Investment Memo - 2019

After a long hiatus, I have decided to publish annual letter to all readers of my blog. Because of lack of time, I have decided to stop publishing quarterly analysis of stocks. However, tradition of sharing detailed annual investment memo will certainly continue. First of all, I would like to notify readers of this blog about intentions of starting this blog.

Purposes of this blog —

1. Make quality decisions about your investments.
2. Avoid noise in decision making.
3. Create a community of long term focused quality investors in which we will share thoughts, thereby help in improving as an investor.
4. Discuss mistakes as well as wins with fellow readers.

This blog is not for —

1. Short term thinkers like traders, option sellers etc. I strongly believe that wealth can be earned by compounding at reasonable rates without taking unnecessary risks which compromise safety of capital.
2. Earning money. I don’t want to receive any monetary benefits by discussing stocks, mutual funds or any fixed income instruments, neither from readers nor from companies. That’s the reason, I kept this blog free to read.

With purposes made clear, I will start this blog with investment philosophy. I divide my investment process in multiple buckets. In decades to come, this philosophy will not change materially. However, I will evolve myself as an investor.

Investment process

1. Quality of business — One needs to be focused on buying quality businesses. Business should be analyzed from the perspective of return on equity capital. If business earns more return on equity than cost of equity, then investor will earn value in long term. As Warren Buffett describes in his annual letters, there are three types of businesses. Great — The great quality business is the one which doesn’t need lot of capital to run. With given capital, it throws lot of cash back to owners. Vaibhav Global, Caplin Point Lab, Quess Corp, Suprajit Engineering are few examples of such great quality businesses. Good — The good quality business needs capital for going concern. The more you pump, the more you earn. IDFC First Bank, Aditya Birla Capital (NBFC and Insurance arm), Minda Corp and Huhtamaki PPL are some examples of good quality businesses. Gruesome- The gruesome quality business is bottomless pit of capital consumption. The more you put in, more they demand. They will not provide any cash in return. Indian Telecom companies are perfect examples of gruesome quality businesses. One needs to avoid such businesses completely.
2. Quality of management — In investing world (and in life) you need to work with great quality people. Management quality needs to be analyzed from different aspects. Capital Allocation skills —How much value could the management create with the allocation of Rs. 1 of capital in last 10 years. If they could add at least Rs 1 of value behind every Rs. 1 of capital within 3–5 years of span, then you can safely say that management’s capital allocation skills are value creative. Otherwise, they are heading for operational missteps. Operating skills — Do they run their shop efficiently? How do they treat their customers and employees? What is the difference between them and their competitors in operations? Aspirations — Do they want to grow business multi-fold without compromising business fundamentals? Do they have energy to make the business big or are they complacent? Integrity — This quality is least seen in Indian managements. There are many dull quality people found in Indian business who have cheated their minority shareholders in big way. Examples are DS Kulkarni, Sandesaras, Wadhwans etc.
3. Growth of business — Business should grow by capturing market share and growing market size. Management should do value additive acquisitions for revenue and profit growth. However, chasing growth for the sake of gaining market share at the expense of quality of business will kill business. Many businesses funded by private equity players forget that they want to earn money. They give hefty discounts to disrupt markets. But, when economic reality kicks in, such people regret a lot. Remember that qualitative earnings growth is the only way to create value. If your management or business is growing in unhealthy manner then please sell out your stake. One example of unhealthy growth is Future Consumer, Big Basket, Paytm etc. And there are many more !
4. Longevity of products — Ask two questions — Are the product/service of the company needed in next 10 years? Can any private equity backed person disrupt this business? What matters is sustainability of qualitative earnings growth for a decade or more.
5. Reasonable price with margin of safety — I use Prof. Bruce Greenwald’s earnings power based method for valuing company. I don’t use any of P/E, P/B or DCF way of valuations. Depending on the business, buy when price is available at 20%–30% discount to your fair valuations. If you don’t find such buying opportunities, then park your money in Parag Parikh Liquid Fund to get 6%–6.25% returns. Having margin of safety in investment is really important factor to protect your capital.
6. Diversification — I believe that 2 new business opportunities per year are sufficient. I won’t have more than 20 businesses in my portfolio. Currently, I have 8 businesses in portfolio. You need to say yes to exceptional opportunities, not to good or average opportunities.
7. Capital allocation — I allocate minimum 5% of my portfolio size to a company. If opportunity is exciting then, I go for maximum 10%.
8. Selling discipline — I sell when a company is currently trading at expected fair valuation of a business after 3 years. If you don’t sell at this point then market forces will bring down the prices and you will lose gains. If you get such valuations then it would be good to book profits.
9. Working in small cap world — The real challenge in investing is finding right fit early when company is small one. These companies are not known to the market. In such situations, inefficiency in prices can be found. When you find business and management that ticks all boxes in micro or small cap world, jump on it.

Mistakes made this year

1. Sintex Plastics, Bodal Chemicals and Karnataka Bank — I sold out entire stake in these companies. They had multiple issues which required permanent fixes. Management couldn’t address them in timely manner.
2. Buying at high valuations — I bought ABCapital at high valuations. This compromised margin of safety.
3. Not booking profits at high valuations — I bought Huhtamaki PPL at Rs. 225. The stock reached around Rs. 370. Price of Rs. 370 was huge divergence from underlying fundamentals of the business.

Updates on portfolio this year

1. Huhtamaki PPL — The packaging firm hit problems from pollution control board which they successfully sailed through. Currently, slump in growth in Indian FMCG is a concern where Huhtamaki PPL is driving most of the revenues. Apart from these concerns, I see Huhtamaki PPL earning average RoE and growing earnings at 10–15% rate. Business is financially well managed, has less debt and free cash flow generating. I purchased minor quantity this year. Currently, company is trading at fair valuations, leaving no scope to purchase further. Stock is up 28% this year.
2. Aditya Birla Capital — ABCapital’s Asset Management Business is doing really well. It is grabbing market share while keeping existing financial parameters intact. This AMC business is the example of great quality business — with less capital, earns a lot of money. Overall, NBFC sector in India is in tailspin. It is only in down cycle, we will know who were dirty players in multiple sectors. ABCapital’s NBFC business did pretty well by diversifying book and underwriting conservatively. The NPAs, RoE, RoA and growth of loan book was all intact. On the other other hand, they have developed Housing Finance Business. This business is turned around to profits this year. Such kind of business— which keeps all qualitative parameters intact and grow in the downturn of economy — is going to create lot of value in the long term for the shareholders. Insurance business is under development with expectation of break even by 2021. Actually, IRDAI wants insurance companies to make certain provisions in nascent stages that make the business making auditing losses. Otherwise, insurance business is growing well with combined ratio coming down every quarter. Overall, RoE of AMC business is around 60%, that of NBFC business is 18%. I expect insurance business to report RoE of around 20–25% after 2–3 years. Entire conglomerate should report 20%-25% RoE with growth of 20%+ over long term. Stock is already in overvalued zone, creating negligible returns around 1%–2% this year.
3. Quess Corp — I have added Quess Corp aggressively this year when they flagged problems of Trimax receivables Quess is run by very dynamic entrepreneur — Ajit Isaac. The competence of Ajit is immeasurable. He started Quess in 2008-09 in a single flat in Bengaluru. His execution skills lead him to raise private equity from Fairfax, Canada. In a decade, Quess grown to Rs. 10,000 Crs revenue company. This happened by way acquiring turnaround assets, growing existing services businesses and venturing into related areas. Problems of Quess are manifold, but short-term in nature. First, Monster’s loss making business is pulling down the bottom line. Second, entire business operates at wafer-thin operating margin. Third, company has made 22 acquisitions in past, streamlining all these businesses is a challenge. Forth, many unorganized services shop eat up market share as there is less barrier to entry for this business. But, all of them are being handled with competent management lead by Ajit. I am very long on this business. This year, valuation bubble formed around Quess busted taking down 50% price. I gained around 12% as my price was around 470.
4. Minda Corp — As auto slowdown hitting ancillary businesses very hard, severe correction is noticed in quality businesses. Minda Corp is a dominant player in auto ancillary market earning 15–18% RoE. Once, auto sector stages comeback, this business will gain a lot. Stock is down by 43%. I bought around Rs. 100. My stake is down by 8–9%.
5. Vaibhav Global — VGL business is steadily growing its revenues and earnings. VGL completed buyback at Rs. 1000. After this buyback, no. of shares outstanding reduced and my stake increased. This stock is trading at discount to its fair valuation. Regarding buyback — How one should know the buyback activity create value to shareholders or not? If company is trading at significant discount to its intrinsic valuation and management could not find avenues to deploy retained earnings, then management should buyback. If these conditions are not met, then buyback won’t create value. In VGL’s case, I think that buyback has created value. I didn’t surrender my shares in buyback program because management didn’t participate in buyback. I am very long with VGL. VGL shares gain around 9% this year. My gain was around 12%.
6. Suprajit Engineering — Suprajit Engineering is another auto ancillary stock that came under pressure despite great business fundamentals. In his early days, Suprajit’s Ajith Rai went to Canada to complete his PhD. However, he returned to India as entrepreneurship bug caught him. He started making auto cables for TVS Motors. Over the period, because of good capital allocation skills and quality products, Suprajit is one of biggest cable manufacturing company in the world. It caters to the needs of almost every OEMs. Suprajit has consistently earned 25–30% RoE in last 12 years and growing at 20%. Suprajit’s share was quoting at Rs. 5 around 10 years back, currently it is Rs. 175. It is 35X capital appreciation excluding dividends. This is what a great quality, free cash flow producing business backed by dynamic person like Ajith Rai can do to shareholders. I am planning to purchase Suprajit. The stock was down by 23% this year. I gained 8% with Suprajit this year.
7. Caplin Point Lab — Caplin Point Lab is an example of a moat business with lot of growth potential in long term. The primary market for Caplin Point Lab is Latin American and West African countries where affordable healthcare is a distant dream. Business works primarily on advance collected from distributors resulting in negative net working capital. Company also planning to enter into branded and complex generics and formulations business in China and US. If these calls go well, Caplin will generate lot of cash resulting into value creation. Stock is down 18% this year. I have no major positions yet as I was waiting right entry price. I will continue to purchase Caplin Point.
8. IDFC First Bank — V. Vaidyanathan is one of the finest brain in Indian Retail Banking sector. He developed ICICI’s retail loan portfolio and grew it to Rs. 1 lac crore size. Future Capital Holding was loss making company in 2008. V. Vaidyanathan, then serving on board of director of ICICI bank sensed an opportunity while on a business trip. Then, Future Capital Holding became Capital First. Challenges were aplenty in terms of fund raising and establishing business. V. Vaidyanathan pitched his idea of retail lending to Warburg Pincus. After successful fund raise, Capital First grew their loan book to 30K Crs+. In 2018, he merged Capital First with IDFC Bank. IDFC Bank has low yielding infra book whereas Capital First has high yielding retail book. Merger of these two companies will provide significant wealth generation to shareholders because Vaidyanathan is maturing the wholesale book of erstwhile IDFC Bank and growing retail presence. His initiatives are already showing results. But, I am long on IDFC First Bank. This year stock didn’t move too much. I made minor purchase when it went down and earned 8% so far.

I am thankful to all managements for showing exceptional skills in running the business.

Portfolio’s performance of this year

As of now, my portfolio earned around 3%. Most of my portfolio allocations happened in Aug this year.

Mutual fund’s performance of this year

I discussed 3 funds — Parag Parikh Long Term Equity Fund, Parag Parikh Liquid Fund and Mirae Assets Emerging Bluechip Fund. I believe these three funds should suffice investor’s needs of long term capital appreciation. I had published my reasons of choosing these funds here.

Parag Parikh Long Term Equity Fund Direct — This fund returned 15.48% in 2019.

Parag Parikh Liquid Fund Direct — This fund returned 5.98% in 2019.

Mirae Asset Emerging Bluechip fund Direct — This fund returned 14.42% in 2019.

Note — Above returns are for one time investments.

Sovereign gold bond

I was reading about a fixed income instrument which has almost zero risk. Government of India issues Sovereign Gold Bonds. You need to purchase gold bond in multiples of gram. These bonds have 2.5% interest rate paid semi-annually for 8 years. After 8 years, you will receive money as per the gold rate. By investing in this, you will receive benefits of appreciation of gold and 2.5% per annum interest. Lets see how this scheme fared in last 30 years. In 1989, price of gold was Rs. 314 per gram. As of this writing, price of gold was Rs. 3931 per gram. The price appreciation is CAGR 8.49%. Add 2.5% interest paid on effective rate goes to 11%. This is one of the best fixed income returns in India with least risk as Sovereign gold bonds are backed by guarantee of Government of India. If you purchase these bonds online on Akshay Tritiya or Dhan-Teras, Government provides Rs. 50 discount per gram. If you hold these bonds until maturity, then capital gains are tax free, otherwise not. Flip side is — your returns are linked to gold prices. I have decided to purchase these bonds on the auspicious days of Akshay Tritiya and Dhan-Teras starting from next year.

Discussion on stock market

Stock market as usual volatile this year. But, volatility gives multiple buying opportunities. I don’t make decision based on stock market volatility. I always have a fair idea about intrinsic valuation of company. If company is available at 20–30% discount to the intrinsic value, then I pitch in. Stock market is always inefficient in the short term and always efficient in the long run. If you take the metric of intrinsic value of a company and stock price performance for 10 years, you will notice that company always trades at intrinsic valuation. So, the person with long term holding appetite must ignore short term volatility of prices and focus on long term business fundamentals.

BSE Sensex and Nifty 50 index are growing to all time peaks day after day. I believe there is bubble in selected large cap companies. Valuations of such companies are sky rocketing, however earnings growth and fundamentals are telling different story. I think this scenario is not uncommon in Indian Stock markets. In last investment memo, I cribbed about mind boggling valuations of small and mid cap companies. After that, they came down heavily. Remember that when stock price goes way ahead of business fundamentals and earnings growth, then melt down certainly will happen — just timing is not known to anybody. BSE Sensex and Nifty returned around 10% this year. Despite this variance, there are many good quality companies especially in small and mid cap segment available at dirt cheap valuations.

Comments on Indian businesses, economy and financial world

Slow down in Indian economic growth is started way back in Nov 2016 when Govt. announced demonetization of high value currency notes. In Jul 2017, Govt. announced Goods and Services Tax with flawed implementation. After that, Real Estate Regulation Act (RERA) was introduced. All three actions proved deadly for unorganized sector and real estate. Indian public still uses cash for day-to-day operations. Sucking the cash out of system was disruptive. Small Indian businesses are still worried about GST. As economy was not formalized, GST and demonetization disrupted these players throwing economy in tailspin. Such steps should have been taken with prior planning. Move to bring all entities in single umbrella of formalized economy has many implications. First, many blue collar jobs are provided by these segment. People lost their bread and butter as Govt. hit the sector. These two steps lead to closure of many industrial units, hence job losses. This sudden disruptions caused slump in demand. Because of RERA introduction, bad real estate players will be wiped out. But, this consolidation has deadly effect on leveraged players as they will find less avenues to finance debts.

This slump in demand followed by IL&FS, DHFL, PMC Bank scams and Reliance Capital default. Crunch of liquidity in the system has direct effect on leveraged players. That’s why, we see that so many leveraged players finding it difficult to run businesses. Other problem is tagged with corporate governance issues in Co-operative Banks. These banks are found everywhere mainly in states of Maharashtra, Karnataka and Gujarat. Mainly dominated by politicians, people of hinterlands of these states depend a lot on banking needs on co-operative banks. And, these are defaulting leaving depositors in tandem. If widespread default of co-operative banks happens, our economy will go into recession as people would lose their life’s savings. Another aspect of problematic future is deposit schemes at local jewelers. If jewel shop defaults, then people will have nowhere to go.

Unfortunately, our Govt. has not taken decisive steps to boost economy. Actions from RBI are also not satisfactory. RBI’s main responsibility is to stop reckless lending by irresponsible players. Nothing has happened on that front. Co-operative bank’s dual regulatory problem is not solved because of Govt.’s influence. No one could stop jeweler from accepting illegal deposits.

If we want to be 5 trillion dollar economy, we need to fix a lot. Revamps are necessary in many aspects of our country. Sadly, no Govt. has taken right step in that direction. Our land acquisition laws are archaic. We need labor law reforms. Our investor friendliness needs to be improved a lot. Our education and R&D expenditure spend needs to be increased. With this rate, it will take forever to reach 5 trillion mark. Unfortunately, our immature politicians, majoritarian Government and fractured opposition are so self obsessed that national interests are put behind !

As I am not macro focused investor, these factors don’t matter to me. But, as a citizen of this country, I express my thoughts.

Best resource to read

Parag Parikh Annual General Meeting and Financial Opportunities Fund

Parag Parikh AMC started Financial Opportunities Forum and Annual General Meeting. Financial Opportunities Forum is a paid one where you can attend a session per month. AGM is free of cost for unit holders. I missed AGM this year. I assure you that these are one of the best contents in investment world. The YouTube channel can be found here.

Moneylife Magazine

I have subscribed to MoneyLife Weekly magazine. If you want to read unbiased and detailed analysis of contents in financial world, I highly recommend subscribing to Moneylife Magazine. Sucheta Dalal and team is doing commendable job of educating minority investors of India. I am thankful to them.

Farnam Street

This blog by Shane Parrish is master piece on decision making. The podcasts at The Knowledge Project hosts some of the brilliant minds in the world. Subscription is free of cost and can be made here.

The Fundoo Professor

Prof. Sanjay Bakshi is an authority on Business Valuations and Behavioral Finance. The blog can be found here.

Some of the best Twitter Handles —

MicroCapClub

Samit Vartak

Dr Vijay Malik

Sucheta Dalal

PPFAS Mutual Fund

Ian Cassel

Shane Parrish

Vishal Khandelwal

Prof. Sanjay Bakshi

Farnam Street

Disclaimer

Investments in mutual funds, stocks and bonds are subject to market risk. Please read scheme related documents and annual reports carefully. As I have invested in these funds, stocks and bonds, I have positive biases for them. I can be wrong! You are requested to do your home work before investing in any of these instruments. Also, I wrote about these funds, stocks and bonds because I genuinely find them as good investment instruments. As I have discussed that direct instruments should be selected, nobody gets commission. All I want you to understand that I won’t receive any incentives to write about them! Next blog post will be shared by Jan-2021.