Please find below our key excerpts from a investor memo published by Solidarity Investment managers. This memo focused on how to allocate capital between portfolio stocks and how to start exiting core positions once they have become big portions of portfolios. (Emphasis Ours)
- “Don’t time the market” does not mean buy at any price.
- Equities are long duration assets. So one must invest in them keeping long time horizons.
- Governments all over the world, including India, are becoming more protectionist. Implications for global supply chain models relying principally on a cost edge. As a corollary, they will create opportunities for import substitution.
- While we may scratch our heads with bemusement at their valuations and cash burn, we can’t ignore the fact that they are well funded and will attack incumbent’s market share, margins and ability to attract talent.
- Rising formalisation of the economy and consolidation across industries. The big are getting bigger. Odds increasingly stacked against small players unless they dominate niches.
- The world is getting increasingly worried by China’s growing dominance and its narrowing technology/innovation gap with the West, while global supply chains remain deeply reliant on China.
- There is a vast opportunity for Indian companies to gain global market share in knowledge intensive sectors such as Specialty Chemicals, Technical Textiles and Auto Components.
- Banks enjoy natural tail winds by serving a growing economy’s need for Credit. Well run Banks are strengthening their market share of incremental low cost deposits and credit even as they remain well capitalised. Credit market share and fee incomes will be under attack by Fin Tech business models3 . However, trust and a low cost deposit base is at the heart of competitive advantage in Banking – both take enormous time to build. Additionally, India has always had a very conservative approach to regulation and with recent bank collapses that is unlikely to change. There is additionally more demand on regulation for large tech companies. Hence, our hypothesis is that Fin Tech’s will more likely partner or get acquired by Banks rather than disrupt them. Banks are also aggressively embracing Digital (eg Kotak 811 Digital bank account) which will enable them to reduce costs to counter margin pressure and hence continue to grow while maintaining ROEs in the range of 15-18%. However, we are adjusting for these risks by gradually lowering the valuation multiple one is willing to ascribe.
- Under ownership of Term Insurance, greater awareness for the need to protect families, need for retirement products, “S” curve demand effects, low share of protection in current product mix, strong moats in brands and distribution presents a 15-20%+ annualised growth opportunity for over a decade for leading companies. Regulatory moats, long duration contracts where trust in the brand is paramount, means Fin Techs will find this domain harder to challenge than General Insurance.
- The US plan to borrow and spend is unprecedented and nothing has been done at this scale since World War 2. Rising inequality is becoming a greater challenge and the US Govt is prepared to challenge traditional thought process on money printing and risk higher inflation down the road to address a pressing problem today. This stimulus will also support growth indirectly in other parts of the world through trade linkages.
- India has also embarked on a more expansive economic policy and is willing to bear higher fiscal deficits to boost growth by stepping up investments in Infrastructure.
- Valuations in the US market (Blue line) are as high as they have ever been, other than the Dotcom Boom of 2000, even when the pandemic is far from over.
- Head line Index valuations in India are also very high at present vs history but not in dangerous territory. Valuations need to be interpreted in the context of lower bond yields, easy monetary conditions and expectations of rapid EPS growth over next few years. However, markets are a bit ahead of Earnings at present and a time correction will be healthy.
- On the one hand, massive monetary stimulation since 2008, and the monetisation of deficits policy of Japan has not resulted in inflation as was widely feared. On the other, inflation is an outcome of higher demand chasing a finite supply of goods/services and the scale of stimulus being provided to a recovering US economy “risks inflationary pressures one has not seen in a generation”.
- A steep rise in interest rates and inflation will certainly be negative for Equities. However, a gradual rise need not be negative as rise in interest rates can also reflect stronger growth. Fair value is a function of growth and cost of capital.
- Returns in equities are non-linear and one can witness sharp draw-downs any time. The draw-downs should not matter if one believes that the portfolios could be significantly higher at the end of 5 years compared to today.
- Cash calls – ostensibly to manage risk – actually only serve to provide emotional relief and to convince oneself that one has “done something”. However, if one has bought resilient companies, short term relief dents longer term returns as one gets re-entry wrong. Ironically, it takes more effort to not do anything but just wait out the storm.
- One should manage risks through Asset Allocation and buying companies with resilience, not through cash calls.
- Long term Bonds offer very poor prospects relative even to inflation both due to low yields and negative impact on principal as interest rates rise. Equities can do even better if earnings growth rates surprise.
- One needs to beware investing in “quality” companies that are relative more mature on the industry life cycle, yet trade at very high valuation multiples. It is tempting to invest in these companies because they have done well over last few years. When things are good, we forget that almost everything in life is cyclical and what seems comfortable is seldom lucrative. Many such companies have benefitted from significant PE re-rating over the last few years unsupported by change in their fundamental attractiveness due to higher trend growth rates or higher ROCEs. Our hypothesis is that their PE re-rating has been influenced by low bond yields and earnings drought in the broader market, both of which should reverse in the next few years.
- We should be prepared for low probability, but very damaging outcomes.
- If we have very high inflation, that will be negative for Equities. The best protection against inflation is buying well run companies with pricing power. However, even a good business has limits to pricing power. One can plan for very high inflation by diversifying and gradually increasing exposure to hard assets. Gold should do very well in periods of negative real interest rates (very high inflation or if Govt’s practice “yield curve control” to keep interest rates low).
- What is scarce is valuable.
- Fair value is a function of these multiple variables (future earnings, cost of capital, ROCE, terminal value) and hence we believe fair value should be a range rather than a point estimate.
- Well run companies tend to trade at or above fair valuations. Hence, one needs to be balance not over paying with missing out completely by waiting for lower prices.
- One should also not hold a position size wherein one cannot correct errors due to lack of liquidity.
- We organise our portfolio in different buckets based on franchise track record, stock liquidity, debt burden, binary risks that could play out (for example customer concentration). For each position of interest, we define the growth narrative and model estimated IRRs over the rolling 5 year period based on a range of earnings growth we believe the franchise can deliver and what its fair value should be at the end of 5 years. The valuation exercise is done based on first principles (trend growth rates, ROE and our estimate of terminal value) and understanding historical bands based on wisdom of crowds. Some premium is added for market darlings, where companies have significant option value, and if the industry is on the early stage of the growth cycle.
- IRR asks vary based on quality/maturity of franchise and position size increases with confidence.
- For example, for Clear Leader franchises like Divi’s Labs/Kotak Bank, we will take an initial position at an estimated IRR of ~15%.
- However, for an Emerging Leader with low liquidity and customer concentration risk like Shaily Engineering, our IRR ask would be higher at ~18-22%.
- Every position must move the needle; hence an initial position would rarely be less than 3%.
- For a debt free Clear Leader like Divi’s Labs, we could go as high as 15% if entry prices were enabling 5 year IRRs in excess of 30%
- However, for well run, leveraged entities like a Kotak Bank, we would cap the position at 10% irrespective of what upside we model.
- If a franchise carries risks with binary outcomes, eg excessive customer concentration risk (Shaily Engg.) or risk of regulatory intervention (Alcohol), we would cap the weight at 5%.
- Comparing outcomes with estimates provides a feedback loop for introspection on errors and better decision making in future.
- “Better is possible. It does not take genius. It takes diligence. It takes moral clarity. It takes ingenuity. And above all, it takes a willingness to try.”
- Formalisation of the economy is a secular and structural theme. And amongst the key beneficiaries of this theme will be manpower outsourcing companies eg Team Lease. We had stayed away from this business model because very low margin (EBITDA margin of 2%) left no room for error.
- While these businesses have low barriers to entry, the low margin is a significant barrier to scaling. And if Working Capital can be tightly managed, the Free Cash Flow conversion is very high.
- Risk is what remains when you have thought of everything that can go wrong12. In hindsight, we should not have carried such a high position weight in a leveraged business which is always vulnerable to macro shocks.
- We have recalibrated our stance on trimming due to valuation concerns in business models which have prospects of high longevity for growth, ROCE expansion and which are early in the growth cycle. Most businesses tend to commoditise over time and hence one has to be wary of very high multiples – “mean reversion” to fair value is a truism in markets.
- Hence, we believed in the discipline of trimming when valuations get euphoric. However, valuation multiples based on short term earnings and historical valuation bands can be misleading when the probability of non-linear PAT growth is high.
- We looked at trailing valuations and the sharp price increase while overlooking that the theme was under owned and the multiyear growth narrative was just starting to be widely adopted.
- Hence, Gross Margins can grow exponentially both from higher value add and lower RM Costs while Fixed Asset productivity will increase over time from larger scale runs and as life of the plant is higher than time horizons over which a plant is depreciated.
- One can exit a position too early because of concerns on valuation because one underestimates longevity of growth and future ROCE. We need to think about companies with prospects of nonlinear growth/higher longevity differently and allow a longer rope on valuations. A strong narrative is a powerful driver of stock prices and mean reversion of valuations does not happen early in the cycle. However, these need to be rare exceptions as else one risks losing discipline on valuations.
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