The calendar year that went by, was packed with surprises and perhaps is the reason why some investors view the stock market with a sense of fear. The Nifty fell nearly 40%, from its high of 12,430 in January 2020 to its low point of 7,511 in March 2020. Then, from its low point, the Nifty rose 86%, closing up 15% for the calendar year 2020. In the same period, the S&P 500 Index in the US also fell 34% and then has risen 67% from its lows, closing up 15% for the year. Our portfolios have also done fairly well during this period, both on an absolute basis and relative to the market. The sharp fall was triggered by the rapid spread of Covid and the lockdowns, but the subsequent sharp recovery also took most investors by surprise. We have seen similar corrections in the past – in recent decades they have been occurring at a frequency of once in 8-10 years. In the early 2000s, around the dot-com crisis, the Nifty fell nearly 53% from its peak. The fall was even more severe during the global financial crisis of 2008, when the Nifty fell 64% from its peak levels. Apart from these extreme moves, there have been several smaller corrective periods. Eventually the market recovered from these falls and currently trades at an all-time high.

The question that constantly plagues investors is whether one should try to foresee such corrections, or the subsequent recovery, and should one have taken corresponding actions. Timing the market consistently is very difficult. The sharp recovery in the market since March has certainly got us and many others surprised. As investors, we believe in staying focused on the business of our portfolio companies and their valuations, rather than respond continuously to macro-economic events, which to us, seems not only difficult but almost impossible.

We invest in companies which have a proven track record of profitable growth, have weathered several economic cycles in the past, are operating in simple businesses and we try to buy them when they are trading at reasonable valuations. What surprised us over the last 9 months, since the Covid related lockdowns started, is the resilience of these companies. In the quarter ending Sept 2020, the top 10 companies in the portfolio grew revenues by 6.9% on the median, compared with a fall of 4.0% in nominal GDP. We expect the quarter ending Dec 2020 also to be stronger for these companies, relative to the broader economy. We have not seen any of the portfolio companies seeing either a sharp fall in revenues or struggle with a stressed balance sheet. As investors, if we can consistently pack the portfolio with highly profitable companies that can grow better than India’s nominal GDP and buy them at reasonable valuations, over time the results will show. Some companies have a track record of navigating crises well, and as investors there is merit in concentrating your investments around these companies.

The sharp recovery in the portfolios, since the market correction in March was assisted by a combination of factors. Firstly, the Indian market is benefiting from strong inflows from foreign investors. FIIs have invested nearly $20bn since May 2020. Secondly, corporate performance, especially for the companies in the portfolio, have been reasonably good given the context of an extended lockdown. Thirdly, valuations for many of the portfolio companies were not too expensive at the beginning of the year and many of them have benefited from an upward rerating in valuations. Even going forward, investment decisions in the portfolio will be based on the prospects for the individual companies and valuations at which the stocks trade. We have found this disciplined approach to be effective and can lead to superior results if followed consistently.

November was an extremely strong month for Indian equities as the Nifty surged 11.4% during the month, one of the strongest one month returns seen in recent times. The rally seems to be driven by FIIs who have been relentless buyers during the month. FIIs have net bought roughly $21bn of Indian equities in the first 8 months of this financial year as compared to $1.3bn in the previous financial year – of that $21bn, $8.1 bn was purchased in the month of November alone. There has been an increase in global liquidity as the Fed and other global central banks keep interest rates extremely low and the news about the vaccine also boosted sentiment. The high flows into India could be linked to the weakening dollar in recent months against major global currencies, which tends to boost “risk on” sentiment.

With the markets being quite cheerful, we thought it would be a good time to review the aggregate quarterly results of the corporate sector. As we have done before, we looked at a data set of the companies currently in the BSE500 index excluding the banks and financial services companies. The quarter ended June 30, 2020 was obviously terrible in terms of quarterly results because of the nationwide lockdown which has been slowly lifted over the last 6 months – aggregate revenues were down 33% and the median company’s revenues were also down 34% yoy. Operating profits (profit before interest, earnings and tax) were down 45% in the aggregate and 49% for the median company and the profit before tax had similar large declines. In the quarter ended September 30, 2020 however as the lockdown has lifted substantially, the numbers seem to have stabilized – revenues are down 7.4% in aggregate and the median company’s revenue is down only 0.5%. Now comes the somewhat surprising bit – operating profits are up 15.8% in aggregate and 8.9% for the median company. Profit before tax too is up 21.8% in aggregate and 7.3% for the median company. The 3 PSU oil refiners have an issue with the base quarter of September 2019 and also have shown strong growth in profits in September 2020 quarter – if we remove them from the set we are analysing, the aggregate growth in operating profits is still a reasonably strong 10.4% and for the median company the number is 8.0%.

It appears that we are past the worst of the economic effects of the pandemic related lockdown and the economy is showing signs of stabilizing. Some of the strong growth in profits is linked to reduction of various expenses for corporates such as travel, hotel, advertising and selling expenses and others – some of this could be temporary in nature while some part of it could be longer lasting as corporates use this opportunity to use ‘digital’ as a means to drive efficiency in their organizations. Some of the stabilization in revenues could be linked to pent up demand from Q1 and we will need to observe the next few quarters to see how the economy slowly returns back to normalcy.

Meanwhile the strong run up in stock prices (with the Nifty at an all-time high) has meant that valuations are inching up – as such we are finding fewer opportunities to invest among our universe of high-quality companies. It has been a swift turnaround from March, 2020 when we spoke about “mouth-watering” stock prices to now when we are suddenly finding it difficult to invest for the new accounts that are opening with us, because the market is no longer offering a good reward to risk ratio for our universe of high-quality stocks.

In this newsletter, we would like to discuss asset management companies (AMCs). Asset management is a business we have some understanding of, since we are ourselves engaged in the same business. It is a tough business when you are small in terms of asset under management (AUM) because fixed costs are high and the base on which you are earning is small. However, as you attain scale, the business economics improve considerably – the fixed costs can be expensed over a larger and growing revenue base and the operating margin for an Indian AMC that has achieved scale, can be as high as 75%. Moreover, the business requires very little in capital and therefore the business offers huge free cash flow potential – free cash flow is as high as 100% of the net profit over the last 5 years.

What is furthermore attractive about this business is that it has a very long runway of growth. The Indian financial sector is underpenetrated and the financialization of savings in India is a long-term growth story. Out of India’s population of 1.3 bn people, only about 59m file tax returns, roughly 40m have depository accounts and only 21m have folios with mutual funds. The total AUM in the mutual fund industry is just 12% of GDP as compared to 120% in the US and 63% for the global average. One can thus visualize a very long-term growth story for AMCs in India as Indians move away from physical savings to financial savings.

To set up a mutual fund in India requires a license from SEBI, the regulator. The success of a mutual fund depends on 4 pillars – brand, distribution, risk management and performance. Over the years, only a few players have managed to get these 4 pillars right and have managed to achieve scale. The industry is reasonably consolidated with the top 10 players controlling about 84% of the market (up from 79% in FY2015) and continuing to gain share. Given the scale economics, it becomes tough for a new entrant in this space.

An asset management company has 3 levers of growth, particularly for companies who can hold on to their existing investors – first is that the underlying asset is expected to experience some growth, in line with the returns generated; second is that existing investors are expected to add more money over the years as they channel their savings into investments and the third is acquisition of new customers. As such, because of these 3 levers of growth, we expect asset management companies to show robust long-term growth in assets, well ahead of nominal GDP growth. Over the last 10 years, the total assets of all Indian AMCs put together, have grown at 15.1% p.a. while the 20 year growth number is 17.7% p.a.

We have invested in 2 AMCs – HDFC AMC and Nippon India AMC. HDFC AMC is the market leader in the industry with 14-15% market share while Nippon India is the fifth largest with 7-8% market share. Both have achieved scale and are immensely profitable. HDFC AMC is one of the most profitable asset management companies in the world. In 2019 Nippon Life bought a controlling stake from Reliance Capital and became the sole promoter of Nippon India AMC. Since then, the company has been trying to gain back its lost market share and is also working on improving its cost structure to improve profitability. As such both companies present a great opportunity to harvest the long runway of growth available to asset management companies in India – moreover this growth is likely to be accompanied by improving profitability as the companies scale up.

It has been nearly 90 years since Ben Graham, widely considered as the Father of value investing, propounded the theory of value investing in the classroom in Columbia Business School. Ben Graham put a lot of emphasis on deep value investing, where one buys into a company at a significant discount to its intrinsic value, where a lot of focus is on net current asset value of the business – this is also known as “cigar butt” investing. His famous student Warren Buffett refined that concept further with the help of his business partner Charlie Munger and many value investing practitioners draw inspiration from the gentlemen mentioned above. Buffett focused on buying a great business, having a sustainable competitive advantage, at a discount to its intrinsic worth.

The cigar butt investing approach revolves around buying a company trading at a significant discount to book value and often even to the liquid assets of the company. This approach though sound in theory, has a limitation – it can sometimes become a value trap, because although one is buying at a discount to intrinsic value, the underlying value of the business may not be growing and if it takes the market price several years to catch up with the intrinsic value, the expected return may be a lot lower than what was originally anticipated. In bad situations, the intrinsic value may even decline over time, further whittling away one’s expected return from the stock.

Growth in the underlying intrinsic value is thus an important attribute of a high-quality company, in our opinion. With India’s nominal GDP expected to grow at about 10-12% pa over the next several years, it would be fair to expect a good company to grow at least at this rate, if not higher. Needless to say, the higher the sustainable growth rates, the better it is for the investor. We have typically seen such growth coming from companies operating in simple businesses, having a sustainable competitive edge, a large and underpenetrated market opportunity and a management with a proven track record of execution.

Predictable and high growth alone are not sufficient conditions that make for a high-quality business. There are many businesses which can keep growing as long as you can fuel the growth with capital, either equity or debt. On the other hand, these may fail on the critical question – is the business generating a high enough return on the invested capital, and more importantly evident as free cash generation which is used to pay growing dividends over the years.

Finding a high-quality company too is not enough – an important concept of value investing is that such a business must be available at a price that is reasonable in relation to its future prospects. The current market environment has bid up prices for high quality companies in some instances to levels where one is reminded of past occasions like 1994 and 2000 when valuations became excessive and subsequent returns were not too favourable, even for these high-quality companies. We believe that the price you pay in relation to the underlying intrinsic value of the company has a large bearing on the subsequent long term returns from the stock. So as and when valuations of particular stocks reach levels which are in our opinion excessive, we will not hesitate to sell down our positions and continue to look for other opportunities to invest in quality companies which are trading at a discount to their intrinsic value.

In this newsletter, we wish to talk about a business which has been positively impacted during the pandemic – depositories. A depository is an institution where securities are stored. All the stocks that investors own are stored in depositories, via depository participants, who are agents of the depository. Many years back, stocks were held in physical form, and some of us may be aware of the many problems in dealing with physical shares like the long time period between the purchase of stocks and them being registered in your name, not to forget the extreme strain on your tongue in affixing multiple share transfer stamps on the share transfer forms. All this was eliminated when the government introduced paper less trading with the help of depositories.

What attracts us to the depositories business is that it is a regulated duopoly with stiff barriers to entry in the form of a license from the regulator. Also, the percentage holding that a promoter can own over the long term in a depository is only 15% – hence there is a disincentive to enter this business. NSDL and CSDL are the only two players in the market with both players having an almost equal market share (CDSL was trailing until recently, but has caught up of late). So while NSDL has mostly institutional participants (like HDFC Bank, ICICI Bank etc), CDSL has a larger following among broker depository participants. The recent gain in market share by discount brokers (Zerodha, 5 paisa, etc) has placed CDSL in a strong position competitively. Duopolies are attractive to own because they make for strong and sustainable profitability.

The depository business is also blessed with non-linearity – in the sense that once a depository has achieved stability, an incremental increase in revenue is not accompanied by a concomitant increase in expenses – as the business scales up and operating leverage kicks in, the operating margins of the business should expand.

During the pandemic, CDSL has seen a major increase in its business due to various reasons. For one, there is a large increase in new depository accounts as a part of a global phenomenon where retail investors are jumping on to the liquidity bandwagon. It is also possible that in this extreme situation introduced by the pandemic there is a greater emphasis on saving and investment. CDSL has also seen a dramatic increase in its market share over the last few months as discount brokers have gained a larger market share during the last few months. CDSL also offers a number of value added services like e-voting, e-AGM (Annual General Meeting) of companies, e-KYC, etc. These have received a tremendous boost during the pandemic because of the social distancing imperative. SEBI has recently introduced new margin requirements for all trades beginning 1-Sep-20 – depositories are expected to play a nodal role in pledging securities in order to provide margin to complete trades – both for buying and selling of securities.

Over the long term, the depository business offers good long term potential as more and more Indians enter the capital market. Further opportunities exist in terms of unlisted companies adopting the digital means of holding shares – this business is seeing decent traction over the last couple of years and is expected to be a long term driver for growth. One can also visualise other asset classes, like mutual funds, debt securities and even possibly real estate using depositories over the long term. The business is asset light, requiring very little fixed assets or working capital and is therefore a good fit for our universe of quality companies.

The last few months have been challenging for investors. The Nifty fell 26% in FY2020 and it is up 29% over the last 4 months, leaving the Nifty still trading 5% below its 31-Mar-2019 level. Given the economic pain brought about by covid, it is important to understand the reasons for the market strength and to plan how to navigate the coming months.

In the third week of March, the Indian economy went into a long lockdown and we are now going through various phases of re-opening. Many customer facing businesses suffered severely. On the other hand, there are some positives – work from home became a reality, schools started to conduct classes online, digital payments worked, video calling replaced business meetings, lending to companies happened without meetings, direct benefit transfer reached out to the people in need, food & grocery supplies continued, e-commerce came of age. Companies were forced to transition to the new way of working and in many ways discovered a lower cost of doing business. In parallel several businesses have been severely impacted and so are their employees.

While the pain in some sectors is very evident, in the backdrop of the economy being shut for a good part of the last quarter and with companies not having had any notice to plan for such a contingency, we find that the results of some companies have been better than the worst fears of the market. Companies in IT services, foods, home products, financial services and even some of the stronger banks announced reasonable results despite the lockdown. Many of the companies in our portfolio announced decent results and we were reminded of how resilient some of these high quality companies can be, during a crisis.

One of the large reasons for the strength in the market globally is the massive infusion of liquidity from central banks as also the fiscal stimulus provided by governments around the world. The other reason perhaps is that as economies are re-opening up, there is hope of a gradual return to normalcy over the next few months. One of the positives of abundant liquidity is that capital availability for companies in India is also becoming better. We strongly believe that the companies in the portfolio are navigating the storm better than the average company in the economy, and this should translate to them increasing market share over the medium term. There is a fair bit of uncertainty that continues to hang out there in relation to the virus spread, as also fear of the virus and only time will tell how the next several months pan out, but things look positive for our portfolio companies over a 2-3 year period.

Over the last 15 years, we have been investing using a simple principle – focus on the individual company and the valuation. We have avoided responding to macro-economic factors. Over the past several years, we have seen several extraordinary crises – such as the dot com bust in 2000, financial crisis of 2008, and several others before that. Through all these times, many companies have been badly affected, but many other companies also emerged stronger post the crisis. Even in the current times, we will stay focused on individual company performances and valuations. Most companies in the portfolio are being resilient in the storm and performing better than the larger economy. We are monitoring the situation closely and will act if the business case fails or valuations become irrational. As valuations do get stretched in some cases, we will look to sell some of these positions.

The Nifty was down 26% in the last financial year (FY2020) driven by a sharp fall in February & March as Covid-19 started to spread rapidly across the world and most major economies went into lockdown mode. This sharp fall took most investors by surprise, but what is equally surprising is the speed with which markets have been gaining momentum over the past 3 months, with the Nifty up 19.7% since 31st March. The lockdown has brought several businesses to a standstill, job losses are widespread and balance sheets of many companies are stretched. Moreover, with high levels of Covid-19 related fears, customers are not yet ready to venture out and start their normal consumption.

The Nifty bottomed out on March 24th, which is coincidentally around the date when India went into a lockdown mode. The recovery in the Indian markets closely follows global markets and the S&P 500 bottomed out around the same time. Since then the S&P 500 has staged a sharp come back, currently trading at about 10% below its previous peak (The Nifty is trading about 17% below its peak seen in Jan 2020). Global sentiment does have an impact on Indian markets, especially with FPIs (Foreign Portfolio Investors) holding nearly 19% of all companies listed in India. Many large economies have also infused huge amounts of liquidity to support their economies and this helps India too indirectly. Large companies like Reliance, Kotak, Airtel, etc have been on a capital raising spree and many other companies & promoters are also in the process of raising capital. One of the primary purposes of capital markets is to provide capital to businesses and it is good to note that the system is working well even in times like this. Markets were also very cheap on valuations towards the last week of March, which supported the recovery.

There are some limitations to a liquidity led rally. Eventually corporate performance and valuations will dictate the future direction of stock prices. It is well known that the June 2020 quarter would be the weakest quarter for corporate India in known history, due to the lockdown. On the other hand, we notice that all businesses and companies are not equally affected. Many companies have seen nil revenues, or close to that, for 2 months and it is going to take a long time before these businesses get back to pre covid levels – in some cases they may never get back. On the other hand, there are several businesses where the customer demand is still relatively intact. Sectors which are less affected by the lockdown include FMCG, pharmaceuticals, IT services and non-lending financials among others. We can even expect a few businesses to see some tailwinds as the post-Covid world emerges. The world will increasingly move to the digital way of doing business and companies facilitating that will benefit.

Stronger companies with better balance sheets and strong competitive strengths (many of our portfolio companies fall in this bracket) are expected to gain market share in this environment as they are better prepared to deal with adversity. This is a great source of comfort for us, as we all deal with the post covid world. Over the years, these companies have used their competitive strengths and strong balance sheets to navigate the different challenges that they have confronted over time and we expect this time to be no different. Having said that, we would like to repeat what we said in our last newsletter – Can we continue to have drawdowns from current levels in the short term? It is certainly in the realm of the possible. But we do expect that the long term upside remains very good, given current valuation levels of the stocks in our portfolio.

India as well as most parts of the world have been under lockdown for more than 2 months. While Covid-19 presents its own challenge, the impact of the lockdown on the economic situation presents a different and equal challenge for authorities around the world. In the latest lockdown 4 which was announced by the government on 17th May, there has been a significant easing of the lockdown in India. Restrictions on having only 33% attendance in offices and factories were removed, and various other measures were undertaken which has allowed economic activity to begin to get back to a path to near normalcy, which is the best that one can hope for, given the situation. It will be a slow recovery as the world tries to find different and innovative ways to deal with the new way of life post-covid-19.

The Indian government finally released its economic package, partly to deal with the situation surrounding Covid-19 and partly to introduce reforms. While many announcements were made, a few things stood out for us. The first and foremost were the reforms in the agricultural sector, which many observers are calling path breaking. The primary thrust of the proposed reforms is to look at farmers as businessmen who need to be given access to free markets, rather than seeing them as needy people who constantly need support. The policy firstly proposes to give farmers the freedom to sell their produce to anyone and liberates them from the clutches of the local APMC mandi (marketplace). Second is to amend the Essential Commodities Act which will allow the buyers to buy and store in bulk and will provide a floor on the prices for the farmers during harvest season and create modern food produce storage infrastructure in India. Third is to allow the farmers to get into contracts with buyers which will give them a guaranteed buyer for the crops they sow at pre-determined prices. Needless to say, we need to see the fine print of the proposed law(s) as the devil is always in the detail. It appears, on the face of it, that this is a major reform for the agriculture sector.

The other noteworthy thing was the relief package for micro, small and medium enterprises (MSME). The key measure there was a 100% credit guarantee for MSMEs by the government for Rs 3 lakh crore of loans, limited to 20% of the borrower’s existing credit limit. There has been some concern expressed that this excludes those MSMEs particularly in the services sector, who don’t have an existing credit limit. Also, there has been some concern that the banks could use this to green existing NPAs. Notwithstanding these concerns, Rs 3 lakh crore is a large amount and will help in providing much needed support, to the MSME sector.

The question facing all Indian investors at the moment is: What should be one’s attitude towards investing in the face of the coronavirus induced economic crisis? On the one hand, you have a lot of uncertainty, as Covid-19 cases in India are continuing to increase. On the other hand, stock prices are down sharply over the last 3 months. When we look at our portfolio of stocks, we are comforted by the fact that except for the banking and financial services sector, all our companies hold cash on their balance sheet and that’s a huge comfort in these times of scarce liquidity. What we also find is that on our historical valuation matrix, valuations are very low compared to history. Can we continue to have drawdowns from current levels as the country faces this crisis over the next few months? It is certainly in the realm of the possible. But will we look back on this situation as a great potential investment opportunity 3 to 4 years from now? The answer to that is a resounding Yes for us.