Central to our investment process is the idea of investing in ‘high quality’ companies for the long term and to buy them at prices which are at a discount to their intrinsic value. Our experience over the last several years confirms our belief that if one sticks to this process in a disciplined manner, it not only leads to superior returns over the long term, it also reduces the overall risk to the portfolio. In this note, we would like to present data to support this thesis.

A high-quality company is one that is highly profitable and is able to grow consistently, at close to, or higher than nominal GDP growth rates. We have found that some sectors are naturally more profitable, as measured by their return on equity (RoE) than others because they are less capital intensive, both in terms of fixed assets and working capital. The following table presents the price performance of various Nifty sectoral indices over the last decade and the annual Earnings per Share (EPS) growth and the RoEs for different sectors.

Index	10Y Index Return	10Y EPS CAGR	10Y Median RoE
Nifty IT	20.2%	13.7%	26.6%
Nifty Private Bank	17.6%	13.5%	13.3%
Nifty FMCG	13.9%	11.1%	41.2%
Nifty Healthcare	13.7%	8.5%	17.5%
Nifty Oil & Gas	12.9%	9.2%	13.2%
Nifty Auto	12.4%	4.1%	17.9%
Nifty Realty	10.1%	-2.4%	7.9%
Nifty Metal	8.4%	1.4%	11.7%
Nifty PSU Bank	-0.3%	-11.4%	5.7%

The correlation between Index performance and EPS growth is 95% and correlation with RoE is 54% (80% if FMCG is excluded from the calculation). Essentially historic data suggests that an investor can make superior returns with businesses that have high levels of profitability, and high rates of growth. One also observes that the sectors in the bottom half of above table are far more capital intensive than those in the top half. The top half of the table has superior price performance as well as better profitability and growth. The sectors that are capital intensive also tend to raise more capital from investors, thus diluting their earnings growth. You will notice that most of the stocks in our portfolio are low in capital intensity and are typically from sectors in the top half of this table.

Over the past 12 months the best performing sectors have been Metals, IT, Realty and PSU Banks. IT has been witnessing a structural tailwind, whereas the other strong performers for the year are coming off some serious pain over the last several years. Metals have benefited from strong commodity prices and in real estate there is some optimism of a turnaround after several years of a slowdown. PSU banks which have been flat in terms of price performance over the last decade, are coming off very depressed levels. The weakest performing sectors over the past 12 months include private sector banks and FMCG, which have a long-term track record of fairly good price performance. We are not too concerned about short term performance of companies and intend to remain focused on our universe of high- quality companies that have performed well over long periods of time.

The Nifty was strong in the early part of November 2021, but just like October, it slid in the latter part of the month, to end the month down 3.9% over October 2021. The sharp fall towards the end of the month seemed to stem from fears of a highly mutated version of the SARS-Cov-2 virus, Omicron, which was detected in South Africa.

Most of the companies in our BSE-500 non-financials cohort have reported earnings for the quarter ended 30-Sep-21 and as promised last time, we would like to spend some time looking at these numbers.

Total Revenues are up at a 9.7% 2-year CAGR and there has been a gradual improvement over the last 4 quarters. EBIT is up strongly at a 22.7% 2-year CAGR. EBIT margins are strong at 12.2%. A comparison with the historical EBIT margins is instructive – margins in Sep-21 are close to a 10-year high.

Revenue growth of 9.7% suggests that the corporate sector is reporting numbers which are as good as normal, and when you consider that in the context of the pandemic, it is quite surprising. A very significant contributor to the high EBIT growth in the Sep-21 quarter is the ‘Material’ sector which contains steel and non-ferrous metals as big contributors to the total. If we were to exclude the Material Sector, EBIT growth would drop to 12.5%, which though significantly lower, is still healthy. This throws up some interesting questions – is this pent-up demand? Or are we witnessing a turn in the economy which has been patchy for several years now? These questions will perhaps get fully answered only with the passage of time and when we have more data at our disposal.

Meanwhile stock markets all over the world were rocked by the discovery of a new highly mutated variant of the Sars-Cov-2 virus in South Africa, which has been detected in several countries around the globe in recent times. There are many conflicting opinions on the Omicron variant but this is still early days and the market has reacted to the uncertainty surrounding the new variant since the market always hates uncertainty. We will hopefully find out more about this new variant in the coming days. The Indian stock market has been in corrective mode for the last 6 weeks and this has increased the number of opportunities available to us among our universe of high-quality companies.

The Nifty was strong for most of the month and at one point in the month was up 4.9% for the month. There was a subsequent sell off over the last 2 weeks – the Nifty gave up all its gains and was virtually flat (up 0.3%) for the month. Many of the high-flying stocks are down as much as 30% from their peaks and one senses a slight gloom in the air. It’s amazing how our brains are wired – we anchor to the highest price of a stock or index without realizing that the Nifty was actually flat for the month.

We wrote in our September newsletter about how the strong growth in corporate tax collections was suggesting that corporate profit growth has been quite strong and corporate profits have not only recovered from the shock of the pandemic but seem to be growing well and the early results bear out our theory – we will be able to comment better on aggregate corporate results next month. There are other indicators which are showing healthy signs. GST collections for the month of August, which are collected in September grew at a 2-year CAGR of 12.8% which is quite strong. Petrol consumed in September 2021 was 3.5% higher than the petrol consumed in February 2020 (pre-covid), suggesting increased mobility across the country. While fears of a third wave of covid have been around for quite some time, fingers crossed, it has not yet materialized and as a greater proportion of the population gets vaccinated, the likely human damage from a third wave may also be minimized.

We now look at the property sector because it plays a pivotal role in the economy through its linkage with a large number of industries as also the employment it generates in the economy. The property sector has been in a funk for the last several years – the property cycle peaked in 2012 and although there has not been a major drop in prices – the passage of 9 years and a flat lining in prices have meant that affordability of homes is at a multi-year high. Interest rates on housing loans are at a two-decade low as one can see from the graph below:

Now we look at the housing unit sales for the quarter ended 30-Sep-21 for the top 8 cities in India (Please see graph above). Sales of housing units dropped dramatically in the first wave of covid, grew sharply in Q4FY2021 as the first wave receded and was also helped by the stamp duty waiver in a few states. In the September 2021 quarter, housing unit sales have grown at a 2-year CAGR of 5.1%. The increased momentum in hiring in the IT services sector is also expected to boost the real estate sector. With interest rates at multi decade lows and affordability quite good, we could well see a cyclical upturn in the property sector over the next few years, which could augur well for the economy as a whole.

Different pieces of the jig-saw puzzle like corporate tax collections, GST collections, historically low interest rates and the optimism about the real estate sector are coming together to suggest that the Indian economy which has had a prolonged cyclical downturn since 2012, could possibly be turning up cyclically. The total PE/VC investments into India in the first 9 months of CY2021 have reached $49 bn, up 52% yoy – this could further propel the Indian economy. The cyclical upturn in the Indian economy could also be the reason that the market has been much stronger than most expectations – markets tend to discount events into the future.

While the Nifty is flat for the month, the rough and tumble of moving stock prices has resulted in a few stocks in our investment universe coming close to the buy zone – if the trend of lower stock prices continues, we may see an expansion of the number of opportunities available to us to buy into. With the economy possibly ready for an upturn, we look forward to these opportunities and will continue to stay focused on the discipline of buying high quality companies at reasonable prices.

The Nifty continues to scale new highs and despite some nervousness relating to the Evergrande issue in China, and rising bond yields in the US, was up 2.8% for the month of September 2021. The rise in the equity market has caused some nervousness among investors about whether the market is running ahead of reality given the context of the pandemic.

The income tax department of the government of India in a recent press release, gave out the direct tax collection figures for the current financial year up to Sept 22, 2021. The numbers are quite good – net corporate tax collections have grown at a 2-year compound annual growth rate (CAGR) of 11.1% and net income tax collections have grown at a 12.7% 2-year CAGR. What is even more impressive about the 11.1% corporate tax growth, is that the 6 months ended September 2019 figure included Dividend Distribution Tax while the tax on dividends in 2021, which are now taxed in the hands of the shareholder, are included in the income tax collection figures reported by the income tax department. Further on September 20, 2019 (after the last date for paying advance tax) the Finance Minister had announced a corporate tax cut from 34.9% to 25.2%. In the context of both these factors, our estimates suggest that profit before tax for all corporates put together has grown at 23-24% per annum over the 2-year period. Given that the tax rate has come down, the net profit after tax growth would be even higher. It is to be noted here that corporates pay advance tax based on their estimates of profits for the full year since they are required to pay 45% of their tax due for the year by September 15. We shall await the September quarter results to get confirmation of this.

Now we look at the growth in the Nifty value over the last 2 years. The Nifty value on 30 September 2021 has recorded a 23.9% 2-year CAGR over its value on 30 September 2019. It appears that the Nifty has grown at a rate which is in the same ball park, as our estimate of profit before tax growth over the same period. One can conclude therefore that the Nifty is about as expensive in relation to earnings, as it was 2 years ago.

We need to bear in mind that earnings during the pandemic are supported by a number of factors. First, companies are seeing an improvement in their operating margins because of cost cuts in the work from home paradigm. Economic growth is also likely boosted by higher government spending as also the very low interest rates prevailing in the economy thanks to the very accommodative monetary policies. We have to wait and see whether the earnings will continue this trajectory when things return to normal.

So, while the rise in the Nifty is perhaps supported by higher earnings (as evidenced by higher corporate tax growth), it is also true that we are increasingly finding a dearth of opportunities to invest among our universe of high-quality stocks and for our new accounts we have a high quantum of cash in the portfolio. For our older clients, we have been using the rally in the market to pare some positions and are looking to deploy that cash in other opportunities within our universe, and if opportunities are scarce, this results in cash accumulating in our portfolios. We intend to maintain this discipline.

In this newsletter, we will review the corporate results for the quarter ended June 2021 as also some other interesting data coming out of the economy. For corporate results we looked at the non-financials in the BSE-500, most of whom have now announced results for the quarter ended 30 June 2021. Since the June quarter last year was a washout because of the nationwide lockdown, we looked at a 2-year compound annual growth rate (CAGR). Revenues for the median company in the sample set are up at a 7.2% CAGR for the Jun-21 quarter – this compares with 1.9% for the Dec-20 quarter and 5.1% for the Mar-21 quarter. As can be seen from these numbers there is a gradual improvement over the quarters. The 2-year CAGR for Profits before Interest and Tax (PBIT) for the median company is at 14.3% for Jun-21 – this compares with 12.0% and 15.4% for Dec-20 and Mar-21 respectively. There is a clear improvement in profitability and the 2-year CAGR is actually slightly ahead of historical trends and is somewhat contrary to what one may expect for a quarter when the country was facing a deadly second wave of covid and much of the country was in a lockdown.

The BSE publishes data for the earnings per share (EPS) for the BSE Sensex on a regular basis – we are using Sensex data instead of Nifty because NSE has changed its data set from unconsolidated earnings to consolidated earnings starting from 31-Mar-21 and this has made the data set not comparable with prior years. The EPS for the Sensex on 28-Feb-20 (ie pre-covid) was 1650 while the latest reading is at 1901, which is a 15.2% increase. It appears that both, for a narrower set of large companies (Sensex), as well as a broader set (BSE500) earnings are growing at a healthy pace.

The data on tax revenues of the Central Government for the quarter ended 30-Jun-21 also tells an interesting story. Gross Tax Revenue for the quarter ended 30-Jun-21 is up at a 2-year CAGR of 15.2%. GST collections for the June 2021 quarter are up at a 2-year CAGR of 1.6% (for the month of June 2021, the number is 6.8%). Corporate tax revenue is up at a 2-year CAGR of 32.3%, income tax revenue is similarly up 12.5%. These are very impressive numbers and we shall wait for confirmation of this in the coming quarters.

The Nifty has been scaling new highs for the last several months and ends August 2021 at yet another life time high. The broader market indices such as the mid cap and small cap indices too have been exhibiting strength. The strength of the market has puzzled many observers, particularly in the context of the pandemic which is still perhaps not behind us. Seen now in the context of the improving earnings picture as also the improved tax revenues of the government, this perhaps could be one of the reasons for the strength in equity markets. What has also kept the market buoyant is the very accommodative monetary policies followed by the RBI as well as other global central bankers.

We have been using the strength in the market to pare positions in stocks that have become more expensive on their historical valuation ranges and our attempt is to look for other stocks in our high-quality universe which may be available at reasonable valuations. If we are unable to find enough attractive investment opportunities, it results in cash accumulating in our portfolios. We intend to continue with this discipline.

This August we will complete 17 years since incorporation and it is now 16 years since we got our SEBI portfolio management license. First, we would like to thank each of our existing and past clients who have placed their trust and savings with us, without whom we would not be here today. Many of you may not be updated about Banyan Tree (BT) as an organisation or may not have had the opportunity to interact with the wider team – hence we thought it may be a good idea to brief you on the same.

Some of you entrusted your savings with us in our early days and may be aware that BT was set up in Bangalore by Ravishankar & Sandeep Talwar. Over time, Shyam Prabhu, Jigar Shah and Vishal Thakkar joined the firm. These 5 partners/directors, own and manage the firm on a day-to-day basis. Most of the partners have known each other for a long time – have either studied together at college or worked together, prior to setting up of BT.

It is also important to note that the top management of BT have a significant part of their personal and family wealth, invested in exactly the same process as we do for our clients. We have only a single investment philosophy – Buy a good company, Buy it at a sensible price.

Our team comprises 31 people across Bangalore and Mumbai and we have consciously invested in our team to ensure high quality research, client servicing, operations, IT and compliance. The aim has been to build redundancies and ensure business continuity for the long term.

Today we manage assets of over Rs 3600 crores for over 1500 client accounts including over 220 NRIs. We have grown primarily from generous referrals from existing clients and their family and friends as also the consistent and above market portfolio performance over the years, with lower volatility. While we do feel happy about the growth in client base and AUM, what makes us particularly proud is that we have managed a very high client retention rate (95%) – so clients have stayed over the long term and have also referred their friends/family to us. The stability of our clients allows us the freedom to manage the money with a long-term orientation without worrying about short-term performance. We have been equally fortunate to have a very steady base of other important stakeholders and business partners – employees, distributors, brokers, custodian, tax and legal advisors all of whom have been part of this journey. Last but not the least, we must mention our family members who have been greats pillars of support in this journey together.

As we grow larger, our focus would to be build the firm to ensure the current investment process continues for a long time and we live up to the promise we have given our investors. We would like to thank all the clients who have trusted us over all these years. Some of the fond memories are the first meetings with many clients and we are delighted to see these relationships strengthen over time. We began this journey with the core belief that it is possible to generate superior returns over the long term by avoiding higher risk and sticking to one’s investment discipline. As we look ahead, we commit to remain steadfast to this discipline and look forward to many more years of a mutually rewarding journey with you.

One of the first metrics that we look for in a high-quality business worth investing in, is the long term return on equity (ROE) of the business. ROE is the net profit divided by shareholders’ funds (or networth) of the business. This is the core engine of growth of a business – shareholders’ funds are the funds invested in the business and net profit is what is generated annually on these funds. Some part of the net profits is then distributed to shareholders as dividends and buy-backs and the rest redeployed in the business. The long-term ROE has a strong correlation with the long term returns provided by the company’s stock.

Below we have looked at the long-term ROEs of companies with a market capitalisation greater than Rs 500cr (sample set of 970 companies) belonging to different sectors and grouped them under Great, Good and Gruesome based on their long-term ROEs.

 

It appears that some sectors are naturally more inclined to make high ROEs – and while ROEs have declined as a whole for the period FY2012-20, they have held up much better for the companies in the Great category. Sectors with high ROEs naturally tend to be less capital intensive as reflected in the higher Sales/Total Capital Employed for these companies. This also explains our preference for businesses which are low on capital intensity – both fixed assets as well as working capital. You will also find that when we are choosing companies for our portfolio, we are often investing in sectors which belong to the Great and Good categories rather than in the Gruesome category. For ROEs to sustain over the long run, the business needs a competitive edge or ‘moat’ to keep competitors at bay – else the excess profitability will be eaten up by new competition. For this reason, we require all our investee companies to have a competitive edge.

The Nifty scaled a new high towards the end of May 2021 and we have come a long way from the situation 12 to 14 months ago when the market was gripped with fear on account of the pandemic. The month of May was strong for Indian equities and our portfolios also benefited. Some analysts are suggesting that a new all-time high portends good things for the market going forward.

Last month we had spoken about the “early birds” among the BSE 500 companies (non-financials) that had reported till then. Now more companies have reported quarterly results and we thought it would be a good idea to look at how corporate results are shaping up. We looked at a 2 year CAGR because the quarter ended Mar-20 was impacted by the nationwide lockdown. For the 294 out of the total 430 non-financials in the BSE500 that have reported so far, the 2 year aggregate revenue CAGR is 4.6% – this compares with -5.4% in Sep-20 and -1.0% in Dec-20 – so there is reasonable improvement seen with passing time. The aggregate EBIT (Earnings before interest and tax) growth for these companies has recorded a 2 year CAGR of 16.8% which is very impressive indeed. EBIT margin is at 13.9% which is among the highest recorded for the last several years. The higher profits are aided by better performance from the commodity sectors as also a reduction in several costs because of work from home. These are obviously numbers prior to the second wave of the pandemic, and one can argue that the numbers for the June 2021 quarter may not be as robust. Yet these numbers do give us a picture of what has been happening to corporate results during the pandemic and it is possible that the market is looking beyond the second wave of the pandemic as increasing vaccination will likely result in lockdowns being lifted over the next few months and the economy reverting to its normal trajectory.

We have witnessed a significant slowdown in net profits for the corporate sector over the last several years, as the economy has faced the brunt of several problems, from the demonetization in 2016 to GST implementation and then the ILFS crisis, as also the recognition of NPAs (non-performing assets) by the banking sector. The results over the last few quarters give us some hope that the economy may be reverting to a more normal trajectory. We will have to watch the corporate results over the next few quarters to get confirmation of this.

With the market scaling new highs, we have seen some of our portfolio companies moving to the higher end of their valuation ranges and we have chosen to take some chips off the table, by trimming some of these positions. This is part of our usual process whereby, we look to buy stocks when they are at the lower end of the valuation range and look to reduce positions when the stocks are at the higher end of their ranges. What is interesting though, is that even with the market at a new high, there are some stocks in our portfolio which are offering dividend yields in the 4-5% range, which is quite close to the rate offered by fixed deposits in the current low interest rate scenario. So, it remains a stock specific market with some stocks offering a reasonable reward to risk ratio. We shall continue to be focused on the reward to risk ratio offered by the different stocks in our investment universe of high-quality companies to decide what to do with the portfolios that we manage.