In our last communication on 5 May, we had shared that we need to be realistic in return expectations as monetary policy is reversing which will have an impact on multiples.  We are seeing this play out as the market reprices risk.  There is a higher probability vs the last few months that inflation will stay elevated and that developed world Central Banks will need to raise rates aggressively and that could push their economies into recession. 

Hence, the narrative on growth and Cost of Capital has changed significant over the last few months.   In our Q1 FY 21 Letter (written about 2 years ago) we had explained how change in narratives and change in interest rates impact fair valuations.  Please see Pages 7-9 if you would like to read in more depth.

Our preferred way to navigate the current environment is

1. To have realistic expectations (keeping in mind the changing macro) and
2. Wait out the storm rather than take cash calls. 
3. Act to buy, when prices come in favour while appreciating they could decline even further as one can never estimate the bottom.

Draw-downs are never pleasant, but are inescapable.  Cash calls provide emotive relief but inevitably one realizes after a period of time that one would have been better staying invested.  We have learnt this the hard way.  Hence, over 97% of the portfolio today  is in companies that would not make us panic even if prices fell 30% so we can average down with confidence.  (Note, Solara was a mistake at our end which we will write about in depth including what we have learnt from this experience).

Many partners worry about draw downs.  I empathize with that very rational concern.  However, we must understand trade-offs.  If we pack the portfolio with large caps (smaller draw-downs), we reduce the probability that we can create Alpha.  <15% of Large Cap MFs have outperformed the Index over the last 5 years (data as of 28 Feb 2022).   If we take large position sizes in Large caps, we are taking on another form of risk (arrogance).  Hence, we need to treat volatility as an opportunity and not something to be feared.  Unfortunately, finance theory uses volatility as a measure of risk – but that is a subject for another day. 

Hence, our portfolio is constructed to optimize “stability” (lower draw down names) and opportunities for “higher returns” (these names are often higher volatility)

1. Our largest positions with weights of between 7-10% are in Large Caps: ICICI Bank, HDFC Bank, Bharti Airtel, SBI Life, Syngene.  These are companies which will provide stability to the portfolio but are unlikely to have speed.  They are well discovered and we have no unique variance perception vs the market on them. 
2. We have large weights of 5-6% in many Emerging Leaders: India Mart, Team Lease, Mayur Uniquoters.  These are primarily debt free companies which generate free cash flow and dominate niche segments.  Some other names we own (Hester Bio, Privi Spec Chem) have debt due to Cap ex programs under way.
3. We have small weights of 3-4% in Emerging Leaders which are a bit illiquid, eg Shaily Engineering, RACL Gear Tech.  These too dominate niches but lack of liquidity means they can be more volatile as panicked sellers dump but buyers don’t provide an easy exit.  Hence, we will never have large position sizes here as steep draw downs can be expected.
4. Very small weights of 2-3% in companies which are “Special Situations” where we don’t lose much if we are wrong, but can make over 3-4x if we are right. 

As expected, the Emerging Leaders are witnessing steep draw-downs at present.  This is a feature, not a bug.  These are the names that will provide Alpha if one has the equanimity to handle draw down and the conviction to buy more.  As long as the Earnings power is undiminished, these draw-downs are temporary.  Over 70% of valuation lies in Terminal value (Earnings power beyond 10-15 years) even as the market reacts to short term results.

I encourage you to keep at least 5 year time horizons and keep investing via small top ups.  We don’t know when the storm will pass.  But you can be secure in the knowledge that we are buying strong franchises and many of them are now available at very attractive prices and many names in our Watch List have now come into buying zone.