May 2023: Growth has slowed over the last 4 years

As we are almost done with the corporate results season for the last quarter of the financial year (FY) March 2023, we thought we would have a look at it. If we go back in history, the omicron variant first emerged in India around December 2021 and as it spread, it became the natural vaccine for the populace. It was relatively less virulent and its spread offered herd immunity to the populace at large. So, FY2023 is the first financial year where covid was largely absent and a comparison of these results with FY2019, a pre covid year could be interesting.

As usual, we looked at the non-financials segment of the BSE500 to gauge corporate performance. 405 out of the 433 non-financial companies in the BSE500 have reported results so far and they represent ~97% of the market cap of the BSE500 (non-financial).

The first thing we notice is that despite strong revenue growth, EBIT growth YoY for the sample set is negative. The material sector (mineral & mining, steel, chemicals, sugar, etc.) is a large contributor to the negative growth, and ex-material, the EBIT growth is a more reasonable 7.9% YoY. EBIT grew very strongly in FY2022 at 34.5% YoY aided by the material sector, and ex-material, the growth rate was still strong at 23.5% YoY.

Then we look at the 4-year picture to get a view of pre-covid to now – Total revenue growth is 12.2% and EBIT growth is 8.8%. EBIT growth, though muted compared to history, is perhaps understandable considering the ramifications of covid and the strict lockdowns.

Now we turn our attention to the GDP data which got released today. Real GDP growth for the quarter Q4 came in at 6.1% and for the year FY23 at 7.2%. While the GDP growth for FY2023 appears reasonably strong, there is a base effect at play here. In FY2022 the first quarter saw the impact of the second wave of covid and in FY2021 we had the first wave of covid. Hence the base effect distorts the image. When we look at the 4-year CAGR of real GDP growth, to eliminate the base effect, the number is 3.4% for real GDP growth and the nominal GDP has a CAGR of 9.6%.

Growth has been slow over the last 4 years compared to history, both for GDP as well as for corporate profits. The pandemic and the resultant lockdown have impacted the economy, which is visible in the numbers. With the pandemic now out of the way, a large clean-up of the corporate sector through the Insolvency and Bankruptcy Code, and a number of reforms like GST and RERA implemented, one can perhaps look forward to better GDP growth and corporate growth in the years ahead.

April 2023: Competitive edge is at the heart of company selection

The competitive edge of a business is at the heart of what we look for, when looking at investment opportunities for our portfolio. Most markets in the world are highly competitive and the high profitability of a business cannot be sustained unless the company in question, has a competitive edge over its peers.

There are many sources of competitive edge. We list down the important ones here:

  1. Economies of scale: A very large extant market share can allow a company to spread its overheads over a larger base and hence allow it a competitive advantage. Amazon’s “scale economies shared” mantra is a very good example of this. By sharing the economies with its customers, Amazon continues to be the cost leader and a dominant player in its business.
  2. Intangibles : Examples of intangibles are a) Brands b) Patents c) Licenses
    1. Brands: A brand provides an emotional connect with the customer. It usually translates into high market share and an ability to charge a premium over competitors. Companies who have a dominant brand should have high rates of profitability as measured by return on equity.
    2. Patents: This presents itself as a technological edge, as competitors are unable to copy the company’s innovations. A technologically superior product or process can also impart a competitive edge to companies. However, in a highly competitive world, this edge can fade unless the company innovates continuously.
    3. Licenses: Licenses or other regulations can restrict the number of players in a business – examples of this are credit rating agencies, depositories, etc. These can create monopoly, duopoly or oligopoly situations which can result in very high profitability that can be sustained over long periods. There is however the ‘stroke of the pen’ risk in this – at any future point in time, for some reason or the other, the license can be taken away.
  3. Switching costs: Switching cost is the cost associated with switching from one supplier to another or one brand to the other. These can be monetary, psychological, effort-based or time-based. This hold on the customer can be a source of competitive edge.
  4. Network effects: This is a situation in which the value of a product, service or platform grows as the network grows and can impart a competitive edge to a company. For example, a social networking site, or a dominant stock exchange.

Whether a business has a competitive edge or not, is often debated by investors. The true test of whether a business has a competitive edge or not are a) Does the business have high return on capital employed? b) Are the relative market shares of the different players in the industry stable over time?

While judging the competitive edge of a business, it is important to think about how the competitive edge is strengthening or weakening. The best companies are razor focused on increasing their competitive edge and they keep working at it continuously.

March 2023: As banks fail around the world, Indian banks seem safe

Headlines this month all over the financial world, were about bank blowups. First, there was Silicon Valley Bank (SVB), a bank closely associated with tech startups all around the world. Then came another regional US bank, Signature Bank. And then the news spread across the pond to Credit Suisse (CS) which was forced into a shotgun wedding with UBS.

Silicon Valley Bank’s problems seemed to stem from an asset-liability mismatch, or what is also called a duration mismatch. A very large percentage of SVB’s liabilities were deposits, which were short-term in nature in the sense that the depositors could pull them out, at short notice, while it had invested a bulk of these funds in long-term US treasuries and mortgage-backed securities (MBS). Most of these long-term investments were bought when interest rates were very low and the average yield on their MBS portfolio was 1.56%.

Once the US Fed recognized that inflation is not ‘transitory’ and began raising the Fed funds rate aggressively over the last year, it pushed up bond yields across the tenure spectrum. From the price at which SVB bought the MBS which was 1.56%, the yield on the mortgage backed securities index reached a peak of 5.12% and is currently at 4.33%. As bond yields go up, bond prices go down. As a result, SVB had mark-to-market losses on its bond portfolio which when it became apparent to the market, caused a run on the bank as all depositors, particularly those above the $250,000 insurance limit rushed to withdraw their money. Uninsured deposits constituted 88% of SVB’s total deposits.

SVB’s problems seemed to spill over to Credit Suisse, the second largest bank in Switzerland with $575 bn in total assets. SVB by comparison had $212 bn in assets as of Dec-22. Credit Suisse has a long history of problems and has been fined by regulators on a regular basis over the last many years. Clients began to withdraw their money from CS at a rapid pace and on 19th Mar 2023, the Swiss authorities announced a merger of CS with its larger rival UBS. To ensure that this gets done before markets open on Monday, the Swiss authorities in an unusual move, said that this would not require approval from shareholders of the two banks.

The genesis of these events is the extremely loose monetary and fiscal policies during the covid pandemic. Interest rates were brought to zero and along with that, the US Fed did significant Quantitative Easing (QE). QE refers to the Fed buying US government securities and mortgage-backed securities from the market and the Fed balance sheet eventually reached $8.9 trillion at its peak. Trillions of dollars were also spent by the US government as a fiscal stimulus to help the millions cope with the pandemic. The net result was that all these measures stoked inflation when demand returned to normal after the pandemic. This is true not only of the US but also of Europe where inflation readings have been very high over the last 22 months. The playbook was the same here too with a huge amount of monetary and fiscal stimulus during covid.

In India too, inflation has been on the higher side over the last 14 months. In India, the RBI has the mandate to keep inflation within a corridor of 2% to 6%. India’s latest inflation print was 6.4% in Feb 2023. On the other hand, the US Fed is on record saying that they want to keep inflation near the 2% mark and the latest inflation print in the US came in at 6.0%. As we can see, while in India too, we are suffering from high inflation, it is not nearly as acute as it is in the US in the context of their respective histories of inflation. As a result, while interest rates in India have increased since the covid lows, they are lower than levels in 2018. In September 2018, the India 10-year government bond yield was at 8.2%, while currently it is 7.3%. As a result, losses on bond holdings are less of a concern in India as compared to how it has been for US and Europe, where inflation is way above historical norms. As such we do not foresee an interest rate risk led issue for banks in India.

We have been saying for a while that opportunities are hard to find. However, over the last few months the market has corrected a little and that has widened the opportunity set for us as investors. We are reminded of the words of Benjamin Graham that we must use the manic-depressive nature of Mr. Market to our advantage by being greedy when others are fearful and vice versa. Many investors treat volatility as something to be worried about. However, if you understand well the value of what you own, volatility can be a friend for the intelligent investor.

February 2023: Poor corporate governance can invalidate an investment hypothesis

We have often spoken about high quality businesses that we like to invest in – companies generating a high return on equity, having consistent free cash flows and hence low debt, having a competitive edge or ‘moat’ and good corporate governance. We would like to devote this letter to the inverse of our preferred set – low-quality companies ie companies that we want to stay away from in our portfolio. We particularly want to focus on the corporate governance angle as that assumes importance in the current context.

Low-quality companies typically have a return on capital employed which is below the cost of borrowing money – in essence, they are destroying wealth over the long term. These companies are typically very capital expensive – both in terms of fixed assets and working capital. As such they are always capital hungry and are continuously raising money either through debt or equity issuances which dilute existing shareholders.

What we particularly want to run away from as investors, are companies with poor corporate governance. One of the tenets of value investing is that when you buy a stock, you are not buying a scrap of paper whose price is fluctuating on a daily basis, but you are buying the underlying business. However, we as investors, are not running that business – some one else is running it for us and unless the manager of the business treats us fairly as minority investors, our entire investment hypothesis will fall apart.

Poor corporate governance presents itself in many ways – we will try to name some instances, though this list is not exhaustive:

  1. Gold plating capex – this is a common practice among poor quality management, particularly of capital-intensive businesses.
  2. Compensation for promoters – in many companies, promoters take away a large percentage of profit before tax through their disproportionate compensation.
  3. Royalty payments to the MNC parent – sometimes these can be excessive.
  4. Transactions between group or associate companies – in many instances, these transactions can be structured, either a merger or a buy-out or other such transactions, in a way that favours the unlisted entity over the minority shareholders of the listed entity.
  5. Related party transactions – a large number of such transactions which can create an element of doubt among investors.
  6. Conflict of interest – promoters may have different companies in same/similar lines of activity and one of those companies may be favoured over others.
  7. Shady accounting – accounting which may try to present a more favourable situation than actually exists within the company whether with respect to the Profit and Loss Account or the Balance Sheet.
  8. Serial acquirers – companies which make many acquisitions, particularly when paid for by an inflated stock price of the acquirer.
  9. Cash transactions – companies in which a lot of transactions take place in cash.
  10. Expanding working capital cycle – a company whose inventory and receivables are growing at a much faster pace than revenues can also be a red flag for investors.

As we said earlier, this list is not exhaustive and poor corporate governance may present itself in many ways. We as investors need to watch out for the various shenanigans of the management by which they favour themselves over minority shareholders. In our experience, we have found that companies with poor corporate governance have a history of doing these things and a study of history can be a guide in this respect.

What motivates managements who indulge in poor corporate governance? For a high quality company life is relatively simple – generate a high return on capital employed and reinvest into their business to grow steadily over time. Managements who pursue poor corporate governance, are usually stuck in hum drum businesses, which are not earning an adequate return on their capital. However, they have big ambitions and want to take a short cut to become big or rich. This leads them to cut corners, maybe indulge in some creative accounting or use other measures to grow fast. We have learnt over time that wealth can only be generated slowly, over time by investing in high quality businesses which are generating a good return on their capital employed and the free cash flows generated from the business are invested to grow the business. We don’t believe in short cuts as short cuts not only lead to loss of capital over the long term, but also loss of sleep.

January 2023: Momentum Investing vs Value Investing

In this letter we would like to discuss two different styles of investing – momentum investing and value investing and then we would like to look at two different kinds of value investing.

Momentum investing is popularly defined as an investment strategy that aims to capitalise on the continuance of an existing trend. A momentum investor is looking to buy a stock that is rising, in the expectation that the price will rise further. Proponents of this style of investing have pointed to Newton’s First Law of Motion as per which an object in motion will stay in motion until it is acted upon by an external force. The valuation of a company is less of a factor of consideration here. Critics however have called this “The Greater Fool Theory” where you are looking for the greater fool to take the stock off you when you are ready to sell.

Value investing is an investment strategy that involves picking stocks that are trading at a discount to their intrinsic value. Within value investing, there are broadly two groups – one which is the traditional deep value investing as described by Benjamin Graham, considered the Father of Value Investing. Here the focus is on assets of the company – Ben Graham was looking to buy stocks of companies whose market value is less than the net current assets, i.e. cash, investments in marketable securities, inventories and sundry debtors. This has also been called cigar butt style of investing – because typically these are poor quality businesses, which are not growing their intrinsic value. While the strategy is theoretically sound, our criticism of this style of investing is that one often does not know how long it will take for the market price of the stock to catch up to the intrinsic value and the intrinsic value may not be growing– so time is your enemy in this strategy.

The second subgroup within value investing is what is known as GARP or Growth At a Reasonable Price. GARP investors are focused on buying businesses whose value is growing with time – usually growth which is close to nominal GDP growth or higher. Here the intrinsic value may be defined as the sum total of all free cashflows of a company until infinity, discounted back to today. Here the accent is on free cash flows (FCF) rather than on earnings – FCF is net profit plus depreciation minus the capex and working capital required to maintain the business. Higher the sustainable growth in free cash flows into the future, higher should therefore be the value of the business. In GARP investing, you make time your friend.

GARP investing is also what we practise a lot of, as in our view it also offers a lower risk approach to investing because the value of the business is growing. The difficulty often becomes the price to be paid for a company growing its free cash flows into the foreseeable future. Over the last several years many stocks in India have been trading at expensive valuations on the basis of a prevalent momentum style of investing which says that whatever is going up, will continue to go up. This of course works for a while but eventually the gravity of valuation has to have its say – either the companies in question need to grow into their valuations by exhibiting high growth in revenues and free cash flows or there could be an eventual correction in these stocks. We have been mentioning in past letters that we are finding it difficult to find high quality companies growing at a pace near or higher than historical nominal GDP growth at a reasonable price – our quest continues.