Letter to Investors – March 2020 – Extracts

April 6, 2020 No Comments

EXECUTIVE SUMMARY

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

Dear Fellow Investors,

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

Poem “IF”, Rudyard Kipling

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

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

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

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

A. PERFORMANCE

A1. Statutory PMS Performance Disclosure

Portfolio	Current YTD Jul 24’19 to Mar 31’20	Outper- formance	Average cash bal.
CED Long Term Focused Value (PMS)	-9.5%		23%
NSE Nifty 500 TRI(including dividends)	-23.6%	14.1%	NIL
NSE Nifty 50 TRI (including dividends)	-23.5%	14.0%	NIL
Note: Commenced on Jul 24, 2019. As required by SEBI, the returns are calculated on time weighted average (NAV) basis. The returns are NET OF ALL EXPENSES AND FEES. The returns pertain to ENTIRE portfolio of our one and only strategy. Individual investor returns may vary from above owing to different investment dates.

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

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

A2. Performance Disclosure pre-PMS

Portfolio	Since Inception (CAGR) Aug 2012-Mar 2019	Outperformance (Annualised)
Erstwhile Multi Family Office (7 yrs)	17.4%
NSE Nifty 500 (including dividends)	14.5%	2.9%
NSE Nifty 50 (including dividends)	13.7%	3.7%

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

A3. Underlying business performance

Period	Past twelve months¹	FY 2021 EPU (expected)³
	Earnings per unit (EPU)²	Earnings per unit (EPU)
Mar 2020	5.7	UE³
Dec 2019	5.1	–
Annual Change (vs Mar19)	16.3%	–
¹Last four quarters ending Dec 2019. Results of Mar’20 quarter will be declared by Jun’20 only. ² Total adjusted earnings accruing to the aggregate portfolio divided by units outstanding. ³Please note: the forward earnings per unit (EPU) are conservative estimates of our expectation of future adjusted earnings of underlying companies. In past we have been wrong – often by wide margin – in our estimates and there is a risk that we are wrong about the forward EPU reported to you above. UE – Under evaluation

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

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

A4. Underlying portfolio parameters

Dec 2019	Trailing P/E	Forward P/E	Portfolio RoE	Portfolio Turnover¹
CED LTFV PMS	15.9x	NA	19.8%	3.7%
NSE 50	19.4x³	–	13.7%⁴	–
NSE 500	21.8x³	–	8.9%⁴	–
¹ ‘Higher of purchases or sales of equity shares’ divided by ‘average portfolio value’ during the period. We built our portfolio this quarter and did not sell anything. ² Monthly average ³ Source: NSE ⁴ Source: Capitaline

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

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

DB CORP

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

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

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

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

B4. FLOWS AND SENTIMENTS

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

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

C. OTHER THOUGHTS

TACKLING FEAR

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

-Benjamin Graham, The Intelligent Investor

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

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

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

***

SHOULDERS OF GIANTS

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

In the Bhagvad Gita, Shri Krishna tells Arjun –

“दुःखेष्वनुद्विग्नमनाः सुखेषु विगतस्पृहः ।

वीतरागभयक्रोधः स्थितधीर्मुनिरुच्यते ।।”

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

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

-Chapter 2 Verse 56, Shrimad Bhagvad Gita

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

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

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

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

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

Late Mr. Chandrakant Sampat on investing during crisis:

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

Warren Buffet on the 2008 crash:

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

***

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

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

This too shall pass…

Kind regards,

Team Compound Everyday Capital

—————————————————————————————————————————————————–

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.

Investment Process, Value Investing

QAAP/ GAAP

December 22, 2019 No Comments

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

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

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

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

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

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

Investment Psychology, Value Investing

Behaviour As An Edge

December 21, 2019 No Comments

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

-Jeff Bezos

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

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

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

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

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

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

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

Macroeconomics

Assessing Demonetisation’s Impact on Indian Equity Markets

December 9, 2016 No Comments

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

Jean-Baptiste Alphonse Karr

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Government – the chief actor

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

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

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

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

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

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

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

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

Investment Process, Value Investing

Owners’ Manual

August 24, 2016 No Comments

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

Here it goes:

Partners’ trust is our asset, their money our liability

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

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

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

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

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

Second key is to buy at or below intrinsic value

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

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

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

Actions driven by rationality rather than emotions

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

Reporting philosophy

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

Investment Psychology, Value Investing

Human Diffuculties in Value Investing

August 24, 2016 No Comments

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

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

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

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

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

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

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