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