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Q2 2018 Letter

We are suffering our biggest drawdown yet, and broadly, there are three sources of this misery, a) our mistakes, b) re-rating of small and midcap companies, and c) depreciation in the Indian Rupee.

In our estimation, one-third of the loss is simply our own doing. We are in the business of buying great companies. We sometimes compromise and buy merely good companies, only if they trade at low enough price. We are obviously not in the business of buying bad companies- regardless of the price. Unfortunately, some of our recent purchases turned out to be just that.

Four positions, Idea Cellular, Suzlon, IL&FS Transport, and Lasa Supergenerics, fall into this category. All four operate in large markets. All four were going through turmoil when we bought them. In each case, our bet was that price was too low and the turmoil was temporary. In every case we were proven wrong. As the fundamentals deteriorated we had no choice but to close our positions.

Idea, until recently was India’s 3rd largest mobile operator. It’s now a piñata. The bloody battle for subscribers, started by Reliance Jio, has led to EBITDA losses for every single operator, including Idea. Revenue per user, which was already obscenely low at ~ $2/Month, has quickly dropped to about the lowest in the world, despite data usage per sub growing more than 10x. CapEx spends remained unabated, lest the incumbents lose even more subs. Debt balances have ballooned.

We believed this was unsustainable - eventually the industry would consolidate, pricing would improve, and Idea would remain one of the last guys standing. We were right, but only partially. Idea and Vodafone India are merging to create India’s largest mobile operator. The industry has gone from a dozen players to three. However, the pricing has only become progressively worse. It will take immense amount of luck and management skill to remedy the situation. We can’t rely on the former and are not seeing much of the later.

IL&FS and Suzlon both have one ultimate customer, the Indian government. The customer is extremely price sensitive. Financially, the customer is not doing particularly well. And the customer is about to battle for its survival in 2019. So, the businesses face immense revenue pressure. The companies are levered – it’s the nature of these businesses, which makes them tenuous. Once again, both require some serious management skill to weather the storm.

Lasa is a manufacturer of medicines for animals. This business was recently spun out of a father-son-controlled chemicals company. Father kept the chemicals business and son got the fast-growing animal health subsidiary. The industry has excellent economics, and the son, who is now running Lasa had grown this little subsidiary 10x in last five years. We had high expectations from this company. It turned out to be an utter disappointment, not because of business impairment, but due to corporate-governance shenanigans by the father-son combo. We can sometimes stay invested in businesses doing poorly, but it’s impossible to stay invested with managements behaving poorly. Our exit in this case was an ugly outcome but an easy decision.

Even though mistakes are a part of our business, we were surprised by how many simultaneous ones we had just made. Our post-mortem leads to believe that first, we got a bit too seduced by the low prices, and second, we underestimated the importance of management in each case. Lessons learnt.

Moving along, at least one third of our drawdown is due to the indiscriminate sell-off amongst the non-large-cap companies while the largest 5-6 companies make all-time highs. The dispersion has seldom been starker. Some of this is dispersion warranted. Corporate scams have recently been uncovered. A few dozen auditors have refused to sign on annual accounts. Credit has become tighter. Most of this is affecting smaller companies. However, there are 5,000 or so listed companies in India. Majority are viable enterprises. Less than 1% are represented in the SENSEX and NIFTY indices, and the largest ¼% make up half the index-weight.

We invest in businesses with little attention to their market caps. If the market suddenly fancies large companies over smaller ones, then great! It leads to irrational discounts, which leads to better future returns for us. There was one undesirable outcome of this dispersion, however - our market hedges were all short the USD denominated India index. Since the index hardly budged, the hedges didn’t offset our drawdowns. We are working on putting better insurance contracts in place.

The final third of our drawdown is due to currency depreciation. As we have written repeatedly, we model an annual 5% drag due to currency. We can hedge INR, but that makes little sense given the cost of hedging runs close to 5%. In some years, like 2017, INR rallies, and we save the hedging cost. In some years, like 2018, INR sells off. If it sells off more than 5% then the case for hedging looks compelling, though only in hindsight. We don't worry about this, and don't want you to worry about this either. It’s our endeavor to generate returns large enough to compensate for such noise.

In closing, although we cannot guarantee the magnitude of future returns, future mistakes, or future drawdowns, we can absolutely guarantee two things, 1) we will keep improving our process, and 2) a large percentage of our and our family’s wealth will always be invested alongside you. We continue to believe that India will remain a stock picker’s market for years to come. It will also remain volatile. We intend to use both these features to their fullest extent.


Rahul Bhatia

Aniket Khera


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