Letter to Investors – Dec’23 – Extracts

 

EXECUTIVE SUMMARY

    • Trailing twelve months’ earnings of underlying portfolio companies grew by 59%.
    • NAV grew by 28.1% YTD with 73% funds invested in equity positions. Balance 27% is parked in liquid funds.
    • We share our favourite learnings from Charlie Munger.
    • We added to one position, it’s now a major position. We exited from a minor position at a good gain.
    • Euphoric retail participants drive flows into risky segments. Their lack of fear should be feared.
    • Stance: Cautious

Dear Fellow Investors,

 

Bull markets go to people’s heads. If you’re a duck on a pond, and it’s rising due to a downpour, you start going up in the world. But you think it’s you, not the pond.”

-Charlie Munger, 1924 – ∞

 

Charlie Munger, partner of Warren Buffett, passed away last quarter at the age of 99. Warren credits Charlie for the mindset shift and phenomenal track record of Berkshire Hathaway. Charlie’s teachings have had an important impact on our thoughts and behaviour. While it is difficult to do justice to cover it all here, but as a token of tribute, we take a shot at sharing some of his worldly wisdoms around thinking, living and investing better:

 

Better Thinking

  1. Lifelong multidisciplinary learning: “To a man with a hammer the world looks like a nail”.

                                           

                                            Munger said that a single discipline often lacks tools to look at the world holistically. Having key mental models from multiple disciplines – compound interest from Mathematics, margin of safety from Engineering, natural selection from Biology, breakpoint, tipping moment and autocatalysis from Physics and Chemistry, behaviour from Psychology and many more – give better tools to analyse problems or opportunities. For eg. Economic theory predicts that demand falls as price increases. However psychology provides exception to this rule– often high prices of certain products indicate their exclusivity and in turn increase their demand.

  1. Read read read: “In my whole life, I have known no wise people who didn’t read all the time – none, zero. Spend each day trying to be a little wiser than you were when you woke up. I believe in the discipline of mastering the best that other people have ever figured out. I don’t believe in just sitting down and trying to dream it all up yourself. Nobody’s that smart.”

                                              The road to better thinking and learning is to read. Munger read in truck loads across diverse topics. Buffett said that Munger has the best 30 second brain, he can think about the answers before the question ends. Munger admits that he is able to do this because of hours of study and analysis that has gone into forming opinions on wide range of topics of general importance. Those who keep learning will keep rising.

 

  1. Seek to invalidate: “Any year that we don’t destroy one of our best-loved ideas is probably a wasted year. Recognize reality even when you don’t like it – especially when you don’t like it.”

                                              Seeking to invalidate long held incorrect beliefs is necessary to progress. The key is not to ignore disconfirming evidence but to embrace them. Munger gave example of Charles Darwin (father of the theory of natural selection), who trained himself to intensively consider any evidence that went against his hypothesis.

 

  1. Human Biases: In his famous talk “Psychology of Human Misjudgement”, Munger shared 25 human tendencies/ biases that lead to judgement errors. An awareness about them can reduce errors. Here are a few popular misjudgements:
    1. Incentive caused biases: it is difficult to do something that goes against incentives. For eg: AUM based fee or brokerage will lead to asset gathering or portfolio churn respectively.
    2. Reciprocity bias: tendency to return favours and disfavours. For eg: releasing favourable equity research reports in exchange for investment banking deals (IPOs, M&A, block trades etc.).
    3. Liking/ loving bias: tendency to ignore faults or grant favour to those liked or loved. For eg: getting investment opinions influenced by good looking/ presentable top management of a company.
    4. Confirmation bias: tendency to look at facts selectively so as to support already held beliefs or conclusions. What a man wishes, that also will he believe. For eg: overlooking bad news around owned stocks.

 

Better Living

  1. Invert, always invert – “If you want to achieve X, find how to avoid non-X. Invert, always invert. To live a good life, find how to live a bad life and don’t do it. All I want to know is where am I going to die so that I donot go there. It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”
  1. Track Record: “I think track records are very important. If you start early trying to have a perfect one in some simple thing like honesty, you’re well on your way to success in this world. Remember that reputation and integrity are your most valuable assets – and can be lost in a heartbeat.”
  1. Work/ Career: “Three rules for a career: Don’t sell anything you wouldn’t buy yourself. Don’t work for anyone you don’t respect and admire. Work only with people you enjoy.”
  1. Happiness: “Avoid envy, avoid self-pity, avoid resentment and have low expectations.”
  1. Mistakes: “A meaningful life cannot be lived without making mistakes (corollary: pursuit of returns higher than risk-free rate will invite chances of mistakes). But try avoiding fatal ones by first learning from others’ mistakes.”

 

Better Investing

Below are few useful thoughts that Munger has shared on investing:

  1. All intelligent investing is value investing – acquiring more than you are paying for. You must value the business in order to value the stock. (inference: growth and quality are components of value)
  2. A great business at fair price is superior to a fair business at great price. (Warren Buffett attributes the shift of his style and resultant success of Berkshire Hathaway to this one secret.)
  3. There are worse situations than drowning in cash and sitting, sitting, sitting. I remember when I wasn’t awash in cash —and I don’t want to go back.
  4. We have three baskets for investing: yes, no and too tough to understand.
  5. The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, which can be very long, they don’t. It’s just that simple.
  6. I want to think about things where I have an advantage over others. I don’t want to play a game where people have an advantage over me. I look for a game where I am wise, and others are stupid. And believe me, it works better. God bless our stupid competitors. They make us rich.
  7. How could economics not be behavioural? If it isn’t behavioural, what the hell is it?
  8. Bull markets go to people’s heads. If you’re a duck on a pond, and it’s rising due to a downpour, you start going up in the world. But you think it’s you, not the pond.
  9. Understanding both the power of compound return and the difficulty of getting it is the heart and soul of understanding a lot of things.
  10. It’s (investing) not supposed to be easy. Anybody who finds it easy is stupid.

Book suggestion: Those interested in reading more about him can start with Poor Charlie’s Almanac

 

A. PERFORMANCE

 

A1. Statutory PMS Performance Disclosure

Portfolio YTD FY24 FY23  FY22 FY 21  FY 20* Since Inception* Outper-formance Cash Bal.
CED Long Term Focused Value (PMS) 28.1% -4.3% 14.9% 48.5% -9.5% 15.5% 27.0%
S&P BSE 500 TRI (includes dividends) 34.1% -0.9% 22.3% 78.6% -23.4% 19.7% -4.2% 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. W.e.f. April 01, 2023 SEBI requires use of any one from Nifty50, BSE500 or MSEI SX40 as a benchmark. We have chosen BSE500 as our benchmark as it best captures our multi-cap stance.

 

Protecting our wicket

Broader markets scaled new peak this year. BSE 500 index was up 34% since Mar 2023. Higher euphoria was seen in mid and small caps with BSE Midcap and BSE Smallcap indices being up 53% and 58% respectively. Despite being only 73% invested, we were also up 28% thanks partly to the general rise in market prices.

While evaluating investment performance in bullish times like current one, entire focus needs to be on portfolio risk with a complete blind eye to headline returns. For, these are the heady times that mess up human mind and engender mistakes. Without worrying about lagging index or FOMO, we continue to adhere to price and quality discipline while deploying capital in the current expensive market. This discipline, we hope, will allow us to fall less and make up for current relative underperformance versus the index. To invoke cricket parlance, the pitch is difficult, conditions overcast and the ball is swinging and bouncing. This calls for playing defensive and protecting our wicket. Stance: Cautious.

 

A2. Underlying business performance

 

Past Twelve Months Earnings per unit (EPU)2 FY 2024 EPU (expected)
Sep 2023 8.61 8.0-9.03
Jun 2023 (Previous Quarter) 8.1 8.0-9.03
Sep 2022 (Previous Year) 5.4
Annual Change 59.3%
CAGR since inception (Jun 2019) 14%
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: Trailing twelve months Earnings Per Unit (EPU) of underlying companies, grew by 59.3% (including effects of cash equivalents that earn ~5%). 

 

1-Yr Forward Earnings: We had upgraded the expected earnings per share for FY24 in the last letter from 6.5-7.5 to 8.0-9.0. The actual earnings are moving in the direction we had expected and therefore we maintain the guidance.

 

A3. Underlying portfolio parameters

 

Dec 2023 Trailing P/E Forward P/E Portfolio RoE Portfolio Turnover1
CED LTFV (PMS) 22.0x 21.0x-23.7x 19.0%3 3.1%
BSE 500 25.8x2 15.5%2 3.4%2
1 ‘sale of equity shares’ divided by ‘average portfolio value’ during the year to date period. 2Source: BSE. 3Portfolio RoE is on core equity positions

 

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

There were no new mistakes this quarter. A rising market generally hides them, to be fair.  

Update on Music Broadcast (Radio City) position: We have recovered our 30% loss in this small position. The position is up 3% as of writing of this letter. The annualised yield to maturity if we sell the equity position immediately and hold the preference share till maturity is 6%. This is net of tax and therefore better than liquid funds or FDs.

A brief background: We had participated in a special situation whereby we got free bonus preference shares of Music Broadcast (aka Radio City). Our thinking was that this play could give us a low risk 10% return on our free cash that otherwise was earning 6-7% in liquid funds (the tax effect is also favourable on former). The combined position (equity shares + bonus preference shares) was around 3% at inception. At the end of that quarter we were down 30% (or 1% of portfolio). We had shared that we made a mistake and learnt that we should engage in these plays only if the underlying equity shares are traded in futures so that we can lock our selling price. However we decided not to sell immediately, believing that upcoming elections will help radio advertising.

Cut to today, the net position has changed from -30% to breakeven. Hike in central government radio advertisement rates before elections and a buoyant market helped. We will take a decision to sell the equity part of the position in due course to harvest tax losses (will save tax).

B2. MAJOR PORTFOLIO CHANGES

We increased our position in one holding. It is now a major holding. We exited from one minor position at an annualised gain of 19% including dividends. 

When to sell

Selling is easier when either the thesis turns out to be wrong or unexpected events impair the business fundamentals. However, the difficulty arises when business and share price both are doing well. The biggest mistake many renowned investors have admitted making is selling winners too soon (selling a potential 10-50 baggar at 2x). If the business is fundamentally sound, interim price fall may be temporary. Selling sooner would mean forgoing all the future upside.

On the flip side, however, endowment effect – overvaluing one’s things/ efforts – can fool us to mistake an ordinary company to be a future winner. Even if we remain dispassionate in assessing the business quality and immune ourselves from endowment effect, we are dealing with the future which can bring negative surprises. Promoters often failing to predict the future of their companies is a case in point. Therefore, on the sell date, we can never be fully sure that we have sold right.

Another aspect around selling is an opportunity to re-balance the portfolio by reducing strongly correlated positions. Over time, the mutual weights of positions change. If price changes lead to increase in portfolio exposure to one or more themes/factors – capital expenditure, crude oil, rural demand or capital markets for instance – selling may allow lowering excess exposure to a single theme/factor.

The middle road, then, is to vary the extent of selling depending on dispassionate assessment of fundamentals, portfolio exposure to a theme/ factor and degree of overpricing.

 

B4. FLOWS AND SENTIMENTS

Fearing absence of fear

Retail participation and general sentiments towards equities remain worryingly exuberant. This is evident from highest ever flows to SME IPOs, higher number of smaller companies in main board IPOs, high inflows into riskier mutual fund schemes and record derivatives volumes. Insiders (promoters and private equity investors) are using this opportunity to happily exit at lofty valuations. It is not difficult to guess that in this bi-party trade involving retail buyers and insider sellers, who is going to be proven right.

SME IPOs are at the riskier end of IPO segment. 181 issues have raised Rs. 4,600cr in CYTD 2023. This is highest ever and double of past high recorded in 2018. BSE SME IPO index is up 99% in last twelve months indicating high retail participation even post listing. Many of these companies have weak business models and unknown governance track records.

45 main board IPOs concluded in CYTD 2023, second highest in last decade. The average size of IPOs this year is half of average of last 6 years indicating higher share of many smaller IPOs. Smaller IPOs indicate wider retail tolerance.

Smallcap, midcap, and thematic schemes of mutual funds garnered over Rs 87,000cr net inflows in last 12 months, constituting over 57% of all net inflows into actively managed equity schemes, an all-time high. These schemes gain favour mostly during bullish times.

Derivatives volumes as a factor of cash volumes has reached alarming proportions in India. Derivatives volumes that used to average around 26x of cash volumes in India between 2015 and 2021 and much lower in the world, have jumped to over 400x of cash volumes in the current year. This is mainly due to higher participation in weekly expiring options contracts that allow low ticket bets. Sadly, as per a recent SEBI study, over 90% of retail derivatives traders lose money.

Promoters and private equity investors (insiders) have smartly used the retail euphoria to sell stakes in their companies. Insiders have sold over Rs 90,000cr worth of their stakes in CY2023, highest in last 5 years.

There is no fear among common investors today. This calls for fear.

 

C. OTHER THOUGHTS

India’s inflation in last 150 years

What has been the rate at which Indian Rupee has lost its purchasing power in last 150 years? We stumbled upon an objective measure some days ago.

We had an opportunity to visit a coins exhibition. Amid coins and currencies as old as the 3000 years old Magadha silver coins, one gold coin caught our attention. This was an extremely rare 5-Rs currency coin of year 1870 weighing 3.88 grams in gold. The exhibitor was kind enough to allow us to take a picture.

This coin, which is of 22k (91.7% purity) gold, tells us the price of gold – Rs 5 for 3.88 grams or Rs 1.4/gram in 1870 for 24K gold. The price of same gold is around Rs 6,500/gram today. Rs 1.4 turned to Rs 6,500, a growth of 4600x in around 150 years.

Gold is considered as a hedge against inflation. If we take liberty to equate rise in gold price as rough indicator of inflation, this translates to an inflation of 5.5% annually over 150 years. To cross check, we inquired price of Ghee (clarified butter) with some senior citizens. They recollected it to be around Rs 5 per kg during 1940-1950. That also translates to inflation of over 6%.

What does this convey about future? We can take a 5%-6% as possible inflation range over this generation. A savings instrument should beat this after tax to keep the purchasing power of our savings intact. This translates to a pre-tax asking return of around 8% (for those in highest tax bracket).

***

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

 

Wishing you a great 2024,

Team Compound Everyday Capital

Sumit Sarda, Surbhi Kabra Sarda, Punit Patni, Arpit Parmar, Sanjana Sukhtankar, Anand Parashar

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

 

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Letter to Investors – Sep’23 – Extracts

 

EXECUTIVE SUMMARY

    • Trailing twelve months’ earnings of underlying portfolio companies grew by 35%.
    • NAV grew by 16.7% YTD with 72% funds invested. BSE 500 grew by 19.4% including dividends in the same period.
    • Our investment process needs to be based on eternal truths, intellectual honesty and sustainability.
    • We added further to our top two positions and initiated a toehold position in a new company.
    • Smallcaps are in bubble territory. Insider-selling is at an all-time high. Craziness is going on in SME IPOs.
    • Stance: Cautious

Dear Fellow Investors,

 

असतो मा सद्गमय। तमसो मा ज्योतिर्गमय। मृत्योर्मामृतं गमय

(May we move from untruth to truth, darkness to light, and mortality to immortality.)

– Brihadaranyaka Upanishad

 

Truth: There are only a few eternal truths in investing. Some of them include: (a) Stocks are not pieces of paper, they represent partial ownership in live businesses. (b) The value of a business (and therefore stocks) is the present value of cash that can be taken out of the business over its life. That depends on opportunity size, competitive advantage and management quality. And, (c) Risk stems from acting without understanding this value and/ or paying above the conservatively assessed value. The closer our actions are to these truths, the better our long term performance will be.

 

Light: Returns lie in the future. However, future is uncertain and dark. Only an intellectually honest understanding of a business can shine light on its character and help predict its future. While perfect understanding of a business is impossible, honest working understanding of key variables is sufficient. Mistakes occur when we think we understand a business when actually we don’t. Hence there is need for humility, sceptic mindset and use of common sense, forensics, and triangulations. Unless proved otherwise, every incoming information about a company needs to be doubted. Keeping our hypothesis always in question and seeking to invalidate our most loved beliefs can allow us to move towards light.

 

Another aspect of darkness is our biases and emotions that prevent us from seeing the light. Greed, envy, fear of losing or missing out, overconfidence, and hubris obstruct the light of rationality. While these biases and emotions have evolutionary importance, they become counterproductive while investing. It may sound funny, but the first impulse is usually wrong in investing and it would be safe to act opposite to it. Being greedy when fearful, for example. Yes it is difficult to go against our evolutionary programming, but staying aware of our emotions and biases can take us towards right action.  

 

Immortality: Being a custodian of wealth that is going to be useful not only for the current but even future generations, we need to think in terms of decades instead of quarters. Our first objective as investors should, therefore, be to avoid mortal mistakes, financial ruin and permanent loss of capital. Focus on risk should precede expectation of riches. This requires preference for sustainability and repeatability.

 

Prices often rise in short term due non-fundamental reasons including narrative, liquidity and news flow; many times against fundamental reality. While riding such rise due to luck or design looks temptingly doable, it is not sustainable (at least for us) and may eventually reverse. In longer run, paying below carefully assessed fundamental value is the only way we understand to sustainable returns.

 

Lastly, when assessing value or behaving, we should remember that most things – high growth, high margins, success and failure are impermanent. Prices move from being expensive to being cheap and vice versa. By retaining equanimity and behaving counter-cyclically, we can use these swings to our advantage.

 

**

In summary, we have to keep moving towards and sticking to a process that is based on eternal truths, intellectual honesty and sustainability.

 

A. PERFORMANCE

 

A1. Statutory PMS Performance Disclosure

Portfolio YTD FY24 FY23  FY22 FY 21  FY 20* Since Inception* Outper-formance Cash Bal.
CED Long Term Focused Value (PMS) 16.7% -4.3% 14.9% 48.5% -9.5% 13.9% 27.9%
S&P BSE 500 TRI (includes dividends) 19.4% -0.9% 22.3% 78.6% -23.4% 17.7% -3.8% 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. W.e.f. April 01, 2023 SEBI requires use of any one from Nifty50, BSE500 or MSEI SX40 as a benchmark. We have chosen BSE500 as our benchmark as it best captures our multi-cap stance.

 

Overvaluation in Smallcaps and Midcaps too

BSE 500, our benchmark, is an index of top 500 companies. The index’s 19.4% rise in last six months is hiding the divergence in performance of large companies versus medium and smaller companies. In last six months while the larger companies (represented by the BSE Sensex) were up 12%, the smaller and medium size companies (represented by the BSE Smallcap and the BSE Midcap indices) were up 40% and 35% respectively.

Even within small and midcaps; railways, defence, PSU banks and capital goods sectors contributed to most of the gains. We remain away from these pockets due to extremely high valuations and/or weak business fundamentals. In our portfolio, the current weight of smallcaps (<10,000cr mcap) is low at around 20%.

Only a subset of our wish-list stocks remain cheap today. We are adding in these names till their target weights. For other positions, we are sticking to pricing discipline and acting only when they come in our valuation range. This discipline may take temporary toll on relative performance if the current expensive market keeps on rising, however it will prevent heartburn later.

 

A2. Underlying business performance

 

Past Twelve Months Earnings per unit (EPU)2 FY 2024 EPU (expected)
Jun 2023 8.11 8.0-9.03
Mar 2023 (Previous Quarter) 5.9 6.5-7.53
Jun 2022 (Previous Year) 6.0
Annual Change 35%
CAGR since inception (Jun 2019) 12%
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: Trailing twelve months Earnings Per Unit (EPU) of underlying companies, grew by 35% (including effects of cash equivalents that earn ~4-5%). 

 

1-Yr Forward Earnings: We upgrade the expected FY 24 earnings per unit range to Rs 8-9 per unit from last quarter’s estimate of Rs 6.5-7.5 per unit due to better than expected performance of portfolio companies.

 

A3. Underlying portfolio parameters

 

Jun 2023 Trailing P/E Forward P/E Portfolio RoE Portfolio Turnover1
CED LTFV (PMS) 21.5x 19.3x-21.5x 17.1% 0.6%
BSE 500 24.7x2 14.5%3 2.2%2
1 ‘sale of equity shares’ divided by ‘average portfolio value’ during the year to date period. 2Source: BSE. 3Ace Equity. 

 

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

We did not commit or discover any new mistakes this quarter.

Critical readers will remember that we had shared our mistake about Music Broadcast Bonus Preference Shares in the March’23 letter. We had decided to wait it out at that time. We share the current update. The marked to market losses have fallen by 60% in last six months from 1% of portfolio to 0.4% of portfolio (same portfolio basis) now. We are still holding the position.

 

B2. MAJOR PORTFOLIO CHANGES

We increased our position in our top two holdings. We also took a toe hold position in a new company that we are evaluating. We will share more details should we choose to scale it up.

 

B4. FLOWS AND SENTIMENTS

 

Retail Euphoria

What the wise do in the beginning, the fools do in the end

-Warren Buffett

 

Valuation of smaller companies (smallcaps), insider selling and options volumes are pointing to a retail euphoria in some pockets of Indian equity markets today.

In January 2018, the BSE Smallcap index as a percentage of BSE Sensex – indicator of relative expensiveness of smallcaps versus largecaps – touched a decade high. From that peak, the Smallcap index fell over 20% in the following six months even as the Sensex was up 2%. Today, this ratio has crossed the 2018 peak. Similar is the case with the BSE Midcap index.

In a perfect case of vicious cycle, higher returns have pushed up retail flows into small and midcap mutual funds, which has increased flows into small and midcap stocks leading to even higher returns and so on. Rs.54,000 crores have flown in last 12 months (till Aug’23) in mid and small cap funds, 40% of overall inflows in actively managed equity schemes. Lower liquidity of small cap companies cannot absorb such deluge of flows and this has pushed their prices higher.

Promoters and private equity investors (insiders) are using these frothy markets and investor enthusiasm to cash out of their companies. Insiders have sold stakes worth Rs 87,000 cr in their companies in 2023 calendar year-to-date. This is more than each of last 5 full years, 5x of 2018 and 2x of last year. IPO activity is also heating up. You would have seen first 8 pages of leading financial dailies filled with full page IPO advertisements. The IPO pipeline for rest of the year is even stronger. Lastly, there is total madness going on in SME (small and medium enterprises) IPOs. Overall, about 100 SME firms have raised a record Rs 2,600 crore of funds in the SME segment in 2023, breaking the previous record of Rs 2,300 crore in 2018. Many issues, some with ordinary & untested businesses, have been oversubscribed over 100x, some even 450x (!!). The BSE SME IPO index is up 99% in last twelve months.

Retail investors are also dabbling in the risky futures and options segments in record numbers. Active monthly retail users in the NSE Options segment which used to average 2.8mn monthly shot up to 4mn in August. Volumes have especially soared in zero day expiry options which are pure gamble.

Finfluencer menace is partly to blame this rising retail participation in risky and expensive pockets of markets like SME IPOs and Options. SEBI has initiated consultation papers to curb the pump and dump schemes and misleading investment solicitation by finfluencers.

Many new investors who joined during lockdown days of Covid-19 to supplement their incomes, have only seen markets going up in their limited experience. They have been led to believe that making money is easy in markets. Like flies flocking to jaggery, many will learn the right lessons the hard way.

 

C. OTHER THOUGHTS

Immediate Vs Delayed Outcomes

Often we judge the success of an activity by its outcome. We run a sprint, we know at the end who has won. We write an exam, results in few hours/weeks tell us how we did. When outcome is immediate, cause and effect relationship is easy to understand.

However, this outcome based evaluation can mislead if the outcome occurs, not immediately, but over long periods of time. More so, if immediate outcomes are different from long term outcomes. Consider healthy eating. Giving away junk food for healthier alternatives look painful today but is beneficial in longer run. Or consider working out. Going to the gym looks a chore in near term but immensely beneficial eventually. Conversely, smoking or gambling may feel great in the near term but are harmful over longer term.

For such activities with longer term outcomes, a judgement based solely on immediate outcomes – healthy eating or workouts are undesirable, smoking or gambling are desirable – will be wrong.

Investing is more like the latter set of activities. There is an element of luck in the near term which can lead to false positives – great returns despite buying wrong things; or false negatives – poor near term returns despite correct process.

If the immediate outcome of an activity is poor, how do we know for sure that we need to stop or continue that activity? We need to look at historical evidence of longer term effects. And we need to ask whether it makes sense in longer term.

 

Multiple Mutual Fund Schemes = Below Average Performance

As per a recent study of over 47,000 mutual fund portfolios by Value Research, an average portfolio holds over 10 mutual fund schemes. If we include family members, a family of 4 may be owning even more. This means an average family may have exposure to over 200 stocks and over 100 debt instruments.

Such a family portfolio is bound to deliver average market returns. Deduct the mutual fund fees (1.5% – 2% for regular plans if we include brokerage, STT and GST and 0.5%-1.5% for direct plans), and after fee portfolio returns will always be below the average market returns.

A similar exposure to large number of stocks, instead, can be gained through market wide index funds at a fractional cost automatically leading to higher returns by 0.5% – 2% annually. And just to recall, 1% higher return over 30 years can increase future value of investments by around 30%. To complete the popular mutual fund advertisement:

म्युचुअल फंड सही है। …..लेकिन बहुत सारे नहीं है ।।

(Mutual funds are right. But having a plethora of schemes is detrimental to returns)

***

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

 

Kind regards,

Team Compound Everyday Capital

Sumit Sarda, Surbhi Kabra Sarda, Punit Patni, Arpit Parmar, Sanjana Sukhtankar, 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.

 

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Letter to Investors – Jun’23 – Extracts

 

EXECUTIVE SUMMARY

    • Trailing twelve months’ and quarterly earnings of underlying portfolio companies grew by 16% and 32% respectively.
    • NAV grew by 9.9% YTD with 73% funds invested. BSE 500 grew by 13.2% including dividends in the same period.
    • Understanding, opportunity size, competitive advantage, management quality and valuation are our five investment filters.
    • Barring a few pockets, markets are expensive. There is bubble in quality
    • Stance: Neutral

Dear Fellow Investors,

 

Five hurdle checklist that reduces risks and improves returns

Surgeons, pilots and many critical professionals have saved lives using checklists. In last 12 years, our investment checklist has evolved after being battle tested with real life wins and losses. Here’s that checklist summarised into five key hurdles/ questions that every company we own or wish to own has to pass:

First and the biggest hurdle is that we must be able to independently understand the business. This involves understanding how the business makes money and why do consumers demand its product/ services. Due to complexity of the business or our own ignorance, many businesses are not able to pass through this screen. No understanding, no conviction, no investment case. Time, reading and thinking help us improve understanding of new or existing businesses.

The second key question that we ask is how large is the opportunity size. A company that is serving an essential product/ service with no threat of substitution and has low penetration can be said to have a long runway (for example demat accounts, air conditioners, health insurance etc). A definite disruption threat is a key risk to avoid.

Long runway, however, in itself is not enough. The business should have some inherent competitive advantage that allows it to tap the runway profitably. Competitive advantage allows the company to protect profits from competition or regulations. Low cost, network effects, patent/ license/ copyright, switching costs, consumer habits, culture etc. can be some of the sources of competitive advantage. Without competitive advantage, growth does not create shareholder value. This is an area where we spend a lot of time. High returns on capital hints presence of an advantage in the past. We probe the causes and durability of such high returns. It is important not to mistake cyclical tailwind/ headwind as competitive advantage/ disadvantage.

The fourth and the most difficult filter is management quality. We look at the past actions of management around three areas. First is execution track record i.e. ability to create distribution, human resource, and supply chain capabilities that allows it to maintain or grow its market share. Second is capital allocation i.e. investing incremental earnings on return accretive projects or in absence, returning them back to shareholders in best possible way. Last is treatment of minority shareholders as evident from accounting quality, embezzlement, remuneration and skin in the game.

The last but important hurdle is valuation. For core equity positions, valuation alone is useless unless the company passes all the four hurdles above. Our preferred method to value is to see what growth and margin assumptions are built into current price versus (a) past and (b) our conservative imagination of its future. Often a company that passes the above four tests does not come cheap. While quality demands paying up, paying any price can be a mistake. We need to wait for temporary hardships or size discount (smaller companies can remain mispriced due to lack of attention from larger investors) that can create mispricings.

**

Despite failing to pass one or more of the above five hurdles, a company’s stock may do temporarily well. An 80 P/E stock may go to 100P/E; stock of a company in a new long runway sector but no entry barrier may rise in initial euphoria; temporary tailwinds may be mistaken for enduring advantage etc. But if the truth around the five steps hold, weak thesis gets its due punishment. Conversely, a company passing through all the five hurdles sooner or later gets it due reward. Keeping the investing bar high and executing all five of them with discipline and margin of safety is the key to minimise investment mistakes and improve long term returns. Funnily, the five hurdle process eventually works because it does not always work.

 

A. PERFORMANCE

 

A1. Statutory PMS Performance Disclosure

Portfolio YTD FY24 FY23  FY22 FY 21  FY 20* Since Inception* Outper-formance Cash Bal.
CED Long Term Focused Value (PMS) 9.9% -4.3% 14.9% 48.5% -9.5% 13.1% 27.0%
S&P BSE 500 TRI (includes dividends) 13.2% -0.9% 22.3% 78.6% -23.4% 17.3% -4.2% 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. W.e.f. April 01, 2023 SEBI requires use of any one from Nifty50, BSE500 or MSEI SX40 as a benchmark. We have chosen BSE500 as our benchmark as it best captures our multi-cap stance.

 

What are we waiting for?

Our cash levels (invested in liquid funds) have been high at 25-30% in last few quarters. The only thing that we are waiting for is better entry prices. For, a high entry price can lead to subpar future returns.

At surface, the price to earnings (P/E) ratio of BSE 500 companies is 24.4x, moderately high if not exorbitant. But if we exclude financials, LIC, and GIC-RE where earnings are at cyclical highs, the P/E of remaining BSE 442 companies jumps to 30.4x P/E, one of the highest since inception in 1999. The effect is similar if we use other valuation metrics like price to book (3.7x to 4.4x) and enterprise value to ebitda (15.3x to 16.3x).

Within the above set, if we look only at quality stocks (high returns on invested capital, low debt and high sales growth), their P/E is over 40x. Many are pricing in earnings growth that are 1.2x-2.0x of their past 10 year run rate. This is despite their larger size today and higher interest rates (that pull stock prices down). We believe, there is bubble in quality.

Only a subset of our coverage stocks pass all the five hurdles (understanding, opportunity size, competitive advantage, management, and valuation) currently. We have made full allocations towards them. For rest, the valuations (fifth filter) are high and we are waiting. Nonetheless, we continue to actively track them as if they are part of the portfolio. When price will be right, we will be ready.

The spare cash is the dry powder which will be valuable at those times. We donot want to take any capital risk on that. Hence our preference to park it in liquid funds.

Underperformance of a Style

Practicing a sensible investment style consistently is important for investment performance. There will be periods when a style will be out of favour. And with each year of underperformance, one will wonder if the style works (Warren Buffet in 1998-2000; Prashant Jain in 2015-2019). The tendency to dump the out of favour style and hug the popular style is highest at the time when the out of favour style starts working again (both Warren and Prashant came out on top as cycle reversed). So if the style makes economic and rational sense, there is need to endure especially when confidence is low. We might be at that point today. Not overpaying for quality has been tested before (Nifty Fifty bubble in US) and it will work.

 

A2. Underlying business performance

 

Past Twelve Months Earnings per unit (EPU)2 FY 2024 EPU (expected)
Mar 2023 5.91 6.5-7.53
Dec 2022 (Previous Quarter) 5.5
Mar 2022 (Previous Year) 6.2
Annual Change 16%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: As against our lowered expectation of 5.2-6.2, trailing twelve months Earnings Per Unit (EPU) of underlying companies came in at Rs 5.9. Excluding two companies with temporary and reversible losses, this is a growth of 16% over last year (including effects of cash equivalents that earn ~4-5%).  Due to Covid related one offs and higher cash balance our earnings growth since inception (2019) has been lower than our minimum target of 15%. However, we are set to reach there gradually.

 

1-Yr Forward Earnings: We expect FY 24 earnings per unit to be between Rs 6.5-7.5 per unit, an annual growth of around 18%.

 

A3. Underlying portfolio parameters

 

Jun 2023 Trailing P/E Forward P/E Portfolio RoE Portfolio Turnover1
CED LTFV (PMS) 27.5x 21.6x-24.9x 16.8%3 0.7%
BSE 500 24.4x2 15.0%2
1 ‘sale of equity shares’ divided by ‘average portfolio value’ during the year to date period. 2Source: Ace Equity. 3Excluding cash equivalents. 

 

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

There were no mistakes in this quarter.

 

B2. MAJOR PORTFOLIO CHANGES

We increased our position in one existing company. At ~9%, it is now our largest position.

 

B3. UNDERLYING FUNDAMENTAL PERFORMANCE

Earnings per unit (earnings of our portfolio companies accruing to us divided by units outstanding) of our portfolio grew by 32% in the last quarter (no exclusions) and 16% in last year (excluding two companies companies due to temporary reasons). Prices of most companies in the portfolio are cheap or reasonable given the expected strong earnings performance.

 

B4. FLOWS AND SENTIMENTS

 

Going back to Zero Interest Rates?

Buoyant flows: Both domestic and foreign flows have been strong in last few months providing liquidity to the market. Gross SIP flows into Indian mutual funds continue to remain robust crossing Rs 14,000cr in last month. Foreign investment flows crossed $12bn in last 4 months. It is surmised that China has become less investible due to slowing growth and political issues and that is making India attractive to foreign flows.

Insiders selling: Insiders and promoters are using high valuations as an opportunity to sell their stakes either through market sale or IPOs. In last three months, promoters/ investors have sold stakes over $4bn (highest since 2020) through block deals and offer for sale in over 30 companies. Not to mention stake sale in open market by many promoters. IPO/ QIP/ FPO pipeline that had dried up is full again with some IPOs being oversubscribed by 85x-106x. All this indicates that promoters/ insiders find these times opportune to exit.

Zero interest rates?: US markets are back to their 52 week highs. The breadth has been narrow with a few tech stocks accounting for all the gains in US S&P 500 index and remaining stocks being flat. This is thanks to new bubble in town – Artificial Intelligence (AI). Not to undermine the power of this technology (we are using in our research and writing this letter too), but winners are hard to predict and prices often get ahead of reality. When markets were at similar level last time, US interest rates were near zero. Now they are 4%-5%. US core inflation too continues to remain high at 5% even at higher base. If exit from zero interest regime was the reason for fall in stocks globally, and stocks are back to where they were before fall, are markets assuming that we will go back to zero interest rates again?

 

C. OTHER THOUGHTS

Emperor has no clothes

You might wonder why we are so worried when most around us are not so alarmed by high valuations in general and in some pockets in particular. We will try to answer this through a popular kindergarten story:

Once upon a time an emperor was miss-sold an empty dress hanger claiming that it had a special dress which only clever people could see. While the emperor could not actually see the dress – as there was none- he pretended that he was wearing one just to look clever. He then paraded around naked, while his subjects, advisors and courtiers, feared speaking the truth due to their incentives or fear of looking foolish. It took the innocence and honesty of a child to point out that the emperor had no clothes.

Similarly, in the financial world, conflicting incentives or biases prevent market participants from openly acknowledging certain realities, such as overvalued markets. Various participants, such as stock brokers, investment bankers, mutual funds, mutual fund distributors, finfluencers and financial press may have a vested interest in promoting positive market sentiment and encouraging investments. For, that allows them to earn commissions or fees based on trading volumes or assets under management or eyeballs or page visits.

If these market participants were to openly express concerns about overvalued markets or caution against excessive risk-taking, it could potentially deter clients from investing or trading actively, leading to a decrease in their own revenues. Hence, there can be an inherent conflict of interest that discourages them from highlighting the potential risks or warning about market frothiness.

This mal-incentive when combined with human fallacies of trend extrapolation (rising prices will keep on rising), envy (those around getting rich), greed and FOMO (fear of missing out) create a powerful force that tricks investors to fall for the narrative of investing at any price.

Only antidote against this force is to pay attention to the incentives of one’s financial advisor and remind oneself that focus on risk (and not return) should become the most important consideration while investing in a heated market.

***

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

 

Kind regards,

Team Compound Everyday Capital

Sumit Sarda, Surbhi Kabra Sarda, Punit Patni, Arpit Parmar, Sanjana Sukhtankar, 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.

 

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Letter to Investors – Mar’23 – Extracts

 

EXECUTIVE SUMMARY

    • Adjusted trailing twelve months’ earnings of underlying portfolio companies grew by 11%.
    • FY23 NAV fell by 4.3% with 70% funds invested. NSE Nifty 50 and Nifty 500 grew by 0.6% and -1.2% respectively.
    • We made one mistake that cost us 1% of AUM. Details inside.
    • We added to tracking position in one company and made it a major position. Detailed thesis was shared with investors.
    • Regime changing from TINA to TANIA is leading to flight to safety.
    • Stance: Neutral

Dear Fellow Investors,

 

“Risk means more things can happen than will happen”

-Elroy Dimson

In a rising market, most investment/ trading styles do well despite overpaying. For, money gushing into any asset class can raise its price irrespective of underlying value. Prudence and safety are needless, even penalised during such times. But like most good things, such good runs – even if they extend over a long time – eventually reverse. Waking up to build controls after such reversal is too late.

The decade old world wide party-tide of low interest rates that raised all asset prices is ebbing. Not only has it brought down risky pockets like crypto and expensive tech/ growth/ IPO stocks, but even those exposed to otherwise deemed risk-free assets like US government securities (two regional US banks that held US government securities have been closed). As they say, risk is what is left after you have thought through everything.

Portfolio safety is like a car’s seat belt. Both are minor irritants in good times, but life-saving during accidents. Just as it is prudent to always wear seat belts tolerating minor discomfort, it is important to control risk in portfolios even in good times tolerating lower relative returns.

Our preferred way to reduce risk in the portfolio is to buy a diversified set of good companies cheaply and hold them till they remain good and don’t get super expensive. Yes, there is an inherent conflict in this goal. Markets have become more efficient and everyone is trying to do the same. So good companies donot come cheap. Mostly. But there are two pockets where mispricings are common. First is temporary hardships either in the world, country, sector or company during which even good companies get traded at throw away prices. And second is smaller companies which are not so well tracked and/ or are less liquid and can remain mispriced.

Doing the above is easy in theory but difficult in practice. We need to exercise discipline and have safety margin in all the three components – (a) diversified uncorrelated positions, (b) good companies, and (c) reasonable valuations.

And while doing the above, there are bouts of luck and mistakes. Many times, probable outcomes don’t happen and/ or improbable outcomes happen. Often we get good outcomes beyond our expectations due to plain good luck. These times call for humility and trimming positions that get super expensive. Conversely despite doing the right thing our positions can fall. If there is no material deterioration in underlying fundamentals, these are times not for despondency or self-pity, but raising our bets. Lastly, we make mistakes; they are normal in a pursuit of higher than risk-free returns. When we make mistakes, mention of their cumulative account precedes that of achievements so that we don’t lose the lessons.

When evaluating our performance, please see whether or not we have bought good companies at good prices. Also see whether we have behaved appropriately while going through good or bad luck. Lastly, see if our mistakes were new (pardonable) or repeat of old (unpardonable).  Our letters try to help you do that. Looking only at trailing short term return may not give full picture.

 

A. PERFORMANCE

 

A1. Statutory PMS Performance Disclosure

Portfolio FY23  FY22 FY 21  FY 20* Since Inception* Outper-formance Cash Bal.
CED Long Term Focused Value (PMS) -4.3% 14.9% 48.5% -9.5% 11.2% 30.0%
NSE Nifty 500 TRI (includes dividends) -1.2% 22.3% 77.6% -23.6% 14.3% -3.1% NIL
NSE Nifty 50 TRI (includes dividends) 0.6% 20.3% 72.5% -23.5% 13.5% -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.

 

We were down marginally this year. Being in the same boat as yours, we did not charge any fees in FY23.

Many of our positions are sector leaders going through temporary hardships. They are trading at low/ reasonable valuations in light of their fundamentals. We have used this opportunity to add to these positions. Cash balance has fallen from high of 38% early this year to 30% currently including new inflows.

 

A2. Underlying business performance

 

Past Twelve Months Earnings per unit (EPU)2 FY 2023 EPU (expected)
Dec 2022 5.51 5.2-6.23
Sep 2022 (Previous Quarter) 5.4 5.2-6.3
Dec 2021 (Previous Year) 5.9
Annual Change 11%4
CAGR since inception (Jun 2019) 6%
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: Adjusting for temporary losses in the base and current period, trailing twelve months Earnings Per Unit (EPU) of underlying companies grew by 11% (including effects of cash equivalents that earn ~5%). 

1-Yr Forward Earnings: We are retaining the last letter’s estimate of FY 23 earnings per unit to Rs 5.2-6.2. 

 

A3. Underlying portfolio parameters

 

Mar 2023 Trailing P/E Forward P/E Portfolio RoE Portfolio Turnover1
CED LTFV (PMS) 26.8x 25.5x 16.8%4 5.5%
NSE 50 21.1x2 15.1%3
NSE 500 20.4x2 13.7%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

Mistake: Music Broadcast Bonus Preference Shares (Special Situation)

We have a paper loss of 1% of AUM in a special situation that we participated in last quarter. This was about bonus (i.e. free) preference shares to the equity shareholders of Music Broadcast ltd.

Please note this is not a core equity position; it was a way – unsuccessful till now -to put our spare cash to temporary use. Such cases are called as “special situations” in investing parlance.

Music Broadcast runs the radio channel Radiocity. The newspaper group Jagran Prakashan is the parent of the company with a 74% stake. Radiocity announced bonus preference shares to its minority equity shareholders in the ratio of 1 bonus preference shares of FV of Rs 100 each for 10 shares of Music Broadcast (then CMP Rs 25). The bonus preference share were to be allotted for free. In simpler words any non-promoter shareholder holding shares worth Rs 250 was entitled to bonus shares worth 100 free (i.e. 40% of cost). Additionally, these preference shares will list on stock exchanges soon (we can sell in the market) and will be ultimately redeemed @ Rs 120 in 3 years.

Think of bonus preference shares as delayed dividend. Instead of paying immediately, the company will distribute the sum after 3 years (at 20% premium). Normally a dividend equal to 10% of market cap leads to fall of 10% in share price once the stock goes ex-dividend. Given that these bonus shares are being given to minority shareholders that hold only 26% stake, post record date the stock price should fall by 40% of 26% i.e. 10.4%.

We made a 3.5% allocation to Music Broadcast at price of Rs 26.6 per share to play this special situation. Even if price were to fall 30% once stock goes ex-date we would have made 12% in a couple of months.

Or so we thought! In reality, post the ex-date, while we got the free bonus shares (worth 38% of our cost), the equity share actually is down 59% as of this writing. Even if we go back to the price of Rs 17.7 on Oct 22, 2020 when the bonus was first announced, the stock has fallen 39% from then price.

The only explanations can be that (a) bonus was already in price way before we thought and/ or (b) owing to low liquidity and rush to sell the main equity shares after ex-date, the stock has corrected steeply.

Now that reality has not turned as we had imagined, should we sell the equity shares immediately? Four reasons require us to pause. First, free cash will form over 75% of market capitalisation (including preference shares) of the company. Second, this is pre-election year which is normally good for Radiocity’s advertising revenues. Third, management has been pro-shareholders (Jagran Prakashan, the parent has done 8 buybacks in last 9 years).

And the forth reason is harvesting tax losses. If we hold this position for 9-12 months, (a) we claim tax loss on main equity shares (bonus stripping) and (b) have that as short term loss (15%) versus long term (10%). This means if we sell between 9-12 months, we can use 15% of the ‘notional’ loss to set off future capital gains. Notional because, it is not actual loss, we have received bonus preference shares for free in exchange. Nonethless, we will sell it before 9 months if we are getting a good price.

The bonus preference shares on the other hand will list shortly, and we will decide to sell, buy or hold based on the price at which they start trading.

Learnings – We should not leave such positions open. A perfect special situation is one when returns are locked irrespective of how market moves. So if similar situation was to take place in a stock that was also traded in futures & options (F&O) we could have sold the stock in futures and locked the gain. Second, we need to undertake special situations in companies that we would be okay to hold if things donot immediately turn the way we expect.

**

Previous mistakes (2014-2018): From our two past mistakes- “Cera Sanitaryware (2014)” 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 increased our tracking position to a ~4% position in one of the companies. In addition we added to our position in four other companies as the prices became reasonable.

 

B4. FLOWS AND SENTIMENTS

 

SVB and Flight to Safety

US based Silicon Valley Bank (SVB), 16th largest US bank by assets, closed down last quarter due to run on the bank. This was precipitated by rise in US interest rates from nil to over 4% within a year.

Concentration in deposit and loan book was the main mistake that SVB made. Here is the summary of what happened:

SVB had invested most of its deposits in long dated US government securities (bonds). Sharp rise in US interest rates led to mark to market losses on its bond portfolio (bond prices fall as interest rates rise). SVB had raised deposits from start-ups and they began pulling out deposits as venture capital dried up (again a fallout of rising interest rates). This forced SVB to sell bond portfolio at losses which nearly wiped out its equity capital. And then rumours led to run on the bank. US government guaranteed the deposit holders and closed the bank.

Globally, central banks including the US Fed are caught in the dilemma of maintaining financial stability and controlling inflation. We believe they will continue to safeguard bank depositors and keep interest rates high until inflation is firmly under control. Preference for safety over returns may, therefore, continue leading to moderation in global equity flows.

***

Back in India, retail flows including mutual fund SIPs continue to counter the selling by foreign investors. That partly helped Indian equity market remain insulated from global turmoil so far. As last 12-18 month returns turn negative, retail flow may moderate.  All this should mean that we will continue to get opportunities to deploy our spare cash in coming days ahead. Average valuation of last 10 year’s TINA (there is no alternative) regime may not be correct benchmark for upcoming TANIA (three are new investment alternatives) regime. We will be mindful of this while deploying.

C. OTHER THOUGHTS

An “investment” product to strongly avoid

 Rs 144 trillion. This is the size of India’s favourite financial savings instrument– bank fixed deposits. Rs 30 trillion. This is the next favourite instrument. Can you guess what is it? This is the size of savings plans of life insurance companies. This is twice the size of debt mutual funds in India and is 50% higher than combined sum held as current and savings deposits with banks.

A typical insurance savings product is pitched like this (LIC Bima Jyoti): Invest Rs 10,000 every month for 15 years. Get Rs 30 lacs at the end of 20 years. Get tax benefit under section 80C. Redemption proceeds are tax free as well.

What is not expressly told is that this will give a return of just 6.6% p.a. after GST and income tax benefits (assuming 30% tax bracket). And that there is a lock-in period of 5 years. Failure to pay premium in any of the first five years, not only will lead to loss of tax benefit but also attract surrender charges. Sadly, around 50% of people close their policies before 5 years and their net returns are much lower.

For such a long duration commitment there are better alternatives. A PPF that comes with similar benefits and 15 year term returns 7.1%. In fact, an ELSS (equity mutual funds that are eligible for section 80C benefits), which has just 3 year lock-in can return even higher. In last 20 years it has returned over 12% p.a. after tax. For death benefits a pure term insurance plan is much better. A Rs 1 crore cover can be obtained at an annual premium of around Rs 20,000.

It is extremely fascinating how the confluence of (a) high commissions, (b) tax benefits and (c) human fallacies have created such a colossal but nearly useless product. 

  • Life insurance savings products pay around 30% commissions to agents on first year premium and upto 15% from second year onwards. An agent will prefer selling these over a mutual fund that earns him just 1% for same investment garnered. That’s why your favourite finfluencer has started peddling these products in their “educational” Youtube channels. And that’s why your bank RM or distant relative talks so sweetly to you while suggesting investment options.
  • Life insurance products were given tax benefit so that more and more people secure financial safety of their dependents. The tax benefits were created envisaging pure term policies that only pay death benefit. However insurance companies have misused this benefit for creating FD like products.
  • Lastly, investors drop their guards as soon as they hear “guaranteed returns” and “tax benefits”. Many are not able to calculate the internal rate of return (IRR) embedded in these products. Finally, they rush to buy these products in March, just before the end of financial year without proper evaluation.

Best exit action for those stuck with such products, is to hold them till the lock in period of 5 years and then surrender the policies. This will help retain the tax benefit on redemption and minimise surrender charges.

***

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

 

Kind regards,

Team Compound Everyday Capital

Sumit Sarda, Surbhi Kabra Sarda, Punit Patni, Arpit Parmar, Sanjana Sukhtankar, 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.

 

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Letter to Investors – Dec’22 – Extracts

 

EXECUTIVE SUMMARY

  • Adjusted trailing twelve months’ earnings of underlying portfolio companies grew by 2%.
  • NAV grew by 0.5% YTD with 64% funds invested. NSE Nifty 50 and Nifty 500 grew by 4.8% and 4.7% respectively.
  • Amid growing noise on inflation and interest rates, we need to continue focusing on intrinsic values.
  • Rise in interest rates is a creating pressure on expensive/ risky assets like growth stocks and crypto.
  • Stance: Neutral

Dear Fellow Investors,

 

“What do you see, son”? Asked Guru Dronacharya. “Only the bird’s eye, Sir”, replied Arjun.

-the Mahabharat

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.

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) 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)
Sep 2022 5.41 5.2-6.23
Jun 2022 (Previous Quarter) 6.0 6.2-7.23
Sep 2021 (Previous Year) 5.7
Annual Change 2%4
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%
NSE 50 21.8x2 15.0%3
NSE 500 22.9x2 13.7%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

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.

Key Findings*:

  1. There were 560 companies whose stock shot up over ‘3x or more’ in a rolling 3-year period between 2012-2017.
  2. 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.
  3. 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

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

 

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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.

 

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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.

 

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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.

 

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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

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

 

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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.

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Kind regards,

Team Compound Everyday Capital

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

 

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

 

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