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2018 was a disappointing year for us. Disappointing not just because of the negative performance, which obviously was painful, but more so because of our unforced errors. Poor choices caused about one-third of our negative performance. Rupee depreciation and indiscriminate mid-cap selling caused the rest, in roughly equal measures. We spent the entire Q2 letter dwelling on our four problem stocks so we will not rehash it here. We fixed the problems when we found them, even though the temptation to “just wait things out” was quite high at the time. We have a process for handling bad outcomes, and we stuck with it. For that, we are proud of ourselves. Now we just have to work on being less stupid when buying. That’s work in progress.
During the second half of 2018 we were busy stock searching, and soul searching. Stock searching resulted in two new positions, which we describe at the end of this letter. Not much changed in the soul department. We still believe that India has tremendous ground to cover. It’s overflowing with young, hard-working, and ambitious people. Yet it is so grossly underserved. Sure, many of its citizens are poor, but that’s just half the story. The other half – the real half, is the breathtakingly poor systems of governance India has endured for seven decades. That second half is now getting fixed; in its own haphazard Indian way, but in a big way nonetheless. And that is truly exciting. Take, for example, India’s new bankruptcy process introduced two years ago. Out of the first twelve cases, which made up one-fourth of the banking system bad debt, half have been resolved. In each case the promoter who ran the firm into the ground is out. This may not sound like a big deal to those familiar with a developed market framework like Chapter 11. But for India this is absolutely radical. Large promoters tend not to lose their fiefdoms in India, despite serially defaulting. You get the loans evergreened, you shove the cases into a painfully slow legal system, you buy your own distressed assets via related entities. You do what it takes but you never let go. The new bankruptcy process is an attempt to change all that. Thus far close to 800bn Rupees have been recovered. Another 1.2trn is imminent. More importantly, every time a promoter tries finding loopholes the law-making body tweaks the law. It’s vigilante-justice and it’s ugly, but it’s working. Other such examples include the recent Goods and Services Tax, and the Real Estate Regulation Act. Every one of these regulations will be agonizing in the short run. For decades, people have conducted their business a certain way; that old way is becoming prohibitively expensive. 2018, for instance, was a bumper year for corporate governance scandals. First, a few dozen auditors resigned without signing off on their clients’ annual financials. Then some bankers got sacked. A few of them will likely get prosecuted for encouraging the cronyism. In a couple of high-profile cases, owners who were unable to settle bank loans fled the country and are now fighting costly extradition battles. Companies with stock-pledges are getting pummeled, which is forcing the pledgees to liquidate the stock collateral, further pressuring the stock price. Weak corporate governance, for long considered the cost of doing business, is now a front-and-center issue. We don’t know how long the malaise will last. But we know this: a) it will eventually result in a far better business climate, and b) it will throw up some big winners, and big losers. Our investment process, designed specifically for this, will stay the same. The only slight tweak we’ll make is to put an even greater emphasis on the promoter quality. In this long-drawn business transformation we only want to partner with folks who have a demonstrated track record of shareholder stewardship. They will be the winners. One final point; this is election year in India. Things are about to get populist and socialist-like, which tends to spook the markets. Already, the Congress party has promised a minimum income guarantee. As elections draw closer (April – May) things will get noisier. We take great care in making sure that our companies and their promoters are not overly politically levered. So the earnings prospects of our portfolio companies will not change, but their stock prices can swing considerably. We are not terribly worried about that. In closing, these are exciting times for India. While the country remodels itself, a few well-run Indian companies will make spectacular amounts of money. We intend to make the best of this immense opportunity. As always, we are grateful for you to be a part of our journey. New and Current Positions <private> The malaise afflicting the small and midcap companies has now spread throughout the market. In fact, this correlation-one event is not just restricted to India. Remember, in our 2017 annual letter, we mentioned how 42 out of the 43 markets we track rallied last year? This year 37 of those markets are down. Investors are running away from anything that’s not America, fundamentals be damned.
When 88% of the world markets are bleeding red one must be careful pinning the sell-off on to India specific problems. Nevertheless, were we forced to offer a reason, our candidate would be the financial panic caused by IL&FS, a large project financing entity with approximately $12bn in debt. IL&FS, in early September (almost exactly ten years to the day of Lehman’s bankruptcy) announced that it had missed payments on its short-term debt. Even though the company made its lenders whole within 3 days, the market knew that something was up. The company has more than $500m in payments coming due within the next 6 months, and not nearly enough cash to cover these. Its assets - cashflows from its toll roads, tunnels, bridges etc., are all long dated and heavily dependent on the government’s whims and fancies. These long- dated assets are financed with large amounts of short-term commercial paper (CP) that needs to be rolled over every so often. It’s a risky business in any country. Done in India, and financed with short-dated debt, doubly so. The default led to mass ratings downgrades, which led to markdown across all non-bank financials CP, which led to banks and debt mutual funds dumping some of it, which led to concerns that several financiers will not be able to roll over their debt. About 60% of all non-bank financial CP issuance sits on the books of debt mutual funds that are now facing redemptions. It’s all very Lehman-like, and even though the Indian financial system is not nearly as complex or interconnected as the US was back then, the situation is concerning. We are monitoring it closely. Thus far, companies that have their assets-liabilities appropriately matched are getting adequately funded. Credit is flowing, albeit at a higher cost. Earnings across the board will take a hit and the business of lending will likely slow down temporarily. However, credit penetration in India is so low, and the runway so long, that it will only lead to stronger players getting even more entrenched as the weaker ones exit. Our largest financials holding, Piramal Enterprises, is one of those stronger ones. Apart from the IL&FS drama there’s also the problem of lower Rupee (down 5.3% q-o-q) and higher oil (up 7% q-o-q). We can always count on those two to explain any Indian crisis. Our view on the Rupee and oil remains the same - we don’t have a good one. Maybe it’s all happening because of Fed tightening (but haven’t they been doing so since 2015?), or maybe it’s due to OPEC (but wasn’t fracking supposed to solve all that?), or maybe it’s the tariffs, trade deficit, elections. We don’t know. Of course, a weaker Rupee and a pricier oil is bad for India but what exactly the Rupee or crude oil will do next is anyone’s guess. In a quarter that’s been so volatile we have surprisingly little to write about our portfolio. It has changed little. The urge to act during times like these is extremely high, and we do want to fix mistakes as soon as we find them - we did so last quarter. But reacting to prices without regards for fundamentals is not our policy. After closing out the four problematic positions we detailed in our last letter we are left with businesses that continue to go from strength to strength. If they keep this up, the market will eventually reflect it in the stock prices. For now, we are focused on looking through this market debris and picking up great multi-year compounders if they come for cheap. We will have detailed updates on our businesses in the (upcoming) annual letter. Meanwhile, if you have any questions regarding this letter or your portfolio, please do not hesitate to ask. We are suffering our biggest drawdown yet, and broadly, there are three sources of this misery, a) our mistakes, b) re-rating of small and midcap companies, and c) depreciation in the Indian Rupee.
In our estimation, one-third of the loss is simply our own doing. We are in the business of buying great companies. We sometimes compromise and buy merely good companies, only if they trade at low enough price. We are obviously not in the business of buying bad companies- regardless of the price. Unfortunately, some of our recent purchases turned out to be just that. Four positions, Idea Cellular, Suzlon, IL&FS Transport, and Lasa Supergenerics, fall into this category. All four operate in large markets. All four were going through turmoil when we bought them. In each case, our bet was that price was too low and the turmoil was temporary. In every case we were proven wrong. As the fundamentals deteriorated we had no choice but to close our positions. Idea, until recently was India’s 3rd largest mobile operator. It’s now a piñata. The bloody battle for subscribers, started by Reliance Jio, has led to EBITDA losses for every single operator, including Idea. Revenue per user, which was already obscenely low at ~ $2/Month, has quickly dropped to about the lowest in the world, despite data usage per sub growing more than 10x. CapEx spends remained unabated, lest the incumbents lose even more subs. Debt balances have ballooned. We believed this was unsustainable - eventually the industry would consolidate, pricing would improve, and Idea would remain one of the last guys standing. We were right, but only partially. Idea and Vodafone India are merging to create India’s largest mobile operator. The industry has gone from a dozen players to three. However, the pricing has only become progressively worse. It will take immense amount of luck and management skill to remedy the situation. We can’t rely on the former and are not seeing much of the later. IL&FS and Suzlon both have one ultimate customer, the Indian government. The customer is extremely price sensitive. Financially, the customer is not doing particularly well. And the customer is about to battle for its survival in 2019. So, the businesses face immense revenue pressure. The companies are levered – it’s the nature of these businesses, which makes them tenuous. Once again, both require some serious management skill to weather the storm. Lasa is a manufacturer of medicines for animals. This business was recently spun out of a father-son-controlled chemicals company. Father kept the chemicals business and son got the fast-growing animal health subsidiary. The industry has excellent economics, and the son, who is now running Lasa had grown this little subsidiary 10x in last five years. We had high expectations from this company. It turned out to be an utter disappointment, not because of business impairment, but due to corporate-governance shenanigans by the father-son combo. We can sometimes stay invested in businesses doing poorly, but it’s impossible to stay invested with managements behaving poorly. Our exit in this case was an ugly outcome but an easy decision. Even though mistakes are a part of our business, we were surprised by how many simultaneous ones we had just made. Our post-mortem leads to believe that first, we got a bit too seduced by the low prices, and second, we underestimated the importance of management in each case. Lessons learnt. Moving along, at least one third of our drawdown is due to the indiscriminate sell-off amongst the non-large-cap companies while the largest 5-6 companies make all-time highs. The dispersion has seldom been starker. Some of this is dispersion warranted. Corporate scams have recently been uncovered. A few dozen auditors have refused to sign on annual accounts. Credit has become tighter. Most of this is affecting smaller companies. However, there are 5,000 or so listed companies in India. Majority are viable enterprises. Less than 1% are represented in the SENSEX and NIFTY indices, and the largest 1⁄4% make up half the index-weight. We invest in businesses with little attention to their market caps. If the market suddenly fancies large companies over smaller ones, then great! It leads to irrational discounts, which leads to better future returns for us. There was one undesirable outcome of this dispersion, however - our market hedges were all short the USD denominated India index. Since the index hardly budged, the hedges didn’t offset our drawdowns. We are working on putting better insurance contracts in place. The final third of our drawdown is due to currency depreciation. As we have written repeatedly, we model an annual 5% drag due to currency. We can hedge INR, but that makes little sense given the cost of hedging runs close to 5%. In some years, like 2017, INR rallies, and we save the hedging cost. In some years, like 2018, INR sells off. If it sells off more than 5% then the case for hedging looks compelling, though only in hindsight. We don't worry about this, and don't want you to worry about this either. It’s our endeavor to generate returns large enough to compensate for such noise. In closing, although we cannot guarantee the magnitude of future returns, future mistakes, or future drawdowns, we can absolutely guarantee two things, 1) we will keep improving our process, and 2) a large percentage of our and our family’s wealth will always be invested alongside you. We continue to believe that India will remain a stock picker’s market for years to come. It will also remain volatile. We intend to use both these features to their fullest extent. If you have any questions regarding this letter or your portfolio, please do not hesitate to ask. A broad market sell-off in India was partly responsible for our Q1 drawdown. Additionally, since most of our holdings are of the small cap kind, a category that sold off violently, we underperformed the benchmark indices. It’s disappointing when your better-than-average stocks do worse-than- average. But history tells us that Indian market can pretty much make anything happen in the short term. Letting that dictate our investment process would be a sure-shot road to ruin. We buy good businesses at good prices. After that, we have no choice but to wait for the market to agree with us. So far it has.
As to why the sell-off happened? We offer our standard answer – we have no idea. We can probably conjure something up – trade war, high valuations, global uncertainty (whatever that means), or, if all else fails, Donald Trump. But we are not very good at that, and it’ll be a waste of your time. Instead, we want think aloud about how, if at all, could such random market drawdowns affect our long term performance. Funds like ours, that manage concentrated portfolios of cheap, small-sized, and sometimes troubled value stocks, often make their lives unnecessarily difficult in a few predictable ways. For starters, they at times onboard investors whose philosophy is at odds with the long-term nature of the business. Folks worried about every short-term fluctuation will inevitably quit when the occasional drawdowns happen. In the process, they make the situation worse by forcing the fund to sell positions at exactly the wrong time. Fortunately, thanks to you, we have never had to worry about that. Second, some managers, while picking relatively safe stocks, make their portfolio vulnerable by using excessive leverage. Drawdowns in such cases lead to margin calls, and margin calls lead to forced sales at low prices, often starting with the best stocks. A portfolio that would have otherwise led to a great long-term outcome ceases to exist, with large and unrecoverable losses! Again, we don’t have to worry about this because we use zero leverage. Finally, sometimes managers load up their portfolios with companies that are exposed to nasty feedback loops. For such companies, not only does the business affect the stock price, which is normal, but the stock price also affects the business. During a downturn, the stock sells off, which dampens the earnings, which makes the stock sell off more, etc. The culprit here, again, is leverage. Companies that repeatedly access the capital markets for their survival, find their financing costs shoot up when their stocks misbehave, which directly affects earnings. We currently hold two such companies, which together make up about 5% of our portfolio. They both sold off more than 30% during the last quarter. The underlying businesses have certainly not gotten worse in the last three months, so the stocks look even cheaper. If these were normal companies, we would have added to our positions. In this case we have no choice but to pass. There’s some room for such companies in our portfolio – when the likelihood of risk is small and commensurate reward is huge, but that room is very small. Overall, our portfolio is performing well. Our companies keep getting stronger and more profitable, and that’s all that matters in the long run. As a positive side-effect, the random market sell-off is giving us cheapskates a chance to go back shopping. We welcome that. We will likely add to our favorite positions and buy some new ones. Willow turned five this year. We thank you for your support through all these years. Many of you have been with us from day-one. Most of you have had to endure significant drawdowns, more than once. None of you left us. Several of you have asked to increase your allocations. We could not have possibly hoped for better.
Since the beginning we have asked that you evaluate us on a 3-5 year time frame. You now have a total of six periods (three 3-year rolling, two 4-year rolling, and one 5-year period) to use for your evaluation. We have outperformed the India index in all such periods, our 5-year cumulative outperformance being 74%. Back when we started, we expected the Indian market to do better than the US market. We were utterly wrong about that. US investors were much better off staying home. Fortunately our own outperformance over the S&P 500 somewhat made up for our lack of our prediction skills. No more predictions. India will do very well over the next decade. Invest in India! The broad Indian market rallied hard in 2017 posting its second-best year in the last decade. As stated several times before, we fully expect to underperform during such years. Our nitpickiness and caution made new highs in 2017. We kept significant amounts of cash. We even bought Index puts. Despite all this we managed to stay close to even with the broad market. Frankly, this surprised us. When a market rallies this much it is natural for people to look for reasons. Punditry at large has converged upon India’s “structural reforms” as the primary reason. In our view that’s pure garbage. For starters, here’s a list of reforms; the top five in our opinion.
Moreover, consider this ... a total of 42 out of the top 43 equity markets across the world were in the black in 2017 (sorry Pakistan!). Exactly HALF of those were up more than 30% for the year, in US dollar terms. Clearly, not every country in the world (OK, except Pakistan) could somehow be undergoing structural reforms in the same year. So what’s causing this rally? Could be easy monetary policy, could be growth in corporate earnings, or could some worldwide joie de vivre. According to President Trump it’s all him. We don’t know and frankly, we don’t care much. Our plan remains the same; bottoms-up, fundamental stock picking. Fortunately, we have a few things going for us. First, the absurdly high correlation between the markets does not exist within the markets. For every two high-flyer stocks there’s also a loser that has gone nowhere in several years. In other words, scratch the surface and it’s very much a stock-picker’s market. In our 2015 letter we wrote: We intend to stick to our plan and go wherever bargain hunting takes us. Lately, most of our energy is focused on companies in sectors undergoing turmoil. When analyzing such companies we ask ourselves three basic questions; 1) can the company make money even if the sector remains depressed? 2) if we buy the stock at current prices will we stand to make money in the long run, i.e., is the price right given the current depressed level of earnings and 3) is there a reasonable chance that conditions will get better soon? Three yesses usually mean outsized future returns. This still works. Secondly, while the markets everywhere celebrate new records, the volatility as implied by options dips to all-time lows. In other words, it costs next to nothing to insure against future bad outcomes. We plan to keep our insurance contracts alive and buy some new ones while they are still cheap. As usual, we are completely OK with these expiring worthless; that’s generally the intent with insurance. These contracts will help us invest more aggressively, especially when the inevitable market drawdowns do happen. Lastly, while it’s true that current government’s zeal is causing considerable pain, it will almost certainly be a point of differentiation for India in the coming years. India is transitioning from being a mish-mash of small unorganized businesses to a collection of large corporates. This is bound to cause societal upheaval but is also bound to lead to higher system-wide efficiency. In sector after sector, year after year, small family owned businesses are ceding ground to larger players. This is as true for consumer products (jeans, paints, packaged food) as it is for B2B (trucking, tiles, PVC pipes). Notwithstanding the possible societal downside, the effect on well-run listed companies is obvious – they will do very well. The process will take time and picking winners at the right price will require patience. Buffett once quipped, “Lethargy, bordering on sloth remains the cornerstone of our investment style”. Ours too! As usual, detailed write-ups and updates on our major positions follow this letter. Alert readers will notice that little has changed since last year. This is by design. We wish you a happy new year and thank you once again for investing with us. If you have questions regarding this letter or your portfolio, please do not hesitate to ask. Like always, you will receive your statements from NAV Consulting Inc. Update on our significant positions <private> We started our previous letter by pointing out that despite its 20%, Indian market is not very special – other countries have rallied as well, some far-far more. The ensuing three months have made Indian equities even less special. Everything seems to be rallying. Economist ran a cover feature recently called The bull market in everything. It had a picture of a bull with Bitcoin hanging from one horn and iPhone hanging from the other. How appropriate.
We see two common reactions to this market, Reaction A: I’ll just wait. It’ll come crashing down. It always does. Or the less common, Reaction B: Can’t miss this one! This time is different. After all, Bitcoins and smartphones were not even a thing a few years ago so don’t let history get in the way of making money. We prefer reaction C: There’s still so much misery all around. Let’s go shopping. Consider this, more than one-third of all major US stocks are in the red for the year. Many are close to their 52-week lows. Several, like Exxon and GE, are lower than they were 10 years ago. The situation is no different in India. The problem is not that it’s a bull market in everything. The problem is that what’s good is expensive and what’s cheap is garbage, for most part. To us it still makes sense sift the garbage and evaluate each situation on its own merit. Like Tolstoy once famously said about the stock market – “All high fliers are alike but each shitty situation is shitty in its own way”. When we rummage through the trash we ask ourselves some simple questions such as, Can this particular problem be solved? Why would anyone solve it? How long will that take to solve? Will the emergent entities make money? Will they make money for us, the minority shareholder? Most of the times the answers say “do nothing” but sometimes interesting stuff turns up. For example, for years now we’ve been following the non-performing loan circus at the government owned banks. By most accounts the total amount of bad loans at these banks – (INR) 8.5 trillion plus, is higher than their combined net-worth of about 6 trillion. Reasonable people can disagree on the exact numbers but there’s no denying that many public sector banks are de facto insolvent. Miraculously, solvency issues have not yet led to bank runs. The left side of the balance sheet, roughly 90 trillion, of which 10% is impaired, keeps getting worse. Yet the right side keeps financing it while patiently waiting for things to get better. Depositors, who finance close to 75 trillion, stick around because either,
Government, who directly owns more than 50% of the equity, has little incentive to do things that will lead to turmoil amongst employees and their unions. More than one-fifth of the remaining equity is owned by LIC, the government owned life insurer. Bankers don’t want to just write bad loans off since that will make them look clueless or corrupt, likely both. Besides, there is hardly enough equity to absorb the losses. The central bank is trying hard to move the process along – with constant monitoring, public shaming, forced liquidations, etc., but to little effect. Our starting hypothesis is that until we face a real liquidity crisis we’ll tread water. In the midst of this milieu, the Modi government recently announced a 2 trillion recap plan with a two year timeline. The details of the plan are not out yet but it’s looking a little bit like the bank recaps done in Korea, Indonesia, and others in late 90s. Net-net the government will end up owning more bank equity. The money required to buy the new equity will be lent by the banks themselves. In exchange for cash-like assets (the banks have more of those than they want after demonetization) the banks will receive government backed recap bonds. Presumably the government will pay the extra interest on this bond issuance from higher tax revenue and dividends received from banks, which in turn will happen because a recap will lead to higher growth. That’s it, problem solved! Call us crazy but we are not biting, at least not before we see more evidence. Interestingly though we might see other tangential opportunities as a result of this exercise. For instance, we are now getting close to election season with a slowing and (relatively) underperforming economy. It’ll soon be critical for Modi government to start some banner projects - projects like roads and power plants that make for good electioneering platforms. This will require some abandonment of fiscal targets, some arm twisting of banks to make them lend, and some bailouts for the currently hamstrung infrastructure developers. The recap exercise seems like a step in that direction. If we are right then Infrastructure, one of the worst performing sectors of the recent past, will throw spectacular investing opportunities. So far it’s mere speculation but a promising one with enough historical precedent. We continue looking for best ways to gather evidence, express our view in case we’re right, and limit our downside in case we’re wrong. New investment <private> Despite the continuous barrage of negative newsflow, which has us all believing that the world as we know it is coming to an end, India is up more than 20% percent. What a special country.
But wait – Poles and Mexicans are saying the same about their countries. After all, their markets are up even more, 38% and 31% respectively. What about Greeks, Italians and Hungarians? Same! Turks, Koreans, Chileans? Same! In total, 38 of the 40 markets we track are up year to date. It’s worth keeping our celebrations and our anxieties in this context. Back home, the aftereffects of demonetization are wearing off. Cashless adoption, which was up 3-4X at first, has settled lower. Growth has slowed down. Cash heavy businesses such as unorganized retail, microfinance, and small manufacturing, have all predictably suffered but adjusted. Life goes on. The new and shiny for Q2 was the Goods and Services Tax (GST). Rolling a dozen or so taxes into one, the new tax system promises to make doing business easier. There are some obvious benefits such as reduction in tax cascades and border check-posts. But there are also irritants, like different rates for similar looking things, e.g., 18% tax at air conditioned restaurants and 12% at non-AC ones. Its early days, and thus far the nation is confused about the whole thing. We are too. Over time, it will certainly result in higher tax compliance and lower logistical waste. It needs time. Much less advertised, but almost as important, was RBI’s action against India’s largest distressed companies. Together, their borrowings constitute over half of the rotten bank loans in the system. RBI’s message to these companies is clear – restructure quickly or liquidate. This will be the first big test of India’s new, faster and more stringent, bankruptcy law. We wait with bated breath. In general, the pattern of Modi administration’s modus operandi remains consistent – tighten the leash, shake things up, inflict whatever pain needs to be inflicted, and get on with it. Critics be damned. Portfolio Update We initiated a short India position last quarter through index derivatives. This may seem at odds with our views so let us explain. As bottoms-up investors we look for bargains wherever we can find them. When bargains abound we invest aggressively. When it’s slim pickings we stay away. We don’t move from cash to stocks, or stocks to cash, based on any macro view. The movement is simply a result of our stock specific research. Along the same lines, if we find index insurance contracts to be cheap then we buy those. It does not mean that we are actively betting against India. As an analogy, imagine a fire insurance contract on your house. Assuming the insurance is not mandated, when you buy such insurance you are not predicting a fire, and you are most certainly not rooting for a fire! You just feel that the risk justifies the price paid. Moreover, all else equal your desire to buy such insurance should become stronger as the premium drops. Same goes for an index insurance contract. The price of insurance on Dollar denominated Indian market is at multi-year lows. This is partly due to the extrapolation of recent INR and market performance, but mostly due to technical factors in the options market. Simply, the price is factoring in how volatile India has been but not how volatile it can be. We bought a small amount of this mispriced insurance. The upshot: in a market crash we’ll be relatively stable and in a fantastic rally we’ll look like dogs. We are OK with that for now. As we find other opportunities (we’re working on some exciting ones) our return profile will adjust. Overall we continue to be long India and extremely upbeat about its future. If you have any questions regarding this letter or your portfolio, please do not hesitate to ask. Since that fascinating November day when India switched its banknotes and America its president, both the markets have done rather OK. Expectations for them had been anything but OK. So quite naturally the bears are getting progressively shriller. Apparently the valuations are so high - both NIFTY and S&P 500 are now trading at 24x P/E (some coincidence!), that markets will soon spontaneously combust. We have our doubts but will happily side with the bears. It’s been a long time since we have seen a market-wide garage sale so a part of us yearns for a sell-off.
The other part worries what will happen to our portfolio in case of a sell-off. To be clear, it’s not the drawdown that worries us. We will certainly suffer drawdowns during downturns. In fact, some of our smaller market-caps holdings will likely get disproportionately punished. We can’t avoid that and we absolutely cannot time that. We can only avoid buying sub-par companies at high prices. What really worries us is whether a sell-off will affect the underlying operations of our portfolio companies? In other words, can the effect become the cause? The phenomenon has many names: Feedback, Reflexivity, or just tail-wagging-the-dog (or is it dog chasing its tail?). Consider the following scenarios:
The list goes on … Clearly, this ugliness happens often enough that we have to worry about it. Mitigating this risk involves putting some rules in place. First and foremost, we want to make sure that drawdowns for us don’t result in forced fire-sales by us. So we choose the right level of portfolio leverage – ZERO, and we choose the right kind of long-term investor – YOU. We are extremely fortunate that you share our views on investment horizons. We also mitigate market risks by avoiding companies that require large amounts of debt or equity-raises in order to grow. Some of our portfolio companies are in fact woefully under-levered. Although they have plenty of assets and earnings to support leverage they’re run by conservative owners who don’t like debt. We are okay with that. Many of these companies will gain marketshare during down cycles due to their cost leadership and ready access to cash. Finally, we stay mindful of our total commodity and FX exposure when making new investments. All else equal, we like inward looking companies that are hitched to the long-term India growth story. We believe that if we do all this well then we’ll do fine in the long run. We are convinced, and we hope through our communications we have convinced you too, that market volatility is a good thing. In fact, it is a pre-requisite for an operation like ours. Without it value investing dies. Fortunately, we haven’t found any scarcity of volatility in India just yet. Lucky us! At the end of this letter, we describe two recent purchases, both of which highlight the aforementioned issues. The price is low, the quality high and the business resilient to market shocks. New Positions <private> Our long-term goal remains the same – to significantly outperform the Indian market in US Dollars. We believe that India will do very well over the long term. We want to improve upon that performance.
Although the fund performed very well in 2016, one year performance means very little. Let’s defer our victory laps for another time. For now, we would like to focus on something more important, - not how well but how differently the fund performed in 2016. Differently not just from the index but also from ALL the well-managed India funds we track. It’s a big difference so we should explain what’s causing it and what that means for our future. In our 2015 letter we wrote: We intend to stick to our plan and go wherever bargain hunting takes us. Lately, most of our energy is focused on companies in sectors undergoing turmoil. When analyzing such companies we ask ourselves three basic questions; 1) can the company make money even if current depressed conditions remain intact? 2) if we buy the stock at current prices will we stand to make money in the long run, i.e., is the price right given the current depressed level of earnings and 3) is there a reasonable chance that conditions will get better soon? Three yesses usually mean outsized future returns. As promised, we went wherever bargain hunting took us. Recently it has taken us to destinations not often visited by modern day value investors. The scenery here includes distressed commodity producers, managers who have misallocated capital in the past, government policy controlled sectors, and such like. Of course, given a choice we would rather stuff our portfolio with high quality companies. However, sometimes the mispricing amongst the most hated companies is simply too large to ignore. Consider as an example commodity producers in a sector going through an extended slump. Most value investors won’t touch these since there is no brand, franchise value or moat to speak of. Moreover, given the market’s tendency to extrapolate the sector gets priced as if the slump will never end. Finally, at the worst of the times every company gets priced as if it’s going out of business regardless of its history, balance sheet, management strength, cost of production or any other fundamental. Traditionally, even we would not have looked at such situations - after all, investors we admire don’t so why should we? Or so the reasoning went. However, as time goes by, we appreciate more and more how badly bad news gets priced in the Indian market. We have also come to appreciate the difference between temporary and permanent distress. So when the stress is temporary, the company is fundamentally solid and the price is stupid we invest. The key here is to pick a company that survives even as many others die. Or said another way, for our company to die the entire sector must die! At the end of this letter we describe our major positions. There you can read in detail about IMFA, Triveni, HOEC and PTC India, which are all solid companies in hated sectors. All these stocks contributed significantly to performance in 2016. Our portfolio is currently split evenly between high quality long term buys and temporarily mispriced opportunities. The mix will change based on where we find bargains going forward. Given the current mix there could be periods where we have little correlation with the broader market. 2016 was one such period with a happy outcome. We will not be surprised if it goes somewhat the other way. However, over the long run it should all even out and result in a performance that is better and different than the market. In order to get different results we have to act differently. As we start 2017, we see fewer opportunities. But that will likely change given the recent turn of events, especially the events of November 8th, 2016. On that day, America chose its new president, Donald J. Trump. A few years (hard to tell how many he will last for) of Trump presidency can lead to a wide variety of outcomes for Indian companies. New trade deals, reneged trade deals, drug price controls, H1-B visa restrictions, etc. will all influence businesses meaningfully. From a purely stock picking perspective we welcome such disruptions since they lead to individual stock level mispricing. In a world where large money managers treat India as just another item in their basket of many emerging markets such events provide a welcome edge for us stock pickers. Also on November 8th (some coincidence!), by the decree of India’s prime minister, all existing 500 and 1000 rupee notes ceased to be legal tender. These notes were to be replaced by newly issued notes of different denominations. The old notes totaled about 15 trillion rupees or 86% of the total currency. Since Indians conduct 98% of their transactions in cash, this resulted in obvious outcomes-endless bank lines, empty ATMs, fights, police action and a few deaths. We were personally there to witness some of it. It was not pretty but things are now getting back to normal. The long term impact of this event, though large in magnitude, is hard to pin down just yet. There are bound to be unintended consequences when you yank the sole medium of exchange from a population this large this quick. In our view: a) A large portion of cash, which has been converted to deposit will stay as deposit. Certainly, India will “re-monetize” as ATMs start working and the absurdly low cash withdrawal limits end. However, not to the previous extent. Bank balance sheets will likely be positively impacted, as will be the government’s ability to spend. b) India will use less cash. Cards, digital transactions, mobile wallets etc. are here to stay. Once people get over the initial hesitation of using a new (more convenient?) payment mechanism they will keep doing so. The government is determined on making that happen and it will. c) Less cash will mean lower opportunity to evade taxes. Although, the Indian ingenuity was on full display days after the announcement – jewelers writing backdated invoices, bank managers selling new notes in the black market, businessmen clearing debt in old notes, folks paying their household help months in advance, etc., the cost of tax-evasion is on the rise. In absence of tax evasion arbitrage it will become more difficult for the small businessman to compete with the organized corporates. India was already slowly moving from the unorganized to the organized sector. This will just hasten things. d) Goods and Services Tax, a new nationwide tax regime will only serve to compound the problems of the unorganized sector. e) By most accounts the unorganized sector employs 70-80% of the working population so this shift is bound to be socially painful. Moreover, there has been a massive loss of productivity in the short run as people spend inordinate amount of working hours attending to their cash needs. The immediate impact on overall economy cannot be good. f) With several major state elections around the corner ‘tis the season of giving in India. Handouts will be given, votes will be bought. The prime minister took a major gamble and in the process caused a great deal of disruption. He will make up by giving employment guarantees, subsidies and debt jubilees for the rural India. So in the short term we see a slowdown, alleviated somewhat by increased social spending. In the long term, we see higher corporatization, higher efficiency, and a structural shift in how business is conducted in India. Netted out, we are more optimistic about the country’s economic future. Moreover, as these events unfold they will create big winners and big losers. Good stock picking will be rewarded and our price sensitive, contrarian approach should lead to superior outcomes. We look forward to the days ahead. We wish you a very happy New Year and thank you for investing with us. If you have questions regarding this letter or your portfolio, please do not hesitate to ask. As usual, you will receive your statements from NAV Consulting Inc. A detailed write-up on our major positions follows. Unlike the previous quarter, this one produced very little in terms of news-flow unless you consider Summer Olympics to be newsworthy. We certainly do. Everyone needs a little inspiration now and then and what could be more inspiring than watching mere humans do superhuman things? Call us stupid but we fall for the same magic trick every four years. Compare this to the political drama that’s currently dominating the American news media. Nothing could be more uninspiring. Growing up in India, where such nonsense is commonplace, we are largely immune to it. It’s sad nevertheless.
We made no new purchases this quarter. There were two significant sales – we sold our entire position in Infinite Computer Solutions for a gain of around 60% and in Aptech for a gain of around 125%. Both these positions were bought in early 2015 resulting in satisfactory IRRs. Infinite is a mid-size IT company and has its roots in off-shoring. Aptech is an IT enabled education company. Neither of these are great businesses in their current form. Our decision to sell these stocks will take a little bit of explaining, especially since we have seldom written about our selling criteria. As you are aware, our portfolio consists of a) high quality businesses bought at reasonable prices, b) average quality businesses bought at fire-sale prices, c) special situations such as spin-offs, mergers etc., and d) cash. The proportion of each of these components depends on the market conditions but the list roughly reflects our order of preference. Being cheap skeptics, we find buying high quality companies very hard. We are extremely suspicious of long term moats. There are way too many things that can go wrong in the long run. Furthermore, if we do find something we like it’s almost never available at a price that we like. When we do buy high quality companies our selling decision is rather simple. Either the market price has to increase far in excess of the business’ intrinsic value or there has to be meaningful business deterioration. So for most part when we hold a position in this category, we spend our time updating our assessment of the business while paying little attention to the market prices. Our approach towards average quality businesses is a bit different. We like buying solid companies in industries undergoing turmoil. We also like companies going through issues that are on their way to being fixed. Sometimes the market is slow to price these correctly, especially as the sell-side suspends coverage and institutional investors leave in droves. We can generate substantial edge in such situations as we do our own research and have a far longer term orientation than an average institution. We start selling these stocks as the stock price converges towards intrinsic value. Our intent here is not to squeeze the last paisa out of these positions. In fact, it would be pure luck if we are able to sell at the highs. Both Infinite and Aptech belonged in the second category. We will not be surprised if these stocks keep on climbing. Similarly, we won’t be surprised if they do just the opposite. The businesses in their current form are mediocre and the market price fairly reflects that mediocrity. So we sold and moved on. Our cash balance as a result has increased a bit and we are actively looking for viable replacements. Given the market conditions, however, we are not in a terrible rush. As usual we will give you a detailed update on our positions when we write to you next time at the end of 2016. In closing, our portfolio composition or our investing strategy changed little in Q3. If you have questions regarding this letter or your portfolio, please do not hesitate to ask. As usual, you will receive your statements from NAV Consulting Inc. In a quarter filled with exciting news items like Britain’s exit from the EU, and Raghuram Rajan’s from the Reserve Bank of India, our views and our portfolio changed little.
Brexit, no doubt, has serious long-term repercussions for Britain, but what exactly those repercussions are, is anyone’s guess. Notwithstanding the knee-jerk effect on asset prices, Brexit’s effect on global economy is debatable. Its effect on the Indian economy is even less clear. Finally, its long-term effect on the health of companies we own, or would like to own, is likely nothing. And that is all we really care about. The other exit - Rajan’s, was of far more interest. Full disclosure: we have been Rajan fans for quite some time so we were disappointed to see him go. Under him the RBI was a bit more independent, a bit more data-driven, and a bit less unyielding to political pressure than in the past. Almost everyone in politics, and many in the industry, argue that Rajan was more hawkish than required. With him gone, we will almost certainly see a more accommodative short-term monetary policy. This is not a happy outcome for a country repeatedly mired in high inflation and capital flights. However, the argument goes that the real reason for India’s chronic inflation is constrained supply, a problem that can be fixed with good governance. In other words, India needs more coal, more power, more spectrum, more roads, more bridges, more everything, and the current government will make these easier to come by. Amen! We are stock pickers and try to stay away from macroeconomic analysis. However, if rates do stay low and supply unconstrained then Indian economy will likely outperform most expectations. Our portfolio, under such a scenario, will do extremely well. So as much as we like Rajan, we are secretly rooting for his critics. We made the following change to our portfolio in Q2. Bought Suzlon Energy Limited Suzlon is in the midst of a turnaround. At least we hope so. In general, our view of turnarounds is rather grim. Most end up languishing for very long and frustrate shareholders. Yet, if done right and extremely selectively, turnaround investing can work. We have done it a few times before with net positive results. This new position in Suzlon is currently small (sub 2%) but we intend to add to it as the story unfolds. Suzlon is the largest wind-turbine producer in India, and one of the largest in the world. At its peak in 2008, Suzlon did more than 50% of all wind turbine installations in India, and was the fifth largest wind turbine manufacturer in the world. Wind generation business in India before 2010 was mainly motivated by a tax policy, which allowed for corporate buyers to depreciate roughly 85% of the deployment costs in the first year. The government also gave some generation linked sops to encourage wind power. Businesses got to save on taxes and government got a quick ramp up in wind install base. Everyone was happy. These were great times for Suzlon and it expanded aggressively, locally and internationally. It acquired Hansen Transmissions and REPower (later rechristened Senvion), a German powerhouse in high wattage and offshore wind segments. As usual, large amount of debt, a lot of it USD denominated, was used to pay for these purchases and ever increasing working capital. Eventually, the party stopped. The first crack came from the government pulling back the incentives due to cost parity between wind and conventional energy. A large part of Suzlon’s customer base vanished. The next to crack were the turbine blades, literally. Although a manageable issue, it led to awful press and loss of marketshare. Due to an onerous German law, Suzlon was not allowed to use REPower’s cash flows to pay down the debt, or use REPowers technology to address the faulty blade issue. To do so, it had to acquire 100% of the outstanding equity of REPower, and that required more money. Problems compounded as a lot of capacity built up in anticipation of continued growth became underutilized. In 2011, the company sold its stake in Hansen Transmissions. In 2012, it defaulted in its USD debt. In 2013, it undertook a debt restructuring with its Indian lenders. Between 2012 and 2014, the company tried to shore up liquidity by selling equity and tried to reduce the debt burden by restructuring the terms of its debt. In 2014, once the Modi government took office, it reinstated the accelerated depreciation incentive and started re-emphasizing clean energy, largely solar and wind. In 2015, Suzlon got a fund infusion by Dilip Sanghvi, the founder of Sun Pharmaceuticals, the largest pharmaceuticals company in India. It was able to successful restructure its long-term USD and Rupee debt. It sold REPower/Senvion and used the proceeds to pay down debt. In 2015-16, it showed its first yearly profit in 5 years. In our opinion, things will get better for Suzlon. Here’s why: First, for Indian promoters, the most painful steps are to acknowledge the problem, reduce their span of influence by selling prized assets, use the proceeds to pay down debt, and move on. The difficulty and importance of these steps cannot be overemphasized. Suzlon is past this hurdle. Suzlon’s promoters seem sincere in their efforts and our checks suggest that they are basically honest. It is futile to hope for a turnaround unless at least this much it true (case in point: Kingfisher Airlines). Second, we do not believe that the renewable bandwagon will stop anytime soon. Renewable use will grow for a long time and wind will remain a significant portion of renewable install base. Third, Suzlon has enough spare capacity, meaning little capex for some time. It has about 3000 MW per year of wind turbine capacity, and it is presently making about 450 MW per year. It is growing around rapidly once again. In two years, it should do 1200 MW of turbine installations, which is about the size of its order book. The company is hoping to clear this up in 18 months. This can easily be a 1,000 Cr EBITDA operation with a market valuation that’s about 3x from here. Finally, given the debt repayment schedule and the working capital needs we see little chance of further dilution. Suzlon is on a good track, but it still has a lot to prove. We will continue assessing Suzlon over the next 3-4 quarters and consequently increase our holding, or exit. In closing, our portfolio composition or our investing strategy changed little in Q2. If you have questions regarding this letter or your portfolio, please do not hesitate to ask. As usual, you will receive your statements from NAV Consulting Inc. Our portfolio experienced higher than usual volatility last quarter, as did the broader market. MSCI India was down about 14% by the end of Feb, and then up 13% in March. China, yet again, was the scourge. In other words, if markets were to be believed, something happened China, which made things materially worse in India for two months, and then suddenly awesome in March. We wonder what that “something” was. We have looked around but haven’t found it yet. If we do, we will be sure to report it.
Of course, China’s problems are large. Any emerging market (yes, China is still EM) with a debt load of 280% of GDP is likely to get encounter a fiasco at some point. Add to that the breakneck speed of debt accumulation, quadruple since 2007, and we are almost certain to see some fireworks. Exactly how the country will get out of this bind is anyone’s guess. Debt to equity swaps, financial repression, outright repudiation, imprisonment of short-sellers, hope, and prayers, are all viable options in a country like China. A serious recession in China will no doubt be ugly for India. China is India’s largest trading partner and accounts for almost 10% of its total global trade. More importantly, foreign investors are yet to wean themselves off the basket EM mentality. When stuff hits the fan, everything in the EM basket is a basket case, regardless of fundamentals. But let’s shift our attention back home for a bit. India, post the global financial crisis, has experienced four mini-crises:
Going back through the annals of financial media, we found the following India specific reasons for the sell-offs:
Finally, here is how we currently stand on the aforementioned issues:
So, fundamentally, India is progressing in almost the opposite direction as China. Operating under this big China overhang, but a tangible improvement in Indian economy, we, as your portfolio managers, have the following choices:
To us, option c, by leaps and bounds, is the most optimal strategy. We firmly believe in India’s future as an investment destination. We also believe that following a contrarian, value strategy, like ours will lead to large outperformance over the long run. So we stick to it. We made the following major changes to our portfolio in the last quarter: <private> Our long-term goal remains the same – significantly outperform the Indian market in US Dollars. Although ultimately it’s the absolute, not relative performance that should matter – after all you cannot eat relative performance, we believe that Indian markets will do very well over the long run and we intend to do better.
Consider this – For the last decade, MSCI India in US Dollar terms has returned an annualized return of 7%, similar to that of the S&P 500 including dividends. For the last 15 years, India has returned 11% while US has returned 5%. That’s a cumulative difference of 300%. Meanwhile, the US Dollar which used to be worth 43 Rupees in early 2000 is now worth 67 Rupees. In other words, despite several recessions, massive currency depreciation, corrupt governments, weak central bank, inadequate infrastructure and many other hurdles, India has performed rather well. We see no reason why that should end now. If anything, recent developments have made India stronger than it was a few years ago. The oil import bill, and crude is India’s biggest import by far, has been cut in half. We import far more than we export to China, the country that seems in most trouble lately. We have an activist central banker who is laser focused on fixing the state owned banks. We have a reform minded central government headed by the best salesman-prime-minister India has ever seen. We are excited about India’s future. As we write this, the Indian market is down close to 10% for 2016. To us, there is nothing unusual about that. Such volatility is a great feature of the Indian markets that only helps us in the long run. As we have written in the past, we want the market to present us with dislocations, and we want these dislocations to correct quickly. So volatility is a good thing. Another great feature of the Indian market is its, sometimes absurdly high, dispersion. Indian stocks often dance to their own individual tunes. As some stocks are making new lows several are making new highs. While that’s true with any market, the extent of such dispersion in India by far the highest amongst comparable markets. So not only do Indian stocks move wildly but they also move in wildly different directions based on company and sector specific issues. In our opinion, the best way to invest in India is to pick stocks based on company level or at best sector level analysis, while consistently maintaining a contrarian mindset. The wrong way to invest then would be to treat the entire country as one big stock and panic every time the market drops 10-15%. Most foreign investors do just that. Unfortunately they also own 4 times the amount of Indian stocks than the domestic investors do. So again, the recent sell-off is neither all that surprising nor fundamentally logical. We intend to stick to our plan and go wherever bargain hunting takes us. Currently, most of our energy is focused on sectors going through distress. When analyzing such companies we ask ourselves three basic questions; 1) can the company make money even if current depressed conditions remain intact? 2) if we buy the stock at current prices will we stand to make money in the long run, i.e., is the price right given the current depressed level of earnings and 3) is there a reasonable chance that conditions will get better soon? It takes three unequivocal yesses to get us excited. To be prudent, we are size these positions smaller and seek a higher margin of safety than do for high quality companies. Investing this way in 2015 has led to a portfolio that consists of a select few high quality stocks and several widely-spread, asymmetric bets placed within the most hated sectors of the economy. We describe the composition of our portfolio in more detail at the end of this letter. We have written about many of these positions at various points in our previous letters so our regular readers will find considerable repetition. In closing, we remain optimistic about the Indian markets. Moreover, the value investing philosophy that we follow, though almost a century old, still works well in present day India. We certainly hope that it continues to do so for long time to come. We wish you a very happy New Year and thank you for investing with us. If you have questions regarding this letter or your portfolio, please do not hesitate to ask. As usual, you will receive your statements from NAV Consulting Inc. For a contrarian value investor like us, a lot of good things happened last quarter. It all started with China. Shanghai Composite, after the June sell-off, dropped another fourth or so. We aired our concerns regarding the Greek exit and Chinese slowdown in our last letter. It turned out that China was a far bigger problem than Greece. This is not entirely surprising given that Chinese economy is now responsible for about half of world’s GDP growth. However, the extent of slowdown, the Chinese government’s reaction to it and the resultant fall-out took the markets by a huge surprise. Then came the US Fed’s do-nothing decision, which just added to everyone’s confusion. The US market, worried sick at this point, promptly dropped to make the quarter one of the worst since the global financial crisis.
In fact, the drop in the US equity markets somewhat understates the extent of the panic. Consider the high yield bond market, which generated fourth straight month of losses – a first for the asset class since 1994. Alternatively, consider VIX, a measure of future stock market volatility which is popularly known as the fear index. US VIX crossed 40 in late August. Last time that happened (in Q3 2011) we were dealing with the Euro crises and a US downgrade. The price action in the emerging markets such as Brazil, Indonesia, Malaysia, Turkey and several others, was even worse. The Indian economic story was quite a bit different. Consumer price inflation steadily came down to sub-5%. Industrial production data, though still weak, progressively got better. The country, being net commodity importer, reaped substantial benefit from the commodity sell-off. The prime minister was busy selling the country to foreign investors, and they liked what they heard. FDI inflows are close to record highs. Finally, RBI cut the benchmark repo rate by 50 bps, a substantial loosening resulting in the lowest rates since April 2011. We, at Willow, could not have asked for more. As mentioned in our previous letter, we had been busy shopping in Q2. We accelerated our pace in August and are now close to fully deployed. Like everyone else, we don’t enjoy marked-to-market losses on our investments. However, if we can trade some un-realized losses for a chance to invest at extremely cheap valuations, we would do it all day long. Q3 gave us just the opportunity. As usual, we will present a detailed overview of our portfolio composition our annual letter. Meanwhile, we describe our two most recent purchases below. <private> In closing, our long term confidence in India remains high, and fortunately we were able to buy some deep discounts last quarter. We believe that we are now sitting on the most lucrative portfolio since mid-2013. The seeds have been sown. Now we patiently wait for the bounty. If you have questions regarding this letter or your portfolio, please do not hesitate to ask. As usual, you will receive your statements from NAV Consulting Inc. The harmless looking selloff – MSCI India US is down 3.61% for the quarter, is hiding a far more interesting dispersion. Several companies, and some entire sectors, have suffered massive sell-offs. Valuations, after a long time, have started making sense in some cases. We are looking through the rubble with substantial deployable cash on hand. The returns from these investments will take a few months to show up but they’ll be substantial.
Our portfolio has remained volatile through the quarter. In order to generate long term returns through a concentrated portfolio strategy, we, at times, suffer more than our fair share of short term fluctuations. As always, we are OK with that trade-off and we have a terrific set of partners who share our philosophy. We thank you, our partners, for that. Two situations have resulted in most of our losses for the quarter. We describe them in detail here. <private> On China and Greece There’s always something scary going on in the world of macro events, the latest boogeymen being Greece and China. As always, we are watching closely but acting indifferently. In order to sensibly incorporate a macro view into our investing strategy we need to good handle on three things: the outcomes, their likelihood and their effect on our portfolio. Take Greece for example; what exactly will the Drachma II world look like? We don’t know. No one does. Greece is at best a $100bn problem that’s been lingering for more than five years now. At this point, we see little possibility of this problem manifesting itself into a global contagion. If Greek loans been sufficiently ring-fenced by now, which we suspect is the case, then a Greek exit will happen sooner rather than later. Eventually, a monetary union without political and fiscal union is bound to unravel. Greece will be the first step. However, how long that takes and what effect it has on our portfolio is far from clear. As we mentioned in our previous letter, foreign portfolio investors hold large amounts of free float of the Indian market. A global “margin call” can certainly lead to some ugly consequences for Indian stock prices and the Rupee. The last time we experienced this was two years ago. However, India is in far better shape now than it was in 2013. Our current account deficit has halved, so has the price of oil which is India’s biggest import, and our foreign exchange reserves are the highest ever. Our political leadership couldn’t be better. Finally, what effect will a Grexit have on the earnings of Shriram Transport, CARE ratings, Piramal Enterprises or any of our portfolio companies? In the long run … not much. These companies don’t need to repeatedly access the capital markets in order to thrive. Ultimately, that’s what we care about. New investment <private> In closing, as much as we would like our portfolio value to increase 10 basis points every trading day, leading to a healthy 30% return for the year, we know of no legal way to do so. Our formula is simply to buy great and/or buy cheap. Then wait. India is one of the best countries to practice our style of investing and we look to its future with excitement. If you have questions regarding this letter or your portfolio, please do not hesitate to ask. As usual, you will receive your statements from NAV Consulting Inc. By all traditional valuation measures the Indian equity markets are now looking expensive. The reasons are two-fold. First, there’s a flood of liquidity that’s inflating asset prices across the world. Global discount rates are now at unprecedented levels – a dozen or so countries have negative short term rates. A few of these are fast approaching negative long term rates (imagine buying a bond and having to pay interest for the next few years!). Surely, some of this liquidity is finding its way into the Indian markets. Foreign Institutions currently hold 50% of the entire free float for the 200 biggest Indian stocks – an all time record. We are concerned. Secondly, most traditional valuation measures are backward looking and, the last few years have not been kind to Indian corporates. The outlook for India’s future is perceived to be vastly different form its immediate past. We agree with this prevailing opinion. Notwithstanding the justifications, a lot of good news is priced into these valuations. This is especially true for high quality companies that compound their earnings at high rates without using much capital. We own a few of these but are loath to buying more at these prices. In other words, the days of easy bargains are gone. Our focus has accordingly shifted towards good, though not great, businesses trading at deep discounts. Severe, and sometimes unwarranted, mispricings exist amongst companies scarcely followed by the investor community. Investing in these situations requires considerably higher effort; the corresponding reward being performance that’s largely independent of the market. A large proportion of our time is now spent on researching and trading these idiosyncratic situations. Thus far, our results have been mixed. As discussed in our Q4 2014 letter, we had invested in J&K Bank. One terrible quarter later, the stock is down 30%. Contrast this with another investment we made this quarter, Infinite Computer Solutions, which is up 90%. While these results are diametrically opposing, our underlying decision framework when buying these stocks was very similar. They are both severely mispriced situations, involving companies going through temporary problems. The problems are fixable and, there are people in place who are committed to fixing them. Also similar is the volatility of these stock prices. We are OK with that. As long as we pick more winners than losers and carefully size our positions, we’ll come out fine. The portfolio volatility will somewhat mask what lies beneath but we’ll make every effort to reveal what’s important. Fasten your seatbelts! We are also getting more and more involved with risk-arbitrage situations. Typically, a risk-arbitrage focused fund spreads its bets over 20-30 situations. At Willow, we invest in a small subset, where we believe that the likelihood of losses is extremely low. Such opportunities don’t come by often. So far this year, we have traded two risk-arb situations. One of those, a rights offering, was a flat trade. The other, involving a tender offer, will most likely result in high single digit return over a 3-4 month period. Our intent here is to generate market independent returns and keep our cash in rotation until we find better longer-term opportunities. In summary, while our job has become more challenging, it has also become more fun. Our current strategy is a slight departure from our recent framework and, in some sense, a return to our roots. We started out as bargain hunters, moved towards buying high quality names at fair prices and now have gone back to bargain hunting. When the market conditions change - they change quickly in India, we’ll change accordingly. As always, we’ll keep you informed. In all likelihood, our 2014 performance was atypical. We hope that 2013 was atypical as well. Together, the two years resulted in satisfactory returns. Our goal is to significantly outperform the Indian market in USD terms over the long run. Two years is hardly long run, but we are pleased to get off to a good start. These returns have, and will in future, come with considerable volatility. The Indian markets and our investing style all but ensure that. We are contrarian investors. We want the market to present us with deep discounts, and we want these discounts to disappear as the market rallies. In that sense, an inefficient and volatile market is far more preferable than a stable one.
For folks who haven’t paid attention, the big event of the year in India was, of course, the election. According to the popular claim, BJP’s decisive victory marked a watershed. We hope that’s true. However, having lived all our lives in large democracies, we fall squarely in the “believe it when we see it” camp. To its credit, the Modi government has, so far, made all the right noises. The government is much smaller, at least at the top levels. It’s much quicker - judging by the pace of bills tabled so far. It’s also more decisive – it has the luxury of an absolute majority. Even so, it will take time before anything of significance really happens. Opposition parties, while individually meaningless, collectively still have enough clout to stall if not block. This is especially true in the upper house, where the ruling party does not have absolute majority. In the latest parliament session, the upper house worked for approximately 60% of its scheduled time, while the lower house worked for a record 98%. In democracy, where there’s a will there’s a way – to get nothing done. The government is now trying to push through reform using ordinances - blunt instruments, akin to executive orders in the US, only much blunter. We welcome the aggression. If the government delivers on its promises, and we’re optimistic that it will, sectors such as infrastructure, mining and capital goods will perform very well. We are actively looking for opportunities in these sectors. However, our first preference will always be businesses that will do well despite the government. Betting on policy outcomes doesn’t come easy to us, especially under current market conditions. Right now, companies with strong franchises are doing well and are fully valued. On the other hand, commodity type, capital intensive businesses are still paying for the sins of their past. The “growth debt” of yesteryears continues to haunt them as their order books, or their customers’ order books, remain mired in red tape. Take, for example, the road builder who was promised 20% ROI by the government but, after several years, can’t get the right of way to start. It’s now selling off the contracts to pay off debt. Or consider the steel company that owns four (highly underutilized) captive iron ore mines, but has to import iron ore to make its steel. Or the airline industry, that has seen one major player fold and another at the verge of doing so. Over time, and with good governance, this too shall pass. Meanwhile, investors are left with but two choices, expensive and mediocre. Under current conditions, you will see your portfolio lean a bit more towards situations with hair on them. Specifically, we’ll be looking for fire-sales involving companies with localized, fixable problems. We described MCX as being one such investment in our Q3 investor letter. Our most recent position in Jammu and Kashmir Bank (described below) is cut from the same cloth. Current significant positions Jammu and Kashmir Bank J&K bank has close to 60% share of both the deposits and advances in a region replete with constant strife. Naturally, wanting to diversify, the bank has aggressively expanded geographically over the years. It now has 15% of its branches and about 41% of its book outside of J&K. Full marks to the management on fulfilling their goal in terms of quantity. Quality, however, is a different issue. Although reputed for its strict credit practices, the bank made some poor choices during the expansion process. Starting mid-2014, the bank was hit by a series of high-ticket NPAs, namely Bhushan Steel, REI Agro and HDIL, exposing about 3% of its 450bn loan book. The management quickly took ownership, acknowledged their mistake, promised never to repeat it, and appropriately provisioned for the soured loans. The return ratios and earnings were predictably hit. Just when things were getting back on track, a major flood hit the Kashmir valley. Being the worst flood in the region’s recorded history, it wreaked havoc on the lives and businesses of the bank’s customers. The stock plummeted from 180 to 130, while the bank index rallied 30% during the same timeframe. Though the price movement piqued our interest, what really got us excited was the bank’s history. Before the twin crises, J&K Bank happened to be one of the best run banks in business, with a long history of top decile returns. On almost any metric, whether it’s the interest spread on its loans or the quality thereof, it has performed very well over the years. Available at 1x the book and about 5x earnings, JKB was a great investment opportunity. We think that the market is overly penalizing the company for one-time problems. As things improve we’ll quickly see a re-rating. Opportunities to re-build the infrastructure in flood affected areas will also act as a catalyst. Another, not so small, bonus is the bank’s 5% stake in Metlife that it’s actively looking to sell. As holders of stock we find ourselves in the company of a few admirable value investors with excellent long term record. We have high expectations from this position. Credit Analysis and Research Described in our Q2 2014 letter. As expected, the company is comfortably growing its earnings at 10-12%. Moreover, it’s doing so without using much capital. It still trades at about half the valuation of Crisil and ICRA. We expect that gap to close but we’re not holding our breath. The real value proposition here is the long term compounding nature of the business. Exide Industries Exide is the largest player in the automotive batteries industry with over 70% market share in the OEM segment and over 30% share in the aftermarket segment. It also has a large industrials battery business and an insurance company, which it recently took control of. The company has a long history of 20%+ unlevered returns, but had recently seen some trouble due to higher cost structure, investments in its low return insurance arm, and capital spending on capacity expansion. Moreover, the Indian auto sector (especially commercial vehicles) has been going through some serious funk for the last few years. Battery manufacturing is a tough business marred with competition, predatory pricing and technology obsolesce risk. However, we believe that Exide’s problems are temporary in nature and that its current price discounts most of these. The company remains debt free and is aggressively taking marketshare from unorganized sector, which makes about 40% of the batteries made in India. Piramal Enterprises Over the last three years, post the sale of Piramal Healthcare (at a record 9x sales) to Abbott, Ajay Piramal has morphed this branded formulations company into a conglomerate dealing in financial services, real estate funds, contract manufacturing of drugs, information systems for clinical trials, and a few FMCG personal care brands. Obviously, the market dislikes this lack of focus and has penalized the stock accordingly. Moreover, a large part of cash received from the Abbott transaction has been deployed in an equity portfolio that yields little in the way of EPS. Finally, the nascent nature of its businesses makes the company unprofitable on paper. With this backdrop the stock has now sold off to levels where it’s trading at half its intrinsic value. The company is run by one of the most astute and shareholder friendly managers in India. The story of this man, Ajay Piramal, and his feats is an interesting one, but perhaps too long to be told in this space. In case of Piramal, our bet is as much on the man as it is on the business, at valuations that make the bet a no-brainer. MCX Described in our Q3 2014 letter. The turnaround at this company continues. Despite a few hiccups we are pleased with the progress so far. MCX is now completely ring-fenced from its erstwhile parent’s problems. The recent commodity rout has not been kind to this commodity exchange; however the company has managed to maintain its marketshare and remain profitable. Shriram Transport Finance Company Described in our Q1 2014 letter. STFL is a compounding machine that we bought at the depths of the worst commercial vehicle cycle in a decade. As expected, the earnings growth has not been pretty. However, it still underwrites 70%+ of the used CV loans in India and is wildly profitable. There were some regulatory concerns around its funding model last year. Those concerns are out of the way at this point. We expect STFL to remain a growing and profitable company for a long time to come. All in all, this year was a big deal for India. What she makes out of it, only time will tell. We have high hopes. We wish you and your families a happy and prosperous 2015. If you have questions regarding this letter or your portfolio, please do not hesitate to ask. As usual, you will receive your statements from NAV Consulting Inc. The rally in Indian indices, denominated in USD, has now been going on for almost a year, and has many spooked. After all, how can I do so well while B, R, C, S, and even the west remain flat to abysmal? How should we react to the rally? Should we sell?
For starters, the data is clearly improving. Inflation is now at a manageable sub 7%. GDP estimates are being revised upwards. Trade deficit and foreign reserves are under control. There is a stable, business friendly government in place. If all this doesn’t completely explain the rally, it explains a goodly portion of it. With valuation and business quality as our guideposts, we have picked outstanding companies at good prices. Although the wholesale bargains of mid 2013 are no longer available, our portfolio companies largely remain fairly valued. We hold healthy cash balances and remain net buyers, with a slight shift in focus towards special situations. These situations often involve companies going through significant issues, and selling at fire-sale prices. Some of these wounds are self-inflicted and result from an adventurous management embroiled in a scandal. To be sure, regardless whether one thinks of corporate scandals as investing opportunities or not, there is nothing more damaging than buying a company with scandalous management before the scandal breaks. Our formula for avoiding such accidents is simply to err on the side of caution. We hold the management to a high enough standard that even unwarranted blemishes often tie our hands. Along the way, we sometimes miss great opportunities. We are okay with that trade off. However, after the management is caught with their pants down, the situation deserves more attention. As the news comes out, momentum traders are the first to cut and run; followed by money managers who can’t afford an egg-on-their-face (most can’t). Then there are those savvy foreign investors who knowingly partnered with the wrong guy, thinking: “if he can seduce us, he can surely put the government in trance”. By the time the dust settles, the stock sells off by 30-40% or more. Sell-side suspends coverage, so portfolio managers who rely on sell-side to do their work (many do) either abandon the stock or have no interest in buying it. For investors willing to put in the research hours, special situations can be extremely lucrative. The price to value gap is an obvious draw but more importantly, the gains are largely idiosyncratic. These are pure alpha plays with little market correlation. Of course, not every scandal presents an investible situation. A few key pieces need to fall in place for a situation to be special. Firstly, one must be able to value the company in order to know the price to value gap. That, in itself, is often an insurmountable hurdle when the company is in such flux. We take the easy way out, and only consider companies that maintain most of their pre-crisis economics. Diverse customer base, leading market share, secured financing, etc., are all tremendously helpful here. Secondly, for us to get paid, the business needs to remain a going concern. Orderly liquidation, especially in the case of industrial companies, is an oxymoron even in developed economies. So we want the resolution to be quick, painless and somehow sympathetic to equity holders’ interests. Take, for example, the case of Bhushan Steel. Possessing more than 5 million tons in capacity, it’s amongst the largest steel producers in the country. It’s also amongst the most indebted, with close to $6 bn in borrowings. While the debt was always going to be a problem, the straw that maimed the camel was a corruption scandal involving Bhushan’s top commander, Neeraj Singhal. Allegedly, Mr. Singhal’s idea of debt restructuring was to simply bribe a bank official. He was caught in the act, quite literally. The stock promptly dropped 75%, wiping out close to $2bn in equity value. It’s not very difficult to get a handle on the bare-bones NAV for this company and by our estimates, the stock is trading at a hefty discount. However, it’s uncertain whether shareholders can make money holding the stock. Liquidation will certainly be disorderly and restructuring will require severe sacrifice from equity holders, especially the minority kind. Our final criterion for investing in corporate scandals is a favorable change of control. The recent drama surrounding DLF, a large real estate developer, is a good case in point. The company went public in 2007 with a hugely successful IPO, which is now the center-point of the drama. Although DLF was never a poster-child for good corporate governance, and carried substantial debt, it never got into serious trouble. The company is by and large cash flow positive and holds high quality real estate that can easily be encumbered. The drama happened when SEBI dinged them for poor disclosures on their IPO documents. The company and its executives are now barred from raising any money from the public equity or debt markets for a period of three years. A slowing real estate market was already forcing DLF’s hand and the company was busy offloading non-core assets to pay off the lenders. But the SEBI ruling just made its life exponentially more difficult. DLF has close to 60mm sq. ft. of real estate under construction and badly needs money to fund that development. The stock is down 35% since the news broke and currently sells at substantial discount to the NAV. The company remains cash flow positive and there’s a good chance that it can sell some high quality real estate assets to lower the debt burden. However, we just don’t trust the current management to do right by the minority shareholders. Unless there is a meaningful change at the top, our hands will remain tied, at least at the prevailing price. One wonders the, whether special situations, mired in so much uncertainty, could ever be worth investing in. Yes, but rarely. A great one we found earlier this year was MCX. MCX is India’s largest commodity exchange. It has close to 85% market share of all commodity trading done in India with individual market share of 90%+ in gold, silver and crude, the most actively traded commodities. It was promoted by Financial Technologies (FTIL), which is also owned NSEL, the now defunct spot exchange. In general, financial exchanges are great businesses. Historically, the jurisdiction converges onto one or two dominant exchanges, as it should, owing to exceptional network effects. Exchanges also tend to be excellent long-term value compounders with an impenetrable moat, as long as an honest and able management runs them. Therein lies the rub. In mid 2013, it was discovered that NSEL was illegally facilitating lending arrangements between a few brokers and a large number of lenders who were promised 12-14% return on “commodity arbitrage trades”. To the regulator’s dismay, the short side of these trades often involved naked futures positions with phony warehouse receipts as the collateral. If push came to shove, the shorts would not deliver. Once the activity was discovered and clamped down, the whole scheme unraveled and the borrowers defaulted. Top management was found to be complicit in this scheme and was jailed. FTIL, the parent company, was also found to be hand in glove. Every business owned by FTIL, including MCX, bore the brunt of FTIL’s reputational damage. SEBI subsequently banned FTIL from owning any exchange and ordered the liquidation of its stake in MCX. A couple of other items, such as introduction of commodity transaction tax and import duty on gold, threw enough fuel to the fire that the stock lost about 80% of its value. We followed the situation for a few quarters (perhaps waiting too long) before finally buying MCX in the middle of 2014. The business is easy to understand and retained its entire pre-crisis market share albeit in a shrunken market. It’s debt free and has no contingent liability due of its parent’s missteps. In fact, SEBI forced FTIL to shed their entire stake, which was sold to reputable and honest shareholders. This has been a good position for us so far, but the stock is still trading at a substantial discount to its own valuation, and the valuation of comparable global exchanges. During sustained bull markets, we expect our allocation in special situations to increase. We will write more on this in our forthcoming letters. What a difference a quarter makes! The recovery-rally of late 2013 turned into full-blown euphoria in the aftermath of a historic election. While we expected the scale to tip in Modi’s direction, we were surprised by how far it tipped. Such one sided results can have significant economic implications and market has perhaps started discounting some of the positive ones.
The question of the hour has changed from “Will NDA get an absolute majority?” to a longer and more complicated “Will Modi be able to reign in the fiscal deficit yet be able to spend on growth initiatives while keeping the inflation in check as he tries to make sure that he fulfills his social and foreign policy promises?” The answer of course is, unlikely. However, given how dismal things have been for the last few years, any step in the right direction will be a welcome change. The best this government can do is to perhaps get out of the way. Fortunately Modi has shown the propensity to do just that. Eliminating the Empowered Group (EGoM) and consolidating the Prime Ministerial Office were encouraging moves. The rhetoric around retroactive taxation, GST and foreign investments has also been largely positive. To us, this election appears to be a game changer in two key aspects: 1. Firstly, for the first time in the history of the country, a candidate running largely on an economic platform has won such resounding majority. The make-up of the Indian voter somehow seems changed. We wholeheartedly welcome the change and hope that it’s permanent. 2. Secondly, long-term bullish investors, ourselves included, have lost their favorite excuse. It has been easy to blame the lack of a strong and reform oriented government for India’s recent woes. Well, now we have the verdict we hoped for, i.e., clear majority for a candidate who has the will and the skill to make things work. Obviously, not everything will be fixed (it never is) but if we don’t see meaningful improvement over the next few years then we should just “pack up and go home”. As optimistic as we are about India’s economic future, our attitude towards macroeconomic events is that of deference. We fully acknowledge their significance yet admit to our utter inability to predict them. Our unit of analysis remains individual businesses and we’re focused on high quality companies selling at substantial discounts to their intrinsic value. Our portfolio remains similar to last quarter’s except one change. We bought CARE, India’s third largest credit rating company. We have often professed our love for the Indian credit rating business in our letters. The business requires almost no capital and enjoys huge barriers to entry. Moreover, the miniscule Indian corporate bond market at 4% of GDP has significant room to grow making the ratings business a high growth industry here. In our 2013 annual letter we wrote about ICRA, the second largest player and our biggest holding at the time. We also wrote about the possibility of Moody’s increasing their shareholding through a tender. That possibility materialized earlier this year as Moody’s tendered for 24.5% of the outstanding shares. We sold into the tender and subsequently swapped our stake for an equivalent position in CARE. The business and the economics of CARE are essentially the same as CRISIL and ICRA but it sells at half their valuation. In fact, both its return on capital and historical growth has been the highest in the industry. It’s a cash rich company owned by a few PSU banks that are trying to unload non-core assets to raise capital. We believe that any meaningful ownership transfer in the company will likely result in a public tender. We also expect the valuation gap to close over time. Meanwhile, the company should keep growing its earnings over time. We see multiple ways to win with relatively little downside. In closing, we believe that quality of Indian businesses will improve substantially in the near future. The market will do its job and express that improved quality through higher valuations like it has done recently. Such rallies make it difficult for us to find the wholesale bargains that we saw in the fall of 2013. However, there are still isolated pockets of undervaluation that look interesting to us. Overall, we remain almost fully invested. Please reach out in case of questions or concerns. As usual, you will receive your statements from NAV Consulting Inc. Sincerely,  In light of a spectacular six-month rally in the Indian Rupee and the SENSEX a few topics of concern have been repeatedly coming up in our conversations with fellow investors. We list these topics below and offer our thoughts.
#1: Indian market has rallied too far too fast and the moment of reckoning is nigh We have absolutely no idea if the market is going to rally further, stop, or make an abrupt U-turn. However, there’s nothing quite that spectacular about this rally. In fact, the beauty of this rally depends largely on the anchor of its beholder. Use September 2013 as the anchor and you see an unprecedented move. Use January 2013 as the starting point and things suddenly look quite bland. The following chart of BSE Dollex 30 index, the US Dollar linked version of SENSEX, illustrates the point. In fact, compared to the 32%+ rally in the US markets, India’s 15 month performance looks utterly disappointing. The underperformance is even starker for small and mid cap companies that make up the bulk of our portfolio. #2: There is no economic justification for this rally While this is certainly true if one looks at Industrial Production numbers or GDP figures, we think that a good portion of this slowness is due to pre-election caution. Capital Expenditure often comes to a screeching halt before the elections as approvals get more difficult, Election Commission questions every significant policy change and the policy makers are busy politicking. Moreover, we clearly remember the 2013 sell off being squarely blamed on India’s bulging Current Account Deficit (CAD), rampant inflation and a cornered central bank. CAD is now at four-year lows of 1.2%. Inflation, at 8%, is the lowest it’s been in 25 months. RBI, with its new chief, has presided over some of the most progressive policy decisions in a long time. #3: The market is pricing in a favorable election outcome that may not materialize We’d rather not speculate the cumulative decisions of an electorate as vast, complex and diverse as India’s. Polls predict all sorts of outcomes with the common thread being that incumbents have little chance of winning outright. There is no doubt that a huge opportunity has been squandered by India in the past decade. We don’t know if we should blame the government or the circumstances. However, firing the management team that presided over such horrible performance seems logical to us. The market, perhaps correctly, anticipates a change in governance for the better and has rallied accordingly. We see nothing wrong with this. Maybe we are naïve but we believe that India’s political and corporate governance will be better in the next decade than the last. Ironically, part of the reason for this is the depths to which our political and corporate system sank in the past few years. Like a typical contrarian investor we see upside from here, though not in a straight-line fashion. Recent Portfolio Addition Our mantra remains the same: Invest in great companies at highly discounted prices. Shriram Transport Finance Limited (STFL), a company we recently bought for our portfolio, squarely falls in that category. STFL is the only game in town when it comes to financing used commercial vehicles (CV). Being mobile assets, CVs are quite difficult to value and collateralize. Moreover, the borrower is often a first time small trucker with very little credit history. STFL has been profitably lending in this risky niche for more than two decades with an average ROE of 28%. The company has one of the best NPA ratios in the non-bank finance sector and sources its funds at a cheaper rate than any of its competitors. In fact, several auto lenders have publicly acknowledged their inability to compete with STFL in its niche. It is a model of corporate governance and is run by one of the cleanest management teams in the country. Attrition rate runs around 12-15% with 40% being the industry average. Despite all these virtues the stock was selling at a measly 11x earnings and about 2x book when we bought it. We believe that investors are unreasonably extrapolating the current slump in CV sector into the foreseeable future. Even if there’s no end in sight for the worst CV cycle in decades (something we seriously doubt), STFL will keep earning double digits returns on equity. When we do see a pickup then this stock should trade at least 20x earnings giving us substantial upside. We are getting paid to wait. In closing, our posture is no different than it was in the previous quarter. We remain cautiously optimistic and firmly believe that we own a portfolio of special companies at special prices. As usual, you will receive your statements from NAV Consulting Inc. Please reach out in case of questions or concerns. As temperatures drop in New Delhi and New York, things economic and political are only getting hotter. US markets closed the quarter with a 10% rally making 2013 a scorching 30% year. Ben Bernanke gave way to even more dovish Janet Yellen. The Fed taper started with $10 Billion being taken away from monthly purchases but the market took it in stride.
In India the election season is almost in full swing. With a surprise strong showing by the openly socialist AAP in Delhi the impending Lok Sabha elections have become even more interesting. The market longs for a government without coalition though recent history makes that a long shot. India’s NIFTY index rallied 9.92% for the quarter and hope is once again in the air. Hope for better governance, a stronger central bank and a robust economy. We hate to rain on this parade but India’s recent record of meeting expectations is rather sobering. The news from the business community at large, whose opinion we value far more than the economists’, is not great. India’s share of corporate profits to GDP stands at a decade low of 4.5%. The mood is slightly more buoyant than last quarter. However, all it takes is an unfavorable election outcome, a regressive policy stance or a bad monsoon for things to take the wrong turn. We remain cautious buyers of cheap high quality companies with extra emphasis on quality. India as an investment destination We invest in India because we believe that we understand Indian businesses better than the investor base at large. This relative advantage is crucial in our business, which is largely a zero-sum game. But is India inherently a worthy investing destination? We certainly think so, especially for rational, business minded investors. There are two primary reasons and to sound like we know what we’re talking about we’ll call them drift and noise. By drift we mean favorable long-term growth prospects and by long term we mean decades, not the next 2 or 3 years. The Indian consumer, as it currently stands, is grossly underserved. His consumption of almost everything material remains abysmally low; be it cars, toothpaste, bank loans or hours of TV watching. Even when compared to other emerging counties. On top of that he’s getting younger, richer and more literate by the day. He’s far more prone to borrowing and spending than his predecessors. This confluence of hunger, means and access will create enormous demand in the coming years. Companies that profitably fulfill this demand will make their owners immensely prosperous. In the short term though the noise rules. Indian economic and socio-political landscape has always been volatile and will remain so for the foreseeable future. Most investors, especially the foreign kind, think of it as a problem of magnitude rather than frequency. In other words, there is widespread belief that India’s crises are somehow worse than other countries’. We disagree. Be it financial debacles, scams or plain old business cycles, the pain is as deep when it comes to places like US, Europe and Japan. However, India takes the cake when it comes to the frequency of such scams and crises. Whether it’s the 2G scandal, NSEL fraud, implosion of a highly levered sector or our nagging current account deficit, its never a dull day in India. This economic uncertainty coupled with a nervous investor base makes Indian markets bounce around like a Japanese seismograph on steroids. But “that” as Martha Stewart would say “is a good thing”. Rational investors are in the business of buying a stock when it trades at a discount to its intrinsic value and selling when it trades at a premium. Without the random market noise they would never get the opportunity to do so. In other words, the drift creates great businesses to choose from and the noise creates great prices to transact those. India with its ample supply of both should be near the top of every value investor’s list. Lessons learnt from the year past The biggest detractor to our 2013 performance was the Indian Rupee. In hindsight we should have hedged against this risk but there are two reasons why we thought it was a bad idea. Firstly, our record of macro predictions is rather unreliable, especially since we don’t make them. Frankly, we think the swarms of economists crawling this planet share a very similar record. Secondly, a hedge is an insurance policy. One buys an insurance policy only when it makes sense. While most of us carry health insurance we don’t buy trip insurance every time we buy air tickets. Insurance policies come with costs and the cost of insuring against a Rupee decline seemed far too high to us at the time. In fact had we hedged our entire portfolio on January 1st 2013 for a year using available options we wouldn’t have done materially better. The second biggest performance drag was company size. Specifically, the annualized performance of each of our stocks was almost 100% correlated to its market capitalization. Our larger cap stocks did well and smaller cap stocks capsized. We prefer small cap stocks for a good reason, i.e., they are very sparsely followed by the investor community and hence sometimes trade at stupid prices. However, during times of market distress such stupid prices often get stupid-er. This is exactly what happened in 2013 and small and mid-cap indices dropped by significant amounts. We have done very well relative to these indices and expect to fully participate in their upside as prices recover over time. However, going forward we will demand a higher margin of safety from our smaller cap stocks. This will make our portfolio more resilient in distressed markets while making it lean towards slightly higher capitalizations. The most important lesson learnt in 2013 was from mistakes that we did not commit. There were a few instances during the year when we loved a stock for its underlying business as well its price. However, we decided not to buy purely for corporate governance reasons. We are happy to report that it saved us considerable amount of money. If we have one wish for 2014 it is be to repeat this inactivity on our part. Current Positions <private> Apart from these stocks we have a few other positions that we are in the process of buying. As we complete our purchases we will update you further in our letters. Please reach out to us with any questions or concerns. Our brand of investing is simple. Find great companies. Buy them at the right price. Sell when they get properly valued. Rinse and Repeat.
If we're able to do this we make money. Its a simple formula that hinges on four things and four things only. Or as a sceptic would put it ... How do you know that the company is great? How do you know what the right price is? Why would sellers sell their stock at the right price? Why would a stocks ever converge to their proper value? Volumes have been written on the first two questions. We ourselves write about these in our investor letters fairly regularly. So in this post lets focus on the last two. Besides, these are much easier to answer anyway. The answer to questions three and four simply is "We do not know but they do". To both the questions. Since we don't know the answer let's check what Ben Graham, the father of value investing, had to say about it. Here's an excerpt from a Senate committee hearing on Factors affecting the buying and selling of equity securities. Specifically, this is the statement and the Q&A section for Graham. Towards the end of a rather candid and insightful interview the following exchange takes place ... THE CHAIRMAN: When you find a special situation and you decide, just for illustration, that you can buy for 10 and it is worth 30, and you take a position, and then you cannot realize it until a lot of people decide it is worth 30, how is that process brought about-by advertising, or what happens? Mr GRAHAM: This is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. We know from experience that eventually the market catches up with value. It realizes it one way or another. Even Graham didn't know! We can perhaps speculate why someone would be in a hurry to sell something at a ridiculous price. It could be any of the following ...
The point is that it's often impossible to put one's finger at THE reason. From the sellers perspective the reason could in fact be quite rational. The result is always the same; more volatility. And this volatility is EXACTLY what creates opportunities. Strangely though most of the finance community does not agree with us. Volatility is a dirty word especially the academic part of the finance circles. Volatility to them is risk. To us the possibility of capital loss is risk. Risk a mistake made valuing a company or a drill rig that catches fire or an owner who decides to plunder the company. Volatility, to us, is what makes the investment world go round. To be fair we can think of at least two ways that volatility can harm an investor. First has to do with a human being's emotional make up. Without volatility there will be no trading. After all, if the slot machine always comes up with 2 bananas and an apple then what's the point in playing? So more volatility (to an extent) equals more trading, which means more commissions out of an investors pocket. Ergo, lower returns. Moreover, if greed and fear belong to the same zip code in your brain as investment analysis then volatility must be avoided at all costs. It will simply force you to buy euphoria and sell misery. The second reason is leverage. A levered position does very poorly in the face of volatility. When a margin call comes you have to liquidate regardless of the long term prospects of your position. However, the volatility-risk mix up in finance literature has nothing to do this these two reasons. Volatility in finance is simply a construct best avoided. Why? We have our suspicions but let's explore those in our future posts. For a value investor of our ilk volatility is a blessing. Volatility happens. People sell things for personal, financial and sometimes totally dumb reasons. Sometimes at the right price (from our perspective). Similarly, once we buy the stock at the right price should we pray for the stock to just sit there? The right price is one that's far below the intrinsic value of the business. In other words we just created a heads-we-win-tails-we-lose-little situation for ourselves. So what's the point of NOT flipping the coin? So in summary while its impossible to know exactly why a stock diverges from and converges to its intrinsic value, it does. And praise the lord that it does. For without this random movement there would be no value investing. A lot has happened since our last letter in July. US Fed apparently sent a “clear” signal to the market that its going to taper its $85 bln/mo asset purchase program. Sensex dropped 2000+ points. Indian Rupee sold off 13%. India’s fledgling bond market saw massive outflows. A run on India’s foreign reserves looked imminent. Sell side research started predicting USDINR at 70, then 80, even 100 by the end of the year. RBI allegedly intervened multiple times in the currency markets but to no avail. Economists and main-stream media invoked the 1991 BOP crisis and openly started asking the government about an IMF bail out. It was India’s Lehman Moment.
Then suddenly in the early days of September things started improving. The Rupee started stabilizing, US Fed decided not to taper after all and India got a new RBI governor with a rock-star resume. A couple of speeches, a US policy (in)decision, some idle chatter by the government around opening up bottlenecks and everything was back to normal. Sensex almost gained back what it lost and so did the Indian Rupee. However, these market rallies belie an economic picture that’s getting bleaker by the month. According to our sources that reside "in the trenches" business is tepid at best. These sources are running small industry units mostly around manufacturing and services. They seem to be the hardest hit. Order-books, that had shrunk to about 4-6 months during the depth of the 2008-09 crash now stand at 1-2 months. Such state of affairs is quite commonplace today. Businesses that had borrowed money to fund expansion over the past 3 years are finding it immensely difficult to pay interest on this borrowing owing to the high rates, as well as keep their machines running owing to the small order book. We feel that there is more economic pain ahead. As is usually the case, this economic pain is somewhat built into the market prices for certain businesses. Our job, as always, is to find solid, lasting businesses that are being grossly and unfairly mispriced in today’s market. We are treading carefully but we are treading nonetheless. The latest addition to our portfolio is Hindustan Zinc (HZL), a firm jointly owned by the Indian government (30%) and Sesa Sterlite (65%), a subsidiary of the UK’s Vedanta group. HZL is one of the largest and lowest cost producers of zinc on the planet. Zinc is an industrial metal used for steel making, die-casting etc. With China slowing down recently and persistent growth pangs in the West, steel and hence zinc has suffered significant price correction. HZL, being a zinc producer and an Indian mining company, suffered a double whammy of sorts resulting in a 40% YTD drop in price when we found it. The stock was implying far lower zinc prices than the prevailing as well as historical average world zinc prices. The company is debt free and has about $3.5 bln of cash (1/3rd of its market cap) on its books. There are two other items of interest that make this investment especially attractive. Firstly, the parent company is highly indebted and needs HZL’s cash to pay off some of that debt. This can only happen if HZL gives a huge dividend or the government sells its stake to the parent. Both these events will be highly profitable for minority investors. In fact the way Indian securities laws are set up the later event can result in a substantial windfall. Secondly, the government is in dire need of money and looking for assets to divest. Hence an HZL stake sake is likely a low hanging fruit. We anticipate some resolution to this situation within the next 6-12 months. Meanwhile, we own a business with solid growth prospects, best in class margins and a 30%+ return on capital. These heads we win, tails we lose a little situations are exactly what we look for while investing. In closing, we acknowledge that Indian economy is going through some serious issues right now. However, these issues are neither novel nor just endemic to India. Time will tell whether last decade’s India growth story was a result of fundamentals (demography, high savings rate, urbanization, open markets etc) or just global credit expansion. We suspect it’s a bit of both though more of the former. Meanwhile we will stick to what we know works and let fundamental research and valuation be our guideposts. Please reach out to us with any questions or concerns. The Rupee with its 10% drop over the quarter admittedly took us by surprise. It now holds the enviable spot of being the worst performing Asian currency for the quarter. If the “macro-pundits” are to be believed then “We ain’t seen nothing yet” and the Rupee is basically doomed. After all, the tapering signals from US Fed, policy inaction in India, election season and a high current account deficit (CAD) all point that way. Well, we are not so sure. We can think of several reasons why Rupee should be stronger. For instance gold, oil and several other commodities that make up majority of our import bill, are getting cheaper. The government is approving infrastructure projects in the earnest ($2bln just this last month). CAD itself at 3.6% was much better than expected. However, our arguments only add to the din of expert nonsense you hear all over the financial media. We cannot predict the direction of Indian Rupee with much certainty and we don’t think the pundits can either. Although fully aware of the macro risks to our portfolio we try not to base our decisions on things we cannot predict nor control.
As mentioned, small and mid cap stocks make up most of our portfolio. This is direct result of the massive chasm that currently exists between small and large cap valuations. Marquee companies in hot sectors such as IT services and FMCG are trading at all time high valuations, reminiscent of the tech multiples of early 2000s and the real estate multiples of 2006-07. On the other hand several promising small and mid caps are available at throwaway prices. This cannot last indefinitely. Despite our small cap bias our performance so far has tracked the better performing large cap indices. We expect this trend to continue. Moreover, as the performance gap between the small and large companies closes we should benefit disproportionately. Most importantly, the operating performance of our portfolio companies remains strong. If this trend continues, and we expect it will, soon enough the market should catch up and reward us amply. Meanwhile, the short-term volatility we suffer seems like a fair price to pay for long run performance. Our plan of attack going forward remains the same, only difference being an increased emphasis on management capability. Large companies with monopoly like economics can be run by sub-par management but can nevertheless achieve above par results. For most others, including the kinds we own currently, the quality of management makes or breaks the business. A good example of a recent investment based largely on valuation and management capability is Capital First Limited. CAPF is a medium sized specialty finance company that lends to individuals and small companies. These loans are secured against houses, land, gold, autos etc. The business is rather simple as in you borrow cheaply and lend at highest possible rates while keeping your expenses low and making sure that you don’t to deadbeats. CAPF until recently was a part of the Future Group, which is run by Kishore Biyani, a bona fide Indian rags-to-riches-to-not-so-riches story. Like many of his counterparts, Mr. Biyani overextended himself to finance his company’s explosive growth and then ran into problems as the economy slowed. In order to pay down his debts he recently sold some of his languishing non-core assets including Future Capital Holdings (now Capital First). In mid 2012 the majority ownership of CAPF was transferred to Warburg Pincus, a leading US Private Equity firm. Also, post transaction CAPF’s CEO V. Vaidyanathan aka Vaidy ended up owning 10% of the company. The new owners quickly infused $20mm in tier 1 capital, off-loaded problematic loans, cleaned house, re-branded the company and put a sensible growth plan in place. As we did our own due diligence it became clear to us that market’s assessment of CAPF was likely way off the mark. While there is nothing special about CAPF’s specialty finance business there were a two factors that made it a compelling investment. One was the low valuation that reflected CAPF’s tainted past rather than the present or the future. The new company looks nothing like the old one but the market doesn’t realize this yet. The second factor was the new ownership. Having a reputed private equity as a majority shareholder has some serious advantages for us. First off all, we can be absolutely certain of management integrity and corporate governance. Secondly, we know that our incentives are completely aligned with controlling shareholders. A private Equity strategy has one overarching goal: to sell their portfolio company at a profit. As Warburg runs, monitors, improves, promotes and ultimately sells its investment we stand to gain alongside them. Finally, the CEO has his fortune tied to the same goal and has a stellar track record of running big finance companies. We fully expect Warburg and Vaidy to succeed in their efforts. Not willing to leave anything to chance we made sure that we buy our stock at a lower price than Warburg did. In conclusion, we admit that these are tough times for Indian markets and the Indian Rupee. However, over the last 20 years or so, or ever since India started on its liberalization drive, there have been countless such moments. More often than not such times present excellent investment opportunities that require patient capital and good temperament. We hope we possess both but we’ll let time be the final arbiter. It will be our pleasure to discuss any part of this letter or other investment related issues with you in more detail so please reach out at will. |
Letters to InvestorsA collection of our views, thoughts and ideas, as we communicated to our investors. Archives
February 2019
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