Dear Fellow Investors,
“What do you see, son”? Asked Guru Dronacharya. “Only the bird’s eye, Sir”, replied Arjun.
We all have grown up listening to this Mahabharat story on importance of focus. Whether its archery or investing, great achievements demand undivided focus. The bird’s eye equivalent in long term investing that demands undivided focus is company’s intrinsic value (or economic worth, in simpler terms). For, only that can help us decide if a company is undervalued or overvalued versus its stock price. Everything else, is noise.
To recall, a company’s intrinsic value is the present value of its future free cash flows. Two broad components of intrinsic value calculation are (1) future free cash flows (i.e. cash earnings less investments) and (2) future interest rates to discount those cashflows to their present values (aka discount rates).
Assessing intrinsic value, thus, requires looking into the future – for both cash flows and discount rates. Unlike Arjun’s bird in the Mahabharat that is still and clearly visible, intrinsic value is therefore a moving and hazy bird.
Future cashflows: Either due to their nature or our current ignorance, we cannot imagine future cash flows of most of the companies. It’s futile to even attempt their intrinsic value calculations. For, in archery parlance, we cannot even see the bird. Nonetheless, there is a sub set of companies where we can. Mostly these companies provide essential, under-penetrated or non-substitutable products/ services competitively and are run by able and honest management. They are expected to see reasonable revenue growth and high returns on capital. Here is where we limit ourselves looking.
Future interest rates: For intrinsic value purposes we are concerned, not with interest rates of next quarter or year, but with long term future interest rates. Just as assuming very low long term future interest rates is mistaken (last 10 years), so is assuming very high long term interest rates (temptation today). We need to assume moderate interest rates over long term in our intrinsic value assessment. Given that 30-yr Indian government securities are yielding around 7.5% today, 4% is too low, and 15% too high for discount rate. Anywhere between 10%-12% sounds okay, today.
We need to place all incoming information including the current inflation and interest rate scare in the above backdrop. As detailed in the June’22 letter, yes, by adversely affecting cash flows and interest rates, inflation does lower intrinsic value of most companies. However for minority of companies, it does not. Or not at least commensurate with price erosion that happens due to near term unfounded inflation fears. Discipline to limit ourselves to such companies and focus on their intrinsic values that correctly embeds future cashflows and long term future interest rates, therefore, offers opportunity to take advantage that this dislocation triggers.
While the world markets were down 10%-30% for the calendar year 2022, India’s Nifty50 index ended in green. This is one of the biggest outperformances in history versus many countries including the US. Though index is near its peak, broader market is not. Within our coverage too, there are a few companies that are still down 10%-30% from their previous highs without material change in their intrinsic values. We are deploying capital here and retain neutral stance.
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)||0.5%||14.9%||48.5%||-9.5%||13.6%||36.0%|
|NSE Nifty 500 TRI (includes dividends)||4.7%||22.3%||77.6%||-23.6%||17.4%||-3.8%||NIL|
|NSE Nifty 50 TRI (includes dividends)||4.8%||20.3%||72.5%||-23.5%||15.9%||-2.3%||NIL|
|*From Jul 24, 2019; Since inception performance is annualised; Note: As required by SEBI, the returns are calculated on time weighted average (NAV) basis. The returns are NET OF ALL EXPENSES AND FEES. The returns pertain to ENTIRE portfolio of our one and only strategy. Individual investor returns may vary from above owing to different investment dates. Annual returns are audited but not verified by SEBI.|
Care while Benchmarking Performance
Regulations require us to benchmark our performance with an index every quarter. While over a full cycle such comparison is useful, we argue that it is dangerous during a one way rising and expensive market like the one of last 2 years. This is because all indices including Nifty50 or Nifty500 are value agnostic indices. In other words, this means that they will increase the weight of constituent stocks that have done well and vice versa irrespective of their intrinsic values (Eg: Adani group stocks). In a rising market, expensive stocks – which a prudent investment approach would normally avoid –will get higher weight in indices helping indices to post higher returns in near term albeit at a higher risk.
Over 3-5 years, falling 5% when indices fall 10% is not a desirable outcome even if we beat indices, for we would have lost even more after accounting for inflation. Investing aggressively in an expensive market like today has higher chances of above outcome. The only antidote to safeguard from this malady is not to overpay and wait for correct prices. Hence our higher than usual cash balance. Problem with this approach is that in short run expensive stocks can get more expensive, propel indices, and make a cautious approach like ours look foolish when compared quarterly with these indices. It is like comparing a marathoner with a sprinter. Both are running different races.
Thus, while looking at the above statutory table every quarter, you should remind yourselves that our race is against inflation first and indices later; absolute returns first and relative returns later. You should therefore prefer checking whether on absolute basis we are able to beat inflation over 3-5 year period. That’s the minimum benchmark we need to beat. Given that our incentives are linked to performance and not AUMs, and we understand what we are doing, we will do better than that.
A2. Underlying business performance
|Past Twelve Months||Earnings per unit (EPU)2||FY 2023 EPU (expected)|
|Jun 2022 (Previous Quarter)||6.0||6.2-7.23|
|Sep 2021 (Previous Year)||5.7|
|CAGR since inception (Jun 2019)||9%|
|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 2% (including effects of cash equivalents that earn ~4%).
1-Yr Forward Earnings: Against our start of the year expectation of earnings per unit of Rs 6.2-7.2 for FY23, we are trimming the estimate to Rs 5.2-6.
A3. Underlying portfolio parameters
|Dec 2022||Trailing P/E||Forward P/E||Portfolio RoE||Portfolio Turnover1|
|CED LTFV (PMS)||28.7x||24.6x-29.8x||17.9%4||5.6%|
|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
We continue to retain higher than usual cash balance due to lack of abundant opportunities. Our incentives and objectives encourage us to act only when it makes sense. In hindsight of rising markets, this might feel like folly, however that’s the cost of running a conservative investment operation. It, nonetheless, pays out over longer term.
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 in underweight accounts. Additionally, we shifted liquid funds from Nippon Liquid ETFs to ICICI Pru Liquid ETFs. While both have similar risk-return profile, the latter has 44bp (Rs 440 per lac) lower expense ratio. The reason we shifted now and not before was liquidity. We were waiting for average daily liquidity to reach adequate amount, which has reached now. Transaction cost for this switch was 0.0042% (or Rs 4 per lac). There was no brokerage or STT paid. Getting Rs 440 p.a. by paying Rs 4 onetime (per Rs 1 lac), and ensuring liquidity, was a good deal.
Liquid Funds Management
We park all our cash in liquid ETFs. You may ask why we choose liquid ETFs and not liquid mutual funds which give slightly higher returns. As of writing of the letter, last one year return of liquid ETFs were around 4% and liquid mutual funds were around 4.3%. Secondly you may also ask is there a merit in investing these funds in other debt products like short term funds or PSU funds to improve the returns.
We keep cash to capitalise on equity opportunities that volatile markets often throw. Liquid mutual fund money is available on T+1 to T+3 days (holidays of mutual funds are difference from equity markets). Whereas liquid ETFs are immediately available. If we have to buy an equity position today, we can buy that stock and sell liquid ETF on exchange on the same date. This flexibility is important as many times opportunities are available only for limited time.
Secondly on return part, we donot want to take any credit or duration risk on the surplus cash that we hold. For, when calamity strikes and opportunities rise in equities, riskier or long duration debt instruments can entail capital loss at the very time when we want cash to be intact. We want to protect the dry powder that will be useful to buy equities during trouble. Consider liquid ETFs as current accounts yielding 4%.
So while ETFs deliver lower returns, they provide better flexibility and safety.
B4. FLOWS AND SENTIMENTS
From TINA to TANIA
The low interest rate and abundant capital regime of 2010-2021 was like a rising tide that lifted all asset prices. As safe investment alternatives were not remunerative, money chased riskier asset classes like growth equities, private equities, venture capital and even cryptos in search for yields. In those 11 years, Nasdaq Composite index (proxy for tech stocks) rose 7x, private equity AUM size grew 4x and crypto went from nothing to 3trn$. This regime has been popularly called TINA – there is no alternative.
Today with rapidly rising interest rates and cautious capital, that rising tide has gone out. TINA is giving way to TANIA – there are new investment alternatives. US treasuries that used to yield 0% few years ago yield 4% today. In India too, fixed deposit rates are rising and now offering 7% risk free returns. Those seeking risk free returns have more alternatives than just risky assets. More so when risky assets have been badly bruised. US tech-heavy Nasdaq Composite index was down 33% in CY2022. Crypto market cap is down 70% from 3trn$ to 800mn$ and has seen bankruptcy/ collapse of FTX, Luna etc.
When interest rate is 1%, Rs 91 are needed today to get Rs 100 in 10 years. At 4% only Rs 67 are needed to reach to Rs 100 in 10 years. The 10-year present value of Rs 100 falls from Rs. 91 to Rs. 67 when interest rates rises from 1% to 4%. As interest rates rise, investors need to keep this in mind while deciding what multiple to pay for equities. Average valuations multiples of last 10 years have an upward bias due to the TINA regime. Using them in TANIA regime to conclude whether current valuations are cheap might be a mistake. Higher interest rates pushes the average valuation curve of all assets downwards. This might bring back the preference for profitable and cash earning companies versus high flying but unprofitable growth/ tech companies. Sensible investing might be back soon.
C. OTHER THOUGHTS
Markets – A Voting Machine In Short Run
When a stock grows 3x or more in 3 years or less, it can have a material impact on portfolio returns (if given adequate weight). Most often when we scan such a list especially during market high, we scratch our heads as to why some stocks that we understand went up so much. And how does price and earnings of these stocks perform in future? Is market right to bid them so high?
With this question in mind we tried to find out how the same turned out in the past. We asked this question:
Question: How did the earnings and stock price grew in next 5-7 years for those stocks that went up atleast 3 times in a 3 year rolling period between 2012-2017 (mini bull run).
Interpretation: For example, share price of company A went up 10x between 2013-2016. We are interested in finding how did the earnings and stock price grow for the company A between 2016-2022.
- There were 560 companies whose stock shot up over ‘3x or more’ in a rolling 3-year period between 2012-2017.
- Just over a fourth of these companies were able to grow operating earnings at 15%+ CAGR over next 5-7 years. Median stock returns for these companies were 16% CAGR over next 5-7 years.
- For balance three-fourth of companies – i.e. companies whose stocks grew 3x or more in 2012-17 but operating earnings grew less 15% in next 5-7 years – their median stock returns were -2% CAGR over those 5-7 year period.
*We have evaluated a very small period of 2012-2022. We have looked at only companies with market cap over Rs. 500cr as on 2017. We have not included companies getting listed after 2017. To remove effects of extraordinary items, we have used operating profits excluding other income.
Between 2012 and 2022, broadly three out of four companies were not able to sustain their earnings or share price performance after sharp share price jump.
In short run a stock that runs up sharply may be due to non-fundamental or temporary reasons. Most of such stocks may not be able to deliver earnings performance warranted by such high price jump and fail to protect or grow returns.
As Benjamin Graham said: “Markets are voting machine in the short run and weighing machine in the long run.”
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 2023,
Team Compound Everyday Capital
Sumit Sarda, Surbhi Kabra Sarda, Punit Patni, Arpit Parmar, Sachin Shrivastava, Mukta Mungre and Sanjana Sukhtankar
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.