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Q2 2013 Letter

The biggest detractor to our performance is by far the Indian Rupee. If the “macro-pundits” are to be believed the Rupee is doomed. After all, the tapering signals from US Fed, policy inaction in India, election season, high current account deficit (CAD) etc. all point that way. Well, we are not so sure. We can think of several reasons why Rupee should be stronger. For instance gold, oil and several other commodities that make up most of our import bill, are getting cheaper. The government is approving infrastructure projects in the earnest ($2bln just this last month). CAD itself at 3.6% was much better than expected. However, our arguments only add to the din of expert nonsense you hear all over the financial media. We cannot predict the direction of Indian Rupee with any certainty and we don’t think the pundits can either. We are well aware of the macro factors that influence our performance but try not to base our decisions on things we cannot predict nor control.

As mentioned small and mid cap stocks make up most of our portfolio. This is direct result of the massive divergence between small and large cap valuations. Large marquee companies in sectors such as IT services and Consumer Packaged sectors are trading at all time high valuations. On the other hand several promising small and mid caps are available at throwaway prices. This cannot last indefinitely. Despite our small cap bias our performance so far has tracked the better performing large cap indices. We expect this trend to continue. Moreover, as the performance gap between the small and large companies closes we should benefit disproportionately. Most importantly, the operating performance of our portfolio companies remains strong. If this trend continues, as we expect it will, soon enough the market should catch up and reward us amply. Meanwhile, the short-term volatility we suffer seems like a fair price to pay for long run performance.

Our plan of attack going forward remains the same with the only difference being increased emphasis management capability. Large companies with monopoly like economics can be run by sub-par management and still achieve above par results. For most others, including the kinds we own currently, the management is what makes or breaks the business.

A good example of a recent investment based largely on valuation and management capability is Capital First Limited. CAPF is a medium sized specialty finance company that lends to individuals and small companies. These loans are secured against houses, land, gold, autos etc. The business is rather simple as in you borrow cheap and lend at highest possible rates while keeping your expenses low and making sure you’re not lending to deadbeats. CAPF until recently was a part of the Future Group, which is run by Kishore Biyani, a bona fide Indian rags-to-riches-to-not-so-riches story. Like many of his counterparts, Mr. Biyani overextended himself to finance his company’s explosive growth and then ran into problems as the economy slowed. In order to pay down his debts he recently sold some of his languishing non-core assets including Future Capital Holdings (now Capital First). In mid 2012 the majority ownership of CAPF was transferred to Warburg Pincus, a leading US Private Equity firm. Also, post transaction CAPF’s CEO V. Vaidyanathan aka Vaidy ended up owning 10% of the company. The new owners quickly infused $20mm in tier 1 capital, off-loaded problematic loans, cleaned house, changed the name of the company and put in place a plan to get the company back on track. As the management surgically executed the early stages of the plan we took notice. After doing our due diligence we bought the stock last quarter.

While there is nothing special about CAPF’s specialty finance business there were a two factors that made it a compelling investment. One was the low valuation that reflected CAPF’s tainted past rather than the present or the future. The new company looks nothing like the old one but the market doesn’t realize this yet. The second factor was the new ownership. Having a reputed private equity as a majority shareholder has some serious advantages for us. First off all, we can be absolutely certain of management integrity and corporate governance. Secondly, we know that our incentives are completely aligned with controlling shareholders. A private Equity company has only one goal: to sell their portfolio company at a profit. As Warburg runs, monitors, improves, promotes and ultimately sells its investment we stand to gain alongside them. Finally, the CEO has his fortune tied to the same goal and has a stellar track record of running big finance companies. We fully expect Warburg and Vaidy to succeed in their efforts. Not willing to leave anything to chance we made sure that we bought our stock at a lower price than Warburg did.

In conclusion, we admit that these are tough times for Indian markets and the Indian Rupee. However, over the last 20 years or so, or ever since India started on its liberalization drive, there have been countless such scary moments. More often than not such moments present excellent investment opportunities that require patient capital and good temperament. We hope we possess both but we’ll let time be the final arbiter. It will be our pleasure to discuss any part of this letter or other investment related issues with you in more detail so please reach out at will.

Sincerely yours,

Rahul Bhatia Aniket Khera


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