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.
#1. Shriram Transport Finance
Shriram, one of our dearest and largest holdings, declined close to 22% last quarter. Before we explain what happened, it makes sense to revisit our original thesis. Here is an extract from our Q1 2014 letter …
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.
Thus far, this investment has paid off in spades. Despite the recent drop, our total return exceeds 70% over 20 or so months. The company still remains a dominant, highly profitable player in its space. The problem this quarter arose from its equipment finance subsidiary. This sub is in the business of lending to contractors working on infrastructure projects. This should be an attractive area for STFL in the long run. However, due to an extreme (and seemingly never ending) slowdown in the infrastructure sector some of these contractors missed their payments and that lead to substantial write-downs for the business. The market is, perhaps correctly, assuming that the problems far from over. However, the impact of these problems is far overstated in our opinion. In terms of total assets, the equipment finance business is a mere 5% of the total business. Even the worst case scenario for this subsidiary deserves nowhere close to the 20% drop that the parent has suffered. In our opinion, the STFL franchise remains strong as ever with possibility of plenty pleasant surprises in the long run. Unless the entire business somehow deteriorates we have no intention of selling this stock in the near future. The stock is up 12x over the last 10 years and we believe that next decade is going to be better than the last one for STFL. We are willing to wait that long.
Our other big miscue was Infinite Computer Solutions Ltd., a smaller position, which was down 35% over the last quarter. Here we are on shakier ground. We bought this company in the first quarter at an extremely depressed valuation of 6x earnings. Infinite is in the commoditized business of IT outsourcing and, like every other company in this industry, is facing huge margin compression. Over the last 5 years the EBITDA margin has come down from 15% to 8%. They also made the mistake of over-hedging their US Dollar exposure which resulted in serious hits to earnings as the Rupee depreciated from 45 to 65 over the last four years. In 2014 the hedges matured, they signed up a couple of big ticket clients and the company initiated a repurchase program. All steps in the right direction. We were confident that the company would re-rate substantially from its prevailing depressed valuation. And it did. But we did nothing! The stock quickly went up 70% and, stayed there for two weeks, but we failed to sell it. In our opinion, there was still substantial price to value gap and we were determined to wait to realize it. Around mid-May, the company announced pretty disappointing earnings and the stock sold all the way down to our original purchase price, a 40% drop within a week. What could have been a home run is right now a mediocre investment. At this point, it’s once again a deep value stock and we’re begrudgingly holding on to it.
We buy companies like infinite for their cheapness so it makes sense to sell when there’s an opportunity to do so at a reasonable price. This is a commodity business that will likely keep struggling and time is the enemy of this investment. The longer we wait for realizing value, the worse our IRR will be (contrast this to Shriram which will steadily grow its earnings while we wait). We have learnt our lesson. We will commit a different mistake next time.
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: AstraZeneca Pharma India
We love situations with lots of uncertainty but very little risk. A broad range of outcomes (uncertainty) is a great thing when most of those outcomes are favorable. However, the market, hating instability of any sort, prices all uncertainty as risk. Such circumstances can sometimes create excellent investible opportunities. AstraZeneca India is one of those.
The company, until mid-2013, was a 90% Indian subsidiary of AstraZeneca plc of Sweden, the global pharmaceutical giant. The parent tried twice (once in 2004 and again in 2010) to buy out and delist the Indian subsidiary’s minority shareholders. However, both the times, the shareholders held out for better price. In June 2013 SEBI started mandating all listed companies with more than 75% promoter holding to either de-list or offer some promoter shares for sale. It was widely speculated that AstraZeneca would opt for a delisting (third time a charm?) leading to a windfall. The stock doubled over the next few months. The broader market remained unchanged during the same period.
Just as the window for delisting was about to close, AstraZeneca plc decided to ruin the speculator party by instead opting to sell 15% of the shares in the open market. Heavy selling promptly ensued and the stock halved in a few quick trading sessions. But there was more to come. After the announcement of sale, the company also decided to shut down production and issue recalls for a few highly profitable drugs. The reason (excuse?) given was that some deficiencies were found in an internal audit conducted voluntarily by the company. The stock sold some more and finally settled around 800, less than one-third its peak from a year ago. The company conducted its offer for sale amidst this chaos.
Perhaps there really were some serious problems with the production process. Why, after all, remove the pig’s lipstick right before selling it? That question got answered when the results of the sale were announced. Almost entire offloaded stake was placed with a single entity, Elliott Holdings, an investment vehicle for a $23bn hedge fund famous for its activist style. Whether there was some serious collusion between the company and the hedge fund remains (yet another) open question. Consider this: according to SEBI rules, it takes 90% of all shareholders and 67% of the minority shareholders to agree to a voluntary delisting at any given price. The parent still owns 75% of the sub. Elliott now owns 15%. Together they satisfy all the necessary conditions to conduct a delisting at almost any price, hence squeezing out the remaining minority shareholders. With this (possible) arrangement in place, the company went at it again in 2014 by announcing their third delisting plan! Extremely frustrated by now, a few minority shareholders dragged the company to court and managed to thwart the delisting plan again.
At this point, it’s highly unlikely AstraZeneca plc will be able to buy the minority shareholders out for cheap. Moreover, there have been significant changes made to the Indian sub’s top management and the business itself is coming back on track. We bought the stock last quarter around Rs.950. We will likely add more at opportune moments. Many good things can happen going forward. The company can easily go back to its 2009-10 (pre-drama) performance levels. Elliott, at some point, will get itchy and look to exit at a reasonable level, leading to a fair delisting. AstraZeneca Sweden itself could be put in play and, a parent acquisition will trigger a mandatory open offer for the Indian sub. Pfizer made a very credible $116bn bid last year for AstraZeneca plc. Besides, the pharmaceutical sector is currently going through its highest deal activity in decades. In other words, there’s lots of uncertainty but very little risk.
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.