Introduction
When we started our investment firm six years ago, our objective was to manage our investors’ assets just as we manage our own by investing in businesses that were durable and were managed by stewards who view their company capital with the same care that we manage our investor assets. Investing in public market equity can appear easy and appeals to many who like the thrill of profits with little work, but that is merely gambling. We have set up an investment process that is rules-based, with extensive due diligence and a focus on generating long-term returns. We stay away from situations where near-term catalysts may mask longer-term business declines or weak or excessively promotional managements.
Our investment process combines qualitative analysis of a company’s strategic positioning, evaluation of financial metrics that verify our qualitative analysis and determination of intrinsic value of the business through a process of triangulation. The qualitative analysis of the company involves industry assessment, positioning of the company within the industry and the leverage it holds with suppliers and customers, management that is both capable and honest and the threat of disruption. The financial metrics that are important to us are cash flow generation, the return on net tangible capital and a capital structure that can withstand economic stress. Our value discipline means that each portfolio holding has to justify its position based on expected return adjusted for the cost of capital. This has often meant that the portfolio has higher levels of cash when there is a dearth of opportunities based on our stringent criterias. Investing with the goal of generating superior long-term returns requires taking risk. Our view is that the key risk to be minimized is the permanent loss of capital- this is generally driven by the lack of due diligence prior to investing or the failure to correct investment mistakes when they manifest. We discuss our success in generating superior absolute and relative (to benchmark and peers) in a subsequent section, but our key message to investors is that we have always maintained the discipline in implementing our rigorous process in analyzing companies and constructing our portfolio.
Last year when discussing India in our investor letter, we paraphrased Warren Buffet and Charlie Munger when we said “this may be the time to be on India”. Over the one year ending March 31, 2022, MSCI India was +17.86% vs MSCI Emerging Markets -11.37%, MSCI China -32.54% and MSCI ACWI (All Country World Index) +7.28%. On a longer term basis, over ten years, MSCI India returns were +8.64% vs MSCI Emerging Markets +3.36%. MSCI China +4.55% and MSCI ACWI +10%. While in the short-term, relative performance can mean revert, we remain positive on the long-term prospects for the Indian economy and the equity markets. In the Appendix 2 of our annual letter last year, we had discussed some of the reasons for our positive long-term outlook while addressing some of the near term concerns, especially inflation. That inflation concern has fully materialized not only for India but for the western world with supply-side problems exacerbated by Russia’s invasion of Ukraine. In Appendix 5, we discuss additional factors that are reshaping the Indian economy from a long term perspective.
Review of the Year
Financial year 2021-22 was a rollercoaster of a year. With the 3rd wave of Covid, ease of restrictions, and a strong vaccination drive, the first half of the year was dominated by strong earnings recovery with stock prices touching record highs and IPOs witnessing the highest mop ever. This was also augmented by a strong support from the Government and the Central Bank – keeping interest rates low and maintaining adequate liquidity. However, the year lost its sheen in the second half in which the markets had to deal with the fear of tight monetary policies, rising inflation, geopolitical tensions, and one of the highest selling by the FIIs. In fact, in the last month i.e. in March 2022, the CPI inflation index had surpassed the 10-year treasury bond rate leading to a negative real interest scenario. Despite this turbulence, the benchmark BSE 500 returned 22.3%
Sameeksha PMS also braved these headwinds and outperformed the benchmark by generating returns of 25.14% (before application of performance fees) for the fiscal year, despite holding an average cash level of 13.3% during the year. The performance fees of some investors, payable once in every three years, was due in this fiscal year and the said fees amounts to ~ 2.76% of the entire AUM of Sameeksha PMS. After applying this performance fees, Sameeksha PMS managed to marginally outperform the benchmark by generating returns of 23.4%. There are a range of practices prevalent in the industry in terms of how performance fees are factored into the reported performance and hence it may make sense to compare performance on a gross basis as well. While this performance is reasonable, we strive to do better. We analyze the Fund performance for the year in greater detail in Appendix 1 and further discuss key contributors to the portfolio performance in Appendix 2.
Market Outlook
The Covid lockdowns resulted in a severe short-term economic contraction that were alleviated by fiscal and monetary stimulus. These stimulus measures and the recent supply chain problems across the world have resulted in a sharp uptick in inflation. Central banks around the world including in India have tightened monetary policy in recent months and interest rates have risen. On June 8th, the Reserve Bank of India raised their policy measure repo rate by 50bps to 4.9% and we expect further rate increases till it is clear that inflationary pressures are abating. The Indian stock market has seen a correction albeit to a lesser extent than most other global markets. We expect markets to remain volatile through this period of rising rates. The tighter fiscal and monetary conditions are, the more likely it is for a reduction in economic growth. CLSA estimates FY23 GDP growth to slow to 6.7% from 8.7% in FY22. Rural consumption has been weak, but government spending remains strong with April 2022 showing +21% growth YoY.
As we write this, even several indicators of the Indian economy have been on a positive side (GST collection, PMI for manufacturing and services, credit growth). Some of the structural tailwinds due to China plus one shift and productivity incentives are driving a revival in private capital expenditure after a very long time. The formalization of the economy continues in many segments of the economy. In the near term, the government’s infrastructure push can sustain, especially if prices of key commodities such as steel continue to cool off. Then, there is a forecast of a normal monsoon which can also support consumption. The formalization trends seem to be positive for profitability of listed corporates that are showing expansion in ROEs as well thus supporting higher market cap to networth multiple. While there are many positives, the interest rate tightening cycle has already had its early impact on the equity markets and to some extent western economies of Europe and US . Trajectory for inflation remains a concern because of the prices of crude oil notwithstanding some signs of plateauing of CPI due to fall in prices of many of the commodities. Russia’s invasion of Ukraine may not be grabbing headlines anymore but the war continues and more importantly, the supply of crude remains constrained. That does present a material risk to the resilience of the Indian economy in the short run even though further rise in crude can affect demand and hence lead to eventual fall in crude. From a longer term perspective,. The formalization of the economy continues in many segments of the economy. In the near term, the government’s infrastructure push can sustain, especially if prices of key commodities such as steel continue to cool off. Then, there is a forecast of a normal monsoon which can also support consumption. We remain hopeful that buoyancy in the Indian economy may sustain and interest rates may not need to rise to a point it starts to seriously hurt the economy. However, we will have to remain watchful of the risks due to the unresolved Russia equation.
On various valuation parameters, the Indian market as a whole appears to be reasonably priced though excessive valuations of highly sought after stocks in some sectors (consumer, building materials, chemicals) do concern us and ROEs have to sustain to justify elevated market cap to net worth multiples. While global sell off in equities may further suppress Indian markets, we will remain focussed on factors that can sustain continued growth in corporate earnings and cash flows in India over a longer term. Hence, we view the current market weakness as an opportunity to build positions in well managed companies with durable business models when they trade at attractive discounts to intrinsic value. In Appendix 3, we discuss our current view of the top positions in the portfolio.
Review of our Long term performance
We invest for the long term and hence it is very important to look at our long term performance. While we discuss our long term performance in greater detail in Appendix 4, we summarize key findings in Appendix 1.
Sincerely,
Bhavin Shah Eswar Menon
Links:
Appendix 1: Performance of the fund for FY2022
Appendix 2: Key Performance Contributors in FY2022
Appendix 3: Current view on top seven positions
Appendix 4: Performance Analysis for Longer Periods
Appendix 5: Additional factors affecting Indian Economy / markets