Investor Memo March 2024

Dear Investors,

The following chart depicts our returns viz BSE 500 TRI:

In this month’s update, we discuss our approach of tackling the frothy valuations in small cap stocks. Since we are mainly a smallcap investment strategy, our investors may be concerned whether small caps stocks have peaked out and are poised for an imminent correction. 

Valuations of small cap stocks are at an all-time high, and it is very highly likely that returns will be muted over the next 1-2 years. However, we don’t think it means this is the time to exit or not initiate investments in small cap stocks. We don’t believe it is possible to time the market and sitting out will lead to missing opportunities that may not deliver in the near term but will deliver outsized returns when the next bull phase starts, the timing of which no one can predict.

Our investment approach is a bottom up one in that we work to identify good quality businesses run by honest and driven management at attractive valuations. All 3 aspects:  Business quality, attractive valuation and stellar management are equally important, and we don’t compromise on one. In times of stretched valuations like current, we find it hard to invest in reasonably valued opportunities so naturally our rate of capital deployment for new client accounts slows down. However, we won’t recommend new investors to sit out as markets are volatile and can correct substantially on any given day thus giving us the opportunity to deploy capital. For e.g., the small cap indices corrected by more than 10% over 1st-13th March while individual small cap stocks corrected by 25-30%. We had cash in all our client accounts that we invested to take advantage of the corrected prices.  Moreover, as we mentioned in our earlier updates, we have been exiting stocks with stretched valuations in our portfolio. So, our valuation conscious approach takes care of frothy market situations like the current one.

However, we will not take an overall cash call to liquidate investments to reach a certain cash level like 25% of portfolio value. We have consistently communicated that we don’t time the market as we believe it is impossible to do so in a manner that can create meaningful alpha consistently over time. So, we will not disinvest client portfolios just because the market has reached a certain level, or the past 12 months return has been outsized. The problem with this approach is that it is impossible to exactly time your exit and re-entry. For e.g, the BSE Smallcap index has been appreciating since April 2023 and small cap valuations started to turn expensive back in July August last year. So, objectively one should have exited his/her investments at that time only. If one had done that then he/she would have missed ~20% appreciation from those levels even after the recent correction in March. 

Moreover, there is no clear rule as to when one should re-enter the market. Should we re-enter after a 15%, 25% or even larger correction? There is no guarantee that when the market, as represented by a benchmark index, will correct to that level. Also, tracking an index in this way will make us miss many good growing businesses during this period of sitting out. Valuation is just one aspect of the investing framework; earnings growth is an equally important one. Good companies with growing earnings catch up to their expensive valuations. So, just to reiterate, we don’t take cash calls depending on macro factors or indices hitting certain levels. It is a bottom-up call for us whether an existing investment has become too expensive to hold or a good business is available at a reasonable enough valuation to buy.

Just as an exercise, we wanted to see how market timing has performed historically. We used the S&P 500 as the benchmark index as we wanted a trading history of at least 50 years to have enough data points. Below is the S&P 500 chart for past 50 years

To evaluate the upside from trying to time the market, we compared the returns generated by 2 sets of investors over the last 50 years. The first investor group only invests when the S&P 500 hits an all-time high. There will be multiple instances when the S&P 500 would have hit an all-time high over the last 50 years. The table below shows the median, min and max of the 1 year, 3 years, 5 years and 10 years returns (CAGR in case of periods more than 1 year) if one invested at all-time high points of S&P 500 over past 50 years:

The second investor group only invests when the S&P 500 corrects by 20% or more from previous all-time high over the last 50 years. The table below shows the median, min and max of the 1 year, 3 years, 5 years and 10 years returns (CAGR in case of periods more than 1 year) if one invested at all-time high points of S&P 500 over past 50 years:

The approach of the first investor group can be viewed as aggressive as they invest only at market highs. On the other hand, the second group is clearly timing the market and only invests when the S&P 500 has corrected by a substantial amount of 20% or more. However, there is no material difference in the returns generated by the 2 different approaches. In fact, the median returns generated by the all-time high investing approach are somewhat higher than the return generated by the market timing approach across all periods. This can be explained by the fact that in equities, the bull phases last much longer than bear phases. 

For example, the bull cycle of US equities (one can look at NADAQ or S&P 500) that started in mid-2009 lasted till March 2020.  During this period, the S&P 500 did not witness even a single correction of 20% or more. The bull cycle ended with a sharp and quick correction in global equities when Covid-19 pandemic broke out in March 2020. As equities reflect how well an economy and hence businesses are doing, it makes sense that bull phases last much longer than bear phases as economies (or per capita GDP) expand over time. 

A key risk of exiting the market or stopping follow-on or new investment in equities at market highs is that it is not known how long a bull phase will last. More so for an economy like India that is expected to keep growing at 6-7% real rates over next 25-30 years. So, how does one know that the current market high is not a part of 10-year or longer bull phase of Indian equities? Staying out of Indian equities during such a phase will lead to missing out on an exceptional wealth creation opportunity. This is not to suggest at all that Indian equities will move in a linear upward fashion. That will be a nightmare for valuation conscious investors like us as we will find it very difficult to invest in reasonably priced opportunities. In fact, equities are volatile by nature, especially small cap stocks due to their low institutional ownership and thus will keep correcting from time to time. This will give us an opportunity to invest during corrections for patient investors like us.   

Just reiterating the key takeaway from this, we agree that valuations of Indian small cap stocks are stretched, and we have become more cautious in making new investments as well as are exiting expensive invested positions. However, we don’t believe market timing moves like taking portfolio level cash calls, sitting out of the market and waiting for corrections to top up or initiate equity investments are the way to respond to expensive market levels.

Regards, 

Prescient Capital    

Investor Memo Feb 2024

Dear Investors,

The following chart depicts our returns viz BSE 500 TRI:

In this monthly update we plan to highlight the performance of our portfolio companies, their key characteristics and our risk mitigation for a downside. 

Q3 was a healthy quarter for the portfolio as the portfolio companies demonstrated a YOY ~12% sales and ~27% earnings growth respectively. 

Our portfolio also delivered a return of 18% during the Sept 2023-Jan 2024 period when compared to 14.5% for the BSE 500 TRI Index. 

Our funds cash balance level is at 22% (on a cost basis). 

As we speak, our portfolios trailing twelve months PE multiple is 28.2. Refer to the chart below where we compare our portfolios Trailing PE multiple to that of the BSE SENSEX.

Our portfolio has moved from trading at a discount to the BSE SENSEX index to trading at a premium to the same. The trend is indicative of the run the small and mid cap stocks have seen with respect to the Index. 

The above thought may trigger a question on our capital deployment strategy for the near term. Conservative investors like us are first preserving capital and then deploying capital. We are exiting past investments which are expensive in valuation or are underperforming due to a delayed execution.

In the last 2 months we have exited the following portfolio companies: 

• JB Chemical (Exit at a TTM PE range of 45-50x), 

• Matrimony (slower than expected new customer growth), 

• SBI Cards (sector hitting a bad credit cycle), 

• Mangalam Cement (trading at mid-expensive valuation), 

• Amrutanjan (Exit at a TTM PE range of 45-50x)

During the same period, we have initiated positions in: 

• Bharat Bijlee: BBL is one of the leaders in the electrical engineering industry in India. The company has two primary business segments: Power Systems (~46% of revenue) segment that comprises Transformers and Projects divisions; and Industrial Systems segment (~56% of revenue) comprising Electric Motors, Drives & Industrial Automation and Elevator Systems divisions. There is a strong revival in the Indian capital goods sector, especially power equipment segment, owing to revival in private industrial capex, shift towards renewable power, govt. push on infra development as well as on power transmission capex, etc. We have initiated the purchase of BBL at a TTM PE of ~ 22x. 

• FDC Limited: FDC is a backward integrated pharmaceutical company manufacturing and selling both APIs (intermediates) and formulations in India and international markets. ~81% of its FY23 revenue came from manufacturing and marketing branded formulations in India. We have initiated the purchase of FDC at a TTM PE of ~ 25x.

• Orient Electric: OE is a household name in consumer durables. It is the no.2 player in fans and the no.3 player in room coolers. The company stands out in its balance sheet prudence (ROCE of ~ 23%) and a negative working capital cycle. The performance of the durables sector has been lacklustre in the last 18 months due to: change in energy norms of fans, weak rural demand and a high cost inflation. The stock has corrected by ~ 50% from its peak and is attractively priced at a Market cap to Cash flow from Ops of ~ 22x. 

• Indigo Paints: Indigo Paints is the 5th largest paints brand in India. It has been the fastest growing (>20% sales growth) paints brand for the last 8-9 years and it’s on the ground execution stands out. The paints industry has strong branding and channel related entry barriers. Indigo has demonstrated the ability to create a recall and channel acceptance over the last 8-9 years. The stock is down by ~ 50% from its listing price. We have initiated the purchase of Indigo at a TTM PE of ~ 45x.     

Some of you may rightfully have concerns about where the markets are and the rich valuations of the small and mid-cap stocks. Through this memo we also wanted to capture some key aspects of our portfolio companies and explain why the current portfolio is of high quality and is trading at a nearabout reasonable valuation. 

• Our portfolio has been demonstrating a 3 year sales and profit growth of 13% and 21% respectively. In the last quarter, the sales and earnings of our portfolio companies have grown at 12% and 27% respectively. 

• Our portfolio companies do a very good job of converting profits to cash flows, implying they are balance sheet efficient. They do not lock in capital in working capital and/or capex. Our portfolio companies convert ~88% of the profits into cash flow from operations. The closer this ratio is to 100%, the more capital efficient a business is.  

• Our portfolio is also low on leverage. The debt to equity ratio of the portfolio is 0.06. Typically low leverage is a sign of a healthy balance sheet. The portfolio has a net working capital days of ~ 50 days, implying capital doesn’t get stuck in debtors, raw material and finished goods inventory. Our portfolio companies convert Rs 1 of sales to Rs 1 of cash in ~ 50 days.  

• Our portfolio’s trailing 12 months Price to Earnings ratio is 28.2x and it has demonstrated an earnings growth of 21% in the last 3 years. Assuming the same earnings growth continues, the portfolio is trading at a PEG ratio of 1.5x. The PEG ratio highlights the PE multiple one is willing to pay for earnings growth. The closer this multiple is to 1, the more conservative the entry valuation is. As we speak, we have a portfolio that is nearabout reasonably valued. Having said this, we would want our portfolio’s PEG ratio to be closer to 1x.

One may also ask: Despite a strong portfolio, can the portfolio correct from hereon? The answer is “absolutely yes”. The chart below shows our portfolio's returns and drawdowns viz the index.

Since our inception 52 months back in Oct 2019, the BSE 500 index has given negative returns in 18 months and positive returns in 34 months. In these 18 months of negative returns, our portfolio has corrected less than the index in 16 of the 18 months. Implying our drawdown/correction has been lower than the index in 16 of the last 18 drawdowns/corrections. 

In the 34 months of positive returns by the Index, our portfolio has beaten the Index returns in 17 months and it has underperformed the Index in the balance 17 months. 

This implies that our portfolio has a more robust performance during drawdowns/corrections than during bull runs. The key reason for the same is our discipline of investing in great promoters at a reasonable price. During periods of correction, market participants tend to deploy capital in fundamentally strong businesses and hence these correct lower than the others. 

We hope this data helps you understand how we have been building our portfolio to mitigate risk of a drawdown/correction in the future. 

To conclude, investing is a longer term game and any investor has to bear a period of correction/drawdown to enjoy the returns thereafter. We too have faced periods of a drawdown of 10-18% across times. In the longer term, we however have been compounding capital at 36% since inception when compared to ~ 20% for the Index.

What makes the recovery post a drawdown more predictable is the earnings growth of the companies and the economy at the macro level. Per us, Indian manufacturing, housing and services are growing at a decent pace, and are expected to do well over the longer term too. The longer term outlook for most of the sectors in India look good.

Investor Memo Jan 2024

Dear Investors,

The following chart depicts our returns viz BSE 500 TRI:

In this month’s newsletter, we will share some general musings on the market. Since it is the beginning of 2024, it is natural to ponder whether Indian equities will deliver positive returns this year. Of course, no one knows the answer to that and for a long-term investor, it should not be a matter of concern. However, we share the historical annual performance of BSE Sensex over the last 43 years. Sensex has delivered negative returns in 10 out of the last 43 years so the chance of positive performance is generally high at 75% in any given year. On the other hand, Sensex has been on its longest streak of consecutive positive returns over the last 8 years so the probability of this streak getting broken is high this year. It is up to you to be optimistic or pessimistic about 2024 performance.

The graphic below highlights how strong the inflow of funds from domestic investors (mainly MF SIPs) has been in the last 10K journey of BSE Sensex from 60K to 70K. The strong domestic investor inflow has completely nullified the negative impact of FPI outflows during this last 10K journey of Sensex. In fact, it is the first time in its history that Sensex appreciated by 10K despite strong selling by FPIs. This is truly a moment that shows the Indian domestic investors have arrived and fully control the direction of Indian equity market, which is no longer solely dependent on FPI inflows.

The chart below shows the composition of Indian household assets at end of March 2022. Even after the strong domestic inflow into Indian equities over last 3-4 years (refer to graphic above), equities just make up 4.8% of total Indian household assets. This is significantly lower than in the US, where equities make up ~25% of household assets. Moreover, if we look at the trend over last 15 years, the share of equities as % of Indian household assets has not moved up significantly. So, there is a large headroom for equities to gain popularity among Indian investors and increase its share of Indian wealth.

Source: RBI

Coming to current valuation, the charts below highlight the valuation of large cap, mid cap and small cap indices at the end of 2023. As expected, valuations of mid and small cap indices are at a premium to their long-term average while large cap valuation is at long term average level. Since March 2020, small and mid cap stocks have in general delivered much better returns than large cap stocks. As we are investors in small and mid cap companies, we have been cautious in our approach (we have discussed the same several times over the last few months). We are exiting stocks whose valuations have become too expensive and leave no room for further upside. Also, we have been cautious in deploying additional capital, that we are investing in few opportunities where valuations are still reasonable with decent growth prospects.

However, we do want to highlight that small and mid cap companies have delivered much better earnings growth in the last 3-4 years so the higher returns in these stocks is justified. This is because certain sectors like engineering & capital goods, real estate, textiles, building materials (except paints), manufacturing, etc, that have delivered the best returns since March 2020, mainly have only small and mid cap companies. These cyclical sectors performed quite poorly during the decade of 2010-20 but have revived since then due to pick up in capex, infra and real estate cycle. Moreover, in certain sectors like IT services, mid and small cap IT companies focusing on niche areas like ER&D services, outsourced product development, KPO, etc have delivered much better growth than large cap IT companies with broad based offerings. Overall, there has been a strong surge in listed corporate earnings over the last 3-4 years, so the premium valuation is arguably justified to a certain extent.

The chart above shows the trend of increasing share of listed companies in India’s total corporate earnings. This is because of 2 factors – one that we discussed already that cyclical sectors like manufacturing, commodities, engineering & capital goods, etc have really turned around since FY20. Most of the companies in these capex heavy B2B sectors are listed and hence led to increasing contribution of listed companies to Indian corporate earnings. The second factor is that Covid disruption was much better managed by large listed corporate players leading to market share gains by listed companies in most sectors. This has also led to increased share of listed companies in India’s total corporate earnings.

To sum up, 2024 comes with a mixed environment. On the one hand, valuations are stretched so we need to be careful while on the other hand, earnings prospects are still bright for several sectors so we feel one cannot completely sit out. So, it will be a challenging task for us and we hope to do our best.

Regards, 
Prescient Capital 

Investor Memo Dec 2023

Dear Investors,

The following chart depicts our returns viz BSE 500 TRI:

In this memo we will cover two broad topics: 

• Our take on the investing in IPOs

• Current state of the markets and our strategy of capital deployment 

Our take on the investing in IPOs

In the longer term, returns generated by investing in IPOs is at best at par with investing in the index. We analysed the companies that got listed on NSE/BSE main exchange between Jan 2013-Jan 2023. A total of ~ 250 companies got listed during this decade. The median IRR generated by these companies was 13.6% compared to an IRR of 13.3% generated by the BSE 500 index. 

We believe that IPO investing is an asymmetrical form of investing where one invests at rich valuations with limited information on execution track record. Our past experience of investing in Private Equity deals which are heavily negotiated was similar. The seller doesn’t necessarily come to the markets at a time that is best for the buyer. The seller raises capital at rich valuations and best in class financials to support their case for a rich valuation. Buyers gain a limited knowledge of the business due to the tight timelines of book running by the bankers. Competitive intensity between investors for the allocation further reduced the understanding of the business. Needless to say, the post investment dissonance is significant as companies rarely deliver on the aggressive projections to support the rich valuations. The returns generated by investors therefore have been below par. 

In the last 1-3 years, we have seen a lot of mutual fund managers invest in richly priced IPOs as anchor investors. Excessive domestic retail fund flows and cross selling by the book running and the AMC team could be the only meaningful explanations for the same. A small handful of fund managers have either stopped taking additional funds or have gone up in their cash holding. We respect and belong to the latter lot. Our cash position as we speak is ~ 20% of the AUM at cost. 

Our concluding remarks on IPOs is as follows; A lot of well managed/good companies like DMART, SBI Life, have got listed during the last decade. We typically wait for 12-24 months post their IPOs to understand these businesses in greater detail. We also witnessed a time correction in their valuation during this period to make these companies interesting for us. We have seen and learnt from experience that the longevity of the track record in the public domain is the strongest testament of the capital allocation/misallocation by a company. Investments where we have gone wrong (Nazara, Bajaj Consumer, Zomato, Heranba, Capacite) had a limited public history (post their IPO) of capital allocation.

Current state of the markets and our strategy of capital deployment

• The above chart compares our portfolios Median Trailing 12 months PE to that of the BSE 500 index. Our portfolio has moved from trading at a discount to the BSE 500 index to trading at a premium to the same. The trend is indicative of the run the small and mid cap stocks have seen with respect to the large cap stocks. 

• During this period, the small, mid and large cap indices have delivered an IRR of 26%, 20% and 18% respectively. Our portfolio’s IRR during this period has been 36%.  

• The small cap index has also moved from trading at a discount to the large and the mid cap indices to trading at a premium as we speak. Last such valuations of the small cap index were seen around March 2022, post which the small cap index delivered a near zero return for a year.

• The above thought may trigger a question on our capital deployment strategy for the near term. Needless to say, conservative investors like us are finding limited opportunities to invest at current valuations. We are finding a strong earnings momentum in sectors such as manufacturing, auto, cement, banking and FMCG. The valuations however are ahead of the execution. We also understand that the underlying buoyancy in the markets may persist till the national elections in April/May 2024.

• We are hence slowly and gradually deploying capital. Our framework of typically talking ~9 months to deploy capital helps us ride through times like these and be ready with cash to take advantage of any near term correction.

• We are also protecting our returns and exiting companies which are richly valued. We have so far exited from portfolio companies: Mrs Bector Foods (at ~ 55 x TTM PE), Gabriel (at ~ 40 x TTM PE), JB Pharma (at a PE of ~55x), Hawkins (at a PE of ~40x), NRB Bearing (at a PE of ~35x). As a result, our current cash holding is around ~ 20%.

• The capital from the above exits is being deployed in sectors such as chemicals, pharma and pharma intermediates, banking and brown goods. Companies in these sectors are reasonably valued and have a modest growth prospect.

• Times like now also challenge the fund managers to either deploy capital at expensive valuations in companies having a strong earnings momentum or look for sectors that are reasonably valued but may have a short term headwind in growth/earning. Needless to say, both approaches require more diligence and a more patient approach to investing.

Will end this memo with a quote by Warren Buffett: “For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favourable business developments." 

Regards, 

Prescient Capital  

Investor Memo November 2023

Dear Investors,

The following chart depicts our returns viz BSE 500 TRI:

Indian equity markets, especially small and mid-cap companies, have been scaling new highs for the past few months. The question on the mind of most of our existing as well as prospective client is whether it is a good time to initiate investment or continue to remain invested in Indian equities. We have covered this topic several times in the past, but we are going to revisit this topic in this month’s note given how hot it is.

Our stance continues to be that it is impossible to time the market. No investor can accurately predict when the market has topped out to exit / stay out of equities or when the market has bottomed out to enter / re-enter the market. So, we believe there is an overwhelming risk of missing out on great investment opportunities if one tries to continuously time the market. This is not to say that one should be oblivious of stock valuations. In fact, we closely track the valuations of each investment in the portfolio and are very objective in exiting positions that have become expensive. Also, we try to be as disciplined as possible about entry valuations and never overpay to invest in hot or trending stocks.

However, what we have never done and will not do is take overall portfolio calls like completely exiting the market depending on market levels and macros. That is market timing, and we reiterate that it is impossible to do it to make meaningful alpha. Our belief is that alpha generation can mainly come from stock selection rather than market timing.

Just to highlight the futility of market timing, below is a chart of NIFTY SMALLCAP250 index (we have selected as it is a correct benchmark for our small cap focused investment strategy). The index, just like small caps in general, has been on a tear since April this year making new highs with time. At what point during this rally, should we have liquidated our portfolios due to concerns of overvaluation or markets making new highs? If we would have done that, it would have turned out looking so wrong in hindsight. As we have shared earlier, how does one know that the current buoyancy we are seeing in the market is not the start of a multiyear bull cycle? The opposite might as well playout that a correction might be just around the corner. The point we want to emphasize is that no one knows, and a rational investor should be aware that he/she does not know. So, we believe the right course of action is to stick to one’s investment framework. We are bottoms up investors and approach any market condition on a stock-by-stock basis. As we speak, we are partially exiting companies/stocks that are expensive on an absolute basis. We are gradually redeploying this capital into names that have a strong growth prospect and are reasonably valued.

With the benefit of hindsight, the only actionable insight from the above chart is that the one year or so leading up to March 2023 was a good time to invest or top up your investment in Indian equities when the valuations were attractive. We did communicate the same to all our clients during this phase advising them not to panic during this market consolidation and in fact taking advantage of it by investing more. Here, we would like to highlight that taking advantage of market correction / consolidation is the only form of market timing that we have seen to always work out consistently during our decade plus investment journey. As your fund manager, we would continue to advise you to take advantage of any market corrections in future.

Market timing is also difficult because there is no proven correlation between macros and performance of equities. The biggest example of this is the Covid-19 pandemic. The one and half year post break out of Covid-19 in March 2020 turned out to be the one of the best phases for equities globally when humanity was facing its worst calamity of the past 50 years. Very few predicted the rally in equities from April 2020 to Dec 2021.  Below is a table of quotes from some of the greatest investors and economists (some of them Noble laureates) predicting a severe bear market in March 2020 and the market humbled them all.

Similarly, the chart below highlights the futility of using macros to predict equity performance. GDP growth rate is probably the single most important factor to gauge the health of an economy. However, as seen in the chart below, there is no strong correlation between nominal GDP growth and corporate earnings growth.

Source: Motial Oswal Financial Services

Similarly, the table below shows the impact of wars, which is again a major macro negative, on performance of leading Indian index Nifty 50 immediately after the breakout of war and 1 year after the event. It is clear from the table that there seems to be no negative impact of wars on Indian equity performance 1 year down the line. 

It seems that key macro factors like GDP growth and breakout of war do not have any meaningful correlation with equity performance in the long term. So, using macro factors to try to time the market appears quite futile. What has always worked out for investors is remaining patiently invested in equities in the long term. The table below shows the stellar performance that few Indian MFs have delivered for over long periods of time. The unfortunate truth is also that very few investors of these MFs have actually enjoyed these returns because most investors have not remained invested during such long periods of time. Most MF investors would have tried to time their investment in these MFs by exiting during corrections and entering during bull phases thus giving up these outstanding returns in the process.

Source: Bloomberg, Data as on 16th June 2023

To summarize, our advice to any prospective / existing investors worried about the current peak of the market is to have a long-term orientation and initiate or remain invested. We again reiterate that it is impossible to time the market so our approach will be to continue to invest conservatively in high quality businesses at attractive valuation while exiting existing investments that have become expensive.

Please feel to reach out if you have any questions / concerns.

Regards,
Prescient Capital

Investor Memo October 2023

Dear Investors,

The following chart depicts our returns viz BSE 500 TRI. 

In this memo we will be discussing the two polar opposite sides of India’s economic growth. We in the capital markets often see a limited (read positive) side of the Indian economy. Listed markets represent only a fraction (NSE 500 PAT is <5% of the GDP) of the economy. Lastly, the stakes in the capital markets are sometimes aligned to only share the good news. The cumulative news on the ground however, is that only one part of the economy (read urban) is firing and the balance rural is still reeling under the stress of COVID induced shocks/inflation and a poor monsoon. 

In this memo we will share some data points to highlight the same:

The broader growth of Agri and allied activities has been lagging: 

Source:RBI

If you look at the chart above, it is apparent that a large part of our economic growth has been driven by services which primarily employ urban India. Agri & Mining have had kind of a muted rebound post COVID. These sectors employ the masses in rural and non Tier 1/2 cities.

Rural Daily Wages have been declining in purchasing power for the last 5 years:

Source: Indian Labour Bureau

As we see from the data above, the rural daily wages for agri/non agri activities have been roughly constant for the last 5 years. For the same period of 5 years, average annual consumer inflation has been ~7%. This data is fairly alarming, as it implies that the earning capacity of rural India is down by ~35% over the last 5 years. The same is corroborated by the next section too.  

Wages at the lower end of the income pyramid have been reducing:

The table above highlights a stark K shaped recovery that the Indian economy has had since COVID. The Income of the richest 20% has at best caught up with inflation, whereas for the rest, the average household income has de-grown by 30-50%. The contrast of income growth is even more stark if we compare the top 1% of the population. This has had a direct impact on the consumption patterns which we will highlight in the following sections.

Passenger vehicle growth outstrips the 2 Vehicle Growth: 

Source: SIAM

Passenger vehicles which are primarily sold in Urban India have shown a strong rebound post COVID, whereas 2 Wheelers which are predominantly sold in smaller towns (~ 50-60% of sales is rural) haven’t come even closer to their 2018 levels
Within, passenger vehicles, SUVs, which have a > INR 10 L price point, have shown a phenomenal growth when compared to the Hatchback vehicles in the lower/entry price point, refer below:

If we look at the last 12 months, urban consumption has outpaced rural consumption. CEOs of leading companies such as HUL, Dabur, Marico have highlighted the same in their management commentaries over the last 12 months. A recent study by AC Nielsen, attributed rural demand in Q2 FY 24 to be 300 bps lower than that for urban demand. Even Q1 or Q2 volume growth of rural focused FMCG businesses have been sluggish. Companies such as those mentioned above, have demonstrated a yoy 3-5% revenue growth and a negative volume  growth.

When we widen the canvas to paints, shoes, innerware the commentary has been similar.

Few reasons for the sluggish demand of FMCG and consumer goods are: 1. Higher inflation of goods in rural India when compared to urban India, 2. Lower/erratic rainfall. Unseasonal rainfall in the first quarter of 2023-24 resulted in significant crop damage and lower output. In the second quarter, the erratic monsoon has hurt crop sowing. Refer charts below:

Impact on Capital Markets: 

Leading consumer goods companies like HUL, Marico, Dabur, Asian Paints, Relaxo, have therefore underperformed the larger market. Some of our portfolio consumer companies have also faced slowness in demand: Amrutanjan, a dominant player in pain balm, has seen muted demand for the last 6 months. Our near term focus remains on investing in consumer brands that have a predominant urban footprint (Such as: Jyothy Labs). We are also closely tracking signs of recovery in rural demand so that we can invest ahead of time (read at a good valuation) in some leading brands. 

Regards, 
Prescient Capital 

Investor Memo September 2023

Dear Investors, 

The following chart depicts our returns viz BSE 500 TRI. 

The markets have done very well in YTDFY24 delivering positive returns consecutively every month over April-August 2023 before undergoing a minor correction last month. A question bothering everyone, especially prospective new clients, is whether it is a good time to invest or to hold given the current peak of the market. Our response to this investor concern has always been that it is impossible to time the market so efficiently that one is able to enjoy upsides without having to bear the pain of any downside.

Investors who have been with us since Jan 2022 would have experienced that their returns over Jan2022-Mar2023 were meagre, in line with the consolidation phase that Indian equities underwent. However, if they would have exited during this phase of consolidation, they would have never been able to benefit from the sharp upside Indian equities have delivered since April 2023. 

Fundamentally nothing major has changed in the global or Indian macro situation or corporate performance to warrant the sharp run up we have seen in H1FY24. The Russia-Ukraine war continues, and global inflation has not been tamed with chances of further rate hike by US Fed while RBI continues to keep rates high. There are some long-term macro positives for India like bank balance sheets at their healthiest in over a decade, strong growth in tax collections, continued govt. focus on infra building and early signs of pick up in Indian private sector capex. On the other hand, some macros have also turned negative like increased probabilities of recession in US and Europe, cut back in global IT spends and falling Indian exports for the past few months. 

However, anyone who even slightly tracks the Indian equity market would have observed that the narrative has changed completely in the last 6 months from caution to over optimism. Suddenly, India has become the hottest investment destination because of its favourable demographics, long runway for high growth, etc. These factors were very much in place in CY22 when Indian equities went nowhere. So, the key point we want to highlight is that it is impossible to gauge when or why the market narrative will change and time it. One must be invested in the market to enjoy healthy long-term returns. If one cannot bear the pain of short-term corrections in equities, then they also don’t deserve its long-term compounding benefits. 

Another thing we consistently communicate with investors is to only invest in equities for the long term. The starting investing valuations become more and more irrelevant as one’s investment horizon becomes longer. Most investors would have seen the chart below for US equity returns:

Apart from the above chart, leading Indian discount broker Zerodha also shared the following insight about last 10-year returns delivered by listed Indian equites:

As can be seen from the chart above, there is a 71% chance of earning higher than 7% return CAGR (which is the typical Indian FD return) if one just remains invested in Indian equities for 10 years. Also, there is a 50% chance of earning 15% or higher return CAGR if one remains invested for 10 years. So, if one has some decent stock selection capabilities, one can easily earn a return of 15% or higher given he/she is a patient long-term investor.

Moreover, active investing or stock selection has worked the best in India. In an earlier investor update, we highlighted this and discussed the reason for the same. A Goldman Sachs study looked at rolling 5 year returns of stocks in 10 major markets since 2000: India, Korea, Brazil, South Africa, China, and Taiwan among emerging markets; and the U.S., Japan, Europe, and Australia among developed markets. The study concluded that India has produced the highest %age of multibaggers (stocks that returned 10x or higher over any 5-year period):

Despite this overwhelming evidence in favour of investing in Indian equities, why is that most investors have a poor experience of equity investing. Typically, investors end up earning much inferior returns compared to those of the indices or mutual funds. The key reason for this underperformance is that most Indian investors are not patient enough to remain invested for long periods of 10 years or higher.  In fact, most make the worst possible mistake of exiting equity investments during periods of correction thus permanently booking losses. The chart below shows the short-term orientation of most equity MF investors:

To summarise, our advice to any prospective / existing investors worried about the current peak of the market is to have a long-term orientation and initiate or remain invested. We again reiterate that it is impossible to time the market so there is no way anyone can know when the right opportunity to enter / re-enter equity markets will present itself. We agree that current equity valuations are expensive, and most stocks are overpriced. However, we believe the answer to that is not to stay away but following the below approach:

• Not to overpay and remain conservative about valuation. If we don’t find businesses at attractive valuation, we are happy to remain in cash.

• Identifying sectors or businesses that are still trading at attractive valuation. There are always some businesses / sectors that are out of favour in markets but have good prospects.

• Exit current positions that have become too expensive. Thankfully, most of our investments are still not expensive but we have started exiting a few that are in a phased manner.

The past 6 months have been easy for fund managers like us due to the broad-based rally in Indian equities especially small and mid-cap companies. The next 1 year or so will be much more difficult and will test the quality of any strategy. We hope to do our best by sticking to our philosophy of investing in quality businesses run by honest and competent management at attractive valuations.

Investor Memo August 2023

Dear Investors, 

The following chart depicts our returns viz BSE 500 TRI. 

In this memo we will be discussing the journey of new age tech private companies going public. Prescient founders have spent a reasonable amount of time working with both Public and Private companies to understand and appreciate the nuances. In this memo we will be covering the key differentiators that determine how Public markets value companies differently and how private companies might stack up adversely on those.

Capital Allocation

Capital allocation is a nuanced topic that even large established companies get wrong. A wrong capital allocation call takes easily 4-5 years to fix and turn around.

1. New age tech companies that got listed in the last 2-3 years frequently compromise capital allocation for chasing revenue growth and valuation. 

2. A significant amount of capital is misdirected to enter into related/unrelated businesses categories. Sometimes excess liquidity is sucked into making large acquisitions. Case in point is the acquisition of Blinkit by Zomato.  

3. Best to consider capital as a thing that is easier to disburse/allocation but something which is very very difficult to retrace if gone wrong.  

4. Good capital allocators are far and few. Behaviourally, good capital allocators have neutral relationships with markets/investors as they do not need external capital. Their businesses have a return of capital at par or higher with the growth of their businesses. 

5. For some of the startups which have already raised large amounts of capital, a good way to start looking at capital allocation is to: 

• Work with 30-40 % of the funds available. Assume the balance never got raised. 

• For future projects/growth expansion, start looking at things that can payback capital max in 3-4 years, i.e. improve the incremental return on capital employed (ROCE) of your business to 25-33%. Over time, the combined businesses ROCE will start looking better. 

• Shelf projects that have a longer payback period as they are balance sheet traps and would rarely return capital, forget generating returns.

6. The buck for capital allocation stops with the MD/CEO, not with the consultants and bankers or anyone else. Have seen enough examples where both old age and new age management pass the buck to consultants and focus solely on growth. 

7. In the longer run, your capital allocation is the one size fits all barometer of your competitive advantage. We have a transformer company in our portfolio which me and my partner have been closely tracking for more than a decade now. For reference, Transformers are a low on tech, medium growth sector that is full of capital misallocation minefields. The company has a 10 year ROCE of ~ 15% while the next best player will be close to a zero ROCE. During the same decade, the company has reinvested only ~ 100 cr of its internal accruals in (only 1/6 of its cash earnings) to generate a cash profit of nearly 600 cr. Needless to say, the company has converted ~Rs 250/share of retained earnings during this period to ~ INR 5000 of share price appreciation. Each rupee of retained earnings has been amplified by 20x in market cap over the decade. 

8. Behaviorally what we have learnt from this management, something which can be replicated: 

• No forward or future guidance, razor sharp focus on delivering good profitable growth

• The management feels responsible to return capital as dividend and buyback to the shareholders. 

• They call a spade a spade, in good times they are modest in their outlook and in bad times they give you to the worst case scenario. 

• They always and always look to preserve their balance sheet.          

Sustainable cash flow profitability is the only thing that matters

We have seen a few new age founders boast on social media that they are the only PAT profitable startup or a few file their DRHPs after only 1-2 quarters of PAT/EBITDA profitability. Per seasoned public market investors, all this is white noise. One should always remember this phrase: Revenue is vanity, Profit is sanity and Cash Flow is reality.  

1. Examples of companies like Zomato and Policybazaar had/have a cash generating business which can arguably grow for the near/mid term at a high growth rate. There was/is no need to grow into unrelated businesses and turn their back on cash flow profitability. 

2. It has been observed that some companies have gotten listed on the back of 1-2 quarters of only P&L profitability. This is kinda silly as those doing this are ill advised. For a lot of these companies a reduction in operating cost (mainly marketing burn) during the COVID lockdown turned the business from red to black for a short while. Seasoned public market investors can catch this and carry a wrong perception about a management that stays for a while. 

3. Other public market investors like MFs, Insurance companies are eager to get in but are impatient for results too. They often need to see a business turn to black within 2-3 quarters of listing. This is true for seasoned tech markets like the US too. During their last correction in the markets, stock prices of the businesses that were in red bore the maximum brunt.

4. In Banking/NBFC especially, being PAT profitable has no meaning. One can be PAT profitable and be running a book that accrues NPAs at 5% of amount lent. Consider a Debt to Equity of 10:1, this implies you are eroding 50 % of your net-worth.    

Large total addressable market (TAM) doesn’t mean anything

As aptly stated by Pulak Prasad, TAM based investing in a company is detrimental to returns. A promoter’s over emphasis around TAM therefore is meaningless.  

1. Conventional sectors like steel, oil and gas, branded food, apparel, and shoes that have large TAMs are the most crazily competitive sectors and to our understanding have very low profitability pools.    

2. Usually it has been seen that large TAMs attract competition and over time reduces the returns profile of the sector

3. What matters is the ability of a company to define, safeguard and improve its profit pool over a long period of time. 

4. Further, TAM does not tell us which firms in the sector will turn out to be profitable. Take the case of Nykaa, an e-commerce company which sells beauty and fashion products. It was such a sought after stock when it was listed due to a lack of understanding around its presumably endless addressable market. Overtime, the investors figured out that this is a business which can be easily replicated and has no real moats surrounding it.

5. On the flip side, consider the case of AIA engineering that makes high grade abrasion and corrosion resistant castings that are used in mining/cement/quarry. Back in 2013, we decided not to invest in the company due to mature/stagnant market shares and exposure to low volume growth sectors. The company has surprised us. The company was founded by a metallurgist (from IIT Kanpur) and has innovated through product engineering. The company has found ways to reduce corrosion/abrasion of their products and reduce downtime for the grinding applications. This has helped them command higher prices for their products. As against our expectations of low single digit profit growth, during the last 10 years the company’s PAT has grown at a CAGR of ~18% and it has improved its ROCE profile from ~ 20% to ~ 25%. The stock price during the same period is up >10x.             

ESOPs/Related Party Transactions

While dealing with public markets, founders should remember that markets have a long term memory. They reward professional conduct, but remember any misgovernance for a long time.     

1. Preferential allocation to founders in the form of ESOPs, or pref shares has been a common practice before the listing of a company. 

2. While the transactions may look commercially right, they often are a huge burden on the minority shareholders, when items such as ESOPs are vested and cause dilution.  Public markets usually encourage grant of ESOPs to promoters/staff, but the same cannot dilute minority shareholders by >2-3%.   

3. Some startups also merge their promoter group entities right before their IPOs. This is sometimes done to boost promoter shareholding in the merged entity. 

4. Also under scrutiny has been the dealings of a company getting listed with family/friends and associated group entities. 

1. Dealing with related parties as vendors or investing in them for strategic P&L benefit, is also short sighted. The opacity of commercial dealing with related parties is often seen as a sign of misgovernance. 

5. Companies such as TCS, Infosys in their early growth stages in 2000 set new standards of disclosures and clean governance, which became the hallmark for other IT companies and listed universe by and large. The same is expected of the current lot of tech companies. 

Stepping off the fundraise rollercoaster

Markets reward patient and honest communication by founders. Narratives like “Markets do not understand the disruption my business is creating or will have to be taught more about my business's potential” are futile.   

1. Behaviorally pitching to public markets is different from pitching to private markets.  

2. In private markets money is raised at steep valuations by creating a pitch around the disruptor, winner takes all, or the first mover advantage theme.  Large portions of capital are cornered to eliminate or dissuade competition. 

3. In public markets it is the other way round. Money is not a zero sum game. Money is available for investing in, for example, a sick company, a challenger, a leader and/or the disruptor in the same sector. Sometimes the best returns are made in investing in a sick business that shows signs of a turnaround. So it is very very difficult to make a pitch to corner all the capital available. Founders who come to terms with this reality that are a drop in an ocean, are more likely to succeed. 

4. New age founders would find it easy if they consider markets as a source of infinite capital if they take time to make markets understand their businesses potential, its differentiation, any risk and cyclicality in your business and the efforts you as a management are making to improve the return profile of your business.   

Overemphasis on hiring CVs

1. Lots of listed startups make a stack of awesome CVs and forget their people cost. 

2. Hiring talent, integrating them with the company’s vision and then making them execute above their potential are painstakingly difficult tasks. Hoarding of CVs at the senior level, with often overlapping roles, no clear direction and incentives often leads to high attrition, which is not considered favourably by markets. 

3. Good tech companies hire good C-minus leaders and then use their leverage to grow and ace execution. This truly creates operating leverage. 

Investor Memo July 2023

Dear Investor, 

Below chart depicts our returns viz BSE 500. 

In this month’s update, we will look at how Indian manufacturing is doing. We have a large allocation to manufacturing (auto & auto ancillaries, engineering & capital goods, chemicals, etc) in our portfolio. Manufacturing, especially engineering & capital goods sector, has done very well in the last 2 years. It is the most important sector for generating employment and driving higher GDP growth. All the Asian miracles of the last century like Japan, Korea, China, Taiwan, etc have attained high employment rates and prosperity through manufacturing and exporting for the world. 

In the last 15 years, the share of manufacturing in India’s GDP has continuously fallen as India’s GDP growth has been driven entirely by growth in services. However, services can neither generate enough employment for the millions of Indians entering the workforce every year nor uplift the majority of Indian forced to work in the agri sector because of lack of decent employment opportunities. 

Source: World Bank

The contribution of manufacturing to India’s GDP at ~13% is much lower than the 20-28% for much more prosperous Asian economies like China, Japan, Korea, Malaysia, Thailand, etc. Just as contrast, countries like Vietnam and Bangladesh have done much better than India in growing their manufacturing sector during the same period.

Despite India’s much touted low labour costs, India’s rank in global exports is quite low. The same can be explained by low labour productivity, poor infra & logistics, lack of trade agreements with most of the developed economies, etc.

Source: IMF

However, since FY21, manufacturing, especially engineering and capital goods, companies have shown strong growth. In the last 5 years, the govt. has implemented several measures like lowering corporate tax rates, especially for new established manufacturing companies, Production Linked Incentives (PLI) schemes for several sectors, subsidies for electric vehicle manufacturing as well as negotiating trade agreements with Europe, UK, Australia, etc. There has been a sharp rebound in the Index of Industrial Production in the last 2 years.

In fact, global manufacturing is going through a challenging phase currently as interest rate hikes by most central banks have taken a toll on economic outlook and prospects for manufacturing are bleak for most economies. India is the only country where manufacturing PMI has been expanding every month since June 22.

The commentaries of managements of most of the manufacturing (engineering & capital goods, auto ancillary, etc) companies in the recent earnings call have also been very positive in the last 5-6 quarters. We believe this is the strongest guidance /commentary we have witnessed manufacturing companies give in the last decade or so. There is an upbeat tone and confidence to become a global leader in their respective components in these management commentaries. We have shared below snippets of comments by managements of manufacturing companies including those by some of our portfolio companies like KOEL, TD Power, MM Forgings, FIEM, etc:

________________________________________________________________________

Company: Cummins India

Products manufactured: Engines

Management commentary: 

Q4FY23 Call: 

So, what we have endeavoured to and what we have been saying for the last couple of years is our ambitions as a company are to grow at twice the GDP and to continue to attempt to increase our profitability by 100 basis points year- on-year.

As far as segments are concerned, the segments I have continued to mention in my previous two calls such as data centre, infrastructure, hospitality, hotels, and now we have been manufacturing, continue to remain very, very strong. We are seeing even commercial and residential realty start to slowly bounce back and get stronger. So, when I look across segments, I am continuing to see in proportion to the growth of the GDP the segments continuing to hold. So, all those segments which are contributing to the growth of GDP are contributing to demand for us. So, that's the way I am looking at it. 

Company: Kirloskar Oil Engines (KOEL)

Products manufactured: Engines

Management commentary:

Q4FY23 Call: 

A little less than a year ago, we started a journey of 2X-3Y. We said that core as an organization will grow 2x in 3 years. With that strategy in place, we started working on a major business transformation effort. The transition is still a work in progress.

Company: Steel Strip Wheels

Products manufactured: Steel & alloy wheels

Management commentary:

Q1FY24 Call:

Analyst: Hi, thanks for the opportunity and good afternoon to everyone. Sir, my question is on your exports. I have two questions. So first one is on, if I look at your global, maybe global players who are in the same business, can you please tell us how different are our segments compared to let’s say Maxion Wheels or Ronal Group in Europe? 

Management: So our wheels are not different. They’re absolutely not different. They are the same.

Analyst: So then in that case, for example, Ronal Group, the average realization per wheel is about you know, INR5,500 to INR6,000? 

Management: That is in EUR. Again, the exchange rate makes a difference, plus the cost is higher in Europe… 

Analyst:  Sir, I am only talking about INR terms. So I know...  

Management: So you convert that in INR, what exchange rate? You converted that by INR95, INR90, it all varies. And secondly, aluminum prices are much different in Europe, than in India. And the cost structure in Europe is much higher than it is in India. So you cannot say that, the same thing, it's like buying a McDonald's in India versus buying a McDonald's in America. It is not the same. 

Analyst: Right, so then my subsequent question to this is, if I look at their cost structures, maybe if I focus on employee cost only, in percentages terms, they are paying almost double the percentage that we pay. So we in India are… 

Management: That’s the advantage, absolute advantage, yes.

Analyst: So can you please talk more about it and tell us maybe in the future, your growth will be much higher because this arbitrage is there and therefore... 

Management: I said in the beginning of the call that I am looking at 10 million wheels predicated on the fact that. I will be the lowest cost producer of wheels in the world with the quality amongst the top five vendors of the world. There is nothing new in this to add.

Company: MM Forge

Products manufactured: Forged parts mainly for auto sector

Management commentary:

Q4FY23 Call: We are looking at almost close to 25% growth vis-à-vis 72,000. We are looking at close to 90,000 MT for FY24 and with exports being stable. We are continuing to focus considerably on the domestic market, and we see a lot of traction over there.

Company: FIEM Industries

Products manufactured: Lights for auto sector

Management commentary:

Q4FY23 Call: Analyst: And sir, could you tell us how this would ramp up in the next 2, 3 years? We are talking about adding 3 new models of Yamaha and also starting with Hero. So if you could tell us how it will shape up in FY '24 -'25? New order... 

Management: So specific numbers, we won't be able to give you. But overall direction, we are giving you the new customers that have been added and specifically with regards to Hero and the EV segment, which are new. Basically, we are very bullish on that. 

Analyst: Okay. So we expect to outperform the industry by 10%, 15% in the next 2, 3 years? 

Management: Yes. That we have always maintained that we will outperform the industry given our diversified mix that outperformance, we are pretty confident.

Company: TD Power

Products manufactured: Generators

Management commentary:

Q4FY23 Call: Management: We have seen a huge jump in the order book in this segment on a year-on-year basis up about 55%. Orders have increased both from the domestic market as well as export market across the board. The domestic market is seeing a big revival in capex, and we are seeing demand broadly across all sectors. In the export market, we're seeing the same factors playing out as we have been discussing in the past few quarters. Macro factors continue to drive the business, move to renewables, waste to heat energy, garbage burning plants, etc.

Analyst: I had a follow-on question that you guided for the 20% volume value growth for FY '24. Now given where the cycle is, do you think this kind of growth can be sustained in the medium term, say, 3 to 5 years?

Management: No, that's a good question, and I don't want to be overly optimistic in saying that this kind of growth will be sustainable. So -- but as far as our company is concerned, we have a strategy to sustain the growth based on diversification of products and diversification of markets. So today, we see order increases taking place by 38% and 48%. That kind of a sustainable -- that kind of a huge growth may not be -- it may flatten to about 20%, 25%. This is my expectation.

________________________________________________________________________

We continue to be optimistic about the performance of Indian manufacturing going forward. There are very early signs that Indian manufacturers are focusing on becoming globally competitive and on increasing their market share of global exports. Over the 2012-21, Indian manufacturing was in a deep down cycle during which manufacturing companies with outstanding managements focused on improving their capabilities by developing new products, establishing credibility in international markets, building relationships with foreign buyers, lowering their cost structures, preserving their balance sheets, etc. 

We now believe such outstanding Indian companies are poised to benefit from the double benefits of revival in the Indian capex cycle as well as the focus of developed economies like US, Europe, Australia, etc to diversify their vendor base from being acutely China specific. We are cautious and aware that the Indian capex revival is in early phase, and it is difficult to predict how long it can sustain. So, we will be tracking the sector and our portfolio companies from this sector closely, but we repeat that we are optimistic considering the current demand environment and prospects for the sector.

Please feel free to reply if you have any queries / concerns.

Thanks & Regards

Prescient Capital

Investor Memo June 2023

Dear all, in this memo we wanted to compare our performance viz major indices and answer the following leading questions: 

1. Are we nearing the peak of the small/mid cap index? Is a correction imminent?

2. How does our portfolio stand in terms of valuation viz leading indices? 

3. What are we doing to preserve returns in your portfolio?

4. Sectors that we find interesting to invest in

The chart below highlights our performance viz BSE 500 TRI index: 

Our performance mirrors the rise in the small/mid cap indices and a lot of you might argue and ask if we are nearing the peak for these indices and a correction is imminent. We will try and answer this question through the following analysis.

NOTE: Calculated for data between Oct 1, 2009-June 20, 2023

We have tried to tabulate the longer term profiles of BSE 500 (representing largely large caps), BSE Mid Cap and BSE Small Cap index. From the data above the following observations are pertinent to set the right expectations: 

• Small and Mid cap stocks give you a higher return but one has to bear higher volatility, something that you may have seen in your portfolios over the last 18 months when compared to large cap stocks/portfolios. 

• We think and the data also proves that if invested well, the returns in small/mid cap far exceed the volatility. Between small and large cap, the median daily returns are almost 2x whereas the median volatility is higher by ~ 10%. 

• Over the last ~ 14 years, the BSE small cap index has been up ~ 58% of the time when compared to the BSE 500 which has been up ~ 55%. This also breaks the often believed myth that it's safer to invest in large cap stocks. Per us, most of the large cap stocks are often rich in valuation which increases their volatility and hence increases the odds of a downside. 

• Small/Mid cap investing requires a higher order of patience when compared to large cap investing as there could be elongated periods where earnings growth doesn’t translate into stock price movement. While there may be marginal daily movements, small/mid cap stocks can remain corrected for a long period of time. 

• If you consider data given above, a 50% correction in an index for a 2 year period is mentally very daunting for even experienced fund managers, leave alone the retail/institutional investors. Compare this ~ 50% prolonged 2 y correction in the small cap index to ~ 22% correction in a large cap index. This is where we enter the behavioural part of investing where conviction kicks in. We have often found portfolio companies demonstrating a healthy >15% earnings growth but their stock prices have corrected by 50% for 12-18 months. During this period we often dig in and do more work to build a conviction around strong future growth in earnings. 

• Capital invested during this period of a prolonged drawdown has the highest IRR. As shown by data too, capital invested during this prolonged drawdown in small cap index can compound at even an IRR of ~ 50% for a 2 year period. 

• It therefore becomes even more pertinent for fund managers who invest in small and mid cap companies to have a detailed understanding of their portfolio promoters, business and pay the right price. Any of these three if goes wrong, one could be looking at a prolonged period of correction.

  The chart below highlights the movement of the small and mid cap index since Oct 2009:

• Both Small and mid cap indices are up by 18-20% from their lows in the first three months this year. The indices have however returned 12-15% returns over the last one year. This implies that we are still not in the heated up zone. 

• We believe that a near term correction is likely given the global macros haven’t improved significantly. We therefore remain cautiously optimistic about investing in the small mid cap companies in the near term. 

• Our portfolio continues to be fairly priced viz leading indices. Our portfolio's median trailing 12 months PE is 20.7x compared to  24.3x for the BSE 500 index. Refer:

• We continue to exit richly priced companies in the portfolio (Mrs Bector Foods exit at a TTM PE of ~ 55x, Hindware exit at a TTM PE ~ 40x) and add companies that are attractively priced (MM Forge entry ~ 17x TTM PE, Kirloskar Oil entry at ~ 15x PE, Jyothy labs entry at ~ 30x TTM PE, RPG Life entry at around 20x TTM PE, Just Dial entry at a cash to Mcap of ~ 75%). 

• We also continue to reassess and exit companies where our thesis needs more validation or where there is a risk of loss of capital. We already discussed our investments in agri chem space in the last memo. We also exited Sharda Motors post ambiguity around its Income tax paid and due.

• During peaking markets it is imperative to not drop the quality bar. Value investors like us are often short of ideas due to rich valuation of good companies. Deployment of capital creates pressure to look for value bargains by either dropping the bar on promoter quality or by quoting secular growth for all (good to bad players) in a sector. This is a long term trap that may cause permanent loss of capital. We therefore continue to follow the discipline of taking 6-9 months to deploy your capital. This period gives us enough time to validate/revalidate our allocation behind a company and also provides time to take advantage of a downcycle in the markets. For instance, we were aggressive in deployment of capital during the March 22-June 22 period and Jan 23-March 23 period of correction. 

Lastly, the on the ground outlook in India is tepid. The GDP growth of ~ 5% and bottoms up sector assessment also highlights the same:  

1. BFSI: Will continue to demonstrate 12-15% credit growth for the next 12-18 m. Segments such as MSME are still struggling to come out of the covid impact. Personal loan growth has shown a slowdown due to degrowth in brown goods and personal vehicles. On the other hand, corporate, commercial vehicle and gold loans continue to grow. Housing loans growth may taper given the impact of rising interest rates. 

2. Pharma: Domestic pharma continues to grow at 10-12% with chronic illness segments doing better than acute illness segments.  

3. Cement: Demand continues to hold and easing raw material prices will improve margins and performance. 

4. Manufacturing: Probably the only sector showing signs of a secular growth in demand across most engineering and manufacturing segments. 

5. Auto: Sluggish 2W demand and slow growth in 4 W may persist in the near term. Strong demand for 2w EV and its components is a demand driver. Exports of auto components is a dominant driver. 

6. FMCG: Sluggish demand for another 6 months due to high price rise and expensive inventory in the channel. Regional players expanding distribution reach, helping in growth.                 

Thanks & Regards

Prescient Capital

Investor Memo May 2023

Dear Investor, 

The chart below compares our returns viz leading index BSE 500.

In this memo we will like to share our assessment of our performance since we started our PMS journey in Dec 2021. The comparison is done for a period ending April 2023.

We started our PMS service in November 2019 and FY23 was the first full financial year of our operation. In this update, we wanted to share some info on our performance, both absolute and relative to other PMSes / benchmark indices / MFs, as well as a brief analysis of the same. We do want to be clear that a single year’s performance is not a long enough timeframe to evaluate any investment track record in equities. We firmly believe that equity investing should only be for wealth preservation and appreciation over longer term periods of 5 years+. However, we do face questions about our performance from both prospective and existing clients, so we are sharing an overview of last 1year’s performance.

Equity markets globally witnessed multiple tailwinds over FY23: the Russia Ukraine war, spiralling inflation mainly in energy & commodity prices, subsequent sharpest rate hikes by central banks to tame inflation, leading to failure of banks in US and Europe. We are happy to note that we were able to perform decently generating healthy returns for our clients. There is no doubt that there is an element of luck in our performance, but we would also like to believe our disciplined approach of only investing in high quality, resilient businesses at attractive valuations and then closely tracking each investment to constantly verify that they are not being challenged by any structural issues have also contributed to the reasonable performance.

Below is the performance of our PMS during the last 1 year, 6 months and 3 months ending April 2023 compared to the performance of key benchmark indices over the same time periods. The return delivered for your portfolio will be different depending on when you started investing with us as well as if you increased your investment corpus.

Apart from indices, we have also benchmarked our performance with that of MFs. The chart below compares the last 1 year return generated by us with the last 1-year average returns generated by each category of Indian equity MFs like large cap, small cap, mid cap and multi cap funds. 

Apart from comparing with average MF returns, we have also benchmarked the last 1-year return generated by us with those of leading small cap MF funds. We have specifically benchmarked against small cap funds as 90% of our holdings are small cap companies so we are essentially small cap PMS.

We have also benchmarked our last 1-year performance against that of PMSes. As per the APMI (Association of Portfolio Managers of India) website, there were 159 PMSes with AUM greater than 50 Cr as on April 2023 end. We were the 11th ranked PMS in terms of last 1 -year performance among these 159 PMSes, which means that we are placed in the top 10%ile. Below charts highlight the relative performance of our strategy against these 159 PMSes:

Now we will just cover a brief analysis of where we went right that contributed to our healthy performance during the tough last year. We will also discuss some areas in which we feel we could have done better and that could have led to an even better performance. We believe the factors that led to healthy performance were:

• We stayed away from certain fad sectors like APIs & chemicals manufacturers that had benefited significantly from spike in demand due to supply chain disruptions during Covid. These delivered handsome returns in 2020 and H12021 but have since corrected significantly since, because the supply chain issues got resolved leading to reversion in margins and topline.

• We were right in taking the call to exit IT services names like Birlasoft, Mphasis, etc at the start of ~2021 only because their valuations got stretched. It was not because IT services may have a few tepid quarters or a year due to possible recession in key markets of US, Europe, etc. We are strong believers in long term secular growth prospects of IT services but of course we will invest in that at a reasonable valuation. Our call to exit most ITS names turned out right in hindsight mainly because valuations contracted for the sector even though most ITS companies did well in FY23. We are invested in one ITES company, eClerx, because we believe it is grossly undervalued. We continue to be positive about the prospects of the ITES sector and will invest if valuations cool down from current levels.

• Overall, the valuation of our portfolio was much cheaper compared to the broader markets at the start of FY23. This is especially because most of our portfolio companies delivered industry leading earnings growth in FY23. The combination of earnings growth and valuation rerating helped deliver solid returns for many of our positions like TD Power, Voltamp Transformers, Mrs Bectors, etc.

The 2 key areas where we feel we could have done better are:

• Engineering & capital goods sector was the clear standout sector in terms of returns in FY23. We were bullish (and still are) about the revival of Indian manufacturing at the start of FY23. However, we tried to play that theme through a larger allocation to auto ancillaries (FIEM, Gabriel, NRB Bearings, MM Forgings, GNA axles, etc). We did have an allocation to engineering companies like TD Power and Voltamp; both have done quite well in the last 1 year. However, in hindsight we must agree that we could have done better with a higher allocation to engineering companies.

• On the other hand, our auto ancillaries have delivered meagre returns in the last 1 year despite very strong earnings growth. These continue to trade at sub 20xTTM P/E even though they have good growth prospects, lean or net cash balance sheets, improving RoE, etc (see table below). Sometimes, we need to patiently wait for the market to reward us. We continue to be bullish about the prospects of these companies.

• Agrochemicals is one sector in which our call went wrong in FY23. We made 2 investments in this sector: Heranba and Sharda Cropchem. Heranba has been the standout bad performer with share price halving in the last 1 year. What we missed out in our evaluation of this sector was that agri inputs also benefited from an element of excessive channel stocking and thus transitory swell in demand due to Covid fears. Moreover, unpredictable lockdowns and openings in a key agrochemical intermediate producing country (as well as the end market for Heranba), China, impacted the industry in a big way. We are still positive about the prospects of these 2 companies as we believe the challenges facing these companies are transitory industry issues.

We hope to deliver healthy returns in FY24 by continuing with our philosophy of investing in good management teams at attractive valuations. Please feel free to reach out if you have any queries / concerns. 

Please feel free to reach out if you have any queries / concerns.

Thanks & Regards

Prescient Capital

Investor Memo March 2023

Dear Investor,

The chart below compares our monthly returns viz leading index BSE 500.

Equity markets including Indian equities have been very volatile since Oct 2021 (almost for 1.5 years now) and have delivered negative to flat returns. All of our clients have been very patient in remaining invested and have even deployed incremental capital to take advantage of this correction. However, a valid concern / question in everyone’s mind is whether the market has corrected enough to form a bottom and can be reasonably expected to rebound from here on. It is an extremely tough question to answer because it depends on a lot of factors like macros improving from here on (inflation falling sustainably and consequently interest rates topping out), relative attractiveness of Indian equities to other markets, investor outlook regarding prospects of equity as an investment option especially that of FIIs, etc. 

Overall, our sense is that markets are fairly valued at present and future returns will be broadly determined by earnings growth. This is mainly true for large and mid cap companies, but the small cap space has corrected significantly and offers attractive opportunities. We have repeatedly stated in the past that small cap space is more volatile due to factors like low institutional ownership, low liquidity, higher concentration of low-quality businesses / management, etc. However, good stock picking based on thorough due diligence of business and management quality and business prospects combined with conservative entry valuations can lead to significant alpha creation. We believe the correction in the small cap space presents an attractive opportunity to invest in high quality businesses at attractive valuations for the long term.    

As we start a new financial year, we present some interesting data points on the current state of market: 

Market cap to GDP ratio

India’s market cap to GDP ratio is currently at 94% compared to a 10 year mean of ~88%. India is at a steep discount to the US while it is at a premium to China and emerging markets like Brazil, Russia, etc. This has always been the case historically and can be explained by the constitution of the different equity markets. US market cap is heavily dominated by tech giants like Apple, Microsoft, Amazon, etc and has the highest RoE among all equity markets globally. Indian markets are somewhere in the middle in terms of RoE and have a healthy mix of companies from high RoE sectors like IT Services, FMCG, healthcare, etc to commodity and highly regulated businesses like banking, metals, oil & gas, etc. Most emerging markets like Brazil, Russia, etc have a high concentration of highly regulated and commodity industries like metals, mining, govt. owned banks, etc leading to lower valuations. Chinese equity market valuations have derated since 2012, when Xi Jingping assumed leadership of China, and the derating has only accelerated since 2020 due to increasing perception of China becoming more opaque in sharing of economic and social data, tighter regulation of businesses, etc.

The chart below compares the current market cap to GDP ratio for Indian equities to the historical levels. As can be seen, the current situation is not as attractive as March 2020, when the markets  corrected sharply due to fear of impact of Covid-19, or late 2008 during the global financial crisis. So, we cannot expect a strong rebound like 50% or higher gains in benchmark indices over next ~2 years from current levels. However, the chances of a sharp correction from current levels also appear quite low. 

Current valuation

As can be seen from the chart below, Nifty 50 is trading close to its 20 year median valuation, which indicates fair valuation.

However, the broader markets (represented by Nifty 500) and especially the small cap space (represented by Nifty Smallcap 100) has underperformed Nifty 50 by a large margin over the last 1 year, 2 and 5 years time frame.

Performance of different indices as on 30th March 2023 end

We believe the underperformance of smallcap stocks v/s large cap stocks should mean revert in future. The key is to be invested in high quality small cap businesses that are sector leaders in their small and niche markets and are run by honest, competent and driven management teams. Historically Indian equities have created the largest number of multi baggers (10x or higher return in 10 years) amongst all equity markets globally (see chart below). In a previous update, we had discussed the reasons as to why Indian small cap space offers investors an opportunity to make VC type returns while taking much lower risks. Indian equity markets are most conducive for active stock picking due to factors like availability of listed businesses early in their life cycle, leadership of niche market spaces, low risk due to proven business viability unlike most VC funded unlisted businesses that pursue growth over profitability, etc.  

All asset classes are cyclical in nature

Typically most investors believe that equities are more cyclical and volatile in nature whereas other assets like gold, real estate, etc have secular and predictable returns. Nothing could be farther from the truth as all asset classes are cyclical and deliver poor or no returns over long time periods. Case in point is the performance of gold price in $ historically as shown in the chart below. Real estate also suffers from similar cyclicality though we could not find a chart to highlight that as real estate is not standardized product like gold (has many different micro markets).  

Overall, we want to emphasise the importance of being patient and systematic in equity investment approach despite short term volatility. As per the S&P 500 historical data since 1926, the possibility of positive returns increases from 63% over 1 month holding period to ~95% over 10 year holding period. 

Please feel free to reach out if you have any queries / concerns.

Thanks & Regards

Prescient Capital

Investor Memo Feb 2023

Dear Investor,

In this memo we will do a review of the Q3 results of our portfolio companies and will also share our take on the markets.

Equity markets globally have been challenging since October 2021 and equity returns have been very meagre in the last 1.5 years or so. We had communicated last year in March that any sort of correction is always a good time to increase allocation to equity because outsized returns can only be made when investing is initiated, or allocation is increased during a phase of market correction or consolidation. It has been almost a year since then and markets continue to be difficult with no visible respite in macro headwinds. The Russia-Ukraine war still goes on and can possibly turn uglier, inflation has cooled a bit but continues to be sticky and high still, central banks are still hiking rates and the possibility of any reversal with a rate cut is very remote now.

However, we will stick with our advice that markets currently are offering an attractive point to increase allocation. Valuations have turned quite attractive, and we are finding much better investment opportunities compared to the start of 2022. Even in our portfolio, there are several companies that have delivered strong growth (portfolio performance discussed below) but their share prices are either flat or even have fallen in the last 1.5 years or so.  So, it makes sense to allocate more to equity now though we will be candid we have no clue of when there will be reversal in market trend or whether even the market has bottomed out. No one can time the market so there is no way to predict whether there will be further correction or the time frame in which markets will bounce back. But we are sure that when the market trend will reverse, the return from that point on will be significant. Equity returns do not come in a linear manner and the average long term ~13-14% CAGR of Indian indices have been delivered in a very volatile way if one looks closely at annual returns over the last 15-20 years.  

So, we will repeat our advice of increasing your allocation to equities to take advantage of the current market mood. We expect markets to remain tough over the next few months as macro challenges persist, so it is better not to expect any quick returns from here on. However, to handle the volatility, a good approach can be to invest whatever amounts one can one in a SIP manner during this volatile phase. The incremental allocation does not have to come in a large lumpsum. 

In this month’s update, we will be discussing the Q3FY23 (Oct-Dec 2022) and 9MFY23 (Apr-Dec 2022) performance of our portfolio. The table below shows the company wise performance. Depending on different factors like vintage of portfolio, valuations at which the portfolio companies were trading at, cash in portfolio, etc, different client portfolios will have different compositions.

Some highlights of the portfolio performance are:

1. In 9MFY23, the median sales growth (yoy) and EPS growth of the portfolio companies were 23% and 15% respectively. In the latest quarter, i.e. Q3FY23, the corresponding figures were 17% and 19% respectively.

2. The profit growth in 9MFY23 was substantially lower than sales growth due to inflation in commodity & energy prices, freight rates, etc as well as other supply bottlenecks like chip shortages in the auto sector. However, inflation seems to be subsiding as most portfolio companies reported improved profitability sequentially as is visible in higher profit growth than sales growth in Q3FY23.

3. The median P/E (ttm) and P/B (ttm) of the portfolio were 17.3 and 9.9 respectively. Our portfolio is trading cheaper at a 16% discount to the Nifty 500 index, which is trading at a P/E of 21.25.

4. The balance sheet of our portfolio companies is very healthy with 13 out of 18 Non BFSI portfolio companies having net cash on books.

We continue to be bullish about selective sectors that we believe will continue to deliver strong growth despite macro challenges like:

• Capital goods & engineering companies with globally competitive products

• Auto ancillaries that are making products for the EV space

• Cement companies with industry leading cost competitiveness 

• Regional consumer plays that are increasing their distribution foot prints

• Pharma companies with market leading Indian drug brands 

• Banks / NBFCs with razor sharp focus on asset quality and creating a strong liability franchise

The key point we want to emphasise is that the portfolio performance in Q3FY23 was above our expectations for the majority of the companies. There were a few disappointments mainly Heranba Industries and Mangalam Cement that delivered poor results due to sectoral headwinds and company specific challenges. However, overall, the portfolio performance is satisfactory, and the portfolio is quite healthy with most companies having net cash on balance sheet and strong growth outlook.

The market has been challenging since the start of 2022. We experienced that even those portfolio companies that beat expectation by a large margin in Q3FY23 did not witness any share price appreciation. While those companies that even slightly underperformed expectations have been punished severely. This is true not only for our portfolio companies but for the broader market in general and especially for small and mid-cap companies. The chart below compares our returns viz BSE 500 TRI index.

*This is a time weighted return for the overall PMS capital pool net of all fees and charges. This is not the return for a particular client. 

The markets can continue to remain challenging given most of the macros are negative whether it is inflation not subsiding as much as expected globally, possibility of higher than expected hikes in interest rates, Russia Ukraine war escalating further, etc. It is impossible for us to predict market direction and macros so we will remain focused on bottoms up factors like earnings performance, growth outlook, valuation and balance sheet strength of our portfolio companies. 

This is not to say that we will not be mindful of downward risks but that we will manage those by turning more conservative about valuations and by more stringent tracking of any challenges that our portfolio companies can face. We cannot predict when the markets will enter an upcycle, but our best efforts will be to minimise drawdown till we reach that stage. We will request you to remain patient through this difficult phase as you have been for the last year or so.

Please feel free to reach out if you have any questions or concerns.

Thanks & Regards

Prescient Capital

Investor Memo Jan 2023

Dear Investor,

Below chart depicts our performance viz the baseline index.  

A lot of you would have read or heard about the recent Hindenburg report on the Adani Group. In this memo, we wanted to draw a parallel from that report and write about why in investing a promoter’s corporate governance is more important than his/her business and/or its valuation. We at Prescient Capital follow the following framework, in that order: 

1. Good/clean promoter

2. Good business

3. Good price 

Through our decade long journey in investing, we have seen that: 

• The single largest source of value destruction in markets is a promoter with a chequered governance track record. 

• Promoter quality is not a linear scale that can be priced in valuation. A lot of our peers think otherwise.

We typically end up investing in small and mid-cap companies which have low institutional shareholding as large institutions/MFs cannot build a sizable position without affecting the price. Third party diligence therefore doesn’t exist or is minimal. Whatever needs to be done is your own independent research. Our promoter research is a mix of both subjective/objective assessment.

In this memo we will try to lay out our promoter governance/evaluation framework which we think is quite robust. The framework has help us significantly reduce the odds of permanent loss of capital. 

Promoter/Promoter Group members salary 

The ministry of corporate affairs, lays down the maximum limit of remuneration that a Managing Director, Wholetime Directors of a company can together draw as 11% of PAT. Any increase in the absolute value of remuneration of Managing Director, Wholetime Directors should be approved in the AGM. We, however, adopt a more pragmatic commercial stand to the same, as many promoter families fill their middle management ranks with their family members. 

• We believe that the sum total of salaries of all these family members should not exceed 5-7% of the PAT for that year. 

• We have often seen red flags whereby a young son of a promoter with a mediocre education background is drawing a salary higher than a senior professional with greater than a decade of professional service experience. 

• We also raise a reg flag if the salary of a promoter is low. We have come to learn that “less is bad”. A promoter who discloses and takes a flat high remuneration, is far better than the one who draws less and then finds ways to create leakages in the company. Leakages are in the form of movable assets, related party businesses, inducting more than reqd. family members, entering new businesses that match the promoter's lifestyle.

• Same applies to the salaries of the key management. Less is bad. Will share an instance about an apparel company, in which the fund we previously worked at, invested in. The salary on the books for two senior business heads was very low. We were invited to a new EBO launch and to our surprise saw them both getting out of their own expensive luxury cars. When we casually enquired about the same with the promoter, the promoter in a sheepish manner, mentioned “They work hard, have given them cars to rest well during their commute!!”. We knew we had a lemon. We soon found out that the balance sheet of that company was completely fake.

• We also investigate instances where the salary of a promoter/group is growing higher than the rate of growth of profit of the company. For instance, in 2017, Neeraj Kanwar, the MD of Apollo Tyres asked shareholders for a 43% raise in salary whereas the profits of the company declined by ~ 2%. The shareholders of the company rejected the salary raise and the promoters were forced to take a salary cut. The profits of the Apollo group in FY 2022, are still lower than those in FY 17 and FY 16.

• Some promoter groups use buyback to get disproportionate pay out of their companies. The procedure for applying for a buyback is cumbersome for an individual investor and hence their allocation is sometimes unused. Some promoter groups participate in the buyback and get a preferential allocation of the shares not tendered.  Groups that use the buyback to their advantage, are a clear pass.

Auditors Remuneration & Diligence

• Auditors remuneration is a key monitorable both in absolute terms and as a trend. We are not a big fan of Big 4 or Big 10 in the Indian context, but we question things like: How can an auditor audit a 1000 cr + topline company for 7 Lakh of fee? Sometimes, it just doesn’t add up. This is a huge problem we grapple with Pharma, Speciality Chemicals, Building Material and Consumer Durables Companies in India. The Auditor's salary just doesn’t add up. How can one audit a multi-location plant, sales, distribution set up having a 1500 cr plus topline in less than 25 Lakh? Not saying that these companies are bad, but one needs to find ways to get comfort that they are professionally managed. 

• Speaking with auditors or someone in the team is a good thing to have. We remember speaking with the auditor of a leading bag company. We had called them to know about the promoters. To our surprise, the auditor told us that the company is involved in a VAT fraud.  

• We also use our auditor/CA network to identify/meet companies respected in the CA community. 

Scanning for related parties: 

• We typically find related party dealings more than 20% of the sales or purchase of materials as a red flag. On one hand, it diminishes the assumptions of MOAT of a business, on the other, as public market investors we do not have the wherewithal to question the fairness of the dealings event when audited by the Big 4. 

• We have seen instances, where related party dealings in raw material purchase brings about volatility in margins. We prefer to stay away from such companies. In some cases, promoters take a loose approach and do not mention a competing business by a family member, as a related party. Such companies and groups are a big no. 

• We also dig for other listed/unlisted promoter entities at the same registered address by looking at websites such as ZAUBA. In case, there is a web of these entities or they have dealings in politically sensitive sectors such as mining, infra, real estate, we stay away from that group. 

• Some Promoter groups use their family members for key roles like procurement, HR, business development. We prefer to scrutinise these companies more as we understand it is quite easy to fake bills under a family member and syphon funds. 

• Some promoter groups have inter-corporate deposits (ICDs) where they use cash-flows from one business to support the expansion of the other. The logic often given to minority shareholders is that ICDs will yield more coupon that a treasury yield and hence a win-win for both. In our experience, such groups rarely create value for minority shareholders. 

Hidden Liabilities & Receivables

• It has been often seen that long term assets and liabilities are a way to brush current receivables and liabilities under the rug. Sectors such as EPC, construction, IT provide an opportunity for milestone-based revenue booking. Promoter groups often use the same to show lower receivables days and impress the investor community. 

• Inventory write down/off practices in businesses such as apparel, building materials are a way to understand how professional/conservative a promoter is? We have often seen inventory not being written down aggressively to protect the projected profitability and value of assets of a business with shareholders and lenders respectively. Such businesses require one headwind, and the business suddenly turns to red from black.       

Business with government/industry bodies with poor credit history

We avoid companies working solely with the government, pseudo government bodies, and development agencies. Dealing with these bodies on social/health/infra projects is a complex task and has been seen to stretch the balance sheet of a company. We cannot quantify this risk and hence stay away from companies such as the Adani Group. 

Credit rating by rating agencies

• Per us, CRISIL is the only rating agency in India that still does its job diligently. We have seen CRISIL downgrade a promoter group debt due to its inability to pay interest on time or pull back its assessment if the promoter group doesn’t cooperate in CRISILs diligence. 

• The ultimate test of cash generation of any company is its ability to pay its liabilities (debt & interest) and shareholders (dividend/buyback). We have seen scenarios whereby on one side a company has a significant cash on its books but still delays payment of debt interest and/or principle. Such groups are a red flag. 

How distracted or disciplined is a founder

• We started this as an informal exercise a decade back but soon realised that this is core. What we are digging for is “How distracted is the founder”. We use this for elimination, rather than for selection. For instance, the MD of a leading consumer durables company being a Lok Sabha MP is a red flag. Or the MD of a leading men apparel brand was more bothered about his silverware, planes, and snow cars than his plans to turnaround his business. 

• We also look for expansion/acquisition into arguably not related areas. We made the mistake of investing in a gaming company knowing fully that gaming is a non-linear acquisitive business. The promoters of the business recently decided to buyout media companies producing gaming content and a gaming hardware/accessories company. The rationale given was to own the gaming ecosystem. The business has been dumped by most public market investors. 

• Promoters who become dealers/brokers for their stocks by talking about share blocks need more diligence.  

• We look for candour in annual disclosures. We look for behaviour whereby a promoter takes undue credit for a macro tailwind in a business and/or delays disclosure of bad news.  

• Lastly, we are all for a company being run by a professional management. We, however, believe that a management just incentivised by salary/bonus is usually not aligned with the long-term sustainable growth of the company. We stay away from companies where promoters have given the day-to-day control of their business to a management and have not incentivised them by reasonable ESOPs. Such promoters are kept away from the reality of the business by their management.   

Look for events of shareholder wealth creation

• This is a litmus test that is above all. Prior behaviour of founders to distribute cash reserves, not dilute minority shareholders, high dividend pay-out, not participate in buybacks, and no event of a preferential allotment are all very strong indicators of a good governance.  

• Another event to measure the same is the terms of merger of a group entity. We do not like promoters who merge/de-merge group entities too often. If done too often, it is usually good only for founders. 

• Also, a promoter who pledges his stake for equity infusion in another business is a big no. Usually such companies are not left with much chance and your wealth creation (already a low prob) is not aligned with that of the Promoters.  

Thanks 

Prescient Capital

Investor Memo Dec 2022

Dear Investor, 

Happy new year. Wishing you and your family great health and happiness. Below is the chart comparing our performance to the benchmark.  

In this update, we will examine whether timing the market can lead to better returns. The most common query we are posed by our prospective clients is whether it is a good time to invest given maybe the market is at an all time high. In fact, we have experienced that this is a question we are asked more often than other more relevant questions that prospective clients should ask of active fund managers like us: how our strategy is differentiated, how do we manage risk in our strategy, are we flexible to change our strategy in different market scenarios given no strategy works in all market scenarios, etc.  

We will be looking at historical data of the past 50 years of S&P 500 to check whether market timing can lead to better returns. We have chosen a US Index only because we don’t have 50 years trading history for Indian indices like Nifty 50 or BSE Sensex. Also, S&P 500 index is a more broad-based index and is thus a much better representation of overall market behaviour. 

We compare the returns generated when invested in S&P 500 on any day historically with 2 different scenarios:

• Returns when someone invests in S&P 500 only on the days when it hits an all time high (ATH). Logically this sounds like a very risky strategy as investment is being done when markets (as represented by the index) are at an all time high. This will help answer whether an investor should wait to invest for markets to correct if it is hitting an all time high. A most common question posed to us as we noted above.

• Returns when someone invests in S&P 500 on the days when it has corrected 20% from its previous all time high level. Logically this sounds like a safe strategy as investment is being done when the market has entered a bear phase. A correction of 20% from previous high is considered as the market entering a bear phase. So, investing at bear market levels should logically offer better than average risk reward pay off.

Below is the chart of S&P 500 index over last 50 years:

First, we look at the statistics of 1 year, 3 years and 5 years returns (CAGR in case of greater than 1 year holding period) generated if we invested on any day in S&P 500 over the last 50 years.  There were 12,607 trading days of S&P 500 over the last 50 years period ending on 23rd Dec 2022. We calculated the 1 year, 3 years and 5 years returns generated if we invested on each of the 12,607 days. Below is the distribution of 1 year returns in a chart form as well as different statistics like mean, probabilities, etc for the set of 1 year, 3 years and 5 years returns in a tabular form.

*when holding period is > 1 year, return means CAGR generated wherever mentioned in table

Now we will look at the statistics of returns generated when an investor invests only on days when the S&P 500 hits an all-time high. There were 864 such days in the last 50 years of trading history of S&P 500 thus the set of samples is obviously smaller compared to the above analysis. Below is the distribution of 1 year returns in a chart form as well as different statistics like mean, probabilities, etc for the set of 1 year, 3 years and 5 years return in a tabular form for this analysis.

*when holding period is > 1 year, return means CAGR generated wherever mentioned in table

There is hardly any difference in the statistics in the above table compared to the statistics in the table when investing was done on each trading day in S&P.  The median 1 year, 3 year and 5 year returns are almost the same. Moreover, the probabilities of loss in capital invested (-ve returns) and of generating 10% or higher annual returns is almost similar to if one invested on any given day in S&P 500. The only difference is that the min, max returns as well as the volatility of returns (as measured by standard deviation) in this case are lower than if we invested on any given day in S&P 500. This we guess is a positive trait as it indicates lower volatility.  

The results seem to be contradicting our intuition that returns should be significantly lower if one invests in equities when the market (as represented by a benchmark index) is at an all time high. There are couple of reasons for this:

A.) Bull markets last much longer, typically 5-6 years, than bear markets, typically 1.5-2 years. If we just take a look at the 50 years chart of S&P 500, we can see bull cycles:

• From 1991-2000 till it ended with the dotcom bust

• From 2003-2007 till it ended with the Lehman crisis 

• From 2009-2021 end with a very minor (time wise) blip related to the coronavirus pandemic scare lasting only ~6 months or so over March to October 2020

So, if one stays away from the market when it hits an all ATM, specially in early days of a bull cycle, he/she will find it most difficult to get in at a later stage due to anchoring bias and may miss the entire cycle. An important question to consider is how does one know when the market starts to hit an all-time high that it is not the start of a multiyear bull cycle?

B.) Indices or particular equities only hit a high typically when macros are positive, earnings growth prospect is strong, etc. Most often this confluence of positive factors remain in place for a while till some macro turns negative or in case of a particular stock if there is a major misstep by the company. So, it makes sense that when the index hits an all time high, there is a good probability it will keep on hitting further highs for a while. A very popular and proven technical style of investing - ‘momentum’ investing is based on investing in stocks when they hit an all-time high. There are active fund managers who have used this strategy to deliver attractive returns.

We are fundamental bottoms up investor and do not use any technical style but even for us, our greatest winners like TD Power, FIEM Industries, etc have kept on making new highs over time and contributed the most to our returns. We first started investing in FIEM at INR ~400 level and in TD Power at around INR ~25 level for our oldest clients. Subsequently we kept on averaging up both of these 2 stocks in older portfolios as well as bought these at different higher levels in new clients. In fact, we are still investing in both these companies at current levels or at slight discount for our new clients as well as averaging up in older portfolios. A very important point to remember is how a stock or overall market has reached a particular level is irrelevant. If it makes sense to invest from a bottom up perspective due to attractive valuation and strong earnings prospects, then one should obviously invest rather than hoping and waiting for a better entry point.

The last analysis we will do is evaluate whether investing only on days when S&P 500 corrected 20% or higher from previous high is an attractive investing scenario. Below is the distribution of 1 year returns in a chart form as well as different statistics like mean, probabilities, etc for the set of 1 year, 3 years and 5 years returns in a tabular form for this analysis.

*when holding period is > 1 year, return means CAGR generated wherever mentioned in table

Comparing the results from this scenario with the above 2 scenarios, one thing which is clearly different is that the probability of -ve returns or basically dip in capital invested reduces substantially. This makes sense because if one invests after the index is already down 20%, then chances of losing money from that point is significantly lower. Other parameters like median return and probability of generating 10% or higher annual return are almost similar to the above 2 scenarios. So, one can conclude a 20% or higher correction offers better than average risk reward payoff as risk of capital loss is lower.

Overall, our conclusion from the above historical analysis is that it does not make sense to wait for a correction to invest when markets are at an all time high or in general post a period of good returns. However, on the other side, market correction by 20% or higher from a previous high offers a better than average risk reward payoff.

Please let us know if you have any questions / concerns.

Thanks 

Prescient Capital

Investor Memo Nov 2022

Dear Investor, 

Hope you are doing well. Below is a chart depicting our returns viz BSE 500.

In this monthly update we will discuss the following: 

1. Our current portfolio construct and the rationale for the same

2. The valuation of our portfolio viz the BSE 500

3. Performance of our portfolio companies in Sept 2022 and their near term outlook

Portfolio Construct

The chart below depicts the current construct of our portfolio. Your individual pie chart may vary based on your vintage with us. 

We have a high allocation to: Auto/Auto ancillary, BFSI, Branded Consumer goods and Manufacturing. These are four segments where we have deployed ~ 65% of your capital. Our core investment thesis in these 4 segments is as follows: 

Auto/Auto Ancillary

The auto industry is coming out of a 4-5 year period of demand contraction/stagnation. We are now seeing: a.) strong sustainable demand for passenger vehicles, refer chart below b.) steep rise in adoption of 2 & 3W EVs, c.) cyclical revival for commercial vehicles, d.) easing of supply side bottlenecks like semiconductor shortages. We are currently investing in OEMs which are segment leaders or in ancillary vendors of these OEMs. 

Source: SIAM, Vahan Dashboard

BFSI

The BFSI industry has weathered the COVID asset quality storm reasonably well. With rising interest rates and a strong demand across all segments of lending: housing, personal, corporate, MSME, vehicle and micro-finance (in that order) are segments we are interested in. We have been tracking the most conservative/high quality managements in each segment and building our position at reasonable valuations. A lot of research reports have been written about strong demand in BFSI and one should be less concerned about asset quality as the same will improve for the sector as a whole. There is a temptation to pick an asset at dirt cheap valuation as the whole sector will do good as a whole. We have however, seen that the culture of conservative lending is like reputation/trust: takes long but evaporates with one mistake. We therefore like to back only the best quality lenders at a reasonable valuation. Building a position at a reasonable valuation is possible only by investing in a sector before it becomes a hot sector.  

Branded Consumer

Core demand for consumer goods remains subdued due to either the high base effect of COVID or steep price rises taken to pass on inflation in prices of commodities. We have been investing behind players who are a.) breaking out from being small/regional players to multi region players, b.) Or are dominant players in their core verticals and are expanding into adjacent verticals. This thesis is playing out well, given that in the last 10 years FMCG distribution has been democratised. 

Manufacturing

Leading sectors in India: power, tyres, cement, pharma and chemicals are currently investing in expanding capacity and/or optimising their energy consumption. Refer to the Gross Fixed Capital Formation chart given below. The Russian-Ukraine war has also triggered discussions of energy self reliance around Europe. Indian companies which are globally competitive in manufacturing of power equipment are expected to gain from this trend. 

NOTE: Figures in INR Bn.

Portfolio PE Multiple and Performance

We are comfortable with our Portfolio’s PE multiple. We however have become cautious in the deployment of fresh capital given the background of rising markets. The current cash balance of ~ 12% on average is an indicator of the pace of deployment. 

Q2 FY 23 was a tough quarter due to rising input/fuel costs and weakness of demand in some pockets and high volatility in global currencies. 

1. In Q2 FY23, our portfolio as a whole grew sales and profit by 18.8% and 17.5% y-o-y respectively. 

2. 20% of our portfolio companies demonstrated subpar topline growth (less than 5% sales growth YoY). 40% of our portfolio companies de-grew their profits YoY in Q2 FY 23.  

3. We are closely watching these companies for their near term outlook and building subsequent positions accordingly. 

4. In situations like these, we focus on the metrics that are under the control of the management and eliminate short term blips due to external factors such as freight/supply shocks/currency/fuel as these external factors reverse equally fast.   

5. We are already seeing commodity/metal prices and currency fluctuations taper.

6. The balance 60% of the portfolio demonstrated a median sales and profit growth of 24% and 32% respectively. 

7. We continue to allocate more capital towards names that can deliver a sustainable IRR of ~ 25% for the next 3 years. 

8. We continue to find opportunities at reasonable valuation in Cement, BFSI, Auto Ancillary and Domestic Pharma.   

We have exited from R systems due to its sale and delisting from the exchanges. We believe that we can deploy the capital in other interesting ideas.

Thanks 

Prescient Capital

Investor Memo Oct 2022

Dear Investor, 
Hope you are doing well. Below is the chart depicting our Portfolio returns viz. BSE 500.

In this month’s memo we compare active and passive investing: 

As an investor, a very pertinent question for you to ask is whether it makes sense to just invest in passive strategies, basically index funds, rather than invest in active strategies like us (bottom-up stock picking). This is also an important existential question for us because an active fund management career for us only makes sense if we can beat benchmark indices sustainably. We do believe that sound stock selection can generate significant alpha over long investment horizons in case of Indian equities. However, the belief needs to be supported by some historical analysis so in this update we will evaluate whether an active investing style works in Indian equities or not.

This debate of active vs passive is a hot topic in US equities investing because most active strategies have not beaten benchmark indices like S&P 500 in the last 10-15 years. Given the higher fee structure of active funds, this has led to massive outflow of funds from active strategies into passive index tracking funds in the US. Also, the common perception is that equity investing, especially investing in small cap companies, is very risky and leads to losses. This is highlighted by the graphic below that was part of a recent article in financial daily Mint about the perils of small cap investing. It highlighted the fact that only 12% of small cap companies in India delivered more than 25% CAGR over the past 5 years and 14% of these companies die (get delisted or have trading suspended) over the same period.

Given what has happened in the US and the low probability of hitting upon a multibagger stock idea, one would think active strategies do not deliver alpha in India as well. In India, most of the public market funds are invested in active strategies so it makes sense to check whether historical data supports active investing in case of Indian equities. The table below compares the performance of Indian MFs against relevant benchmark indices over the last 10 years. We have chosen a period of 10 years as equities by nature is a long-term investment tool.

The data above clearly shows that Indian active fund managers have beaten benchmarks handsomely over the last decade. In case of all market cap-based categories of MFs, the median return CAGR is similar or better than the return CAGR delivered by the relevant benchmark index. The top performing fund has comprehensively beaten the benchmark returns while the return CAGR delivered by the top 20th percentile fund has also beaten the benchmark by a decent margin. The outperformance of active fund managers over benchmark is most pronounced in the case of the small cap category. In the small cap category, even the median return CAGR of small cap funds is ~500 bps higher than the return CAGR delivered by the benchmark. So how does one explain the dichotomy between these 2 facts:

• Small cap companies have high mortality and low chance of success

• Small cap MFs have generated the highest absolute returns as well as the highest alpha on average over the relevant benchmark

Apart from the above issue, another thing to consider is why has active management worked well in India over the past 10-15 years and failed in the US over the same period. We think there are a couple of reasons why active investing, basically stock picking, has worked especially in case of small cap companies in India:

High promoter ownership and lack of activist investors in Indian equities

Indian equities, except those in the banking sector, across market caps have high promoter ownership. This is in stark contrast to US equities in which typically institutions are the majority shareholders. This makes it extremely difficult to replace promoters and take control of the board in case of Indian listed companies. In addition to that, investor activism is low in India, and it is only in the past few years that there have been cases that minority shareholders have rallied together to oppose promoter mismanagement like unreasonably high compensation, totally unrelated diversifications, or acquisitions. There is no active investor in India of the stature of Carl Icahn, Dan Loeb, Paul Singer, etc in Indian investing. The low investor activism in India has both pros and cons for stock picking. On the one hand, there are many cases of obnoxious corporate misgovernance in Indian listed companies, especially mid and small cap companies that have even low institutional ownership. This leads to high mortality or poor returns in these companies, but these can be easily avoided by stock pickers who do a basic due diligence on promoter integrity. While on the other hand, there are many cases of market inefficiencies, again mostly in small and mid-cap companies, resulting in deep undervaluation. These are well run businesses but ridiculously underpriced compared to the value of their underlying assets and investments due to varied reasons like industry downcycle, low institutional interest, etc. In the US, such inefficiencies are quickly exploited by activist investors but in India these persist over considerable time periods. Such opportunities offer patient stock pickers to invest and wait patiently for any trigger to unlock the underlying value.   

Business scale needed to get listed in India much lower than in US or China

The scale of business needed for a company to get listed in India has always been much lower than in China or the US. This has historically been the case as there are some ~2,900 companies with revenue of less than 500 Cr (<100 Mn $) out of total ~5,000 listed companies in India (a share of ~60%). The latest company to get listed “Tracxn Technologies Ltd.” had FY22 revenue of INR 63.4 Cr (<10 Mn $). A company of this scale will find it impossible to get listed in the US or China. So, the small scale of most of the listed companies explains the dichotomy in small cap investing that we covered earlier. On one hand, it is natural for many such small businesses to find it very difficult to scale or even survive over time resulting in low probability of small cap companies to be multi baggers. On the other hand, there are many niche small businesses with differentiated models that offer active investors to find venture-like return opportunities with much lower than venture risk. In the small cap space, there are many companies operating in niche areas in industries like pharma, chemicals, consumer, engineering, etc that can scale rapidly just like any tech businesses that are funded by VCs on the private side in India. Below are 2 such examples:

Astral Ltd.

Astral was a small cap company with a market cap of just 219 Cr on 1st Jan 2010 and today its market cap is 41,730 Cr, which is same as that of Paytm today. It has delivered a 191x return over the last ~13 years or so. It is a very differentiated business started by first time entrepreneur Mr. Sandeep Engineer. Astral pioneered the branding of housing plastic (PVC & CPVC) pipes. You might have seen Salman Khan appearing in Astral Pipes ads on TV. No one thought that something as commoditized as plastic pipes could be branded and made into an aspirational product for homeowners. Astral was able to do that over the past 2 decades and the result is its multibillion $ market cap.

P I Industries Ltd.

PI Industries had a market cap of 269 Cr on 1st Jan 2010 and today it has a market cap of 49,506 Cr delivering a return of 184x over this period. PI pioneered the business model of outsourced manufacturing for global agrochemical innovator giants like Bayer, Dow, Syngenta, etc. 

There are many more such examples of companies from the small cap space that have scaled up to be multibillion $ market companies. So, there clearly are venture like investment return opportunities in the small cap space in India. However, the risk is much lower than in the venture space because these companies do not have easy access to capital like in the VC space in India. These companies have to use their accrued cash from business to scale, so these companies must be viable / profitable first and then scale using these internal accruals over time. Public market investors like us have the luxury to selectively pick viable and in fact most profitable businesses using simple financial metrics like high ROE / low leverage / lean WC cycle, etc to filter companies. It is relatively easier to cull out poor businesses that will most probably die or generate subpar returns than in venture area where even businesses with multibillion $ valuation are yet to prove their business viability. Thus, the large number of small and mid-cap listed businesses and the associated probability of errors of commission can be minimised by basic research on business fundamentals and management competence. The main analysis that needs to be done is whether these businesses have the right management, processes, business differentiation, etc to scale up and deliver outsized returns. Obviously there will be several cases in which the thesis on growth and scale up may not work out as in the initial investment hypothesis. However, we believe the downside risk of permanent capital loss or subpar returns is much lower in listed small and mid-cap listed space compared to venture capital, but the upside or rewards are almost similar.

The thesis shared above in support of stock selection in Indian equities, especially in the small and mid-cap space, is obviously biased by our strong belief that sound stock selection in Indian equities can lead to alpha generation. This makes sense as we need to be optimistic about the asset class and stock picking that we do and we hope we will be able to deliver healthy absolute returns for our clients.

Thanks

Prescient Capital

Investor Memo Sept 2022

Dear Investor, 

Hope you are doing well. The following chart depicts our returns compared to BSE 500 TRI benchmark

We wanted to start this month’s memo by drawing inspiration from the memo of Legendary investor Howard Marks. The memo is titled after his memo “Nobody Knows”. His memo was written during the peak of the COVID crisis, the message and where we are however is apt for the current context. I wanted to start this memo with a kind of a rhetorical question: 

Did we correct anything post the 2008 crisis or was it a debt patch work? The signs of the current crisis were loud and clear in 2018. The zero interest rate regimes and spends backed by more Debt, just made sure that the problem got magnified. India and Germany to an extent are the only two exceptions amongst large economies where the fiscal debt has been controlled. Refer chart below: 

Refer to our 2019 note: “Burn Baby Burn”, “Burn More” — Prescient Capital for a read of the situation in 2019, pre-pandemic. The COVID liquidity package just delayed the downward trigger by 2 years and made the problem even bigger. 

In the midst of all this global macro-economic chaos, a lot of you may have asked this question: Is India insulated from these events? Surprisingly, India has so far weathered the storm well and the Rupee hasn’t moved south much when compared to other leading currencies of the world. This however, is a static view as the global macros can deteriorate even further. The US, Europe and China (that constitute ~ 80% of global GDP) are slowing down and have a significant Fiscal debt overhang. Nobody knows or can predict the impact of the same on India and its equity markets. It is also not worth spending time to assess the same as the effort is best spent elsewhere. India will slow-down due to rising interest rates that directly affect spend on housing, automobiles and brown goods. The rise in prices to pass commodity inflation has also delayed/postponed the demand. Brands are working hard to pass on the high price inventory and re-kindle this demand. On the flip side, commodity and energy prices have cooled off and are likely to help in improving corporate profits. We have also seen corporate India spend heavily on CAPEX to address both domestic and export demand. All this implies that investing from hereon will not be based on macro/secular trends/momentum. We believe that bottoms up investing is key for making and preserving returns for the next 18-24 months.  

How are we spending our time: We are focusing on the companies in our portfolio, assessing them for the impact of a global slowdown, and re-evaluate their inclusion in the portfolio. Over the last 6 months, we have taken the following actions:  

• Moved out of US focused drug formulations/intermediate companies due to a significant competition and price erosion and now the risk of slowing demand.  

• Moved out of our IT sector bets where the trade-off between future growth and valuation was not in our favour. As we see things right now, the IT sector is slowing down due to a global slowdown. The IT sector may grow at a lower rate, and hence the valuations have to correct further for the sector to be investable. 

• Domestic demand is expected to accelerate post the commodity cooldown. We have invested more in companies that have a domestic consumption play: Domestic Branded Pharma, Consumer Staples, Branded building material. 

• We have invested in auto and auto ancillaries due to strong growth prospects in domestic Passenger vehicles and 2w EVs. We have capped our position in auto-ancillaries that are exporting or are evaluating them carefully QoQ for sustainable growth.

• Increased allocation in BFSI across retail and commercial vehicle finance. We had to exit and limit our drawdown in a leading housing finance company after its MD put in his papers. We may invest more in regional banks/NBFCs investing in secured assets such as gold and working capital. We see revival in rural demand through the Microfinance route too. We however plan to stay away from MFIs as the risk reward is never in the investors favour.  

• We have added companies in manufacturing that have a dominant client base/order book in India.  

• Sectors where we plan to deploy more capital in the next 1-3 months: domestic demand based manufacturing, domestic pharma, FMCG and BFSI. 

We believe that the next 12-18 months will see high volatility in equity markets. There may be multiple rallies and multiple troughs. We plan to exit richly valued companies during these rallies and deploy aggressively during these corrections. We believe that times of uncertainty are best for returns in equity markets. Hence, if you have long term capital that you wish to deploy, this may be a good time.       

We want to end this memo with a quote from Howard Marks: “Waiting for the bottom is folly. What, then, should be the investor’s criteria? The answer’s simple: if something’s cheap based on the relationship between price & intrinsic value you should buy and if it cheapens further, you should buy more”. 

Thanks 

Prescient Capital

What are five key things to keep in mind for successful long-term investing

Stop chasing after each short term trend or fad in the market.

Generating healthy returns by investing in every new fad or hot sector and continuous portfolio churn without true understanding of fundamentals is impossible. Only deep understanding of sectors and businesses developed after thorough research & diligence and then patiently remaining invested in good quality businesses and management teams can lead to outsized investing returns.

Learn to endure market volatility and short term corrections.

Markets will be volatile driven by fluctuating investor sentiments, liquidity, FII inflows, etc. All factors over which businesses have no control but which impact their share prices in short term. Moreover, given how volatile macros are, businesses will face short term challenges like rising inflation, blips in demand, irrational competition, etc from time to time. If the businesses one is invested in are inherently high quality businesses run by honest and competent managements then they will overcome short term challenges to deliver industry beating performance in long term and outsized returns. One has to endure short term volatility and corrections to enjoy the long term outsized returns delivered by exceptional companies.

When investing in any opportunity, form a clear investment hypothesis and identify key operating and financial metrics to track whether one's ingoing thesis is working out or not.

For example, you may invest in a business with the thesis that its RoE (return on equity) will increase substantially during your investment horizon and so it will rerate and deliver great returns. For that to happen, some operating metric(s) has/have to improve like working capital should reduce or utilisation should go up or product mix should improve leading to higher profitability during our holding period. So, one has to identify the metrics at time of initial investment and then track their progress over time. Obviously one should be patient and give the company appropriate time to improve that metric. However, if one sees that there is no measurable improvement in that metric even after remaining invested for ample time, then one should exit or reduce the size of that position. On the other hand, if there is better than expected improvement in the identified metrics, then one should increase investment in such positions. It is important to double down on winning investments and cut down on losing positions over time to generate outsized returns.

Stop benchmarking you returns with other investors or indices or other benchmarks constantly.

While one should definitely benchmark longer term returns like over 2 years or longer, it is detrimental to compare 1 month, 3 months or even 1 year returns. Equity investing is meant only for long term as short term factors like volatility, liquidity, etc cancel out and only the business performance matters for delivering returns. So, one should be patient enough to allow an investment strategy to work out. Moreover, no investment strategy will work out in every market conditions. Every strategy is bound to underperform in different short periods of term. However, if the strategy is a sound one it will deliver healthy long term returns. So, one should avoid constantly benchmarking equity returns and be patiently invested.

Keep track of regulatory and technological disruptions that can structurally impair the fundamentals of any business.

While it is important not to be bothered by short term factors, it is equally important to keep track of any structural change like regulatory disruption or technological obsolescence or permanent shift in consumer preferences that can permanently damage a business’s fundamentals. If that happens, it is important to exit that position immediately.

Refer our article: https://www.zeebiz.com/market-news/news-what-are-five-key-things-to-keep-in-mind-for-successful-long-term-investing-analyst-decodes-196146

How can one avoid the odds of permanent loss of capital in markets?

Never loose capital, no other rule counts. As institutional investors, we have typically seen that there exists an information asymmetry between institutional and retail investors. Retail investors have limited access to quality research and to add the intermediaries that serve them sometimes do not have their incentives aligned. Retail investors therefore are left with no option but to: 1. Either buy a stock at expensive valuations, 2. Invest in momentum behind a stock, 3. Or are caught off-guard when a management ill-treats minority shareholders. All these actions greatly increase the odds of a permanent loss of capital. We believe that the golden rule of investing is never loose capital, and all other rules comes afterward.

The following tools/framework can help a retail investors and anyone in general to reduce the odds of loss of capital:

Quality of a Management: In our discussions with a lot of retail investors, we have seen than what is often not in public knowledge is the quality/ethics of a management. Life would have been much simpler if we could tag a management as red/yellow/green based on their governance practices. Investors could however, use the following thumb rules (list is not comprehensive) to safe-guard themselves from corrupt/low quality managements:   

• Look for related party transactions in the annual report & stay away from managements that have either >20% of their sales or cost related to a group entity.

• Stay away from companies that do not declare dividends/buybacks even though there is cash sitting on the books.

• If total promoter remuneration/perks are greater that 2-3% of the top-line, it is a red flag.

• If a company’s cash flow from operations is less than 50% of the PAT for the last 3-5 year period, such businesses are not attractive as they cannot recover their sales and capital gets stuck in working capital.

• Stay away from turnaround and/or managements that are acquisitive. These have a very low probability of success even with a good management.

Quality of a business: Try to find companies that have a return on equity (ROE) > 15% for a 5-10 year period. Statistically speaking, companies that have a ROE >15% in the last 5-10 years, have compounded capital at a higher rate than the companies that have a sub-par ROE. Refer table below:

We can see from data mentioned above that investing in high quality businesses greatly reduced the odds of a permanent loss of capital to less than 2%.  

Pay a conservative valuation: Retail investors investing in a mutual fund or a PMS should always check for its trailing Price to Earnings multiple (TTMPE) and check whether it is at a discount or a premium to the index. A significant mistake a lot of investors and fund managers make is to invest in high quality businesses at any price. The same increases the odds of a loss of capital or increases the holding period to recover capital. Retail investors often lack the patience to hold stocks for long and end up taking a capital hit. Best thumb rule for anyone is to not pay more than a TTM PE of 15x for B2B businesses and a TTM PE of 25x for a consumer facing business. The data below further backs this argument that in the short term (up to a 3 years of holding period), entry valuation is a significant determinant even amongst well managed companies. As the holding period increases to 5-10 years, entry valuation becomes less critical determinant to returns and capital protections.

To sum up, if we get the management and the business right, the odds of permanent loss of capital are less than 2%. Therefore, retail/SIP investors should focus on investing in clean managements running good quality businesses that are available at a reasonable price.