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.
Godrej Properties Limited
Much like Americans Indians also love owning homes. Some of this love is simply cultural and some of it stems from the need to protect against persistent inflation that seeps into asset prices (“Property prices only go up”. Sounds familiar?). But a large part is borne out of the need to hoard undeclared income. Not surprisingly, landlords are happy keeping their “investment” properties empty or at best receiving a puny 2% rental yield. Also not surprisingly, most real estate transactions happen in cash. This pushes up home prices for both hoarders and real buyers who purchase a home for living in it. Moreover, the cities are bursting at the seams further exacerbating the housing situation. Builders have been all too quick to oblige by supplying a constant stream of new projects. The money collected upfront from these “launches” was often used to start other new projects. In a typical ponzi fashion, as long as people kept paying, the builders kept expanding.
In 2015 the party suddenly slowed down. This normal looking slump then turned into a debacle as credit tightened. Construction slowed down and the delivery time on these projects got stretched. Buyers complained and the government responded with a real estate bill fortifying consumer protections. This made matters worse for the builders. Next came the ban on large cash transactions, and Modi’s demonetization scheme, which suddenly sucked all cash out of the system. More bad news followed with a prominent builder getting jailed and another one getting barred from securities market. Builder stocks plummeted en-masse regardless of the quality or reputation of the company.
We bought Godrej Properties Limited (GPL) in this backdrop. In our opinion the new home market is now completely polarized where the strong will get stronger at the expense of the weak. Consumers are finally willing to pay appropriate premium for builders who have a long track record of quality and on time delivery. GPL has a 30 year history of doing just that. This builder is backed by the 120 year old Godrej group, one of the most well-known and highest regarded brands in India. GPL’s residential business is relatively asset light where it lends project management, sales, and brand expertise to large projects and charges a premium. In its commercial business it has developed and owns highly sought after office space in the heart of Mumbai’s business district. The company is currently monetizing these assets at significant premiums. A transaction in FY 2016 involved selling forty thousand sq. meters at a 30% premium to the market. Another one in the works will likely be done at similar terms. Funds received from these transactions are being poured into the residential business when other weaker players are getting decimated. The Godrej brand, being nationally recognized, travels really well so there is no dearth of opportunities. We expect great things from GPL and intend to hold it for a long time.
TD Power Systems Limited
India being the third largest producer of power in the world (after the US and China) has a huge power sector, which is going through a multi-year slump. Retail consumers and farmers want power for free. Politicians are quick to oblige in order to get votes. State owned utilities bear the brunt amassing continuous losses and debts. Black outs (called load-shedding) still routinely happen in many states. Where power is available, around 30% of it is routinely stolen or lost in transit. The current government is working hard to fix this situation but it will take time.
Meanwhile, the industrial segment, requiring 24x7 access to large amounts of power relies on captive plants. In fact, India is unique amongst large power producers in its widespread use of small captive power plants. TD Power supplies the equipment and expertise for such captive plants.
In 2015-16 as Indian banks started struggling with their bad loans, credit tightened, and consumer demand waned, the manufacturing sector started postponing their plans to put up captive power plants. TD’s margins shrank to almost zero and its stock price shrank to half. In the wake of demonetization the stock further sold off and traded next to nothing when adjusted for cash and non-operating assets. For this zero debt, low working capital company the price made little sense. As the management started proactively shutting down loss making businesses, cutting fixed costs and setting up JVs to enter foreign markets we bought this stock, betting on an eventual turnaround. We paid close to 175 Rupees per share for a company that earned 60 Rupees per share in its heydays. When normalcy eventually returns for the banks and the manufacturers, we will see those days again. Meanwhile, our low purchase price affords us ample margin of safety.
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:
- Market sells off -> high growth company that needs constant issuance of equity cannot do so at the right price -> it shuts down (e.g., US tech 2000-03, Indian startups 2015-now)
- Market sells off -> credit tightens -> a highly levered company is not able to refinance its debt -> it dies (e.g., Earth 2008-09, India 2011, 2013, 2015)
- Market sells off -> foreigners flee -> currency sells off -> imports get expensive -> margins shrink for companies that import raw materials and sell domestically (e.g., India 2013)
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.
Godrej Properties Limited
Much like Americans Indians also love owning homes. Some of this love is simply cultural and some of it stems from the need to protect against persistent inflation that seeps into asset prices (“Property prices only go up”. Sounds familiar?). But a large part is borne out of the need to hoard undeclared income. Not surprisingly, landlords are happy keeping their “investment” properties empty or at best receiving a puny 2% rental yield. Also not surprisingly, most real estate transactions happen in cash. This pushes up home prices for both hoarders and real buyers who purchase a home for living in it. Moreover, the cities are bursting at the seams further exacerbating the housing situation. Builders have been all too quick to oblige by supplying a constant stream of new projects. The money collected upfront from these “launches” was often used to start other new projects. In a typical ponzi fashion, as long as people kept paying, the builders kept expanding.
In 2015 the party suddenly slowed down. This normal looking slump then turned into a debacle as credit tightened. Construction slowed down and the delivery time on these projects got stretched. Buyers complained and the government responded with a real estate bill fortifying consumer protections. This made matters worse for the builders. Next came the ban on large cash transactions, and Modi’s demonetization scheme, which suddenly sucked all cash out of the system. More bad news followed with a prominent builder getting jailed and another one getting barred from securities market. Builder stocks plummeted en-masse regardless of the quality or reputation of the company.
We bought Godrej Properties Limited (GPL) in this backdrop. In our opinion the new home market is now completely polarized where the strong will get stronger at the expense of the weak. Consumers are finally willing to pay appropriate premium for builders who have a long track record of quality and on time delivery. GPL has a 30 year history of doing just that. This builder is backed by the 120 year old Godrej group, one of the most well-known and highest regarded brands in India. GPL’s residential business is relatively asset light where it lends project management, sales, and brand expertise to large projects and charges a premium. In its commercial business it has developed and owns highly sought after office space in the heart of Mumbai’s business district. The company is currently monetizing these assets at significant premiums. A transaction in FY 2016 involved selling forty thousand sq. meters at a 30% premium to the market. Another one in the works will likely be done at similar terms. Funds received from these transactions are being poured into the residential business when other weaker players are getting decimated. The Godrej brand, being nationally recognized, travels really well so there is no dearth of opportunities. We expect great things from GPL and intend to hold it for a long time.
TD Power Systems Limited
India being the third largest producer of power in the world (after the US and China) has a huge power sector, which is going through a multi-year slump. Retail consumers and farmers want power for free. Politicians are quick to oblige in order to get votes. State owned utilities bear the brunt amassing continuous losses and debts. Black outs (called load-shedding) still routinely happen in many states. Where power is available, around 30% of it is routinely stolen or lost in transit. The current government is working hard to fix this situation but it will take time.
Meanwhile, the industrial segment, requiring 24x7 access to large amounts of power relies on captive plants. In fact, India is unique amongst large power producers in its widespread use of small captive power plants. TD Power supplies the equipment and expertise for such captive plants.
In 2015-16 as Indian banks started struggling with their bad loans, credit tightened, and consumer demand waned, the manufacturing sector started postponing their plans to put up captive power plants. TD’s margins shrank to almost zero and its stock price shrank to half. In the wake of demonetization the stock further sold off and traded next to nothing when adjusted for cash and non-operating assets. For this zero debt, low working capital company the price made little sense. As the management started proactively shutting down loss making businesses, cutting fixed costs and setting up JVs to enter foreign markets we bought this stock, betting on an eventual turnaround. We paid close to 175 Rupees per share for a company that earned 60 Rupees per share in its heydays. When normalcy eventually returns for the banks and the manufacturers, we will see those days again. Meanwhile, our low purchase price affords us ample margin of safety.
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