Dear Carnelian Family,
Hope everyone is safe and fine at your end.
We are happy to report that our strategy is back in the positive and has outperformed the Benchmark by ~2.27% in June and ~10.63% since inception. While outperformance is welcome, we continue to travel during these unprecedented times keeping our seat belt and risk hat on and seeking investment opportunities. We are quite comfortable with our portfolio holdings as well as our cash levels of ~12.8%.
We firmly believe the current unprecedented time will present many investment opportunities owing to excessive fear. Since our investor update on 1st April 2020 highlighting the faith vs fear mythology, our fund has delivered ~19.9% returns. The Faith Vs Fear mythology coupled with our extensive stress test results has helped us to keep our objectivity and the much needed optimism level high at time when broader markets were engulfed in extreme pessimism. We have not only kept the structural names intact in our portfolio but also got an opportunity to add few more names at very attractive risk-reward metrics.
While a large part of recovery has been contributed by the co-ordinated action of all the central banks across the globe pumping in record liquidity, the market has also presented unprecedented opportunity in select names. We were fortunate to be ready with our research and could grab some of the names at very interesting valuations. We expect more of that to happen in the coming months. We are keeping our research funnel list and dry powder ready to grab opportunities should market again go in the grasp of excessive fear.
We have used the current lock down period to get some structural improvement to our organisation as well as to our research platform:
1. Re-launching of the Carnelian website - with much larger and richer content. We encourage you to visit our website and share your feedback.
2. Strengthening our MCO framework with back testing.
3. Strengthening our research processes backed by the PIU and CLEAR framework.
4. Thorough stress testing of our portfolio which involved granular scrutiny of all the material line items in the financial statements followed by management interaction.
5. Realigned our portfolio more towards large caps with favourable risk reward metrics.
6. Building our hypothesis around upcoming trends for next 5-10 years.
7. Strengthening our operational and digital capabilities.
What is driving current rally? Is it sustainable?
Most of you might have this question as to what is driving the markets amid collapse in the level of economic activity. Most of us see the real economic pain on ground and can feel it in our interaction with most businesses but yet why are the stock markets ignoring this?
The real answer is in the unprecedented amount of fiscal and monetary measures taken by Governments and Central Banks across the globe. This time the stimulus is almost twice the size of the Global Financial Crisis of 2008 and much quicker too! (Refer chart 1).
Assets typically get sold due to fear and liquidity constraints. Both these have significantly receded after the initial panic in March. In fact, liquidity is abundant in case of most economies like the US, EU, and Japan.
The real question most people have is – are the markets running ahead? How will the divergence get corrected? Will the market correct or will the economy recover quickly? The truth is no one knows, but everyone should have an opinion based on the data/information one sees combined with experience.
Our opinion is that the economic recovery will take time; specially in case of India it may take much longer than the market’s expectation. Our base case scenario is 12-15 months to get back to normalcy, but markets normally discount that much ahead. The answer lies in the statement below which we have highlighted in our March 2020 newsletter.
When we do valuation of equities, large part of the value is attributed to the Terminal value. Then the obvious question is why are stocks down 40%-60% because of 12-15 months of disruption?
Markets generally operate at least 12 months ahead. Markets are basically ready to ignore one year’s earnings impact. Part explanation to this also lies in the significant drop-in the interest rates. There is no alternative for people to invest capital. Equities still at least offers good earnings and dividend yield, with growth bias.
What are the Air Pockets we envisage?
In a long journey, there will always be air pockets. One must constantly watch our risk factors. Foremost, a rise in the number of fresh COVID infected cases are forcing several governments to re-initiate partial lockdowns. We have seen this happening in the US and in many cities in India. This surely dampens & delays the recovery to normalcy hypothesis. While things seem better than April and May on the economic recovery front, this impacts the pace of recovery.
Secondly, the developing geopolitical tension between India and China is worrying. The US-China geopolitical situation also seems to be deteriorating. We might be getting into a cold war kind of a scenario. This will distract the governments’ attention away from economic recovery (may be that is China’s intention!). This will also impact the supply chain between India and China. We are already seeing many industries facing raw material supply issue.
Thirdly, India’s fiscal and monetary response to stimulate the economy has lagged as compared to other nations across the globe and is far behind the need! There will be second / third order effects which can occur impacting the economy and markets. We are watchful of the second order effects post the opening up of the lock down which may result in elevated NPAs once the moratorium effect is over. We strongly believe that the Indian economy needs significant fiscal measures for struggling businesses.
Lastly, job losses, salary cuts and cuts on discretionary spending by corporate India in a lot of sectors will impact demand and maybe the current bounce could be more in terms of pent up demand. On the supply side, labor has gone back to their hometowns and hence supply side may also take some time to normalize.
How do we see opportunity?
We have two big beliefs – first “the India story is here to stay irrespective of COVID” and second “the best portfolios are built in times of uncertainty”.
Rural India is doing well. Current situation is pushing the government in the direction of structural reforms. We are sure these reforms will move the needle one step at a time. Indian manufacturing is surely getting a boost. Banking system is getting cleaner and better. Weak businesses are getting sold to stronger hands. Indian aspirations of upgrading lifestyle are here to stay. We remain complete believers in the India story, despite all pessimism.
Whenever market gets engulfed into extreme pessimism it exhibits significant divergence between price and value and there lies investment opportunity. This is also the time of uncertainty where you hardly get comforting data and news. But this is the one which gives you the best returns! Idea is to manage risk and keep building the portfolio with long term objective in mind. Reward per unit of risk is the highest in times like these.
Our approach is to keep our head down and continue doing what we must keeping the objective unemotional approach. We need to be careful not fearful.
We are making a new hypothesis around the future trends and researching around them. While some things will never change but some things will not be same again.
We shall share with you once we are ready with that, hopefully in the next month’s letter.
Till then, stay healthy, stay happy. But keep your seat belts on.
Disclaimer
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