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

————————————————————————————————————————————————————————————————-

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.

 

Continue Reading

Letter to Investors – Jun 2022 – Extracts

 

EXECUTIVE SUMMARY

  • Trailing twelve months’ earnings of underlying portfolio companies grew by 17%.
  • NAV fell by 8.2% YTD (Apr-Jun) with 62% funds invested. NSE Nifty 50 and Nifty 500 fell by 9.1% and 9.7% respectively.
  • Inflation is high globally and money supply is getting tighter, bringing in much missed sanity to asset prices.
  • Being prepared for this, we are investing our above-average cash reserves gradually. Valuations are still high in some pockets.
  • Stance: Neutral

Dear Fellow Investors,

It was the best of times, it was the worst of times

-Charles Dickens, The Tale of Two Cities

Rising global inflation and resulting tightening of liquidity has pulled global markets including Indian equities lower. While exact causes and future trajectory of inflation are neither easy nor interesting topics to discuss, the impact inflation has on businesses, valuations and investment opportunities is real and therefore deserves your investment attention. 

Intrinsic value of a business is present value of its future free-cash-flows (cash profits less investments) discounted at an expected reasonable rate of return. Inflation can adversely affect all the three elements of this value equation – (1) profits, (2) investments in working capital & fixed assets and (3) expected reasonable rate of return (aka cost of capital).

Profits – When revenues fail to increase as fast as costs during inflation, profitability suffers. There are two antidotes to this– (a) raise prices, and/or (b) control costs. There are many nuances to each of them.

Companies that sell unsubstitutable necessities such as staples, utilities etc. can raise prices without material effect on volumes. Inflation raises output prices for commodity producing companies (steel, copper, aluminium, oil etc.), but the benefits are temporary due to cyclicity – higher prices reduce demand and/or attract new supply that cool prices. For lenders, interest rates on loans are reset faster than cost of deposits and supports margins. Industries with low spare capacity can raise prices in near term without materially affecting volumes. On the other side, often regulatory caps on pricing can become a deterrent. If end consumers are seeing strain on their budgets, they will try to delay, substitute or downtrend. However, companies serving higher income consumers may be hit less.

On cost side, companies with high operating margins can maintain absolute profits without large increase in output prices during inflation. Illustration: if revenue is 100, operating cost is 30, then operating profit is 70 (and operating margin 70%). If costs rise by 10% to 33, just a 3% rise in sales price to 103 can protect absolute operating profits of 70. Whereas if the operating margins are 30%, a 7% rise in sales prices will be needed.  Continuing on costs, companies with high operating leverage (high fixed costs) can see rise in margins with rise in volumes (rise in fixed costs is slower than rise in volumes and improves margins). Lastly, a lower cost player can breakeven when others in the industry bleed and can get stronger as competition dwindle.

Finally, if inflation leads to rise in interest rates or currency depreciation, companies with high debt or imports can see sharp rise in their interest and forex cost, that can further hurt profits.

Investments – Working capital and capital expenditure (capex) rise with inflation. Rising input prices increase investments in inventory, and rising output prices increase receivables. Some of this is negated by rise in payables. Dominant companies who can keep low inventories, receive dues faster from customers and delay payment to vendors can keep working capital low. Capex heavy businesses are worst hit during inflation. Maintenance or new capex rise in line with inflation. The rise has to be paid out of profits and this reduces free cash that can distributed to shareholders. Capex and working capital light businesses are best saved during inflation. Services are generally less investment intensive than goods. Companies where large capex is already done will also be less affected by inflation.

Discount Rate: Central banks usually raise interest rates to control inflation. This raises the hurdle rate that risky investments like equities should deliver. A higher discount rate reduces present value of future cashflows. There is no running away from this for any company, but loss making companies with back ended cashflows are hit more. Higher discount rates should make us wary of paying high multiples even for strong companies. Keeping other things constant, what was deemed fair at 30x earnings during low inflationary period can become expensive during high inflation.

For a given company, the net effect of inflation on all three variables – profits, investments and discount rate – need to be studied together to understand its investment merit. High points on profitability and/or investments may be nullified by low points due to high valuations. Moreover, short term effects need to be separated from longer term effects. Pricing tailwinds for many commodity producers may be cyclical. Stronger companies may sacrifice margins in near term to capture market share from weaker ones. In short, assessing impact of inflation on intrinsic value is little messy and we need to err on the side of caution. This means accepting that the sub set of companies whose intrinsic values may rise during inflation is very small.

By threatening to adversely impact cashflows and discount rates, inflation has arrested the unidirectional worldwide rise in asset prices. This is the bad part. However after two years, barring a few sector/ companies, valuations in many of our coverage stocks are coming back to reasonable levels. This is the good part. We are changing our stance from cautious to neutral.

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) -8.2% 14.9% 48.5% -9.5% 41.7% 38.0%
NSE Nifty 500 TRI (includes dividends) -9.7% 22.3% 77.6% -23.6% 49.8% -8.1% NIL
NSE Nifty 50 TRI (includes dividends) -9.1% 20.3% 72.5% -23.5% 44.3% -2.6% NIL
*From Jul 24, 2019; Note: As required by SEBI, the returns are calculated on time weighted average (NAV) basis. The returns are NET OF ALL EXPENSES AND FEES. The returns pertain to ENTIRE portfolio of our one and only strategy. Individual investor returns may vary from above owing to different investment dates. Annual returns are audited but not verified by SEBI.

 

As shared in recent past letters in the backdrop of high valuations, our efforts have been to fall less. This quarter we have started to see small progress towards that. Versus Nifty500 we have fallen less by 1.7%. What gives us satisfaction is that for capital that was introduced in last twelve months (a period of high valuation), the weighted average marked to market loss is 0.5% versus Nifty 500’s loss of 7.9% in the same period.

Our minimum objective is to beat inflation on every incremental Rupee that we invest. At one stock price this is not possible and we wait. And at another it looks possible or even better and we act. We will continue to be guided by this principle.

A2. Underlying business performance

 

Past Twelve Months Earnings per unit (EPU)2 FY 2023 EPU (expected)
Mar 2022 6.21 6.5-7.53
Dec 2021 (Previous Quarter) 5.9
Mar 2021 (Previous Year) 5.3
Annual Change 17%
CAGR since inception (Jun 2019) 10%
1 Last four quarters ending Mar 2022. Results of Jun quarter are declared by Aug only. 2 EPU = Total normalised earnings accruing to the aggregate portfolio divided by units outstanding. 3 Please note: the forward earnings per unit (EPU) are conservative estimates of our expectation of future earnings of underlying companies. In past we have been wrong – often by wide margin – in our estimates and there is a risk that we are wrong about the forward EPU reported to you above. 

Trailing Earnings: Trailing twelve months Earnings Per Unit (EPU) of underlying companies, grew by 17% (including effects of cash equivalents that earn ~4-5%).  This was in line with our start-of-the-year expectation. In Jun 2021 letter, amid very high uncertainty, we had pegged the FY22 expected EPU at Rs 5.8 per unit. Actual EPU has come at Rs 6.2.

1-Yr Forward Earnings: We introduce estimate for FY 23 earnings per unit at Rs 6.5-7.5 per unit. This wide margin is an acknowledgement of difficulty in predicting earnings during inflationary periods.

 

A3. Underlying portfolio parameters

 

Jun 2022 Trailing P/E Forward P/E Portfolio RoE Portfolio Turnover1
CED LTFV (PMS) 22.9x 20.2x 17.4% 1.4%
NSE 50 19.5x2 15.6%3
NSE 500 20.1x2 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

There were no new mistakes to report this period. We continue to remind ourselves of our past mistakes:

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

B2. MAJOR PORTFOLIO CHANGES

We added to our existing positions in four companies. Additionally, we trimmed our position in one company in some over-weight portfolios.

B4. FLOWS AND SENTIMENTS

Sentiments and flows continue to remain weak due to fear of monetary tightening and interest rate hikes required to cool down inflation that has crossed 8% in the US and the Euro Zone. Yields of 10 year US government bonds are up from 0.5% in Aug 2020 to 2.9% as of this letter. At 7.04%, India’s inflation has remained above RBI’s target of 6% forcing the RBI to announce out of schedule hike in policy rates of 0.4%.

Suddenly, the world that has been awash with liquidity is finding capital getting costly.

In the US, Tech heavy Nasdaq Composite index is down 32% from its recent highs. Morgan Stanley’s unprofitable Tech Index – an index of loss making tech companies – is down over 60% percent since the start of 2022. Covid darlings like Peleton, Zoom and Robinhood are down 80%-90% from their Covid highs.

IPO pipelines have dried up in the world including India. Private equity and venture capital funds including biggies like Sequoia Capital are advising their investee companies to change their focus from growth to profitability and cashflows. Many startups have been giving ESOPs to attract talent. With stock prices falling sharply, and ESOPs are no longer attractive, hiring cash costs will rise for startups at the time when capital is not easy to raise without downrounds. Startup layoffs are rising.

Total market capitalisation of all crypto currencies is down from peak of 3trn$ to under 1trn$. Bitcoin’s price is down from 60,000$ to 20,000$. Tokens like Terra and Luna have collapsed and Celsius has halted withdrawals (so much for de-centralised currencies).

In India, FPI (foreign portfolio investors) outflows have crossed 33bn$ in last 9 months since Oct 2021, highest ever. Infact, monthly FPI outflows of May 2022 were just 10% lower than Mar 2020 when markets fell over 30% (In May 2022, markets fell 4%). Thanks to continued retail inflows especially through domestic mutual funds the FPI selling has not caused as sharp a selldown as in the past.

In short, while retail enthusiasm remains intact, the general mood has turned from euphoria to caution. We like that.

C. OTHER THOUGHTS

Imagining a different world

If we dial back back a year, US 10 year G-sec were 1.3%, inflation had been below 2% in the rich world for over 11 years and capital was abundant. Tech businesses scaled massively and their stocks galloped at an unprecedented pace. New concepts such as SPAC, Crypto and Unicorns became popular buzz words. Capital was a moat. First mover startups with capital backing kept on growing despite losses. It was difficult to fathom a world of capital scarcity, rising inflation or disciplined valuations. Yet imagining a pause or reversal was an important part of an investor’s toolkit to control risk.

Cut to today, most of those unimaginable things have turned to reality. Inflation is above 8%, US 10 yr bonds are at 2.9%, and capital has become cautious. Tech stock, Crypto, SPAC and Unicorns are looking weak. If capital dries up it will be difficult to see loss making startups commanding multi-billion dollar valuations. Discipline capital spending and sensible valuations are making a comeback. And if this will continue for few quarters more it lead to an exact opposite situation to the one described in previous paragraph. Lower inflation, lower interest rates, growth, will look impossible. Yet imagining them to reverse in some point in future will be an important part of an investor’s toolkit to grab opportunities.

Most things in business including growth, margins, capital availability and valuation multiples turn out to be cyclical. Investment risks can be reduced if (a) we can understand where we are in the cycle and (b) we can position for gradual reversal of the cycle. This involves going slow when bottom up valuations donot makes sense and going fast when they do. We have traversed the first part by being cautious for last 18 months and keeping high levels of cash (often looking foolish). We need to be ready for the second part!

The right discount rate

As we discussed in the opening section, intrinsic value of any asset is the present value of its future free cashflows discounted at an appropriate discount rate. The appropriate discount rate should be the realistic return that one expects from investing in that asset. Such expectation is shaped by returns on risk free instruments of similar maturity. An equity share is a long dated asset, good ones are perpetual. Many great companies are in existence for over 100 years (For eg. Coca Cola, Unilever, P&G etc). In India, the longest dated risk free instrument is the 30 year government bonds. Their current yields are 7.5%. Given that equities are riskier and longer dated than this, we need to add some spread to this. Indian equity discount rates, thus, should be above 7.5% currently, but how much above is a matter of judgement.

Financial theory tries to use past volatility to arrive at this number and involves needless mathematical jugglery. We use a 10% discount rate for quality businesses and keep raising this for lesser ones. Mind you, present values are very sensitive to discount rates. A fall of 1% in discount rates, raises the present value of a 30 year cashflow stream growing at 5% annually by around 11%-13%. Without mathematical acrobatics, our practice is to use a high discount rate. If the business looks fairly valued leave alone cheap at that rate, we become interested.

***

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

 

Kind regards 

Team Compound Everyday Capital

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

————————————————————————————————————————————————————————————————-

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

 

Continue Reading

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

————————————————————————————————————————————————————————————————-

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.

 

Continue Reading

Letter to Investors – Dec 2021– Extracts

 

EXECUTIVE SUMMARY

  • Trailing twelve months’ earnings of underlying portfolio companies grew by 22%.
  • NAV grew by 15.6% YTD with 61% funds invested. NSE Nifty 50 and Nifty 500 grew by 19.3% and 22.8% respectively.
  • Outlook for global inflation and coronavirus remains a concern.
  • Sentiments across the board – IPOs, Unicorns, Crypto-world, M&A and stock valuations- remain euphoric.
  • Stance: Cautious

Dear Fellow Investors,

If you can keep your head when all about you are losing theirs

If you can wait and not be tired by waiting

Poem “IF”, Rudyard Kipling

Global inflation is rising after decades and remains a threat to equities globally. Last quarter results showed margin pressure for commodity consuming companies and record earnings for commodity producing ones. Commodity consuming companies will try to pass on the input inflation to their consumers. Many may not be able to do that without adverse impact on sales volumes due to stagnant/ falling purchasing power. For the commodity producers, the current jump, driven by rise in commodity prices, may turn out to be temporary as demand normalises and new supply comes up.

Additionally, rising inflation can cause rise in interest rates. That will increase the rate of return that investors demand on equity investments and may lead to fall in equity multiples. To oversimplify (and this is not a prediction): when risk free (or bank FD) interest rates are 5%, equity investors are happy with a 5% dividend yield on stocks. When the risk free rate rises to 10%, stocks should halve to make investors earn 10%.

In addition to inflation, the speed and intensity of the coronavirus continues to remain uncertain. Omicron, the new variant of the coronavirus is said to transmit more quickly than the preceding Delta variant. However the hospitalisation rates in countries where Omicron’s spread is highest, are mild. Nonetheless, the uncertainty of restrictions/ lockdowns and accompanying economic pain looms.

Yes, a sub-set of companies are indifferent to, or even benefit from, inflation and/or virus. We own a few of them ourselves. However sentiments remain buoyant across the board and good news looks priced in. IPO activity, Unicorn production, Crypto-mania – all are at record high. Stock valuations too are at a record high – over a quarter of listed Indian companies by market cap are trading at 60+ trailing Sep 21 earnings, highest ever. Some of it corrected in late December but recovered soon after.

Like a pendulum, markets ebb and flow between despondency and euphoria over cycles. This is something that we eagerly look forward to. For, it creates mispricings and offer the low risk-high return opportunities we actively seek. An important part of this pursuit is to stomach relative underperformance and tackle greed, FOMO and impatience during above average valuation periods like the current one. “Not losing one’s head” and “waiting” are an active part of safeguarding and benefiting from bubbles. Cautious stance stays.

 

A. PERFORMANCE

 

A1. Statutory PMS Performance Disclosure

Portfolio YTD FY22 FY 21  FY 20* Since Inception* Outper-formance Avg YTD Cash  Bal.
CED Long Term Focused Value (PMS) 15.6% 48.5% -9.5% 55.3% 38.7%
NSE Nifty 500 TRI (includes dividends) 22.8% 77.6% -23.6% 66.7% -11.4% NIL
NSE Nifty 50 TRI (includes dividends) 19.3% 72.5% -23.5% 57.4% -1.8% 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 year to date December 31, 2021 the NAV of our aggregate portfolio was up 15.6%. During the nine 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 22.8% and 19.3% respectively including dividends.

While regulations require us to present quarterly relative returns, our focus remains on long term (3–5yr) absolute returns. Temporary underperformance in a frothy market is an essential part of doing that. Our past record (2020) is a testimony to the fact that we fall less during market drawdowns and make up for this underperformance.

A2. Underlying business performance

 

Past Twelve Months Past twelve months FY 2022 EPU (expected)
Earnings per unit (EPU)2 Earnings per unit (EPU)
Dec 2021 5.71 6.03
Sep 2021 (Previous Quarter) 5.6 5.8
Dec 2020 (Previous Year) 5.1
Annual Change 12%4 21%
CAGR since inception (Jun 2019) 6.0%
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 +22% if we exclude one position where there was temporary loss due to Covid-19.

 

Trailing Earnings: Trailing twelve months Earnings Per Unit (EPU) of underlying companies, excluding one position where there was temporary loss due to Covid-19, grew by 22% (including effects of cash equivalents that earn ~4-5%). 

 

1-Yr Forward Earnings: We upgrade the expected FY 22 earnings to Rs 6 per unit from earlier estimate of Rs 5.8 per unit due to improvement in underlying fundamentals.

 

A3. Underlying portfolio parameters

 

Dec 2021 Trailing P/E Forward P/E Portfolio RoE Portfolio Turnover1
CED LTFV (PMS) 27.2x 25.5x 15.1% 6.4%
NSE 50 24.1x2 14.9%3
NSE 500 25.4x2 13.2%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

Thanks to our past mistakes, there are four broad categories of risks that we continuously guard against:

  1. Business disruption
  2. Management malfeasance
  3. Misunderstanding cycles
  4. Selling early

Quantitatively, the first three types of companies look cheap and the fourth one expensive. In the former three cases the sustainability of the companies/ cash flows are in doubt and most of times these companies end up as value traps. Dish TV and DB Corp were in the first category. Treehouse and Talwalkars were in the second category. Tata Motors was in the third. In the last case (selling early), the durability and growth of the business is underestimated. What looks expensive today, becomes cheap due to earnings growth. Cera Sanitaryware was in this category.

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 10% towards the end of December before recovering. We added to one existing position in a few underweight client portfolios. The stock was, at the time of our addition, down 30% from its 52week high. There were no other changes to our aggregate portfolio in the reporting quarter.

We continue to add more companies to our research coverage. There are only two reasons that you don’t find certain companies in our portfolio, yet: either we don’t understand them, or find them expensive.

B4. FLOWS AND SENTIMENTS

Inflation is rising world over and central banks have started tightening monetary policy stance. The British central bank raised interest rates by 0.25% in December, first in last three years. The US Fed has advanced its tightening trajectory after US inflation remaining above 5% for last few months.  Rising inflation leads to rise in interest rates that in turn act as gravity to equity prices. To over simplify, higher inflation equals lower equity multiples. Surprisingly the market reactions to this change in stance was muted.

Omicron, the new variant of the coronavirus, forced many counties into various degree of restrictions including lockdown. The faster pace of its mutations led markets to fall a bit momentarily worldwide including in India before rising back due to lower hospitalisation versus the Delta variant.

Inflation and Omicron, however, failed to dampen the continued bubble like uptrend in the IPO, startup, crypto and retail world.

Around 2400 IPOs closed globally in CY2021, raising a total of 450bn$, 64% higher than last year. Two-thirds of US IPOs, however, are trading below IPO price. It was a record year for IPOs in India too. In CY 2021, over 60 Indian companies have raised over Rs 1,26,000 cr in IPOs, highest ever. Importantly, total subscriptions were 30x of that amount. Yes, the average IPO listing day pop has been around 32%, but with meagre allotments or high HNI leverage (taking loans to apply in IPOs), they have failed to move the portfolio needle after interest cost. Mutual funds used the optimism to launch record new funds. They raised over Rs. 51,000cr in NFOs (new fund offers) in the CY 2021, highest in a decade.

Crypto exchanges (440+) have become hotter than crypto currencies (7000+) themselves. Top two global crypto exchanges –Coinbase (63bn$), and FTX (25bn$) are today valued at 88bn$, higher than the CME group (81bn$). They are sponsoring everything from sports to F1 cars to prime time shows and acquiring crypto exchanges in many countries including India. Many offer 100x leverage to trade crypto/crypto futures – Rs 1Lac account in an exchange can give exposure to Rs 1 cr. worth of bet. In last six months, 12 crypto unicorns (startups valued over 1bn$) were born globally. Two of them are Indian (CoinDx and Coinswitch Kuber). It is other matter that they are not legally recognised in many countries.

Coming to Unicorns, as per CB Insights, total number of unicorns worldwide has reached 943 with cumulative valuations of over $3 trn (just under India’s market capitalisation). In the 10 years up to 2020, 37 unicorns were made in India. As many as 42 new unicorns came out just in 2021. Startup valuations are a curious thing. A 100cr valuation can jump to 400cr if the company raises 1 cr additional capital by giving away just 0.25% stake (instead of earlier 1%). Many startups have reported 10x rise in their valuations in matter of a few months, thanks to this funny valuation method. Some have successfully IPOed at these high valuations leaving, inter alia, retail shareholders with the hyped can. Many more are in pipeline.

Retail participation continues unabated. IPO participation, mutual fund inflows, new demat opening, share of options volumes and participation in technical analysis courses have hit all-time high.

Again to clarify, we are not saying that markets will fall tomorrow or that we should be fully out of equities. By tracking these factors we are trying to take the temperature of the markets and investor sentiments. Current state suggests us to continue with our cautious stance.

 

C. OTHER THOUGHTS

Capital as Moat

Tech businesses bring together network effects and worldwide market. The speed with which many tech titans have scaled is unprecedented. Yes, some of them definitely deserve their multi-billion/ trillion dollar valuations. But many others are free-riding.

Unlimited access to capital, propelled by unprecedented central bank monetary easing, has emerged as a new source of moat (competitive advantage) for many in recent times. Sell below cost, even for free, build revenues (it’s not difficult to sell for free) and dream of conquering the market. Given inadequacy of profits, such model would have fallen flat in normal times. But add unlimited access to capital and this model suddenly gets wheels. Sell below cost or for free, grow revenues at break neck speed, raise funds on the promise of eventual monopoly, rinse, and repeat. Many companies in the tech space – unlisted unicorns, and listed tech stocks–have suddenly found access to money without showing current profits. They are seeing rise in market capitalisation and using the high market capitalisation to still raise further rounds of capital. Their private equity investors are happy to cash out with stellar returns. Prudent ways of doing business – focus on profits and capital efficiency- have turned old school.

Sadly, take away the benevolent unrestraint flow of capital – which will co-occur with rise in interest rates – and the moat can turn into a collapsing house of cards. It’s much safer to prefer profits over growth fantasies. Of course growth is great, but that should be accompanied by profits, efficient use of capital and importantly, reasonable price.

***

 

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 2022,

Team Compound Everyday Capital

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

————————————————————————————————————————————————————————————————-

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

 

Continue Reading

Letter to Investors – Sep 2021– Extracts

 

EXECUTIVE SUMMARY

  • Adj. TTM earnings of underlying companies grew by 26%. Jun2021 quarterly earnings are 17% above Jun2019 (pre-Covid).
  • NAV grew by 16.3% YTD with 62% funds invested. NSE Nifty 50 and Nifty 500 grew by 20.8% and 23.0% respectively.
  • Multiple parameters that we track are suggesting very high optimism built into current prices.
  • We remain averse to investing in life insurance sector owing to very high valuations.
  • Stance: Cautious

Dear Fellow Investors,

Value investing is simple, but not easy

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

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

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

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

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

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

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

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

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

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

 

A. PERFORMANCE

 

A1. Statutory PMS Performance Disclosure

Portfolio YTD FY22 FY 21  FY 20* Since Inception* Outper-formance Avg YTD Cash  Bal.
CED Long Term Focused Value (PMS) 16.3% 48.5% -9.5% 56.2% 38.3%
NSE Nifty 500 TRI (includes dividends) 23.0% 77.6% -23.6% 67.0% -10.8% NIL
NSE Nifty 50 TRI (includes dividends) 20.8% 72.5% -23.5% 59.5% -3.3% 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 half year ended September 30, 2021 our NAV was up 16.3%. During the period we were invested in equities, on monthly average basis, to the extent of 62%. The balance 38% was parked in liquid funds/ liquid ETFs in your demat accounts. NSE Nifty 500 and Nifty 50 were up 23.0% and 20.8% respectively including dividends.

Return is visible. Risk is not

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

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

A2. Underlying business performance

 

Period Past twelve months FY 2021 EPU (expected)
Earnings per unit (EPU)2 Earnings per unit (EPU)
Sep 2021 5.61 5.83
Jun 2021 (Previous Quarter) 5.3 5.8
Sep 2020 (Previous Year) 5.2
Annual Change 8%4 21%
CAGR since inception (Jun 2019) 5.0%
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 +26% if we exclude one position where there was temporary loss due to Covid-19.

 

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

 

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

A3. Underlying portfolio parameters

 

Jun 2021 Trailing P/E Forward P/E Portfolio RoE TTM4 Earnings Growth Portfolio Turnover1
CED LTFV (PMS) 27.9x 26.9x 14.1%5 26.0% 6.6%
NSE 50 27.0x2 15.1%3 48.2%3
NSE 500 28.0x2 13.3%3 86.8%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

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

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

B2. MAJOR PORTFOLIO CHANGES

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

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

B4. FLOWS AND SENTIMENTS

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

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

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

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

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

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

 

C. OTHER THOUGHTS

AVERSION TO LIFE INSURANCE COMPANIES

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

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

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

Mutual-Fund/Bank FD-like Products

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

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

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

Company Share of Protection Products* (FY21)
HDFC Life 13%
ICICI Pru Life 16%
SBI Life 12%
Bajaj Allianz Life 4%
Max Life 14%
*As % of annual premium equivalent, Source: Investor Presentations

 

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

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

  1. Assured return products are called non-participating savings The returns to policyholders are fixed. Any spread that life insurance earns over that assured return is retained by the life insurance company. These products are just like bank FDs. Bank retains all the spreads over FD interest that they pay to FD holder.
  2. ‘Assured+’ return products are called participating savings Here too, the base returns to policyholders are fixed. In addition, 90% of spreads over guaranteed returns are shared with policyholders in form of bonus. Only 10% is enjoyed by the life insurance company. These products are like low risk mutual fund products, where fee earned by a life insurance company is not a fixed % of AUM but 10% of spreads.
  3. Market linked returns products are called as Unit Linked Insurance Policy or ULIPs. Here the premiums are invested in debt and equity instruments and returns to policyholders are not assured but depend on market behaviour. ULIPs are similar to debt/ equity mutual funds.
Life Insurance Products Similar To Approx. Share in Industry Premiums
Pure protection Insurance 10%-20%
Non-Participating Savings Bank FD 20%-30%
Participating-Savings and ULIPs Debt/ Equity Mutual Funds 50%-60%

 

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

Less Efficient Products

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

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

Rs Cr.
Company

(FY 2021)

Commission Expenses

(A)

Other Operating Expenses

(B)

Total Expenses of Management

 (C = A+B)

Avg AUM

(policyholders)

(D)

Total Exp as % of AUM

(C / D * 100)

HDFC Life 1,710 4,590 6,300 143,330 4.4%
ICICI Pru Life 1,500 2,690 4,190 172,980 2.4%
SBI Life 1,740 2,450 4,190 181,070 2.3%
Max Life 1,230 2,700 3,930 75,890 5.2%
Bajaj Allianz Life 580 1,930 2,510 54,980 4.6%
TOTAL 6,760 14,360 21,120 628,250 3.4%
Source: Annual Reports, Public Disclosures

 

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

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

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

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

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

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

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

Valuation of mutual fund companies

There are two broad methods to value mutual fund companies:

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

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

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

Mutual Fund AUM (June 2021), Rs Cr. Market Cap, Rs Cr. Mcap as % of AUM
HDFC AMC 429,200 62,000 14.5%
Nippon AMC 248,130 26,400 10.6%
UTI AMC 193,570 13,500 7.0%
Source: AMFI, NSE

 

Valuation of banks

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

Private Sector Banks P/Bx (Sep 30,2021)
Kotak Mahindra Bank 4.7x
HDFC Bank 4.2x
ICICI Bank 3.1x
Axis Bank 2.3x
Source: Annual Reports, NSE

 

Life Insurance multiples

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

Life Insurer Policyholder AUM (June 2021), Rs Cr. Market Cap, Rs, Cr. Mcap as % of AUM P/Bx
HDFC Life 172,300 146,200 85% 16.9x
ICICI Pru Life 211,930 96,500 46% 11.4x
SBI Life 219,880 121,500 55% 11.5x
Source: Public Disclosures, NSE | Note: Market values of AUM are 2-4% higher than those stated in Annual Reports
 

 

 

A combined reading of above three tables tells us:

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

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

What will change our view?

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

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

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

What will further strengthen our view?

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

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

 

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

 

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

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

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

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

***

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

Kind regards,

Team Compound Everyday Capital

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

 

————————————————————————————————————————————————————————————————-

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.

 

Continue Reading

Letter to Investors – Jun 2021– Extracts

 

EXECUTIVE SUMMARY

  • TTM earnings of underlying companies grew by 26%. That of Nifty 50 and Nifty 500 grew by 15.4% & 39.0% respectively.
  • NAV grew by 10.3% YTD with 63% funds invested. NSE Nifty 50 and Nifty 500 grew by 7.5% and 9.8% respectively.
  • Covid 2.0 has ravaged India, however markets choose to look at a brighter and healthier future.
  • Demand revival and weak supply chains have led to commodity inflation. Central banks believe that it’s temporary.
  • Stance: Cautious

Dear Fellow Investors,

“First, Do No Harm”

-Hippocratic Medical Oath

At the outset, we hope that you and your loved ones are staying strong and safe during this devastating second Covid wave. Unlike the first wave, the second wave has inflicted more damage physically, mentally, and financially. Yet, markets continue to rise focussing firmly on a better future. A future that is expected to see vaccinations rise and hopefully infections fall or remain less troubling.

While current markets may offer a guidance on staying positive, as investors we need to assess whether market’s calmness leaves adequate margin of safety from objective standards. On this account, our cautious stance stays. Nonetheless, we continue to evaluate new businesses and increase our coverage. We are ready with the work. And waiting.

Our stance has been cautious since last two quarters. Broader market indices are up 13%-20% since. A counter question that you can pose is, may be markets are seeing something we are not and may be we are wrong. May be. Or may be not. Time will tell. Here’s the thought process behind the stance:

Intrinsic worth of a business is the present value of future free cash flows discounted at a rate that compensates for risks. This is the one of the few principles in investing that has stood the test of time. Today when we assess businesses that we understand, on this touchstone of financial worthiness, we see that current prices are building in optimistic assumptions of future free cash flows and/or discount rates, leading to above average valuations.

Large part of current elevated markets is due to central bank induced liquidity and investor myopia. Financial incentives of most investment managers remunerate them for focussing on short term relative returns. Amid flush liquidity, chasing momentum has been profitable way to invest in last 15 months as multiple stock indices have risen uni-directionally without a 10% plus fall – a first since last two decades.

Our focus, instead, remains on delivering reasonable long term absolute returns.  This requires us to sit out when prices donot leave high chance of beating inflation. Like medical professionals, we are bound by the investment profession’s version of the Hippocratic Oath: FIRST, PROTECT CAPITAL.

 

A. PERFORMANCE

 

A1. Statutory PMS Performance Disclosure

Portfolio YTD FY22 FY 21  FY 20* Since Inception* Outper-formance Avg YTD Cash  Bal.
CED Long Term Focused Value (PMS) 10.3% 48.5% -9.5% 48.2% 36.7%
NSE Nifty 500 TRI (includes dividends) 9.8% 77.6% -23.6% 49.0% -0.8% NIL
NSE Nifty 50 TRI (includes dividends) 7.5% 72.5% -23.5% 41.9% 6.3% 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 quarter ended June 30, 2021 our NAV was up 10.3%. During the quarter we were invested in equities, on monthly average basis, to the extent of 63%. The balance 37% was parked in liquid funds. NSE Nifty 500 and Nifty 50 were up 9.8% and 7.5% respectively including dividends.

A2. Underlying business performance

 

Period Past twelve months FY 2021 EPU (expected)
Earnings per unit (EPU)2 Earnings per unit (EPU)
Jun 2021 5.31 5.83
Mar 2021 (Previous Quarter) 4.8 5.8
Jun 2020 (Previous Year) 5.3
Annual Change 0%4 21%
CAGR since inception (Jun 2019) 2.0%
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 +26% if we exclude one position where there was temporary loss due to Covid-19.

 

Trailing Earnings: Trailing twelve months Earnings Per Unit (EPU) of underlying companies, excluding one company where current earnings donot represent normalised earnings power, grew by 26% (including effects of cash equivalents that earn 5% net of tax).  In comparison, the adjusted earnings of Nifty 50 and Nifty 500 companies grew by 15.4% and 39.0% respectively in the same period (source: Capitaline).

 

1-Yr Forward Earnings: We expect our FY22 earnings per unit to grow by around 20% to Rs 5.8. This is partly helped by the low base as well as businesses getting better.

A3. Underlying portfolio parameters

 

Jun 2021 Trailing P/E Forward P/E Portfolio RoE TTM4 Earnings Growth Portfolio Turnover1
CED LTFV (PMS) 27.9x 25.5x 14.7%5 26.0% 1.5%
NSE 50 28.3x2 13.0%3 15.4%3
NSE 500 30.2x2 11.5%3 39.0%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

We did not find ourselves making any new mistake last quarter. A rising market like current one can hide mistakes. Our stance remains cautious and this might prove be a mistake later. The jury, however, is still out on this. We shall let you know if that becomes the case. So far, we are doing fine.

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 trimmed position in two companies in a few portfolios where it had crossed our desired allocation. This was mainly due to 4.7x and 2.6x rise in their share prices respectively versus our average cost in last eighteen months. There were no other changes to the portfolios.

In last twelve months we have studied fourteen companies across multiple sectors – healthcare, insurance, chemicals, consumer, auto ancillary, building materials, staffing, real estate, financials etc. Most of these companies are either market leader or strong number two in their sectors. We have decided not to invest in any of them – a few due to weak business quality, but most due to high valuations. The latter ones remain in our active coverage list ready to be picked up when valuations turn more amenable.

B3. UNDERLYING FUNDAMENTAL PERFORMANCE

Helped partly by Covid affected low base of last year, profits of the underlying companies for the latest quarter grew by 89%. Trailing twelve months (TTM) profits, a normalised indicator, were flat. Excluding one position whose current earnings donot reflect normalised earnings power, TTM profits grew 26%.

The second covid wave has led to local lockdowns in April and May 2021 and this may affect earnings of June quarter. Although on year on year basis (June quarter last year vs June quarter this year), it may still be positive owing to washout last June quarter. From economic point of view, Covid 2.0 is less severe than the first episode and with active cases down meaningfully and unwinding of lock downs in progress, business activity will resume faster than last year.

B4. FLOWS AND SENTIMENTS

Owing to low base and Covid-led demand-supply disruption, inflation is rising worldwide. Latest annual inflation was up 5% in the US, 6.3% in India, and 2% in the EU. Next few months will decide whether this is temporary or permanent. Central banks worldover, including India, think it’s former and maintain loose monetary policies. Keeping an eye on inflation is important as it will decide the trajectory of interest rates and liquidity that will have a bearing on worldwide equity prices.

After a two months of hiatus due to Covid 2.0, IPO activity is back in India. To recall, high activity in IPO market is one of the hints of rich valuations – a time for caution. A few IPOs that have launched have seen subscriptions of over 100x again. The IPO calendar looks busiest ever for next nine months with some large ones lined up including LIC (7-8bn$), Paytm (2-3bn$), Zomato (1bn$), Aadhar Housing Finance (1bn$), Nykaa (500-700mn$) etc. Pre IPO market also getting warmed up. Paytm’s pre IPO prices are up over 3x in last few months.

Retail investor activity remains elevated and borders on hazardous levels in some pockets. Again to recall, in every past bubble, retail investor participation has been highest at the market peak. Equity MF saw inflows of 22600 cr in three months ended May 2021, highest since March 2020. Monthly SIP inflows were also strong at 8800cr.  INR 27000cr were raised by 60 NFOs (new fund offers, aka IPO of MF schemes) by mutual funds in last six months. 71 lac new demat accounts were opened in June qtr (vs ~23 lac in the Jun quarter of last year). In June 2021, the share of retail participation in equity cash markets has further risen to 70% by value, a 15-year high.

 

C. OTHER THOUGHTS

Capital Cycle in Action

Covid-19 has adversely affected both demand and supply globally. By hitting health, jobs and incomes, it has hurt demand. And by lockdowns, it has rattled global supply chains. Disruption of this scale is probably first since the world wars. As we had seen in March and June 2020 quarters, effects of demand and supply collapse on business earnings are alarming.

But even more alarming are the effects of disrupted demand and supply rushing back to equilibrium. Demand is far more volatile than supply. Pent up-demand can come back fast. However workers, cargo ships, production capacities take time to revive. And when supply cannot match pent-up demand, the result is rise in prices. With a receding pandemic, this is what is happening today across commodities – crude, copper, steel, lumber, coal, rubber etc. The producers of these commodities are having a party – their earnings and share prices have grown multifold.

The supply– mind you- is delayed, not denied. It’s pertinent to recall the cardinal law of capital cycle: without entry barriers, rising demand will see gradual rise in supplies. New capacities will be set up, rising prices will be used to lure more workers on higher pay, and even new cargo ships will be built. The aggregate effect will be that by the time supply will come on-stream, the demand may or may not remain so high. That will lead to price wars. What looks high margins today will turn to low margins owing to price competition. The rise in earnings that we are seeing today needs to be seen in this light. Most of things will prove to be cyclical rather than structural.

***

We agree that markets have tested our patience in last six months. However this is a temporal blip in an investment journey spanning decades. Lure of rising prices is too tempting to resist and triggers unwise actions. But resist we must.  That’s the only safe thing to do.

Kind regards,

Team Compound Everyday Capital

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

 

————————————————————————————————————————————————————————————————-

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

 

Continue Reading

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

 

————————————————————————————————————————————————————————————————-

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.

 

Continue Reading

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

 

—————————————————————————————————————————————————–

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.

Continue Reading

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

 

——————————————————————————————————————————————————————————————————

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.

Continue Reading

Letter to Investors – June 2020 – Extracts

 

EXECUTIVE SUMMARY

  • TTM earnings of portfolio companies grew by 2%. That of Nifty 50 and Nifty 500 grew by -4% and -24% respectively
  • NAV grew by 18.2% YTD with 78.5% funds invested. NSE Nifty 50 and Nifty 500 grew by 20.0% and 21.3% respectively.
  • Markets swung back nearly as rapidly as they had fallen. Business commentaries suggest uncertainty remains elevated.
  • All of our portfolio companies will survive the covid-19 scare. Many will emerge stronger.
  • Stance: Neutral

 

Dear Fellow Investors,

 

Panic to euphoria in 93 days

Nifty 50 fell 40% from its top in March quarter in 45 trading days due to covid-19 disruptions –the fastest 40% fall in decades. In 48 sessions since then, it rose back 38%. As of June 30, it stands 17% lower from its previous high. Someone sleeping through January-June 2020 would have barely noticed this roller coaster ride.

While India’s lockdown – one of the strictest globally – is gradually opening up, the coronavirus is still out there at large. Active cases and fatalities continue to rise. There is no credible cure found yet. And while high frequency data indicate recovery from April lows, incomes and jobs remain under acute stress. India’s real GDP is expected to contract 2%-7% in FY 2021, first in around 40 years. Yet, markets seem oblivious to the ensuing hardship. Why?

Honestly, we don’t know. It is tempting to weave an explanative narrative after prices have risen (or fallen) – liquidity, US elections, re-opening post lockdown etc. While this gives a false sense of comprehension about random short term price movements, it fails to offer any actionable insight for long term investing. Unfortunately lots of air waves, expert chatter and web space are allocated to this.

Fortunately for us, not knowing what will drive prices in the near term is not a big deterrent. What remains important to us is an assessing current margin of safety and tempering our stance between aggression and defence.

You will recall that at the start of this financial year, our stance was of gradual aggression. Prices were attractive then. We could allocate meaningful portion of our spare cash to undervalued positions. The markets, however, shot back up very swiftly. We have tempered our stance to neutral. We are still not out of covid-19 uncertainty yet and, thanks to you, have enough dry power should fear strike back. We know our batting zone and it has not changed in covid-19 times – (1) to own reasonably priced (2) sustainable businesses (3) within our growing circle of competence. And make fewer mistakes on all the three counts.

 

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) 18.2% -9.5% 6.9% 21.5%
NSE Nifty 500 TRI(including dividends) 21.3% -23.6% -7.3% 14.2% NIL
NSE Nifty 50 TRI (including dividends) 20.0% -23.5% -8.2% 15.1% 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.

 

For the quarter ended Jun 2020 NAV of our aggregate portfolio was up 18.2%. NSE Nifty 500 and Nifty 50 were up, including dividends, by 21.3% and 20.0% respectively. Individual investor returns may vary from above owing to different investment dates. During the quarter we were invested in equities, on monthly average basis, to the extent of 78.5%.

 

A2. Underlying business performance 

 

Period Past twelve months1 FY 2021 EPU (expected)
Earnings per unit (EPU)2 Earnings per unit (EPU)
Jun 20201 5.3 4.0-5.03
Mar 2020 5.7 Under Evaluation
Annual Change 2.0%  
1 Last four quarters ending Mar 2020. Results of Jun quarter will be declared by Aug 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 for the trailing twelve months June 2020 came in at Rs 5.3 higher by 2.0% over last year (including effects of cash equivalents that earn 5% net of tax).  Those of Nifty 50 and Nifty 500 grew by -4% and -24% (Source: Capitaline, Adjusted earnings)

 

1-Yr Forward Earnings: Owing to coronavirus pandemic, assessing the forward earnings for FY 2021 remains challenging.  We still take a swing at it and estimate a broad range as per current information with high risk of being wrong. As per our current assessment our portfolio earnings for FY21 may fall by 5%-25% to Rs 4.0-5.0 per unit. They are expected to bounce back sharply in FY22.

 

A3. Underlying portfolio parameters (PMS)

Jun 2020 Trailing P/E 1Yr Forward P/E Portfolio RoE Portfolio Turnover1
CED LTFV 20.2x 21.4x-26.7x 18.0% NIL
NSE 50 26.3x3 12.3%4
NSE 500 29.4x3 7.6%4
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  Monthly average , 3 Source: NSE , 4 Source: Capitaline

 

OVERALL INTERPRETATION: Table A1, A2 and A3 shows that despite clocking better earnings growth, and higher return on equity, our portfolio is relatively cheaper than broader benchmarks.

 

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

 

Investing involves future and is susceptible to mistakes even after bona fide efforts. Good news is – history and our past performance is a testament – that even if four out of ten investments go dud, overall investment returns will be okay as the winners will pull the returns up. Over last eight years, we have had our share of mistakes and hopefully have become better investors due to them. They have involved mistakes of assessing management quality, not picking cycles, underestimating technological disruptions and being early. It is near certain that we will make more mistakes, hopefully newer ones. When we do, you will find their cumulative mention in this section every time.

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 learnt 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

There were no new names added or deleted from the portfolio. We added to our existing positions as prices fell below their intrinsic values increasing our margin of safety.

 

B4. FLOWS AND SENTIMENTS

 

Don’t fight the Fed

To save jobs and avoid bankruptcies, central banks and treasuries around the world, led by the US, have announced massive stimulus programs going as high as 10% of GDP. This unabated money printing is finding its way, through the plumbing of global finance, into asset prices everywhere. While the virus pain continues to affect real economy, financial economy is buoyed by liquidity and seen a sharp recovery. In India, FIIs have bought stocks to the tune of $2bn in June quarter after selling over $10bn in Mar quarter. Domestic SIPs in mutual funds also remain above INR 8,000cr per month (till May 2020) making domestic institutions net buyers of stocks.

While economic activity seems to have surged post April lows, sentiments remain linked to the uncertain Covid-19 trajectory. Reduced incomes will limit near term consumer and capex demand. India’s FY 21 real GDP is expected to contract by 2%-7%. Corporate earnings will fall even more. Markets, nonetheless, seem to have taken much of this bad news in stride and are focussing on FY22 earnings.     

C. OTHER THOUGHTS

DIVIDEND TAXATION

Till last year, dividends were taxed at the distributing company’s hands (@~20%) and were tax free in the hands of recipients. This year’s Union Budget has changed this regime. Starting this year, there will be no dividend distribution tax at the distributing company’s end. And, dividends will now be taxed in the hands of the recipient at the marginal tax rate applicable to them. For most of you, the marginal tax rate would be higher than the outgoing 20% rate. Assuming a 2% dividend yield, this regime change, ceteris paribus, will lower equity returns by around 0.2% (10% excess tax on 2% dividend yields).

One more procedural change incidental to this is about TDS on dividends. If a company is expected to pay dividends to an investor above Rs. 5000 in a financial year, the company shall deduct TDS at 10% (currently reduced to 7.5% as part of covid-package). When filing this year’s tax returns (you will file it after March 31, 2021) please remind your tax advisors to claim the TDS on dividends in your tax returns. 

A second order impact of this dividend taxation shall be that many companies would prefer buybacks as way to distribute cash to shareholders (including promoters who have marginal tax rate of over 40%). Of course this shall be dependent on share prices and cash availability with a company.

***

The half year gone by was one of the most volatile periods in the history of financial markets. Normally, when stock statement shows deep red, as it did in March, investors typically run for exit. Not here. Not only did all of you stayed put, many of you joined us and/or raised your bet amid scare and uncertainty.  Long term investment orientation is in short supply these days and is an investing edge. Thanks for giving us this edge. We are blessed to have like-minded partners like you.

As always, please help us improve by sharing your thoughts, feedback and criticisms.

 

Kind regards,

Team Compound Everyday Capital

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

 

——————————————————————————————————————————————————————————————————

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.

 

Continue Reading