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.
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)|
|Sep 2021 (Previous Quarter)||5.6||5.8|
|Dec 2020 (Previous Year)||5.1|
|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%|
|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:
- Business disruption
- Management malfeasance
- Misunderstanding cycles
- 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.