Investor Memo - Aug 2022

Dear Investors, 

Hope you are doing well. Below is the chart depicting our fund returns viz index.

When to Exit? 

This month we wanted to discuss our framework on when to exit a stock. Many of you have discussed with us the timing of our exits when the markets have peaked in the background. 

We believe that exit is the most difficult skill a fund manager masters. Needless to say, we have got the same wrong too, at times. What makes things difficult is the emotional cost of staying invested in a stock. It has the ability to colour our decision making. 

We therefore write down our exit conditions when we get in any company or stock and always track the company against that exit condition. This three-point exit framework helps us stay unbiased/unemotional about our exits: 

Exit at any price if we discover any material and credible red flag on the corporate governance, capital misallocation of the promoters. 

If there is any change in assumption on the quality/governance of the promoter, it is best to exit the stock. We have often seen that rich valuations of a stock are supported by a belief in the managements’ ability and their fair treatment of minority shareholders. This trust is often built over years. We have seen time and again examples (Yes bank, DHFL, RBL, Manpasand, Capacite Infra) where a material red flag on corporate governance can significantly de-rate a stock by as much as 80-90%. It is therefore best to exit a stock when we discover any material and credible red flag. 

1. Red flags around capital misallocation (eg: Exide, Kirloskar Oil, Bajaj Consumer) where a management enters not related businesses is often a sign of an incapable management. We believe that if a management has surplus cash (over and above what it needs to support its business growth) it should distribute the same back with shareholders in the form of dividend/buyback. We may sometimes go wrong in assessing a management’s ability to launch a new business successfully. We however believe that any new business typically takes >5 years to establish, a timeframe which is beyond our investment horizon. For that time, the new business is often a drag on the profitability of the existing business. 

2. We do not like over-acquisitive management for the same reason as given above. It has been proven statistically and operationally that mergers/acquisitions are difficult to execute. Managements who are always acquiring are in a state of flux, which hurts a company’s profitability.  We recently exited NAZARA (a gaming company) for the same reason. Their acquisitions in not related categories is a way to buy topline. We also believe that it typically takes 4-5 years for any M&A to fructify in synergies, a period beyond our investment horizon.

3. Lastly, a management's corporate governance track record once tainted, remains tainted, till there is a change of ownership.   

Any material deviation from the stated business/growth plan leads us to reassess the decision to stay invested or allocate more capital to the stock. 

We are usually patient in our approach to assess the execution capability of a management and prefer to have a point of view after 9-12 months of investment. This helps us segregate events that are in the control and that are out of control of a management.  We have often seen that markets are more focused on QoQ performance than the plan over 2-3 years. A management might miss its earnings estimate in a quarter due to events that are one time or not in the control of a management (war, supply shock, trade embargo, commodity price spiralling up). This creates a buying opportunity for us, rather than an exit opportunity. On the flip side, if we believe that an event can dent the earnings of a company for more than 12 months, we prefer to exit or trim our position in a phased manner and revisit the company after the 12 month period. 

Lastly, we invest at conservative trailing PE multiples and are not too greedy in deciding the exit multiple. 

While investing, we define a reasonable exit multiple (typically 70-80% percentile) and stick to the same in exit. For example: In our IT investments, we invested at a PE multiple of 8-12 x in Birlasoft and started exiting the stock at a PE multiple of 30-35x. In Mphasis, we started entering the stock at a PE multiple of 12-15x and exited the stock at a PE multiple of 35-40x. In TD power, we started entering at TTM PE of ~ 8x and have started exiting at a TTM PE of 25-30x. We believe that odds of things going wrong are higher at rich multiples and hence one should re-allocate that capital to ideas where odds of making a sustainable 20-25% IRR are higher.   

We would also like to share our recent coverage in Zee business titled: What are five key things to keep in mind for successful long-term investing - Analyst decodes

Thanks 

Prescient Capital

Investor Memo- July 2022

Dear Investor,

Hope you are doing well. Below is the chart comparing our returns to BSE 500:

Below is our review of the YTD Indian macros,their impact on equities and the way ahead.    

Macros for Indian business in YTDFY22 are a case of glass half full

The first half of 2022 has passed so it will be worthwhile to study performance of Indian equities, understand the key trends and develop an informed opinion of how the rest of the year may pan out for equities. It will be an understatement to say that it has been a difficult and volatile phase for Indian equities since the start of 2022. The large cap benchmark BSE Sensex has corrected by ~8% in YTD2022 while BSE Midcap and BSE Smallcap indices have corrected by 10.3% and 14% respectively. The drawdown is even higher when considered from the all-time highs achieved by Indian equities during Q3FY21. In our view, the correction has been mainly driven by global macroeconomic factors like: 

• Decadal high inflation in commodity and energy prices mainly due to global supply chain issues; key ones being ongoing Russia-Ukraine war and lockdowns in China till recently due to its stringent zero covid tolerance policy.

• Heating up of the US economy due to liberal fiscal and monetary policies as well as inflation is driving the US Fed to hike rates. There is a fear that the Fed will have to hike rates sharply inducing a recession in the US in 2023. 

• High inflation forcing all central banks including India to hike rates resulting in subdued consumer spending and ensuing fall in global GDP leading to fears of stagflation globally.

While global macros have turned negative since start of 2022, India has witnessed several positive macro factors in last 1 year:

• Indian corporate profits are at multi year high while corporate leverage is at a decadal low. Cumulative profits of top 500 market cap companies as a % of GDP hit a 11-year high of 4.3 per cent in FY22. As per India’s leading credit rating agency CRISIL, the number of credit rating upgrades to downgrades reached a decadal high in FY22.

• Indian banking sector NPAs have fallen significantly from their peak in FY18 and will reach decadal lows by FY24. Indian credit growth is witnessing a revival after subdued growth for the past several years.

• In FY22, India achieved the highest ever merchandise exports of US$ 418Bn, a 43% increase from FY21 and a 33% increase from FY20 (pre-covid year). What is even more positive is that there has been a significant improvement in exports mix towards more value added products. Share of conventional goods like gems/jewellery has reduced from 16% in FY17 to 9% in FY22 while share of engineering goods, which has become India’s top exported product, increased from a meagre 5% in FY17 to 27% in FY22.

• Monthly GST collection hit an all-time high in April 2022 and has remained above the key level of 1 lakh Cr / month since July 2021. A portion of this growth is due to stricter tax compliance and stronger anti-evasion measures but this is also being driven by strong economic revival.

• After a decade-long slump, there are early signs of revival in urban real estate demand. Housing prices as well as sales have seen good growth in most of the key Indian real estate markets.  

Negatives seem almost priced in; incremental positives can drive a strong rebound

Equities globally have seen significant correction to the tune of 15-20% or more in the last 6 months with several markets entering into a bear phase. Indian markets have also witnessed similar levels of correction due to fear of global macros worsening and relentless selling by FIIs while we believe most of the Indian macro positives have been overlooked. There is no doubt that high inflation and consequent rate hikes pose risk to Indian economic revival while global slowdown will definitely have an impact on Indian exports. Moreover, rise in crude prices is already leading to higher trade deficit and further price rise can worsen the situation. 

However, we feel that significant correction in Indian equities since the start of 2022 has factored in most of these apparent negative macros. Any incremental positive indicators on inflation can lead to strong rebound in the markets towards the end of 2022. There are already signs of inflation peaking with prices of agri commodities and metals cooling off substantially from their highs in the last month. This resulted in significant outperformance of auto stocks as the auto sector is a large consumer of commodities. Nifty Auto has gained 6.4% in the last 1 month compared to just a 0.12% rise in Nifty 50. Crude, natural gas and energy prices have not shown any meaningful signs of correction so far but our sense is that inflation may top out in the next 2-3 months. If that happens, then there can be a meaningful rebound in Indian equities post that especially if Indian corporate earnings growth remains strong.

Moreover, valuations have become quite attractive after the 15-30% correction in several high quality businesses from their peaks in the last 6 months. Historically, Indian equities have delivered healthy returns over 3-5 year period following a correction of 15-20% over a 6 months period so there is no reason to believe this time will be different. This correction has brought about a sanity in valuations and taken out the froth from the market that was evident in the unjustifiably high valuations of IPOs, especially of new age cash burning tech businesses, and of certain fad sectors last year. In the last 6 months, this correction has brought back a focus on business fundamentals like cash flow generation, pricing power and sound capital allocation. Despite the substantial overall correction, there have been several strong businesses from sectors like capital goods & engineering, auto, agrochemicals, etc, which were neglected by investors over the last few years, that have delivered exceptional returns in the last 1 year. We believe it is time to invest in quality businesses that are available at attractive valuations to generate healthy returns over the next 3-5 years.

Time to be stock specific

Post this correction, valuations are attractive but it is essential to do proper research to invest in quality businesses with strong growth prospects. We believe that certain sectors will outperform in the next few years and it is important to invest in quality names from these sectors. The first sector that looks quite attractive is capital goods and engineering. After almost a decade, there are early signs of capex revival in India as capex heavy sectors like metals, cement, power, etc have plans of significant capacity addition over next few years. In the overall engineering space, there are segments in which unorganized players as well as weak players with poor financial practices have been weeded out during the prolonged downturn of the last decade. As a result, there are several niche market leaders that have gained significant market share and are poised to benefit in a big way from revival in the Indian capex cycle. Moreover, some of these leaders have significantly increased their exports business because the downturn in the domestic market forced their quality management to increase their international business by spending considerable money and effort on R&D, market development and relationship building with international clients. We believe it is a great opportunity to invest in such niche segment leaders in the engineering & capital goods space that have been able to diversify into international markets as well.

The second sector we are quite bullish about is auto ancillaries. The Indian auto sector has been through a very challenging phase over FY19-22 because of multiple issues like multiple Covid lockdowns, semiconductor shortages impacting production, weak demand due to significant increase in vehicle prices due to regulatory changes, etc. The result is that India auto sales in FY22 is either at the same or lower level than FY17 sales. However, factors like cyclical revival in the economy (especially positive for commercial vehicles), significant improvement in semiconductor supply, preference for personal mobility, etc are expected to lead to a meaningful revival in sales of cars and commercial vehicles over the next few years. Even though auto OEM valuations are not that attractive, several quality auto component manufacturers are available at cheap valuations. What is also interesting is that quite a few ancillaries have also been able to meaningfully increase their exports and are suppliers to several global OEMs just like select engineering players. Moreover, several ancillaries were early in identifying opportunities presented by the transition to EVs and in developing solutions for EVs. It is difficult to place a bet on which OEM will make the most successful transition to EV. However, there are several ancillaries that are vendors of EV specific solutions like suspension components, bearings, LED automotive lights, etc to several EV OEMs not just in India but globally. Such players might have several competitors in the ICE space but in the EV space they are the sole supplier of their respective components to EV OEMs. Select auto ancillaries that have been able to meaningfully increase exports over last 2-3 years or are ahead of their competitors in developing solutions for the EV space will be able to grow faster than the Indian auto sector, which anyway is poised for strong growth. We believe now is a good time to invest in such auto ancillaries when valuations are attractive.

Lastly, we are quite bullish about the agrochemical space because prices of agri commodities remain quite healthy even after the recent correction. India has witnessed a normal monsoon for the last 3-4 years and this year is also expected to receive a normal monsoon. Farm economics are quite healthy globally so agrochemical demand is expected to be strong. We are especially bullish about agrochemical exporters as international markets are less price sensitive making it relatively easier to take price hikes in these markets. Since prices of several intermediates mainly imported from China have significantly increased since last year due to lockdowns and other supply chain challenges, export focused agrochemical players have been able to better protect their profitability compared to domestic focused ones as the Indian market is more price sensitive making it difficult to pass on input cost inflation. FY22 was a strong year for export focused agrochemical players and we expect the demand prospects to remain buoyant this year. 

In summary, we believe this correction has presented an opportunity for long term investors to invest in quality business at very reasonable valuation. It is impossible to predict a market bottom but we believe investors should start investing gradually to take advantage of the current drawdown as healthy returns are only generated by initiating investments in a bear market.

Prescient Capital

https://www.prescientcap.com

Investor Memo May 2022

Dear Investor,

Below is a chart depicting our returns viz BSE 500:

In this monthly update we plan to highlight the performance of our portfolio companies in FY 22. Key observations are:

• Our portfolio companies demonstrated a median YOY sales and earnings growth of 23% and 15% respectively. The earnings growth was lower than the sales growth due to the impact of rise in raw material prices when compared to the last year.  

• Despite lockdowns our portfolio companies have grown at a 3-year sales (FY 22/FY 19) and earnings CAGR of 13% and 23% respectively.

• Our portfolio companies have used this period to become more capital efficient. Their median ROE for FY 22 (18.5%) was higher than their 3-year average ROE of 17.4%.

• The cash flow from ops (ex-Banking companies), has dipped YOY, due to the high raw material prices. Companies have stocked extra inventory and/or have paid higher advances to their vendors to secure supply. Our portfolio companies are still able to convert ~ 80% of their PAT into Cash flows. This ratio was >1x for the previous years. 

• There is negligible leverage on the books of our portfolio companies. Their median Debt to Equity ratio is 0.1x.

• We continue to stay bullish on our portfolio companies and plan to deploy your capital at a steady pace.  

• The median PE multiple of our portfolio companies is 19.5 viz PE multiple of 23x for the BSE 500 index. Refer below.

• Our portfolio has seen a drawdown of 10-15% (across portfolios) compared to a drawdown of 14-15% for the BSE Midcap and BSE Small cap index. The drawdown for the BSE SENSEX has been ~ 10% during this period. Considering we run a much more concentrated portfolio, we believe the that the strong results of our portfolio companies give us a good footing in these volatile times.  

• The below scatter plot depicts, our portfolio’s PE multiple to its YOY earnings growth. As discussed in our earlier communications as well, we try to enter a company at lower than a PE of 20x (non-FMCG) and 30x for FMCG (consumer facing) companies. This gives us enough headroom for multiple expansion when a company demonstrates better than expected results.  We are also in the process of exiting companies where the risk/reward between growth and valuation is not in our favor (eg: NAZARA Games exited from the portfolio).

Investment Thesis of Mrs. Bector Foods.

Lastly, we presented one of our portfolio companies (Mrs. Bector Foods) at an Investor forum.  Below is the link to our thesis.

Link: https://www.youtube.com/watch?v=_SrNsU8SbTQ

Thanks

Prescient Capital

Investor Memo April 2022

Dear Investor,

The last quarter has been a difficult phase for equities, which is also reflected in the drawdown in our portfolio. We believe the market will continue to see a time and probably some price correction in the next 2 quarters. However, we continue to remain optimistic that we are at the start of an earnings cycle that will drive reasonable stock returns over the next 3-5 years. We think any volatility in markets near term will provide us a great opportunity to buy stocks at attractive valuations. In this month’s update, we look at both the negative factors impacting near time performance as well as some of the positives that keep our optimism regarding long term performance of Indian equities intact.

First, we discuss the negative factors:

Impact of US Fed rate hikes

We think in the near term, Fed raising rates remains a significant risk for markets. A normalization of the Fed policy is inevitable and partly priced into markets. However, the medium term impact of a Fed rate hike is dependent on other factors, the key one being India’s GDP growth as well as growth in Indian corporate profits. During 2004-06, Fed hiked rates 17 times by 25 bps each. During the same period, Nifty went up 99.1% though the Dow Jones went up only 7.2%. This is because India witnessed strong GDP as well as corporate earnings growth. During the 2015 cycle, which was more sober, Fed hiked rates by 2.25%. Markets went up during this period too with Nifty rising 40.1% and Dow Jones rising 31.4%. However, in both these cycles, the markets corrected initially in the first few months. So, a Fed rate hike independently is not a clear indicator of market correction in the medium to long term.

Impact of Russia-Ukraine war

We have discussed the impact of this war in a previous update and continue to believe that military conflicts do not adversely impact returns beyond a year based on historical evidence. We cannot add any new insights to multiple geopolitical perspectives that already exist on this subject but agree that the conflict is reinforcing the inflation fears with commodity prices spiking due to sanctions on Russia. We believe inflation was a concern even before this war started and currently also there are equally impactful factors like the Covid lockdowns in China resulting in a spike in inflation. 

Impact of Inflation

We consider inflation to be the biggest risk to equity returns in the near term. Other factors like Fed rate hike, reduction in Fed balance sheet, fear of recession in US and slower growth in India, etc are consequences or responses to rising inflation. Inflation in the USA currently at 8.5% is at its highest since 1982. The Fed rate at that time hit a high of more than 10% compared to the 0.25-0.50% currently. Hence, even with a slightly lower inflation, we may continue to see multiple Fed rate increases though possibly at a slower pace. Inflation will impact profitability of Indian businesses, including our investments, in the current quarter (Q4FY22) as well as next one (Q1FY23). Companies including ones in our portfolio have been taking price hikes, though with a lag, to pass on the input and energy inflation depending on their purchasing power. However, we acknowledge that inflation will remain a challenge over next few quarters and will hopefully ease off during the later part of FY23 when Covid situation improves in China and with a possible resolution to supply side bottlenecks in energy. As discussed with some of you in recent interactions, we are cautious about impact of inflation on our portfolio positions and monitoring 2 key factors to better handle impact of inflation on portfolio performance: 

• Firstly, we are tracking sectors/companies that can take price hikes (IT services, pharma, consumer) to pass on input inflation without adversely impacting demand or maybe are even benefiting from inflation (agrochemicals). We have decent allocation in each and will even increase allocation if our expectations are met or exceeded in the current quarter (Q4FY22) performance.

• Secondly, we are tracking sectors/companies that are not directly impacted by commodity and energy inflation but will witness revival as Covid related concerns subside (mainly BFSI).

We do have decent exposure to sectors like auto ancillaries, consumer and cement that are getting and will be impacted by rising inflation. In case of auto ancillaries, though the inflation will impact profitability over a few quarters, we believe there should be a strong cyclical revival in demand as auto sales have plummeted to decadal lows in the past few years. Also, all our investments in auto ancillaries are bottoms up stories that benefit from increase in LED auto lighting penetration in EVs, tightening emission norms, increased outsourcing to Indian forging players and NPD for EVs and hybrids. We believe that these company specific tailwinds will help these portfolio companies meaningfully outperform the Indian auto industry over 3 years+ horizon. 

Similarly, all our investments in consumer space are bottoms up stories that benefit from the growth in demand for housing/building materials increased penetration of organized players in packaged food, and segmentation of demand in wellness products. Though demand may be impacted in the consumer space due to multiple price hikes taken by companies, we believe our portfolio of consumer companies will deliver higher than industry growth as they have used this time to expand from a regional player to a national player. 

Cement is one industry where we are cautious because it is mostly severely impacted by energy inflation (fuel & power and freight costs is roughly 40-45% of revenue). Our thesis of investing in cement is based on strong demand revival in residential real estate after a decade-long slump and high infra spending by govt. Also, we were enthused by the continued pricing power demonstrated by the industry, driven by significant consolidation, during the last 2-2.5 years. However, the recent hikes in price of crude (> 100$), coal (increase of 100%+ yoy as well as shortage situation), etc have made it impossible for the sector to take price hikes to pass on input inflation. So, the earnings will be impacted over next few quarters, but we believe the sharp correction in cement stocks have more than factored in these factors. We continue to remain optimistic about the medium to long term performance of the Indian cement sector because strong demand drivers remain intact and expect the industry to further consolidate. Overall, we will monitor the inflation situation and will rejig the portfolio based on the above-mentioned performance indicators.

We feel that negative macro factors have been widely covered in recent times. However, there are India specific positive macro factors that we highlight below. At some level, long term equity investing needs us to be optimistic about medium to long term prospects and the below indicators offer hope in these difficult times.

Banking System NPAs bottoming out

Revival in the credit cycle is crucial to sustaining strong economic growth. During the last decade, credit growth was hampered by the ballooning bad debt of Indian lenders. However, the sector has cleaned up bad debts in the last 3-4 years and NPAs are set to bottom out to a decadal low by FY24 as highlighted in a research report by brokerage Motilal Oswal (MOSL). This should support a strong revival in credit growth and help support India’s growth over next few years.

Revival in corporate earnings and CAPEX cycle

Earnings growth was 32% yoy in the Dec 2021 quarter (Q3FY22) for the broader Indian market. Due to the impact of COVID in Dec 2020, it makes more sense to compare Dec 2021 quarter earnings and Dec 2019 quarter earnings. Growth in earnings in this period for the broader market was 120%. Even after excluding financials, the earnings growth for the broader market was 79%. Earnings for mid-caps grew faster than large-caps and small-caps earnings grew fastest. The strong earnings growth is of course also helped in manifold jump in earnings of commodity companies like refiners, petrochemical manufacturers, metals, mining, paper, cotton yarn makers, etc. That might be a cyclical factor, but it does help other sectors like capital goods, engineering, construction, etc immensely as these commodity companies are the largest capex spenders in the economy. After almost a decade, these sectors have the healthiest balance sheet and near full utilization levels and have thus announced huge capex plans over the next few years. This article highlights the same  - 

https://www.moneycontrol.com/news/business/economy/fresh-capex-announcements-by-private-manufacturers-up-210-in-fy22-says-goldman-8418841.html. 

Though, we don’t invest in commodities (except cement), this capex drive will help sectors of our interest like capital goods, engineering, building materials, etc.

GST collections have been rising m-o-m again indicating good health of Indian corporates

Monthly GST collection hit an all time high in April 2022 and have remained above the key level of 1 lakh Cr / month since July 2021. Q1FY22 (mainly May and June 2021) were impacted by the second wave of Covid but since then GST collections have been higher on a yoy basis every month. A portion of this growth is due to stricter tax compliance and stronger anti-evasion measures but that does not explain the entire increase. Strong economic revival has also resulted in this growth in GST collections. Not only GST, overall tax revenues for Indian govt. have increased sharply in FY22 beating the govt.’s own estimates repeatedly -

https://www.hindustantimes.com/india-news/govts-tax-revenue-in-fy22-jumps-34-at-rs-27-lakh-cr-crossing-target-by-rs-5-lakh-cr-101649968830708.html.

This is a big positive as it helps govt.’s ability to spend on infra as well as several PLI (Production linked incentives) schemes it has announced for multiple sectors.

Revival in residential real estate

After a decade long slump, there are early signs of revival in urban real estate demand helped by decadal low home loan rates, need for larger houses due to trend of wfh (work from home) and reduction in supply demand mismatch – 

https://www.theweek.in/news/biz-tech/2022/01/03/housing-launches-up-85-as-realty-revival-continues.html

https://economictimes.indiatimes.com/industry/services/property-/-cstruction/positive-outlook-for-indias-real-estate-sector-as-healthy-demand-expected-2022-outlook-report/articleshow/88186247.cms?from=mdr

Real estate is a key sector of the economy as construction is one of the biggest employers and it is also a big demand driver for building materials and other ancillary sectors. Also, when real estate does well, it has a big wealth effect and improves overall consumer sentiment. If the real estate revival sustains, it will be a big positive for Indian economic revival.

To summarise, we are cautious about the near term (next 6-9 months) performance of Indian equities and believe this will be a volatile phase with limited upside, if any, but we continue to remain positive about the long-term prospects. Unprecedented inflation is a key risk challenging corporate profitability so we will keep monitoring its impact on our portfolio positions and rejig the portfolio accordingly. 

Prescient Capital

Investor Memo-March 2022

Dear Investors, 

Hope you are doing well. Below is the chart depicting our portfolio returns to date viz BSE 500 index.  

In this memo, we wanted to highlight three points: 

1. The Russian/Ukraine war has been a no event for financial markets

2. The lockdowns in China is likely impact global supply chains for another 12 months

3. The impending food inflation can impact demand in India

SUMMARY: We maintain that this is a good time to invest. We are investing incrementally in Pharma, IT, Consumer, BFSI and Manufacturing.    

Markets back to where they were pre the Russia-Ukraine conflict

We begin with the discussion from where we left in our last memo where we highlighted that statistically speaking markets tend to overreact to geo-political conflicts in the short term and recover well in the medium term. The same has played out. The MSCI all country world index is now trading higher than the value when NATO first raised the alarm bell for an attack. Thanks to this panic selling, fund managers having a long term investment outlook had a good buying window. Refer below: 

Similar trend has been seen in the BSE 500 index which is up by ~ 9% from its lows in the last 3 months. During the same period, the divergence in the returns of sectors that have been adversely impacted by energy/oil (Cement, chemicals, manufacturing) and sectors that are not (Energy, Mining, Metal, O&G) has been significant. Refer to the chart below. 

While we would love to find investable (>15% ROCE) businesses in these sectors, the cyclicality in price and inability of the managements by-and-large to control their P&L, makes us cautious. As a result, you would see our portfolio performance lag energy/commodity indices in the short term. 

Our investing framework is most suited to finding sectors/companies that have a strong MOAT, have underperformed in the past due to non structural reasons, and have a good growth outlook which is not baked in the current valuations. As displayed in the 1 to 5 year data above, we find the risk reward between growth and valuation right in the following sectors: 

1. Auto/auto-anc (~ 20% of portfolio): Growth driven by strong exports and EV tailwinds. Valuations still in mid- teens.

2. Pharma/Agrichem (~25-30% of portfolio): Domestic branded pharma growing at steady pace. Spl chemicals exports continue to expand.

3. BFSI (10-12% of portfolio): Credit growth improving MoM, valuation at bottom 10-30% percentile.

4. Consumer and Consumer tech (~20% of portfolio): Able to pass on RM price rises. Demand remains robust so far.

5. IT/ITES (~ 15% of portfolio): Selectively investing in names where valuation is at par with growth. 

The lockdown in China and its likely impact on global supply chains

The recent stringent lockdowns in China have been in response to a sub variant of Omicron. The same has affected ~ 50-60 mn people in 5-7 major cities in China. The same has disrupted functioning of ports, mfg plants, mines and the like. Honk-Kong and Korea are already reeling under their worst COVID-19 spread. The situation could become worse for the next 3-6 months and can not only further hamper supply chains but could also lead to a rise in COVID infections in India. We have typically seen a 3-6 months lag between caseload rise in China and India. We are therefore carefully evaluating our portfolio for any future disruptions in topline and margins.          

The impending food inflation and its impact

The Reserve bank has been so far maintaining its low interest rates/pro-growth stance largely due to range bound numbers of inflation. Refer below. 

We however believe that the food inflation would rise significantly in the near term. The urban demand environment for consumer goods has been buoyant so far. We believe that future pressure in prices of wheat, oil and packaged goods can dampen demand for the near term. Our future portfolio additions in consumer goods will be determined by QoQ performance on earnings.     

Please feel free to write to us. 

Prescient Capital

Contact us: https://www.prescientcap.com/contactform

Great time to invest follow on capital-Prescient Capital

Dear Investors, 

You are well aware that there has been a sharp and quick global correction in equities since the start of Feb 2022 due to the fear of the impact of the Russia-Ukraine war (charts below) on the global economy. This is very similar to the quick and sharp correction that had happened in March 2020 due to fear of unknown impact of Covid-19 on the global economy. Our portfolios have fallen in line with the correction in benchmark indices and we understand that such a sharp drawdown would be a cause of concern to you. 

We write this interim memo to highlight the need for a capital call. We believe that this is one of the best times to deploy more capital in equities in general and with us in particular. We make the argument basis the following points: 

• Our portfolio’s performance in Q3 remains strong and has no correlation with geo-political conflicts or with US interest rate/US inflation. Our portfolio companies have grown at a YOY sales CAGR of 12%. The earnings growth has been a mixed bag due to cost/wage pressures or fixed marketing/sales burn to support next year's high growth. We remain confident about the earnings performance of the outliers in the portfolio and see them reasonably valued (at a PE to growth ratio of less than one) post this correction. In fact a lion share of our portfolio companies have low correlation with Oil & Gas. Our investments in BFSI, IT, Consumer and Capital Goods have a low correlation with Oil & Gas price. We have been buying these companies off late and would want to allocate more capital behind these names. 

• The BSE SENSEX has corrected to a PE of ~23x (was around 19x during the Mar 2020 lows) and is fairly valued. On the contrary, we have seen the best growth in the corporate earnings since the last 20 years. Refer charts below. We have covered the same in our Jan 2022 memo (Refer Jan Memo).

• We are not experts in geopolitical conflicts. We however can draw some inferences from the correlation of markets to war. The charts below clearly highlight that markets tend to overreact to geo-political conflicts in the short term and recover well in the medium term. Infact, we believe that the only variable that matters in the end is how strong is the earnings growth.

• We feel that the Ukraine war is a much less significant event than Covid-19 that had several social and business impacts like global supply chain disruption, reimagining of workspace, labor migration and great resignation, huge loss of lives, etc. Despite all these pandemic challenges, Indian businesses have fared very well and in fact are in the best of their health in a decade in terms of prospects of exports, leverage on their balance sheet, fiscal support from govt., early signs of capex revival in economy, etc. The main impact of the Ukraine war can be in terms of further inflation in energy prices. However, we believe the current govt. has done a commendable job in maintaining fiscal prudence and should be able to handle the situation relatively well. More importantly, Indian companies have been tackling rising inflation for a few quarters now and we believe fundamentally good businesses will be able to take steps like price hikes, cost control, etc to better handle rising costs. 

• Just like during COVID-19 pandemic, some sectors and businesses were able to handle the situation well and emerge stronger, this time too different sectors and businesses will be able to better handle the crisis. Hopefully, as your fund manager, we will be able to identify those sectors and businesses that will do well and increase allocation to them. 

• Lastly, we are not an expert at timing the market however we could see more market correction from hereon. Our plan is to deploy capital judiciously on days of correction and ride out this period.  However, if one is invested in quality and durable businesses that can deliver healthy earnings growth over the medium to long term (horizon of at least 2-3 years), then the risk of poor returns or permanent loss of capital is very low or non-existent. Many of our clients run or are in leadership roles in businesses and an important point to ponder is whether they believe their businesses have been impacted deeply by the Russia Ukraine war. It’s just that the price of listed businesses are determined by market sentiments every day that investors feel that their value is so volatile.

We believe that disproportionate returns are made by investing during times of macro-economic pessimism. We believe that we are in the middle of such a period. 

Please reach out to us for a detailed/informal discussion. Happy to share our views. 

Prescient Capital

Investor Memo Jan 2022

Dear Investor, 

Hope you and your loved ones are doing well and are safe from the third wave of the COVID pandemic. Below is a chart depicting the fund performance viz BSE 500 TRI index. 

In this memo we will discuss the following:  

• How the global interest rates and the policy rates in India can affect the capital markets. 

• Our portfolio’s PE, PEG ratio and the commentary around it. 

• Why it is a good time to top-up your investments

Section 1: Macros

A lot of you would have read the recent commentary by US Fed Chief Mr. Jerome Powell on the possibility of a rate hike and a reduction in USD liquidity. The same had sent the global markets (Including India) in a nosedive during the last month. While we agree markets are in the rich/expensive multiples territory, we wanted to put some historical perspective to the same. The below chart highlights performance of the US markets and the Indian markets during the last few interest rate cycles. 

US market returns during different policy rate cycles:

Indian market returns during different repo rate cycles:

What we can infer from the above data is as follows: 

• The data indicates that there is no stark difference between returns during the rate hike and rate drop cycles. For India the difference is even more marginal.

• Interest rates affect the markets in different ways and the most important of those is triggered by inflation. High inflation for the medium to longer term can suppress demand. In the last 4-5 years, India has seen one of the lowest consumer price inflation when compared to the last decade. As we speak, CPI is rising and may influence policy rates in the near term. Refer CPI chart below:

• Inflation also triggers higher lending rates. It has been seen that banks/NBFCs margins expand during a rising rate cycle, which in turn boost their earnings and markets (BFSI is ~ 36% of index). The fallout though is that the CAPEX cycle weakens and can affect the longer-term growth of the Manufacturing/infrastructure sector; something that countries such as India (which have seen a lost decade of CAPEX) cannot afford. We have already seen a big push by GOI on infra/manufacturing and PLI during this budget. Refer to the chart below on Gross Fixed Capital Formation (GFCF) of India which is barely back to pre-covid levels.

• We believe that the more dominant driver of returns in the market is the growth in corporate earnings. Markets have come under pressure when growth of corporate earnings do not keep pace with the underlying multiples. 

• The data below corroborates what we have been discussing in the past memos (Refer November and December 2021 memos here) that growth in corporate earnings are in their best cycle in the last 20 years. The charts below highlight that we are in a cycle similar to the 2003-07 cycle. 

Section 2: Portfolio Review

Bottoms up investors like us see the economy from the eyes of the companies we invest in. We find hard working and ethical entrepreneurs that are growing their businesses at >15% CAGR and are available at reasonable valuations. Sometimes the reward of the same is back ended and the journey in between is full of doubts, but time has taught us that real returns are made by investing when a company’s earnings are breaking out, and valuations are cheap. We stick with those companies even at the cost of returns in the 3-9 months but believe that mean reversion would happen. We sell these companies when the business fundamentally changes or the incremental PE to Growth ratio (PEG) is not in our favor. We would like to highlight the same through some of the examples in our portfolio: 

* Returns calculated by taking the price of first entry and first exit. Yellow: Exit, Green: Current

Key points to make are:

• Our winners have been companies that are run by great founders and were at the cusp of their high growth when we invested. The markets however didn’t price in this growth or was looking elsewhere. This fundamentally created a gap between their reasonable valuation and future growth. Such companies barely move for a while. The wait can extend from 3 to 24 months. 

• The process however is to have a sharp focus on sustainable growth in earnings and to have some patience. 

• As you would see some of these companies still have a Price Earning to Growth multiple of less than 1. This implies that their growth/growth potential is still not factored in their valuation. We continue to build our position in such companies. 

• You would also see we have exited a few companies where the Price Earning to Growth multiple is far greater than 1, implying that the valuation bakes in too much growth which is not coming. We would rather sit out and wait for a correction that hope growth catches up with valuation. 

We are still comfortable with our Portfolio’s PE multiple and continue to find opportunities in BFSI, auto ancillaries, IT/ITES and consumer. Refer chart below:

Median PE multiple

Section 3: Time to top up your investments

Based on both our bottoms up and top-down discussed above, we can safely say that this is a good time to top up your investments. The recent and near-term correction in the US/Global markets has nothing to do with the intrinsic growth of Indian companies in general and our portfolio companies in particular. It has made investing in companies we like more compelling. Our portfolio companies are growing well and are available at reasonable valuations. We would want to deploy more capital at this stage and enhance your portfolio returns.  

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

Regards

Prescient Capital

Contact us: https://www.prescientcap.com/contactform

Investor Memo Dec 2021

Dear Investor, 

Wish you and your family a very happy, healthy and prosperous 2022. 

Below is a chart depicting our portfolio returns viz BSE 500 TRI index. 

As 2021 ended, we are sharing some interesting insights and data from 2021:

• Indian equities as represented by benchmark index Nifty 50 have delivered an annual positive return in 20 out of the last 28 years (71% probability of positive return in a year). So, the odds of positive returns are quite healthy entering any given year. On the other hand, the longest streak of positive return years is 6. So for 2022 to be a positive return year, it will have to break a historical record as last 6 years have already delivered continuous positive returns. It is up to you as an optimist or pessimist on how you believe 2022 will pan out for Indian equities.

• The last 2 years have taught us that equity markets are completely unpredictable and no one can predict the short to medium trend of equities. No one predicted the sharp fall witnessed in March 2020 as well as no one foretold the subsequent rally in equities from April 2020 to Sep 2021. Below is a table of quotes form 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.

We believe and have seen firsthand in our investing journey that the only prediction that has always worked is “ Time is the friend of the wonderful company, enemy of the mediocre” by Warren Buffet. Long term investing in high quality businesses has always delivered healthy returns irrespective of market cycles.

• The general perception is that the markets are overvalued post the rally since March 2020 but that is incorrect. NIFTY 50 index (a market benchmark) was trading at P/E of 24.11 on 31st Dec 2021. This is very close to the last 10 year median P/E multiple of NIFTY 50 that is 23.34 as can be seen from the chart below:

Actually the rally in 2021 was driven by strong earnings growth and P/E of NIFTY 50 compressed from 38.55 on 1st Jan 2021 to 24.11 on 31st Dec 2021. This is despite the 24% rally in NIFTY 50 because the earnings growth was much higher. We believe earnings of listed Indian businesses will continue to be strong in 2022 and will drive market returns. The table below shows the strong expected earnings growth for FY23:

• Another common misconception is that smallcap and midcap companies are in a bubble zone as they have rallied more than large cap companies. While it is true that small and mid cap companies have delivered higher returns than large cap companies, it has to be seen in the context of the fact that they have also delivered higher earnings growth and are expected to continue that trend. The chart below compares the 2 year forward (FY23) P/E with expected earnings growth (Bloomberg consensus) of small (represented by NIFTY Smallcap 100), mid (NIFTY Midcap 100) and large cap (NIFTY 50) companies. As can be seen, small and mid cap companies are not trading at higher valuations compared to large caps once the strong earnings growth is factored in.

• The rally in Indian equities in 2021 was quite broad with all sectoral indices ending in green as can be seen from table below. However, there was a rotation in sector leadership in terms of returns delivered from 2020 to 2021. Pharma which was the top performing sector in 2020 was the second worst performing sector in 2021. The top 3 performers of 2021 were metals, IT and real estate but metals and real estate had delivered meagre returns in 2020.

IT services continued its dream run delivering 50%+ return for the 2nd consecutive year. This performance is mirrored in the boom that technology is currently witnessing – tech adoption has become a top priority for every industry not only for productivity improvement but basic business continuity since start of Covid-19 pandemic, adoption of digital sales and marketing channels has become a do or die for businesses, talent crunch is severely acute in technology resulting in best ever compensations and high attrition, etc. The rally in commodities and metals in 2021 is being driven by supply chain disruptions due to the pandemic and is resulting in high inflation. Sectors like auto, financial services and FMCG have been underperforming for the last 2 years since the pandemic began. While we believe that the underperformance in FMCG is justified given the very high valuations consumer companies were trading at, auto and financials should perform strongly going ahead. Some of our investing decisions related to this data are:

• We believe IT services is in a structural bull run for the next 2-3 years due to the strong demand for digital adoption. We have a healthy allocation to IT services with 2 positions – eClerx and R Systems. Ideally we would have had an even higher allocation to ITS but valuations for most listed IT companies have run up significantly and we are only comfortable with the valuation of these 2 names.

• Earnings growth prospects are not as strong or broad based for the pharma sector as for ITS. There are 2 challenges for the Indian pharma sector: One is on the supply side due to its heavy reliance on China for key starting materials and intermediates. The other is the intense competition in generic drug markets especially the US, which is the largest export market for Indian pharma. It is very difficult to make a call on how long it will take to resolve or to even understand the nature of the supply side challenges in China. Similarly, it is very difficult to understand the competitive landscape in the US generics market as well as the regulatory challenges posed by heavy scrutiny by US drug regulator US FDA. So, we have decided to stay away from pharma companies that have a heavy reliance on China inputs and also those that have a very large contribution of business from generics. We continue to be quite bullish about the prospects of companies that derive majority of revenues from Indian branded drugs business because these have the pricing power to pass on input cost inflation and maintain margins as well as are witnessing strong growth in Indian drug demand. So we remain invested in India branded pharma focused companies like Ajanta Pharma, JB Chemicals & Pharma, Alkem, etc. We are also excited about pharma businesses that are very R&D driven and focused on niche and very high value drugs like Natco.

• Auto sector has been impacted by multiple factors that are not at all related to demand like multiple lockdowns that impacted auto retailing over the last 2 years, acute supply side shortages in semiconductor chips that has crippled global auto production, etc. In fact, there is a significant pent up demand and order backlog for cars in India as well as globally but OEMs are unable to manufacture to meet that due to the ongoing chip shortage. It is difficult to predict when the global auto chip shortage issue will be resolved but we are still excited about auto components manufacturers that have large export contribution in revenues (like GNA Axles, NRB Bearings) and / or are focusing on developing products for EVs (like FIEM, NRB). We believe globally competitive auto component manufacturers that are focusing on exports as well as tapping the EV opportunity can deliver much higher than industry earnings growth.

• Lenders (banks, NBFCs, HFCs, MFIs, etc) have been the biggest laggards in the last 2 years due to valid concerns on impact of the Covid-19 pandemic on asset quality as well as on loan growth. However, we believe that certain pockets like housing finance and retail focused banks will do well due to the strong revival in real estate demand (helping HFCs) and strong retail liability franchise (helping retail focused banks). So, we are quite bullish about the prospect of our investment in IDFC First bank and Can Fin Homes.

Overall, we believe that 2022 will not deliver the very high returns that the last 2 year delivered simply because starting valuations are not that attractive as 2 years back. So, investors need to temper their expectations from 2022 but we do believe that earnings growth will be strong in certain pockets of the economy. 2022 will definitely not witness a broad based rally in Indian equities like last year but with proper stock selection, we believe one can definitely deliver healthy returns and we have our task cut for that.

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

Regards

Prescient Capital

Contact us: https://www.prescientcap.com/contactform

Investor Memo Nov 2021

Dear Investor, 

Hope you are doing well. 

Below is a chart depicting our performance viz baseline indices:

As of Nov 30, 2021

In this monthly update we will try and summarize the performance of our portfolio companies in Q2 and H1 FY 22.  The link to the summary table is as follows: 

Key observations are: 

• Our portfolio has demonstrated a YoY sales and earnings growth of 21.6% and 12% respectively on a YoY basis for Q2 FY 22. The portfolio has demonstrated a YoY sales and earnings CAGR of 32% and 44% respectively in H1 FY 22. 

• It is apparent from the data that the portfolio has seen margin pressure in Q2 FY 22. The same is attributed to a near decade high prices of input commodities such as Steel, Coal, Palm Oil, and the like. The choke around global shipping lines also ensured that the freight costs were also at an all time high. 

• Compared to Q1 FY 22, ~ 50% our portfolio companies witnessed a reduction in EBITDA margin. 

• Margin pressure was minimum in: 

  1. IT/ITES services businesses due to a strong demand

  2. Branded consumer goods/Branded pharma due to the company’s ability to pass on multiple price rises. 

  3. BFSI as interest rates harden and their book quality improves. 

• Margin pressure was maximum in intermediate chemicals and businesses with a low dependence on own manufacturing. 

• We would like to segregate the margin pressure in two categories: one where basic commodities are input. Second, where the input is not primarily a commodity but is dependent on a global supply chain. 

• The pressure on margins in the former is transient as we see steel (corrected by 25% from peak), palm oil (corrected by 10% from peak), Crude Oil (corrected by 20% from peak).  We also see these businesses being able to pass cost inflation with a lag. 

• The pressure in margins for the latter where the inputs are linked to a global supply chain looks more long term and is not expected to improve in the next 1 year. Our checks with experts running global manufacturing setups indicate that the current covid driven lock downs in China, Europe and Asia are likely to affect the supplies for at least one year. We therefore are closely looking at the intermediate product makers companies in our portfolio and exiting them selectively (Granules). 

• At this moment we are confident that the margins of the companies in our portfolio will recover in the next 3-6 months. This confidence stems from a strong demand environment and a 5-6 year low inflation period in India. We believe that our portfolio companies have a strong MOAT (median ROE of ~ 20%) and can weather this high inflation environment.  

• We are seeing a strong demand in the following segments and are aligning our portfolio to the following themes: 

  1. Auto ancillaries serving the upcoming EV industry (FEIM, NRB).

  2. Auto ancillaries serving the CNG commercial and passenger vehicles. The expansion of the CNG network in India is real and creating a trigger in demand for CNG driven PVs and CVs. 

  3. Banking sector has demonstrated resilience during COVID lockdowns. Demand for home loans, personal loans and corporate loans remains strong. We are investing in companies with a long term history of asset quality discipline and are available at the bottom percentile of the valuation.  (Can Fin, IDFC F)

  4. Domestic pharma has seen a strong demand post the second lockdown. The sector hasn’t run up in valuations. We are investing in branded pharma companies that specialize in chronic/acute segments. (Ajanta, JB, Alkem)

  5. Consumer durables and building materials have seen a sustained strong demand.  We are investing in companies that have a premium positioning and are backward integrated in mfg. (Hawkins) 

• During the last 2 months, we also exited/pruned our positions in the following companies as we think that the trade-off between growth and returns is not favourable.  

  1. Mphasis: Initiated entry at a PE of ~ 19-20x and exited at a PE of ~ 45x. 

  2. Birlasoft: Initiated entry at a PE of ~ 12-20x and exited at a PE of ~ 30x. 

• As a result of this churn in our portfolio, our portfolios median PE multiple has also reduced, refer below. 

As we enter the new year, two main topics look noteworthy: 

• The global liquidity driven rally is at its fag end as inflation in developed world is making real returns negative. This is pushing regulators in these countries to increase bond yields. This is expected to lead to a drawdown of capital from equities to bonds. India still looks insular as GOI has controlled inflation well so far. Refer chart below: 

Source: Charlie Bilello

Secondly, some of you have spoken with us on how we see investing in the short to medium term. Please refer to our September 2021 memo for reference.  

Prescient Capital

Contact us: https://www.prescientcap.com/contactform

Investor memo Sept 2021

Dear Investor, 

Below is a chart detailing our model portfolio returns viz the leading indices. 

In this monthly memo we intend to discuss two broad topics: 

1. Impact of Chinese real estate debt situation on India

2. Macro indicators relevant for investing for the medium/long term in India. 

Impact of Chinese real estate debt situation on India

Real estate contributes to 25-30% of Chinese GDP. The recent clampdown by Chinese Community Party (CCP) on the home prices has sent the already levered balance sheets of Chinese real estate developers in a tailspin. Evergrande is just the beginning, the impact is systemic (stress up to 3-4% of GDP of China) and 10-15 large real estate companies are likely to face a cash flow crunch. Interestingly the first order impact of this debt crisis has been rather limited as a large part of the borrowing of these companies is domestic (>97% of borrowing of Evergrande is from Chinese Banks). What may be of interest from the overall slowdown of the real estate sector is the impact the same can have on the commodity prices. The Chinese real estate sector contributes ~25% of the global demand for iron and steel. The recent credit crunch may taper the demand and may soften the prices of Iron/Steel which have risen by >50% in the last one year. The Iron Ore price, which is a leading indicator of the future Steel price, has already sharply corrected by ~ 40% since July 2021.  This may be good news for Indian engineering/manufacturing companies that have seen their margins getting eroded in the last 6 months.  

The Indian real estate market has no correlation whatsoever with the Chinese real estate debt crisis. After the second COVID wave, the rebound in the Indian real estate market has been phenomenal. For the 9 M of FY22, the residential units sold are up YOY by 65% and the developers have also been able to pass on marginal price rise (1-4%). The overall demand is still hovering around 65-70% of the pre-COVID times though. Our discussions with managements of building material companies also indicate a strong rebound in demand. We typically don’t invest in real estate companies due to their poorly managed balance sheets and low returns on capital employed. We however like its derivative consumer facing businesses: building material and consumer durables. We have invested in SHIL in your portfolios. We believe that new project sales (40% of the sales contribution of SHIL) and pent up demand for building materials and durables (like cooktops, chimneys) should help SHIL grow at a CAGR of 15-20% for the next 2 years. 

Macro indicators relevant for investing for the medium/long term in India.

The regulatory risk around investing in China has increased post CCPs clampdown in real estate, ed-tech, media, and fin-tech. The same could help sustain the high FII capital flows seen by the Indian markets in the recent past.    

Given where the market valuations are, our investors and prospective clients have rightfully asked us this question: “Is it the right time to invest and are we in a Bubble?” As discussed with you in the last few memos, we wanted to discuss the same with some historical empirical data. We have picked up a table from a very well written memo by a peer PMS (Sage One September 2021 memo) to highlight some points: 

Source: SageOne Investor Memo September 2021.

Key observations from the above are: 

• Corporate India is in its prime financial health (better balance sheets and cash flow generation) in FY 21/22 when compared to the last 20 years. The Debt / Equity Ratio, an indicator of leverage on the balance sheet, is the lowest since FY 2000. To add to it, COVID has created a perfect supply/demand shock for a lot of sectors and hence improved working capital for the large/mid/small cap companies. This has helped companies accumulate significant cash. The Cash Flow from Ops/Profit After Tax (CFO/PAT) is a leading indicator of the same. 

• Based on this data, we believe that we are at the beginning of a long capex cycle whereby companies would add capacities by using leverage. One could also argue that the Debt/ Equity ratio has been reducing systematically since FY 01. We would agree to that. However, almost all the manufacturing/engineering/oil & gas/chemical/utility/intermediate products companies we know and are tracking are adding large capacities. We therefore remain optimistic about the prospects of growth of earnings from a 4-5 years perspective. 

Source: BSE

• On the flip side, refer to the chart above: The PE multiple of the BSE 500 index is still high (October 2021 PE of 29.9x) even after correction from its all-time high of 38.8x in Feb 2021. It is fair to argue that the multiple is already factoring in this growth in earnings in the next 2-3 years. 

• There are two main reasons why the current high multiples are holding up: 1.) The growth prospects of Corporate India over the next 4-5 years and 2.) the current low interest rates and high market liquidity. The G-Sec yields are a proxy for lending rates and are at an all-time low (of 6.2%). If we look at the last rally between FY 02-08, the bonds yields came down from ~ 10% to around 5.2%. This propelled capital infusion in the capital markets which returned an IRR of ~ 30% over the 6-year period. At present, RBI is comfortable with the inflation and has kept the policy rates intact. Events such as the slowdown of real estate in China, could help alleviate concerns around inflation and interest rate movement for a while. 

• Worsening of the balance sheet quality of PSU/Pvt Banks could be a deterrent to the availability of leverage to corporate India. The same happened during the 2013-2016 period (refer charts below) during which the banking credit wasn’t available. 

• PSU Banks are the engine of corporate lending and from what we understand from their managements’ reports is that PSU Banks have sorted their asset quality concerns and are back to lending to corporates/SMEs. To our understanding, the overall banking sector has weathered the COVID lockdown well and their asset quality has been marginally impacted. 

Source: BSE

Source: BSE

• Given the background of A) Anticipation of high growth from Corporate India, B) Recovering credit markets, C) High valuation multiples, it is imperative that we continue to invest albeit conservatively. We are investing in companies where the trade-off between growth and valuation is not stacked against us. We would like to highlight the PE multiple of our model-portfolio viz the index.  

• It can be observed and commented upon that the gap between the index and our model portfolio valuations is narrowing over time. We attribute the same to two things: 

  • The higher growth prospects offered by our portfolio viz the index has increased the valuation multiples of the portfolio companies. The valuations are still not at the alarming levels though. 

  • We are at the cusp of exiting from a few companies that have done exceedingly well for us in the recent past however now look rich when we analyze from the framework of trade-off between growth and valuation. The portfolio’s PE multiple should ideally come down over the next 2-3 quarters as we exit these companies. 

• To summarize: We are safeguarding your returns by exiting companies in our portfolio that are at the peak percentile of their valuation multiples. We are redeploying the same capital gradually in new companies at fair/conservative valuation multiples. This will help us to tide well over this period of peaking markets. 

• The sectors where we are deploying capital at present are cement, building materials, auto ancillaries and banking services. 

Prescient Capital

Contact us: https://www.prescientcap.com/contactform

Prescient Capital - August 2021- Investor Memo

Dear Investors, 

Below is our performance benchmarked to major Indices. 

NOTE: As of Sept 06, 2021

After several months of posting strong sequential returns, the small cap space was flattish for the month of August 2021. The benchmark smallcap index BSE Smallcap is flat for the month but does not reflect the correction in the majority of smallcap stocks in the broader market. Since our strategy has a lion’s share of allocation to small and midcap stocks, it is natural for us to turn cautious and introspect on how we should handle a sharp correction or the onset of a bear market in the worst case. The past 1.5 years or so have been great for the equity markets and we have also benefited from the broad rally in equities. However, it is important for us to not only protect our past returns but generate healthy absolute returns from hereon. Over the last 2-3 months we have been reducing our stake in companies where the trade-off between growth and valuation is unfavorable.  Over our long investing career, we have witnessed several market cycles and our experience and mistakes have taught us some key learnings from what we have seen working successfully in a bear market:

•  The most important thing is to remain patient and not get scared by the correction. One should remember that a bear market is actually an opportunity and outsized returns can only be made if one remains invested / initiates investment in differentiated and durable businesses during a bear market. Whenever the cycle turns, the peak of the next bull market is always much higher than that for the previous bull market. Even the bull market in equities that started in April 2020 had its beginning in a very sharp market correction of over 30% during Feb-March 2020. The longest and most rewarding bull market of 2003-08 in Indian equities had its beginning in a very severe bear market of 2001-03. Similarly, the huge rally in small and midcap stocks over 2014-2017 had its beginning in the bear phase in small and midcap stocks over 2010-13. Exceptional equity returns cannot be made without enduring some pain during a bear market phase.

• Several prospective clients ask us if now is a good time to enter the market since returns have been so high. Our answer is always that the best time to start investing is immediately because we have seen that it is impossible to time the market. The only caveat we clearly mention is that we believe investing is for the long term and one needs to remain invested at least 2-3 years especially to reap the benefits of a medium to long term focused fundamentals strategy like ours. It is impossible for anyone to predict the onset of a bear market and fully exit before it and similarly predict the start of a bull market and invest meaningfully then. Just as an example, we believe very few investors would have predicted the sharp and quick correction during Feb-March 2020 and exited immediately to enter subsequently in June-July 2020 when the rally started. What we saw was that investors who panicked and sold out during the crash of March 2020 were never able to meaningfully enter the market until much later thus missing out on a large part of the huge rally especially in small and midcap stocks. Anchoring bias of having seen stocks at much lower levels and fear that the rally is unsustainable made it impossible for such investors to enter until they missed out on a substantial portion of returns. On the other hand, investors who invested with us in 2019 much before the crash of March 2020 and remain invested during that painful phase went on to enjoy very handsome returns on their invested corpus despite suffering sharp correction (drawdown of ~ 18%) in the interim. So, a key learning for us during times of correction or a bear phase is to not try to predict the bottom and time your market entry but initiate investing or remain invested. Time spent in the market is always more important than time of market entry / exit.

• One should not fear corrections during a bear phase. However, one should also not be completely passive. It is a fact that every bull market rally is clearly led by a new sector, and it is seldom the case that different bull markets have common sector leaders. So, during a bear phase, it is very important to evaluate one’s portfolio and determine which investments will do well and correct less during the bear phase and subsequently lead when the cycle reverses. We have a strong focus on evaluating industry fundamentals in our investment framework and we only invest in companies from sectors that we believe will enjoy strong tailwinds during our investment horizon. Even once we are invested, we continuously track industry developments to check which industries are doing well as per our expectation and which are not. We are very objective in exiting industries that are facing challenges and increasing allocation in industries that are doing well. This disciplined method of force ranking industry prospects becomes even more important in a bear phase as it is important to exit industries which will come under stress during a bear phase and increase allocation to industries that are poised to do well and lead when cycle reverses. We did this during the correction of March 2020 when we increased allocation to sectors like IT and pharma that witnessed relatively lesser correction and then initiated the market recovery. We continued to track and evaluate which sectors will do well subsequently and later on rotated into sectors like auto and cement that started outperforming during the later phase of the current market rally.

• Lastly, we believe it is important to stick to one’s investment framework during a bear phase. It is natural to start doubting one’s investment philosophy when one witnesses a sharp correction. However, it is critical to remember that such corrections are majorly driven by temporary market factors such as sharp drop in liquidity, extreme fear among investors, etc rather than by business fundamentals. It is important to separate the business performance from the stock price performance and continue to follow one’s investment process. For us, we try to maintain the discipline of only investing in high quality businesses run by honest and competent management. During sharp corrections, we try to maintain our calm and avoid jumping to other investment philosophies like only investing in large caps just because they are perceived to be better businesses, investing in stocks that have fallen the most and seemingly offer great value despite poor business fundamentals, investing concentratedly in sectors that led the past bull market, etc. We have seen that changing one’s framework during a bear phase can lead to disastrous results.

While we think it is too early to say that the volatility in August is the start of a bear phase, we believe we should be able to handle and in fact take advantage of a possible bear phase by following our learnings from previous bear markets.

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

Prescientcap Investment Advisors

https://www.prescientcap.com/contactform

Prescient Capital - July 2021 - Investor Memo

Dear Investors, 

Hope you and your family are holding up fine. 

Below is our performance viz benchmark indices: 

In this update we will talk about two topics that some of you have raised in your formal and informal discussions with us: 

Topic 1: Investing in IPOs.

We are very excited by the quality of founder/promoters and the companies that are getting listed recently. Especially, some of the tech companies that have filed for their IPOs (Zomato, Nazara, Nykaa, Paytm, Policy Bazaar and Car Trade etc) are unique businesses that we have previously seen as private deals. At Prescient, we have often thought about investing in US tech stocks (for eg: Amazon, Google, Microsoft, Zoom) as these are high growth, sticky businesses with very strong MOATs. These Indian tech IPOs now offer us a more meaningful opportunity to invest in tech businesses given our experience of Indian equity investing help us better track these. 

However, the valuations of IPOs in the last 2 years have been expensive to say the least. The chart below summarizes the valuations of companies that have IPOed since 2019:

Average Listing PE

At such valuations, there is more room for downside (due to a macro correction or a bad quarter in a company’s performance). This also puts undue pressure on promoters to generate returns for incoming institutional investors and may trigger a vicious loop for the company. We have often seen businesses not able to match their pre-listing performance for 1-2 years post their listing.  

Our criteria for investing is such companies are as follows: 

• Thorough diligence on the promoters: Due to their limited public track record, more time needs to be spent on the governance track record of the founders/promoters. Collection of both subjective and quantitative data on these promoters becomes critical. As a part of our diligence on these companies, we speak with funds/investors who have been with these companies for the longer term and understand the promoter’s motivation reasonably well. 

• Amongst the tech businesses, we like those that spend more capital on customer retention/product R&D than on pure customer acquisition. Platform businesses built with such R&D and customer centricity have very high customer retention. 

• We stay away from valuing on Price to Sales or Price to GMV multiples and work hard to model some sort of future profitability and cash flows and then value on forward  P/E or Price to Cash Flow multiple. Given that a lot of value of such businesses is from its high growth trajectory, we focus on the sustainability of the high growth of these businesses 2-3 years hence. We like to invest in business closer to a PEG (Price to Growth multiple) of 1x. 

• If we can’t invest at the time of IPO, we wait for good quality companies to correct reasonably due to market correction or a temporary blip in their performance. We believe that good companies provide you with a narrow window of opportunity to get in and hence our work should be done before this correction. We have built partial positions in the companies in our portfolio post their corrections. 

  1. Heranba: Initiated purchase at a P/E multiple of 19x when the stock corrected by ~ 25% post its listing in Feb 2021

  2. Mrs Bector Foods: Initiated purchase at a P/E of 31x when the stock corrected by ~ 45% post its listing in Dec 2020

  3. Nazara: Initiated a position at a correction of ~25% post its listing in March 2021.    

• Our balance position gets built based on the performance of these companies or on a sharp correction in the markets. 

Topic 2: Portfolio Construct

The second topic we want to discuss today is the construct of our portfolio. A lot of you have often asked us if it is a good time to invest/invest more given the valuation for the index. We would like to answer this by highlighting that we are bottoms-up investors and are very conservative on valuation. As long as we find investable companies in their bottom 20-30% percentile valuation, we will continue to invest. The chart below highlights our model portfolio PE multiple and compares the same to the PE of the BSE Sensex. 

Key comments we want to make are: 

1. We typically take 6-9 months to fully deploy your capital. This period factors in any up/down movement in the market. Due to our conservative pace of investment, our older client accounts were 40-60% invested before the March 2020 correction. Our deployment was maximum during the March 2020 quarter when the valuations were at their rock bottom. The availability of cash helped us invest the capital at the right valuation when the time came in March 2020. We believe that small/big corrections are part of the course of this deployment cycle.  

2. If you see our portfolio PE multiple, we have always stayed conservative even when compared to the BSE Index. Individual companies in our portfolio have been selected at conservative valuation. Staying conservative on valuation always gives us a headroom for returns and multiple expansion even when the markets are peaking. If you see the chart above, post March 2021, the index PE has shrunk by ~ 12% whereas our portfolio PE has expanded by ~5%. 

3. As we see things today, we are actively selling companies in our portfolio that are richly valued (>30-40x PE depending on the sector) and do not have promising growth prospects in the next 1-2 years. These names are replaced by well managed companies that are reasonably valued and have better growth prospects for the near term. You would also see that our median portfolio PE has reduced between June 2021 and now. This is the numerical evidence of this portfolio churn we are undertaking. 

4. In case you invest in other PMSes or funds, a metric that you can track and compare is the portfolio PE. A low portfolio PE compared to index / market PE helps protect the downside of your portfolio during market corrections. When we started in the Oct-Dec 2019 period, our portfolio PE was 15x compared to a PE of 26x for the index. During the March 2020 correction, the index corrected by 31% compared to a correction of 20% in our portfolio’s valuations.  

Regards,

Prescient Capital

Contact us: https://www.prescientcap.com/contactform

May 2021 Investor Memo

Dear Investor, 

Hope you and your family are holding up well in these torrid times. We hope and pray to god that you and your family have not been exposed to the COVID pandemic. The last one month particularly has been tough for all of us and will be an event we will remember throughout our lives. 

Below is a chart detailing our performance viz major indices: 

NOTE: Dated June 04, 2021

Q4 FY 21 & FY 21 Annual Portfolio Performance Update

In this portfolio update we would like to capture the last quarter and annual results of our model portfolio companies. Some of you may or may not have all these companies in your portfolio as portfolio build-up depends on your vintage. Key takeaways from 16 of the 20 model portfolio companies that have declared results so far are: 

1. Our portfolio demonstrated a robust median sales growth of ~10 % and earnings growth of 40% in FY 21 over FY 20. 

2. Our portfolio has a moderate PE ratio ~ 24x, providing us both a headroom for multiple expansion and a cushion for downside protection.

3. Our portfolio companies improved their Return on equity from their 3 year average of 16.6% to 19.1%. If one were to simplify, returns made by investors converge with the longer term ROE of their underlying portfolio. 

4. Our portfolio companies were efficient in converting their profits to cash on books (Cash flows generated from ops were 1.2x PAT); an evidence of efficient balance sheet management during torrid times. 

Sectoral Trends

In our previous updates we have spoken about tailwinds in the IT and the Pharma Sector. In this update we will write about tailwinds in the gaming and the women hygiene sectors in India.  

Gaming

The gaming industry in India is estimated to be ~ 2 Bn USD and has grown at a CAGR of 30% over the last 4 years. If we were to do a like to like comparison, our mobile gaming industry is where China was in 2013 (now at USD 25 bn). Both mobile gaming and gaming viewership is fast emerging as a viable entertainment replacement option to conventional forms such as movies. While we match China in terms of mobile gamers, the market size is roughly a tenth of the same. This is largely attributable to both our disposable capital and acceptance of gaming/e-sports as a viable alternative to physical sports. The switch is already happening in developed economies in the west and in Asia, India is a little behind both in the revenue pool and the regulations around luck based/skill based games. COVID driven lockdowns have been a boon for the gaming industry in India (gaming hrs up by 35%). An interesting subsegment in gaming is e-sports, which is like playing any physical sport. This segment has seen a 2x growth in audience (to 17 mn) and 25% growth in revenue pool (of ~ 110 Mn) between 2018 and 2020.  We have stayed away from both Casinos and luck based games that are closer to gambling. We have invested in a market leader in the fast-growing e-Sport segment (80% share) in India.

Female Hygiene

We have looked at the Female Hygiene products market since 2014-15 more from a Private Equity side. The penetration of Female Hygiene products in India has grown from ~ 15% to 20% now. It is still low when compared to Thailand 50% and 90-95% in the developed world. Over the last 5 years, this segment has grown at a CAGR of ~ 8% to ~ USD 550 Mn. The Market is dominated by Whisper of P&G (51% share), Stayfree of J&J (12% share) and Sofy of Unicharm (7% share). The last 5 years have seen both segmentation and innovation in this category with the launch of both premium products and alternatives like Menstrual Cups. Both these are good signs for any new and growing market. The price per unit of product varies from INR 22.5-3.5, and both ends of the spectrum have scaled up players like Comfy, Pee-Safe, Niine and Whisper.  We have invested in a company, which owns the Comfy brand of sanitary napkins. Comfy is a value for money brand that is priced at ~ INR 3.5-4 per piece. Comfy has a market share of 1% and the management has plans to grow comfy from a 55 cr sales business in FY 21 to a 100 cr sales business in FY 22. As a reference, it is very difficult to scale up brands in India and there are very few (<250)  scaled up (>100cr) consumer brands in India. 

Thanks

Prescient Capital

April 2021 Investor Memo

Dear Investors,

Hope you and your dear ones are doing well. 

Below is our newsletter for the month of April 2021: 

This is a very difficult time for all of us as we face the biggest crisis of our lifetime. The Covid-19 crisis is a generation defining crisis for us just like partition, war, famines, etc would have been for our previous generations. We sincerely hope that all of us are able to navigate this challenge successfully and emerge unscathed. Even though the crisis is taking a big mental toll, all of us are trying to carry out our responsibilities as best as we can. As an investment adviser, that for us means working to deliver the best investment outcomes for our clients during this challenging phase. In order to do that, we are trying to gauge the impact of this brutal second wave of Covid-19 pandemic on Indian equities and managing the risks to our portfolio as well as possible.

Overall our sense is that this time Indian equities should not correct to the same magnitude and as quickly as it did in March last year because of couple of factors:

• We have seen that equity markets correct sharply and irrationally when there is sudden emergence of a risk whose impact is unknown. If a risk is relatively well understood, then the reaction is generally not that severe. Unlike in March 2020, when the business impact of the Covid-19 pandemic was not clear at all and equities globally reacted with the sharpest and quickest fall in decades, this time the market has seen the impact of the crisis on businesses in FY21. So, the risks from this second Covid-19 wave is relatively much better understood by investors compared to last year and it is highly unlikely that there will be a knee jerk and widespread correction in equities this time. This is already evident from the fact that since the onset of the second wave in late March this year, Indian equities have been volatile but have not witnessed meaningful correction till date.

• It is clear from the last time that just like any crisis, the impact of Covid-19 crisis is not uniform on all industries. In fact, this crisis has even created unexpected opportunities in many sectors. There are few sectors like travel & hospitality, retail, media, movie theatres, etc that were and will continue to be severely impacted. On the other hand, there are several other sectors like insurance, pharma, IT, metals & commodities, etc that have actually benefited from the crisis. Most other sectors like banking, auto, consumer durables, cement & building materials, engineering, agri inputs, etc did not witness any significant earnings impact in FY21 because of the crisis. These sectors were seriously impacted in Q1FY21 (April-June 2020) due to the imposition of the nationwide lockdown. However, these bounced back very quickly from Q2FY21 itself and few sectors like auto, consumer durables actually enjoyed significant growth due to release of pent up demand in the rest of the quarters last financial year post Q1. Thus leading companies in these sectors ended FY21 with minimal degrowth as is clear from the sales data of leading auto companies below. Even within the auto industry, it was one of the best years for tractors because the rural economy remained healthy and resilient last year due to lower incidences of Covid-19, strong support by government policies and normal monsoon.

So, it is rational to believe that the second wave of Covid-19 crisis will have a different impact on different industries as was the case last year. Travel & hospitality, retail, aviation, etc, which were beginning to show some signs of recovery in H2FY21, will again suffer significant business loss. Our expectation is that select companies in pharma, ITS, etc will witness some benefits. For example, now that Indian drug regulators are approving vaccines for Covid-19, some pharma companies like Dr Reddys, Cadila, etc that have Covid-19 vaccines in their portfolio will see meaningful earnings from this vaccination opportunity. However, the same sector and companies will not witness identical impact as last time because circumstances in this second wave may be different. For example, we don’t believe agri plays like fertilizers, agrochemicals and tractors will witness the same tailwinds as last time as the pandemic’s impact in this second wave is much more widespread and tier 2/3 cities as well as rural areas have been much more impacted this time compared to last year. It is precisely our job as your advisor to identify sectors / businesses that will do well and also those that will suffer significantly due to this second wave and make investment decisions accordingly.

• It is abundantly clear that the central govt. as well as most state governments clearly do not want to impose months long stringent nationwide lockdown like last time. Several states starting with Maharashtra and followed by Delhi, UP, Karnataka, Haryana, Bihar, etc have imposed localized lockdowns / restrictions of varying intensity this time. However, manufacturing or construction activities have not been banned anywhere like it was during Q1 of last financial year. All states have come up with standard operating guidelines for these and the common feedback from ground is that even local authorities are not interfering arbitrarily with manufacturing or construction activities. Moreover, this time till date there has not been a mass migration of labour like last time. Even though there may be specific instances of some factories being shut down temporarily due to spread of Covid-19 among workers, there is no blanket shutdown of plants and factories this time. So, if conditions deteriorate meaningfully from here on, there is a chance that a highly restrictive nationwide lockdown is imposed like last year but our sense is that the government will only do it as a last option.

• Most of the economic indicators till end of April have not shown any meaningful deterioration:

o   Monthly GST collection was at an all-time high in April 2021 (https://www.business-standard.com/article/economy-policy/gst-revenue-collected-in-april-2021-is-at-a-record-high-of-rs-1-41-trn-121050100471_1.html )

o   Manufacturing has held up in April despite the onset of second wave and local lockdowns (https://timesofindia.indiatimes.com/business/india-business/manufacturing-activity-steady-in-april-despite-covid/articleshow/82380158.cms )

o   Both exports and imports picked up significantly in April this year. Since manufacturing was completely shut down in April 2020, so a y-o-y comparison is not correct but April exports were higher even compared to April 2019 (https://www.thehindubusinessline.com/economy/indias-exports-in-april-rise-197-per-cent-with-growth-across-sectors/article34462983.ece ). Exports growth is expected to remain strong as several international markets like the US, UK, Asia, etc are now out of the Covid crisis and witnessing strong economic rebound.

o   Both IMD and Skymet have forecasted a normal monsoon this year which is a relief for India’s agri economy.

o   Metals, especially steel, are witnessing the best pricing as well as capacity utilization in over a decade. The pricing and utilization levels of Indian steel industry is further expected to improve due to Chinese policy actions like removal of export incentives on steel, curbs on export of specialized steel alloys as well as intense environmental clampdown on highly polluting steel plants, etc. The improving business prospects of the steel industry will have a significant trickle down effect on other areas of Indian economy like power equipment, engineering goods and consumables, power consumption, etc. This is because it is expected that a phase of substantial capex in Indian steel industry will begin due to the onset of the current upcycle. Steel sector is one of the biggest capex spenders in a manufacturing economy. So, the upsurge in metals should have a substantial positive impact on manufacturing especially engineering & capital goods.

• The impact of the Covid-19 crisis on large organized Indian businesses across industries has been much less compared to MSMEs and the unorganized players. Due to strength of their balance sheets, large scale, significantly better management quality, etc most sector leaders in industries that have a large share of unorganized segment were able to wrest away market share from unorganized players in FY21. So, even though the Covid-19 crisis has led to large scale unemployment, severe stress for India’s MSME sector, MFIs, small NBFCs, etc the impact has been nowhere as brutal on listed sector leaders across industries and leading listed banks / NBFCs. Below are a few examples of such listed companies:

Lastly, investors have seen the massive rally in equities from the bottom of last March and are well aware that even if businesses get impacted for a few quarters, they will eventually bounce back and in fact are much well prepared to handle this challenge compared to last time. So we believe that whenever there is a meaningful correction of like 10%, investors would rush into buy into equities providing support to the market

In summary, our assessment is that Indian equity market will not suffer a drawdown as large and especially as quick as the last time but it will definitely remain volatile as long as the Covid-19 crisis persists and even witness 5-10% correction on inflow of any unexpectedly bad news. We will request all our investors to remain calm and not lose faith in equities during such short phases of correction. Also, we believe that markets would undergo time correction due to current levels of relatively high valuation in several pockets and one should expect a much muted market return in FY22 compared to FY21. Moreover, it is highly likely that there will be subsequent waves of Covid-19 pandemic until 60-70% of Indian population is immunized and herd immunity is possibly achieved. So, Indian businesses and equities may be facing a long period of uncertain and challenging environment and our job as your advisor is to manage your investments well through this phase.

Given this phase will most probably be a long and volatile one, this is a much more difficult task compared to last year when the markets recovered from the lows in March very quickly and then witnessed an unidirectional rise over the next 7-8 months. Obviously we have our task cut out this year but we believe that our strategy of investing in quality businesses with good earnings prospects at attractive valuations should help us deliver better than market returns in the medium to long term. We will continue to focus on keenly tracking the impact of the Covid-19 crisis on our portfolio companies and rebalance the portfolio to increase allocation to positions that are less impacted or can even possibly benefit from some opportunities thrown up by the crisis while exiting positions that are materially impacted by the crisis. We will of course also be on lookout for new investment ideas that will do well despite the challenge of the Covid-19 crisis. We might miss some opportunities like we did even last year but we believe if we stick to our time tested strategy of patiently investing in quality businesses run by competent and honest management, we should be able to do a good job for our investors.

Hope you all stay safe and healthy and please feel free to reach out to us in case of any queries / concerns.

Regards

Sonal / Anubhav

Prescient Capital

March 2021 Investor Memo

Dear Reader, 

Hope you and your family are doing well in these testing times.

Below is a chart detailing our performance viz major indices: 

The last one year has been an unpredictable roller-coaster to say the least. In this investor update we wanted to do an annual review of the markets, the underlying sectors and how behavioural biases played a role in shaping the returns the markets have delivered. 

One Year Review

The lockdown came into effect on March 23, 2020 and led to a correction of ~35% in the broader indices. Zoom out one year, the index is up by ~100% from its lows and by ~25% from its pre-lockdown peak values. During the peak of the lockdown, we heard narratives ranging from a 25-40% contraction in GDP, to a 2-3% mortality of the Indian population due to the COVID-19 pandemic. Some experts forecasted a complete collapse of real estate, auto and the travel sectors. While we are not delving into whether the government did a great or a poor job of managing the pandemic, we surely wanted to write about why some of the biases and perceptions were wrong and the economic impact of the pandemic was far less in comparison to what was estimated by analysts. 

1. During phase 1 of the lockdown, the impact of the pandemic spread was restricted to Tier 1 cities. The Semi Urban and Rural India did not see a significant spread of the pandemic. Apart from disruption in movement of migrant labor, COVID did not impact the crop sowing and production. India saw its 5th successive year of record harvest of wheat/rice (up at a CAGR of 4% for the last 5 year) during this period. As a result, the sales of Agri inputs (3 year growth CAGR of 14%) , tractors (yoy sales growth of 20%), 2 Wheelers (yoy down by only 3%) saw a sharp rebound.

2. As countries around the world wanted to de-risk and beef up their drug supply chains during H1 of FY 21, exports of both the formulations (up 18% yoy) and the API (up 9% yoy) saw a sharp upswing in demand. 

3. The lockdown also caused a disruption in the organized and unorganized labor force during its peak (24% unemployment rate in April 2020). The impact however lasted for 3-4 months as a strong demand rebound in auto, chemicals, pharma and IT led to a revival in demand for the workforce. The unemployment rate in March 2021 is lower than its pre COVID value in Feb 2020 (at 6.5% compared to 7.7%). 

4. Almost all of the listed companies saw their overheads (rent, travel, power) come down by 5-15%. A benign raw material pricing further created a cash cushion. This created surplus cash for the companies and reduced the pressure on wages. 

5. During the lockdown, people saved on discretionary products and services. It is estimated that domestic savings went up to 21.4% of GDP in Q1 FY 21, when compared to 7.9% in Q1 FY 20. This savings formed the base for spending in the subsequent quarters. 

6. We had seen a growth of passenger vehicles in China post the opening of the lockdown, as people found it safer to travel in their own vehicles than shared mobility solutions. India followed the same journey as higher savings and lower cost of funding helped people buy new vehicles. If we consider the two months of the lockdown where people could not buy cars, passenger vehicle sales is down by only 3%. 

7. Between March and August 2020, the RBI imposed a moratorium on both principal and the interest payments due during the same period. They also rolled out extra  lines of credit for the MSME and the unorganized companies with a good credit history. Markets initially feared that the moratorium period will permanently alter consumer behaviour and the NPAs in the banking sector could be between 10-30%. As we see the situation right now, and at the cost of not overly generalizing the argument, banks/nbfcs that had prudent lending and collection practices pre-covid, have come out stronger post-covid. Their peak NPAs are expected to be in the range of 2-5% and they have gained a significant market share. 

8. During the same period, the Indian economy also consolidated its fiscal and monetary position. The forex and gold reserves of the country have been up by 22% and 5% yoy respectively. This has helped stabilize the INR. The GST collected is seeing a sharp uptrend and has been down only by 7% (given the economy contracted by 25% in Q1 FY 21). 

Markets & Portfolio Deployment Update

As equity fund managers, we wear the hat of an optimist when the world around is a pessimist, and a pessimist when the world around is an optimist. During the peak of covid, we tried to be an optimist and continued to invest in sectors where growth hadn't been hampered by COVID. In all honesty, while we could forecast and invest in companies/sectors whose businesses were resilient to COVID (in the IT, Pharma, BFSI and Chemicals), we lagged in fully understanding the revival in auto, consumer durables, metals and capital goods. 

The table below shows sector returns and growth during the COVID period. We have taken the BSE/NSE sector indices and companies constituting the index as a proxy for the growth in the sector and the returns delivered. 

Key observations from the above are: 

1. We prefer to invest in sectors with a positive demand outlook. If you look at the chart above, we have invested in sectors (Pharma, IT, BFSI, FMCG) where the demand has been robust or is least impacted by COVID. 

2. We do not understand some sectors (metals, real estate). They have delivered 30% and 10% returns in the last two months, compared to 8% for the broader index. These sectors typically have a low ROE/ROCE profile and are highly cyclical in nature. 

3. Our medium to long term buy and hold strategy generally requires patience over a 1-2 year period, hence switching between sectors and companies to follow a momentum in stock price is tough for us.

4. We continue to focus on sales/ earnings growth and quality of earnings and believe that the same is a leading indicator of sustainable wealth creation.   

April 2021 Onward Lockdowns

We have been keenly monitoring the ramp-up of the second wave of COVID-19. The ramp up has caught the healthcare infrastructure providers and pharma companies by surprise and hence lockdows have been the best counters. While the situation on the ground is changing rapidly, we do not believe that this government can bear the economic impact of one more complete lockdown. From the investing perspective, any uncertainty in this regard will and have led to a correction in the markets. Headline indices are down by 2-3%. From a portfolio perspective, we continue to deploy capital in sectors that are least impacted by COVID. Our incremental deployment has been in Auto, IT and Consumer staples. 

On the portfolio front, we continue to be cautious in our capital deployment and have created reasonable cash reserves in both old and new accounts. We continue to exit companies where valuation has hit top quartiles and the trade off between growth and valuation is not in our favour. Over the course of the next 2-3 months, you will see us exit more such companies in our portfolio. The cash generated will be redeployed gradually into new ideas. 

Prescient Capital

Second Guessing Promoters

Investing sometimes is a tight rope walk between what we think might be true based on our outside in knowledge and what the promoters think is true based on their inside out understanding of the opportunity in hand. In investing in small caps the walk become interesting as the companies one is dealing with are low on public information, and often not clear about the opportunity in hand due to their niche business or their rank in the supply chain. To add to the ambiguity, analysts often seek QoQ guidance from these companies, leading to often heartburn and random pump and then dump decisions.

This blog was triggered by one such discussion on a company that overachieved its growth projections by 18 months. The founders are not super communicative, but are very conservative. As investors, we often tend to stick to a number shared by a founder, and when the company over or underachieves that number, we are in unknown waters. Not many sophisticated market estimate studies or projections can help: A) due to the lack of availability of market data for such small niches or B) just too many moving parts in the business for anyone (including the founders) to understand it linearly.

Such a situation triggers two behaviours amongst us, and this note is more a self-reflection:

1. We think we know this better and start fitting conservative projections and valuation. For me, 4–5 years back, the perfect way to find an entry multiple for such a situation was to project the earnings of the company 3–5 years hence and then back calculate an entry price for a 3x return. Surprisingly enough, that entry price was always 20–30% lower than the current market price, no matter if I do this assessment over a gap of 1–3 years.

2. We shorten our investment horizon to hedge our risk from such ups and downs in the performance.

What I have realised from such mistakes of selling early or not buying at all is that I was not willing to give time/rope to my winners. This is where the non-quantitative part of investing kicks in. I have tried to counter (still learning) such behaviour by asking myself some questions:

1. The promoter is more aggressive than you and will find opportunities beyond the current expansion/ product segment to grow over the longer term. In the longer run, great promoters always pleasantly surprise you.

2. Also ask yourself, given today’s day and age, how can someone small have an insight to his business beyond a 2–3 year horizon. This leads me to ask myself, is this question appropriate for the scale of a business? Can I invest without knowing the answer to my question?

3. It also sometimes helps to start with a little lower allocation to such companies but not shy away from averaging up as more answers come our way. Have learnt this the right and wrong way, your winners ought to be >15% of your cost allocation over time. Else, stop wasting your time romanticizing that some company in your portfolio became a multi-bagger with a 5% allocation. Or you lost a multi bagger, but you would have only put 5% of your capital in it.

4. Lastly, a bit of sanity check is the balance sheet prudence. Even during these periods of ups and downs/consolidation, promoters who do not lose their balance sheet prudence, get a much longer rope than those who don’t.

The balance between procrastinating and reacting in investing

When I joined investing a decade back, I asked a friend what should I do to succeed, he answered wisely “Don’t get killed, because others will”. “With this, you will land in the top 95% percentile”. No complaint, but the balance 5% is where it starts.

The balance 5% honestly is the most difficult and the lonely part. There is no textbook to teach that part. Quite like other professions, the 5% defines you. I haven’t heard a surgeon say, he/she is better than others because he has done no operation and hence has zero fatalities. Unless you don’t act, you don’t act right. The balance 5% makes or breaks you as a surgeon. You are either a good surgeon or you are not one.

The point I am getting to is that, one has to decide what to do as much as what not to do. It’s like one has to invest in 5 things along with rejecting 95 things. It is easier to reject than to select. In this article, I will cover what helps us act and act wisely.

Trust how you feel after talking with an entrepreneur:

Our analytical mind is wired to find holes in an argument to taper things down. True value creators in public markets are the companies that have changed their return profile over a 5–7 year period and hence require an understanding of the founders. If you feel an entrepreneur is different in his approach and execution, it will show up in his discussions and actions. Never let a good feeling die down. Work on it, till the timing and valuation to invest is right. Companies that I have liked have a.) honest and professional management, b.) track record, c.) MOAT and longevity of the business, d) valuation. In a subtle way, they add up and follow one another. No maths here, things just add up. So talk more with entrepreneurs. The ability to stay invested for long with an entrepreneur is a mix of both subjective and objective observations. The same way, never overrule a bad feeling or vibe by valuation. That is wrong. Work on it, to convert it into an objective data or an observation.

When the outlook looks gloomy, find positive data, and vice versa:

Something I have learnt from the last two cycles, when you in the middle of a bubble or a crash, you feel rational. Whereas the baseline of our rationality is by default siding towards optimism or pessimism. During this time, it’s important to take baby steps, reduce your bite size, but don’t exit. More wealth has been left on the table by those who time the market than those who stay invested. As a Private Equity professional, in 2008, we were given instructions to be on a standby on all deals. Not do anything at all. Gladly, I didn’t follow the advice on my personal finance. Have spoken with a few friends post covid who exited the markets at the peak and entered again around the trough and were happy to make 20–30% return in 3 months. While the returns are good, two things happen when you dig deeper and reinvest in the companies you like, a.) your conviction to average up and down improves b.) you concentrate your portfolio towards your winners; both of these improve your IRRs.

The next risk in a business will be the one you would not have factored in, so relax and build some margin of safety:

It’s wrong to be in the virtuous loop of cursing yourself on not being able to predict negative/black swan events. One might lose time and money. Best to absorb it, chin up. Assess if the initial thesis on the business is still intact, if yes, average down, else exit. There are no marks for romanticizing with an idea and your constant brooding will not help a penny in recovery of a company. I was recently speaking with a MFI company, and the promoter nicely summarized his business as the first to get hit come what may, by a new factor every time. He has built his business in a manner to work in crisis every quarter. On the contrary, I also remember having invested in a steel company that couldn’t execute much over a 7 year cycle. We kept the faith in the management, whereas the learning was that between a bad sector and a good management, the sector wins.

People will show splendid returns for 100 companies, don’t feel pathetic, you can only choose a few:

With all due respect, post covid, have been seeing charts on 50 odd companies that have more than doubled since March 2020. Sometimes it makes me feel miserable to have only 2–3 names of the lot in our portfolio. I have, but learnt to ask: if there was a fund manager who had 8o percent of his/her portfolio in these multibaggers, he/she would be god’s gift to mankind. We are limited by our perception of loss (read sunk cost), risk, price and circle of competence. This limits the options and creates an in-action bias. My take: Its best to know your winners and double down on them over time. That will make you successful.

Entry price should be the last thing one should work on:

In my early days as an investor, I used to prioritize companies based on the valuation multiples. While it created inaction bias for the ones which were expensive, it created an action bias for the ones that were cheap or value traps. Dig deeper on the sector, growth opportunity and the management quality before a valuation discussion. Valuation first approach leaves out a large part of the investable universe. I believe that one only gets a really good thing cheap once in 10 years, for the balance one has to pay up.

Pharma: Prospects Turning Bright

If you track Indian equities, you would be aware that the pharma sector has outperformed the broader markets as well as benchmark indices like NIFTY50 in the last few months. The table below compares the performance of the pharma sector represented by NIFTY Pharma index against the main index NIFTY 50 and the more broader index NIFTY 500:

This outperformance has been driven by few factors. The most important one is that demand for drugs has not been hampered in medium to long term because of the Covid-19 crisis. In fact, Covid-19 pandemic being a healthcare crisis has only increased the demand for affordable drugs both in India and globally. There was a slight disruption in drug demand in the domestic pharma market in April and May as patients couldn’t go for doctor consultations during the nationwide lockdown. However, the demand improved drastically in June when the country started to unlock as is shown below:

SOURCE: IQVIA

Moreover, India being one of the largest exporter of generic drugs globally has stepped up to its role of being the world’s pharmacy during this Covid-19 crisis. There has been a surge in global demand of drugs like HCQS, Azithromycin, Paracetamol, etc, after it was found that these might be effective in treating Covid-19. Indian pharma companies like IPCA, Cadila, Alembic Pharma, Granules India, etc, which are one of the largest manufacturers of these drugs globally, were able to meet this increased demand and thus witnessed good growth in their exports. Covid-19 has also thrown up new product opportunities for Indian pharma companies. Some have collaborated with MNC innovator pharma firms to manufacture and sell their novel drugs for Covid-19 in India and other emerging countries. Some are even working to come up with their own novel drugs or vaccines for Covid-19.

So it has become apparent that the impact of the Covid-19 pandemic will be minimal on the pharma sector. In fact, the crisis has benefited select Indian pharma companies by presenting new business opportunities. Compared to this, the impact of Covid-19 is much more structural and pronounced on other sectors like travel & hospitality, movie theatres, consumer durables, auto, NBFCs, etc. Due to superior prospects of the pharma sector, investor money has flown into pharma companies partially driven by reallocation from other sectors. This has resulted in recent appreciation of share prices of pharma companies and has driven the current outperformance of the pharma sector.

However, an important question is whether the pharma sector can deliver further gains from this point on? Specially given that prices of most pharma companies have appreciated considerably so is there room for further upside. Also, is Covid-19 crisis the only factor driving pharma outperformance? If that’s the case then the performance of pharma sector  from here on should be in line with or even below market as the economic impact of Covid-19 starts waning. We believe that the outperformance of the pharma sector during this Covid-19 crisis is just the beginning of a long term bull run for the sector. We see several tailwinds for the sector that can help it deliver good returns over the next 2-3 years.

However in order to understand the medium to long tailwinds for the pharma sector, one will need to look at how the pharma sector has done in the past 4-5 years. The pharma sector has performed well recently but if we look at a longer time frame then it underwent a phase of substantial correction over 2015 to 2019. The underperformance of pharma is even more stark if we compare it against the performance of another sector like financial services over this period. This is highlighted by the charts of NIFTY Pharma and NIFTY financial services below:

This correction over 2015-19 was driven by the poor business performance of pharma companies during this phase. This was due to a couple of factors impacting different business segments of pharma firms. Firstly, the Indian pharma market was impacted by the implementation of GST in 2018 because GST led to pharma channel disruption for a long time as pharma wholesalers and retailers reduced their inventories. In FY18, the domestic sales growth for pharma companies slowed down considerably and the impact on profitability was even higher as typically the domestic business is the most profitable segment for Indian pharma companies.

Secondly, exports to US for several Indian pharma companies was impacted over 2015-19 due to increased scrutiny from US drug regulator called FDA (Food and Drug Administration). US is the largest export market for Indian pharma and exports of generic drugs from India to US had been growing considerably. Prior to ~2015, US FDA officials would come down from US to inspect Indian pharma plants and companies would be intimated well in advance about any upcoming inspections. So, companies would have the time to prepare the plants so that these could meet US FDA standards during such inspections. However, from ~2014-15 US FDA began increasing its local presence in India with several FDA officials settling down here. These inspectors started conducting surprise inspections at Indian pharma plants dedicated for manufacturing and supplying drugs to US. They would show up completely announced at plants so companies wouldn’t get time to spruce up their facilities at last moment. Moreover, the number of inspections conducted as well as the scrutiny of the inspections both increased drastically as shown in the chart below:

Most Indian pharma companies at that time did not have the manufacturing standards to comply with this increased scrutiny by US FDA. As a result, FDA either banned exports completely from few firms like IPCA, Wockhardht, etc or stopped any new product approvals from the non-compliant plants of others like Dr Reddys, Sun, etc. This severely impacted US exports for several companies leading to poor earnings performance over FY15-19 because US generics is typically a large segment contributing anywhere between 30 to 50% of sales and net profit. The table below mentions few pharma companies that were flagged by US FDA for not adhering to its manufacturing standards during 2015-2019:

Lastly, emerging markets in Latin America, Asia, Africa, etc which are also large drugs export destinations of Indian pharma companies were also impacted by general economic slowdown and currency depreciation. So, almost all key business segments for most Indian pharma companies were impacted due to different factors leading to poor business and consequently poor share price performance over 2015-19. There was a loss of investor confidence in the sector, which is best reflected in the falling contribution of pharma sector to the main benchmark index NIFTY 50. As shown in the chart below, the share of pharma sector in NIFTY 50 fell from 5.23% in Mar-2014 to just 2.42% in Mar-19 compared to an increase from 27.45% to 38.85% for financial services sector during the same period.

However, the prospects for the pharma sector started improving around a year back due to a confluence of factors. Firstly, Indian pharma companies worked on improving their manufacturing standards for US exports over the last 3-4 years. They put in place the necessary processes, automation as well as trained their workforce to ensure compliance with US FDA regulations. All these efforts bore fruit as most of the Indian pharma companies, whose plants were deemed non-compliant by US FDA during 2015-19, were able to regain regulatory clearance from FDA in the last 1 year. The US FDA itself acknowledged that the quality standards of Indian pharma plants dedicated to US generics have improved drastically. Also, the Covid-19 crisis has been an impetus for US FDA to increase the pace of clearing such plants in order to ensure sufficient supplies of essential drugs as has been covered here and here. Moreover, there have been several instances of drug shortages in US, especially injectables, over last 3-4 years even before the onset of the Covid-19 pandemic in March 2020. The Covid-19 crisis has just been a tipping point that has prompted US FDA to support the growth of India’s generic exports to US. In fact, prompt clearance of Indian plants has become a priority for US FDA as it looks at alternative ways to inspect them even during the Covid-19 crisis as physical inspections are not possible.

The much improved culture of regulatory compliance at Indian pharma plants as well as the supportive stance of US FDA are a big positive for India pharma’s prospects for US generic exports. Being one of the largest business segment for Indian pharma, US generics should drive strong earnings performance for the sector over the next 2-3 years at least. Similar to the US business, the prospects of the domestic business has also improved drastically over the last 2 years. The impact of GST on the domestic pharma market has waned and the market has grown a healthy double digit of 11% in FY20. The Covid-19 crisis has further added an impetus to the domestic pharma market growth as spend of Indian govt. on healthcare and purchase of drugs is expected to increase manifold. Driven by all these tailwinds, the pharma sector should deliver strong earnings growth over next 3-4 years. 

This high earnings should translate into higher than market average returns for the pharma sector over the next few years. This is also because the pharma sector is trading well below its long term historical median P/E valuation. As can be seen in the chart below, NIFTY pharma is currently trading at a P/E of 31.2 that is at a substantial discount of 28% from its long term historical median P/E of 43.2.

Many people believe that the Indian equity market is expensive currently as it has pulled back substantially from the bottom formed in mid March when the markets corrected sharply due to fear of unknown business impact of Covid-19. This belief is well supported by the fact that NIFTY 50 is currently trading well above its long term historical median P/E multiple. As can be seen in the chart below, NIFTY 50 is currently trading at a P/E of 27.9 that is at a substantial premium of 29% from its long term historical median P/E of 21.7.

So, it is very stark that the NIFTY pharma is trading at 28% discount to its long term median valuation even though its prospect amid this Covid-19 crisis is much better than that of the broader market, which is clearly overvalued, as is evident in NIFTY 50 trading at 29% premium to its long term median valuation. We believe that the undervaluation in NIFTY Pharma will correct in the medium term especially driven by the fact that pharma sector will do well while the broader markets will take 1-2 years to revert to pre-Covid level earnings. This is because other sectors like financial services, auto, travel & hospitality, consumer durables, real estate & construction will take long time to recover. We have strong conviction that outperformance of pharma sector during the current Covid-19 crisis is just the beginning of a long term bull run for the sector driven by reasonable sector valuation and multiple business tailwinds for the sector.

Not all is well…

Last one month has magnified what we have felt for a long time: there has never been a wider divergence between the real world and the markets. India is grappling to keep the bottom 30% of its population away from dying of hunger. Our national unemployment rates are peaking at 25%. Still, the markets are up 25%!!

This contrast between the real world and the markets often disillusions us and is tougher behaviourly than anything else we see/read. It reminds us of a quote from the movie “Big Short”:

“This business kills the part of life that is essential, the part that has nothing to do with business”

…And the more you stay out of this bubble and gaze at the real world (read essential), the greater are the odds that you will end up questioning what is so wrong.

We think, markets and desktop warriors hate to think about bad things happening so they always underestimate their likelihood. Indian markets are underestimating the impact of the lockdown on peoples income and their purchasing power. They are busy making the V, U and W shaped recovery. Just read a report from UBS that showed a V shaped rebound !!

While we are no better at guessing the alphabets that best represent the rebound (if at all), we know from the past data that the recovery is going to be slow. We will try to capture this through a series of charts and sum up with our investment strategy:

GDP Growth Vs PE of the BSE 500 index

Source: BSE and RBI

1. Our GDP growth for the next year will be closers to zero, which side of it is anyone’s guess.

2. Markets typically have a lag in response to GDP growth data. Maybe starts reflecting in company performance with a time lag.

3. GDP bounce-back is gradual, albeit 2008–09, where it was more global and less an Indian crisis.

4. If India’s real GDP is going to grow between -3% to +1%, markets haven’t yet corrected to factor this in.

5. If PE is a real reflection of the future earnings, it shld be between 12-15x for the benchmark index than at 18–19x now !!

   

Unemployment likely to skyrocket

Source: CEIC

1. We are inching towards 25% unemployment rate. As a reference, we were at 9–10% unemployment rate during demonetization.

2. From what we know, startups/MNCs have either slashed salaries or are cutting their manpower.

3. Travel, hospitality, real estate, infra and small scale manufacturing, which employ a large part of the labor force, are dented for at least 6–9 months.

4. IT and tech companies are preponing their automation drives as this is the right time to fire without giving much justification.

Household debt as a share of income continues to rise

Source: RBI

What we are staring at is a customer who typically:

1. Has financed his personal expenditure through short term debt, largely due to easy access and the lure of zero cost EMI.

2. Has financed his/her her home, which has depreciated in value by 20–25% over the same period. Likely to depreciate more in the future.

3. Hasn’t seen his income grow as much as his expenses.

Refer chart below, both overall consumption loans and in-particular credit card outstandings have grown at 20% and 23% respectively between 2012–2020. During the same period, personal income has grown at a CAGR of 11%.

Source: RBI

Consumers economic and employment sentiment is at an all time low

Consumer sentiment on economic situation, Source : RBI

Consumer sentiment on employment , Source : RBI

How does this translate into investment recommendations for the next 12 months:

1. Stay in cash and debt instruments if you don’t understand what is happening.

2. Have said this earlier too: personal fin companies will see headwinds. Expensive multiples are a trap and carry an illusion of growth. Will stay away from pure-play personal fin businesses.

3. Stay away from consumer stories where expenditure can be postponed or can be replaced by lower cost substitutes: ACs, brown goods, Auto.

4. Consumer businesses that have utilitarian consumption demand such as staples, education, healthcare, gas, communication are more predictable and secular. Demand has held well in these segments.

5. Businesses that have heath/wellness as demand drivers are interesting at a reasonable price. Look for: OTC consumer businesses, health/general insurance, domestic pharma.

6. With an average per user data consumption growing 10x in the last 4 years, keen to look at businesses that are riding the communication/data consumption story. Eg: OTTs, internet infrastructure, hardware/software, digital brokers, banks that are using digital interface well to get customers.

7. Companies will de-risk marginal supply away from China. Will be interesting to look at speciality chemical companies. However, we acknowledge that these companies already trade at FMCG type multiples.

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Never loose capital, no other rule counts…

When we started our private equity investing career around 2008, we were told that it is ok to have 2–3 winners in a portfolio of 10. The winners will make up for the losses in 3/10 duds. Just return capital in the balance 5. In hindsight, this framework was so VC’ish, to say the least. In India, owing to difficulty to scale, smaller addressable markets, rich entry valuation and promoter integrity issues, the winners could never hit the ball out of the park, but the duds could take your investment down to zero, albeit very quickly. Profitable growth was and remains difficult.

Another framework that we had to quickly unlearn was super natural growth projections. Owing to high valuations and best in a decade margins (which never came back), private equity investors were forced to make models that had their top-lines and bottom-lines growing at 20–30% yoy. Why not, this was the only way to justify crazy valuations and white space market assumptions. Give capital to companies and then have them on steroids. Needless to say the survival rate of those on steroids is pretty low. Pretty low for even the 100 mts globally competitive sprinters. In fact for some sectors like lending, this is a recipe for failure (will dedicate a full blogpost on the failed banks in my portfolio).

The reality is however, very very far from this. If these hyper-growth assumptions and portfolio success theory were to be applied to the public investing, one could loose his shirt very quickly. What we learnt from returns made in public equity are as follows:

Phenomenal topline growth rarely translates to commensurate returns. What however does translate is sustainable good quality of business. To prove this hypothesis, we studied listed companies with a time frame of 3/5/10 years. We classified companies into two buckets, those that grew >15% yoy and those that had a sustainable return on equity of >15% (proxy for quality) for the same period. To de-noise, we considered companies that had a market cap of >200 cr 3/5/10 years back.

What we witnessed is as follows:

Companies that had a sustainable high quality of business (ROE> 15 %), returned higher return than the cohort of companies that were growing fast (sales growth >15%).

The deviation in returns of high growth companies is much higher than the deviation in returns of companies that have a predictable quality record.

In investing it is very important to understand and quantify the risk one is taking for a return. One can make infinite returns but also loose ones shirt. Some risks are not worth losing capital. As shown by data, chasing growth also means one could lose capital permanently.

So investing in high quality business doesn’t only give higher longer term returns, it also significantly reduces the risk of losing capital.

If we were to the same analysis for a lower sales growth rate (10%), the findings do not change.

Over the longer run (10 y), high growth and high ROE converge in returns. This also implies that people are looking for more predictable businesses.

A good analogy we are borrowing from a recent blog we read from Nalanda capital: public investing is like playing a test match. One has to only play balls where you know you can hit high quality shots, something like what a Dravid/VVS would do. If you are always racing to a 50/100 score, you better be a god like Sachin/Lara or a maverick like Sehwag.

In the next post will be taking a deeper dive on some characteristics of good quality businesses that can be dug up bottoms up: free cash flow generation, dividend yield, change in promoter stake and management compensation.

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