Greetings from Team Carnelian!!
Wishing you and your family a very happy and healthy 2022!
The turn of the year is a good time for reflection of the year gone by…it offers insights, both good and bad. Also, a time to plan and build for the future. In this letter, we shall do both.
2021, with the backdrop of 2020, was another challenging year full of twists, turns and uncertainties.
A. What worked
1. We are extremely happy with the way the entire team at Carnelian stayed focussed and delivered another year of spectacular returns to our investors.
The most satisfying part for us was that we were able to generate significant outperformance by keeping Beta way lower than the index (Beta is one of the measures to assess risk undertaken to generate returns vs benchmark). It means we took less risk and delivered more returns while maintaining liquidity
Every success always reinforces faith as long as it is the result of a process and not out of adhocism. We are very glad to state that team stayed true to the processes.
The above outcome is the result of your trust and patience coupled with our investment philosophy backed by MCO and CLEAR framework.
2. Magic Basket: It is worth highlighting that our Magic Basket truly worked wonders for us. Magic Basket contributed significantly (~60-80%) to the outperformance. Stocks in the Magic Basket across strategies witnessed re-rating.
3. Non-Consensus calls: We were in minority while taking aggressive call on the IT & Manufacturing (China +1) theme way back in September 2020 and positioned our portfolio accordingly. This contributed very well to our performance this year.
Few of our non-consensus picks in the Magic Portfolio include LTTS, Mindtree, Max Financials, ICICI Securities, Praj Industries, KPR Mills, Mastek, Birlasoft, etc. which have generated multi fold returns for our investors.
All the names highlighted above carry impeccable governance track record, leverage free balance sheet and have cleared all the tests under our CLEAR and PIU framework.
Sector wise contribution
Compounder Strategy (Top 5 contributors)
Our picks within the IT sector have delivered 81% returns vs IT index 60% clearly showing that we could pick winners like Mindtree/LTTS/Birla Soft.
Our picks within the BFSI non-credit have delivered ~55% returns vs financial services benchmark of 14%.
Shift Strategy (Top 5 contributors)
Our picks within the IT sector have delivered ~98% returns vs 60% of the IT Index, clearly highlighting our ability to pick winners like Mastek/L&T Technology Services/Birlasoft.
B. The Misses (what didn’t work)
HFC, Auto and Auto Ancillaries
Despite our strong conviction on real estate, we missed creating alpha in Real estate/building material. We were a bit unlucky with our real estate names which had CEO exits, which made us exit the stocks. One thing we are very clear – whenever there is material change in our original investment hypothesis, we will not be afraid to book losses.
We also played the real estate sector through one of the leading HFC’s which owing to repeated lock downs and concern on asset quality has not performed. However, considering their conservative accounting and superior liability franchisee along with industry consolidation, we believe that this bet will eventually play out in 2022.
In Auto, we invested in players like Eicher motors, which are unlikely to get disrupted by the EV shift; however, owing to shortage of chips the stock has not created the desired alpha during 2022 despite of all growth ingredients in place.
We will learn from every learning and keep building our repertoire of experiences and knowledge. It is a continuous and never- ending learning process.
Now let’s look forward…
We have time and again outlined through our writings and seminars that India is in the middle of a structural bull run and is in one of its golden phases. This will lead to a massive wealth creation, though not without short term uncertainties and volatilities from some or the other quarters.
While 2021 was one of the best periods for global and Indian equity markets, the journey in 2022 is likely to face plenty of speed bumps. Few of the things one should watch out are:
New wave of Omicron virus spreading rapidly. One doesn’t know how long and what shape it will take.
Significant political events like UP elections ahead
High commodity prices, supply chain bottlenecks
Likely increase in global interest rates & tapering off of excess liquidity from the system
Valuation de-rating in cases where current rally is driven more by hope than facts
Disruption risk will certainly be more visible for select sectors resulting in terminal value risk
Huge Capital raise lined up in IPOs taking away liquidity from markets
There has been a stupendous rise in the prices of commodities across the board, logistical challenges, shortages etc. which has kind of taken the raw material prices and other costs through the roof – we believe this is not sustainable and industry players have already started taking price hikes. This may dampen the margins for 1-2 quarters; however, we believe margins will get normalized in the quarters to come.
However, one cannot rule out a possibility that if this remains out of control for a long period of time, it may force the FED to panic react and raise interest rate sharply ahead of its plan. This Risk, one should bear in mind through this year.
What does it mean?
All these trends show one clear thing - rising interest rates & inflation: Interest rates & deflation seems to have bottomed out and we foresee gradual inching up in this year. We do not see an out-of-control inflation but expect a mild inflation which is good for the certain pockets of economy and harmful for some.
This year one should align their portfolio keeping in mind this reality. Everything else will be subservient to this.
Within Equities, Focus on four sectors BRICs is likely to do well. (Read our note - Speed bumps ahead: Focus on Risks and BRICs in Samvat 2078)
(B)anking and financials: Banks are well placed to capture the benefit of rising interest rates and mild inflationary environment. We have a banking sector which is well consolidated, capitalised and ready for growth with flush of liquidity. Mild rising rates help Banks as asset repricing is always faster than liability repricing and thereby leading to increase in NIM. With high growth and low credit cost, the operating leverage will be very high thereby leady to ROE expansion.
In nutshell, mild inflation coupled with strong balance sheet, ample liquidity, supportive central bank & upcoming capex cycle are the best ingredients for the banking sector to prosper. Moreover, sector consolidation will ensure market share gains for the players with strong balance sheet.
(R)eal Estate and ancillaries: RERA implementation and financial crisis led to sharp consolidation in the sector over last 4-5 years. Business model has got rechristened in favour of large, well-capitalized and competent players. After almost 7 to 8 years’ inventory levels have come down on the back of good demand and also in certain pockets, we have seen prices starting to rise as well. Improvement in affordability ratio on account of lower interest rates has also helped uptick in the demand. With job creation picking up, demand is expected
to remain robust. Mild inflationary environment always helps push up demand of housing. We see sharp value creation in the sector.
(I)T: Indian IT companies are all set to capture 4th wave of IT – Cloud being the new ERP. The pandemic has only accelerated the cloud and digital implementation across the globe. Robust demand environment coupled with weak rupee (rising inflation and CAD due to oil) augurs well for the sector. While higher attrition and cost escalation can be a dampener over next the 2 quarters, currency and demand give a good cushion. This sector also offers a good hedge against any volatility in the environment.
(C)apital goods: There have been ample data points which suggest initial uptick in the capex cycle. After a long period of 10 years, we see most corporate embarking on expansion plans. This is good sign. If India has to realize its goal of Atma Nirbhar (Self Reliance) and manufacturing dream, capex of USD 40-50 bn annually on manufacturing will be essential. We are witnessing massive order book accretion across capital good companies. We see a big Pot of Gold here.
Within Equities, another very interesting segment of stocks which are much better placed where companies own physical assets, generate good cashflow (10-11%) and dividend yield (5-6%) and benefit from inflationary cycle. A combination of yield and growth strategy is likely to do well from risk reward perspective. Contact us for more on this.
Summary
Year 2021 was a year of big returns more driven by re-rating due to easy liquidity and low interest rates. Both are likely to reverse, Hence we are likely to see 2022 as the year of somewhat de-rating and modest earnings growth.
Whenever such an environment is created, markets are volatile and alpha creation becomes difficult. So, one should be prepared for a difficult 2022 in the middle of a structural bull market. Investors’ true test is in this kind of a market. One’s Emotional Quotient is fully tested and challenged. Staying calm helps navigate these times better.
While there will be many speed bumps this year though no U turn, we continue to remain structurally bullish over the next 3–5-year period. Obstacles are what we see when we take our eyes off the ultimate destination, we are excited and focused on long term wealth creation.
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