Business Analysis, Investment Psychology, Quarterly Update

Letter to Investors – Mar’25 – Extracts

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EXECUTIVE SUMMARY

    • Trailing twelve months’ earnings of underlying portfolio companies grew by 15%. 
    • NAV grew by 10.3% with 79% funds invested in equity positions. Balance 21% is parked in liquid/ arbitrage funds.
    • Nearly half of the top 700 companies are trading at over 40x P/E, building in lofty expectations.
    • We added further to two existing positions. We exited from one older position (details in the letter).
    • Tariffs and Artificial Intelligence calls for being more demanding in multiples we pay for equities.
    • Investment beliefs are shaped by the era that investors spend their early investment years in.
    • Stance: Neutral

Dear Fellow Investors,

High expectations (valuations) steal the joys of life (investing) 

Stock prices reflect future expectations. The higher the expectations, the lower the room for positive surprise—both in life and investing. When valuations are stretched, the risk of disappointment rises, making aggressive investments at elevated prices a potential recipe for regret.

As of 31st March, about 50% of the top 700 companies (market cap > Rs 5,000cr) traded at or above 40x trailing price to earnings (P/E) ratio (including loss making companies). This is after some moderation from Sep 2024 highs when that count was over 60%.  Average P/E of BSE 500 index has been around 22x for past two decades.

A 40x P/E roughly builds in an expectation of an 18% annual free cash flows growth for a decade, followed by 5% growth for the next 90 years. At 100x P/E, those expectations rise to 25% and 8%, respectively—expectations that nearly 10% of these companies are pricing in today! 

Of these 40x+ P/E companies having listing history of 10+ years, only 20% have been able to grow their earnings at or over 18% for last 10 years. The median 10-year earnings growth of these companies has been 15%. A caveat here – many sectors are at their cyclical top – for example PSU banks, railways, defence, capital goods, real estate, power, oil & gas, hospitals, hotels, capital market facing firms etc. There are high chances that the median future 10-year earnings growth for this cohort will be lower than 15%.

Sustaining high growth for decades requires two ingredients—moat and demand. Moat or competitive advantage refers to entry barrier(s) that provides protection against competition, while demand determines the size of the opportunity. Of the two, moat is essential. Without a moat, rapid growth attracts competitors, squeezing margins and returns. Even if this is temporary, picking ultimate winner becomes difficult.

Today, Indian companies trading at or above 40x P/E span diverse sectors – auto and auto-ancillary, paints, wires and cables, quick commerce, airlines, hospitals, hotels, footwear, clothing, retail, luggage, solar, wind, jewellery, FMCG, QSR (quick service restaurants), electrical appliances, salty snacks, writing pens, plastic products, commodity chemicals etc.

Many of these sectors have no, narrow, or weakening moats. Two broad factors are driving such high valuations:

1. Overestimating fundamentals:

  • Misjudging growth: Cyclical/ temporary growth is misjudged as structural tailwind (e.g., the Indian chemical sector post-2014, COVID-driven demand spikes in healthcare, capital goods due to government capex etc.).
  • Overestimating market size: Many consumer categories in India have a smaller actual market than initial optimism suggests. Also, a part of consumption is fuelled by unsustainable debt.
  • Weakening competitive advantages: Technological shifts and new distribution models (e-commerce, quick commerce) have weakened moats in many sectors including FMCG, retail, consumer durables, and quick service restaurants (QSRs). Artificial Intelligence may also disrupt moats in future.
  • Growth attracting competition: High-growth sectors such as telecom, paints, wires, airlines, retail, and diagnostics have seen new entrants dilute profitability.
  • Overestimating management quality– Great managements protect and/ or strengthen the moat through culture, capital allocation and efficient execution. Without moat, however, their abilities to protect growth and profitability is reduced (passenger vehicles for example). The subset of businesses, where management is the moat (banking and general insurance for example) is small. Outside of this set, giving high multiples for business lacking strong moat only because of quality management may lead to overvaluation.
  • Regulatory tailwinds – Regulations or government protection can give temporary bouts of growth (eg, public capex, license etc); however, regulations and governments can change. Price curbs or caps can be introduced in consumer interests (eg telecom, real estate, micro finance, city gas distribution etc.).

2. Flows driving prices: Often non-fundamental reasons like global and local flows (due to momentum, index inclusion, or lack of alternative opportunities) can drive prices. The current episode of buoyant prices in India can partly be attributed to unprecedented flows from retail investors further supported by ease of trading and positive narratives painted by media and fund managers. In such an environment, price movements become shorthand for quality, and the belief that “rising prices equal strong fundamentals” can take hold. This creates a self-fulfilling prophecy where valuation metrics and underlying business fundamentals are overshadowed by the prevailing market sentiments.

In the short run, imaginations can continue to run wild and valuations can stretch beyond reason. However, the maths ultimately needs to add up. Time ultimately acts as a reality check. If growth, profitability or capital intensity turns out weaker than lofty expectations, price resets can be sharp.

Investing involves looking into the future and many times it is not that easy to judge the nature of moat and future growth. These are all the more reasons to demand margin of safety.

Markets fell from their Sep’24 highs and they recovered some ground in the month of March. As of writing of this letter, US tariffs have led to fall across markets including India. While valuations in many pockets continue to imply unreasonably high expectations, some entry points have emerged. Changing the stance from Cautious to Neutral.

 

A. PERFORMANCE

 

A1. Statutory PMS Performance Disclosure

Portfolio FY25 FY24 FY23  FY22 FY 21  FY 20* Since Inception* Outper-formance Cash Bal.
CED Long Term Focused Value (PMS) 10.3% 29.2% -4.3% 14.9% 48.5% -9.5% 14.0% 21.0%
S&P BSE 500 TRI (includes dividends) 6.0% 40.2% -0.9% 22.3% 78.6% -23.4% 17.2% -3.2% 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. 

 

Risk is under our control, not returns

The above statutory performance table captures returns but not risks. That’s because risk isn’t a neatly quantifiable number that can be benchmarked periodically. Yet, managing risk—not predicting returns—is the one aspect of investing firmly within our control. A simple but difficult way to do so is by focusing on the quality of the businesses we own and the price we pay for them. And, in absence of either, waiting for them by parking the cash in liquid and safe instruments.

The secret in equities is that in long term, low risk can lead to moderate to high returns for most investors, but high risks lead to lower returns for most investors. Operating word is “most”. A few may achieve extraordinary short-term success through sheer luck or randomness, but for the vast majority, the only dependable way to earn satisfactory returns is through consistent risk management.

However, much like vaccines or insurance, risk control often feels unnecessary in investing. As long as things are going well, all three seem like an avoidable cost, a needless drag. But their true value becomes clear when uncertainty strikes. The prudent approach is to spread this cost over time, rather than defer it, because risks, when ignored, can compound and strike with fatal force.

Investors got a glimpse of this in the latter half of FY 2024-25. For many newer participants, the market correction may have been a shock. But for experienced investors, it was not unexpected. We had been preparing—not by making dramatic market calls, but by being cautious and accepting smaller, more manageable doses of discomfort: the pain of underperforming and looking out of sync when euphoria prevailed. Our higher cash equivalents amid lack of meaningful opportunities over last few years was a result of this caution. It took its toll in terms of lesser relative returns. But that’s a far better price to pay than the alternative—finding oneself out of money, conviction, or emotional strength when the tide turns.

 

A2. Underlying business performance

 

Past Twelve Months Earnings per unit (EPU)2 FY 2025 EPU (expected)
Dec 2024 9.21 8.5-9.53
Sep 2024 (Previous Quarter) 8.9 8.5-9.53
Dec 2023 (Previous Year) 8.0
Annual Change 15.0%
CAGR since inception (Jun 2019) 13.0%
1 Last four quarters ending Dec 2024. 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: So long as we do not overpay, our returns will track or exceed the earnings growth of our underlying companies. We track the earnings available to per unit of PMS through Earnings per Unit (EPU) metric. This is calculated by taking normalised earnings accrued to our portfolio divided by PMS units. For the trailing twelve months ended Dec 2024, our EPU came in at Rs 9.2 per unit, higher by 15% year on year.

 

1-Yr Forward Earnings: We retain our EPU guidance for FY25 at the range of Rs 8.5-9.5 per unit.

 

A3. Underlying portfolio parameters

 

Mar 2025 Trailing P/E Forward P/E Portfolio RoIC Portfolio Turnover1
CED LTFV (PMS) 23.0x 22.3x-24.8x 37.0%3 11.7%
BSE 500 23.4x2 – 16.5%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 added to two existing positions. 

 

Sold: We have completely exited from CDSL at 8x gain from our average cost.

 

CDSL Exit (8x gains) and Learnings

In our past letters, we’ve shared our approach to selling—while we tolerate some overvaluation as long as fundamentals remain stable, we reassess when they weaken. In the case of CDSL, we believe the fundamentals are now weakening.

CDSL’s revenue is significantly tied to equity market activity, including cash market deliveries, IPO applications, corporate actions (rights issues, bonuses, buybacks, etc.), and KYC transactions. A bull market of last four years has helped CDSL increase its profits by 3.3x. However, as markets declined 7-9% in the December quarter, CDSL’s revenue growth slowed. Given CDSL’s high fixed-cost base, profit after tax (PAT) grew even more slowly than revenue.

Looking ahead, we expect India’s exceptionally high retail participation—up 3-10x over the past four years—to moderate as market valuations remain elevated and volatility increases. Meanwhile, fixed costs like employee and technology expenses will remain sticky, putting further pressure on profitability. At the price we exited, forward valuation multiples looked demanding in this context.

We have exited our CDSL position with an 8x gain over five years. CDSL allowed us to experience, first hand, the power of duopoly, capital-light businesses and impact of mega trends—surge in retail investor participation in this case. Hopefully, we will over allocate to such cases next time. For now, it goes back to our watchlist.

 

B4. FLOWS AND SENTIMENTS

Smallcap and midcap equity indices fell 16 and 11% respectively last quarter, despite continued positive inflows into smallcap and midcap mutual funds. The decline was driven by selling from foreign and high-net-worth investors on thin volumes rather than a slowdown in domestic fund flows.

This correction has tempered excessive bullishness in riskier market segments—a welcome development. However, if retail investors start redeeming from mutual funds, liquidity constraints could amplify the downturn. On the other hand, sustained inflows might mark a bottom. As always, timing is uncertain, and with valuations still elevated, caution remains key.

Globally, trade tensions are back in focus, with the return of US tariffs under President Donald Trump. Trade policies are unpredictable, and history suggests that protectionism often leads to economic inefficiencies and, in extreme cases, geopolitical instability. While growth slowdown and inflation concerns in the US may limit aggressive escalation, the risk of negative surprises has risen.

Meanwhile, artificial intelligence (AI) is reshaping the technology landscape. US tech giants are investing heavily in AI infrastructure, while Chinese firms like DeepSeek and Baidu are emerging contenders. As with past technological revolutions—railways, radio, automobiles, and the internet—the winners remain uncertain. AI’s impact on healthcare, mobility, security, and automation presents both opportunities and disruption risks.

Both tariffs and AI add to global uncertainty, reinforcing that we remain demanding of multiples we pay for equities.

 

C. OTHER THOUGHTS

Market Eras and Investment Beliefs

Beliefs are shaped by direct and vicarious experiences – both in life and investing. Market regime/ era that investors live through influence their risk appetite, valuation frameworks, and core investment beliefs. Here are some of the historical investing eras:

  • The 1930s and the Great Depression: The 1929 crash in the US led to prolonged stagnation, with U.S. stocks not recovering for 25 years. Investors from this era viewed equities as risky, favouring bonds, dividends, and capital preservation.
  • The Inflationary 1970s: High inflation during 1970s in the US compressed valuations and led to negative real returns. Bonds and commodities became preferred investments, reinforcing inflation sensitivity among investors of that era.
  • The Great Bull Market (1980–2020): 40 years of falling interest rates fuelled a multi-decade bull market, driving valuations higher and benefiting long-duration assets like technology stocks. Passive investing and private equity thrived, while ‘buying the dip’, became a reliable strategy.
  • The Japanese Equity Winter (1990–2020): Japan’s post-real-estate-bubble stagnation left investors conservative, prioritizing cash preservation. Even decades later, Japanese households remain underweight equities despite global market strength.
  • India’s ‘Lost Decade’ (1992–2001): After the Harshad Mehta crash, the Sensex remained flat for nearly a decade, fostering scepticism toward equities. Many Indian investors turned to fixed deposits (FD rates were over 12%), real estate, and gold, delaying the cultural shift toward equity investing until the mid-2000s.

Those who have lived in declining or stagnant markets develop cautious attitude and those having lived through bullish times develop a carefree attitude to investing. Much like Plato’s allegory of cavemen, these attitudes are so strong that it is difficult to convince them that other eras exist. In The Republic, Plato shares a story about a group of people who lived their entire lives chained inside dark cave facing a wall. Behind them was a fire, and between the fire and the prisoners was a walkway. On this walkway, others carried objects, puppets, and shapes, casting shadows on the wall in front of the prisoners. When one of the cavemen escaped and discovered the real world, his attempts to enlighten the others were met with disbelief and resistance.

India’s Post-Pandemic Boom (2020–2024): Of the 20 crores demat accounts live today in India, 15 crores (75%) were opened in the last four years. Many of these investors have only seen a rising market, believing 20% annual returns are the norm. Veteran investors, who have experienced multiple cycles, warn against such high expectations. But much like the cave prisoners dismissing the freed man, such advice falls on deaf ears.

Common themes and thinking about current Era

While it is nearly impossible to predict start or end of an era, one commonality is that like night following day, bullish eras have been followed by bearish ones and vice versa. The duration of either of them is unpredictable. However, aspects like peace, free markets, capitalism, technological progress elongate a bullish era. India has a great future if we look at these factors barring the high valuations. While this in itself does imply an era of falling or stagnant prices, past does warn us not to take good times for granted.

 

***

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

Sumit Sarda

Partner and Portfolio Manager

————————————————————————————————————————————————-

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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Investment Process, Quarterly Update

Letter to Investors – Dec’24 – Extracts

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EXECUTIVE SUMMARY

    • For the Dec’24 quarter, the BSE500 index reported a change of -7.8% including dividends. We reported -0.6%. 
    • Trailing twelve months’ earnings of underlying portfolio companies grew by 25%.
    • In an elevated market like current one, falling less might be more important than rising more.
    • Looking at our batting average and equity IRRs.
    • We introduced a new toehold position.
    • Stance: Cautious

Dear Fellow Investors,

Falling less > Rising more

 

Investment success is often celebrated through spectacular gains, but history and track record of great investors suggest that falling less is equally important. Focus on capital preservation and avoiding large drawdowns has higher probability of doing well than chasing high returns. This is all the more important in an elevated market like current one.

 

Mathematics of falling Less

20% annual returns for 6 years followed by -15% annual returns in next two years reduces the 8-year CAGR (compounded annual growth rate) to ~10%. Conversely, 12.5% annual returns for 6 years followed by 7.5% p.a. return in next two years leads to a CAGR of ~11%. The table below illustrates this:

Scenario CAGR

(Years 1-6)

 CAGR

(Years 7-8)

 8-Year CAGR
Portfolio 1: Steady growth, no drop 12.5% 7.5% 11.2%
Portfolio 2: High growth, then drop 19.9% -15.6% 9.8%

 

These are not imaginary portfolios. The first portfolio above is Nifty 50 index and the second portfolio is BSE Smallcap index. And the 8 years in question are CY2011-2019 (a full cycle). This is neither a praise of the former nor a critique of the latter and may not hold true in all periods and portfolios. But it is a good reference period for the largecap-smallcap divergence we are seeing today. This illustration underscores that buying price matters and valuations & returns tend to mean revert. 

Rising more + falling less?

It is tempting to imagine holding “Portfolio 2” during high growth years and switching to “Portfolio 1” before the downturn. While this strategy sounds appealing in hindsight, it’s difficult to execute in practice. A “rising more” approach is pro-cyclical, encouraging higher risk-taking in an already risky market. It works like magic when things are going well amassing praise, confidence and money. FOMO (fear of missing out) makes it difficult to let it go. Also, professional managers following “rising more” style set wrong expectations for incoming investors/ money and find it difficult to justify moving to an opposite strategy. Some, either due to luck or skill, may be able to straddle both styles. But for most, its either one or the other. 

Buy high, sell low

A “rising more” strategy can lead to challenges when fund inflows and outflows are unrestricted. Stellar bull-market performance attracts inflows at peak valuations, raising the probability of subpar future returns. Conversely, during market corrections, such strategies often face deeper drawdowns, prompting panicked investor exits at a loss. The 2011-2019 performance of smallcap indices exemplifies this phenomenon. Morningstar’s “Mind the Gap” study consistently finds that investor returns lag fund returns by 1-2% annually due to poor timing decisions, with the gap widening for more volatile strategies. Lower volatility in a “falling less” strategy reduces these risks, ensuring newer investors are not disadvantaged and minimizing the likelihood of buying high and selling low.

Balancing risk and return

A simple way to minimize losses could involve staying 100% in cash, earning a risk-free rate (currently 6-7% p.a.). However, risk avoidance leads to return avoidance too. Plus, timing market tops and bottoms credibly is nearly impossible. Hedging using options is another way. It is hoped that options turn in the money when markets fall. However, hedges come at a cost, may not be fully efficient and need continuous monitoring and adjustments. They can take focus away from studying and tracking companies. We are yet to find a simple, cheap and effective way to hedge using options. The better path, for us, lies in selectively taking risks where rewards are commensurate and avoiding those where they are not.

Trying to fall less

We continue to stick to the following combination to improve chances of falling less in a heated market:

  1. Quality focus: Investing in companies with strong balance sheets, large opportunity size, competitive advantages and being run by able and fair managements tends to cushion portfolios in volatile markets. While they too fall when aggregate markets fall, they normally get stronger and recover faster.
  1. Valuation discipline: Quality stocks bought at expensive valuations may not protect the downside. Ensuring reasonable purchase prices is key. Result of quality focus and valuation discipline is waiting for right opportunities and parking money in safe and liquid instruments. As a sidenote, current cash balance of Berkshire Hathway (Warren Buffett’s company) has reached 30% of its asset values, highest since 1990s.
  1. Smart diversification: A well-diversified portfolio reduces exposure to any single adverse event. Selecting quality companies at reasonable valuations across less-correlated exposures ensures resilience against unforeseen shocks. 
  1. Careful performance evaluation: A “falling less” strategy often underperforms in euphoric markets. Fair evaluation requires assessing performance over a full market cycle and focusing on metrics like batting averages (frequency of outperformance) and invested IRR (portfolio IRR excluding cash). We will share these metrics in a later section. 

Falling less isn’t about avoiding risk altogether; it’s about managing risk intelligently. By prioritizing capital preservation, one can position to participate in recoveries and harness the full power of compounding. When valuations are elevated, defence is the best offense. 

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) 17.3% 29.2% -4.3% 14.9% 48.5% -9.5% 16.0% 19.7%
S&P BSE 500 TRI (includes dividends) 10.8% 40.2% -0.9% 22.3% 78.6% -23.4% 19.0% -3.0% 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. 

 

Trying to fall Less

The BSE 500 index fell 7.8% including dividends in the December 2024 quarter – highest quarterly fall since June’22. We posted a return of -0.6% in the same period – falling less by 7.2%. Falling less in one quarter may be due to luck, or mean reversion of past few years’ underperformance. Time will tell. To try falling less in an elevated market, we remain steadfast on price-quality discipline. For more colour on our performance, we share two metrices:

Batting Average (64%)- Batting average measures the ratio of successful investments to total investments. Here, we are defining success as generating an IRR (internal rate of return) above 15% – roughly the average long-term return of the BSE 500 index.

  • Batting average by Count: Since our inception in 2019, we have made 26 investments. Out of these, 19 investments delivered IRRs exceeding 15%, resulting in a batting average by count of 73%.
  • Batting average by Value: Above metric doesn’t account for the size of each investment. When we evaluate batting average by value—i.e., the proportion of capital allocated to investments generating over 15% IRR—the batting average is 64%. This means that out of every ₹100 deployed over the last five years, ₹64 has delivered returns exceeding 15%.

Equity IRR (25.5%) – Of that ₹64 delivering IRRs exceeding 15%, there have been few investments that have delivered 25%-100% IRR. So, another way of assessing performance is to look at IRR of equity performance excluding cash. As of today, the actual IRR of our equity portfolio (excluding cash allocations) stands at 25.5%, reflecting strong overall performance. Cautious stance and higher cash balance is the only factor that has led to slightly lower returns when compared to BSE 500 in last few years. To summarise:

SN CED PMS (2019-2024) Details
1 Headline returns 16.0%
2 Batting Average – 15% IRR threshold (count) 73%
3 Batting Average – 15% IRR threshold (value) 64%
4 Equity IRR 25.5%

 

 

A2. Underlying business performance

 

Past Twelve Months Earnings per unit (EPU)2 FY 2025 EPU (expected)
Sep 2024 8.91 8.5-9.53
Jun 2024 (Previous Quarter) 8.8 8.5-9.53
Sep 2023 (Previous Year) 7.1
Annual Change 25.4%
CAGR since inception (Jun 2019) 14.1%
1 Last four quarters ending Sep 2024. 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. 

 

Trailing Earnings: Earnings Per Unit for last twelve months ending Sep’2024 came in at Rs 8.9 per unit, a growth of 25.4% over last year.

 

1-Yr Forward Earnings: We maintain FY25 forward earnings per unit guidance at Rs 8.5-9.5.

 

A3. Underlying portfolio parameters

 

Dec 2024 Trailing P/E Forward P/E Portfolio RoIC Portfolio Turnover1
CED LTFV (PMS) 25.2x 23.6x-26.3x 38.0%3 4.5%
BSE 500 26.1x2 – 15.2%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 one new toe hold position (1% weight). The company is a global leader in an emerging disruptive product and has returns on invested capital of over 80%. Valuations at over 50x trailing earnings stopped us from raising our position. We will share further details in future should we scale up this position.

Sold: We did not sell anything in the reporting period.

 

B4. FLOWS AND SENTIMENTS

हर शख़्स दौड़ता है यहाँ भीड़ की तरफ़

फिर ये भी चाहता है उसे रास्ता मिले

(everyone is running towards crowds and still wishes to get a clear path)

-Wasim Barelvi

 Retail investors’ activities have increased by factor of 3x-11x over last 5 years and have been the key determinant of ~25% and ~32% CAGR returns of midcap and smallcap indices respectively in that period. The below table captures the growth in retail participation metrices:

SN Particulars 2019 2024 Change
1 Equity oriented active mutual funds – assets under management (lac cr.) 10.6 37.7 3.6x
2 Demat accounts (cr.) 3.9 18.2 4.7x
3 Unique investors (PAN) (cr.) 3.0 10.2 3.4x
4 Gross monthly SIP in equity mutual funds (Rs cr./month) 8,500 25,300 3.0x
6 Individual Future & Options participants (lacs) 8.5 95.8 11.3x
Source: SEBI

To be fair, before 2019, Indian retail investors were under invested in capital markets. Their higher equity participation is welcome. However, looking at various parameters, it seems things are going to the other extreme. FOMO and not valuations is the main driver of investor enthusiasm today. And in a classic example of circular loop, the resulting momentum of flows is raising the stock prices and rewarding their risky behaviour.

One outcome of higher retail participation is the outperformance of smallcaps over largecaps. While largecap indices have risen 2x, smallcaps have surged 4x in last 5 years. In CY2024, largecap indices gained 9%, but smallcaps outperformed with a remarkable 29% increase. Post September-October, when most broader indices fell nearly 12%, smallcaps’ recovery has been notably faster. Smallcap indices are now only 5% below their recent peaks, compared to largecaps being lower 10%. This trend is unusual. Historically, largecaps have rebounded faster than smallcaps after a correction. The divergence can be partially attributed to foreign investors, who have been net sellers primarily targeting largecaps, while retail investors (directly or through mutual funds) have channelled their buying efforts into small and midcaps.

Smart money is exiting. Promoters, and private equity investors have sold stakes worth Rs. 3 lac crores in CY2024, highest ever through IPO/ QIP/ stake sales. In a first, India has outpaced China in value and the US in volume of IPOs launched in CY2024. In addition, foreign investors have sold 14bn$ in Oct and Nov 2024, highest ever in two months.

In a welcome move, regulators have started introducing curbs on excessive speculations. SEBI has issued restraining circulars on three high risk pockets – zero-day options, SME IPOs and distribution commissions on NFOs (new fund offers). RBI has also put restrictions on unsecured lending a part of which might have been going into equity markets.

 

C. OTHER THOUGHTS

HANDLING INVESTMENT ADVICE IN A BULL MARKET

A bull market often acts as a “business season” for the investment and financial world. Brokers experience a surge in trading activity, investment bankers work on more IPO and QIP deals, and mutual funds see higher inflows. At the same time, mischievous promoters, influencers, and tipsters (often fraudsters) find opportunities to exploit unsuspecting investors.

With the rise of app-based trading, acting on recommendations has become effortless—one moment you’re reading a stock tip, the next you’re executing a trade. But this convenience can also lead to costly mistakes.

Ultimately, the investor’s best defense against subpar or risky products is vigilance and self-awareness. Here’s a checklist to help navigate any investment solicitation: 

Questions to Ask Yourself

  1. Do I understand the company or product?
    If the investment doesn’t make sense even after thorough research, it’s best to avoid it.
  2. Are the past returns unrealistically high?
    Extraordinary returns often revert to the mean. Be cautious if it seems too good to be true.
  3. Am I following the crowd?
    Are you drawn to this investment because friends, family, or social media are hyping it up? Social proof can be misleading. Return to Question 1.

Questions to Ask the Seller

  1. Are you an Insider?

If the proposer is sharing a material non-public information obtained from insider access, strongly avoid and prevent falling foul with insider trading violations.

  1. Are you SEBI-registered?
    If the seller isn’t registered with SEBI, it’s a clear red flag. Avoid.
  2. What are your incentives?
    Find out how the seller benefits:

    • Are they earning commissions or fees based on your investment or training course purchases?
    • Or are they incentivized by your actual investment gains?
      Be sceptical if it’s the former, even if they are your friends or family (especially if they are).
  3. Are you personally invested in what you’re selling?
    Request for documentary proof of their own investments in the product they are selling. If the seller hasn’t put his/her own money into the product, it’s a sign they may not believe in its potential.

By asking these critical questions, maintaining a healthy scepticism and using calm judgement, you can avoid being taken for a ride and protect your hard-earned money.

***

We welcome two CA industrial trainees –Dhruva Koolwal and Aayush Choudhary to our team. Dhruva is a school topper, holds rank in CA Foundation and is district topper in CA Intermediate exam. He is ex-Grant Thornton. Aayush cleared CA Foundation and Intermediate exams in first attempt mostly through self-study. He is ex-Protivity.

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 2025!

Kind regards,

Team Compound Everyday Capital

Sumit Sarda, Surbhi Kabra Sarda, Punit Patni, Arpit Parmar, Dhruva Koolwal, Aayush Choudhary

————————————————————————————————————————————————-

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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Quarterly Update

Letter to Investors – Sep’24 – Extracts

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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 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 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.

***

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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Macroeconomics, Market Cycles

Manias and Panics – Lessons from last 400 years

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“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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Investment Process

Investing during elections

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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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Investment Mistake, Investment Process, Market Cycles

From Beginner’s Luck to Winner’s Curse?

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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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Quarterly Update

When to sell

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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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Value Investing

Tribute to Charlie Munger

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“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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Investment Psychology, Performance Evaluation

Immediate Vs Delayed Outcomes

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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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Investment Process

Embracing Truth, Light and Immortality in Investing

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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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