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

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

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

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.

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

Kind regards,

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.

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

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

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

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!

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

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.

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

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

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

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.

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

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

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

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.