Letter to Investors – Sep’24 – Extracts

 

EXECUTIVE SUMMARY

    • Trailing twelve months’ earnings of underlying portfolio companies grew by 8.7%.
    • NAV grew by 18.0% YTD with 79% funds invested in equity positions. Balance 21% are parked in liquid/ arbitrage funds.
    • Incessant retail demand is pushing markets higher. History suggests sooner or later demand subsides or attracts supply.
    • We introduced a new 5% position, and exited from an existing position.
    • Are flows into equities slowing down bank deposit growth?
    • Stance: Cautious

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

Portfolio YTD FY25 FY24 FY23  FY22 FY 21  FY 20* Since Inception* Outper-formance Cash Bal.
CED Long Term Focused Value (PMS) 18.0% 29.2% -4.3% 14.9% 48.5% -9.5% 17.0% 22.0%
S&P BSE 500 TRI (includes dividends) 20.2% 40.2% -0.9% 22.3% 78.6% -23.4% 21.9% -4.9% 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. 

 

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

 

Past Twelve Months Earnings per unit (EPU)2 FY 2024 EPU (expected)
Jun 2024 8.81 8.5-9.53
Mar 2024 (Previous Quarter) 8.5 8.5-9.53
Jun 2023 (Previous Year) 8.1
Annual Change 8.7%
CAGR since inception (Jun 2019) 13%
1 Last four quarters ending Jun 2024. Results of Sep 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. 

 

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

 

Jun 2024 Trailing P/E Forward P/E Portfolio RoIC Portfolio Turnover1
CED LTFV (PMS) 25.7x 23.2x-25.1x 34.0%3 2.5%
BSE 500 27.9x2 15.7%2
1 ‘sale of equity shares’ divided by ‘average portfolio value’ during the year to date period. 2Source: Asia Index. 3Portfolio Return on Invested Capital (RoIC) is on core equity positions. For BSE 500 index we share the RoE (Return on Equity)

 

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:

Year Number of Issues Amount Raised (Rs cr) Median Times Oversubscribed
2024 till date 197 7000 cr 179x
2023 182 5000 cr 41x
2022 110 2000 cr 14x
Source: BSE, NSE

 

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.
  1. 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.

 

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Manias and Panics – Lessons from last 400 years

 

“I can calculate the movement of stars, but not the madness of men.”

Sir Issac Newton (after losing money in the South Sea Bubble, 1720)

 

Financial bubbles and crashes have been a frequent occurrence throughout the recorded world history. Almost all have led to bankruptcies, job losses, and financial distress.  If meltdown of bubbles is so painful, why can’t we stop them? Won’t it be better if prices remain etched to the financial worth of underlying securities/ assets, and owners earned the natural yields of those assets?

We scanned over 10 episodes of bubbles and crashes of last 400 years – including Tulip Mania of 1636, the Great Depression of 1929, the Dot Com bubble of 1999, the Sub-prime crisis of 2008 etc – to try and understand the causes of bubbles and crashes. The objective was to pull out/ revise lessons that today’s enthusiastic investors can learn from and avoid similar mental and financial toil.

Initial Rational Source: In almost all the bubbles of last 400 years, one or more of the following were the initial source(s) of economic exuberance:

SN Initial Rational Sources Examples
1 Inventions/ Productivity growth o    US 1920s (railways, radio, automobiles),

o    US Tech Bubble 1990s (internet)

2 Expansion of credit, excessive leverage, easy money, low interest rates o    Japanese Real Estate 1980s,

o    US Subprime Crisis 2000s,

o    Global Venture Capital boom 2015-2022

3 Globalisation, exports, cheap currency o    Japanese Real Estate 1980s,

o    South East Asia 1990s,

o    China 2000s

4 Economic Reforms/ Liberalisation o    Mexico 1980s,

o    US abandoning the Gold Standard 1970s,

o    India Harshad Mehta episode 1990s

5 Monopolies o    South Sea Bubble 1720,

o    Mississippi Bubble 1720

 

Most of the above measures were taken in pursuit of progress and economic well-being. And most of these measures were justified reasons for imagining a brighter future. They did improve lives and general wealth.

Wealth Effect: Anticipation of higher demand and growth due to above initial events leads to rise in asset prices. Banks get comfortable lending funds against security of these inflating assets. Raising money through equities become cheaper. Easy availability of both debt and equity capital at low cost of capital encourages capital investments and job creation. This raises incomes and thereafter consumption. The wealth effect thus feeds itself. 

Greater Fool Theory: What turns initial optimism into euphoria and bubble is the over estimation of brighter future, animal spirits and emotional outburst of greed, envy and fear of missing out (FOMO). Wealth effect leads to general sense of prosperity. It triggers envy and FOMO among sideliners. Prices start to detach from underlying reality. People buy in the hope that others may buy from them at even higher price – the Greater Fool Theory.

Timing the top: Sadly, sooner or later the supply of greater fools run out. Some external event happens that makes prices to first stop rising and then start falling. Those not able to service debt or expenses are forced to liquidate falling assets. Gradually greed turns to fear and wisdom of crowds turns into stampede of folly. If we try to pick clues about being able to time the peaks, we will return disappointed. For, there is no upper range of time in months when a bubble pops. However, sooner or later, it does pop. Following have been one or more common crash triggers/ escalators of the past:

SN Crash Triggers/ Escalators Examples
1 Frauds or Swindles o    Enron/ Worldcom During US Tech Bubble 1990s,

o    Satyam, India 2008

2 Default or Bankruptcies o    US Maring Debt 1920s,

o    South East Asian Crisis 1997,

o    Lehman Brothers 2008,

o    IL&FS default 2018

3 Contraction of credit or money supply o    Japanese Real Estate 1980s,

o    US Tech Bubble 1990s

4 Geo-Politics, Terrorism, War o    Yom Kippur War and Oil Crisis 1973,

o    9/11 Attack 2001

5 Natural Calamities including Pandemics o    Spanish Flu, 1918,

o    Covid -19, 2020

 

 Saviour: Primary protection against emotional follies of envy, greed, fear of missing out and overconfidence in an overheated market is to remember what Benjamin Graham and Warren Buffett said about bubbles and human nature –

“The investor’s chief problem, and even his worst enemy, is likely to be himself”

“Be fearful when others are greedy”

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Investing during elections

Government policies and regulations have a material impact on business growth and profitability. Research has shown that business/ capitalism friendly policies add to general national prosperity. Take for instance the 1991 Economic Liberalisation in India. That single decision has altered the trajectory of wealth creation by Indian businesses. Respect for trade, commerce, enterprise and property rights has been a common source of wealth creation across multiple countries including Switzerland, Singapore, America, Japan, and to a limited extent, even China.

It is not surprising that Indian markets are cheering the expectation of the Modi government’s relection in the forthcoming elections. Over last 10 years, the Modi government has spearheaded many notable reforms including GST, reduction of corporate income taxes, speeding up infrastructure spends, fostering digitalisation through JAM – Jandhan, Aadhar and Mobile – trinity and promoting Make in India to name a few.

While the impact of policies on business growth is clear, the near term impact on the markets is less so. Two key challenges are (a) double counting and (b) impact of other factors:

Often, expected election outcomes already get baked into prices. Expecting a further rise when markets have already risen can be a double counting error.

Also, politics is not the only factor that affects markets. Global interest rates (falling interest rates since 2008 to 2022), global economic cycle (Chinese commodity boom in 2003-2007), geo political issues (Kargil war, 9/11, Ukraine-Russia war), technological changes (internet in 2010s and AI currently), demographics etc. all can have multiplicative or countervailing effect on markets.

Here are few examples of how correlation between elections and stock market is messy:

After rising 3x post Economic Liberalisation of July 1991, (partly due to the Harshad Mehta scam), the BSE Sensex remained flat for next 11 years even as the benefits of Liberalisation continued. There was the Asian crisis, Pokhran nuclear test (leading to global sanctions), and the Kargil War all in between.

In the 2004 elections, there were high expectations of the BJP-led government’s re-election under Mr. Atal Bihari Vajpayee. We all remember the optimistic “India Shining” campaign. Contrary to expectations, the Congress-led United Progressive Alliance (UPA) won, initially leading to a 14% drop in the Nifty Index over the month following the election. However, the market was up 24% next year due to the Chinese commodity boom.

Or, take the 2009 elections, when Sensex was up 81% for the full year on re-election of The UPA’s government with a stronger coalition. How much of this was due to UPA re-election and how much a recovery from steep fall the previous year due to the Global Financial Crisis, is difficult to segregate.

In summary, it is not very easy to pinpoint election outcome’s exact and solitary impact on stock markets both in near term and longer term. This is because not only do prices bake in expectations, but there are other factors at play too.

Our approach is taking election outcomes as one of the many inputs into assessment of a company’s economic worth and comparing that worth with prices. Election outcomes stack lower than many other more important inputs like size of opportunity, competitive advantage, management quality etc in the pecking order. While there may be some businesses that directly benefit from who is in the power (infra, mining, defence, capital goods etc), economic cadence of businesses that we like (not many in the above list) are not materially affected by who’s in charge of the country so long as capitalism and free enterprise flourish.

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From Beginner’s Luck to Winner’s Curse?

 

Consider this: If 1000 monkeys had constructed portfolios of Indian stocks in the calendar year 2021, how many of those 1000 portfolios would have beaten the BSE 500 index after 3 years?

The surprising answer: ALMOST ALL OF THEM (997 of 1000).

No, these aren’t specially gifted/ trained primates; they’re random monkeys with random portfolios. We conducted a simulation with 1000 random portfolios. Each portfolio picked 100 equal weighted stocks at random from the BSE 500 universe in calendar year 2021. To remove starting period bias, we excluded period from May 2020 to December 2020 (marked by a sharp recovery from Covid-19 lows). Additionally, we assumed that stocks were added on a monthly basis throughout calendar year 2021. Then, on March 31, 2024, we compared the performance of these 1000 portfolios with that of the BSE 500 index, assuming a similar monthly purchases of the index. Remarkably, almost all monkey portfolios outperformed BSE 500’s 15% annualised returns from 2021 to March 2024, recording a median return of 22% p.a.

The secret behind this superlative performance lies in the starting point and market’s direction during the study period. Stocks have been on a relentless ascent since Covid-19 lows in May 2020. Many small and midcap BSE 500 stocks with less than 1% weight in the index have surged 3x to 12x. An equally weighted portfolio of random 100 stocks would allocate 1% weight to these stocks. Just a few such stocks are sufficient to improve the portfolio performance materially. Moreover, hardly any stock experienced significant declines to drag down the overall performance. If these portfolios were allowed to include micro caps, IPOs and SME IPO stocks (currently excluded) or reduce the number of stocks from 100 to say 50 or even 30, their performance would have risen further (100% outperformance; over 22% median return).

This outcome – call it beginner’s luck – mirrors the experience of many new investors who entered equity markets post Covid-19. Consistently beating the index is challenging even for seasoned investors. So, after outperforming the index over 3 years, many novice investors may start to believe that they possess a Midas touch for stock picking. However, in reality, the past 3 years’ success is largely attributable to luck. Worryingly, nothing sets up someone for financial and/or emotional ruin more than luck mistaken as skill and/ or an imprudent approach rewarded handsomely. Emboldened by their riches, many investors will raise their bets (trade in options, dabble in stocks of questionable companies etc.) precisely at the wrong time, and fall victim to the winner’s curse.

We also conducted a reality check: we made those 1000 monkeys repeat the same exercise in calendar year 2018. How many of them would have beaten the BSE 500 by June 2020? Only 200 out of 1000, with a median return of -6%. The reason? The markets were in decline from 2018 to June 2020.

Liquidity can propel stock prices to any level in the short term. However, fundamentals and valuations ultimately serve as anchors. Until then, ironically, a thoughtful investing approach may seem foolish, while a foolish investing approach may appear thoughtful. It’s therefore difficult to correctly evaluate performance in a uni-directionally rising market. The true test of investment skill lies in a falling market. Correct evaluation period should encompass a full market cycle, not just one phase as is the case with last three years. A full cycle is when margins and multiples both mean revert. A strong performance across full cycle results from being mindful of risks in a rising market and maintaining the price and quality discipline consistently.

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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.

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Tribute to Charlie Munger

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 recently 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 as well. 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

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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.

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Embracing Truth, Light and Immortality in Investing

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.

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Underperformance of an Investment 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 the confidence is low. 

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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

 

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