky assets. More so when risky assets have been badly bruised. US tech-heavy Nasdaq Composite index was down 33% in CY2022. Crypto market cap is down 70% from 3trn$ to 800mn$ and has seen bankruptcy/ collapse of FTX, Luna etc.

When interest rate is 1%, Rs 91 are needed today to get Rs 100 in 10 years. At 4% only Rs 67 are needed to reach to Rs 100 in 10 years. The 10-year present value of Rs 100 falls from Rs. 91 to Rs. 67 when interest rates rises from 1% to 4%. As interest rates rise, investors need to keep this in mind while deciding what multiple to pay for equities. Average valuations multiples of last 10 years have an upward bias due to the TINA regime. Using them in TANIA regime to conclude whether current valuations are cheap might be a mistake. Higher interest rates pushes the average valuation curve of all assets downwards. This might bring back the preference for profitable and cash earning companies versus high flying but unprofitable growth/ tech companies. Sensible investing might be back soon.

 

C. OTHER THOUGHTS

Markets – A Voting Machine In Short Run

When a stock grows 3x or more in 3 years or less, it can have a material impact on portfolio returns (if given adequate weight). Most often when we scan such a list especially during market high, we scratch our heads as to why some stocks that we understand went up so much. And how does price and earnings of these stocks perform in future? Is market right to bid them so high?

With this question in mind we tried to find out how the same turned out in the past. We asked this question:

Question: How did the earnings and stock price grew in next 5-7 years for those stocks that went up atleast 3 times in a 3 year rolling period between 2012-2017 (mini bull run).

Interpretation: For example, share price of company A went up 10x between 2013-2016. We are interested in finding how did the earnings and stock price grow for the company A between 2016-2022.

Key Findings*:

  1. There were 560 companies whose stock shot up over ‘3x or more’ in a rolling 3-year period between 2012-2017.
  2. Just over a fourth of these companies were able to grow operating earnings at 15%+ CAGR over next 5-7 years. Median stock returns for these companies were 16% CAGR over next 5-7 years.
  3. For balance three-fourth of companies – i.e. companies whose stocks grew 3x or more in 2012-17 but operating earnings grew less 15% in next 5-7 years – their median stock returns were -2% CAGR over those 5-7 year period.

*We have evaluated a very small period of 2012-2022. We have looked at only companies with market cap over Rs. 500cr as on 2017. We have not included companies getting listed after 2017. To remove effects of extraordinary items, we have used operating profits excluding other income.

Between 2012 and 2022, broadly three out of four companies were not able to sustain their earnings or share price performance after sharp share price jump.

In short run a stock that runs up sharply may be due to non-fundamental or temporary reasons. Most of such stocks may not be able to deliver earnings performance warranted by such high price jump and fail to protect or grow returns.

As Benjamin Graham said: “Markets are voting machine in the short run and weighing machine in the long run.”

***

 

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 and wishing you a blissful 2023,

Team Compound Everyday Capital

Sumit Sarda, Surbhi Kabra Sarda, Punit Patni, Arpit Parmar, Sachin Shrivastava, Mukta Mungre and Sanjana Sukhtankar

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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.

 

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Letter to Investors – Sep 2022 – Extracts

 

EXECUTIVE SUMMARY

  • Compound Everyday Capital completes 10 years of operations.
  • Trailing twelve months’ adjusted earnings of underlying portfolio companies grew by 22.5%.
  • NAV fell by 2.9% YTD with 64% funds invested. NSE Nifty 50 fell by 1.2%. Nifty 500 was flat in the same period.
  • Inflation has taken hold across the world and central banks are raising interest rates aggressively, pulling markets down.
  • India has outperformed all major markets on YTD basis. History suggests this has not sustained for long.
  • Stance: Neutral

Dear Fellow Investors,

Journey is the destination

We completed 10 years of Compound Everyday Capital this quarter and take this opportunity to thank you for trusting us along this exciting journey so far. While the learning never ends and we would like to compound everyday, we take a moment to reflect and summarise seven key learnings over this time:

1. Risk > Return: In our initial days while we thought we were risk conscious, our primary focus was on returns. We didn’t know that we didn’t know. Despite taking risks that we were unaware of, we did well due to luck. The wrong lessons led to mistakes, heartburn and learning. The learning is that risk management and capital protection should be the primary goal of investing. And the simplest way to reduce risk in equity investing is not to overpay after doing proper valuation work that incorporates quality of business and management, uncertainty, cyclicity, possibility of being wrong and base rates. Putting risk first, however, is not as easy as it sounds. For, in a rising market a risk based investment approach will feel like what insurance premium feels until there is an accident – a needless cost. However over the longer term this risk focused approach, like insurance, will avoid large drawdowns and come out better even if it lags in interim.

2. Seek to invalidate: Evolution has ill prepared human mind for investing. Emotions, while good for surviving in the savannah, work counter-productively in investing. In past, ego and confirmation bias had stopped us from rejecting our delusions. We were caught trying to justify low valuations without looking at perils. If we had worked on an idea, it started looking good to our mind -ego. We selectively looked at positives to justify holding – confirmation bias. Bruised ego, we learnt painfully, is better than burnt pockets. Today when we get a new idea, our first reaction is to try to actively kill it. Our initial research focuses on searching for evidences that proves that the bet is subpar and therefore not worth spending more time. Only if we find ourselves unable to actively kill an idea, we move ahead with it but try to remain ready to ditch if thesis doesn’t unfold as we though. Care is needed not to take this too far, for it can foster cynicism and inactivity. It’s a difficult balance to achieve, but we are trying. On balance, this approach has saved us on more occasions than leading us astray.

3. Two key risks – Poor Management, Disrupted Business: We have made a handful of mistakes that tick this box. Management that, in past, has not allocated capital well, not has executed well, has not adopted conservative accounting or has not treated minority investors well are clear red flags. Similarly when we find evidence that a business is definitely disrupted or if the new technology weakens a company’s competitive positioning, we are worried. In both these cases, we avoid/exit irrespective how mouth-watering surface valuations look. They are mostly traps.

4. Temporary hardships are good: Often the type of company that we like – exceptional business run by able and honest management – is what everyone likes as well. This means most of them are well tracked and efficiently priced most of the time. However temporary setbacks in either the company, sector, country or the world engenders fear which breaks their efficient pricing mechanism. These are the only times when exceptional businesses can be found at exceptional prices. Benefitting from temporary hardships requires preparation and waiting. Preparation for understanding the right companies, and waiting for temporary hardships. Caution, however, is needed to ensure that the hardships are indeed temporary and not permanent.

5. Most things are cyclical: In investing, like in life, good times are followed by bad and vice versa. Demand, supply, growth, margins and multiples go through cycles and mean revert. Peak growth, peak margins and peak multiples often occur in life of a company. During such times, FOMO (fear of missing out), accolades, media narratives and halo effect can tempt one to give in and enter at wrong times. Opposite happens when cycle reverses. Awareness of cycles, therefore, is a good way to profit from them.

6. Expanding circle of competence: Doing proper valuation work is the bed rock of risk based investing. We cannot assess whether a company is over or under valued unless we have an opinion about its intrinsic value. Forming this opinion requires good understanding of a company – it’s business model, size of opportunity, competitive position, key drivers etc. It’s usually safe to skip an idea if we cannot understand the business and if it falls outside our circle of competence – which happens often with us. While this discipline is important, what makes our work both engaging and challenging at the same time is the efforts required to expand this circle of competence one company at a time. Larger the circle, larger is the fishing pond.

7. Smart Diversification: All returns lie in the future, but the future is unknowable. Despite best efforts, rapid technological change, uncertainty, ignorance and mistakes will remain investing challenges. Too much concentration can raise risks. To provide for these risks, we need humility in sizing our bets and diversifying intelligently. An intelligently diversified portfolio is one where constituent securities donot always move in one direction and thus lend resilience across multiple adverse scenarios over longer term. Care, conversely, is also needed not to over-diversify else winners will not move the needle.

A. PERFORMANCE

 

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) -2.9% 14.9% 48.5% -9.5% 49.8% 36.5%
NSE Nifty 500 TRI (includes dividends) 0.4% 22.3% 77.6% -23.6% 66.6% -17.0% NIL
NSE Nifty 50 TRI (includes dividends) -1.2% 20.3% 72.5% -23.5% 56.9% -7.0% 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.

 

Current volatile market conditions are allowing us to keep adding to positions that come in our range of valuations.  The volatility may continue and we will keep using our cash reserves to opportunistically add to current or wishlisted positions. The right way to evaluate in the near term is to review the fundamental performance of underlying companies. Please read the relevant sections in the latter part of this letter to track that.

Yes, year to date returns are mildly negative. Our year to date fees is also nil.

 

A2. Underlying business performance

 

Past Twelve Months Earnings per unit (EPU)2 FY 2023 EPU (expected)
Jun 2022 6.01 6.2-7.23
Mar 2022 (Previous Quarter) 6.2 6.5-7.53
Jun 2021 (Previous Year) 5.6
Annual Change 22.5%4
CAGR since inception (Jun 2019) 10%
1 Last four quarters ending Jun 2022. Results of Jun quarter are declared by Nov 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. 4 Adjusted earnings.

Trailing Earnings: Adjusted Trailing twelve months Earnings Per Unit (EPU) of underlying companies, grew by 22.5% (including effects of cash equivalents that earn ~4-5%).  This was in line with our start-of-the-year expectation.

 

1-Yr Forward Earnings: Going by current estimates, we lower the estimate for FY23 earnings per unit to Rs 6.2-7.2 from earlier guidance of Rs 6.5-7.5, out of abundant caution. Again, this wide margin is an acknowledgement of difficulty in predicting earnings during current inflationary periods.

 

A3. Underlying portfolio parameters

 

Sep 2022 Trailing P/E Forward P/E Portfolio RoE Portfolio Turnover1
CED LTFV (PMS) 24.9x 20.8x-24.2x 17.2%4 1.3%
NSE 50 20.6x2 15.8%3
NSE 500 21.7x2 14.5%3
1 ‘sale of equity shares’ divided by ‘average portfolio value’ during the year to date period. 2 Source: NSE. 3Source: Ace Equity. 4Excluding cash equivalents. 

 

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

There are few stocks in our portfolio that are down 30-40% from their all-time highs. This, per se, doesnot mean they are mistakes. All of them are still above their acquisition costs (after accounting for dividends received) despite such a fall. Question that we need to answer is whether the set-back they are seeing is temporary or permanent. We have explained in next section why we think the set-back is temporary and many of them present attractive risk-reward characteristics. Like always, we recall learnings from our past mistakes below:

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 five companies . They were, at the time of our addition, down 34%, 39%, 31%, 38% and 44% respectively from their 52week highs. We also initiated a toe hold position in a new company that we were tracking since last few months. It’s still under evaluation.

B3. DETAILS ON PERFORMANCE

Disruption: “AND” Vs “OR”

Disruption is one of the biggest threat to a business and its stock price. Disrupted or soon to be disrupted businesses optically look cheap but are in fact value traps because the businesses are expected to decline as new technology/ way of doing things takes hold. Recall the cases of newspapers, film camera, feature phones etc.

In most cases future disruption is clearly visible. But in some cases it is hazy, even unfounded. This haziness can be a breeding ground for bargains. Often it is feared that existing way of doing business will completely end and new way will take hold. It is framed as an “OR” problem. Newspaper or online news, film camera or digital camera, feature phone or smart phone. But in many minority of cases the question may not be of “OR” but of “AND”. The new and old may co-exist. Or, the incumbents may adapt and be able to offer new products as well. Internal combustion engine (ICE) auto-companies may, for example, transition to electric vehicles (EVs). Physical newspapers may transition to digital versions. Whenever disruption threat is overplayed, it can create mispricings. We have a few such instances in our own portfolio:

One such instance, you will remember, is multiplexes. With the advent of over-the-top (OTT) streaming, it was assumed that theatres will close and everyone will watch movies directly on their TVs/ mobile phones. Pandemic – when theatres were closed – further strengthened that line of thinking. However today we see that theatres are back in demand. It’s not a matter of this or that but both. Both OTT and multiplex will co-exist. In addition to co-existence the incumbent businesses are getting stronger through consolidation and attrition of single screens.

Another such instance is active Vs passive investing. While adoption of passive investing will increase, it can coexist with active. Active managers can create passive products. And if passive is better for investors, more and more investors who have never invested in financial markets will enter markets. Distributors may create a balanced portfolio of active and passive products for investors – passive for meeting benchmarks, active for (hopefully) beating them.

Care, however, needs to be taken to see whether the “AND” phenomenon is actually supportive to industry structure and profitable growth. Returning to the example of ICE vs EV auto companies, while incumbents may migrate to EV, it is not clear which company will win. Also given inputs to battery packs are still not indigenously made, margins and returns on capital are uncertain.

Few “And vs Or” questions are easy to solve, few are not. But whenever all questions are painted with the same fear brush, they can create mispricings.

B4. FLOWS AND SENTIMENTS

We don’t know

To all the leading macroeconomic and geo political questions of current times – where will inflation end, how high will interest rates rise, will there be a recession, how will the Ukraine war end – we have a simple answer: We don’t know. There are far too many variables at play to allow for any actionable forecast. All we can try is to be intelligent observers, watch the data as it comes in and adjust our assessment of intrinsic values of companies that we cover. Most of these issues will turn out to be temporary hardships, which is good for long term investors like us.

In the US, financial markets are caught in the dilemma of which will happen first – entrenched inflation or recession. The US Fed reiterated its intent to continue raising interest rates till inflations comes down meaningfully near its 2% target from current 8.5% even at the cost of near term economic growth. One year US G-sec rates are up from near zero to 4% in a year. Many commodities are down 10%-30% from their recent tops on fears about possibility of recession.

Home loan rates in the US have doubled from 3% to 7% in a year. This is slowing new home sales and should have multiplier effect on many ancillary sectors such as metals, cement, home improvement and construction labour in the US.

Energy prices especially that of gas remain on tear and has put Europe and UK in a spot. If the sanctions on Russia continue and gas prices remain elevated, many European countries will stare at serious economic pain. Currency and bond markets in Europe and UK are seeing unprecedented turmoil. Euro, Pound and Yen are down 20%, 22% and 29% respectively versus the US dollar since 2020. UK and German 10-yr G-sec yields are up from 0.14% and -0.71% in 2020 to 4.18% and 2.26% respectively.

Though not as alarming, inflation in India also crossed 7% and the Reserve Bank of India is raising interest rates.

Amid this backdrop, flows in India improved a little bit in the June to August before slowing down from September. FIIs turned buyers after relentless selling since October 2021 and Indian retail investors continue to invest directly and through mutual funds. IPO launches have resumed to take advantage of market recovery.

India has outperformed most of the markets on year to date basis. While equity indices in US, China, and Germany are down between 15-30% since start of the calendar year, India is down only 2%. How long this decoupling can last is difficult to judge. History, however, suggests that markets are more interlinked today than ever and it is difficult to outperform in either direction for too long.

C. OTHER THOUGHTS

Success Parameter

As we complete 10 years of investing public money, we mull over what should be the true measure of our success.

It can be assets under management (AUM). Fund managers and asset management companies that manager higher AUMs command respect in the industry. Higher AUMs demonstrate that more and more investors have reposed trust with their money. The issue in using AUM as north star is that incentives are designed to gather AUM even during times when it’s best not to.

Or, it can be annualised returns. Managers who can deliver the highest return for longest period of times make huge money for themselves and their clients. However data suggests that despite Indian mutual funds earnings around 14-15% annual returns over long term, many mutual fund investors have lost money due to incorrect entry and exit timing.

AUM and returns are good measures, but the one measure that we truly aspire for is not losing money for any investor.

While right investing – Buying right stocks at right price and giving them adequate weight – can partly ensure that, it’s not enough. Given the volatility in markets, it is certain that despite best efforts we will see drawdowns. But is there a way to ensure investors donot lose money despite interim falls of 20-50%?

Yes, we believe there is. That way is right investor behaviour. We try using our incentives, conduct and communication to nudge investors towards behaving in a manner that ensures fund returns translate into investor returns.

Due to volatile nature of equities, it is a given that there will be paper losses. If one is not hard pressed due to financial need or emotional weakness to sell during downturns that is a win. That preparation cannot be done after markets have fallen. That preparation, in fact starts, when we onboard investors.

We take/ invest money only when we see that we can beat inflation. Moreover, we ask investors to send us money only after having one year of worst case expense liquid with them. And when we do take the money, we want investors to stay invested atleast for a decade. Of course, that requires that our results are not extremely volatile, for a large drawdown can scare the most determined investor. Hence, our conservative stance. Our letters suggest upfront what our current stance is (aggressive, neutral or cautious) and why. We are able to do all this as our fees is linked to returns and not AUMs.

Investing in true sense, thus, is a partnership between investor and fund manager. Both – right investing (from fund manager) and right behaviour (from investor) – are needed for good outcomes. Thankfully, we have been able to do that in last 10 years. No investor has lost money in last 10 years. This is despite last 10 years seeing taper tantrum, GST, demonetisation, IL&FS, Covid-19 and Ukraine war. If there is one thing that we want to be associated with it is this – there is very little chance of losing money investing with us.

That has been our journey so far. We aim for that as the destination too. The journey is the destination!

***

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

 

Festive Greetnigs!

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.

 

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Letter to Investors – Mar 2022 – Extracts

 

EXECUTIVE SUMMARY

  • Trailing twelve months’ earnings of underlying portfolio companies grew by 23%.
  • NAV grew by 14.9% in FY22 with 61% funds invested. NSE Nifty 50 and Nifty 500 grew by 20.3% and 22.3% respectively.
  • Inflation is above 5% mark in many large countries in the world. Ukraine-Russia crisis will keep it high.
  • Markets across geographies and asset classes fell sharply in the quarter, but recovered most of it by the end of the quarter.
  • Stance: Cautious

Dear Fellow Investors,

Broader equity indices fell 13%-20% in Mar’22 quarter before recovering. Many stocks in our coverage fell between 10% and 30%. Some even went near or below their pre-Covid levels. After being cautious and waiting for over twelve months, we have started deploying our 40% cash equivalents gradually. Four factors prevent us from changing our cautious stance. First, valuations in many good and safe companies are still expensive. Second, the outcome of Russia- Ukraine conflict remains uncertain. Third, the issues of rising inflation and interest rates pose real headwinds to equity multiples. And fourth, a new Covid wave seems to be rising in Europe and Asia (esp. China).

 

Long term (multi-year) price movements and long term track record are good barometers of investing prowess. However, volatile prices can make an investment action look smart or dumb in short run irrespective of its real merit. Buying something expensive which gets further expensive due to momentum can look smart. Waiting for high prices to cool during such times can look stupid, as we were looking till last quarter. Similarly buying something cheap which gets further cheap due to momentum can look dumb. In short run, an investment action therefore needs to be evaluated independently of price movements. Two most important yardsticks that you can use for our short term evaluation are understanding and waiting.

 

The foundation of investing is understanding of a company’s business: understanding about its unit economics, growth, profitability, competitive characteristics, disruption threats and management’s track record of capital allocation and fair play. If we fail to understand any of the above areas or find material red flags in any of them, we have learnt to abandon such companies irrespective of how tempting quantitative valuations look or any famous investor owning it.

Once we have companies that we understand and which don’t have material red flags, we attempt to do a reverse valuation exercise. In simpler words, we try to see what growth, profitability or capital requirement assumptions are built in the current price. When prices are discounting reasonable or pessimistic assumptions, we get interested. Unfortunately, good companies run by good management donot come cheap. But sometimes, temporary hardships in either or all four areas – world, country, sector, or company – create mispricing. That requires waiting. Thanks partly to you and partly to the way we are structured, we are able to endure a longer wait than others. So long as we understand our companies and wait for good prices for new investments, you can ignore short term under performance. Our effort in these letters is to apprise you of our efforts on these two crucial aspects of our process.

A. PERFORMANCE

 

A1. Statutory PMS Performance Disclosure

Portfolio  FY22 FY 21  FY 20* Since Inception* Outper-formance Avg YTD Cash  Bal.
CED Long Term Focused Value (PMS) 14.9% 48.5% -9.5% 54.3% 38.5%
NSE Nifty 500 TRI (includes dividends) 22.3% 77.6% -23.6% 65.9% -11.6% NIL
NSE Nifty 50 TRI (includes dividends) 20.3% 72.5% -23.5% 58.7% -4.4% 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.

 

For the financial year ended March 31, 2022, the NAV of our aggregate portfolio was up 14.9%. During the last twelve months we were invested in equities, on monthly average basis, to the extent of 61%. The balance 39% was parked in liquid funds. NSE Nifty 500 and Nifty 50 were up 22.3% and 20.3% respectively including dividends. Newer portfolios are up lesser due to our cautious stance in recent past.

Falling Less: Within the March 2022 quarter, NSE Nifty 500 fell 14% from its quarterly top to quarterly bottom, a first since Mar 2020. In comparison our aggregate NAV fell less at 9% from its top to bottom in the same period. For the near term, we are trying to fall lesser. The fallout of this stance is that if markets continue to rally further – the probability is low, but not zero- we might underperform. That’s the cost of protecting capital.

A2. Underlying business performance

 

Past Twelve Months Past twelve months FY 2022 EPU (expected)
Earnings per unit (EPU)2 Earnings per unit (EPU)
Mar 2022 5.91 5.9-6.03
Dec 2021 (Previous Quarter) 5.7 6.0
Mar 2021 (Previous Year) 4.8
Annual Change 23%
CAGR since inception (Jun 2019) 8.0%
1 Last four quarters ending Dec 2021. Results of Mar quarter are declared by May 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 23% (including effects of cash equivalents that earn ~4-5%).  We are not happy with our annual earnings growth of around 8% in last 2.5 years. Covid-19 and cautious stance leading to higher cash balance had something to do with it. We aspire for at least 15% annual earnings growth over 5+ years.

1-Yr Forward Earnings: We expect FY Mar 22 earnings to be Rs 5.9- Rs 6 per unit versus our earlier estimate of Rs 6.0 per unit. Inflation has made predicting near term earnings difficult.

 

A3. Underlying portfolio parameters

 

Mar 2022 Trailing P/E Forward P/E Portfolio RoE Portfolio Turnover1
CED LTFV (PMS) 26.1x 25.6x 15.3% 6.5%
NSE 50 22.9x2 16.0%3
NSE 500 23.7x2 14.1%3
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

 

We were in two minds till last quarter whether our cautious stance in last twelve months was a mistake. Inflation and Ukraine crisis can invoke confirmation bias and fool us to conclude that we were right in our caution. To be fair, it will be too early to conclude. Short term price movements can make us look stupid and smart within a year.

Continuing on our opening discussion on “waiting”, we would like to share our take on waiting vs timing.

Timing involves selling in hope of buying back later at lower levels and repeating this over. Importantly, it is usually practised irrespective of underlying company fundamentals. Waiting, at least how we practice it, is limited to only buying. And it is tethered to underlying worth of the company.

Buying is an irreversible decision. Overpaying can permanently lower future returns. We are therefore extremely careful of getting new clients/ capital good entry points. When margin of safety on stock by stock basis is low or negative and when expected future returns on a portfolio basis look below inflation, we try to wait for better prices. But once we buy – and here is what differs this from timing – so long as a company’s fundamentals are intact, we bear with moderate overvaluation and donot sell unless overvaluation is bizarre. You would have noticed our portfolio turnover has been under 5% since Mar 2020 as we held on to most of the positions in older portfolios even as prices rose.

***

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

Broader indices corrected over 13% from top during the March quarter before closing 4% down. We added to our existing position in four companies. They were, at the time of our addition, down 38%, 36%, 30% and 30% respectively from their 52week highs.

We have taken toe-hold positions in two new companies who we believe are besieged by temporary hardships. They remain tracking positions as we check our thesis with unfolding reality. 

B4. FLOWS AND SENTIMENTS

Flows and sentiments moderated in the last quarter, first time since March 2020. Covid-19 led monetary stimulus and now Ukraine crisis have raised global inflation from near zero to over 5%. The US central bank has raised interest rates by 0.25%, a first since 2018 and has guided for 6 more raises in CY2022. US-government’s 10 year bond yields are up from a low of 1.2% in Aug 2021 to 2.4% now. The falling interest rates tailwind, that supported global asset prices since 1980s, is seeing its first stress test in 2022. Sidenote: Rising interest rates act as gravity to equity prices; higher interest rates normally leads to lower equity multiples.

 

Before recovering, at one point the Nasdaq 100 index (US technology) was down 21% from top in the quarter. Leading tech stocks like Facebook and Netflix are still down 41% and 46% respectively from their recent tops. India’s leading index NSE Nifty 50 was also down 13% from its highs before recovering. Large Indian IPOs are down between 25%-75%. Not surprisingly, pace of new IPOs has slowed down. Foreign portfolio investors (FPIs) have sold equities worth Rs 1.4 lac crore in last 12 months, highest ever. Had domestic institutions not chipped in with near similar buying, markets would have fallen even more.

 

That brings us to the continued buoyant retail participation. Equity mutual funds have seen 12 months of consecutive net inflows to the tune of Rs 145,000cr, highest ever. While IPO-rush seems to have taken a pause, mutual fund NFOs (new fund offers) continue to tap retail interest. SBI Multicap Fund garnered Rs. 7,500cr in its NFO. As per Prime Database, Retail+HNI shareholding in NSE companies is at all-time high at 9.6%. Their share in exchange turnover has also increased from 38.8% in 2109-20 to 44.7% in Apr-Oct 21. In the same time FPIs holdings fell to nine year low at 20.74%. FPIs and retail investors are having diametrically opposite outlook. Upcoming LIC’s ~Rs. 50,000cr IPO will be an interesting opportunity to see the retail investor behaviour.

C. OTHER THOUGHTS

Absolute Return Mindset

The minimum objective of any investment pursuit should be to beat inflation. Any return over inflation is a bonus. A sustainable way to achieve this minimum objective is to buy good assets cheap. At a price, an asset is expected to meet the said objective and merits investments. At other price it is not so expected and therefore does not merit investing. This is an absolute return mindset and it is focussed on beating inflation.

An investment pursuit that is focussed on earning less than inflation is a fruitless exercise. A return of -5% is not an idle objective. And a professional investor who earns this for his clients should definitely not deserve being remunerated. Surprisingly, over time, investment industry has forgotten this principle and has favoured a relative return mindset which is focussed on beating index.

The reason is “Business-isation” of investment profession that favours AUM (assets under management) based fee and relative returns mindset.

When returns are benchmarked to an index, suddenly a -5% investment outcome looks acceptable when indices have delivered -8%. And investment funds can retain their AUMs and keep earning AUM linked fees (a fixed % of AUM) despite investors losing money. Relative-return focus and AUM based fee also makes business easier to scale. Many distributors require upfront/ recurring commissions and AUM based fee helps earn that. So long as investment managers can match or relatively do better than index, they can earn pat at the back from investors and retain their AUM and fixed fees.

Investment objective has slowly and deceptively morphed from “beating inflation” to “beating index”. And fund managers have convinced investors to pay them as % of AUM irrespective of investment outcome for investors. It’s like paying for getting an entry to a good looking hair salon irrespective of actually getting the hair cut.

In an expensive market, it is not a rocket science to deduce that future returns may not beat inflation. An absolute return mindset, during such times, guides a fund manager to wait for better prices. Mostly, this can only happen if his/ her remuneration is linked to investment returns and not AUM.

While we are not against investment profession turning into investment business, an investor has to think for himself how relative return mindset may misalign incentives and mislead investment actions. When someone asks you to invest with them, ask how are they remunerated!

***

 

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 

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.

 

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Letter to Investors – Mar 2021– Extracts

 

EXECUTIVE SUMMARY

  • TTM earnings of underlying companies grew by 5.7%. That of Nifty 50 and Nifty 500 grew by -6.2% & 3.3% respectively.
  • NAV grew by 48.5% YTD with 71% funds invested. NSE Nifty 50 and Nifty 500 grew by 72.5% and 77.6% respectively.
  • Covid-19 led worldwide lockdowns created 1930s like depression threat. Assets worldwide fell 30-50% in shortest time.
  • Unprecedented global stimulus and vaccine development flipped sentiments and sent markets up 80-100% from lows.
  • Stance: Cautious

Dear Fellow Investors

Test match Vs T20 match

 

10 Overs, 40 runs, 0 wickets. How’s this for a first innings cricket match score? You will rightly ask – What’s the format of this game? It’s a bad score for a twenty-twenty (T20) match, average score for a one day (ODI) match and a decent score for a test match. And if it’s indeed a test match with bouncy pitch, overcast conditions and the best bowling unit in the world – you will say it’s a fantastic score.

In cricket and in investing, it’s impossible and, even, unfair to judge a score without knowing what format of the game it is. What’s good for T20 may be bad for test matches. What’s good for momentum trading may be bad for long term investing.

We are playing a test match and not a T20. The key to success – both in test match batting and long term investing – is to leave or defend the balls that are risky. And, hit only when the ball is in the sweet zone.

This investing sweet zone for us is buying sustainable businesses, run by able and honest management, at reasonable prices. And so long the ball is not in this zone – either the business and/or management and/or price are bad – and the last one is a case today – we wait, and wait and wait. For that juicy half volley or full toss right in our zone. They normally come.

T20s are more popular than test matches. Similarly, short term investment horizon and momentum based trading are more common than long term horizon and value oriented investing. Popular attention is focussed on what’s going to happen next day, week or month in markets. This should not let us forget that we are playing a different game

As we complete twelve Covid-19 affected months, the market sentiments have flipped from fear to greed. Prices in most of the pockets, today, are discounting optimistic future earnings with low discount rates from today till infinity. While risk should always be primary investing focus, it’s all the more necessary when prices are discounting optimism. Reiterating in test cricket parlance, the batting conditions have again become difficult and it’s time to protect our wickets. Cautious stance stays.

 

A. PERFORMANCE

 

A1. Statutory PMS Performance Disclosure

Portfolio FY 2021  FY 2020* Since Inception* Outper-formance Avg YTD Cash  Bal.
CED Long Term Focused Value (PMS) 48.5% -9.5% 34.3% 29.0%
NSE Nifty 500 TRI (includes dividends) 77.6% -23.6% 35.7% -1.4% NIL
NSE Nifty 50 TRI (includes dividends) 72.5% -23.5% 32.0% 2.3% 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.

 

For the year ended March 31, 2021, NAV of our aggregate portfolio was up 48.5% after all expenses and fees. NSE Nifty 500 and Nifty 50 were up 77.6% and 72.5% respectively. During the year we were invested in equities, on monthly average basis, to the extent of 71%. Your returns may differ from this depending on the date of your investments.

One needs to guard against the desire to be a top performer at all times. Markets are not always rational and often go through bubbles. The most popular sectors during bubbles trade at exorbitant valuations and see a rise in their weights in benchmark indices. A top quartile performance during those times can be obtained only by going overweight on popular sectors. And what’s popular is seldom cheap – tech in 1999, infra and real estate in 2007 and quality/ growth in 2020. Other things remaining constant, an underperformance versus the benchmark is a leading indicator of risk reduction during buoyant times.

A2. Underlying business performance

 

Period Past twelve months FY 2021 EPU (expected)
Earnings per unit (EPU)2 Earnings per unit (EPU)
Mar 2021 4.81 5.83
Dec 2020 (Previous Quarter) 5.1
Mar 2020 (Previous Year) 5.7
Annual Change -15.8%4 20%
CAGR since inception (Jun 2019) 0.1%
1 Last four quarters ending Sep 2020. Results of Dec quarter are declared by Feb 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. 4 +5.7% if we exclude one position where there was temporary loss due to Covid-19.

 

Trailing Earnings: In line with our earnings per unit (EPU) guided range of Rs 4.0-5.0, Mar 2021 trailing twelve months EPU came in at Rs 4.8, lower by 15.8% over last year (effects of 29% cash equivalents is included). If we exclude one position which posted temporary loss due to Covid-19, our EPU grew by 5.7%. In comparison, the adjusted earnings of Nifty 50 and Nifty 500 companies grew by -6.2% and 3.3% respectively in the same period (source: Capitaline).

 

1-Yr Forward Earnings: If the vaccination against Covid-19 gathers pace, the lower base of current year will help us put a healthy earnings growth for FY 22. Given the present conditions and assuming no material surprises, we expect our next year’s EPU to close around Rs 5.8, a growth of ~20%.

A3. Underlying portfolio parameters

 

Mar 2021 Trailing P/E Forward P/E Portfolio RoE TTM4 Earnings Growth Portfolio Turnover1
CED LTFV (PMS) 28.0x 23.2x 13.5% -15.8% 3.6%
NSE 50 33.2x2 11.9%3 -6.2%3
NSE 500 35.9x2 17.2%3 +3.3%3
1 ‘sale of equity shares’ divided by ‘average portfolio value’ during the year to date period. 2 Source: NSE. 3Source: Capitaline. 4Trailing Twelve Months

 

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

The biggest treasure that we have built over last 9 years is not the compounded returns, but direct experiences of many mistakes. Mistakes are stupid, but they are also beautiful. Learnings from a mistake that comes with monetary loss sticks. And it is 10x (arbitrary number) impactful than learning from others’ mistake. When we say that we should avoid bad businesses and/ or bad managements and/or bad prices, we know what it means. So we keep reminding ourselves:

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.  

B4. FLOWS AND SENTIMENTS

The US government approved an additional 1.9trn$ Covid-19 stimulus. This along with previous rounds, takes the total US Covid stimulus to 6trn$ (28% of pre covid US GDP). The 10Yr US government security (G-Sec) yields have risen from 0.5% to 1.7% in last 8 months and inflation fears are making the rounds. The US Federal Reserve, however, repeated their tolerance for higher inflation till the goal of full employment is achieved. Thus, fiscal and monetary stimulus in the US continue to support global sentiments towards risky assets including equities. It is difficult to guess when this will pause/ reverse.

 

Back home, the markets were pleased with absence of any new tax in the Indian Union Budget 2021. Announcements on stimulating growth by increasing public capital expenditure by over 25% also improved market sentiments. FPIs equity inflows continued and surged over 37bn in FY21 as against net inflows of USD 1.3 billion in FY20 (source: NSDL).

In sequel to the last letter about observations of crazy behaviour in markets, we continued to observe more such behaviours, as noted below. To clarify, it is still difficult to conclude a bubble, however we need to remain watchful.

 

Globally, IPO markets continue to remain buoyant. Airbnb that went public at 68$, closed at 187$ recently despite Covid restrictions on travel. Kuaishou, a Tik-Tock rival, raised 5.4bn$ in the biggest IPO since Uber, and listed on HK with 160% listing pop. Bumble a loss making dating app, had 68% listing pop valuing it at 7.7bn$. Coupang, touted as baby Amazon of South Korea, raised $4.6bn in its IPO with an 81% listing pop.

 

Combination of social media and zero/low cost trading is promoting curious behaviour. Gamestop, a traditional US video game company, was a short squeeze target of Wallstreetbets, a chat forum on Reddit (social media site). Powered by social media and no-cost-Robinhood-trading, many forum members kept on buying the Gamestop stock, pumping the price up 15x in 20 days. This forced hedge fund Melvin Capital to close its short position (the hedge fund had borrowed and sold the shares in the bet that its price will fall) and raise 3bn$ to save itself.

 

As per a Financial Times report, global mergers and acquisitions (M&A) have seen their strongest developments in four decades in the March quarter of 2021. There were around $1.3 trillion in deals agreed, more than any first quarter since 1980 and higher than the dotcom boom of the 1999-2000.

The bubble in Electric Vehicle (EV) space continues to grow bigger. As per an Economist report, the collective market capitalisation of EV and EV related stocks such as Tesla, CATL, BYD, NIO, LG Chemicals, and Samsung SDI has jumped from $163bn in Jan 2020 to $1,275bn in Feb 2021. Their P/E ratio has risen from 30x to 123x.

Price of crypto currency Bitcoin hit 60,000$, a rise of over 9x in one year. Tesla is allowing customers to buy its car using Bitcoins. A few hedge funds have recognised it as an investible asset. We have no insight into crypto currencies, but it amuses us how a currency can be so volatile.

Back in India, like in the initial stages of every past bubble, retail activity is rising in direct equities. As per AMFI, equity mutual funds have seen net outflows for 8 consecutive months since July-Feb to the tune of INR 58,000cr. At the same time, 1cr new demat accounts were open in last year, a growth of 25%. Retail holdings in NSE listed companies have reached an 11 year high of 7% last year. Investors are booking profits in mutual funds and investing/ trading in direct equities on their own. Commissions of listed brokers’, who cater mainly to retail clients, have risen 80-100% in recent quarters. Upstox a retail discount broker has become multi-year official partner of the Indian Premier League (the only capital market entity on IPL’s sponsor roster) and is planning a US listing. A unidirectional rising market and listing pops in many IPOs continues to fuel retail investors’ interest.

Since July last year, 29 IPOs have hit the India market. Of the Rs 30,000cr they have raised, around two-third was ‘offer for sale, or OFS’ – money going to the selling shareholders and not to the company. These insiders wait for market optimism to time their sale to maximise their selling price. This is reflected in their 31x median P/E. Yet the retail and institutional portions were oversubscribed by average 25x and 60x respectively. There are additional 21 IPOs worth Rs. 19,000 cr that have received SEBI approval. This doesnot include the proposed mega IPO of LIC.

 

C. OTHER THOUGHTS

Low interest rates = Low future equity returns

Low interest rates have been often cited as a justification for higher current equity valuations. When fixed income instruments are yielding 0%-2% in the developed world, investors flock to riskier assets in search of higher returns and equities benefit from this lack of investible opportunities.

However, a corollary to this is lower future equity returns. If investors believe that lower interest rates offer arbitrage benefit to equities and bid up equity prices, this act should reduce the arbitrage and make future returns of all asset classes converge. In other words, if interest rates of 1% around the world pushes money towards equities, future returns from equities will not be different from 1%. Many investors are not taking this into account.

Secondly, there is an implicit assumption that interest rate will remain so low forever. If that’s not the case and rates do rise, they will hit a long tenured asset harder. A 10 year bond falls more in % terms than a 1 year bond for a same rise in interest rates. And equities are perpetual assets. If interest rates do rise, equities are going to fall substantially more.

While everyone’s happy that lower interest rates and abundant capital supports rising equity prices, here’s an outcome that many investing carelessly today may not like: low equity returns if interest rates remain low; and negative equity returns if interest rate increase even marginally. When prices are bid up aggressively – heads you lose, tails you lose too!

The one safeguard against this is to buy equities assuming that interest rates are already high and leave some margin of safety.

Buy High. Sell Low. Repeat. Go Broke

Nothing is as financially ruinous as consistently buying high and selling low. Yet we see it happening all the time. Ignorance, emotions, and miss-selling interact with each other to powerfully induce this folly.

Without a sense of a company’s worth, it is impossible to judge whether its share price is high or low. Assessing that worth requires understanding of underlying business and many investors donot have time, interest or ability to do it. Price trend is generally used as a substitute for this ignorance about intrinsic value. Companies seeing price rising are considered as good and vice versa. When more people believe in this momentum, it becomes a self-fulfilling prophecy. Ignorance encourages buying assets that are rising.

Nothing intoxicates human mind as rising prices. Rising prices trigger emotions of envy, FOMO (fear of missing out) and greed. Those sitting on side-lines get interested. And those making money feel invincible and take more risks even on leverage.

Times of rising markets is business-season for many “experts” – distributors, advisers, brokers, merchant bankers etc. Sadly, financial incentives of almost all “experts” are linked to selling financial products – stocks, mutual funds, IPOs, insurance policies – and not good outcomes for investors. This leads to miss-selling. Mutual funds, life insurers and capital raising companies paid over INR 37,000cr (rough conservative estimate) worth of commissions last year to these “experts”. This was paid without any linkage to the buyers’ returns from the financial products sold.

When willingness to buy during rising prices is met by advice that pays the advisor for selling expensive products, it creates a powerful force to buy high.

The same story reverses when prices fall. In absence of sense of intrinsic value most investors fail to assess whether paper losses are temporary or permanent. Momentum and emotions trigger a rush for the door. And those “experts” who peddled the products during rising prices either disappear or are not heard.

Here’s a crude antidote to this: When past returns of an asset class are high, ignore all temptations and “expert advice” of even higher returns. Conversely, when past returns of an asset class are low or even negative, ignore anything that stops you from investing. Lastly, when taking help from “experts”, see that they are remunerated for results, not selling products. When you get a call from a life insurance agent, just hang up!

***

We have been through a very difficult year. It posed serious challenge to many businesses including ours. Importantly, the volatility that it brought along unnerved many investors. Our businesses have withstood the litmus test well. Importantly and please don’t undermine this – your behaviour has been praiseworthy.

 

Thanks for sticking by. And thanks for your continued trust. You can be absolutely sure that we keep your investment interests at the fore of everything we do at this firm. That is the only way we will continue to be worthy of your trust.

 

Please feel free to share your thoughts, feedback and criticisms.

 

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.

 

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Letter to Investors – Dec 2020 – Extracts

 

EXECUTIVE SUMMARY

  • TTM earnings of portfolio companies fell by 12.1%. That of Nifty 50 and Nifty 500 fell by 10.7% & 15.0% respectively.
  • NAV grew by 44.3% YTD with 74% funds invested. NSE Nifty 50 and Nifty 500 grew by 63.8% and 65.8% respectively.
  • Abundant liquidity and vaccine developments have lifted prices of all assets including equities.
  • We are starting to see deals getting done at valuations that donot make sense.
  • Stance: Cautious

Dear Fellow Investors

Needless Prudence?

 

Financial markets continued their unbridled rise in this quarter as well. In India, NSE Nifty 50 stands 12.5% over its pre-Covid high. In less than 10 months, Nifty has seen 40% unidirectional fall from top – fastest ever, and then 86% almost unidirectional rise from the bottom.

Today, of ~1600 actively traded companies on the NSE, 1155 companies are trading over their pre-Covid highs, 802 companies are trading at 20% over their pre-Covid highs and  467 companies are trading 50% above their pre-Covid highs.

Frankly, we are surprised by this ferocious one way rally.  Like insurance premiums that seem unnecessary costs when insured events (accidents) do not happen, our cautious stance has been found unnecessary, so far.

India was already slowing down even before Covid-19 hit. The coronavirus has surely affected incomes of many people which should further add to the slowdown. And yet broader Indian indices are up 12%-14% from their pre-Covid highs.

Liquidity, and not fundamentals, justify large part of this rally. As per one estimate, 20% of entire US money supply has been created in 2020. Completion of US elections, and beginning of Covid-19 vaccination drives has further improved the sentiments. Global inflation and interest rates remain near zero and central banks worldwide continue to print money. Rising tide of abundant money, thus, continues to lift all boats including equities.

Many pundits have been wrong about reversal of global liquidity and inflation in last decade and we have no special insight to add on this difficult matter. Liquidity may or may not reverse and inflation may or may not arise in next decade. We don’t know. Nonetheless amidst this dilemma, we continue to stick to enduring investment basics – trying to own durable businesses which look reasonably priced even for higher interest rates (interest rates have inverse relationship with equity value.). They will benefit if interest rates remain low and liquidity conditions benign. But should inflation resurface and easy liquidity reverse, these will not turn out to be expensive buys. While this limits our universe, it protects us from overpaying. Cautious stance stays.

 

A. PERFORMANCE

 

A1. Statutory PMS Performance Disclosure

Portfolio FY 2021 YTD Dec’20 FY 2020* Since Inception* Outper-formance Avg YTD Cash Eq. Bal.
CED Long Term Focused Value (PMS) 44.3% -9.5% 30.5% 26.2%
NSE Nifty 500 TRI (includes dividends) 65.8% -23.6% 26.7% 3.8% NIL
NSE Nifty 50 TRI (includes dividends) 63.8% -23.5% 25.3% 5.2% 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.

For the nine months ended December 2020 our NAV was up 44.3%. NSE Nifty 500 and Nifty 50 were up 65.8% and 63.8% respectively. During last nine months, we were invested in equities, on monthly average basis, to the extent of 73.8%.

Our higher than usual weight of cash equivalents, especially in portfolios of clients onboarded on or after September 2020, is the result of lack of margin of safety in the prices of securities that we track. Our incentive structure remunerates us for results – not size, not activity. And this makes us extremely focussed on protection of capital.

In a breakneck rising market like current one, this can hurt temporary returns. However it allows us to control risk in an uncertain world. While regulations require us to benchmark and report our relative performance quarterly, our attention remains on absolute returns.

 

A2. Underlying business performance

 

Period Past twelve months FY 2021 EPU (expected)
Earnings per unit (EPU)2 Earnings per unit (EPU)
Dec 2020 5.11 4.0-5.03
Sep 2020 (Previous Quarter) 5.2 4.0-5.0
Dec 2019 (Previous Year) 5.8
Annual Change -12.1%
CAGR since inception (Jun 2019) 0.1%
1 Last four quarters ending Sep 2020. Results of Dec quarter are declared by Feb 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) came in at Rs 5.1, lower 12.1% over last year and flat versus last quarter (including effects of cash equivalents that earn ~5%).  In comparison, the adjusted earnings of Nifty 50 and Nifty 500 companies fell by 10.7% and 15.0% respectively in the same period (source: Capitaline).

1-Yr Forward Earnings: We continue to expect FY21 earnings per unit of our aggregate portfolio to close between Rs4.0-Rs5.0 per unit.

 

A3. Underlying portfolio parameters

 

Dec 2020 Trailing P/E Forward P/E Portfolio RoE TTM4 Earnings Growth Portfolio Turnover1
CED LTFV (PMS) 25.6x 26.1x-32.6x 18.1% -12.1% 5.9%
NSE 50 38.5x2 11.2%3 -10.7%3
NSE 500 43.4x2 14.7%3 -15.0%3
1 ‘sale of equity shares’ divided by ‘average portfolio value’ during the year to date period. 2 Source: NSE. 3Source: Capitaline. 4Trailing Twelve Months

 

B. DETAILS ON PERFORMANCE

 

B1. MISTAKES AND LEARNINGS

A cautious approach in a rising market can look like a mistake if judged over a short time frame. Conversely – and history is a testament- rising markets can be the breeding grounds for future mistakes. When our and investors’ hard earned money is involved, it’s okay to err on the side of caution in the above dilemma. Underperforming in a rising market temporarily and looking stupid is the small price of long term safety. Jury is still out whether our current cautious stance turns out prudent or foolish.

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. 

 

B4. FLOWS AND SENTIMENTS

US election results and vaccine announcements have augmented flows and sentiments towards risky assets including equities. Some signs of crazy behaviour have started surfacing. Deals are getting done at valuations that don’t make sense. While we are not concluding that everything is going nuts, such incidences point to building up of optimism that ultimately fuels bubbles.

Global primary markets have heated up significantly. As per Refinitive, over 770bn$ worth of equity funds were raised by non-financial firms in 2020 worldover, the highest ever. Renaissance Global IPO index was up 81% in CY2020 vs MSCI’s all-country equity index that was up 14%.

Listing pops– the first day rise of newly listed companies – have become a daily news. DoorDash which had private market value of 2.5bn$ few years ago, jumped 85% on listing day to 60bn$ market capitalisation after raising its IPO price twice. AirBnb closed the listing day 110% up to market cap over 100bn$ (despite travel restrictions in Covid). In Asia, JD Health rose 50% on its listing date in Hong Kong. Recently listed Nongfu Spring, China’s mineral water company, made its founder the richest man in Asia. Chinese toymaker Pop Mart International registered 112% listing gain. In otherwise sombre and conservative Japan, Balmuda – a premium toaster maker – rose 88% on listing day.

Electric car maker Tesla is up 10x since Nov 2019 and is now a part of S&P 500. It now has a greater market cap than the sum of all the other U.S. European, and Korean automakers put together who sold approximately 100 times as many cars as Tesla did in 2019. 

Private companies are not lagging behind in optimism either. In June 2015, there were a little over a hundred private companies worldwide with a valuation greater than US$1 billion. Today, over 500 companies are a part of this club of unicorns.

Back in India too, we can see initial signs of exuberance. Fear of US dollar depreciation owing to unprecedented dollar printing and an increase in weight of India in MSCI index from 8.1% to 8.7% led to record foreign inflows in Indian equities. In the December quarter, foreign portfolio investors (FPIs) have bought stocks over 18bn$ (over Rs.1.3 lac cr.), highest ever in a quarter.

Indian primary markets are heating up as well. Burger King and Mrs. Bector Foods IPOs were subscribed over 150x and jumped 100% each on listing day. The 15 IPOs of CY 2020 were oversubscribed, on an average, to the extent of 75x with average listing pop of over 35%, highest in last decade. Only 13% of the proceeds went to the companies, rest was offer for sale by existing investors including smart private equity investors. Thirty two (32) new fund offers (NFOs) were launched by mutual funds between August and December, one of the highest ever. In December alone, mutual funds are estimated to have raised INR 8000cr through NFOs.

Retail participation in Indian markets is rising. 8 million new demat accounts were opened in 8 months (April-Nov) this year, twice the number of accounts that were opened up in full FY20. Retail holding in listed companies has touched an 11-year high at 7%, as more and more people have opened up to investing directly in markets while working from home.

Many questionable companies of past decade are finding favour again. Many jumped over 100% in November. A renewable energy company is up 6x in 2020. It has entered MSCI India Index. Vanguard bought 13.1mn shares in September. It’s market capitalisation has crossed 165 trn Rs (pushing it in among top 21 companies in India by market cap) and is now trading at 77x book.

These discrete data points donot conclude a bubble, but as Buffett says “be fearful when others are greedy”.

 

C. OTHER THOUGHTS

 

Envy, FOMO and Greed

It’s agonisingly difficult to stay on sidelines as stock prices rally. Every day’s rise, calculable from daily prices, reminds of returns forgone. And, if friends, family and neighbours are gloating about it on social media, the chance of staying cautious amidst rising prices is close to nil.

Envy and fear of missing out (FOMO) are evolutionary emotions that supported survival of human beings. It propelled our hunter forefathers into action and ensured that they were not staying behind in the survival queue.  So is greed. There were survival benefits in over eating or storing excess food or accumulating things beyond immediate need. We inherited these emotions as their legacy.

Envy and FOMO pushes those staying on sidelines to participate in a rising market, often at the top. And greed pushes those who are making money to continue chasing rising prices often on leverage (trade on borrowed money/ margin). This fuels feel good emotions and a feedback loop. Sadly, financial history shows that what cannot go on forever, will stop someday. While good for survival; envy, FOMO and greed are hazardous during investing.

You will be attracted to narratives about how things are different these times and time to make money is now. The origins of these narratives are often from those who get their payday selling part or full of assets/ companies. When someone comes to you with a deal, check how is he/she getting remunerated.

Most of the times, most of the prices donot go in one direction. What’s wise at one price, is foolish at another. Plan of buying assets in hope of passing it on to a greater fool can backfire and one can end up holding the can.

The only antidote against succumbing to envy, FOMO and greed in investing is a sense of intrinsic value and discipline to wait if prices donot leave a sufficient margin of safety against bad luck or error. Both of these – sense of intrinsic value and discipline – come from an understanding of underlying assets/ businesses. Avoid poor businesses &/or poor managements &/or poor prices. And one can avoid many mistakes.

***

In a world gush with liquidity and incentives driving short term behaviour, it’s a blessing to have company of partners who truly think long term. Thanks to you, we can act rationally and choose to opt out of ‘craziness race’ once in a while.

2020 has been a forgettable year. Wish you a normal 2021!  

Kind regards,

Team Compound Everyday Capital

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

 

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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.

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Letter to Investors – Sep2020 – Extracts

 

EXECUTIVE SUMMARY

  • TTM earnings of portfolio companies were up 2%. That of Nifty 50 and Nifty 500 fell by 14.6% and 19.5% respectively.
  • Our NAV grew by 31.8% YTD with 75.7% funds invested. NSE Nifty 50 and Nifty 500 grew by 31.5% and 34.2% respectively.
  • Markets continue to believe that despite current economic pain, things will get back to normal soon. We don’t know.
  • Temporary hardships make good companies available at reasonable prices. Caveat is an understanding of the business.
  • Stance: Cautious

 

Dear Fellow Investors,

What’s already in the price?

 

At first glance it seems surprising that the NSE Nifty 50 index is up 48% since March lows when economic data on incomes, jobs, consumption, and production is showing clear signs of Covid-19 inflected pain. However, if we recall that stock markets are future-discounting machines and stock prices are meant to reflect the future and not the present, this seeming Dalal street-Main street disconnect looks less puzzling.

Solutions to Covid-19 will be found and economic activity will recover swiftly thereafter. At most one year’s earnings will be washed out – not material to the intrinsic values of most of businesses. In hindsight, current prices will not look inefficient or irrational if this scenario plays out without any hiccups.

But what if it doesn’t?

Uncertainties still remain elevated. While there is month on month improvement in economic activity since April lows, Covid-19 has still not peaked out. It remains a bottleneck to supply-chains, incomes, consumption, and debt repayments. Globalisation – the fountainhead of global prosperity- is under threat due to unequal distribution of its proceeds. Unbridled money printing – probably the only economic balm to Covid distress- keeps the risk of all-illusive inflation alive even if it may be years or decades away. And the world continues to remain susceptible to geopolitical shocks. These and more continue to remain adverse, uncertain and non-zero portability events.

It seems that prices today are building in only the former optimistic version of the future and assigning zero probability to latter. Margin of safety stands reduced today and this requires us to change our stance from neutral to cautious.

Of course, different companies are affected by Covid-19 differently. Most of those favourably placed but seen sharp price rise as well as most of those structurally disrupted and seen price fall, both leave little margin of safety. Those affected temporarily but where prices are discounting permanent damage, present opportunity if one understands the underlying business. We are focussing our energies here without compromising on business and management quality.

 

A. PERFORMANCE

A1. Statutory PMS Performance Disclosure

 

 

Portfolio 2021

YTD Jun’20

2020* Since

Inception*

Outper-

fromance

Avg. YTD

Cash Bal.

CED Long Term Focused Value (PMS) 31.8% -9.5% 19.2% 24.3%
NSE Nifty 500 TRI(including dividends) 34.2% -23.6% 2.5% 16.7% NIL
NSE Nifty 50 TRI (including dividends) 31.5% -23.5% 0.6% 18.6% 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.

 

For the half year ended Sep 2020 our aggregate NAV was up 31.8%. NSE Nifty 500 and Nifty 50 were up 34.2% and 31.5% respectively in the same period. We were invested in equities, on monthly average basis, to the extent of 75.7%. In line with your mandate, we will act when things make sense to us, until then we will be happy to wait. Individual client’s NAV and cash balance may differ from the above depending on their date of investment.

 

A2. Underlying business performance 

 

Period Past twelve months FY 2021 EPU (expected)
Earnings per unit (EPU)2 Earnings per unit (EPU)
Sep 2020 5.11 4.0-5.03
Jun 2020 5.3 4.0-5.0
Sep 2019 5.0
Annual Change 2.0%  
1 Last four quarters ending Jun 2020. Results of Sep quarter will be declared by Nov only.

2 Total earnings accruing to the aggregate portfolio divided by units outstanding. Earnings exclude extraordinary items.

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: Earnings per unit (EPU) for trailing twelve months Sep 2020 EPU came in at Rs 5.1, higher by 2.0% over last year (including effects of cash equivalents that earn ~5% pre-tax).  In comparison, the adjusted earnings of Nifty 50 and Nifty 500 companies fell by 14.6% and 19.5% (35.2% if we include Yes Bank, Vodafone Idea and Reliance Communication) respectively in the same period (source: Capitaline).

 

1-Yr Forward Earnings: Predicting FY21 earnings continues to remain difficult. Going by the in-line June quarter results of our companies, we maintain our broad estimate for FY21 earnings at Rs. 4.0-5.0 per unit. Please treat this estimate with caution. Depending on how the pandemic unfolds, it can be off reality by wide margin. Nonetheless, FY22 looks normal year as of now.

 

A3. Underlying portfolio parameters (PMS)

Sep 2020 Trailing P/E 1Yr Forward P/E Portfolio RoE Portfolio Turnover1
CED LTFV 23.4x 23.8x-29.8x 16.1% 2.1%
NSE 50 32.7x2 11.0%3
NSE 500 40.6x2 8.3%3
1 ‘Sale of equity shares’ divided by ‘average portfolio value’ during the period. There was no sale of equity shares in this quarter hence the portfolio turnover is NIL.

2 Source: NSE , 3 Source: Capitaline

 

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

Assessing management quality is an important but difficult part of investment process. It cannot be reduced to numbers and remains a qualitative endeavour. Getting better at it is a continuous process and rewarding too – it aids long term returns by avoiding landmines.

One important input to assessment of management quality is capital allocation decisions. Equity value increases when management is able to invest its free cash in projects that can earn returns above the overall cost of capital. Many times, assessing this ex-ante is fogged by sweet talking optimist management whose incentives are mostly linked to growing the size of the company and not shareholder returns.

Normally, investing in (1) same line of business, (2) organically and (3) using internal accruals has shown to be more return accretive. Conversely, (1) diversification or (2) growth through expensive acquisitions, (3) that are debt funded has proven sub optimal. Of course, there can be exceptions but broadly this has held true over time and geographies. And then there are outright burglaries done using related party transactions and/or accounting jugglery.

When there are no value accretive investment projects, next best capital allocation decision is to distribute the cash back to shareholders through dividends or buybacks. Normally when share prices are low, and company has excess cash, buybacks have proven to be a better option than dividends.

We have exited from a minor position last quarter where we sensed that above cardinal rules of efficient capital allocation were violated. You will read more about it further. We hope that this sensitivity to capital allocation has helped us avoid a potential mistake.

Like always, in this section we continue to remind ourselves about past mistakes. It deflates our over confidence, warns us to remain humble and refreshes the important lessons.

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 have completely exited from Bajaj Consumer at a loss of 0.7% of NAV. There were no other material additions or deletions to our holdings.

As we wrote in last few letters, Bajaj Consumer (the maker of Bajaj Almond Drops hair oil) was a minor position which we looked as optionality. While stock rose 50% from its Covid lows and earnings fell only 4% in Covid affected Jun quarter due to cut in marketing spends, company’s recent capital allocation decisions disappointed us and we thought it prudent to move out:

Dividend policy: The company cut down its dividend from Rs. 14 per share in last year to just Rs. 2 per share despite having surplus cash of Rs. 450 cr (Rs. 30.5 per share) as of March 31, 2020. That this happened soon after promoters reduced their pledged shares to nil, makes us more worried. In retrospect, the erstwhile high dividend payout looks like a means for personal debt service of promoters and not a shareholder value creation policy. 

Buyback: The company had a great opportunity to do a buyback given its stock was trading at less than 10x trailing earnings. Even now at 14.7x it’s not a bad proposition. Moreover this could also have led to rise in promoter’s stake (now reduced to 38% after they sold 22% stake to reduce promoter pledge) without any cash outflow from their pocket if they chose not to participate. They repeatedly opposed doing a buyback, despite stated intent of increasing promoter stake in the company.

Keenness to M&A: Instead of maintaining the dividend payout or buying back bits of their own undervalued company, management is keen to grow via acquisitions including international ones. These almost never come cheap and almost never add value.

Active capital misallocation: Management is spending over INR 70 cr in constructing a corporate office for entire Shishir Bajaj group (including Bajaj Hindustan and Bajaj Energy). Rental yields, even if struck at arm’s length, will be around 7-8% pre-tax – not the best use of surplus cash.

While the company owns a popular hair oil brand (~10% market share), has been generating good RoEs (33% +) and looks cheap (14.7x trailing earnings), the above acts (post our purchase) reduce the probability of rerating of the company. In past we have seen that when managements undermine minority shareholders’ interests, business quality and valuations become less important. The right thing during such times as minority shareholders is to take the money and run!

Of course, if management learns from feedbacks and pivots from the current stance, things may improve however we want evidence before committing money. Till then it goes back to our watchlist.

 

B3. UNDERLYING FUNDAMENTAL PERFORMANCE

Temporary Hardships

Good businesses seldom trade at bargain prices.  However some times, very rarely, they are struck by adversity that hurts earnings. In our experience the immediate price reaction to any sudden negative development for good business is mostly negative. If on a calm analysis we can conclude that the hardships are temporary and less impactful than the price has discounted, such bloopers can be a good opportunity to pick good businesses at good prices.

The obvious mistake that can be made is to misjudge permanent hardship as temporary, and structural headwinds as cyclical shifts. The only antidote against making this mistake is a sound understanding of the business and its industry.

So long as demand continues to remain robust, business debt free or has access to capital, raw material or end product prices are cyclical, and remedial measures remain in control of management, the hardships are temporary. However if there is challenge to long term sustainability of demand, or new technology brings in better and/or cheaper solutions hardships are permanent. Curiously temporary hardships have higher visibility, permanent hardships are less noisy. Management and media miss the latter or hope it to be temporary. Nonetheless, ability to distinguish between the two can be profitable. Covid-19 is a temporary hardship for many companies. Wherever prices are misjudging it to be permanent can prove to be good opportunities.

 

B4. FLOWS AND SENTIMENTS

 

Global markets continue to remain linked to the behaviour of US markets. Thanks to fiscal and monetary stimulus, liquidity remains abundant. US Dollar’s weakness against major currency basket had also increased the flows towards emerging markets including India. FIIs invested 6.3bn$ in the month of August (a decade high) in India and a total of ~11bn$ from April-Sep 2020.

 

US Fed revised its policy framework and announced that it is will target “average” inflation and will tolerate higher inflation for periods following period of low inflation. Further, it will not pre-emptively raise rates on reaching high employment unless the inflation rises. This, in effect, implies that US Fed is likely to maintain low rates for longer and will not be raising rates proactively to curb inflation.

 

Back in India, eight IPOs were launched in the month of September and seven more are slated in 2020 raising a total sum over 2.5bn$. Many of these have seen subscription to the extent of 74x-150x and opened 70%-123% higher than IPO price on listing days. Similar frenzy has been seen around the world. Either the bankers, private equity selling shareholders, and promoters to the issue (whose are insiders and incentivised to maximise the issue price) are missing something or, the investors are. No prizes for guessing who it will turn out to be.

 

After rising for over 24 months, net mutual fund equity inflows fell for two months in a row (July and Aug) by Rs.2,480cr. and Rs. 4,000cr respectively . SIP flows fell marginally from Rs. 8,500cr run rate pre-Covid to Rs. 7,792cr. in August. 

The US is entering presidential election season and history suggests that months before the election remain volatile. This is not a bad thing given our spare cash.

C. OTHER THOUGHTS

CAPITAL AND ITS COST

For valuation purposes we are concerned with average interest rates expected over the future. Near zero interest rates and abundant liquidity in most advanced nations has lowered cost of capital and supported equity valuations over the last decade. Is it reasonable to expect interest rates to perpetually remain close to zero?

It’s an important but tough question to answer. Trajectory of future interest rates will influence future returns from equities.

Policy interest rates in Japan have been zero since over two decades without igniting inflation. Higher doses of liquidity and fiscal and monetary stimulus were the only options available to the world during the 2008 Subprime crisis and the current coronavirus crisis. The costs of not infusing relief would have been fatal. Today, there are political incentives to keep kicking the liquidity can down the road to avoid/ delay recessions. Is the world, then, moving on a dismountable liquidity-tiger in the Japanese direction?

Japan may be an exception to the world today. With highest share of senior citizens, Japan faces demographic headwind – stagnant productivity, higher savings and lesser consumption. Its GDP growth rate is low and that’s why Nikkei 225, the Japanese stock index, is roughly at the same lever today as it was in 1991 despite near zero interest rates. Moreover, Japan also has one of the lowest unemployment and inequalities in the world.

Even if we believe that the EU is seeing demographic headwinds similar to Japan, the average age of the world, thanks to India and China, is still low. Youth in developing world seeks employment and improved living standards that accrue from jobs and consumption. Addressing the rising inequality is gaining political currency too. Globalisation is on retreat and producing more at home will raise cost of production. Moreover the fiscal doleouts given to the weaker sections worst hit by the pandemic will maintain demand for goods and services. US Fed has announced its tolerance for 2%+ inflation to get to full employment. Thus unlike Japan, there remains a non-zero chance that inflation can rise and ignite a rise in interest rates around the world. The timing and quantum remains uncertain.

When interest rates are low, present value of profits far into the future are roughly equal to current profits. But when interest rates are high, future profits are less valuable than today’s. What should be the fair P/E multiple for equities therefore depend on where the interest rates will be in future. Honestly we don’t have an answer. However not knowing the answer is itself an answer. It’s not 100% certain that interest rates will remain so low for such a long period. We should keep this mind and not lead the past decade to mislead about the future.

***

LESSONS FROM THE PANDEMIC

Humility and margin of safety: Covid-19 has put a spot light on our ignorance- both known and unknown – things we know/don’t know that we don’t know.  In investing and in business, despite all the research, there will be things that we will not be able to know/ plan for. This calls for humility and need to have a margin of safety. In business, this means (1) having a balance between efficiency & resilience, and (2) being prudent with debt. In investing, this means not overpaying, however rosy the future may look today. 

Timing is difficult – No one can pick bottoms sustainably. Right time to buy is when things are going down even at the risk of near term mark downs. When Nifty50 touched the lows of 7500 in March, the general expectation was that prices will continue to go down further and there was reluctance to invest. It looked like extremely uncertain time to invest. Certainty and low prices donot go together. If we wait for clouds to clear, prices will move up.

Change?: The virus has and will change many things. It’s tempting to accept everything in a flux. But that will be a wrong lesson. There will be many things that the virus will not change. Human propensity to prosper will not change. People will continue to move in the direction that makes their lives easier. This will ensure that businesses that cater to meeting growing needs will remain in force. Consumer behaviour including socialising will also not change materially. The chains of habit formed over decades will be difficult to break by what looks like a 2-3 years virus outbreak. Investor behaviour will also not change materially. Greed, fear, envy, ego and institutional limitations will continue to make prices more volatile than fundamentals.

Health is wealth – In these pages we keep talking about ways to sustainably grow financial wealth. However, as the pandemic has shown, such prosperity is incomplete without good health. It’s important to focus on health equally, or more. Eating responsibly, being physically active, taking adequate sleep and reducing stress should be paid as much attention as wealth building.

***

Last six months have not been kind. Hopefully the worst is behind us. Thanks to your rational behaviour, we have made a good use of this pandemic. We continue to do what’s best for you. That’s how our incentives are designed. Thank you for your trust. Stay safe.

 

 

Kind regards,

Team Compound Everyday Capital

Sumit Sarda, Surbhi Kabra Sarda, Saloni Jindal, Sachin Shrivastava, Sanjana Sukhtankar and Sumit Gokhiya

 

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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.

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QAAP/ GAAP

Many investment styles – along the continuum of growth and value – go in and out of favour periodically. Success of one style sows the seeds of its own failure. When many investors adopt that style, the price rises way beyond most optimistic estimate of value.

One such style that has done well in recent years has been QAAP – Quality at any price or GAAP – Growth at any price. Rising flows and sombre economic outlook has led money to be hidden into few proven names that are perceived to have moats, growth, high returns on capital, charismatic management, and long run way.

Sure, there are a minority of companies that deserve paying up. We too have paid and remain ready to pay up for such exceptional businesses. But the base rate (past experience) of high earnings growth (30% or higher) for long period is very small.

Of 1326 listed Indian companies that existed and were profitable 20 years ago in the year 1999, two-third of the companies grew their earnings at less than 15% CAGR (cumulative annual growth rate) over next 20 years. And only 6% of companies grew their operating earnings at over 20% CAGR in the same period. Moreover, companies that grew over 20% CAGR in initial years saw their operating earnings growth falling to an average 10%. (Source: Capitaline)

Despite this high bar, and despite their earnings growth slowing down in recent 6 months, over 20% of NSE 500 companies today trade at P/E greater than 40x. Often markets get into growth narrative and recent tailwinds are misconstrued as moats.  Stocks start trading at astronomic valuations assuming that high growth rates will continue. Long term earnings data gives clear evidence that such expectations exceed reality. Unbridled quest for QAAP/ GAAP may be a TRAP.

Note: This piece was part of one of our half yearly letters sent to our investors.

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Owners’ Manual

Our Owners’ Manual represents the collective will of all our partners. As trustees of our collective wealth, firm’s managing partners will always honour the manual in designing the firm’s investing and operating actions. We owe the inspiration to create this manual to Warren Buffett.

Here it goes:

Partners’ trust is our asset, their money our liability

    • We put partners first in our incentives, conduct and communication. This is not a vague marketing catchphrase. Having known the compounding power of trust, it makes an immense business sense to do so. It would be foolish to do otherwise.
    • We operate knowing that partners’ hard earned money is on the line. Our investment presupposes protection of capital. And our operations presuppose frugality.
    • Noble intentions should be matched by concrete actions. The managing partners, therefore, have their major portion of networth invested in this firm. We eat our own cooking.

Our long term goal is to keep increasing “our share in economic earnings and net assets of underlying businesses” as % of our investment cost.

    • We donot treat stocks as screen tickers or lottery tickets. For us a stock represents part ownership in a live business that has an intrinsic value which may be different from its price.
    • By owning a stock we get to own a share in economic earnings and net assets of underlying business. By economic earnings we mean normalised earning power.
    • We will do well if, in long run, we can increase “our share in economic earnings and net assets of underlying businesses” as % of our investment cost.
    • Essential to seeing this happen is that we buy good businesses at or below their intrinsic values and hold them till they remain good and inexpensive (points 3, 4 and 5 below).

First key to our work is conservative assessment of intrinsic values of underlying businesses

    • Stated simply, intrinsic value of any business is the present value of its future cash flows.
    • To make intrinsic values reliable, we try to limit our research to good businesses that have some competitive advantages, are simple to understand and are run by able and honest management.
    • Moreover, our analysis presumes that most things in business– commodity prices, interest rates, and demand – will turn out to be cyclical. We give due credit to this reality while imagining future.

Second key is to buy at or below intrinsic value

    • Key to reduce the risk of permanent loss of capital is not to overpay. Good businesses are rare and situations that make them available below intrinsic values are rarer still. Such situations broadly include:
      • Out of favour business (cyclical downturns, one time difficult but solvable problem)
      • General market downturns (recessions, depressions)
      • Contrary analysis (time arbitrage, different view)
      • Disinterest (small size, index exclusion)
    • Owing to this dual rarity (rare business, rare prices), often we need to sit on cash (or cash equivalents) and wait. When owing to the four factors above (i to iv), opportunities do present themselves, we bet big by limiting our portfolio to 10-12 concentrated positions.

Third key is to hold businesses till they remain good and inexpensive

    • Big money is mostly made, not by frequent buying and selling, but by holding.
    • If the businesses that we buy (after step 3 and 4 above) remain good and inexpensive, holding them for long term renders focus and saves costs– two essentials for benefitting from the power of compounding.

Actions driven by rationality rather than emotions

    • Owing to greed, envy or fear, short term prices sometimes get de-anchored from intrinsic values.
    • Execution of points 3, 4 and 5 above will require us to remember this dichotomy, and keep our focus on intrinsic values.
    • By not chasing hot stocks during bull runs, we like all value investors will see temporary but reversible periods of underperformance. Bear with us during those periods. We would be conserving cash to put to use when the bubble bursts. When bubble does burst, resist selling and if possible invest more. During those periods markets go on SALE and our hard work is rewarded.
    • As a corollary, it would be unwise to gauge our performance from short term price movements. We, therefore, look at changes in fundamentals to review our performance.

Reporting philosophy

    • We will follow the agreed reporting format irrespective of good or bad performance.
    • The spirit of the reporting format is expectations managing partners will themselves have if our roles are reversed.
    • Mention of mistakes will precede mention of accomplishments.
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