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.
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)|
|Dec 2022 (Previous Quarter)||5.5|
|Mar 2022 (Previous Year)||6.2|
|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%|
|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!
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.