Please find below our key excerpts from a investor memo published by Solidarity Investment managers on Among many things that we found brilliant in this memo - the key highlight was the "exit decision" process explained in the memo which highlighted various methods to take a "sell" decision in a stock. (Emphasis Ours)
- NIFTY performance is not representative of the economy. The Banking Index is the closest proxy to the economy and is down ~28% from 1 February 2020, reflecting the pain.
- One should be realistic on future return expectations. A 12-15% compounded IRR over 5 years from here may be a satisfactory outcome when similar duration FDs offer -5.5% pre-tax. This assumes gradual increase in interest rates over time which will result in head winds to valuation multiples.
- We recommend evaluating performance over rolling 5-year periods as that time horizon separates good process from luck. We believe 3% outperformance over benchmarks, post fees, is a good outcome. Fund management is not only about upside gains but how well one can protect the downside.
- Broader equity markets are doing well with the NIFTY/NIFTY 500 almost at pre Covid-19 levels while the economy is expected to contract by ~ 10% this year. Are the markets disconnected from the performance of the economy?
- Indicator:
- Movement of goods
- Steel Consumption
- Insurance Premiums
- New Vehicle Registrations
- New property registrations
- Electricity consumption
- GST collections
- PMI Index
- The NIFTY composition does not mirror the economy and hence is a misleading proxy. The only Index that can serve as a proxy to the economy is the Banking index as Banks are a direct play on the performance of the economy.
- While markets may be a bit ahead of themselves, there is no mass hysteria.
- A very small number of companies are driving the market. Reliance alone accounts for ~50% of NIFTY gains since 1 April 2020.
- Decadal low interest rates in India and liquidity infused by global central banks’ are also supporting valuations. Interest rates are inversely related to fair valuations as they influence discounting rates (lower cost of capital) as well as relative attractiveness of equities vs bonds4 (flows).
- Select pockets of euphoria co-exist with opportunity
- We do see some sign of euphoric valuations in select pockets (e.g. Specialty Chemicals, Digital). Specialty Chemical companies have favourable tail winds at present. Many of them have gained ~100% from February. While opportunities for them are real, they are 20-25% ROE businesses and still have to execute on their promise. However, some of them are now trading closer to Consumer valuations.
- However, there are also very compelling opportunities at present in themes such as Leading Financials, Telecom, and in some companies in manufacturing. For example, HDFC Limited, a blue chip, is trading ~30% below pre-Covid levels and is at close to decadal low valuations despite strong possibility for growth coupled with ROE expansion over the next 5 years.
- Consumption accounts for over 60% of the Indian economy. There may be a psychological impact of the crisis on job security and hence consumer spending may be tepid till confidence returns.
- We make 4 types of “sell” decisions
a) When we have made a mistake, or facts change and the thesis is no longer valid.
b) When we act purely from a risk management perspective.
c) When companies in “Special Situations” reach their price target.
- The tricky decision is when companies in our core bucket (“Clear and Emerging Leaders”) have good growth prospects, are performing well but are trading at euphoric valuations.
- While there are a lot of books written on buying right, conventional investment wisdom does not offer clear guidance when it comes to selling. While many fund managers claim that their “biggest mistakes are selling winners too early”, this view suffers from “survivorship bias” of winners. We believe lessons from history – to glean learnings on what can be a good process - should be examined at a portfolio level - and not an individual company level to separate good process from luck.
- A few examples below highlight the survivorship bias mentioned above. For example, measured over last 5 years:
- Investors who held on to some good but richly valued businesses like Blue Dart, Page Industries, Eicher Motors, Cera or Symphony when valuations were euphoric would be nursing very sub-par returns.
- However, those who stayed invested in Bajaj Finance made significant returns.
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- Portfolio choices need to be aligned with investor time horizons. An investment should justify its place in the portfolio based on return prospects over every incremental 5- year periods. Someone taking a decadal perspective may act differently and not be wrong.
- The future is probabilistic. Every business is exposed to random events outside its control. Hence, the concept of “margin of safety” should apply not just during entry but at all times.
- A sound investing approach will also take into account human behaviour. It is very hard to hold on to an investment when confronted with large draw downs, especially when managing other’s savings. Theory often does not work while confronting real world situations.
- We need to recognize the role of cycles in portfolio actions. Capital tends to chase a sector with earnings momentum. That results in valuation excesses till a trigger point causes stock prices to correct dramatically. This cycle is illustrated below with what happened in the Pharma sector between 2012- 2020. The same story played out in NBFCs (2015-2018). Hence, we believe it is appropriate to gradually reduce positions when valuations are euphoric.
- Our process for exit (and entry) decisions is as follows:
- We estimate a range of stock price IRRs over a rolling 5-year basis based on what rate we think earnings/cash flow/book value can broadly grow, and what fair range of multiples a stock should trade at the end of 5 years.
- We determine fair value multiples based on first principles(growth, longevity, ROE). We make some adjustments based on long term valuation bands (wisdom of crowds) and if we believe a stock deserves a premium due to a justified halo effect (quality of governance, past execution record).
- When rolling 5-year IRRs start dropping below our thresholds in bull case scenarios and the position weight is very high, we start to trim the position. We will trim more aggressively in “Emerging Leaders” (as liquidity evaporates during a crisis) and more gradually in “Clear Leaders”.
- The challenge in this approach is determining what defines “euphoric” valuations when a sector has earnings momentum. The argument can become circular because fair valuations are a function of growth and its longevity (terminal value), which are always an estimate.
- In certain sectors like Banking, this is not very difficult to answer as companies have stayed within historical valuation bands and growth rates/ROEs tend to remain range bound. Similarly, in manufacturing, growth is unlikely to surprise significantly because capacity acts as a constraint on growth.
- However, in sectors like Digital, longevity of growth is hard to estimate. Digital tends to be high free cash flow, has no capacity constraints and is “winner takes all” with leaders often having very dominant market share. This means companies have enormous pricing power and hence Earnings growth can significantly surprise on the upside through both volume growth and margins. For example, India Mart has an EBITDA margin of ~26% while Info Edge’s Naukri division is at ~56%. The ability to use free cash flow to enter adjacencies means one could be very conservative in assumption of terminal value. Info Edge has used the cash flow from Naukri to build new verticals in Real Estate, Matrimonial services and also via significant minority stakes in business models of the future like Zomato and Policy Bazaar. One could not have forecast all the above if one was modelling Info Edge a decade ago. Hence, there is always some judgement based on qualitative aspects.
- Why trim and not sell out of a position completely?
- The market has moods of euphoria and despair. Just because a stock is expensive, it does not mean it will correct tomorrow. Stock prices can remain elevated for significant periods as long as the earnings momentum lasts. Selling too early could leave significant gains on the table.
- The table below illustrates how stock prices can continue to rally ~200-300% from expensive to euphoric valuations before they eventually correct.
- By gradually trimming over time, one also has the ability to re-examine assumptions as good companies can surprise on the upside. For example, Divi’s Labs delivered 50% PAT growth in Q1 of this year which was significantly above our estimates. Hence, one has an opportunity to recalibrate assumptions.
- Why not stay invested and exit at first sign of disappointment?
- While theoretically elegant, practically this approach does not work. Firstly, one cannot conclude, for sure, whether the earnings disappointment is temporary based on macro events, competitive behaviour or reflects a more fundamental challenge to the business.
- Participants with a short-term outlook sell aggressively at the first sign of earnings disappointment and stock prices can correct deeply – often on lower circuit- because this is the precise moment when liquidity becomes very thin because everyone rushes to the exit at the same time. And when stock prices have corrected 30-40%, the disappointment seems to be in the price and it makes no sense to exit if valuations have come in favour.
- Our approach will never maximize gains on one position and will cause some regret of premature exit. However, when acted on methodically, it will provide a good balance of returns with downside protection at a portfolio level.
- A mature mind should be able to operate with two opposing constructs.
- Partners are aware that Solidarity believes that the principal edge of any Bank lies in its cost of deposits as that determines the level of credit risk it needs to take. Kotak’s cost of funds17 has reduced significantly over the years and is now almost at parity with HDFC and ICICI Bank. This will allow them to enter competitive segments such as mortgages and its much lower asset base may allow faster growth vs the leaders. Kotak is also available at 5-year low valuation multiples (Consolidated Price/Book).
- While Divi’s is a great company with strong track record on growth execution, it also has very high key man risk.
- Banks do not disclose their exact cost of funds. We have calculated this based on average interest-bearing liabilities (Deposits, borrowings, Perpetual, sub debt and tier 2 bonds). The exact cost of funds number may differ a bit from the numbers above. Our point is to illustrate the narrowing gap.
- Compounding works its magic only over long periods of time. Hence, one should not break the process of compounding unnecessarily.
- “The history of the stock market is that it goes up a lot in the long run but falls often in the short run. The falls are painful, but the gains are amazing. Put up with one and you get the other. Yet a large portion of the investing industry is devoted to avoiding the falls. They forecast when the next 10% or 20% decline will come and sell in anticipation. They’re wrong virtually every time. But they appeal to investors because asking people to just accept the temporary pain of losing 10% or 20% – maybe more once a decade – is unbearable. The majority of investors I know will tell you that you will perform better over time if you simply endure the pain of declines rather than try to avoid them. Still, they try to avoid them. The upside when you simply accept and endure the pain is that future declines don’t hurt as bad. You realize it’s just part of the game".
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