Stalwart PMS completed its first full year of operation in May 2024, this memo is intended to help our initial partners understand our risk mitigation strategy, assess the portfolio performance vs benchmark and the taxation vs MF.

In a roaring bull market like we witnessed last year, often the risk takes a back seat and all the attention goes to the returns. The stocks that rise the most are usually the ones carrying above-average risk by being either in cyclical businesses (capital goods), PSUs (railways, defense), being debt-heavy, or simply because at higher prices their valuation too has gone up making them riskier to buy/hold. As more money chases the same names, the momentum keeps taking them higher & higher.

Some funds are heavily loaded with such bull-market leaders and these funds tend to do the best in such times. Whereas the funds are underweight these would naturally struggle to even just keep up. As a fund, we follow an investment process that filters out most of the businesses mentioned above either due to the quality of the business or simply because their valuation has gone much above their intrinsic value.

As a new fund launched in mid-2023, it hasn’t been easy to deploy capital given markets have gone one way up, with no correction that was meaningful (>5%) or that lasted more than two days. The gradual deployment meant cash drag (holding idle cash) while having a significant allocation to BFSI (Banking, Financial Services & Insurance), a rare sector still offering some value in this market, but currently in the consolidation phase.

In other words, we have tried to keep the risk profile of the PMS low by avoiding frothy/momentum/over-valued pockets which can reverse their gains in the blink of an eye, and rather invested more in value pockets and holding the rest as cash / pseudo cash (safe large caps) waiting for better opportunities.

Accordingly, we were prepared to make lesser returns given we have exposed the portfolio to significantly lesser risk.  But we are pleasantly surprised that Stalwart PMS could still generate ~40% net returns (after all fees & expenses) which is equal to returns generated by broader market/indices (BSE 500).

In the risk-return trade-off, if one could make the same return despite taking a lesser risk, it would be a desirable outcome. For example, if one could make a 20% return from HDFC Bank or a 20% return from a newly listed SME stock with a leveraged balance sheet, it would be a no-brainer to choose HDFC Bank. Why? Because for the same 20% return the downside risk is materially low in HDFC Bank’s stock even in a bear market versus the SME which can lose 90% of its value or the business could go bankrupt in one bad cycle leading to even its delisting from Stock Exchange.

It is not feasible to prove that we took less risk as the same is not quantifiable; the risk lies beneath and becomes obvious only once it has played out. It could probably take a few years for this market cycle to play out. Only once the eventual time correction or the drawdowns or the permanent loss of capital has played out, would we truly understand the risks that were there in the business models or the valuations.

We consider ourselves to be in the profession of managing risks and not returns. We are not chasing returns. We will continue to focus on avoiding major risks/pitfalls and accepting returns that come as a byproduct of undertaking this exercise of prudent risk management.

Benchmarking with BSE 500

BSE 500 TRI, which is the benchmark for Stalwart PMS, or markets in the aggregate, has generated ~12% CAGR returns in the long-run (10/20/30 years). Our ambition under Stalwart PMS is to generate 15-18% net returns (after all expenses & fees), on a 5-year rolling basis.

Why 5 years? That’s because investing outcomes are driven by a combination of both skill & luck. In shorter time frames, it is more of luck and less of skill, whereas as the time horizon increases the role of luck diminishes and the role of skill increases. We believe a 5-year rolling basis is a decent period for a market cycle to play out as well as to show the drivers of performance in terms of skill (over luck).

To have this outperformance, we have to position our portfolio differently than the benchmark. We try to do that by investing only in our 20 best ideas versus 500 of the market. Some of these 20 businesses are not even part of the BSE 500. Since the constituents of PMS & BSE 500 are so varied, the short-term results too can vary dramatically. In other words, in any given year the index could be up 10% while PMS could be down 10%.

As stated above, the ambition of 3-5% outperformance over the index is on a 5-year rolling basis, which means in shorter time frames of 1-2 years, the underperformance, if any, would have to be embraced. 1 or 2 years don’t mean much – the index could be up because commodities or PSUs or some specific themes are having a massive rally, whereas we might have completely avoided them (on purpose) due to our investment process. In such a phase, PMS performance would naturally lag behind the index. However, as the underlying thesis of investee companies in PMS plays out over 3-5 years the PMS performance could catch up while the cycle could turn negative for existing momentum themes erasing gains for the index, and reversing the performance gap with PMS.

Then why do we compare Stalwart PMS to BSE 500 TRI? Is there some trick or hidden agenda behind choosing this?

No! that’s not our choice. We have a benchmark as it is a regulatory requirement, otherwise we are not guided by it. It is for the same regulatory reasons that we must send a monthly comparison of Stalwart PMS with this benchmark. It is then natural for our investors to look at those comparisons and wonder/question why are PMS returns divergent from the index, if at all.

The intent behind this memo and repeating the same in every letter is to educate and align our investor partners to ignore the comparison. The day we start obsessing with divergence from the index on a monthly/quarterly/yearly basis and try to avoid it, we will start becoming like the index making it impossible to outperform it – after all the same ingredients will lead to the same khichri. In such a case, it would have been better to invest in a low-cost index fund.

Most Fund Managers are scared of even short-term underperformance, hence they fail to outperform indices even over the long-term. A long-term horizon & temperament are our biggest edge – the ability to live through short-term underperformance, letting go of momentum / PSUs / high valuation / order-book driven madness / SMEs, and whatever else that doesn’t fit our well-thought-out framework. We just have to focus on our core – identifying well-run businesses, run by dependable promoters, buying them at sensible valuation, and letting them sustainably compound over the long-run.

Taxation in PMS versus Index/Mutual Funds 

Gains from Equity investments enjoy one of the most favorable taxation in India – taxed at 12.5% for long-term capital gains (held over a year) and 20% for short-term capital gains (sold within a year). This compares favorably over interest earned from Fixed Deposit or our regular income which is taxed at 33% (highest slab).

The average holding period for us is typically 3-5 years, which implies most of our gains would be LTCG and be taxed at 12.5%. Some tactical bets or pseudo cash positions could be churned within a year leading to some STCG@20% too. However, the blended tax rate over the long term will be closer to the LTCG rate of 12.5%. This has to be paid by you as advance tax in the same quarter when we book gains. Referring to quarterly statements on email would help you stay compliant on this. 

How does that compare to an Index or Mutual Fund? Well, they enjoy a structural advantage in India – they can continue churning without paying any tax at their level. In other words, a Mutual Fund can buy and sell stocks without any tax implications at the fund or investor level at that time. This often creates a false impression in investor’s minds that gains from MF are tax-exempt which is not true. The investor would have to eventually pay all the capital gains tax at the time of redeeming their MF units. Should this create a big difference in returns between MF & PMS?

1. Since the tax on MF gains is only deferred and not exempted, the right way to account for the difference vs PMS is by considering the time value of money on taxes paid in advance in PMS vs later in Index/MF. This difference is not material (~1% cumulatively over a decade).
   
2. Further, the long-term capital gains tax in India is on the rise –
   • It was zero till 2018,
   • 10% thereafter and
   • Increased to 12.5% in 2024.
     
     In all probability & based on indications from the Finance Ministry, the trajectory is only higher, with a likely increase to 15-20% over time. Interestingly, there is no grandfathering here, implying it applies retrospectively to all investments made in the past. This could more than erase the slight benefit MF was having over PMS (explained in point number one).
     
3. It is without a doubt that Index/MF structure with deferred tax advantage is superior to PMS, and all things equal (including returns), it would make more sense. However, very few MFs in the long run have outperformed the benchmark. Their NAV is compared to the index on a daily basis and their size (AUM) has become too large to deviate much from the index leading to their inability to outperform. As long as we are able to achieve our stated goal of 3-5% CAGR outperformance in Stalwart PMS in every 5-year block, the excess returns (alpha) would more than justify this tiny advance tax disadvantage, if any.