Business Analysis

Lending Business 101

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At its core, a lending business has three main profit impacting activities: (a) borrowing, (b) lending and (c) recovering the principal with interest. In theory, the best lender is someone who can borrow at lowest rates, lend at highest rates and recover all with interest. In practice, this is an impossible combination especially the latter two activities because lending rates and asset quality usually are inversely related.

High interest rates are usually charged to high risk borrowers or asset classes wherein chances of default are high. In practice, a good lender is someone who has discipline in underwriting and willingness to walk away if he is not remunerated for the risk assumed. Owing to incentive-structures that drive growth at any cost, very few lenders pass this test.

Another hallmark of a good lender is access to a diversified, granular base of low cost deposits. Concentration in deposit base increases risk of run on the lender. That coupled with concentration in loan book has been recipe for bank closures world over in past. Only a lender with trust and wide distribution network can command a low cost and diversified deposit base.

In lending, liabilities are the real assets and assets are real liabilities.

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Investment Process, Investment Psychology

Humility & Conviction

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Psychology plays an important role in investing. A crucial component of investment psychology is the delicate balance between humility and conviction. In investing, we deal with future. Assessment of future outcomes and their probabilities requires humility – acknowledgment of the fact that we may not know everything and what we know may turn out to be wrong.  Just humility will, however, lead to nowhere. Even after factoring in the possibilities of being ignorant and wrong, if Mr. Market provides an opportunity, we got to be ready to act with conviction.

The importance of this delicate balance between humility and conviction should shape one’s investment behavior.

Humility translates into various aspects of investment process namely – conservative assessment of value, investing with a margin of safety, diversifying, willingness to hold cash and sit tight when opportunities abate. To gain conviction, one needs to understand the underlying business, have a long term orientation and bet strongly when odds are in favour.

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Business Analysis, Macroeconomics

Earnings and Multiples Cycle

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One of the few constants in realm of investing is that most of the variables – interest rates, commodity prices, and profit margins – move in cycles and not straight rising/ falling lines. In addition to demand and supply dynamics, human emotions especially greed and fear play a contributing role in creation, sustenance and reversal of cycles. When things go well, greed fuels the rise of a cycle and when things do not go well, fear exacerbates the fall.

A corollary to existence of cycles is the tendency of these variables to revert to mean. Of specific interest to us is the position of earnings and multiples assigned to the earnings in that cycle. Not only profits revert to mean, the multiples that market is willing to pay for the earnings also revert to mean. In a downwards earnings curve, markets – dictated by emotions-  often assume that bad times will continue and assign lower multiple resulting in double down effect on prices. And, vice versa in good times. If our belief is that earnings will revert to mean, we can be reasonably sure that multiples too will revert to mean.

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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

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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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