Investment Process, Investment Psychology, Quarterly Update

Letter to Investors – Dec 2020 – Extracts

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EXECUTIVE SUMMARY

  • TTM earnings of portfolio companies fell by 12.1%. That of Nifty 50 and Nifty 500 fell by 10.7% & 15.0% respectively.
  • NAV grew by 44.3% YTD with 74% funds invested. NSE Nifty 50 and Nifty 500 grew by 63.8% and 65.8% respectively.
  • Abundant liquidity and vaccine developments have lifted prices of all assets including equities.
  • We are starting to see deals getting done at valuations that donot make sense.
  • Stance: Cautious

Dear Fellow Investors

Needless Prudence?

 

Financial markets continued their unbridled rise in this quarter as well. In India, NSE Nifty 50 stands 12.5% over its pre-Covid high. In less than 10 months, Nifty has seen 40% unidirectional fall from top – fastest ever, and then 86% almost unidirectional rise from the bottom.

Today, of ~1600 actively traded companies on the NSE, 1155 companies are trading over their pre-Covid highs, 802 companies are trading at 20% over their pre-Covid highs and  467 companies are trading 50% above their pre-Covid highs.

Frankly, we are surprised by this ferocious one way rally.  Like insurance premiums that seem unnecessary costs when insured events (accidents) do not happen, our cautious stance has been found unnecessary, so far.

India was already slowing down even before Covid-19 hit. The coronavirus has surely affected incomes of many people which should further add to the slowdown. And yet broader Indian indices are up 12%-14% from their pre-Covid highs.

Liquidity, and not fundamentals, justify large part of this rally. As per one estimate, 20% of entire US money supply has been created in 2020. Completion of US elections, and beginning of Covid-19 vaccination drives has further improved the sentiments. Global inflation and interest rates remain near zero and central banks worldwide continue to print money. Rising tide of abundant money, thus, continues to lift all boats including equities.

Many pundits have been wrong about reversal of global liquidity and inflation in last decade and we have no special insight to add on this difficult matter. Liquidity may or may not reverse and inflation may or may not arise in next decade. We don’t know. Nonetheless amidst this dilemma, we continue to stick to enduring investment basics – trying to own durable businesses which look reasonably priced even for higher interest rates (interest rates have inverse relationship with equity value.). They will benefit if interest rates remain low and liquidity conditions benign. But should inflation resurface and easy liquidity reverse, these will not turn out to be expensive buys. While this limits our universe, it protects us from overpaying. Cautious stance stays.

 

A. PERFORMANCE

 

A1. Statutory PMS Performance Disclosure

Portfolio FY 2021 YTD Dec’20 FY 2020* Since Inception* Outper-formance Avg YTD Cash Eq. Bal.
CED Long Term Focused Value (PMS) 44.3% -9.5% 30.5% 26.2%
NSE Nifty 500 TRI (includes dividends) 65.8% -23.6% 26.7% 3.8% NIL
NSE Nifty 50 TRI (includes dividends) 63.8% -23.5% 25.3% 5.2% NIL
*From Jul 24, 2019; Note: As required by SEBI, the returns are calculated on time weighted average (NAV) basis. The returns are NET OF ALL EXPENSES AND FEES. The returns pertain to ENTIRE portfolio of our one and only strategy. Individual investor returns may vary from above owing to different investment dates. Annual returns are audited but not verified by SEBI.

For the nine months ended December 2020 our NAV was up 44.3%. NSE Nifty 500 and Nifty 50 were up 65.8% and 63.8% respectively. During last nine months, we were invested in equities, on monthly average basis, to the extent of 73.8%.

Our higher than usual weight of cash equivalents, especially in portfolios of clients onboarded on or after September 2020, is the result of lack of margin of safety in the prices of securities that we track. Our incentive structure remunerates us for results – not size, not activity. And this makes us extremely focussed on protection of capital.

In a breakneck rising market like current one, this can hurt temporary returns. However it allows us to control risk in an uncertain world. While regulations require us to benchmark and report our relative performance quarterly, our attention remains on absolute returns.

 

A2. Underlying business performance

 

Period Past twelve months FY 2021 EPU (expected)
Earnings per unit (EPU)2 Earnings per unit (EPU)
Dec 2020 5.11 4.0-5.03
Sep 2020 (Previous Quarter) 5.2 4.0-5.0
Dec 2019 (Previous Year) 5.8
Annual Change -12.1%
CAGR since inception (Jun 2019) 0.1%
1 Last four quarters ending Sep 2020. Results of Dec quarter are declared by Feb only. 2 EPU = Total normalised earnings accruing to the aggregate portfolio divided by units outstanding. 3 Please note: the forward earnings per unit (EPU) are conservative estimates of our expectation of future earnings of underlying companies. In past we have been wrong – often by wide margin – in our estimates and there is a risk that we are wrong about the forward EPU reported to you above.


Trailing Earnings: Trailing twelve months’ Earnings per Unit (EPU) came in at Rs 5.1, lower 12.1% over last year and flat versus last quarter (including effects of cash equivalents that earn ~5%).  In comparison, the adjusted earnings of Nifty 50 and Nifty 500 companies fell by 10.7% and 15.0% respectively in the same period (source: Capitaline).

1-Yr Forward Earnings: We continue to expect FY21 earnings per unit of our aggregate portfolio to close between Rs4.0-Rs5.0 per unit.

 

A3. Underlying portfolio parameters

 

Dec 2020 Trailing P/E Forward P/E Portfolio RoE TTM4 Earnings Growth Portfolio Turnover1
CED LTFV (PMS) 25.6x 26.1x-32.6x 18.1% -12.1% 5.9%
NSE 50 38.5x2 – 11.2%3 -10.7%3 –
NSE 500 43.4x2 – 14.7%3 -15.0%3 –
1 ‘sale of equity shares’ divided by ‘average portfolio value’ during the year to date period. 2 Source: NSE. 3Source: Capitaline. 4Trailing Twelve Months

 

B. DETAILS ON PERFORMANCE

 

B1. MISTAKES AND LEARNINGS

A cautious approach in a rising market can look like a mistake if judged over a short time frame. Conversely – and history is a testament- rising markets can be the breeding grounds for future mistakes. When our and investors’ hard earned money is involved, it’s okay to err on the side of caution in the above dilemma. Underperforming in a rising market temporarily and looking stupid is the small price of long term safety. Jury is still out whether our current cautious stance turns out prudent or foolish.

From our two past mistakes- “Cera Sanitaryware” and “2015-16” – we learnt that unless fundamentals are extremely compelling, it is better to be gradual in selling and buying respectively. From our past mistake on “Treehouse Education” we have learnt that bad management deserves a low price, it’s seldom a bargain. In Dish TV we underestimated the competitive disruption but thankfully sold at breakeven. Tata Motors DVR taught us that cyclical investing requires a different mindset to moat investing and one needs to be quick to act when external environment turns adverse. In Talwalkars, we learnt that assessing promoter quality is a difficult job and we should err on the side of caution irrespective of how cheap quantitative valuations look. From DB Corp we learned that industries in structural decline will fail to get high multiples even if the industry is consolidated, competition limited and free cash flows healthy. 

 

B4. FLOWS AND SENTIMENTS

US election results and vaccine announcements have augmented flows and sentiments towards risky assets including equities. Some signs of crazy behaviour have started surfacing. Deals are getting done at valuations that don’t make sense. While we are not concluding that everything is going nuts, such incidences point to building up of optimism that ultimately fuels bubbles.

Global primary markets have heated up significantly. As per Refinitive, over 770bn$ worth of equity funds were raised by non-financial firms in 2020 worldover, the highest ever. Renaissance Global IPO index was up 81% in CY2020 vs MSCI’s all-country equity index that was up 14%.

Listing pops– the first day rise of newly listed companies – have become a daily news. DoorDash which had private market value of 2.5bn$ few years ago, jumped 85% on listing day to 60bn$ market capitalisation after raising its IPO price twice. AirBnb closed the listing day 110% up to market cap over 100bn$ (despite travel restrictions in Covid). In Asia, JD Health rose 50% on its listing date in Hong Kong. Recently listed Nongfu Spring, China’s mineral water company, made its founder the richest man in Asia. Chinese toymaker Pop Mart International registered 112% listing gain. In otherwise sombre and conservative Japan, Balmuda – a premium toaster maker – rose 88% on listing day.

Electric car maker Tesla is up 10x since Nov 2019 and is now a part of S&P 500. It now has a greater market cap than the sum of all the other U.S. European, and Korean automakers put together who sold approximately 100 times as many cars as Tesla did in 2019. 

Private companies are not lagging behind in optimism either. In June 2015, there were a little over a hundred private companies worldwide with a valuation greater than US$1 billion. Today, over 500 companies are a part of this club of unicorns.

Back in India too, we can see initial signs of exuberance. Fear of US dollar depreciation owing to unprecedented dollar printing and an increase in weight of India in MSCI index from 8.1% to 8.7% led to record foreign inflows in Indian equities. In the December quarter, foreign portfolio investors (FPIs) have bought stocks over 18bn$ (over Rs.1.3 lac cr.), highest ever in a quarter.

Indian primary markets are heating up as well. Burger King and Mrs. Bector Foods IPOs were subscribed over 150x and jumped 100% each on listing day. The 15 IPOs of CY 2020 were oversubscribed, on an average, to the extent of 75x with average listing pop of over 35%, highest in last decade. Only 13% of the proceeds went to the companies, rest was offer for sale by existing investors including smart private equity investors. Thirty two (32) new fund offers (NFOs) were launched by mutual funds between August and December, one of the highest ever. In December alone, mutual funds are estimated to have raised INR 8000cr through NFOs.

Retail participation in Indian markets is rising. 8 million new demat accounts were opened in 8 months (April-Nov) this year, twice the number of accounts that were opened up in full FY20. Retail holding in listed companies has touched an 11-year high at 7%, as more and more people have opened up to investing directly in markets while working from home.

Many questionable companies of past decade are finding favour again. Many jumped over 100% in November. A renewable energy company is up 6x in 2020. It has entered MSCI India Index. Vanguard bought 13.1mn shares in September. It’s market capitalisation has crossed 165 trn Rs (pushing it in among top 21 companies in India by market cap) and is now trading at 77x book.

These discrete data points donot conclude a bubble, but as Buffett says “be fearful when others are greedy”.

 

C. OTHER THOUGHTS

 

Envy, FOMO and Greed

It’s agonisingly difficult to stay on sidelines as stock prices rally. Every day’s rise, calculable from daily prices, reminds of returns forgone. And, if friends, family and neighbours are gloating about it on social media, the chance of staying cautious amidst rising prices is close to nil.

Envy and fear of missing out (FOMO) are evolutionary emotions that supported survival of human beings. It propelled our hunter forefathers into action and ensured that they were not staying behind in the survival queue.  So is greed. There were survival benefits in over eating or storing excess food or accumulating things beyond immediate need. We inherited these emotions as their legacy.

Envy and FOMO pushes those staying on sidelines to participate in a rising market, often at the top. And greed pushes those who are making money to continue chasing rising prices often on leverage (trade on borrowed money/ margin). This fuels feel good emotions and a feedback loop. Sadly, financial history shows that what cannot go on forever, will stop someday. While good for survival; envy, FOMO and greed are hazardous during investing.

You will be attracted to narratives about how things are different these times and time to make money is now. The origins of these narratives are often from those who get their payday selling part or full of assets/ companies. When someone comes to you with a deal, check how is he/she getting remunerated.

Most of the times, most of the prices donot go in one direction. What’s wise at one price, is foolish at another. Plan of buying assets in hope of passing it on to a greater fool can backfire and one can end up holding the can.

The only antidote against succumbing to envy, FOMO and greed in investing is a sense of intrinsic value and discipline to wait if prices donot leave a sufficient margin of safety against bad luck or error. Both of these – sense of intrinsic value and discipline – come from an understanding of underlying assets/ businesses. Avoid poor businesses &/or poor managements &/or poor prices. And one can avoid many mistakes.

***

In a world gush with liquidity and incentives driving short term behaviour, it’s a blessing to have company of partners who truly think long term. Thanks to you, we can act rationally and choose to opt out of ‘craziness race’ once in a while.

2020 has been a forgettable year. Wish you a normal 2021!  

Kind regards,

Team Compound Everyday Capital

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

 

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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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Investment Process, Macroeconomics, Quarterly Update

Letter to Investors – Sep2020 – Extracts

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EXECUTIVE SUMMARY

  • TTM earnings of portfolio companies were up 2%. That of Nifty 50 and Nifty 500 fell by 14.6% and 19.5% respectively.
  • Our NAV grew by 31.8% YTD with 75.7% funds invested. NSE Nifty 50 and Nifty 500 grew by 31.5% and 34.2% respectively.
  • Markets continue to believe that despite current economic pain, things will get back to normal soon. We don’t know.
  • Temporary hardships make good companies available at reasonable prices. Caveat is an understanding of the business.
  • Stance: Cautious

 

Dear Fellow Investors,

What’s already in the price?

 

At first glance it seems surprising that the NSE Nifty 50 index is up 48% since March lows when economic data on incomes, jobs, consumption, and production is showing clear signs of Covid-19 inflected pain. However, if we recall that stock markets are future-discounting machines and stock prices are meant to reflect the future and not the present, this seeming Dalal street-Main street disconnect looks less puzzling.

Solutions to Covid-19 will be found and economic activity will recover swiftly thereafter. At most one year’s earnings will be washed out – not material to the intrinsic values of most of businesses. In hindsight, current prices will not look inefficient or irrational if this scenario plays out without any hiccups.

But what if it doesn’t?

Uncertainties still remain elevated. While there is month on month improvement in economic activity since April lows, Covid-19 has still not peaked out. It remains a bottleneck to supply-chains, incomes, consumption, and debt repayments. Globalisation – the fountainhead of global prosperity- is under threat due to unequal distribution of its proceeds. Unbridled money printing – probably the only economic balm to Covid distress- keeps the risk of all-illusive inflation alive even if it may be years or decades away. And the world continues to remain susceptible to geopolitical shocks. These and more continue to remain adverse, uncertain and non-zero portability events.

It seems that prices today are building in only the former optimistic version of the future and assigning zero probability to latter. Margin of safety stands reduced today and this requires us to change our stance from neutral to cautious.

Of course, different companies are affected by Covid-19 differently. Most of those favourably placed but seen sharp price rise as well as most of those structurally disrupted and seen price fall, both leave little margin of safety. Those affected temporarily but where prices are discounting permanent damage, present opportunity if one understands the underlying business. We are focussing our energies here without compromising on business and management quality.

 

A. PERFORMANCE

A1. Statutory PMS Performance Disclosure

 

 

Portfolio 2021

YTD Jun’20

 2020* Since

Inception*

 Outper-

fromance

 Avg. YTD

Cash Bal.
CED Long Term Focused Value (PMS) 31.8% -9.5% 19.2% 24.3%
NSE Nifty 500 TRI(including dividends) 34.2% -23.6% 2.5% 16.7% NIL
NSE Nifty 50 TRI (including dividends) 31.5% -23.5% 0.6% 18.6% NIL
*From Jul 24, 2019; Note: As required by SEBI, the returns are calculated on time weighted average (NAV) basis. The returns are NET OF ALL EXPENSES AND FEES. The returns pertain to ENTIRE portfolio of our one and only strategy. Individual investor returns may vary from above owing to different investment dates. Annual returns are audited but not verified by SEBI.

 

For the half year ended Sep 2020 our aggregate NAV was up 31.8%. NSE Nifty 500 and Nifty 50 were up 34.2% and 31.5% respectively in the same period. We were invested in equities, on monthly average basis, to the extent of 75.7%. In line with your mandate, we will act when things make sense to us, until then we will be happy to wait. Individual client’s NAV and cash balance may differ from the above depending on their date of investment.

 

A2. Underlying business performance 

 

Period Past twelve months FY 2021 EPU (expected)
Earnings per unit (EPU)2 Earnings per unit (EPU)
Sep 2020 5.11 4.0-5.03
Jun 2020 5.3 4.0-5.0
Sep 2019 5.0
Annual Change 2.0%  
1 Last four quarters ending Jun 2020. Results of Sep quarter will be declared by Nov only.

2 Total earnings accruing to the aggregate portfolio divided by units outstanding. Earnings exclude extraordinary items.

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 (EPU) for trailing twelve months Sep 2020 EPU came in at Rs 5.1, higher by 2.0% over last year (including effects of cash equivalents that earn ~5% pre-tax).  In comparison, the adjusted earnings of Nifty 50 and Nifty 500 companies fell by 14.6% and 19.5% (35.2% if we include Yes Bank, Vodafone Idea and Reliance Communication) respectively in the same period (source: Capitaline).

 

1-Yr Forward Earnings: Predicting FY21 earnings continues to remain difficult. Going by the in-line June quarter results of our companies, we maintain our broad estimate for FY21 earnings at Rs. 4.0-5.0 per unit. Please treat this estimate with caution. Depending on how the pandemic unfolds, it can be off reality by wide margin. Nonetheless, FY22 looks normal year as of now.

 

A3. Underlying portfolio parameters (PMS)

Sep 2020 Trailing P/E 1Yr Forward P/E Portfolio RoE Portfolio Turnover1
CED LTFV 23.4x 23.8x-29.8x 16.1% 2.1%
NSE 50 32.7x2 – 11.0%3 –
NSE 500 40.6x2 – 8.3%3 –
1 ‘Sale of equity shares’ divided by ‘average portfolio value’ during the period. There was no sale of equity shares in this quarter hence the portfolio turnover is NIL.

2 Source: NSE , 3 Source: Capitaline

 

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

Assessing management quality is an important but difficult part of investment process. It cannot be reduced to numbers and remains a qualitative endeavour. Getting better at it is a continuous process and rewarding too – it aids long term returns by avoiding landmines.

One important input to assessment of management quality is capital allocation decisions. Equity value increases when management is able to invest its free cash in projects that can earn returns above the overall cost of capital. Many times, assessing this ex-ante is fogged by sweet talking optimist management whose incentives are mostly linked to growing the size of the company and not shareholder returns.

Normally, investing in (1) same line of business, (2) organically and (3) using internal accruals has shown to be more return accretive. Conversely, (1) diversification or (2) growth through expensive acquisitions, (3) that are debt funded has proven sub optimal. Of course, there can be exceptions but broadly this has held true over time and geographies. And then there are outright burglaries done using related party transactions and/or accounting jugglery.

When there are no value accretive investment projects, next best capital allocation decision is to distribute the cash back to shareholders through dividends or buybacks. Normally when share prices are low, and company has excess cash, buybacks have proven to be a better option than dividends.

We have exited from a minor position last quarter where we sensed that above cardinal rules of efficient capital allocation were violated. You will read more about it further. We hope that this sensitivity to capital allocation has helped us avoid a potential mistake.

—

Like always, in this section we continue to remind ourselves about past mistakes. It deflates our over confidence, warns us to remain humble and refreshes the important lessons.

From our two past mistakes- “Cera Sanitaryware” and “2015-16” – we learnt that unless fundamentals are extremely compelling, it is better to be gradual in selling and buying respectively. From our past mistake on “Treehouse Education” we have learnt that bad management deserves a low price, it’s seldom a bargain. In Dish TV we underestimated the competitive disruption but thankfully sold at breakeven. Tata Motors DVR taught us that cyclical investing requires a different mindset to moat investing and one needs to be quick to act when external environment turns adverse. In Talwalkars, we learnt that assessing promoter quality is a difficult job and we should err on the side of caution irrespective of how cheap quantitative valuations look. From DB Corp we learned that industries in structural decline will fail to get high multiples even if the industry is consolidated, competition limited and free cash flows healthy. 

B2. MAJOR PORTFOLIO CHANGES

We have completely exited from Bajaj Consumer at a loss of 0.7% of NAV. There were no other material additions or deletions to our holdings.

As we wrote in last few letters, Bajaj Consumer (the maker of Bajaj Almond Drops hair oil) was a minor position which we looked as optionality. While stock rose 50% from its Covid lows and earnings fell only 4% in Covid affected Jun quarter due to cut in marketing spends, company’s recent capital allocation decisions disappointed us and we thought it prudent to move out:

Dividend policy: The company cut down its dividend from Rs. 14 per share in last year to just Rs. 2 per share despite having surplus cash of Rs. 450 cr (Rs. 30.5 per share) as of March 31, 2020. That this happened soon after promoters reduced their pledged shares to nil, makes us more worried. In retrospect, the erstwhile high dividend payout looks like a means for personal debt service of promoters and not a shareholder value creation policy. 

Buyback: The company had a great opportunity to do a buyback given its stock was trading at less than 10x trailing earnings. Even now at 14.7x it’s not a bad proposition. Moreover this could also have led to rise in promoter’s stake (now reduced to 38% after they sold 22% stake to reduce promoter pledge) without any cash outflow from their pocket if they chose not to participate. They repeatedly opposed doing a buyback, despite stated intent of increasing promoter stake in the company.

Keenness to M&A: Instead of maintaining the dividend payout or buying back bits of their own undervalued company, management is keen to grow via acquisitions including international ones. These almost never come cheap and almost never add value.

Active capital misallocation: Management is spending over INR 70 cr in constructing a corporate office for entire Shishir Bajaj group (including Bajaj Hindustan and Bajaj Energy). Rental yields, even if struck at arm’s length, will be around 7-8% pre-tax – not the best use of surplus cash.

While the company owns a popular hair oil brand (~10% market share), has been generating good RoEs (33% +) and looks cheap (14.7x trailing earnings), the above acts (post our purchase) reduce the probability of rerating of the company. In past we have seen that when managements undermine minority shareholders’ interests, business quality and valuations become less important. The right thing during such times as minority shareholders is to take the money and run!

Of course, if management learns from feedbacks and pivots from the current stance, things may improve however we want evidence before committing money. Till then it goes back to our watchlist.

 

B3. UNDERLYING FUNDAMENTAL PERFORMANCE

Temporary Hardships

Good businesses seldom trade at bargain prices.  However some times, very rarely, they are struck by adversity that hurts earnings. In our experience the immediate price reaction to any sudden negative development for good business is mostly negative. If on a calm analysis we can conclude that the hardships are temporary and less impactful than the price has discounted, such bloopers can be a good opportunity to pick good businesses at good prices.

The obvious mistake that can be made is to misjudge permanent hardship as temporary, and structural headwinds as cyclical shifts. The only antidote against making this mistake is a sound understanding of the business and its industry.

So long as demand continues to remain robust, business debt free or has access to capital, raw material or end product prices are cyclical, and remedial measures remain in control of management, the hardships are temporary. However if there is challenge to long term sustainability of demand, or new technology brings in better and/or cheaper solutions hardships are permanent. Curiously temporary hardships have higher visibility, permanent hardships are less noisy. Management and media miss the latter or hope it to be temporary. Nonetheless, ability to distinguish between the two can be profitable. Covid-19 is a temporary hardship for many companies. Wherever prices are misjudging it to be permanent can prove to be good opportunities.

 

B4. FLOWS AND SENTIMENTS

 

Global markets continue to remain linked to the behaviour of US markets. Thanks to fiscal and monetary stimulus, liquidity remains abundant. US Dollar’s weakness against major currency basket had also increased the flows towards emerging markets including India. FIIs invested 6.3bn$ in the month of August (a decade high) in India and a total of ~11bn$ from April-Sep 2020.

 

US Fed revised its policy framework and announced that it is will target “average” inflation and will tolerate higher inflation for periods following period of low inflation. Further, it will not pre-emptively raise rates on reaching high employment unless the inflation rises. This, in effect, implies that US Fed is likely to maintain low rates for longer and will not be raising rates proactively to curb inflation.

 

Back in India, eight IPOs were launched in the month of September and seven more are slated in 2020 raising a total sum over 2.5bn$. Many of these have seen subscription to the extent of 74x-150x and opened 70%-123% higher than IPO price on listing days. Similar frenzy has been seen around the world. Either the bankers, private equity selling shareholders, and promoters to the issue (whose are insiders and incentivised to maximise the issue price) are missing something or, the investors are. No prizes for guessing who it will turn out to be.

 

After rising for over 24 months, net mutual fund equity inflows fell for two months in a row (July and Aug) by Rs.2,480cr. and Rs. 4,000cr respectively . SIP flows fell marginally from Rs. 8,500cr run rate pre-Covid to Rs. 7,792cr. in August. 

The US is entering presidential election season and history suggests that months before the election remain volatile. This is not a bad thing given our spare cash.

C. OTHER THOUGHTS

CAPITAL AND ITS COST

For valuation purposes we are concerned with average interest rates expected over the future. Near zero interest rates and abundant liquidity in most advanced nations has lowered cost of capital and supported equity valuations over the last decade. Is it reasonable to expect interest rates to perpetually remain close to zero?

It’s an important but tough question to answer. Trajectory of future interest rates will influence future returns from equities.

Policy interest rates in Japan have been zero since over two decades without igniting inflation. Higher doses of liquidity and fiscal and monetary stimulus were the only options available to the world during the 2008 Subprime crisis and the current coronavirus crisis. The costs of not infusing relief would have been fatal. Today, there are political incentives to keep kicking the liquidity can down the road to avoid/ delay recessions. Is the world, then, moving on a dismountable liquidity-tiger in the Japanese direction?

Japan may be an exception to the world today. With highest share of senior citizens, Japan faces demographic headwind – stagnant productivity, higher savings and lesser consumption. Its GDP growth rate is low and that’s why Nikkei 225, the Japanese stock index, is roughly at the same lever today as it was in 1991 despite near zero interest rates. Moreover, Japan also has one of the lowest unemployment and inequalities in the world.

Even if we believe that the EU is seeing demographic headwinds similar to Japan, the average age of the world, thanks to India and China, is still low. Youth in developing world seeks employment and improved living standards that accrue from jobs and consumption. Addressing the rising inequality is gaining political currency too. Globalisation is on retreat and producing more at home will raise cost of production. Moreover the fiscal doleouts given to the weaker sections worst hit by the pandemic will maintain demand for goods and services. US Fed has announced its tolerance for 2%+ inflation to get to full employment. Thus unlike Japan, there remains a non-zero chance that inflation can rise and ignite a rise in interest rates around the world. The timing and quantum remains uncertain.

When interest rates are low, present value of profits far into the future are roughly equal to current profits. But when interest rates are high, future profits are less valuable than today’s. What should be the fair P/E multiple for equities therefore depend on where the interest rates will be in future. Honestly we don’t have an answer. However not knowing the answer is itself an answer. It’s not 100% certain that interest rates will remain so low for such a long period. We should keep this mind and not lead the past decade to mislead about the future.

***

LESSONS FROM THE PANDEMIC

Humility and margin of safety: Covid-19 has put a spot light on our ignorance- both known and unknown – things we know/don’t know that we don’t know.  In investing and in business, despite all the research, there will be things that we will not be able to know/ plan for. This calls for humility and need to have a margin of safety. In business, this means (1) having a balance between efficiency & resilience, and (2) being prudent with debt. In investing, this means not overpaying, however rosy the future may look today. 

Timing is difficult – No one can pick bottoms sustainably. Right time to buy is when things are going down even at the risk of near term mark downs. When Nifty50 touched the lows of 7500 in March, the general expectation was that prices will continue to go down further and there was reluctance to invest. It looked like extremely uncertain time to invest. Certainty and low prices donot go together. If we wait for clouds to clear, prices will move up.

Change?: The virus has and will change many things. It’s tempting to accept everything in a flux. But that will be a wrong lesson. There will be many things that the virus will not change. Human propensity to prosper will not change. People will continue to move in the direction that makes their lives easier. This will ensure that businesses that cater to meeting growing needs will remain in force. Consumer behaviour including socialising will also not change materially. The chains of habit formed over decades will be difficult to break by what looks like a 2-3 years virus outbreak. Investor behaviour will also not change materially. Greed, fear, envy, ego and institutional limitations will continue to make prices more volatile than fundamentals.

Health is wealth – In these pages we keep talking about ways to sustainably grow financial wealth. However, as the pandemic has shown, such prosperity is incomplete without good health. It’s important to focus on health equally, or more. Eating responsibly, being physically active, taking adequate sleep and reducing stress should be paid as much attention as wealth building.

***

Last six months have not been kind. Hopefully the worst is behind us. Thanks to your rational behaviour, we have made a good use of this pandemic. We continue to do what’s best for you. That’s how our incentives are designed. Thank you for your trust. Stay safe.

 

 

Kind regards,

Team Compound Everyday Capital

Sumit Sarda, Surbhi Kabra Sarda, Saloni Jindal, Sachin Shrivastava, Sanjana Sukhtankar and Sumit Gokhiya

 

——————————————————————————————————————————————————————————————————

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 – June 2020 – Extracts

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EXECUTIVE SUMMARY

  • TTM earnings of portfolio companies grew by 2%. That of Nifty 50 and Nifty 500 grew by -4% and -24% respectively
  • NAV grew by 18.2% YTD with 78.5% funds invested. NSE Nifty 50 and Nifty 500 grew by 20.0% and 21.3% respectively.
  • Markets swung back nearly as rapidly as they had fallen. Business commentaries suggest uncertainty remains elevated.
  • All of our portfolio companies will survive the covid-19 scare. Many will emerge stronger.
  • Stance: Neutral

 

Dear Fellow Investors,

 

Panic to euphoria in 93 days

Nifty 50 fell 40% from its top in March quarter in 45 trading days due to covid-19 disruptions –the fastest 40% fall in decades. In 48 sessions since then, it rose back 38%. As of June 30, it stands 17% lower from its previous high. Someone sleeping through January-June 2020 would have barely noticed this roller coaster ride.

While India’s lockdown – one of the strictest globally – is gradually opening up, the coronavirus is still out there at large. Active cases and fatalities continue to rise. There is no credible cure found yet. And while high frequency data indicate recovery from April lows, incomes and jobs remain under acute stress. India’s real GDP is expected to contract 2%-7% in FY 2021, first in around 40 years. Yet, markets seem oblivious to the ensuing hardship. Why?

Honestly, we don’t know. It is tempting to weave an explanative narrative after prices have risen (or fallen) – liquidity, US elections, re-opening post lockdown etc. While this gives a false sense of comprehension about random short term price movements, it fails to offer any actionable insight for long term investing. Unfortunately lots of air waves, expert chatter and web space are allocated to this.

Fortunately for us, not knowing what will drive prices in the near term is not a big deterrent. What remains important to us is an assessing current margin of safety and tempering our stance between aggression and defence.

You will recall that at the start of this financial year, our stance was of gradual aggression. Prices were attractive then. We could allocate meaningful portion of our spare cash to undervalued positions. The markets, however, shot back up very swiftly. We have tempered our stance to neutral. We are still not out of covid-19 uncertainty yet and, thanks to you, have enough dry power should fear strike back. We know our batting zone and it has not changed in covid-19 times – (1) to own reasonably priced (2) sustainable businesses (3) within our growing circle of competence. And make fewer mistakes on all the three counts.

 

A. PERFORMANCE

A1. Statutory PMS Performance Disclosure

 

 

Portfolio 2021

YTD Jun’20

 2020* Since

Inception*

 Outper-

fromance

 Avg. YTD

Cash Bal.
CED Long Term Focused Value (PMS) 18.2% -9.5% 6.9% 21.5%
NSE Nifty 500 TRI(including dividends) 21.3% -23.6% -7.3% 14.2% NIL
NSE Nifty 50 TRI (including dividends) 20.0% -23.5% -8.2% 15.1% NIL
*From Jul 24, 2019; Note: As required by SEBI, the returns are calculated on time weighted average (NAV) basis. The returns are NET OF ALL EXPENSES AND FEES. The returns pertain to ENTIRE portfolio of our one and only strategy. Individual investor returns may vary from above owing to different investment dates.

 

For the quarter ended Jun 2020 NAV of our aggregate portfolio was up 18.2%. NSE Nifty 500 and Nifty 50 were up, including dividends, by 21.3% and 20.0% respectively. Individual investor returns may vary from above owing to different investment dates. During the quarter we were invested in equities, on monthly average basis, to the extent of 78.5%.

 

A2. Underlying business performance 

 

Period Past twelve months1 FY 2021 EPU (expected)
Earnings per unit (EPU)2 Earnings per unit (EPU)
Jun 20201 5.3 4.0-5.03
Mar 2020 5.7 Under Evaluation
Annual Change 2.0%  
1 Last four quarters ending Mar 2020. Results of Jun quarter will be declared by Aug only.

2 Total earnings accruing to the aggregate portfolio divided by units outstanding. Earnings exclude extraordinary items.

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 the trailing twelve months June 2020 came in at Rs 5.3 higher by 2.0% over last year (including effects of cash equivalents that earn 5% net of tax).  Those of Nifty 50 and Nifty 500 grew by -4% and -24% (Source: Capitaline, Adjusted earnings)

 

1-Yr Forward Earnings: Owing to coronavirus pandemic, assessing the forward earnings for FY 2021 remains challenging.  We still take a swing at it and estimate a broad range as per current information with high risk of being wrong. As per our current assessment our portfolio earnings for FY21 may fall by 5%-25% to Rs 4.0-5.0 per unit. They are expected to bounce back sharply in FY22.

 

A3. Underlying portfolio parameters (PMS)

Jun 2020 Trailing P/E 1Yr Forward P/E Portfolio RoE Portfolio Turnover1
CED LTFV 20.2x 21.4x-26.7x 18.0% NIL
NSE 50 26.3x3 – 12.3%4 –
NSE 500 29.4x3 – 7.6%4 –
1 ‘Sale of equity shares’ divided by ‘average portfolio value’ during the period. There was no sale of equity shares in this quarter hence the portfolio turnover is NIL.

2  Monthly average , 3 Source: NSE , 4 Source: Capitaline

 

OVERALL INTERPRETATION: Table A1, A2 and A3 shows that despite clocking better earnings growth, and higher return on equity, our portfolio is relatively cheaper than broader benchmarks.

 

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

 

Investing involves future and is susceptible to mistakes even after bona fide efforts. Good news is – history and our past performance is a testament – that even if four out of ten investments go dud, overall investment returns will be okay as the winners will pull the returns up. Over last eight years, we have had our share of mistakes and hopefully have become better investors due to them. They have involved mistakes of assessing management quality, not picking cycles, underestimating technological disruptions and being early. It is near certain that we will make more mistakes, hopefully newer ones. When we do, you will find their cumulative mention in this section every time.

From our two past mistakes- “Cera Sanitaryware” and “2015-16” – we learnt that unless fundamentals are extremely compelling, it is better to be gradual in selling and buying respectively. From our past mistake on “Treehouse Education” we have learnt that bad management deserves a low price, it’s seldom a bargain. In Dish TV we underestimated the competitive disruption but thankfully sold at breakeven. Tata Motors DVR taught us that cyclical investing requires a different mindset to moat investing and one needs to be quick to act when external environment turns adverse. In Talwalkars, we learnt that assessing promoter quality is a difficult job and we should err on the side of caution irrespective of how cheap quantitative valuations look. From DB Corp we learnt that industries in structural decline will fail to get high multiples even if the industry is consolidated, competition limited and free cash flows healthy. 

B2. MAJOR PORTFOLIO CHANGES

There were no new names added or deleted from the portfolio. We added to our existing positions as prices fell below their intrinsic values increasing our margin of safety.

 

B4. FLOWS AND SENTIMENTS

 

Don’t fight the Fed

To save jobs and avoid bankruptcies, central banks and treasuries around the world, led by the US, have announced massive stimulus programs going as high as 10% of GDP. This unabated money printing is finding its way, through the plumbing of global finance, into asset prices everywhere. While the virus pain continues to affect real economy, financial economy is buoyed by liquidity and seen a sharp recovery. In India, FIIs have bought stocks to the tune of $2bn in June quarter after selling over $10bn in Mar quarter. Domestic SIPs in mutual funds also remain above INR 8,000cr per month (till May 2020) making domestic institutions net buyers of stocks.

While economic activity seems to have surged post April lows, sentiments remain linked to the uncertain Covid-19 trajectory. Reduced incomes will limit near term consumer and capex demand. India’s FY 21 real GDP is expected to contract by 2%-7%. Corporate earnings will fall even more. Markets, nonetheless, seem to have taken much of this bad news in stride and are focussing on FY22 earnings.     

C. OTHER THOUGHTS

DIVIDEND TAXATION

Till last year, dividends were taxed at the distributing company’s hands (@~20%) and were tax free in the hands of recipients. This year’s Union Budget has changed this regime. Starting this year, there will be no dividend distribution tax at the distributing company’s end. And, dividends will now be taxed in the hands of the recipient at the marginal tax rate applicable to them. For most of you, the marginal tax rate would be higher than the outgoing 20% rate. Assuming a 2% dividend yield, this regime change, ceteris paribus, will lower equity returns by around 0.2% (10% excess tax on 2% dividend yields).

One more procedural change incidental to this is about TDS on dividends. If a company is expected to pay dividends to an investor above Rs. 5000 in a financial year, the company shall deduct TDS at 10% (currently reduced to 7.5% as part of covid-package). When filing this year’s tax returns (you will file it after March 31, 2021) please remind your tax advisors to claim the TDS on dividends in your tax returns. 

A second order impact of this dividend taxation shall be that many companies would prefer buybacks as way to distribute cash to shareholders (including promoters who have marginal tax rate of over 40%). Of course this shall be dependent on share prices and cash availability with a company.

***

The half year gone by was one of the most volatile periods in the history of financial markets. Normally, when stock statement shows deep red, as it did in March, investors typically run for exit. Not here. Not only did all of you stayed put, many of you joined us and/or raised your bet amid scare and uncertainty.  Long term investment orientation is in short supply these days and is an investing edge. Thanks for giving us this edge. We are blessed to have like-minded partners like you.

As always, please help us improve by sharing your thoughts, feedback and criticisms.

 

Kind regards,

Team Compound Everyday Capital

Sumit Sarda, Surbhi Kabra Sarda, Saloni Jindal, Sachin Shrivastava, Sanjana Sukhtankar and Sumit Gokhiya

 

——————————————————————————————————————————————————————————————————

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 – March 2020 – Extracts

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EXECUTIVE SUMMARY

  • Last twelve months earnings of our portfolio companies grew by 16.3%. That of Nifty 50 & Nifty 500 grew by 6.7% and -8.7% respectively.
  • Aggregate portfolio NAV fell by 9.5% YTD with 77% funds invested on average. NSE Nifty 50 and Nifty 500 fell by 23.5% and 23.6% respectively.
  • Earnings of our portfolio and broader markets were buoyed by corporate tax rate cuts that were announced in Sep 2019.
  • COVID-19 pandemic rattled all asset classes including equities everywhere including India. While all companies will be affected, long term fundamentals of our portfolio companies remain robust.
  • Stance: Aggressive.

Dear Fellow Investors, 

If you can keep your head when all about you are losing theirs

Poem “IF”, Rudyard Kipling

The Coronavirus has caught the world by surprise. Global lock downs and social distancing has led to supply and demand disruptions. There will be spill over economic effects. This, together with uncertainty about the virus, and panic selling by passive and quant funds explains the steep fall of over 30% across markets including India in shortest ever time. Not financial excess, not war, but a virus has ended one of the longest bull-runs (2009-2019) in global equities since the Industrial Revolution.

A 20-40% fall in portfolio values can induce fear in our hunter-gatherer minds and prompt us to sell everything and run. Before pressing the panic button and converting paper losses into actual losses, looking back into financial history can offer some guidance. Thanks to the pursuit of prosperity and better life, the multi decade trend of markets and economic activity world over has been upwards. The excesses in this upward trend have self-corrected by one or two recessions/ depressions per decade with 20-60% fall in headline indices. However, all such falls have been followed by rapid rise. In every such case those investing/staying put in right companies during the throes of darkness and despondency have made great returns. The reason is that during crises, perceived risks become very high, but actual risk get low owing to attractive buying price. The idea of selling now and catching back a rising tide looks enticing but is practically difficult. Bottoms are made in hindsight. Illiquidity and ego remain high during rise.

Humanity will find a cure to COVID-19, however long it may take. Shops, factories and offices will re-open. Businesses will reboot. Till then, however, we must be ready for hardships and surprises. There may be second or third wave of infections. People may be afraid to step out even if new cases subside. Summers will be followed by winters. What looks like a quarter phenomenon can stretch to one or two years. Investment actions should be cognisant of many such second and third order consequences and unprecedented policy responses to those. The virus is going to test weak immunity and weak balance sheets alike. Only businesses with sustainable demand and balance sheet strength to survive interim cash burn will be better placed to survive/thrive. We should restrict ourselves to such companies. Caveat here, as always, is not to overpay.

Our portfolio companies fall in this category. As we detail in a latter section, except a few portfolio companies that may be temporarily impacted adversely, most of our portfolio companies remain neutral to or stand to be positively affected by the current concoction of Coronavirus + Crude Oil + YES bank scare. Prices of most of them have fallen indiscriminately, in line with market; even building in zero sales growth for next 10 years in few cases. Thankfully, our aggregate portfolio was 20% in cash going into March helping us to fall less than indices. Our current stance has changed from caution to aggression. Of course things may get worse before getting better. We are therefore putting the cash to work, gradually.

A. PERFORMANCE

A1. Statutory PMS Performance Disclosure

 

Portfolio Current YTD

Jul 24’19 to Mar 31’20

 Outper-

formance

 Average

cash bal.
CED Long Term Focused Value (PMS) -9.5%   23%
NSE Nifty 500 TRI(including dividends) -23.6% 14.1% NIL
NSE Nifty 50 TRI (including dividends) -23.5% 14.0% NIL
Note: Commenced on Jul 24, 2019. 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.

For the year to date March 31, 2020 our NAV was down 9.5%. NSE Nifty 500 and Nifty 50 were down 23.6% and 23.5% respectively. We were invested in equities, on monthly average basis, to the extent of 77%.

IMPORTANT: On Jan 20, 2020 NSE Nifty 500 touched it’s all-time high of 10,175. On that day, on YTD basis, Nifty 500 was up 8%. We were up 19%. Since that day, Nifty 500 has fallen 31.2%. We have fallen 24.0%. We were partly lucky. We started in July 2019 when markets were going down – luck. And we held more cash going in to March – deliberate. Nonetheless, this – rising more and falling less – may be due to looking at a very short period and will be a difficult feat to repeat. Realistic long term expectations can be that we will be rising at par/ less and falling lesser.

A2. Performance Disclosure pre-PMS

Portfolio Since Inception (CAGR)

Aug 2012-Mar 2019

 Outperformance

(Annualised)
Erstwhile Multi Family Office (7 yrs) 17.4%  
NSE Nifty 500 (including dividends) 14.5% 2.9%
NSE Nifty 50 (including dividends) 13.7% 3.7%

Prior to launching our Portfolio Management Services, we were running a private multi family office. The above are its audited returns net of expenses and equivalent fees over 7 years of its operation (Aug 18, 2012 to Mar 31, 2019).

 

A3. Underlying business performance

Period Past twelve months1 FY 2021 EPU (expected) 3
Earnings per unit (EPU)2 Earnings per unit (EPU)
Mar 2020 5.7 UE3
Dec 2019 5.1 –
Annual Change (vs Mar19) 16.3% –
1 Last four quarters ending Dec 2019. Results of Mar’20 quarter will be declared by Jun’20 only.

2 Total adjusted 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 adjusted 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. UE – Under evaluation

Trailing Earnings: As against our expectation of earnings per unit (EPU) of Rs 5.3, Mar 2020 trailing twelve months EPU came in at Rs 5.7, higher by 16.3% over last year (including effects of cash equivalents that earn 5% net of tax).  In comparison, the adjusted earnings of Nifty 50 and Nifty 500 companies grew by 6.7% and -8.7% respectively in the same period (source: Capitaline).

 

1-Yr Forward Earnings: Owing to coronavirus pandemic, assessing the forward earnings for FY 2021 remains challenging.  We will introduce FY 21 earnings estimate after one quarter. We report this number to help you decide whether the NAV fall is in anticipation of earnings fall. If it isn’t, it is usually good time to top up or stay put. We can confidently report that while our NAV is down 24% from its top, earnings for next two years will not be down that much.

 

A4. Underlying portfolio parameters

Dec 2019 Trailing P/E Forward P/E Portfolio RoE Portfolio Turnover1
CED LTFV PMS 15.9x NA 19.8% 3.7%
NSE 50 19.4x3 – 13.7%4 –
NSE 500 21.8x3 – 8.9%4 –
1 ‘Higher of purchases or sales of equity shares’ divided by ‘average portfolio value’ during the period. We built our portfolio this quarter and did not sell anything.

2  Monthly average

3 Source: NSE

4 Source: Capitaline

 

OVERALL INTERPRETATION: Table A1, A3 and A4 tells us that despite clocking better earnings growth, higher return on equity and lesser price fall (indicating better quality), our portfolio is relatively cheaper than broader benchmarks.

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

DB CORP

We have fully exited from DB Corp at a marginal loss of 0.4% of AUM.

Mistake: While Indian regional print media is growing and earnings may pan out as per our thesis, they may not translate to substantial share price improvement owing to structural decline of print media. We were waiting for two catalysts to support share price – over 40% fall in raw material (newsprint) prices and rise in dividend payout ratio. Both have played out and, contrary to our expectations, failed to rerate the stock. In fact the stock has fallen 50% since the latest results forcing promoters to increase their pledged shares from 33% to 40% of their stake which is a red flag. Markets remain sceptical of print readership growth sustaining and believe that ad allocations to print will continue to shrink led by rise in digital advertising. We have realised that markets are right and we are wrong. The company may transition to digital subscription model ala international print peers, and we may be proven wrong by selling now, but the chances are slim. Let’s cut losses and move on.

Key learning – Industries in structural decline will fail to get high multiples even if the industry is consolidated, competition limited and free cash flows healthy. 

Past mistakes and learnings: From our two past mistakes- “Cera Sanitaryware” and “2015-16” – we learnt that unless fundamentals are extremely compelling, it is better to be gradual in selling and buying respectively. From our past mistake on “Treehouse Education” we have learnt that bad management deserves a low price, it’s seldom a bargain. In Dish TV we underestimated the competitive disruption but thankfully sold at breakeven. Tata Motors DVR taught us that cyclical investing requires a different mindset to moat investing and one needs to be quick to act when external environment turns adverse. In Talwalkars, we learnt that assessing promoter quality is a difficult job and we should err on the side of caution irrespective of how cheap quantitative valuations look.

B4. FLOWS AND SENTIMENTS

Foreign investors sold around $10bn worth of Indian equities since Feb 24, 2020, leading to highest monthly outflows ever. Most of them would have been forced to, for example, owing to redemption, window dressing or algorithmic reasons. Virus led global risk-off sentiments drove money out of risky assets towards government securities and compressed equity valuations world over. The sentiments have changed, in a month, from optimism to fear and the same is reflecting in sharp fall in prices. Volatility indices, as a result, have risen sharply and touched their all-time highs.

Central banks have announced unprecedented rate cuts and liquidity infusions in markets to pump up sentiments. The liquidity will, at some point once coronavirus panic settles, will be back to risky assets and lead to reversal in flows and sentiments.

 

C. OTHER THOUGHTS

 

TACKLING FEAR

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

-Benjamin Graham, The Intelligent Investor

 

Fear is evolution’s survival gift to humans. Those who were not afraid, passed away. We are, as a corollary, decedents of those who were fearful. It is biological to get afraid in these times. Two data points can offer antidotes:

 

Business Value: Value of a business is the present value of all future free cash flows (cash profits less cash investments in working capital and fixed assets). Life of most good businesses can be safely considered to be 20 years or more. Even if we knock off the next two years of cashflows of such businesses or assume them to be negative owing to coronavirus, our study suggests that the impact on present values will be in the range of 10%-20%. Share prices of many of these are down 20-50%. Most of the virus led hardships are priced in and in some cases, overdone. Selling now will tantamount to selling low, not a good way to make money.

Position in Cycle: While comparing the current crisis with the 2008 global financial crisis, we should remember that India is at exactly inverse position today going in to the crisis vs 2008. Year 2008 was preceded by four years of sharp rise in economic activity. Corporate profits and market capitalisation were at all-time high of 7.8% and 158% of GDP (nominal) respectively. We were at cyclical top. In contrast till Feb 2020, entering into coronavirus crisis, India was going through a slowdown reflected in corporate profits and market capitalisation at 3% and 65% of GDP respectively. Post virus led market falls, India’s market capitalisation to GDP has further fallen to 49% of GDP, lower than 2008 lows (54%). Moreover governments, having learned their lessons of economic management during the 2008 crisis, have done and will do whatever it takes to restore stability and growth.

***

SHOULDERS OF GIANTS

We take a moment to stand on the shoulders of giants and revisit what they have said about panics and fears:

In the Bhagvad Gita, Shri Krishna tells Arjun –

“दुःखेष्वनुद्विग्नमनाः सुखेषु विगतस्पृहः ।

वीतरागभयक्रोधः स्थितधीर्मुनिरुच्यते ।।”

 

“He whose mind is undisturbed in the midst of sorrows and is free from desire amid pleasures,

He who is free of attachment, fear and anger, is called the sage of equanimity (sthit dheer muni).”

-Chapter 2 Verse 56, Shrimad Bhagvad Gita

 

Charlie Munger, Warren Buffett’s partner, was once asked by a journalist about how worried he was on seeing stocks falling 50%. His reply –

“Zero. This is the third time Warren (Buffett, Chairman Berkshire Hathway) and I have seen our holdings go down , top tick to bottom tick, by 50%. I think it is in the nature of long term shareholding of the normal vicissitudes, of worldly outcomes, of markets that the long term holder has his quoted value of his stocks go down by say 50%. In fact if you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times in a century you’re not fit to be a common shareholder and you deserve mediocre results compared to rational people.”

In an investor letter, Boupost’s second in command – Brian Spector reflected the following on going through the pain of Dot Com bubble:

“It turns out buying a dollar for 50 cents is a lot harder than it seems. Every day we added to these positions, thinking we were getting an even better bargain than the day before, only to wake up and watch prices drop further….While both exhilarating and painful at the same time, what I remember most vividly is exhaustion. After countless late nights at the office, I would head home, collapse on my couch and stare at the ceiling. I was unable to read, watch television, or fall asleep. All I could do was worry about what we might have missed in our analysis. It turned out we did not.

Investing in bear markets takes chutzpah. To do so effectively, you need to fly in the face of public opinion, you have to fight normal human emotions, and you have to be prepared to double down on your bets when your conviction is most in question.”

Late Mr. Chandrakant Sampat on investing during crisis:

“Don’t expect any rationality from markets, they are frequently irrational. You have to take advantage of bad times for good inevitable companies, when general public throws their stock in uncertain times.”

Warren Buffet on the 2008 crash:

“Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”

***

While prices can fall 50%, intrinsic values of most of the good businesses donot fall to same extent. Our job in the letter was to apprise you of the inherent characteristics of our businesses so that you feel good about holding them and get greedy with such a mark down in their buying price vs value.

With our wellbeing aligned with yours, we wake up everyday to do better for you: to study and review businesses and profit from mispricings. Of course we make mistakes and deserve your brickbats. But often, interim outcomes are worse despite correct process. In those times we seek your objective assessment and little patience. These are those times and thanks for holding tight. Please feel free to share your thoughts, feedback and criticisms.

 

This too shall pass…

 

Kind regards,

Team Compound Everyday Capital

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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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Investment Process, Value Investing

QAAP/ GAAP

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Many investment styles – along the continuum of growth and value – go in and out of favour periodically. Success of one style sows the seeds of its own failure. When many investors adopt that style, the price rises way beyond most optimistic estimate of value.

One such style that has done well in recent years has been QAAP – Quality at any price or GAAP – Growth at any price. Rising flows and sombre economic outlook has led money to be hidden into few proven names that are perceived to have moats, growth, high returns on capital, charismatic management, and long run way.

Sure, there are a minority of companies that deserve paying up. We too have paid and remain ready to pay up for such exceptional businesses. But the base rate (past experience) of high earnings growth (30% or higher) for long period is very small.

Of 1326 listed Indian companies that existed and were profitable 20 years ago in the year 1999, two-third of the companies grew their earnings at less than 15% CAGR (cumulative annual growth rate) over next 20 years. And only 6% of companies grew their operating earnings at over 20% CAGR in the same period. Moreover, companies that grew over 20% CAGR in initial years saw their operating earnings growth falling to an average 10%. (Source: Capitaline)

Despite this high bar, and despite their earnings growth slowing down in recent 6 months, over 20% of NSE 500 companies today trade at P/E greater than 40x. Often markets get into growth narrative and recent tailwinds are misconstrued as moats.  Stocks start trading at astronomic valuations assuming that high growth rates will continue. Long term earnings data gives clear evidence that such expectations exceed reality. Unbridled quest for QAAP/ GAAP may be a TRAP.

Note: This piece was part of one of our half yearly letters sent to our investors.

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Investment Psychology, Value Investing

Behaviour As An Edge

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“What’s not going to change in next 10 years?”

-Jeff Bezos

Internet, securities regulations and entry of talented individuals have blunted the erstwhile investment edge offered by better information and better analyses. Rational behaviour – buying below intrinsic value and selling above it irrespective of short term noise – still remains a sustainable source of investment edge. That’s because institutional compulsions and human emotions & biases force participants to eschew this rationality and create mispricing. These two factors will not materially change in next 10 years.

Institutional Compulsion: Investment behaviour of fund managers at investment institutions is driven by minimising career risk. Their jobs, promotions and bonuses depend on increasing the assets under management (AUM) which in turn depends on matching or beating their benchmarks net of fees on quarterly basis. Often unconventional and/ or concentrated stock picks cannot offer this guarantee. Therefore most of them construct ‘index aware’ portfolios – euphemism for mimicking benchmark indices. Many companies that are out of index donot find buyers and remain mispriced. Rising interest in Index Funds/ETFs (passive funds that mimic benchmarks fully without any human discretion) will further aggravate this anomaly. Further, redemptions or regulations force fund managers to sell stocks irrespective of value. Recent SEBI reclassification drove lot of money out of mid and small caps to large caps irrespective of fundamental merit.

Human emotions & biases: While good for hunting, gathering and surviving, evolution has ill prepared us to do well in investing. Fear and greed were mental shortcuts that helped our hunter forefathers survive. They ran when there were rustlings in the bushes (fear). And, they overate/ stored whenever food was in excess (greed). These genes are passed on to us as their legacy. Price fall triggers the same fear. Risk aversion rises and future projections get grim. No price is too low. Conversely price rise engenders same greed. Risk taking rises and future projections get rosy. No price is too high. Behavioural Finance has demonstrated that we are not perfectly rational. We are susceptible to heuristics and cognitive biases.

Behaviour Edge: Knowing above, following offers a sustainable investment edge:

  1. Operating only in businesses that one honestly understands and having a sense of their intrinsic values.
  2. Remaining humbly aware of multiple possibilities including our own folly and therefore buying with a margin of safety.
  3. Understanding that (a) intrinsic values are less volatile than price, and (b) emotions revert to mean.
  4. Raising money and/ or investing only when prices make sense (is harder than seems) and willingness to hold cash when opportunities are thin. Our ‘zero fee and profit share only’ structure supports this behaviour.
  5. Looking for opportunities in spaces where price discovery is still inefficient.

Rational Money: A fund’s behaviour is derived from its investors’ behaviour. We may, thanks to above reasons, find bargain securities and buy. Prices however may continue to fall even after that despite fundamentals remaining intact. Interim NAV performance may look poor. If investors panic and withdraw on those times, the paper loss will be converted to actual loss and all our behavioural astuteness (1-5 above) will amount to nothing. A fund manager can be only as rational as the money she manages.

Note: This piece was part of one of our half yearly letters sent to our investors.

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Macroeconomics

Assessing Demonetisation’s Impact on Indian Equity Markets

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“The more things change, the more they remain same”

Jean-Baptiste Alphonse Karr

In a surprise move India demonetised 86% of its currency notes (by value) recently. Given the current size and complexity of Indian economy, there are limited useful precedents to reference its possible impact on markets and investment landscape.

Criticisms of the current demonetisation hover around the fact that demonetisation per se is an inefficient tool to curb black money. It would, however, be unwise to assume that demonetisation will be a standalone episode. There may be further actions to take India on a path of a tax paying and cashless economy.

However, the kind and extent of future measures to curb black money remains uncertain. Hazarding a guess on long term impact on markets therefore remains an arduous task. Given this uncertainty, a probabilistic decision tree approach (possible scenarios and their probabilities) may be right way to think about possible impacts on markets.

Let’s start by an extreme first hypothesis: a 100% tax paying economy. And try to imagine the impact such India will have on its markets. Of course anything less than 100% will dilute the impact commensurately.  We may then proceed to contemplate the probability of this hypothesis coming true.

Aggregate demand is the most critical driver of long term market performance. And money, black or white, is a prerequisite of demand. What we call black too creates its own consumption and investment demand and supports many sectors, their employees and their supply chain.

Take for example real estate. A house needs over 50 agencies – cement, iron, steel, paints, plastic, sanitaryware, ceramics, furnishing, electrical fittings,  etc. All these agencies have their own vendors (for materials and machinery). Further, all these participants in turn have their own employees. In addition, rising real estate prices creates wealth effect and promotes consumption spending. Real estate, thus, has a huge economic multiplier effect.

Few more industries, in addition to real estate, that have prospered from demand generated by black money include  gold, offshore investments, luxury goods, leisure, entertainment, travel, and apparel to name a few. A large informal sector thrives simultaneously with formal economy largely due to tax evasion. These all are industries in themselves that have their own ecosystem of employees and suppliers. It will not be wrong to say that curb on black money should affect all these ecosystems materially. A curb on corruption in China, for instance, significantly affected sales of luxury watches. But before we conclude destruction of wealth in these sectors we need to see mitigating factors.

With curb on black money, large portion of wealth will flow from above sectors to the financial system in from of bank deposits and to government in form of taxes.

Money moving from dead investments like gold and real estate (land) to formal banking channel for further lending may seem like a positive impact of demonetisation. Before cheering, however, we need to subtract two negative consequences: one, the forgone consumption demand generated by wealth effect of rising prices and two, the demand loss from the ecosystem displaced (jewellery, real estate brokers, farmers’ wealth etc). Moreover banking system has its own lending inefficiencies as seen from past bad loans (NPAs).

This leaves us with the windfall going to the government. The way government spends that money, therefore, will have important counter balancing effects on economy and markets.

Let’s present our second extreme hypothesis: government will use the money in the best way. That means government will spend the money on projects that can have multiplier effects: infrastructure (roads, railways, airports, seaports, power etc.), housing for all, tourism, and direct benefit transfers under aadhar.

Displacement from real estate due to curb on black money can easily be counter balanced by public spending on infrastructure and housing. Additionally, infrastructure investing can save time and costs for all businesses.

Tourism is another sector that offers huge potential of job growth and catalysing local economies, not to mention accretion of useful foreign exchange. Countries endowed poorly with natural resources have used tourism to great mitigating advantage.

Aadhar linked subsidies can direct resources directly in hands of left out sections of economy in a leak-proof and efficient manner and sustain their demand.

If the above steps lead to kick starting a multiplier effect and tax buoyancy, government may go ahead and reduce tax rates to further put cash in the hands of people giving further boost to aggregate demand If this second hypothesis turns out to be true, the mitigant effects will be powerful enough to create an overall positive long term impact for economy and markets.

Government – the chief actor

We can see that in a white economy, government becomes the chief actor and its actions will decide long term impact on markets. Unless the government acts right, a move to a white society will not alter behaviour and fail to make much impact on markets. Let’s explore possibilities.

Take for instance real estate transactions where there is a marked difference between market values and guideline values. Unless this system migrates to one used in developed world, how will current practices change?

Take next the tax and judicial administration. Most tax evasion happen by way of understatement of sales and/or overstatement of expenses. In a fiercely competitive business environment, tax evasion led profit margins soon force all players to resort to the same. The administrative and legal machinery somewhere lets them get by. We thus move into the territory of reforming tax administration and judicial system– two of the most challenging reforms.

Infrastructure – one of the best options for public spending – has issues too. Government will need private partnership to do that. Past successes of PPP (Public private partnership) have been limited owing to issues in land and environmental clearances, lack of appropriate risk allocations, mistrust between parties and populist considerations. Focus on low cost bidding has also led to problems of quality and financial viability. While none of these are non-solvable issues, need is of the right mindset and efficient execution.

Thus for citizens to pay full taxes, major reforms are needed in public administration, judicial machinery and real estate regulations to name a few. Realism will dictate us to assign only small probabilities to these issues getting addressed soon. That leaves lot before India moves to a 100% white economy.

Thinking about another extreme side of the argument: if government fails to make best use of the windfall, a white economy will be slightly negative for markets.

High probability is of both hypotheses coming only partly true: a partially white economy and partially efficient government machinery. Such scenario would best be neutral for markets in long term. There will be costs to some sectors in the long term but those would be partly mitigated by government actions. Life would remains as usual!

Disclaimer: This article’s scope is limited to discussing demonetisation’s impact on markets. In no way does it underestimates the positive social, geo political (terrorism and counterfeit notes) and political impacts of this move. Democracy discourages bold decisions with short term pains and long term gains, for the next government may take the credit! The dare, we believe, needs a thumbs up.

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Investment Process, Value Investing

Owners’ Manual

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Our Owners’ Manual represents the collective will of all our partners. As trustees of our collective wealth, firm’s managing partners will always honour the manual in designing the firm’s investing and operating actions. We owe the inspiration to create this manual to Warren Buffett.

Here it goes:

Partners’ trust is our asset, their money our liability

    • We put partners first in our incentives, conduct and communication. This is not a vague marketing catchphrase. Having known the compounding power of trust, it makes an immense business sense to do so. It would be foolish to do otherwise.
    • We operate knowing that partners’ hard earned money is on the line. Our investment presupposes protection of capital. And our operations presuppose frugality.
    • Noble intentions should be matched by concrete actions. The managing partners, therefore, have their major portion of networth invested in this firm. We eat our own cooking.

Our long term goal is to keep increasing “our share in economic earnings and net assets of underlying businesses” as % of our investment cost.

    • We donot treat stocks as screen tickers or lottery tickets. For us a stock represents part ownership in a live business that has an intrinsic value which may be different from its price.
    • By owning a stock we get to own a share in economic earnings and net assets of underlying business. By economic earnings we mean normalised earning power.
    • We will do well if, in long run, we can increase “our share in economic earnings and net assets of underlying businesses” as % of our investment cost.
    • Essential to seeing this happen is that we buy good businesses at or below their intrinsic values and hold them till they remain good and inexpensive (points 3, 4 and 5 below).

First key to our work is conservative assessment of intrinsic values of underlying businesses

    • Stated simply, intrinsic value of any business is the present value of its future cash flows.
    • To make intrinsic values reliable, we try to limit our research to good businesses that have some competitive advantages, are simple to understand and are run by able and honest management.
    • Moreover, our analysis presumes that most things in business– commodity prices, interest rates, and demand – will turn out to be cyclical. We give due credit to this reality while imagining future.

Second key is to buy at or below intrinsic value

    • Key to reduce the risk of permanent loss of capital is not to overpay. Good businesses are rare and situations that make them available below intrinsic values are rarer still. Such situations broadly include:
      • Out of favour business (cyclical downturns, one time difficult but solvable problem)
      • General market downturns (recessions, depressions)
      • Contrary analysis (time arbitrage, different view)
      • Disinterest (small size, index exclusion)
    • Owing to this dual rarity (rare business, rare prices), often we need to sit on cash (or cash equivalents) and wait. When owing to the four factors above (i to iv), opportunities do present themselves, we bet big by limiting our portfolio to 10-12 concentrated positions.

Third key is to hold businesses till they remain good and inexpensive

    • Big money is mostly made, not by frequent buying and selling, but by holding.
    • If the businesses that we buy (after step 3 and 4 above) remain good and inexpensive, holding them for long term renders focus and saves costs– two essentials for benefitting from the power of compounding.

Actions driven by rationality rather than emotions

    • Owing to greed, envy or fear, short term prices sometimes get de-anchored from intrinsic values.
    • Execution of points 3, 4 and 5 above will require us to remember this dichotomy, and keep our focus on intrinsic values.
    • By not chasing hot stocks during bull runs, we like all value investors will see temporary but reversible periods of underperformance. Bear with us during those periods. We would be conserving cash to put to use when the bubble bursts. When bubble does burst, resist selling and if possible invest more. During those periods markets go on SALE and our hard work is rewarded.
    • As a corollary, it would be unwise to gauge our performance from short term price movements. We, therefore, look at changes in fundamentals to review our performance.

Reporting philosophy

    • We will follow the agreed reporting format irrespective of good or bad performance.
    • The spirit of the reporting format is expectations managing partners will themselves have if our roles are reversed.
    • Mention of mistakes will precede mention of accomplishments.
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Investment Psychology, Value Investing

Human Diffuculties in Value Investing

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Charlie Munger, the partner of Warren Buffet and Vice Chairman of Berkshire Hathaway, noted “all sensible investing is value investing”. There are volumes of research on the fact that despite richest investors like Buffett and Munger attributing their success and riches to value investing, majority donot follow value philosophy.

Theoretically, value investing involves buying below and selling above intrinsic value. This sounds simple and sensible. However as Yogi Berra quipped “In theory there is no difference between theory and practice, in practice there is”. Value investing, like many disciplines, is easy in theory but difficult in practice.

It is difficult in practice because it is contrary to normal human nature and accepted social norms at each of its four broad steps:

  1. Assessing Intrinsic Value : Assessment of intrinsic value involves future. The uncertain terrain of future needs large doses of skepticism, objectivity and humility over optimism, group-think and overconfidence.
  2. Buying below intrinsic value: Bargains are found amidst fear and disinterest. Owing to biological adaptation over ages, brain is conditioned to prefer flight over rational thought when induced to fright. Similarly homo sapiens have preferred staying in the comfort of popularity over the risky pursuit of contrary solitude.
  3. Waiting: Most money in investing is made by waiting, not frequent trading. In a world where activity is looked as synonymous to progress, the notion of buying and doing nothing for days stimulates guilt glands and consequently needless actions.
  4. Selling above intrinsic value: Price rise intoxicates human mind. It forces it to keep on dancing long after the music has stopped. Greed, hubris and envy are all at play here. It requires an objective, non-greedy mind to stop dancing before the music is going to stop.

Overconfidence, fear, safety in crowd, needless activity, greed and envy are powerful tendencies that have served some utility in human evolution since hunter gatherer days. They are hard to resist and they operate automatically.

Value Investing calls for curbing these tendencies. This is hard to do. This makes value investing anathema to us homo sapiens. Fortunately, being aware and alert to the nature, cause and stimulant of these tendencies has proved to be a working antidote for successful value investors including Charlie Munger.

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