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.
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)|
|Mar 2021 (Previous Quarter)||4.8||5.8|
|Jun 2020 (Previous Year)||5.3|
|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%|
|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.
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.