Making the best of a fall: the strategy going forward

The month of June has been quite rough for the portfolio on the equity side. We've seen a deep cut in many stocks, and in this letter we'll look at a few reasons why we think this has happened, and what we're looking to do about it.

Like we've mentioned in our earlier letters, one factor has been about liquidity. As FIIs pull money out of Indian markets, the rupee has depreciated somewhat, to nearly 69. For some part, domestic investors invested to make up for it, but they have, overall, taken out more than Rs. 4,500 cr. in June. Even in the US markets, we have see money flowing out of emerging market funds - and China, Brazil and India see some of the money flowing out. The rupee fall hurts them - if you put in a dollar and buy a stock worth Rs. 60 then then at Rs. 69 to a dollar you will get less than a dollar back if the stock remains at the same level. The fear of more such damage causes selling pressure, and the selling pressure causes more damage. Rationality arrives a little late.

The more important thing was local regulation changes. SEBI has now nearly doubled margins in the Futures and Options segments, which means many brokers and players have increased requirements for traders and funds in the market. When you tell a participant they need to put down more money, they will usually sell some stocks and reduce positions, and also not be buyers of stocks as they need to conserve cash. This has some impact on stocks, especially the mid- and small-caps, by reducing the buying interest in them.

To a large extent, liquidity in the market has come down. Traded volumes for June have fallen and most of the stocks, even those in our portfolios, have seen very low volumes of trading.

A liquidity driven fall is good - because it provides opportunities to buy for the longer term, because of panic sales. But is it just liquidity? Time will tell, and we constantly scour the macro and micro bazaars to find out where risk may be hiding.

What about our stocks?

We've seen damage in a few stocks, like infrastructure based companies. Indian Hume Pipes is one of the biggest losers in the portfolio. Ours is a longer term view for this company which helps build water supply projects through government orders. The theme is of a need for more drinking water projects across the country, because with rapid urbanization we should see a rapid increase in the demand for piped water supply. This is indeed happening with their order book and profits growing over 25% a year over the medium term. Their order book remains at 3,000+ cr. and we think this company is very likely to show much better profit numbers in the coming years. A long term investment of this nature will be volatile.

In some of the other infra stocks we have - a road company, and a composite port/road play for India+Singapore, we also see the stocks getting beaten up substantially. The simple opportunity here is that a lower debt profile helps them get a lot more orders and execution than their debt-laden larger competitors, and indeed, KNR was one of them this last year.

Given that, the short term correction gives us an opportunity to add to them.

There's other losers in the portfolio. A JK Paper that's now at an earnings multiple of 7 has fallen substantially, but we think the fundamentals are very good here for a multi year perspective. They've bid for (and won) the bankrupt company Sirpur paper mills, at a relatively low price - this adds about 25% capacity to them and they'll put only Rs. 150 cr. in it (the rest is debt on the books of Sirpur, which will again be relatively less levered) and they will get about 25% more capacity. They've cut debt by 25%, seen profits increase as they rationalize costs, and are expanding capacity via both the acquisition and expanding into pulp+packaging in the next few years. They're very focussed on keeping debt costs low and look to repay half of the current debt in two years. The scale here is in packaging board - a segment we believe will do remarkably well in the next few years. You might be surprised by the amount of paperboard being used by the likes of Amazon or Flipkart when you order from them, and for reliable transportation this is still a better form of packaging than most plastic forms. Paper in general is a very big market in India with scale coming from the increasing need for paper in education and in regulatory measures like e-way bills and so on.

The point of highlighting these companies is not to justify their fall, but to look at the price fall in the context of potential growth. We can't hold companies regardless of price damage - but we believe that prices fall in the market due to different reasons, and some of these reasons needn't be related to long term fundamentals.

What's the strategy then? Keep buying?

Our first point is to control allocations. Most of you will be under 50% in equity at the moment - and we are regularly tweaking allocations to individual stocks - reducing some and increasing others, regularly. However, we don't sell needlessly in your portfolios - we just buy more of the stocks we like more, and less of those where we have reduced allocations. This involves selling some debt where necessary, and in other cases, where you are adding funds regularly we will use those to slowly build up the equity portion.

With our current control, we have ensured that no one has seen double digit falls in their overall portfolio so far. This is largely because we have an average 43% allocation to equity (some of you will be higher and some will be lower). This has saved us from further damage even though some stocks have fallen.

The second is to add more interesting stocks. We have recently added a Tata Chemicals and Hero Motocorp to the list, as we found their prices at more interesting levels. We will eventually have about 30 stocks in the portfolio, and could even increase it to more. The next few months are a good time for discovery. The idea here is to diversify enough so that a single stock won't hurt the portfolio too much.

We don't believe in concentrated portfolios per se. Our backtests show that concentration isn't a huge benefit for the longer term. But there's a caveat - the pareto principle applies, so in the future most of our returns will come from very few stocks. That's how portfolios are in general - even in the last 10 years, the Nifty 50 companies of 10 years ago saw 33 companies with sub-10% annualized returns since. But the remaining 17 companies have done so well that the return of the overall portfolio is staggering, with Maruti alone returning 10x. That is how any portfolio does, in the long term - some stocks will massively beat the others. But you won't know in advance which stocks will work and which will not. So we'll go to about 30-35 stocks and then bring the numbers back down as we see successful stocks.

We continue to invest in certain themes. We believe in the next few years there will be a revival of the niche IT Player - companies that focus on IOT, Automated cars, sensors, and such. This, coupled with rupee depreciation, should help them further.

Another theme is a peripheral play on electric vehicles. Apart from the IT folks, we have a battery recycling player (current lead-acid, looking at lithium). We have a Hero Motocorp which has some exposure to electric bikes, through an investment in Ather, which recently released a pricey but interesting electric scooter in Bangalore. We expect more in this theme going forward.

The third is tax management through harvesting losses. In the next quarter we will sell a few loss making stocks and buy some back, creating a loss that can be used to offset profits made in the selling of debt funds. This will reduce the tax impact for you going forward.

We also think that there is potentially more damage in stocks going forward. The midcap index is down 18% from the peaks in Jan, and we saw a drop of 21% for this in 2016, 24% in 2013 and 38% in 2011. Of course, at this point, some stocks are even worse that - even an Aditya Birla Capital, the listed arm that owns their lending, mutual fund and insurance businesses - was down 40% from it's peaks of 2018. Some individual stocks will do worse than portfolios overall, which is why we diversify.

The point is to build wealth over the long term - to protect us from extreme risk, we use the debt portfolio. We'll gradually be using this time to add to stocks, and to build a broader portfolio. We do expect that some stocks will be huge laggards, and if we believe there continues to be good growth prospects we may retain them. However, we will exit stories where the fundamentals have fallen apart, or if there are other issues with these companies that would hurt it, and reinvest in other stocks.

It's been an incredible time for things overall. For football watchers, it's almost astounding: Germany is out, Italy never qualified, and Brazil is looking like it doesn't even want to win. There will be no "CR7-Messi" final because both teams got knocked out on the same day - Portugal and Argentina won't play further in FIFA 2018. It's going to be fun to watch and find new favourites, even though we don't know how exactly to pronounce their names. In the markets too, exciting times lie ahead!

Here's to an inquisitive future,

Deepak Shenoy