2014 Annual Letter

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 main event of the year in India was, of course, the election. According to the popular claim, BJP’s 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 resorting to ordinances - blunt instruments, akin to executive orders in the US, only much blunter. We welcome the aggression. If it works then 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 macro events and policy outcomes is not our forte.


The recent rally has created an interesting bifurcation of sorts. 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 sales outlook remains mired in red tape. Take, for example, the road builder that 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. Some of our recent additions (described below) are 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 three high-ticket borrowers, namely Bhushan Steel, REI Agro and HDIL, exposing about 3% of its INR 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 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 was 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, J&K Bank was a great investment opportunity. We think that the market is overly penalizing the company for temporary problems. As performance improves we’ll quickly see a re-rating. Opportunities to re-build the infrastructure in flood affected areas will likely act as a catalyst. Another, not so small, bonus is the bank’s 5% stake in Metlife that it’s actively looking to sell. 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 current 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 (the stock price growth is another story). The company 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.


Sincerely,


Rahul Bhatia Aniket Khera