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2016 Annual Letter

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. Since our inception, i.e. from Jan 2013, we have outperformed MSCI India USD index by 56.5% on a cumulative basis and 11.17% on annualized basis. Our 2016 performance, an excess of 30.53% over the index, will be hard for us to repeat.

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. A detailed write-up on our major positions follows.


Rahul Bhatia Aniket Khera


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