Investment Psychology

Overcoming Fear

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If there is one thing that can get in the way of our shared path of wealth creation, it is fear. And if there is one thing that will collectively make us better investors, it is overcoming fear. It is during the darkest hour of fear that greatest bargains are found. And during those times our greatest mistake would be selling instead of buying or holding.

The main cause of fear is that normally when stocks are falling, everything else is falling too including cash and confidence. There are no landmarks or shady trees to take shelter under. Investors would take out money from stocks to meet other expenses/ liabilities. We cannot be fearless just by deciding not to be fearful. We need antidote that works.

The only antidote to fear from price fall is to PREPARE FOR BAD TIMES; to arrange our affairs in such a manner that we are not hard pressed for cash during recessions. 

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Investment Mistake, Investment Psychology

Difficulties of Being in a Bull Market

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“I don’t predict future. I understand human nature”

-Lord Krishna to Arjun in The Mahabharata

Thanks to our genetic wiring; envy, greed and fear (of losing out) are three primary human emotions every bull market stimulates. We acknowledge usefulness of these human emotions. Emotions including envy, greed and fear have been instrumental in human survival and superiority over other species since life’s origin. Being envious forced us to compete and improve. Being greedy made us accumulate and overcome scarcity. And, being fearful triggered the fight/ flight responses necessary for survival. These emotions therefore, with generations, are so etched into human consciousness that they operate automatically and indiscretionally, including, in a bull market. Unfortunately, going by financial markets’ history, these emotions when drive actions, lead to bubbles and crashes.

Focus, however, has to be on business value all the time; especially during bullish times. During bullish phases, envy, fear of losing out and greed sets in. Prices get higher and opportunities reduce. By not chasing momentum, a careful investor is bound to see temporary and reversible periods of underperformance. Being patient is never easy, especially if your neighbour is getting richer in a bull market. But this is exactly what one needs to try to do! This approach is better than chasing hot stocks and burning fingers in next correction. A thoughtful investment approach focuses at least as much on risk as on return. Whenever it has been easy to make money in equity markets, it has been even easier to lose it. Earning 16% for 10 years each will leave one with more money than earning 20% in 9 years each and losing 15% in the 10th.

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Business Analysis

Disruption: “AND” Vs “OR”

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Disruption is one of the biggest threat to a business and its stock price. Disrupted or soon to be disrupted businesses optically look cheap but are in fact value traps because the businesses are expected to decline as new technology/ way of doing things takes hold. Recall the cases of newspapers, film camera, feature phones etc.

In most cases future disruption is clearly visible. But in some cases it is hazy, even unfounded. This haziness can be a breeding ground for bargains. Often it is feared that existing way of doing business will completely end and new way will take hold. It is framed as an “OR” problem. Newspaper or online news, film camera or digital camera, feature phone or smart phone. But in many minority of cases the question may not be of “OR” but of “AND”. The new and old may co-exist. Or, the incumbents may adapt and be able to offer new products as well. Internal combustion engine (ICE) auto-companies may, for example, transition to electric vehicles (EVs). Physical newspapers may transition to digital versions. Whenever disruption threat is overplayed, it can create mispricings. 

Care, however, needs to be taken to see whether the “AND” phenomenon is actually supportive to industry structure and profitable growth. Returning to the example of ICE vs EV auto companies, while incumbents may migrate to EV, it is not clear which company will win. Also given inputs to battery packs are still not indigenously made, margins and returns on capital are uncertain.

Few “And vs Or” questions are easy to solve, few are not. But whenever all questions are painted with the same fear brush, they can create mispricings.

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Investment Psychology, Quarterly Update

Letter to Investors – Jun’24 – Extracts

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EXECUTIVE SUMMARY

    • Trailing twelve months’ earnings of underlying portfolio companies grew by 46%.
    • NAV grew by 8.9% YTD with 78% funds invested in equity positions. Balance 22% is parked in liquid/ arbitrage funds.
    • Solving dilemma of investing in a one-way rising market.
    • We added further to an existing position to make it a major position (>=5% weight).
    • Lessons from manias and panics of last 400 years.
    • Stance: Cautious

Dear Fellow Investors,

Broader markets remain expensive…

Markets continue their one way up-march and valuations in most of the pockets remain stretched. We look at two valuation ratios – price to sales and price to book – to show the extent of over-valuation. Price to sales indicates the ratio of market capitalisation of a company to its net sales. Price to book ratio compares the market capitalisation of the company to its net worth (or book value).

We are choosing these two ratios over the popular price to earnings (P/E) ratio because the denominator of P/E – earnings – can be influenced by cycles or extraordinary/ non-operating items and can be misleading. For eg., earnings of Banks, Oil and Gas companies and Public Sector Undertakings (PSUs) are at cyclical high today and their P/E look low. Sales and book values, instead, are more stable and can capture the extent of over/ under valuation better.

Price to Sales: Over 100 of the top 750 companies currently trade at price to sales of over 10x (versus an average of 25 companies in last 20 years) and over 220 companies trade at price to sales of over 5x (versus an average of 85 in last 20 years). Median price to sales ratio of top 750 companies is at 3.5x versus 20-year average of 1.1x.

 

Price to book: Price to book ratio shows the stark over-valuation in small and mid-size companies. Nifty Midcap 100 and Nifty Smallcap 100 indices trade at 5x and 4.4x price to book ratios, higher by 100% and 153% over their decadal median. Nifty Midcap index is near its past peak of 2008. For the smallcap index, the P/B is twice of 2018 level. 2018 saw the previous smallcap bubble from where the index fell 20% in following 6 months.

 

…But we don’t know what will pause/ reverse the rally…

In 1996 when the NASDAQ was at 1300, Alan Greenspan (the US Federal Reserve Board chairman), said that the U.S. stock market was irrationally exuberant. NASDAQ kept going up for next 4 years to 5000 (>4x). And then crashed 80%.

Alan Greenspan was not wrong. Just early. Markets can remain irrational for longer than one can remain prudent.

Like every time before, it is difficult to predict the nature and timing of events that can trigger market meltdown today especially in India. The political, macroeconomic and microeconomic situation in India remains robust. Retail investors have balanced the volatility caused by foreign flows.  However, we should not forget that inability to imagine the trigger doesnot mean we can avoid one. When valuations are high, margin of safety low, and the world interlinked to the extent as it is today, smallest adverse events can cause default, credit contraction, foreign exchange fluctuation, war or pandemic. In fact, these have been the triggers for past crashes.

So, what do we do….

How do we solve for this dilemma? We continue to stick to reasonably priced quality companies. In most bubbles including current one, there remain some pockets that are of good quality and are not as exuberant. We have been adding weights there (shared in this and past letters). Once our target weights are allocated to these positions, we park the balance in liquid/ arbitrage funds. On selling side, we will tolerate moderate overvaluations. We will trim gradually if overvaluation is very high.

This strategy, like every other strategy, is not full proof. If the markets were to crash tomorrow, our stocks will fall too. We have, with great care and discipline, built a quality portfolio which is reasonably priced. It is our belief, and history is a testament that such quality portfolio built at reasonable price will be first to recover. Moreover, our high spare cash will be useful in buying further. And if there is no crash, our incremental deployment will slow down due to lack of opportunities, cash reserves will build up, existing positions will continue to benefit and we may trim super expensive positions. STANCE: Cautious.

 

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) 8.9% 29.2% -4.3% 14.9% 48.5% -9.5% 16.0% 22.0%
S&P BSE 500 TRI (includes dividends) NA^ 40.2% -0.9% 22.3% 78.6% -23.4% NA^ NA^ 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. ^BSE has stopped sharing index values for time being.

 

Persisting with the discipline

We continue to focus on risk with a complete blind eye to quarterly returns in today’s heady times. This involves double checking our thesis every day, saying no to poor quality or expensive ideas and investing in acceptable positions gradually and fearfully.

Such has been the velocity of the markets currently that stocks that we have rejected due to subpar quality and/ or high price continue to rise relentlessly. The immediate emotional reaction, naturally, is of missing out. However, thanks to our direct and vicarious experiences, we have learnt to ignore these first impulses that the market like current one triggers. 

 

A2. Underlying business performance

 

Past Twelve Months Earnings per unit (EPU)2 FY 2024 EPU (expected)
Mar 2024 8.61 8.5-9.53
(guidance was –>) (7.5-8.5)  
Dec 2023 (Previous Quarter) 8.0
Mar 2023 (Previous Year) 5.9
Annual Change 45.8%
CAGR since inception (Jun 2019) 15%
1 Last four quarters ending Dec 2023. 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: We had revised the Earnings Per Unit guidance for FY24 to Rs 7.5-8.5 last quarter. That was due to sale of two positions where earnings were at cyclical high. Actual trailing earnings per share for FY24 came in at Rs 8.6, marginally above the upper range of the guidance. Trailing twelve months Earnings Per Unit (EPU) of underlying companies, grew by 46% (including effects of cash equivalents that earn ~6%). 

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

 

A3. Underlying portfolio parameters

 

Jun 2024 Trailing P/E Forward P/E Portfolio RoIC Portfolio Turnover1
CED LTFV (PMS) 24.5x 22.0x-24.5x 34.0%3 Nil
BSE 500 26.2x2 – 15.5%2 –
1 ‘sale of equity shares’ divided by ‘average portfolio value’ during the year to date period. 2Source: BSE. 3Portfolio Return on Invested Capital (RoIC) is on core equity positions. For BSE we share the RoE (Return on Equity)

 

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

We continue to hold the arbitrage position in equity and preference shares of Music Broadcast (Radio City). The position remains in the money currently. There were no mistakes to report in this period.

 

B2. MAJOR PORTFOLIO CHANGES

Bought: We added to an existing position . It is now a 5% position (major position). 

 

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

 

B4. FLOWS AND SENTIMENTS

500x leverage in Weekly Options

India has seen sharp surge in derivatives volumes in last few years. India’s derivatives volumes accounted for over 80% of global derivatives volumes in April 2024. Last quarter, the average daily notional options volume of Nifty 50 contract in India (at 1.64trn$/ day) crossed that of US S&P 500 contract (1.44trn$/day). In fact, derivatives volumes are 400x of equity cash volumes in India, an all-time high both in India and the world.

The main contributor for this surge is weekly expiring options, also known as, zero-day options.

Option premium usually falls as time to maturity falls. Therefore zero-day option – that expires on the same day as bought – costs roughly one tenth of a traditional monthly-expiry options. One Nifty-50 zero-day option allows a buyer to have an exposure worth Rs 5 lacs by paying an option premium of just Rs 1,000 – a 500x leverage.

A 500x leverage magnifies gains and losses by 500 times. A 1% change in Nifty 50 can turn Rs 1000 into Rs 6000.  Conversely even a 0.2% fall in Nifty-50 can wipe out the premium. Surprisingly, this leverage which has grown manifold remains uncaptured in periodic debt statistics – money supply, gross advances, debt to GDP etc.

For newer traders that have seen rising prices and low volatility, weekly options have been the goose that lays golden eggs. But in reality, these speculative instruments are more like collecting pennies on a busy highway, or living in a rent-free home in a high-seismic zone. Once the prices start falling, most of the retail traders will incur capital losses. 

—–

 Taking Temperature

We use some qualitative indicator to take the temperature of markets and get hints of where are we in the cycle.

Retail and HNI investors continue to chase past performance. Capital market flows remain extremely buoyant as evident from multiple data points:

  • In last twelve months, of the INR 2.3 trn that flew into equity mutual funds (MF), over 50% went into smallcap, midcap and thematic funds which were already very expense. A sizable part of these MF inflows came from new fund offers (NFOs). NFOs are launched when the theme has already done well. No surprise that around 60% of NFOs have underperformed their benchmarks in last 3 years.
  • IPO pipeline (Hyundai, OLA Electric, Bajaj Housing etc.) is indicating 2024 will again record near all-time high collections.
  • SME IPOs continue to break records in terms of number of issues, extent of oversubscription, amount raised and listing pops. Versus Rs. 4900cr in CY2023, SME IPOs have already raised Rs. 3600cr in first half of CY2024. Also, the SME IPO index is up 250% in last 12 months! Most of the underlying companies have ordinary businesses and unknown corporate governance history.
  • Promoters and insiders continue to offload their stakes and cash out at loft vallations. Over 440 promoters have sold stakes worth Rs 62,000 cr in the first half of CY2024, highest since 2019.

 

Another interesting data point to look at is Skyscraper construction. The underlying theory is that many of the iconic skyscrapers of past have coincided with top of financial cycle. The Empire State Building in New York City was started in 1929. The Petronas Twin Towers in Kuala Lumpur were started in 1993. The Jailing Tower in Shanghai was started in 1995. Burj Khalifa was finished at the height of the market collapse in Dubai. In India, Imperial I &II (840ft each), the then tallest buildings, were built in Mumbai in 2010. Over 30 skyscrapers (600ft+ height) have been completed in last 3 years in Mumbai. Construction of even taller buildings (Ocean Power 1&2 1086ft, Aaradhya Avaan, 1000ft high) are underway right now.

 

C. OTHER THOUGHTS

Manias and Panics – Lessons from last 400 years

 

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

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

 

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

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

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

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

o    US Tech Bubble 1990s (internet)
2 Expansion of credit, excessive leverage, easy money, low interest rates o    Japanese Real Estate 1980s,

o    US Subprime Crisis 2000s,

o    Global Venture Capital boom 2015-2022
3 Globalisation, exports, cheap currency o    Japanese Real Estate 1980s,

o    South East Asia 1990s,

o    China 2000s
4 Economic Reforms/ Liberalisation o    Mexico 1980s,

o    US abandoning the Gold Standard 1970s,

o    India Harshad Mehta episode 1990s
5 Monopolies o    South Sea Bubble 1720,

o    Mississippi Bubble 1720

 

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

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

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

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”

***

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

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

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, Investment Psychology, Quarterly Update

Letter to Investors – Mar’24 – Extracts

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EXECUTIVE SUMMARY

    • Trailing twelve months’ earnings of underlying portfolio companies grew by 45%.
    • FY24 NAV grew by 29.2% with 74% funds invested in equity positions. Balance 26% is parked in liquid funds.
    • We share takeaways from studying performance of 1000 monkey portfolios.
    • We added to few existing positions, and started a new toehold position. We exited from a minor position at >25% IRR.
    • Impact of elections on stock returns.
    • Stance: Cautious

Dear Fellow Investors,

From Beginner’s Luck to Winner’s Curse?

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

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

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

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

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

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

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

 

A. PERFORMANCE

 

A1. Statutory PMS Performance Disclosure

Portfolio FY24 FY23  FY22 FY 21  FY 20* Since Inception* Outper-formance Cash Bal.
CED Long Term Focused Value (PMS) 29.2% -4.3% 14.9% 48.5% -9.5% 14.8% 26.1%
S&P BSE 500 TRI (includes dividends) 40.2% -0.9% 22.3% 78.6% -23.4% 19.7% -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.

 

Discipline or Delusion?

Our commitment to ‘protection first, returns later’ remains the guiding light behind our investment decision. This means we aim to acquire assets at prices below their conservatively assessed values. However, in today’s market, this criterion is often not met. As a result, our prudent course of action remains one of patience and continued study.

We understand the frustration that comes with our cautious approach, especially as it has led to underperformance compared to broader market indices like the BSE 500, which have surged due to rally in midcap and smallcap stocks. It is useful to question whether our stance reflects discipline or delusion, particularly when markets continue to rise, defying any caution.

While short-term market movements can be unpredictable, they cannot defy the fundamental principles of valuation. The mathematics of valuations dictate that the present value of future free cash flows, not current prices, should serve as the anchor for asset prices. Just as trees cannot grow infinitely towards the sky, stock prices cannot indefinitely surpass their intrinsic values. Eventually, the gravity of fundamental factors realigns stock prices with their true worth.

It’s crucial to recognise that enduring the disciplinary pain during lofty markets is precisely what safeguards and fortifies longer term investment returns. Investing is a marathon and tallying scores after every lap is of no use if we fail to complete the marathon. Stance: Cautious.

 

A2. Underlying business performance

 

Past Twelve Months Earnings per unit (EPU)2 FY 2024 EPU (expected)
Dec 2023 8.01 7.5-8.53
Sep 2023 (Previous Quarter) 8.6 8.0-9.03
Dec 2022 (Previous Year) 5.5
Annual Change 45%
CAGR since inception (Jun 2019) 12%
1 Last four quarters ending Dec 2023. Results of Mar quarter are declared by May only. 2 EPU = Total normalised earnings accruing to the aggregate portfolio divided by units outstanding. 3 Please note: the forward earnings per unit (EPU) are conservative estimates of our expectation of future earnings of underlying companies. In past we have been wrong – often by wide margin – in our estimates and there is a risk that we are wrong about the forward EPU reported to you above. 

 

Trailing Earnings: Trailing twelve months Earnings Per Unit (EPU) of underlying companies, grew by 45% (including effects of cash equivalents that earn ~6% post tax currently).

1-Yr Forward Earnings: We downgrade the expected earnings per share range for FY24 from 8.0-9.0 to 7.5-8.5. This is because we exited from two positions where the earnings were at cyclical high and lifted base period’s earnings.

 

A3. Underlying portfolio parameters

 

Mar 2024 Trailing P/E Forward P/E Portfolio RoIC Portfolio Turnover1
CED LTFV (PMS) 23.8x 22.5x-25.5x 30.0%3 8.4%
BSE 500 26.0x2 – 16.2%2 3.4%2
1 ‘sale of equity shares’ divided by ‘average portfolio value’ during the year to date period. 2Source: BSE. 3Portfolio Return on Invested Capital (RoIC) is on core equity positions.

 

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

Music Broadcast (Radio City): You will remember we had initiated an arbitrage position in equity and preference shares of Music Broadcast (aka Radio City) some time ago. From -30% this position broke-even last quarter. We had guided that we will sell the equity end of the position soon. We failed to sell the 2.3% Music Broadcast equity position in time. Music Broadcast equity share price went up by 50% i.e. from 16 to 24 last quarter. We sold just 10% of the position at that price. The price is down to 18. At this price our combined yield to maturity of equity and preference shares is at 7%. We are waiting for government’s decision on TRAI’s recommendations involving lowering of radio license fee and allowing news broadcast for 10min/hour on FM radio. These if accepted, shall support the stock. Nonetheless, it was a mistake to not sell at 24.

 

B2. MAJOR PORTFOLIO CHANGES

Bought: We further added to a major position in all accounts to take it from 5% to 9% of the portfolio. Since Oct’23, we have increased its weight from 3% to 9% We also added to two other positions in underweight accounts. We also initiated a toe hold position in a new stock. Including this, we now have 4 toehold positions, not scaled up yet. See these long tail of small positions as experiments, where we have cleared off the red flags, but are either waiting for more confidence in our ability to see their future or better price. They say, we should try to position ourselves to get lucky. This is one of the ways. We will either scale them up and share detailed rationale or in absence, exit them fully.

Sold: We fully exited from one minor position giving an internal rate of return (IRR) over 25% p.a.

 

B4. FLOWS AND SENTIMENTS

Smallcap’s Abhimanyu Moment?

Smallcap mutual fund schemes invest atleast 65% of their funds in companies ranking below 250 by market capitalisation (smallcaps). Most of these companies have low liquidity. Unprecedented flows have led to one way rise in smallcaps creating an illusion of safe asset class with high returns. Entering into smallcaps may have been the easy part for retail investors. Will they be able to timely exit during the next crisis or will they get stuck like Mahabharat’s Abhimanyu ?

As per latest liquidity stress test, top 5 smallcap mutual funds schemes (70% share) will take 22-60 days to liquidate 50% of their smallcap schemes. This is after assuming that liquidity will be 3x of last 90 days average daily trading volume.

This may be an optimistic assumption and therefore an optimistic timeline. The liquidity present in a buoyant market like current one, can vanish during a crash when everyone including mutual funds and other alternative investment vehicles like PMS & AIF look to exit at the same time. Circuit breakers of 10%/ 5%/ 2% will further scare away buyers. The Franklin debt fiasco of 2020 reminds us that when everyone wants to exit no one can exit. A part of smallcap schemes is parked in largecaps and we think that they will be sold first in the event of redemptions from smallcap schemes. Exit in smallcaps may lead to pressure on largecaps too even if they are not as frothy. Everything is connected to everything else!

 

C. OTHER THOUGHTS

Investing during elections

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

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

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

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

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

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

After rising 3x post Economic Liberalisation of July 1991, (partly due to the Harshad Mehta scam), the BSE Sensex remained flat for next 11 years even as the benefits of Liberalisation continued. There were 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.

***

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

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

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 – Dec’23 – Extracts

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EXECUTIVE SUMMARY

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

Dear Fellow Investors,

 

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

-Charlie Munger, 1924 – ∞

 

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

 

Better Thinking

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

                                           

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

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

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

 

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

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

 

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

 

Better Living

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

 

Better Investing

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

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

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

 

A. PERFORMANCE

 

A1. Statutory PMS Performance Disclosure

Portfolio YTD FY24 FY23  FY22 FY 21  FY 20* Since Inception* Outper-formance Cash Bal.
CED Long Term Focused Value (PMS) 28.1% -4.3% 14.9% 48.5% -9.5% 15.5% 27.0%
S&P BSE 500 TRI (includes dividends) 34.1% -0.9% 22.3% 78.6% -23.4% 19.7% -4.2% NIL
*From Jul 24, 2019; Since inception performance is annualised; Note: As required by SEBI, the returns are calculated on time weighted average (NAV) basis. The returns are NET OF ALL EXPENSES AND FEES. The returns pertain to ENTIRE portfolio of our one and only strategy. Individual investor returns may vary from above owing to different investment dates. Annual returns are audited but not verified by SEBI. W.e.f. April 01, 2023 SEBI requires use of any one from Nifty50, BSE500 or MSEI SX40 as a benchmark. We have chosen BSE500 as our benchmark as it best captures our multi-cap stance.

 

Protecting our wicket

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

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

 

A2. Underlying business performance

 

Past Twelve Months Earnings per unit (EPU)2 FY 2024 EPU (expected)
Sep 2023 8.61 8.0-9.03
Jun 2023 (Previous Quarter) 8.1 8.0-9.03
Sep 2022 (Previous Year) 5.4
Annual Change 59.3%
CAGR since inception (Jun 2019) 14%
1 Last four quarters ending Jun 2022. Results of Jun quarter are declared by Nov only. 2 EPU = Total normalised earnings accruing to the aggregate portfolio divided by units outstanding. 3 Please note: the forward earnings per unit (EPU) are conservative estimates of our expectation of future earnings of underlying companies. In past we have been wrong – often by wide margin – in our estimates and there is a risk that we are wrong about the forward EPU reported to you above. 4 Adjusted earnings.

 

Trailing Earnings: Trailing twelve months Earnings Per Unit (EPU) of underlying companies, grew by 59.3% (including effects of cash equivalents that earn ~5%). 

 

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

 

A3. Underlying portfolio parameters

 

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

 

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

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

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

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

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

B2. MAJOR PORTFOLIO CHANGES

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

When to sell

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

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

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

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

 

B4. FLOWS AND SENTIMENTS

Fearing absence of fear

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

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

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

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

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

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

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

 

C. OTHER THOUGHTS

India’s inflation in last 150 years

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

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

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

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

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

***

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

 

Wishing you a great 2024,

Team Compound Everyday Capital

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

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

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 Psychology, Quarterly Update

Letter to Investors – Sep’23 – Extracts

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EXECUTIVE SUMMARY

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

Dear Fellow Investors,

 

असतो मा सद्गमय। तमसो मा ज्योतिर्गमय। मृत्योर्मामृतं गमय ॥

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

– Brihadaranyaka Upanishad

 

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

 

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

 

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

 

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

 

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

 

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

 

**

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

 

A. PERFORMANCE

 

A1. Statutory PMS Performance Disclosure

Portfolio YTD FY24 FY23  FY22 FY 21  FY 20* Since Inception* Outper-formance Cash Bal.
CED Long Term Focused Value (PMS) 16.7% -4.3% 14.9% 48.5% -9.5% 13.9% 27.9%
S&P BSE 500 TRI (includes dividends) 19.4% -0.9% 22.3% 78.6% -23.4% 17.7% -3.8% NIL
*From Jul 24, 2019; Since inception performance is annualised; Note: As required by SEBI, the returns are calculated on time weighted average (NAV) basis. The returns are NET OF ALL EXPENSES AND FEES. The returns pertain to ENTIRE portfolio of our one and only strategy. Individual investor returns may vary from above owing to different investment dates. Annual returns are audited but not verified by SEBI. W.e.f. April 01, 2023 SEBI requires use of any one from Nifty50, BSE500 or MSEI SX40 as a benchmark. We have chosen BSE500 as our benchmark as it best captures our multi-cap stance.

 

Overvaluation in Smallcaps and Midcaps too

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

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

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

 

A2. Underlying business performance

 

Past Twelve Months Earnings per unit (EPU)2 FY 2024 EPU (expected)
Jun 2023 8.11 8.0-9.03
Mar 2023 (Previous Quarter) 5.9 6.5-7.53
Jun 2022 (Previous Year) 6.0
Annual Change 35%
CAGR since inception (Jun 2019) 12%
1 Last four quarters ending Jun 2022. Results of Jun quarter are declared by Nov only. 2 EPU = Total normalised earnings accruing to the aggregate portfolio divided by units outstanding. 3 Please note: the forward earnings per unit (EPU) are conservative estimates of our expectation of future earnings of underlying companies. In past we have been wrong – often by wide margin – in our estimates and there is a risk that we are wrong about the forward EPU reported to you above. 4 Adjusted earnings.

 

Trailing Earnings: Trailing twelve months Earnings Per Unit (EPU) of underlying companies, grew by 35% (including effects of cash equivalents that earn ~4-5%). 

 

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

 

A3. Underlying portfolio parameters

 

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

 

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

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

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

 

B2. MAJOR PORTFOLIO CHANGES

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

 

B4. FLOWS AND SENTIMENTS

 

Retail Euphoria

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

-Warren Buffett

 

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

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

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

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

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

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

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

 

C. OTHER THOUGHTS

Immediate Vs Delayed Outcomes

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

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

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

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

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

 

Multiple Mutual Fund Schemes = Below Average Performance

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

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

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

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

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

***

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

 

Kind regards,

Team Compound Everyday Capital

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

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

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

 

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Investment Process, Quarterly Update

Letter to Investors – Jun’23 – Extracts

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EXECUTIVE SUMMARY

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

Dear Fellow Investors,

 

Five hurdle checklist that reduces risks and improves returns

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

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

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

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

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

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

**

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

 

A. PERFORMANCE

 

A1. Statutory PMS Performance Disclosure

Portfolio YTD FY24 FY23  FY22 FY 21  FY 20* Since Inception* Outper-formance Cash Bal.
CED Long Term Focused Value (PMS) 9.9% -4.3% 14.9% 48.5% -9.5% 13.1% 27.0%
S&P BSE 500 TRI (includes dividends) 13.2% -0.9% 22.3% 78.6% -23.4% 17.3% -4.2% NIL
*From Jul 24, 2019; Since inception performance is annualised; Note: As required by SEBI, the returns are calculated on time weighted average (NAV) basis. The returns are NET OF ALL EXPENSES AND FEES. The returns pertain to ENTIRE portfolio of our one and only strategy. Individual investor returns may vary from above owing to different investment dates. Annual returns are audited but not verified by SEBI. W.e.f. April 01, 2023 SEBI requires use of any one from Nifty50, BSE500 or MSEI SX40 as a benchmark. We have chosen BSE500 as our benchmark as it best captures our multi-cap stance.

 

What are we waiting for?

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

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

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

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

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

Underperformance of a Style

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

 

A2. Underlying business performance

 

Past Twelve Months Earnings per unit (EPU)2 FY 2024 EPU (expected)
Mar 2023 5.91 6.5-7.53
Dec 2022 (Previous Quarter) 5.5
Mar 2022 (Previous Year) 6.2
Annual Change 16%4
CAGR since inception (Jun 2019) 10%
1 Last four quarters ending Jun 2022. Results of Jun quarter are declared by Nov only. 2 EPU = Total normalised earnings accruing to the aggregate portfolio divided by units outstanding. 3 Please note: the forward earnings per unit (EPU) are conservative estimates of our expectation of future earnings of underlying companies. In past we have been wrong – often by wide margin – in our estimates and there is a risk that we are wrong about the forward EPU reported to you above. 4 Adjusted earnings.

 

Trailing Earnings: As against our lowered expectation of 5.2-6.2, trailing twelve months Earnings Per Unit (EPU) of underlying companies came in at Rs 5.9. Excluding two companies with temporary and reversible losses, this is a growth of 16% over last year (including effects of cash equivalents that earn ~4-5%).  Due to Covid related one offs and higher cash balance our earnings growth since inception (2019) has been lower than our minimum target of 15%. However, we are set to reach there gradually.

 

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

 

A3. Underlying portfolio parameters

 

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

 

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

There were no mistakes in this quarter.

 

B2. MAJOR PORTFOLIO CHANGES

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

 

B3. UNDERLYING FUNDAMENTAL PERFORMANCE

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

 

B4. FLOWS AND SENTIMENTS

 

Going back to Zero Interest Rates?

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

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

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

 

C. OTHER THOUGHTS

Emperor has no clothes

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

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

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

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

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

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

***

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

 

Kind regards,

Team Compound Everyday Capital

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

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

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

 

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Investment Mistake, Quarterly Update

Letter to Investors – Mar’23 – Extracts

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EXECUTIVE SUMMARY

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

Dear Fellow Investors,

 

“Risk means more things can happen than will happen”

-Elroy Dimson

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

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

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

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

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

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

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

 

A. PERFORMANCE

 

A1. Statutory PMS Performance Disclosure

Portfolio FY23  FY22 FY 21  FY 20* Since Inception* Outper-formance Cash Bal.
CED Long Term Focused Value (PMS) -4.3% 14.9% 48.5% -9.5% 11.2% 30.0%
NSE Nifty 500 TRI (includes dividends) -1.2% 22.3% 77.6% -23.6% 14.3% -3.1% NIL
NSE Nifty 50 TRI (includes dividends) 0.6% 20.3% 72.5% -23.5% 13.5% -2.3% NIL
*From Jul 24, 2019; Since inception performance is annualised; Note: As required by SEBI, the returns are calculated on time weighted average (NAV) basis. The returns are NET OF ALL EXPENSES AND FEES. The returns pertain to ENTIRE portfolio of our one and only strategy. Individual investor returns may vary from above owing to different investment dates. Annual returns are audited but not verified by SEBI.

 

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

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

 

A2. Underlying business performance

 

Past Twelve Months Earnings per unit (EPU)2 FY 2023 EPU (expected)
Dec 2022 5.51 5.2-6.23
Sep 2022 (Previous Quarter) 5.4 5.2-6.3
Dec 2021 (Previous Year) 5.9
Annual Change 11%4
CAGR since inception (Jun 2019) 6%
1 Last four quarters ending Jun 2022. Results of Jun quarter are declared by Nov only. 2 EPU = Total normalised earnings accruing to the aggregate portfolio divided by units outstanding. 3 Please note: the forward earnings per unit (EPU) are conservative estimates of our expectation of future earnings of underlying companies. In past we have been wrong – often by wide margin – in our estimates and there is a risk that we are wrong about the forward EPU reported to you above. 4 Adjusted earnings.

 

Trailing Earnings: Adjusting for temporary losses in the base and current period, trailing twelve months Earnings Per Unit (EPU) of underlying companies grew by 11% (including effects of cash equivalents that earn ~5%). 

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

 

A3. Underlying portfolio parameters

 

Mar 2023 Trailing P/E Forward P/E Portfolio RoE Portfolio Turnover1
CED LTFV (PMS) 26.8x 25.5x 16.8%4 5.5%
NSE 50 21.1x2 – 15.1%3 –
NSE 500 20.4x2 – 13.7%3 –
1 ‘sale of equity shares’ divided by ‘average portfolio value’ during the year to date period. 2 Source: NSE. 3Source: Ace Equity. 4Excluding cash equivalents. 

 

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

Mistake: Music Broadcast Bonus Preference Shares (Special Situation)

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

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

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

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

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

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

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

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

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

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

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

**

Previous mistakes (2014-2018): From our two past mistakes- “Cera Sanitaryware (2014)” and “2015-16” – we learnt that unless fundamentals are extremely compelling, it is better to be gradual in selling and buying respectively. From our past mistake on “Treehouse Education” we have learnt that bad management deserves a low price, it’s seldom a bargain. In Dish TV we underestimated the competitive disruption but thankfully sold at breakeven. Tata Motors DVR taught us that cyclical investing requires a different mindset to moat investing and one needs to be quick to act when external environment turns adverse. In Talwalkars, we learnt that assessing promoter quality is a difficult job and we should err on the side of caution irrespective of how cheap quantitative valuations look. From DB Corp we learned that industries in structural decline will fail to get high multiples even if the industry is consolidated, competition limited and free cash flows healthy. 

B2. MAJOR PORTFOLIO CHANGES

We increased our tracking position to a ~4% position in one of the companies. In addition we added to our position in four other companies as the prices became reasonable.

 

B4. FLOWS AND SENTIMENTS

 

SVB and Flight to Safety

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

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

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

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

***

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

C. OTHER THOUGHTS

An “investment” product to strongly avoid

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

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

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

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

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

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

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

***

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

 

Kind regards,

Team Compound Everyday Capital

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

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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 – Dec’22 – Extracts

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EXECUTIVE SUMMARY

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

Dear Fellow Investors,

 

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

-the Mahabharat

We all have grown up listening to this Mahabharat  story on importance of focus. Whether its archery or investing, great achievements demand undivided focus. The bird’s eye equivalent in long term investing that demands undivided focus is company’s intrinsic value (or economic worth, in simpler terms). For, only that can help us decide if a company is undervalued or overvalued versus its stock price. Everything else, is noise.

To recall, a company’s intrinsic value is the present value of its future free cash flows. Two broad components of intrinsic value calculation are (1) future free cash flows (i.e. cash earnings less investments) and (2) future interest rates to discount those cashflows to their present values (aka discount rates).

Assessing intrinsic value, thus, requires looking into the future – for both cash flows and discount rates. Unlike Arjun’s bird in the Mahabharat that is still and clearly visible, intrinsic value is therefore a moving and hazy bird.

Future cashflows: Either due to their nature or our current ignorance, we cannot imagine future cash flows of most of the companies. It’s futile to even attempt their intrinsic value calculations. For, in archery parlance, we cannot even see the bird. Nonetheless, there is a sub set of companies where we can. Mostly these companies provide essential, under-penetrated or non-substitutable products/ services competitively and are run by able and honest management. They are expected to see reasonable revenue growth and high returns on capital. Here is where we limit ourselves looking.

Future interest rates: For intrinsic value purposes we are concerned, not with interest rates of next quarter or year, but with long term future interest rates. Just as assuming very low long term future interest rates is mistaken (last 10 years), so is assuming very high long term interest rates (temptation today). We need to assume moderate interest rates over long term in our intrinsic value assessment. Given that 30-yr Indian government securities are yielding around 7.5% today, 4% is too low, and 15% too high for discount rate. Anywhere between 10%-12% sounds okay, today.

We need to place all incoming information including the current inflation and interest rate scare in the above backdrop. As detailed in the June’22 letter, yes, by adversely affecting cash flows and interest rates, inflation does lower intrinsic value of most companies. However for minority of companies, it does not. Or not at least commensurate with price erosion that happens due to near term unfounded inflation fears. Discipline to limit ourselves to such companies and focus on their intrinsic values that correctly embeds future cashflows and long term future interest rates, therefore, offers opportunity to take advantage that this dislocation triggers.

***

While the world markets were down 10%-30% for the calendar year 2022, India’s Nifty50 index ended in green. This is one of the biggest outperformances in history versus many countries including the US. Though index is near its peak, broader market is not. Within our coverage too, there are a few companies that are still down 10%-30% from their previous highs without material change in their intrinsic values. We are deploying capital here and retain neutral stance.

A. PERFORMANCE

 

A1. Statutory PMS Performance Disclosure

Portfolio YTD FY23  FY22 FY 21  FY 20* Since Inception* Outper-formance Avg YTD Cash  Bal.
CED Long Term Focused Value (PMS) 0.5% 14.9% 48.5% -9.5% 13.6% 36.0%
NSE Nifty 500 TRI (includes dividends) 4.7% 22.3% 77.6% -23.6% 17.4% -3.8% NIL
NSE Nifty 50 TRI (includes dividends) 4.8% 20.3% 72.5% -23.5% 15.9% -2.3% NIL
*From Jul 24, 2019; Since inception performance is annualised; Note: As required by SEBI, the returns are calculated on time weighted average (NAV) basis. The returns are NET OF ALL EXPENSES AND FEES. The returns pertain to ENTIRE portfolio of our one and only strategy. Individual investor returns may vary from above owing to different investment dates. Annual returns are audited but not verified by SEBI.

 

Care while Benchmarking Performance

Regulations require us to benchmark our performance with an index every quarter. While over a full cycle such comparison is useful, we argue that it is dangerous during a one way rising and expensive market like the one of last 2 years. This is because all indices including Nifty50 or Nifty500 are value agnostic indices. In other words, this means that they will increase the weight of constituent stocks that have done well and vice versa irrespective of their intrinsic values (Eg: Adani group stocks). In a rising market, expensive stocks – which a prudent investment approach would normally avoid –will get higher weight in indices helping indices to post higher returns in near term albeit at a higher risk.

Over 3-5 years, falling 5% when indices fall 10% is not a desirable outcome even if we beat indices, for we would have lost even more after accounting for inflation. Investing aggressively in an expensive market like today has higher chances of above outcome. The only antidote to safeguard from this malady is not to overpay and wait for correct prices. Hence our higher than usual cash balance. Problem with this approach is that in short run expensive stocks can get more expensive, propel indices, and make a cautious approach like ours look foolish when compared quarterly with these indices. It is like comparing a marathoner with a sprinter. Both are running different races.

Thus, while looking at the above statutory table every quarter, you should remind yourselves that our race is against inflation first and indices later; absolute returns first and relative returns later. You should therefore prefer checking whether on absolute basis we are able to beat inflation over 3-5 year period. That’s the minimum benchmark we need to beat. Given that our incentives are linked to performance and not AUMs, and we understand what we are doing, we will do better than that.

 

A2. Underlying business performance

 

Past Twelve Months Earnings per unit (EPU)2 FY 2023 EPU (expected)
Sep 2022 5.41 5.2-6.23
Jun 2022 (Previous Quarter) 6.0 6.2-7.23
Sep 2021 (Previous Year) 5.7
Annual Change 2%4
CAGR since inception (Jun 2019) 9%
1 Last four quarters ending Jun 2022. Results of Jun quarter are declared by Nov only. 2 EPU = Total normalised earnings accruing to the aggregate portfolio divided by units outstanding. 3 Please note: the forward earnings per unit (EPU) are conservative estimates of our expectation of future earnings of underlying companies. In past we have been wrong – often by wide margin – in our estimates and there is a risk that we are wrong about the forward EPU reported to you above. 4 Adjusted earnings.

 

Trailing Earnings: Adjusted trailing twelve months Earnings Per Unit (EPU) of underlying companies grew by 2% (including effects of cash equivalents that earn ~4%). 

 

1-Yr Forward Earnings: Against our start of the year expectation of earnings per unit of Rs 6.2-7.2 for FY23, we are trimming the estimate to Rs 5.2-6.

 

A3. Underlying portfolio parameters

 

Dec 2022 Trailing P/E Forward P/E Portfolio RoE Portfolio Turnover1
CED LTFV (PMS) 28.7x 24.6x-29.8x 17.9%4 5.6%
NSE 50 21.8x2 – 15.0%3 –
NSE 500 22.9x2 – 13.7%3 –
1 ‘sale of equity shares’ divided by ‘average portfolio value’ during the year to date period. 2 Source: NSE. 3Source: Ace Equity. 4Excluding cash equivalents. 

 

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

We continue to retain higher than usual cash balance due to lack of abundant opportunities. Our incentives and objectives encourage us to act only when it makes sense. In hindsight of rising markets, this might feel like folly, however that’s the cost of running a conservative investment operation. It, nonetheless, pays out over longer term.

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

B2. MAJOR PORTFOLIO CHANGES

We added to our existing positions in five companies in underweight accounts. Additionally, we shifted liquid funds from Nippon Liquid ETFs to ICICI Pru Liquid ETFs. While both have similar risk-return profile, the latter has 44bp (Rs 440 per lac) lower expense ratio. The reason we shifted now and not before was liquidity. We were waiting for average daily liquidity to reach adequate amount, which has reached now. Transaction cost for this switch was 0.0042% (or Rs 4 per lac). There was no brokerage or STT paid.  Getting Rs 440 p.a. by paying Rs 4 onetime (per Rs 1 lac), and ensuring liquidity, was a good deal.

Liquid Funds Management

We park all our cash in liquid ETFs. You may ask why we choose liquid ETFs and not liquid mutual funds which give slightly higher returns. As of writing of the letter, last one year return of liquid ETFs were around 4% and liquid mutual funds were around 4.3%. Secondly you may also ask is there a merit in investing these funds in other debt products like short term funds or PSU funds to improve the returns.

We keep cash to capitalise on equity opportunities that volatile markets often throw. Liquid mutual fund money is available on T+1 to T+3 days (holidays of mutual funds are difference from equity markets). Whereas liquid ETFs are immediately available. If we have to buy an equity position today, we can buy that stock and sell liquid ETF on exchange on the same date. This flexibility is important as many times opportunities are available only for limited time.

Secondly on return part, we donot want to take any credit or duration risk on the surplus cash that we hold. For, when calamity strikes and opportunities rise in equities, riskier or long duration debt instruments can entail capital loss at the very time when we want cash to be intact. We want to protect the dry powder that will be useful to buy equities during trouble. Consider liquid ETFs as current accounts yielding 4%.

So while ETFs deliver lower returns, they provide better flexibility and safety.

B4. FLOWS AND SENTIMENTS

 

From TINA to TANIA

The low interest rate and abundant capital regime of 2010-2021 was like a rising tide that lifted all asset prices. As safe investment alternatives were not remunerative, money chased riskier asset classes like growth equities, private equities, venture capital and even cryptos in search for yields. In those 11 years, Nasdaq Composite index (proxy for tech stocks) rose 7x, private equity AUM size grew 4x and crypto went from nothing to 3trn$. This regime has been popularly called TINA – there is no alternative.

Today with rapidly rising interest rates and cautious capital, that rising tide has gone out. TINA is giving way to TANIA – there are new investment alternatives. US treasuries that used to yield 0% few years ago yield 4% today. In India too, fixed deposit rates are rising and now offering 7% risk free returns. Those seeking risk free returns have more alternatives than just risky assets. More so when risky assets have been badly bruised. US tech-heavy Nasdaq Composite index was down 33% in CY2022. Crypto market cap is down 70% from 3trn$ to 800mn$ and has seen bankruptcy/ collapse of FTX, Luna etc.

When interest rate is 1%, Rs 91 are needed today to get Rs 100 in 10 years. At 4% only Rs 67 are needed to reach to Rs 100 in 10 years. The 10-year present value of Rs 100 falls from Rs. 91 to Rs. 67 when interest rates rises from 1% to 4%. As interest rates rise, investors need to keep this in mind while deciding what multiple to pay for equities. Average valuations multiples of last 10 years have an upward bias due to the TINA regime. Using them in TANIA regime to conclude whether current valuations are cheap might be a mistake. Higher interest rates pushes the average valuation curve of all assets downwards. This might bring back the preference for profitable and cash earning companies versus high flying but unprofitable growth/ tech companies. Sensible investing might be back soon.

 

C. OTHER THOUGHTS

Markets – A Voting Machine In Short Run

When a stock grows 3x or more in 3 years or less, it can have a material impact on portfolio returns (if given adequate weight). Most often when we scan such a list especially during market high, we scratch our heads as to why some stocks that we understand went up so much. And how does price and earnings of these stocks perform in future? Is market right to bid them so high?

With this question in mind we tried to find out how the same turned out in the past. We asked this question:

Question: How did the earnings and stock price grew in next 5-7 years for those stocks that went up atleast 3 times in a 3 year rolling period between 2012-2017 (mini bull run).

Interpretation: For example, share price of company A went up 10x between 2013-2016. We are interested in finding how did the earnings and stock price grow for the company A between 2016-2022.

Key Findings*:

  1. There were 560 companies whose stock shot up over ‘3x or more’ in a rolling 3-year period between 2012-2017.
  2. Just over a fourth of these companies were able to grow operating earnings at 15%+ CAGR over next 5-7 years. Median stock returns for these companies were 16% CAGR over next 5-7 years.
  3. For balance three-fourth of companies – i.e. companies whose stocks grew 3x or more in 2012-17 but operating earnings grew less 15% in next 5-7 years – their median stock returns were -2% CAGR over those 5-7 year period.

*We have evaluated a very small period of 2012-2022. We have looked at only companies with market cap over Rs. 500cr as on 2017. We have not included companies getting listed after 2017. To remove effects of extraordinary items, we have used operating profits excluding other income.

Between 2012 and 2022, broadly three out of four companies were not able to sustain their earnings or share price performance after sharp share price jump.

In short run a stock that runs up sharply may be due to non-fundamental or temporary reasons. Most of such stocks may not be able to deliver earnings performance warranted by such high price jump and fail to protect or grow returns.

As Benjamin Graham said: “Markets are voting machine in the short run and weighing machine in the long run.”

***

 

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

 

Kind regards and wishing you a blissful 2023,

Team Compound Everyday Capital

Sumit Sarda, Surbhi Kabra Sarda, Punit Patni, Arpit Parmar, Sachin Shrivastava, Mukta Mungre and Sanjana Sukhtankar

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

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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