Dear Fellow Investors,

Without bottlenecks, demand eventually attracts supply. Or, the demand subsides gradually. In both cases, prices fall.

Indian equity markets continue their upward march. Nifty 500 index, a collection of top 500 Indian companies, is up 2.4x from pre-Covid highs of Feb2020 generating a 4.5yr CAGR of 21% p.a. This is significantly higher than the decadal median 5 year rolling returns of around 12%. Whichever valuation parameters we pick and plot, all will point to one conclusion- valuations are expensive today in most pockets. What makes this Indian bull run different is the disproportionate role of retail/ non-institutional money.

As per the law of demand and supply, price rise leads to fall in demand. There are two exceptions to this law- Giffen goods (necessities) and Veblen goods (luxuries). To this list we can add a third exception now: retail demand for stocks in a bull markets. Retail participants are demanding more at higher prices!

In absence of offsetting supply, price agnostic buying has pushed prices higher justifying the increased demand. But the law of demand and supply suggests that without bottlenecks, higher demand is usually met with higher supply. Or, demand can subside gradually. In either case, as supply exceeds demand, prices cool down. Let us revisit history to see how the eventual matching of supply and retail equity demand led to lower prices:

• During the Harshad Mehta episode of the 1990s, speculating in stocks became a national past time. Over 1000 IPOs were launched in 1994 and 1995 each as promoters/ sellers supplied stocks to ever rising speculative demand. Supply gradually surpassed demand. Prices fell and many of those IPO companies vanished from the market

• In 2015, China saw over 30mn new accounts opened in first 5 months alone, with Chinese retail investors accounting for over 80% stock volumes. The CSI 300 index went up 150% between 2014-2015. However, when real economy failed to match the stock price performance and the government imposed curbs on margin debt, sentiments reversed and demand fell. The index crashed 45% in the following 8 months. Trading in many stocks was halted. The CSI 300 index, as of writing of this letter, is 25% below the highs of 2015.

• In the US, the introduction of 401(k)-retirement accounts in 1980 propelled the mutual fund (MF) boom. Share of households owning MFs increased from 5% in 1980 to 45% in 2000. And, share of MF assets in gross household financial assets grew from 5% in 1984 to 20% in 1999. This period also coincided with longest interest rates decline in the US creating favourable backdrop for US equities especially internet related stocks. While it is difficult to isolate one factor, but these two factors – retail MFs and falling interest rates – contributed to the roaring 1990s in the US. When the Fed raised interest rates and tech companies earnings fell short, the dot com bubble burst.

While history suggests that supply will eventually catch up with retail equity demand, it offers no guidance on timing. The US episode lasted nearly two decades, while China’s cycle lasted less than a year. No one knows how long the retail flow into equities will continue in India. As supply from sellers (via IPOs or insiders selling) increase, demand may get exhausted. Furthermore, regulations around options, margin funding, unsecured lending or any external geo-political shock can dampen demand.

We continue to navigate today’s challenging environment by maintaining price and quality discipline. As we discuss in the next sections, we have added a new position expected to be less correlated with India’s equity markets. We also continue to reduce small cap positions (where our allocation is already low) as their prices become expensive. Lastly, we have a significant reserve of cash equivalents, which will be useful if prices cool. Cautious stance stays.

A. PERFORMANCE

A1. Statutory PMS Performance Disclosure

Don’t Evaluate Today

Evaluating or benchmarking performance during peak market periods can be misleading. In such times, both prudent and reckless behaviours are equally rewarded. As Walter Bagehot famously stated, “We are most credulous when we are most happy,” and Warren Buffett cautioned, “Be fearful when others are greedy.” Their messages urge us to look beyond returns in bullish periods and remain vigilant about the risks of overpaying or compromising on quality. Investing is a long-term marathon, not a series of short sprints. It’s essential to prioritize survival and sustainability over the allure of quick victories. As a reminder, let’s reflect on the F1 wisdom often attributed to Rick Mears:

“To finish first, first finish.”

A2. Underlying business performance

Trailing Earnings: Stock prices are not under our control. The only thing that is under our control is choosing companies that grow their earnings at a good rate. And so long as we do not overpay, our NAV growth will mirror earnings growth. Therefore, we track the earnings of all the portfolio companies that accrues to us on per unit basis.

Last twelve months earnings per unit for the reporting period came in at Rs 8.8. This was 8.7% higher over last year. Since inception our earnings have growth at around 13%, lower than our target of 15%+. The key laggard has been one position which has been reporting losses in last few years post Covid-19. However, as we explain later, we expect this to be temporary. The earnings power of this company is intact and improving.

1-Yr Forward Earnings: Post the developments in the quarter gone by, there is no material change in the visibility of FY25 earnings per unit and we maintain the guidance range of Rs 8.5-9.5.

A3. Underlying portfolio parameters

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

There were no mistakes to report in this period.

B2. MAJOR PORTFOLIO CHANGES

Bought: We introduced a new 5% position.  

Sold: We exited a smallcap position that had grown 3x in last 4 years.

B4. FLOWS AND SENTIMENTS

Retail flows into mutual funds, insider selling (by promoters and private equity investors), and record-breaking mainboard IPOs continue to fuel a euphoric market. High-risk pockets, such as SME IPOs and thematic mutual funds, are capitalising on regulatory arbitrage and leading the charts once again:

SME IPOs

In calendar year (CY) 2024 to date, 197 SME issuers have raised approximately ₹7,000 crore, surpassing the full-year totals for 2023. The table below illustrates the rapid rise:

The number of SME IPOs and the amount raised in the first nine months of CY 2024 have already surpassed the totals for all of 2023. Most striking is the increase in median oversubscription, which has surged from 41x to 179x. Five IPOs were oversubscribed by over 900x, and 40 IPOs saw oversubscriptions exceeding 400x. Many of these companies are ordinary, with high debt or insignificant cash flows relative to their earnings.

These astonishing oversubscription figures and listing gains—often from unproven or even questionable-quality companies—should invite scrutiny. SEBI recently issued a cautionary circular, advising merchant bankers and exchanges to exercise diligence when greenlighting SME IPOs. In fact, some merchant bankers are under investigation for charging excessively high fees (around 15% of funds raised versus the usual 1%-3%). SEBI has further cautioned investors to be wary of unscrupulous promoters and pump-and-dump schemes in SME IPOs.

To give a bit a regulatory background, SME IPOs are approved by exchanges and do not need SEBI approval. Minimum application size in SME IPOs is around Rs 1.2 Lacs versus Rs 15,000 in main board IPO – 8x higher. Unlike mainboard IPOs, where merchant bankers or their associates cannot subscribe to offer, on SME exchanges market makers work as associates of merchant bankers with upto 5% of issue size allotted to them – enough to influence prices. BSE SME IPO index is up 3x in last 12 months, but such numbers should be viewed with caution.

Thematic/ Sectoral Mutual Fund (MF) schemes

With Rs 4.2trn in assets under management (AUM) and 25mn folios, thematic/ sectoral mutual mund (MF) schemes have become the largest category in actively managed mutual funds overtaking more popular categories like large-cap and multi-cap schemes. In calendar year-to-date 2024, over 45% of net MF inflows have gone into sectoral/ thematic schemes.

Following SEBI’s 2018 regulations, which simplified schemes, mutual funds are limited to having only one scheme in each category—large-cap, flexi-cap, multi-cap, mid-cap, and small-cap. However, no such limits exist for sectoral or thematic schemes. MFs are capitalizing on this loophole. Unfortunately, many of these new fund offers (NFOs) are concentrated in sectors that are currently popular due to recent high returns but are now overvalued. These sectors include defense, PSUs, manufacturing, EVs, and others.

Investors, attracted by strong past performance, are flocking to these schemes. Meanwhile, mutual fund distributors are happy to oblige, given the higher commissions associated with NFOs. While not illegal, these practices are often not in the best interests of investors.

C. OTHER THOUGHTS

Capital Gains Tax & Buyback Tax

The latest Union Budget increased the rates of long-term capital gains on sale of listed equity shares from 10% to 12.5% and that of short-term capital gains from 15% to 20%. This is going to reduce after tax annual returns from equities by 0.25%-0.75% assuming a band of 10%-20% p.a. long term returns. Before getting disappointed, however, we should remember that capital gains tax is applicable only on realised capital gains. If we do not sell or sell less often, the present value of this higher tax will be insignificant. Thankfully, over last 12 years our portfolio turnover has been less than 5% p.a. Long-term holders of stocks need not worry about the increased capital gains taxes.

Proceeds from buybacks will be now be treated as dividends and taxed at maximum marginal rate of tax (36%+ for most promoters). When done at a low share price, buybacks enhance shareholder value. Until now buybacks were taxed at a lower rate than dividends in the hands of recipients. Most buybacks in India, therefore, were being done for this tax arbitrage (to promoters) even at very high prices – harmful for remaining shareholders. Hopefully this misallocation will stop as promoters will pay same personal tax whether its buyback or dividends. Those doing buybacks now, hopefully, will do them for the right reason.

Bank Deposits lagging Loan Growth

For the fortnight ended Sep 2024, banks’ loan growth was around 13% while deposit growth lagged at around 10%. This trend of slower deposit has persisted for some time. It is tempting to attribute this to shift in retail savings from bank deposits to equity markets. However, the reality is more nuanced.

Every equity transaction involves has both a buyer and a seller. When a deposit holder sells her bank deposit and buys stocks, the money simply moves from her bank to seller’s bank. In aggregate the banking system does not lose deposits.

Even higher currency in circulation ultimately lands up in bank deposit. For example, in a real estate transaction, where the buyer pays part of the amount in cash by withdrawing from bank deposit, the builder will use the cash to buy materials (like steel or cement), returning the cash back to the banking system.

Some argue that forex transactions such as selling by foreign investors, foreign travel, or foreign education cause money to leave the country. However, in these cases rupees are used to buy dollars. As a result, rupee deposits remain within India.

Higher taxes may transfer deposits from citizen’s bank to the government. But, the government eventually returns these funds back to the banking system through its revenue and capital expenditures.

Then what explains the slowdown in bank-deposit growth?

To understand the slowdown in deposit growth, we must revisit basic monetary economics. Money supply is created by two main actors: (a) commercial banks (such as HDFC Bank and ICICI Bank) and (b) central banks (such as the Reserve Bank of India).

1. Commercial Banks: Commercial banks create money through lending. Each loan issued creates a corresponding deposit. For example, when a bank grants a loan to a borrower, it records the loan as an asset. At the same time, the loaned amount is credited to the borrower’s deposit account, either at the same bank (if the deposit is held there) or at another bank and recorded as a liability.

2. Central Banks: Central banks create money by financing government deficits, stabilizing the currency (printing rupees to buy dollars), or buying bonds (printing rupees to purchase bonds).

In recent years, the RBI has been tightening money supply to control inflation. While overall money supply has increased by around 10%, the reserve money (created by the RBI) has grown only by 6%. If we look at previous episodes of high inflation, we see a similar trend: deposit growth lagged loan growth. However as per most recent data, deposit and loan growth have started converging. This lag in deposit should be viewed as temporary phenomenon that will correct itself as inflation is brought under control.

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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 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.

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.