Magic Basket

The Magic Basket aims at capturing earnings growth and valuation rerating. Investing into companies through a catalytic/ change oriented approach.

 

While the literal meaning of Magic is having supernatural power/qualities, however, in the Carnelian investing world, Magic moments are change/catalysts in the life of a company - when the company gets into a new growth trajectory, but not recognized by Mr. Market. Mr. Market starts recognizing them as the change unfolds over a period of time, leading to a valuation re-rating, thereby creating a significant wealth generation opportunity (a twin effect of growth and re-rating).

The catalyst can be either one of or a combination of change of management”, “change of industry/business structure”, “change of business strategy”, “new business product or segment” or “simply long investment phase getting over”.

Through our decades of investing experience, we have found that post such an event, companies usually deliver superior returns over a long period of time. Of course, one has to put in lot of hard work to get it right if these catalysts are well placed.

 

During our study we found that successful magic events, have created significant wealth by the combined effect of earnings compounding and valuation rerating. We have deep dived universe of 250 companies to back test our magic hypothesis and found that average returns generated 14% CAGR during preceding 5 years (prior to magic event) vs 63% CAGR for the following 5 years (post magic event). Even after adjusting for the failed cases where the magic event didn’t play out, this number goes down to 56%. Of course, one would not be able to capture all the opportunities all the time and there could be some survivor bias, but this framework helps in capturing great opportunities.

 

The data below illustrates Returns for pre-magic /post-magic period

Let’s study the case of TCS. TCS went public in 2005 and was growing for more than 3 decades as an unlisted enterprise.  It grew well under the visionary leadership of Mr. Ramadorai. However, when Mr. N Chandra took over as CEO, he restructured the company into 21 business verticals and outlined a strategy to grow at a faster pace, to create India’s largest IT service company. TCS delivered a negative return of 6% between 2005-2009, In the following 5 years, TCS’s profitability grew from Rs 5,300 Crs in FY2009 to 19,300 Crs in FY2014 and in the same period the market cap grew almost 8x. Price to Earnings (PE) ratio expanded from 10 times to 22 times. This is the classic example of how multiplier effect plays when both earnings growth and valuation expansion kicks in.

There are many such case studies. Another interesting case study regarding change in the Industry structure is that of Aarti Industries ltd (ARTO IN).

 

Somewhere between 2012-13, few years after Global Financial Crisis (GFC) in 2008-09, China started rebalancing its economy on a slow pace by making environmental regulations more stringent and pushing labor costs higher. This impacted a few industries in China and across the Globe. India’s chemical industry has always been at the mercy of Chinese counter parts and its policies.  This impacted Indian chemical industry favorably. Not only companies like Aarti Industries who were already very well placed globally were benefited, but entire set of companies like SRF, Navin Fluorochemicals, Atul, Vinati Organics and many more were beneficiaries of this move.

 

Aarti industries profitability grew from 90 Crs in FY12, 133 Crs in FY13 to 504 Crs in FY19. PE ratio in the same period increased from 5x times to 27x, resulting into market cap multiplying by almost 25x. This does not happen overnight. It happens in a gradual manner as more and more players start believing in the theme, growth and potential.

Similar story is true for the entire chemical industry.

History teaches us that no company is always great, no company always remains great. There are cycles in every company’s and every human’s life. Companies go through many changes, internally or externally, which ends up creating “Magic moments” even in the lifetime of companies with already good businesses. Our criterion of good business continues to remain the starting point. If one can rightly identify the catalytical moments, what we call “Magic moments” in the life cycle of a company or business, one can create significant wealth. Under the Magic Basket, our attempt is to constantly find such companies.

 

We will invest 50% - 60% of our portfolio in this Basket.

 

Compounder Basket

The Compounder Basket aims at capturing earnings growth over a long period of time. Many companies having created a significant moat around their businesses, managed by exceptionally talented managers, delivers a superior stable return over long period of time. (MRFG - a combination of Moat, High Return On Equity, Free Cash Flows, Growth & Governance profile). Such companies are usually well discovered, well owned and usually on the higher end of the valuation range. They are richly valued and remain so as long as MRFG characteristics are intact.

 

Often, companies have migrated or are migrating to this basket from the Magic Basket. For e.g. Pidilite Industries, PI Industries, Aarti Industries, etc. Aarti industries as we discussed above was once a Magic story and became compounder in 2018-19 period. Usually, we think it’s a period of 4-5 years of re-rating journey. Reason why such companies do well during Magic period is that they are acquiring MRFG characteristics. Once they have created scale and success, it creates a snowball impact, adds more moat to their position and they continue to deliver for long period of time. Post that, re-rating possibility might be limited, but earnings growth can be captured in the returns (usually 15-20%). For example, TCS still generated 15% CAGR return post Magic period, which is a good return for a company of that size given limited risk.

 

These companies entering this basket can remain here for a long period of time until they start losing their MRFG characteristics either due to internal reasons (complacency, hubris or greed) or external reasons (technology disruption, competition, industry growth).

 

Outperformance of Compounder Portfolio over BSE 200: it out-performed in every year

 

Opportunistic Basket

Aims at capturing short-term opportunities offered by markets from time to time  

 

This basket is an opportunistic way of capturing opportunities market offers from time to time on a short-term basis (3-12 months) and may not meet all the conditions of the first two baskets to hold for long term but we have a high conviction around the risk reward it offers. This could also include special situations including IPO/merger/demerger/delisting, etc where we think ~18-20% return can be made in 3-12 months’ time. Markets tend to offer such opportunities very often.  This is an optional basket and if there are no opportunities, we will not invest.

We will deploy 0-10% of our portfolio in this Basket. 

The picture below explains it in a Nutshell

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