2013 Annual Letter

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 10bln 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 Portfolio positions


Canfin Homes

Canfin is a small housing finance company promoted by a major public sector bank called Canara Bank. This company has had a history of underperformance up until 2011 when new management took over. Their cost of funds at 8.50% was one of the highest in the Industry and their book value grew by a mere 11% CAGR from 2003-11 while the market returned 15%. The stock was priced accordingly at 0.6x book. In 2011 the new management put a turnaround plan in place. We followed their performance for a few quarters and liked what we saw. Moreover, the company had a substantially higher capital base than what’s required by the regulator. It is deploying this excess capital towards loan growth. We believe that we will see the results within the next couple of quarters leading to a re-rating. The stock still trades below book and is cheap both on relative and absolute basis.


Capital First

We wrote extensively about this company in our Q2 2013 letter. Our long term thesis remains the same.


Colgate Palmolive (India)

This is Colgate’s Indian subsidiary and is an excellent business in terms of growth, profitability and corporate governance. Following numbers put Colgate India’s performance in perspective:


ROE for the last 10 years ~90%

Dividend Payout for the last 10 years ~75%

Sales Growth CAGR for the last 10 years ~27%


The company has 55% market share of the toothpaste and 41% of the toothbrush market. The next in line competitor is about half that size. Yet it is tirelessly working on all fronts to increase penetration. At about 130 grams a year India has one of the lowest per capita toothpaste consumption. Compare this with average Brazilian who consumes more than half a kg of toothpaste a year! We believe that there’s ample room to grow. Yet the stock has gone nowhere in the past year and a half on the fears of an onslaught by P&G India, which recently launched their Oral-B brand. We believe that such fears are overplayed. There are several case studies across time as well as geographies that support our view.


Gillette India

Just like Colgate, this is another steady value compounder. In fact the only weakness in this company is its Oral Care division, which has brought Oral B to the market. Gillette’s parent company in fact was amongst Warren Buffett’s favorite holdings and was bought out by P&G for $57bln in 2005. Our position is Gillette India is slightly more tactical than our other positions. A recent 8.77% stake sale by the promoters has artificially depressed this stock. This was done in order to comply with SEBI’s minimum public shareholding norms (al least 25% public shareholding). In fact the market was expecting promoters to buy out the minority shareholders so the news of sale was a bit of a shock. As the dust settled we bought the stock at depressed prices that we think will normalize within a couple of quarters. Meanwhile the company will steadily compound earnings as it always has.


Hindustan Zinc

We wrote about this company in our Q3 2013 letter. Our long term thesis remains the same.


ICRA

ICRA is our long term bet on the expansion of India’s bond market. It’s India’s second largest credit rating agency which counts Moody’s corp. as one its marquee shareholders (26% stake). India has three major credit rating agencies; CRISIL, CARE and ICRA. CRISIL has a similar anchor investor in McGraw Hill’s financial, which is the parent of S&P credit rating agency. McGraw Hill recently increased its stake in CRISIL from 52.7% to the maximum allowed 75% in a tender that valued the company at well north of 30x earnings. While we haven’t pinned our hopes on such an event for ICRA but if it happens it’ll be a major windfall. More importantly though its heartening to see a global major showing confidence in the long term growth of India’s credit markets.


Indian corporate bond market is embarrassingly small at about 5% of the GDP. This is much smaller than even its Asian counterparts. We believe that bond market growth is a one-way street despite short-term hiccups. Moreover bond rating is one of the best businesses in the world. Requiring very little capital it boasts excellent ROIC, often in excess of 60-70% like in the case of ICRA. The industry enjoys huge entry barriers and unseating established players is nearly impossible. We bought ICRA at less than 15x net of cash, when the markets were spooked about interest rate rises and lack of debt issuance in the short term. The stock has rallied close to 50% since then but we still believe that ICRA’s best days are yet to come.


Jyothy Laboratories

We wrote about this company in our Q1 2013 letter. Our long term thesis remains the same.


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.


Sincerely,


Rahul Bhatia Aniket Khera