Following is a copy of memo shared with Stalwart’s clients during August 2017 –

Markets were rallying one way up since the start of 2017 and many began to believe there’s really nothing that can stop this rally amidst so much liquidity and no alternate opportunity for deployment.

Then happened the least expected regulation twist during the month of August which should have ideally effected just those 331 alleged “Shell” companies in whose stocks trading got suspended with immediate effect, but when it comes to markets the ‘cause and effect’ is complex and often goes beyond the obvious and even minor developments could spread into deadly contagion.

 

Some of our stocks too have corrected, however, these are merely mark-to-market changes as long as we have confidence in the underlying thesis. In fact, these corrections are healthy as it gives you an opportunity to add some of the stocks where your actual allocation might be below the suggested allocation.

Value or Momentum?

Some new clients have written to us that not many of the positions which were added during 2017 have delivered any meaningful return till date despite market rally. Through this memo, I will explain the thought process that has gone into adding incremental positions.

 

No doubt focusing only on the upside and following the momentum could have yielded more money in a market like this but that’s not what we do. We will not buy a commodity company just because the price of the commodity which it sells is going up hence it is expected to deliver a bumper quarter or year. We will not buy a fancied Housing Finance Company at five times book even if it is consistently growing at 50%; growing rapidly in lending business is easy, it is risk management and recovery which is difficult. We will not buy the hope story ‘The Complete Man’ is trying to sell given the checkered past of the group. We cannot ignore the downside and re-investment risks while deploying capital. We never have and never will, no matter what the opportunity cost of that is. We are okay looking like fools in the short term but as fiduciary of our clients’ hard-earned money, we will never take a risk which can lead to permanent loss of capital.

 

The market focuses too much on near-term triggers, the companies which are posting healthy quarterly results are getting further re-rated irrespective of existing overvaluation or other negatives.

  

Whereas companies, where there are no near-term triggers or which are posting lacklustre results, are being punished or ignored by markets which is why one can still manage to enter these at reasonable valuations, if not cheap. Some of the companies we added to portfolio this year fall in the similar bucket:

 

1. Company X’s key business segment with offshore operations is expected to show a substantial jump in performance led by recent capacity expansion during FY17 whereas new capacity in other segment is expected to get commercialized in FY19 until then volumes can stay flattish.
2. Company Y is operating its plant at ~90% utilization and until the new plant comes in, likely in FY19, there is no major jump expected in this segment’s revenue.

They may not yield any superior return in next one-quarter or one-year however if thesis plays out one could expect a steep jump in intrinsic value next year or year after that, giving us handsome returns over the entire holding period, with below average risks given the business and valuation comfort.

One could question isn’t it better to buy after a while when triggers are about to play out? Sure, for many people buying things at ‘Inflection Point’ and ‘Timing’ the market works but frankly we do not claim to have any timing skills rather the strategy continues to buy things when they are not the flavour of the day which helps us manage the risks better.

Many such positions added in 2014 and 2015 delivered in 2016 (new clients are suggested to read Initiating Coverage Reports of stocks under Hold & Exit list).

For a value investor, patience is the most important trait to be able to earn high returns over long-term. I assume being an investor associated with us, you subscribe to the value investing philosophy otherwise you are in the wrong place & could be disappointed.

Further, it is important to highlight not all our positions will play out as per thesis as investing is probabilistic and dynamic. But even if six out of 10 workout and as long as we don’t lose much in other four, the portfolio will end up generating more than satisfactory returns.

Out of those six, some could be outliers like Tasty Bite (7x in two years) boosting the overall returns further.

Ultimately what matters most is what is the portfolio return and not so much what each individual position is returning. To win a cricket game not all the players have to hit a century. On the other hand, we could still lose a match even with Virat Kohli hitting a century. For us winning the match (portfolio return) is more important than getting fixated on each player’s (individual stock) performance.

Many of our clients could be thinking our job is to manage returns, but to be honest, that’s not what we do. Our job instead is to manage risks; business selection, management quality assessment, corporate governance checks, valuation, position sizing, cap to sectoral exposure and avoiding fads all play a critical role in avoiding permanent loss of capital. That especially becomes challenging in a raging bull market as sometimes our portfolio would underperform the market. Some clients may not like it however we have no way to outperform the market in every period. We try to be consistent with our strategy which is buying well-run companies at or below their intrinsic value with an investment horizon of 3-5 years, and every strategy will have good times and bad times.

A strong risk management framework could appear as negative in a raging bull market as it leads to underperformance, however, it is only during market corrections one realizes the role it plays in helping us stay the course. If business selection and position sizing are done right, the relevant question during market correction would be a calm ‘What to add?’ rather than a panic ‘Where to book losses?’.

Our portfolio on invested capital has yielded north of 50% CAGR since the inception in 2014 which implies we have front-ended some gains. Going forward even if our portfolio generates 18-20% CAGR with a below average risk, we would consider it a satisfactory outcome. We strongly believe in the power of compounding and even if we could manage an average of ~20% returns across a complete cycle, the end number could be highly satisfying. Valuations across the board seem stretched and we believe ‘return of capital’ should be given more importance than ‘return on capital’ during such times.

It is understandable if some investors find ~20% returns as disappointing and rather aim for much higher returns, and in that case, our investing style would not be suitable for them.

We have highlighted our investing process and return expectation proactively on the website and make it a point to emphasize it in all communication be it through blog posts, video sessions, talks or one-to-one email exchange or calls. It is very important for us to be on the same page and have expectations which are in sync.

Another point worth highlighting is that these returns could be fairly lumpy. We can choose good companies and buy their stocks at an attractive price, however, Mr Market follows its own cycle based on sentiment and 100s of other things that move it every day. There could be a year with 60% return followed a year with nil or negative 30% return. Though we strongly believe that in the long run stock prices follow earnings trajectory and if our business selection is done right, we would end up achieving our stated goal over a 3-5 year cycle despite valuation swings in the interim.

We try to strike a balance when it comes to portfolio construction; typically, our portfolio would have 15-25 stocks, a strategy which is neither too diversified nor too concentrated. Position sizing varies between 3% to 10%; we typically start lower and add as thesis plays out. As a risk management practice we avoid going beyond 10%, however, we let winners ride and do not chop positions even if they rise beyond 10% due to outperformance except when it’s excessively high like we did in the case of Tasty Bite Eatables.

Currently, we have 12 stocks in Buy List and a new subscriber would be able to allocate 56% of his or her portfolio immediately, rest should be held in liquid mutual funds for now. Some new subscribers may have joined with an intention to immediately deploy all capital at once and could be disappointed learning half is to be now kept in liquid funds. It is important to mention that though our coverage universe is much wider, it is the valuation discomfort that is stopping us from having more positions in the buy list. Over time as we find opportunities there will be additions to Buy list, and also based on price or time correction some stocks may get upgraded from Hold to Buy. It is clearly a function of valuations and we cannot do much about it. We understand many times ‘fear of missing out’ is at play, however, markets never go up in one way… there are always opportunities for instance 2016 had two such opportunities – Jan-Feb and then Nov-Dec.

We know investors come to us looking for Stock Ideas, but please note that our suggestion to ‘sit on cash’ and wait for a better opportunity is also an ‘advice’.

Finally, it is imperative to again mention that we are full-time investors ourselves and not just ‘Advisors’. Our own capital is also being invested in same stocks as suggested to you; we make money when you do and we also suffer when our thesis goes wrong.

Best Wishes,
Jatin Khemani