Investor Memo January 2025

Dear Investors,

The following chart depicts our returns viz BSE 500 TRI:

Glass Half Full or Glass Half Empty

January 2025 has seen a sharp correction in Indian markets. Our funds portfolio has also seen a correction of ~ 7% when compared to ~4% for BSE 500 TRI, ~ 8% for BSE Midcap, ~ 10% for BSE Small Cap Indices. Some of you have reached out to inquire about our interpretation of the negative news/macro narrative on India, impact of the Trump administration, and impact of the current Budget on the Indian Economy. In our honest admission, we want to reiterate that we are not economists and believe that the real ground level impact of these macro economic changes is at best fuzzy. They may create volatility in the capital markets in the short term, however their impact in the mid/longer term is often low. Per us there are only two drivers that do and should impact returns:   

1. Earnings growth and its outlook

2. Entry valuation. 

We will try and explain the corrections in the market basis the macro indicators that affect or have affected the earnings outlook of various sectors: 

Consumption Spending Slowing Down:  

You have been reading about the middle class being under pressure from real consumption inflation, which has been much higher than the numbers reported by agencies. We have been seeing the trends of slowdown in Urban consumption for the last one year. The below chart shows FMCG volume growth for the last 9 months. Urban consumers have been downsizing in volume and companies have been forced to cut MRP or launch an economy range of their established products.

Source: HUL, MAT Nielsen

The same trend has been seen in consumer discretionary spend in paints, building materials, entry level cars and other consumption related items. If e-commerce sales is a proxy for consumption, then the same has been growing at a paltry 8-12% for the last 2-3 years.   

The key issue here is that India hasn’t been able to control its headline inflation since COVID-19 outbreak, when compared to other large economies. A lot of this has to do to do with the import dependence of India for energy, food, fertilizers and other inputs. Major economies such as the US, China and Japan have been able to control their inflation by heavy investment in solving for supply and manufacturing/automation. 

This inflation burden has eaten into the savings of the households in India. Since COVID, most of the things in the consumption basket are more expensive by 35-60%. Salaries during the same period haven’t kept pace. 

People have been using debt for consumption. The chart below highlights a rather alarming trend. Indian household debt as a % of Personal Disposable Income has grown from 38% pre COVID-19 to 52% in FY 24.   

The nature of this expenditure is also rather alarming. Typically, debt for asset formation is considered good as it contributes to the future income of the household. Asset formation means: agriculture, business and housing related expenditure. Debt for personal expenditure typically doesn’t lead to revenue generation. As we see from the charts below, a large part of the rise of household debt is attributable to consumption spending (travel, durables, apparel, furnishing, hardware, food and vegetables, utility bills).  

Source: RBI, CEIC, MOFSL

With RBIs clampdown on loans for personal consumption, all consumption categories mentioned above have seen a softness in demand. 

FDI/Manufacturing CAPEX Tapering: 

India’s capex revival in the last two years has largely been backed by the central government. FDI, private capex and state capex has either declined or peaked out during this period. Refer to the charts below, you will see the center has spurred capex spend since FY 21. This led to a rally and re-rating in sectors with direct government spend: defence, railways, power, roads and ports.

Source: CARE

As a context, the center had a spending budget of ~ USD 100 Bn in FY 24, the FDI in FY 24 was around USD 70 Bn and Private Sector capex in the same period was ~USD 100 Bn. So all three, are equally important contributors to fixed asset formation and growth of GDP in the future. 

If we see from the charts below, FDI peaked in FY 22 and has declined by 16% in FY 23. The key reasons for more FDI not coming to India is as follows: 

1. Repatriation: Foreign entities/MNCs have been repatriating capital out of India in record numbers. Repatriation of capital is up from ~ 30% of Gross FDI (in FY 20) mentioned below to 63% of Gross FDI in FY 24. Countries such as China, ensure that a part of the profits are kept in the country as equity reserve and higher repatriation means higher incremental taxes. 

2. Trade Protectionism: Post the US-China trade wars, companies have been wary of investing/committing into geographies. Overall FDI available as a result of trade wars and reverse-globalization, has shrunk. India therefore has to compete harder for the same capital. 

3. FTA: Free Trade Agreements reduce the import duty on foreign goods and hence the incentive to set up plants/manufacturing in India go down. India has entered into FTAs with UAE and ASEAN countries. The impact of the same has been that the trade deficit with these countries has risen, as they were traditionally low import duty countries when compared to India. Hence, more FTA means lower FDI. 

4. Ease of doing business: India has been improving its rankings in EODB, however Labor laws are still archaic and a spoiler. FDI in India has largely come in services where the Labor laws are simpler. 
   

Source: DPIIT

As for private capex, the reason for tapering private capex has been a lacklustre investment in retail, healthcare and metals and alloys. Sectors such as Oil and Gas, Telecom, Power and Chemicals have been spending on adding capacity.

The state capex has been dwindling or has been largely range bound due to poor financial health of the states. Out of the 28 states in India, 11 have a revenue deficit, implying they have to borrow from the center to meet their monthly expenses. Also, ~ 30-40% of the committed state capex never sees the light of the day.

Source: CARE

Why so much bad news now?

The Capital Markets in India had all this data in the background even 6 months back. We have been writing about the same since June 2024. The market participants decided to ignore the risks of a slowdown in consumer and government spending and bake in aggressive growth to support their valuation. Stronger domestic fund flows fuelled the narrative. The slowdown in government spend in Q2 FY 25 hence came as a rude shock to the markets. PSU and/or government interfacing stocks have corrected by ~ 20-50% since then. 

Externalities such as trade wars by Trump, AI product launches and rising interest rates in Japan fuelled the correction of even strong performing Manufacturing, Auto Ancillary and Chemical companies. The stock of these companies in our portfolio have corrected by 25-50% despite strong results and outlook. 

The government in its current budget speech has also acknowledged the stress in consumption and the need to maintain the capex spend. We request everyone to let the dust settle and see the impact of a supportive budget in real earnings of companies. Narrative based investing caused this drawdown and can also cause a sudden euphoria post the budget. 

How are We Navigating the Stress and Building the Portfolio: 

We are investing in sectors where the earnings growth outlook is good and there are no near term headwinds. In our September 2024 memo, we had highlighted sectors we are finding interesting to invest in.

Refer Link: https://www.prescientcap.com/blog-1/investor-memo-september-2024.

We will quickly cover/repeat our hypothesis around investing in these sectors as the same is playing out well even post the results of Quarter 3. 

Rural Demand is Turning Around: Leading indicators of rural demand: fmcg growth, bike sales, monsoon and income growth are holding up well. We have invested in Orient Electric (fans), Jyothy Labs (detergent, whitener) and FIEM (2 wheeler LEDs). The performance of these companies has been good in Q2/Q3 FY 25 and we continue to buy more of these companies at fair valuations. 

Banking Sector in Good Shape: At a macro level, the banking sector is not facing any significant asset quality issues and has been growing at 1.5x the GDP. The sector has been a laggard in terms of returns largely due to a higher interest rate cycle. As a result, the listed BFSI companies have been available at reasonable valuations. We have been buying industry leaders who are demonstrating growth with strong asset quality. 

1. Housing (CanFin Homes)

2. MSME (City Union Bank)

3. Vehicle FInance (Sundaram FInance)

4. Secured Asset Lenders (Capital Small Fin Bank)

5. Micro Finance (Credit Access Grameen).   

Speciality chemicals & agrochemicals are showing a sign of recovery: Post the supply squeeze during COVID, the last 18 months have seen excessive global dumping of speciality/agro chemicals. This has led to reduced demand and a sharp drop in margins across all speciality chemicals companies. Refer to the chart below to indicate the trend. Based on inputs by industry experts and management, the excess inventory levels have bottomed out and growth in sales and margins is returning, refer 9MFY 24 results. We have made 3 investments in Speciality/Agri-chems.

Concluding: Why is it a good time to invest? 

We want to highlight both from a top down perspective and a bottoms up perspective that it is a good time to invest. It is in times like now, the capital invested creates outsized returns in the next bull cycle. The BSE sensex is currently trading at a PE of 22.1x when compared to a long term median of 21.7x. This implies we are clearly in the investing zone and any more correction should be used as an opportunity to deploy more capital. 

Please reach out to us if you have any questions.

Regards, 

Prescient Capital  

Investor Memo December 2024

Dear Investors,

The following chart depicts our returns viz BSE 500 TRI:

In this month’s memo, we will discuss an analysis we did to find the number of multibagger listed companies over the past 5 and 10 years and analyse their characteristics. We define a multibagger as a company that has delivered an IRR of 25% over the past 5 or 10 years. This translates into roughly 3x and 9x stock price return over 5 and 10 years respectively, which is a very healthy return that we aspire for when we make any investment

For this analysis, our consideration set consisted of listed companies that had a starting market capitalization of at least INR 100 Cr at the beginning of 5 years or 10 years back. First, we will consider companies that had a market cap of 100 Cr or higher 10 years back. There were 990 companies with a market cap of 100 Cr or higher a decade back. As shown in the slide below, only 13% of such companies (129 out of the overall universe of 990 such companies) delivered an IRR of 25%+ or ~9x+ return over the past decade.

Some key insights that emerge if we analyse this set of multibaggers:

• Firstly, an overwhelming 77% (99 out of 129 multibaggers) of this set of decadal multibaggers had a starting market cap of 1,000 Cr or less. So, the majority of the multibaggers were small or micro-cap companies to start with.

• Secondly, not a single company out of the 30 companies with a starting market cap of INR 50,000 Cr 10 years back turned out to be a multibagger (>25% IRR return over the decade). This makes sense as it is very difficult to grow your market cap over a decade at 25%+ if your starting market cap is already 50,000 Cr.

• Lastly, the hit rate was also highest in the micro or small cap space. If you look at the above slide carefully, 19% (86 out of 448) of companies with starting market cap between 100 and 500 Cr as well as 10% (13 out of 136) of companies with starting market cap between 500 and 1,000 Cr 10 years back turned out to be multibaggers over the subsequent decade. This is the highest hit ratio in any market cap bracket.

Now, we will consider companies that had a market cap of 100 Cr or higher 5 years back. There were 1,531 companies with market cap of 100 Cr or higher 5 years back. As shown in the slide below, an overwhelming 44% of such companies (672 out of the overall universe of 1,531 such companies) delivered an IRR of 25%+ or ~3x+ return over the last 5 years.

There are several reasons why the %age of multibaggers at 44% over last 5 years is much higher than the 13% over past decade:

• Firstly, the most important / obvious reason is that the bar of delivering 25% or higher IRR over a decade (or 9x+ return) is much higher than delivering 25% or higher IRR over a 5-year period (or 3x+ return). Fewer companies can meet the higher bar.

• Secondly, starting valuations matter a lot. In Dec-2019, which is the starting period of the last 5-year period, small and micro caps had undergone a significant correction from their peaks achieved in March-2018. So, they were available at cheap valuations and delivered very healthy return from then on.

• Lastly, this is common knowledge that the last 5 years has been a bull market for equities, not just Indian but globally.

So, a combination of attractive starting valuations and liquidity driven bull run post Covid-19 outbreak has made investing look easy and super attractive over the last 5 years. However, our sense is that going forward it will be much tougher as there will be much fewer multibaggers given current high valuations. Sound stock selection and valuation discipline will become key to identifying multibaggers from here on.

Few other observations from the 5-year period analysis:

• Even for the last 5-year period, majority of the multibaggers at 60% of total (404 out of 672) had starting market caps less than 1,000 Cr 5 years back.

• Moreover, the hit ratio was again high in the micro or small cap space for the last 5-year period as well. 50% (319 out of 617) of companies with starting market cap between 100 and 500 Cr as well as 44% (95 out of 216) of companies with starting market cap between 500 and 1,000 Cr 5 years back turned out to be multibaggers over the next 5 years.

This is the reason why we focus on investing in the small and mid-cap space as historically the probability of finding a multibagger is much higher in that space.

Next, we did an analysis of what drove the portfolio returns over the past 5 years and decade. For this, we calculated the return delivered by a portfolio of equal weighted multibagger companies (1 stock of each multibagger) of the last 5 years and decade. Then, we analysed how much of the overall return of this multibagger portfolio was driven by P/E expansion and earnings growth, since these are the only 2 factors that drive stock returns.

Over the past decade, we calculated the return of a portfolio consisting of 1 stock each of the 129 multibaggers that individually each delivered an IRR of 25% or higher during the same period. This portfolio delivered an overall return of 15.4x over the decade. If we deconstruct that return, then out of that 9x was from EPS growth of the portfolio and just 1.7x was from expansion in P/E multiple of the portfolio. This also makes sense as there will be a limit to how much valuation multiple can expand over time (no one will be forever willing to keep on paying up to buy a company no matter how good the business is) but there is a limit to the potential earning growth of a company.

9x  *  1.7x  =  15.4x

Portfolio EPS Growth * Portfolio P/E Expansion = Portfolio Return

Similarly, over the past 5 years, we calculated the return of a portfolio consisting of 1 stock each of the 672 multibaggers that individually each delivered an IRR of 25% or higher during the same period. This portfolio delivered an overall return of 5.7x over the last 5 years. If we deconstruct that return, then out of that 2.1x was from EPS growth of the portfolio and 2.7x was from expansion in P/E multiple of the portfolio.

2.1x  *  2.7x  =  5.7x

Portfolio EPS Growth * Portfolio P/E Expansion = Portfolio Return

The key insight from this is that during short time periods, especially if there was a bull market during that period, expansion in valuation multiples due to sharp price appreciation can be the key driver of stock returns. This is exactly what has happened during Dec 2019-2024, when stock prices appreciated more than the underlying earnings growth, effectively meaning valuation multiples have grown richer during this phase.

However, during longer time periods, earnings growth is the key driver of stock price returns. If we look at Dec 2014-2024, the earnings growth of the multibagger portfolio was much higher at 9x than its P/E expansion. As we keep on consistently communicating, fundamentals (earnings growth) outweigh liquidity (valuation expansion) in the longer term. So, our focus is always on identifying businesses with strong long-term growth prospects. 

Finally, we look at the sector wise split of the multi-baggers (companies delivering >25% IRR) over both periods of last 5 years and decade:

As can be seen in the charts above, Engineering & CG and chemicals are 2 sectors that have delivered the highest number of multibaggers both during the last 5 years and the past decade. This goes against the conventional wisdom that sector leadership changes quickly in the stock market and there is a need to churn a lot to get the best returns. If you are able to identify multi-year opportunities like in the engineering and chemicals sectors in the past decade, then these can deliver very high returns for investors.

Overall, the key insight from this study that emerged is finding multi-year growth opportunities with attractive entry valuations can deliver top returns for investors. Most such opportunities are typically niche, well run small or mid-cap companies that execute well and scale up over long periods to deliver multibagger returns. Of course, identifying such exceptional small and mid-cap companies is not an easy task, neither is patiently remaining invested in them over long time periods. However, that is the true test of a good fund manager and something we strive for.

Please reach out to us if you have any questions.

Regards, 

Prescient Capital   

Investor Memo November 2024

Dear Investors,

The following chart depicts our returns viz BSE 500 TRI:

In this monthly memo, we try to stitch together the reasons for the current stress in the micro loans market in India. The attached deck summarizes our top down assessment of the sector.

Summary: Liberal regulatory policy post COVID has created adverse incentives for the sector where the AUM growth is 2-3x the growth in the customer base. VC/PE funded Micro-Fins have further added fuel to the fire. The Industry currently has a sizable customer base which has 4 plus individual loans and 5 plus household loans. The players we have spoken with blame the RBI for the clampdown in the last 3 months. Needless to say, when you don't discipline, you need a regulator to intervene. Stress in the Micro-Fin sector is expected to compound in Q3 FY 25. This will be the moment to test the lending quality of best and worst in class lenders. This is also expected to have an impact on rural/low income household demand which was coming out of COVID and demonetization.

We have initiated buying a high quality Micro-Finance company (down by ~ 50% from its peak) in your portfolio and will build the position over the next 3-6 months.  

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

Regards, 

Prescient Capital

Investor Memo October 2024

Dear Investors,

The following chart depicts our returns viz BSE 500 TRI:

NOTE: Before we dig deeper in today’s memo, we wanted to highlight that right now is a good  time to top up your capital. The small and mid cap indices have corrected by 4% and 7% respectively in October 2024, while the results of the companies we track/invest have been good. This presents a good opportunity to deploy more capital at a reasonable price. It's times like these that create outsized returns. We have several ideas that have come or will come within our buying range with some more correction.

In this month’s memo, we will present our thoughts on the importance of having a long-term orientation and of not viewing stocks as means to get rich quickly, which is what many fin-influencers are portraying over the past few years. Over 1st Apr 2020-30 Sep 2024, Indian equities have delivered stellar returns (refer table below), especially small and mid-cap companies, with only brief periods of correction or consolidation. A significant number of young investors started equity investing post March 2020 and have not witnessed any meaningful time or price correction.

The charts below show the huge increase in the number of Indian demat a/cs over time since March 2020. This trend in increase in demat a/c openings is of course a positive as it indicates that Indians are increasingly investing more into equities.

This chart below also shows the trend of increasing share of equities in the financial assets basket of Indians. The share of equities in financial assets of Indians is still lower than in mature economies like US, Europe, etc but we are heading in the right direction.

While the trend of Indians investing more into equities is a welcome trend, a caveat is that a lot of young investors have entered the market since Covid-19 outbreak in March 2020 (refer chart below). The median age of an Indian equity investor has come down significantly since March 2020 as more and more young investors have started equity investing.

Early start in equity investing is a positive trend as one will have a longer runway for compounding. However, the majority of new demat a/cs are being opened by young investors to trade in F&O. There has been a huge surge in F&O trade volumes over the years as can be seen in the chart below. In fact, The NSE and BSE are the world’s top two bourses in terms of F&O volume and the combined turnover of the two Indian stock exchanges accounted for ~80%+ of the global turnover in YTDFY25.

Recently, SEBI published a study on Futures and Options Trading, revealing the following key insights:

• Retail traders experienced a cumulative loss of approximately Rs. 1.8 Lakh Crores over the financial years FY22-24.

• 91.1% of retail traders lost money in FY24.

• 93% of retail traders incurred average losses of Rs 2 lakh per trader over FY22-24.

• 4 lakh traders faced an average loss of Rs 28 lakh/person over FY22-24.

• Only 1% of retail traders managed to earn profit exceeding Rs lakh over FY22-24.

So, the bottom line is retail traders have faced huge losses in F&O trading, but the F&O trade volumes only keep on increasing. This is because F&O trading in India since March 2020 has become a gambling den where retail trades place bets to get rich quickly. It is not to say that there has not been an increase in the number of patient long term investors over the past few years. However, the growth in equity MF net inflows is much lower than the exponential growth in F&O trade volumes. This is because equity investments demand patience as MFs deliver the best results over the long term. However, very few investors have the patience and resilience to withstand years of volatility to enjoy long term compounding benefits of equity investing.

Just to contrast the losses in F&O trading with the huge wealth creation that can happen by practising long term investing, we share the chart (source: ET online) below. The worst performing small cap fund has delivered an IRR of 16.36% over the past 10 years ending on July 8, 2024. We believe this is a very healthy return across all asset classes like real estate, fixed income, gold, etc over the past decade

So, to summarise, patience is the key to compound your wealth at a healthy return over the long term. Greed to make a quick return is why retail investors end up losing money in trading creating the perception equities are inherently risky with only the lucky making money in equities. We want to emphasise that at the current elevated market levels, one should only invest in Indian equities if one has an investment horizon of minimum 5 years.

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

Regards, 

Prescient Capital 

Investor Memo September 2024

Dear Investors,

The following chart depicts our returns viz BSE 500 TRI:

In this Investment Memo we will try to cover two broad topics:

• How we are mitigating risk of high valuation companies in our portfolio. 

• Sectors where we are seeing growth and are investing in at reasonable valuations

Topic 1: How we are mitigating risk of valuation in our portfolio

Referring to the chart below, our portfolio's Trailing PE multiple is 31.4x, when compared to the 28.1 multiple for the BSE 500. As you may see, we have moved from trading at a discount to the index to trading at a premium. 

The trend is indicative of the run the small and mid cap stocks have seen with respect to the Index. The above thought may trigger a question on our capital deployment strategy for the near term. 

We are first protecting returns and preserving capital. We are exiting past investments which are expensive in valuation. 

In the last 3 months we have exited/partly exited the following portfolio companies: TD Power (Exit at a TTM PE range of 45-50x), Bharat Bijlee (Exit at a TTM PE range of 40-45x), Ajanta Pharma: (Exit at a TTM PE range of 45-50x), Gabriel:(Exit at a TTM PE range of 35-40x), and RPG Life Sciences (Exit at a TTM PE of ~40x). 

The capital generated from exits and the capital of new clients is being deployed slowly and gradually in new names. The deployment of capital is slow and the timeline of deployment of capital is 6-9 months.

Topic 2: Sectors where we are finding investment opportunities:

Theme 1: Rural demand is turning around

In our Oct 2023 Monthly memo, we had highlighted that rural demand was slowing down and had proven the same with some leading indicators. In this memo, we have updated those drivers and have added a few more. It is important to note that for our country to demonstrate ~ 7 p real GDP growth (recent IMF forecast), the rural demand has to lead.

2-Wheeler sales, which is a leading indicator of rural demand, are reviving:

FY 23-25 have been good years for a recovery in 2W demand. Both ICE and EV 2 wheelers have shown a rebound in demand. In FY 24, the overall domestic sales of 2W has grown by ~ 14%. ~ 70% of 2W sales is to non urban centres.

Our deployment strategy: ~ 20% of our fund is invested in Auto ancillaries and in particular ~ 13% of our fund is invested in auto ancillaries having a direct exposure to the domestic 2 wheeler market. The median PE multiple of our auto-ancillary portfolio is 24.7x. We have invested in these companies at a reasonable TTM PE multiple of 15-20x

Rural wages are improving, inflation is tapering, fuelling consumption growth:

Post COVID, the rural inflation remained in double digit while the rural wages went up by early single digit. This led to a significant compression in rural demand. Since the last 18 months, the rural CPI has shown signs of reduction (around 5-7p) and the wages have also gone up by late single digits. If this trend continues, we could expect more disposable rural income. Rainfall also plays a key role in rural demand. With two full years of good rainfall in most of the regions except the North, we are seeing good crop sowing by farmers.

Commentary of Leading Industry Players on Rural Demand:

Our Deployment Strategy: We have been investing in consumer businesses since the last one year. Around 10% of our fund is invested in consumer businesses that have a rural/tier 2 footprint.

Theme 2: Banking has bottomed out

Just like rural, the banking sector took a big hit in asset quality during COVID. Peak NPAs of SCBs went up-to 7-9%.

MSMEs in India have been fragile since demonetization and COVID prolonged the recovery. The situation of MSME banks was no different. Leading MSME banks were running at ~ 10% of their books as stressed. Just like rural, MSMEs are the backbone for a 7% plus real GDP growth of India. Last 2 quarters have seen a pickup in the MSME sector and hence a pickup is MSME credit. MSME is a credit hungry sector for both working capital and expansion credit. We are invested in 2 banks which lend to MSMEs and agri. Both banks have demonstrated remarkable credit and collection prudence during the last 5 years of stress. We have been investing in these banks at a reasonable valuation of 1.3-1.5 x Price to Book.

Another segment in Banking we have been investing in since 2019 is housing finance. We see a longer term secular growth trend in assets of housing finance companies that are responsible/conservative lenders to the non urban population. A reduction in repo rates in the next 2 quarters and the same to provide a fillip in growth to the affordable housing finance companies. The valuation of some of the top quality lenders are near their 50% percentile range and hence are investable at current levels. For more, refer to our June 2024 memo.

Theme 3: Speciality chemicals & agrochemicals are showing a sign of recovery

Post the supply squeeze during COVID, the last 18 months have seen excessive global dumping of speciality/agro chemicals. This has led to reduced demand and a sharp drop in margins across all speciality chemicals companies. Refer to the chart below to indicate the trend:

Based on inputs by industry experts and management, the excess inventory levels have bottomed out and growth in sales and margins is expected to return by H2 FY2025. We faced headwinds of margin contraction in our portfolio companies during FY 24. With companies' balance sheets intact, we believe that the worst is behind us in specialty chemicals. We have an exposure of ~12% of the fund to the speciality and agro chemicals.

To sum up, we are very valuation conscious and the importance of this trait gets magnified in a bull cycle like the current one. If and when correction happens, our portfolio will correct too. The macros for a large part of the economy are strong and hence the rebound should be sharp. Our prudence in promoter selection and valuation will help us avoid any permanent dent in the portfolio. 

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

Regards, 

Prescient Capital   

Investor Memo Aug 2024

Dear Investors,

The following chart depicts our returns viz BSE 500 TRI:

In this month’s newsletter, we plan to share a recording of our webinar on “How we are navigating the current rich valuations in the small/mid cap listed space in India”. Hope you like the webinar.

Also attached is a copy of our deck used in the webinar:

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

Regards, 

Prescient Capital   

Investor Memo July 2024

Dear Investors,

The following chart depicts our returns viz BSE 500 TRI:

In this month’s newsletter, we discuss the hot topic of frothy valuations of Indian small and mid cap listed companies. We have already covered this topic multiples times in the past but admittedly it remains the top concern for anyone interested in deploying fresh capital in small & mid cap equity strategies like ours. 

As always in the past, we will start by repeating our stance that it is impossible to perfectly time the market. No one can predict the future and we feel it is a wrong strategy to take an overall cash call on the portfolio and exit the market believing stocks are overvalued with very little upside left. This is because though valuations may be stretched in the near term and markets poised for a short-term correction, the long-term prospects over the next 3-5 years may still be very bright. Leaving aside frothy valuations, the state of the Indian economy is quite healthy with leverage of corporate India and bank NPAs at all time low, inflation coming down and high possibility of rate cuts not only in India but globally, Indian forex reserves at all-time high, a central govt. that is highly focused on lowering fiscal deficit and improving sovereign credit rating and thus cost of borrowing, etc. So, the chances of the Indian economy performing well is quite high over the next 5 years.

In that case, one might miss the long-term gains just to avoid near term pain and drawdown. The problem with an overall portfolio level cash call or staying out of the market is it is impossible to time your re-entry into the market and one may completely miss the long-term bull run. This happened with investors who exited the market during the outbreak of Covid in March 2020 or during the correction phase of Dec 2021-March 2023. Most of them were never able to re-enter the market subsequently due to anchoring bias and missed the subsequent bull phases.

In summary, we will never take an overall cash call based on market levels and sit out. However, we closely track the valuations of our existing positions and are quick to exit ones that have become so expensive that they don’t offer any incremental upside rationally over the next 2-3 years. In total, we have sold 26.5 Cr of stocks in YTDCY2024 (~10% of June end AUM) and are continuing to exit positions that don’t offer attractive risk reward anymore. 

We will begin our analysis by looking at the current state of overvaluation in Indian equities. The table below shows the past 5 years CAGR ending in June 2024 of large, mid and small cap benchmark indices.  It is very clear that mid and small cap indices have comprehensively beaten the large cap index by a huge margin. The same is true for the broader markets with share price appreciation of small and mid cap companies in general has been much higher than that of large cap companies

The sharp increase in valuations of the broader market is highlighted by the below chart showing the P/B valuation of constituent companies of the BSE 500 index. The % age of companies in the BSE 500 index with expensive valuation of over 5xP/B  is at an all time high of 55% currently.

Source: ACE equities

Another chart below highlights the sharp rerating in valuations of mid cap companies historically. Currently, the share of mid cap companies with 1 year forward P/E of 60 or higher is at an all-time high

We have enough evidence of valuations of most small and mid-cap companies at an all-time high. However, we have also taken a position of not timing the market and continuing to remain invested / deploying capital. So, how does one minimise the risk of suffering permanent capital loss or subpar returns over the long term. We think there are 2 things to do to handle the current situation. One, which we have already shared at the start, is to handle stock expensive valuations in a bottom-up manner. 

As your portfolio manager, we are prudently exiting positions that have become overvalued and rationally leave very limited upside over the next 2-3 years. Also, we are becoming very cautious about investing in new positions. We have become even more disciplined about our entry valuations and business quality and are happy to invest in a staggered manner and hold large cash positions, especially in newer portfolios. However, we are still finding opportunities that are reasonably valued even in current markets so deploying capital is still not a challenge we are facing. These are in sectors / niches that markets do not find hot because these sectors may be going through some near-term challenges. For example, our recent investment in PI Industries, whose stock price has only appreciated by overall ~30% despite delivering a 19% CAGR in the last 3 years (P/E rating has almost halved in the last 3 years). This has happened because of the market's fear of near-term challenges that the agrochemicals sector is facing because of incessant dumping by Chinese agrochemical manufacturers. To summarise this point, we have become cautious about overvaluation in our existing positions as well as about not overpaying for any new investments.

The second and much more important strategy to tackle current market levels is to be committed to remaining invested for the longer term. There is no strategy that can avoid corrections in equity investing completely otherwise it would make equities guaranteed investment products, which they are not. When markets suffer corrections, a prudent strategy will most probably suffer a lower drawdown. To completely do away with the risk of negative returns, the only way is to remain invested for long horizons.

Source: NSE; All above returns are in CAGR (per annum)

The chart above highlights that the minimum return that an investor could have made by remaining invested in Nifty 50 TRI index for 7 years historically is 5% per annum. The minimum return increases to 9% per annum if one is committed to investing for 15 years. On the other hand, the worst possible return in a single year is as high as 55%. So, the message is loud and clear for the investor that he/she needs to be patient and suffer short term corrections to lower the risk of poor returns. In fact, no matter how good the strategy of a fund manager is, the onus is on the investor to remain invested for the long term to take benefit of that.

Another chart (source: ET online) below highlights the benefits of remaining patiently invested for the long term. The worst performing small cap fund has delivered an IRR of 16.36% over the past 10 years ending on July 8, 2024. We believe this is a very healthy return across all asset classes like real estate, fixed income, gold, etc over the past decade. So, the importance of being patiently invested for 10 years is much more than the MF selection at the beginning because the 10 years return is very healthy even in case of the worst performing MF.

We are not making this point to absolve our duty of generating alpha for our investors but just to drive home the importance of being patient long-term investors. We firmly believe that there are very few investors that would have stayed invested for the past 10 years in these small cap MFs to take advantage of the attractive returns generated. 

The table below highlights the drawdowns suffered by these same small cap MFs over the past 10 years. Most of these MFs have suffered huge drawdowns during the long phase of correction in Indian small cap stocks from 1st Jan 2018 to 31st March 2020 (only exception is Axis Small Cap MF, highlighted in yellow, that has a commendable track record of much lower drawdown than category average over a much shorter phase). The small cap MF category average max drawdown is 41.53% during the last 10 years. Very few investors in these MFs would have remained invested during this prolonged 2 years + phase of correction and thus were able to enjoy the bull phase from March 2020. 

Source: Morningstar.in; Funds are listed top to bottom in the above table in decreasing order of past 10 years returns

In summary, we just want to emphasise that we are aware of the frothy valuations of small / mid cap stocks and are taking steps to lower drawdown risks by exiting expensive positions as well as being cautious in making new investments. However, we are still finding undervalued opportunities with good prospects to invest in the market, so deployment is not a constraint for us. For our existing and prospective customers, our advice is just to keep their return expectation realistic and not extrapolate the very high small cap returns of the past 3-4 years to the future. Also, invest now with a patient long term investment horizon of 3-4 years + at least so that the starting point becomes irrelevant.

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

Regards, 

Prescient Capital

Investor Memo June 2024

Dear Investors,

The following chart depicts our returns viz BSE 500 TRI:

In this monthly update we want to share our take on the “Housing Finance Sector in India” and why we think Housing Finance is a secular theme to invest in. Please refer to the link below to access our deck.

Unpacking India’s Housing Finance Industry

The deck was also presented during our webinar on Indian Housing Finance Industry on 25th July 2024

Investor Memo May 2024

Dear Investors,

The following chart depicts our returns viz BSE 500 TRI:

As we close FY 24, we wanted to pen down our last 4 years at running Prescient Capital; our investment journey, track record, investment framework, and how should one go about selecting a public market fund. We are sharing a link below to our corporate video. Hope you like it and could share the same in your network.

Link: https://www.youtube.com/watch?v=IWrABowp3yM

In this month’s update, we will share some general musings on the market. Firstly, we look at the valuations of different equity markets around the world. The table below shows the FY25E valuations of key benchmark equity indices of different markets:

Source: Bloomberg

Some of the key inferences from the above table are:

• NASDAQ (US tech) is the most expensive key benchmark index in the world mainly because of the rally in the top 7 tech stocks (called magnificent 7) that are considered big beneficiaries of the AI boom like Nvidia.

• Indian large cap indices (as represented by NIFTY 50) are reasonably valued with a 1 year forward valuation of 20.3. However, the same cannot be said about Indian mid cap (defined as listed companies with rankings of 101-250 on basis of market cap) and small cap (defined as listed companies with rankings above 250 on basis of market cap) companies, whose valuation we will discuss later in the update.

• Most emerging market and European equities are quite cheap, so India and US markets have been clear outperformers since 2020.

• A cut in US Fed rates may trigger a rally in global equities but it may not have the same effect for Indian equities, especially broader Indian markets, given already elevated valuations of Indian small and mid-cap companies.

Indian small and mid-cap companies have witnessed a sea change in the past ~25 years as seen in the table below. The average market cap of a mid-cap company today is almost the same as that of a large cap company 10 years back while the average market cap of a small-cap company today is almost same as that of a large cap company 25 years back. So, we feel that investing should not be bracketed based on market capitalization as there are enough good small and mid-cap companies that can grow to have large capitalization over time. Obviously, the mortality rate of small businesses is high so the trick is to identify great business and management quality to ensure that one’s investments can survive business cycles to grow big.

The chart below shows the valuation of Indian large, small and mid-cap companies as represented by their respective benchmark indices. As of April 2024 end, the small cap index was trading at the largest premium to its historical average

The above graphs give the impression that mid and small-cap companies are outrageously overvalued and we need to sell these immediately. However, the actual picture is more nuanced because though small stocks are expensive, these have delivered the best earnings growth in the last few years as can be seen below.

The table below shows the last 3 years and last 5 years returns of different sectors as represented by its benchmark index. Clearly, several sectors like industrial, capital goods, power, defence, real estate, etc, which have delivered the best returns in the last few years, have mainly small and mid-cap companies. On the other hand, the biggest laggards like banks and large cap IT have the biggest weights in large cap benchmark indices like Nifty 50. Banks (SBI, HDFC, Kotak, ICICI, etc) have a combined weight of more than 30% in NIFTY while large cap ITS (Infosys, TCS, etc) have a weightage of more than 10% in NIFTY. On the other hand, sectors like power, cap goods, industrials, etc don’t even have a combined weight of 5% in NIFTY while these constitute more than 25-30% of small and mid-cap listed universe.

So, the bottom line is that though small and mid-cap companies are expensive currently, the rally in these stocks was driven by strong earnings growth over the last 3-5 years in certain sectors. Our strategy is a small and mid-cap strategy, so it has naturally benefited from tailwinds in industries like manufacturing, cap goods, building materials, etc. Till now, we had fair representation of sectors like cap goods (TD Power Systems, Voltamp transformers, Kirloskar Oil engines, etc), auto ancillaries (FIEM industries, Gabriel, GNA Axles, NRB Bearings, etc), cement (JK Lakshmi, etc). When we invested in these ideas a few years back, these were available at very attractive valuations. The manufacturing revival in India since 2020 has resulted in strong earnings growth and substantial improvement in financial metrics for all these names and these have generated good returns for us. 

However, we acknowledge that some of these names have now become expensive but still have good earnings prospects. So, we are exiting these in a calibrated manner and rotating into industries that have been laggard till now and are available at reasonable valuations like financial services, pharma, etc. Overall, we are mindful of elevated market valuations and are investing cautiously.

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

Regards, 

Prescient Capital   

Investor Memo April 2024

Dear Investors,

The following chart depicts our returns viz BSE 500 TRI:

In this memo we plan to discuss the recent clampdowns by the RBI on Banks, NBFCs and Fintechs. In the last one year the RBI has come down hard on NBFCs (IIFL Fin, JM Finance, Bajaj Fin), Banks (Kotak, BOB, Federal, RBL) and Fintechs (Paytm, Scapia). 

RBI has applied a slew of hard measures: stopped new customer additions, imposed more than usual financial penalties, questioned margin and LTV computation practices, and questioned customer KYCs norms. 

We wanted to take you back in time to explain the extent of the systemic risk and explain if the curbs are not put in now, it may permanently dent the consumer demand for a long term. 

The chart below highlights growth in household debt as a % of GDP for India.

SOURCE: WWW.CEICDATA.COM | CEIC Data

The chart below also compares the household debt as a percentage of % GDP across leading countries.

SOURCE: WWW.CEICDATA.COM | CEIC Data

It is apparent from the above two charts that the household debt as a percentage of GDP has risen rapidly for India (almost doubled in a decade) and this has sprung RBI into action to put early guardrails. From our limited understanding of household debt or debt in general, we can also conclude that beyond a reasonable level, high household debt can dent consumer sentiment and permanently taper consumer demand for the longer term. We have seen examples of demand compression in Japan, Thailand, UK and Canada, countries that stack pretty high on their household debt as a % of GDP (chart above). 

In the following section we try to explain what categories of debt have grown in India, per the heads defined by RBI. 

Source: RBI

It is quite apparent that personal loans have grown exponentially compared to other leading loan categories in the last 9 odd years. Personal loans have grown from ~ 15% of the total loan basket of scheduled commercial banks to ~ 30%, during this period. Within personal loans, the categories that have grown the fastest are unsecured loans such as credit cards, digital/online loans, instant loans and durables loans, e-commerce loans, and the like. To explain, housing loans although have grown fast too, have a lien on the underlying land/house hence considered secure.

Source: RBI

To put things in perspective, per our assessment the total number of credit card users have remained range-bound/constant/or may have decreased (companies do not publish this data) between 2019-2024. During the same period, the credit cards outstanding have grown at a CAGR of 17% and the total personal credit has grown at a CAGR of ~25%. In a nutshell, credit worthy people have moved from having 1-2 credit cards to 3-4 credit cards, while the total base has remained largely constant.  

The sheer scale and rate of growth in these categories has put under stress the processes used to originate loans, do customer KYC, assessment of credit risk and the security/scale of the customer digital platforms used by these entities.

Following is a summary of the actions taken by RBI against some of the Banks, NBFCs and Fintechs. Please note that the list is just indicative and is being used to support the argument.    

Federal Bank/South Indian Bank: On March 14 2024, the RBI directed Federal Bank and South Indian Bank to stop issuing any new co-branded credit cards with partners (One card and Scapia). According to RBI regulations, only credit-card issuers — banks — can access customer data and not their co-brand partners. For instance, in the case of Amazon Pay-ICICI Bank credit card, Amazon can’t access customer data. Federal Bank was using the software stack provided by One Card and hence the question on the confidentiality of data rose. Federal Bank has also significantly reduced the credit limits it was offering to its Scapia travel card customers (from 4-8L to less than a lakh). Due to credit delinquencies, such credit limits are typically offered to very high value customers. Whereas Federal/Scapia were offering these limits to middle income or new to credit customers. Both have suffered high delinquencies since. As a reference, the credit card portfolio of Federal Bank has grown from INR 270 cr in March 2023, to INR 3060 in March 2024. 

Kotak Mahindra Bank: On April 26 2024, RBI directed Kotak Mahindra Bank to halt onboarding new customers through its mobile/online platforms or issuing new credit cards. This emanated mainly due to unaddressed supervisory concerns emerging from the Regulator’s IT examination for FY 22/23 and from the frequent tech-outages (latest being on 15-Apr-2024). Notably, similar punitive action was taken earlier in the case of HDFC Bank. For Kotak Bank, its active credit cards have grown by 3x in the last 5 years. Kotak 811 (digital only onboarding) initiative has added 2 cr deposit customers in the last 6 years. The KYC norms for onboarding these customers have often been questioned.   

Bank of Baroda: On Oct 10 2023, RBI had directed Bank of Baroda to suspend further onboarding of customers onto the BOB World mobile application. This is driven by concerns on the adverse incentives in the bank to onboard customers online, by bypassing the basic KYC norms of onboarding. The total credit cards outstanding for BoB have grown by 11x in the last 5 years (on a base of 2.3 L outstanding cards in 2019).    

Bajaj Finance: On Nov 15 2023, RBI had asked Bajaj Finance to suspend issuance of its Ecom and Insta EMI cards. RBI highlighted that Bajaj Fin did not issue key terms/facts statements (per RBI Digital lending norms) to its customers while issuing these loans. The ban has now been lifted on May 02, 2024 post RBI scrutiny. 

IIFL Finance: On 4 March 2024, the central bank had suspended disbursement of new gold loans by IIFL Finance until the satisfactory completion of the audit owing to concerns regarding loan disbursement practices of the company. RBI's inspection had indicated a lack of adherence to the standard auction process and a lack of transparency in charges being levied on customer accounts.

Paytm Payment Bank:  From March 2022 till Jan 2024, RBI had been highlighting material non-compliance to Paytm Payment Bank in its new customer onboarding and KYC processes. The regulator initially asked the payment bank to stop onboarding new customers. On Jan 31, 2024, the regulator asked all existing customers to stop top ups and withdraw any balances in a phased manner from their customer accounts, prepaid instruments, wallets, FASTags, NCMC cards, and the like. 

JM Finance: In March 2024, RBI had asked JM Finance to stop being a lead manager in any new debt issuance. JM Finance was found masking itself as both originator and customers to bid for debt placements. JM Finance, did not do the expected diligence to onboard customers who could bid for new debt offerings. These customers were largely fake and their incomes did not justify their credit worthiness to bid for a significant amount of debt securities. 

Per us the key outcome of above clampdown/actions is as follows:  

• Slower credit growth in these categories in the near term. We believe that credit growth could slow down by 5-6 p. 

• HIgher risk weight means lower limits, and higher cost of funds. Cost of credit could go up by 2-3 p. 

• Tighter KYC norms means, banks being made more accountable for risk profiling and KYC of their customers. Fake onboarding, round tripping will be scrutinised more. 

• Per regulations, the fintechs act as just the marketing funnel and do not have access to customer spending data. This would limit the ability of Fintechs/co-branding partners to cross sell, a core revenue stream for them. 

Key actionables for us as fund managers evaluating/managing investments in this sector are: 

• Curtail our positions in Banks with high credit card or personal credit business. Assess the trends in their credit slippages. Build any future position once slippages settle. We are evaluating this space for good quality lenders who can endure this phase and are reasonably valued. 

• Invest in players with strong/modern core banking and lending software and infrastructure. Dig deeper to understand the same. 

• Identify and invest in listed core banking software or banking software companies that provide strong credit and KYC frameworks to banks and NBFCs. 

• Look for other focused and well managed banks/NFBFCs lending primarily in housing, corporate, MSME, commercial credit. These categories have seen good credit growth with strong operating procedures.

Regards,

Prescient Capital

Investor Memo March 2024

Dear Investors,

The following chart depicts our returns viz BSE 500 TRI:

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

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

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

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

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

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

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

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

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

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

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

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

Regards, 

Prescient Capital    

Investor Memo Feb 2024

Dear Investors,

The following chart depicts our returns viz BSE 500 TRI:

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

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

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

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

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

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

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

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

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

• Matrimony (slower than expected new customer growth), 

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

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

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

During the same period, we have initiated positions in: 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Investor Memo Jan 2024

Dear Investors,

The following chart depicts our returns viz BSE 500 TRI:

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

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

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

Source: RBI

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

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

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

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

Regards, 
Prescient Capital 

Investor Memo Dec 2023

Dear Investors,

The following chart depicts our returns viz BSE 500 TRI:

In this memo we will cover two broad topics: 

• Our take on the investing in IPOs

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

Our take on the investing in IPOs

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

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

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

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

Current state of the markets and our strategy of capital deployment

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

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

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

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

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

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

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

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

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

Regards, 

Prescient Capital  

Investor Memo November 2023

Dear Investors,

The following chart depicts our returns viz BSE 500 TRI:

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

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

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

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

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

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

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

Source: Motial Oswal Financial Services

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

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

Source: Bloomberg, Data as on 16th June 2023

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

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

Regards,
Prescient Capital

Investor Memo October 2023

Dear Investors,

The following chart depicts our returns viz BSE 500 TRI. 

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

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

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

Source:RBI

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

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

Source: Indian Labour Bureau

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

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

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

Passenger vehicle growth outstrips the 2 Vehicle Growth: 

Source: SIAM

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

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

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

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

Impact on Capital Markets: 

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

Regards, 
Prescient Capital 

Investor Memo September 2023

Dear Investors, 

The following chart depicts our returns viz BSE 500 TRI. 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Investor Memo August 2023

Dear Investors, 

The following chart depicts our returns viz BSE 500 TRI. 

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

Capital Allocation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Sustainable cash flow profitability is the only thing that matters

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

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

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

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

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

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

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

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

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

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

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

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

ESOPs/Related Party Transactions

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

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

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

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

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

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

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

Stepping off the fundraise rollercoaster

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

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

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

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

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

Overemphasis on hiring CVs

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

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

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

Investor Memo July 2023

Dear Investor, 

Below chart depicts our returns viz BSE 500. 

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

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

Source: World Bank

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

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

Source: IMF

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

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

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

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Company: Cummins India

Products manufactured: Engines

Management commentary: 

Q4FY23 Call: 

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

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

Company: Kirloskar Oil Engines (KOEL)

Products manufactured: Engines

Management commentary:

Q4FY23 Call: 

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

Company: Steel Strip Wheels

Products manufactured: Steel & alloy wheels

Management commentary:

Q1FY24 Call:

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

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

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

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

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

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

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

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

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

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

Company: MM Forge

Products manufactured: Forged parts mainly for auto sector

Management commentary:

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

Company: FIEM Industries

Products manufactured: Lights for auto sector

Management commentary:

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

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

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

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

Company: TD Power

Products manufactured: Generators

Management commentary:

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

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

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

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

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

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

Thanks & Regards

Prescient Capital

Investor Memo June 2023

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

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

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

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

4. Sectors that we find interesting to invest in

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Thanks & Regards

Prescient Capital