Greetings from Team Carnelian!
“Using volatility as a measure of risk is nuts. Risk to us is 1) the risk of permanent loss of capital or 2) the risk of inadequate return”
- Charlie Munger
In our previous newsletter, “Who Stole my return: Me or the Market” (https://www.carneliancapital.co.in/post/who-stole-my-returns-me-or-market-a-different-perspective-on-risk), we shared our broader framework to classify risks in 3 broad buckets.
Type A - Risk of permanent loss of capital: Risk of losing ~70-100% of Capital
Type B - Volatility Risk (MTM Loss Risk): Risk of an investment temporarily quoting below the investment price
Type C - Opportunity loss risk: Risk of investing into
sub-optimal stocks/sectors/asset class due to various biases and lack of
knowledge thereby missing superior returns.
Of the above, while one can manage /control Type A and Type C risks, Type B risk is a market phenomenon which is neither predictable, controllable nor manageable. Unfortunately, most investors waste significant efforts in “trying” to manage or worrying about volatility risk (Type B), in the process missing the real point of managing or investing efforts in Type A and Type C risk. This focus or optimization has costed billions to the investors. Once this is understood, an investor’s ability to allocate capital falls in place with the right perspective.
In this letter, we highlight common causes, impact and risk mitigation tools for managing Type A Risk.
We assign 2 major causes of Type A risk:
- Inferior quality of Management
- Inferior quality of Business
Impact Analysis of Type A Risk
Before we get into the details, let us understand a bit about the impact or significance of this risk. Our detail study* conducted on ~8,300 companies suggest some astonishing facts about wealth destroyed over the last 20 years in the Indian Equity Markets due to Type A Risk.
- INR 32 lakh crores have been destroyed by 570 companies in last 20 years
To contextualize, wealth destroyed is
- 12% of ‘current’ equity market capitalisation
- 2x of Total Mutual Fund Equity AUM
- 2x of Market Capitalisation of Reliance Industries (largest listed company by market capitalisation)
Other interesting data points to note:
- 45% of wealth destroyed is by Top 15 wealth destroyers with visible red flags (CLEAR framework helps us to diagnose these risks)
- 22% of wealth destroyed is either by disruption prone businesses, highly regulated businesses or state-controlled units (PIU framework helps us diagnose these risks)
- 1 in 12 companies listed has ended up in this list “till date”
Needless to mention: One needs a multi-bagger to compensate loss caused by investing in a company with Type A risk. This makes investing really a tough job if one ignores Type A Risk
* The above is result of extensive back testing done across listed universe over last 20 years using our proprietary framework – CLEAR (Forensic framework) and PIU (Business & Management analytical framework). For detailed framework please refer Annexure-A.
Now let’s get into diagnosis of Type A Risk
The main sources of this risk are
1. Inferior quality of management
2. Inferior quality of business model
Inferior quality of Management
We have all heard the analogy “Jockey is more important than the horse” innumerous times. It’s the easiest way of understanding how much influence the management teams have on the businesses. Historically we have seen several examples (Enron, Satyam, ADAG group, Manpasand, Jet, Dewan Housing, Yes Bank, etc...) where serious wealth destruction has happened due to poor management of businesses. Below are few red flags to watch out for, which questions the corporate governance of businesses:
1. Oppression of minority shareholders
2. Aggressive accounting policies
3. Poor resource allocation (time/capital)
4. Conflict of interest
5. Poor risk management culture
6. Excessive leverage
7. Gaps in Financial Statements: “Where is my Profit” vs “What is my profit”
Wealth destruction attribution analysis - Type A Risk
To investigate the reasons of such enormous wealth destruction, we deep dived in 118 companies which contribute to ~80% of overall wealth destruction and below are our findings:
Though wealth creation in Indian market is appreciated, wealth destruction is often ignored. There may be several companies with Type A Risk, where there could be wealth destruction which are waiting for a trigger. The above data also demonstrates a very high probability of existence of Type A Risk. Investing while ignoring existence of Type A Risk is sure shot recipe of stepping onto potential land mine leading to wealth destruction over a long run.
At Carnelian, we spend a lot of time managing this risk.
Our CLEAR Framework (focusing on Forensics) which comprises of detailed cash flow analysis, capital allocation, liability analysis – true vs reported debt, earnings analysis, asset quality and related party transactions and governance checks and our PIU framework which comprises of scoring business & management on many parameters including business disruption risk, management IMPRESS score card protects us from getting into a permanent loss risk (Please refer Annexure A for more details.)
We have a clear NO GO when we find the business bears disruption risk even if rest of the parameters are fine.
Inferior quality of business model
Businesses operate in a dynamic world. Constant changes in the environment in which businesses operate may sometime create a threat on the existence of the company. These disruptions challenge these businesses to keep evolving to stay ahead of the curve or even survive depending on the level of disruption. Failure to evolve and cope up with the changing dynamics eventually leads to the companies going out of business. Disruption can come from various directions but more prominently from the below factors.
1. Innovation/Technology obsolescence
2. Product substitution
3. Increase in competitive intensity from new entrant or incumbents
4. Structural political/geo-political issues
5. Regulatory changes
Since markets are always forward-looking, investors lose money much before the actual disruption. Also, the impact of disruption also has a lot to do with the DNA of the management team since it requires substantial investments in terms of time and cost to prepare themselves for foreseen as well as unforeseen business disruptions.
Finding moats is essential in doing business analysis. We like businesses which have a high sustainable moat and avoid businesses which have potential disruption risk. Businesses which do not have high moat or have high disruption risks are more prone to destruction in value. Investing in cyclicals businesses requires a very different mindset. Sustainable long-term wealth is created by businesses with high moat and good management team, often cause and effect for each other.
We are happy to share the process we follow at Carnelian to manage Type A risk in the following Annexure. Happy to receive your suggestions and feedback.
Annexure -1: An Insight into Carnelian risk mitigation tools to manage Type A risk
How do we manage this risk at Carnelian?
At Carnelian, we channelize most of our time and attention towards understanding Type A risk while evaluating investment opportunities and continue to monitor them regularly. We have chosen to stay away from companies and even exited companies from our portfolio which did not qualify or stopped qualifying as per our framework despite short time upside potential.
Forensic deep dive (connecting the dots)
In Carnelian world, forensic analysis starts with “marrying” the financial statements to find the obvious gaps which are as complicated as the jig saw puzzles.
We follow a two-step forensic deep dive while evaluating a company
Step 1: Automated quality checks
We have developed a proprietary automated template, screening last 10 years of historical data, highlighting potential red flags, basis which we decide whether we should devote any additional bandwidth for the company under consideration.
Step 2: CLEAR Framework
Our unique forensic framework deep dives into the following before investing, what we call “CLEAR” framework.
C Cash flow Analysis & Capital allocation
L Liability Analysis
E Earning Quality Analysis
A Asset Quality Analysis
R Related party transaction & Governance issues
The above framework requires in-depth analysis of the annual reports of the companies. To put things in simple words, we are extremely cautious and avoid companies where we find evidence of:
1. Profits disappearing ‘before’ landing to balance sheet,
2. Profits/Assets disappearing ‘after’ reaching the balance sheet
3. Profits/Assets landing in the balance sheet and remaining there forever
An insight into Carnelian CLEAR framework:
Balance sheet
1. Analyse the quality of assets specially intangibles; deferred expenses; Investments in non-core assets like loans and advances, intercorporate deposits, dubious investments
2. Assess asset-liability mismatch (ALM) risks
3. Net-worth reconciliation: movement not explained by P&L
4. Ever-increasing receivables, inventory, unbilled revenues, intangibles assets
5. Categorization of liabilities – is it an operating liability or debt?
6. Look for off-balance sheet arrangements/ derivative book.
Cash flow Statement
1. Source of OCF is more important than OCF; watch out for “OCF boosters”
a. Sale of receivables;
b. “Non-recourse “channel financing
c. High payables with off BS financing arrangements
2. Gaps between Income statement and Cash Flow
a. Taxes, Interest & Exchange losses
b. Question the Non-cash adjustments
Income Statement
1. “We like capex in profit and loss, we do not like opex in balance sheet”. Capitalization of forex losses & interest cost, revenue expenses.
2. Whether exceptional items are one-offs or recurring?
3. Are profits contributed by inventory gains?
4. ESOP/pension accounting policy & future obligations.
5. Low rate of depreciation, delayed depreciation through delayed capitalization
Look out for other hidden/off-balance sheet issues
1. Business consolidation leading to unexplained net worth creation ---1+1=3 which is disguised revaluation
2. Complex corporate structures
3. Unidentified/identified related party transactions
4. Derivative book and unhedged forex exposures (Time Bomb without timer)
5. High contingent considerations
6. Promoter pledging
Refer www.carneliancapital.co.in/forensicanalysis for detailed reports/case studies.
PIU framework
PIU framework is a proprietary framework specifically designed to score companies under 3 elements: Business, Management and Risk Reward tradeoff. Apart from analyzing numbers, investing requires understanding the relevant qualitative attributes of the business and sector. Our framework is a perfect blend of qualitative and quantitative parameters which aids our understanding of the environment in which businesses operate which keeps our future projections in check.
1. Business part of the framework amongst other parameters focuses on
a. Competitive advantages: We like businesses which have highly “sustainable” moat. Understanding the competitive position of the company and success factors leading/may lead to the leadership is of paramount importance in understanding the quality of the business.
b. Disruption risk: Constant changes in businesses is essential to be relevant in a dynamic world. However, a highly disruptive business environment means constant pressure on the revenue-generating ability/market share, profitability and cash flows of these companies which could structurally damage the financials and competitive advantages of the company. Hence, we have a Clear “No Go” for these businesses
c. Opportunity size of the sector the company operates in: Apart from the disruptions and competitive advantages of the company, headroom for growth of a particular business is dependent of the opportunity size of the company. We like companies which offers either a huge opportunity size or operate in a high growth industry.
2. Management part of the framework helps us understand the DNA of the business managers and the organisation. We give the highest weightage to the management to arrive at the PIU score. We try to evaluate companies on the comprehensive “IMPRESS” framework as defined below
I Integrity
M Modest and Capable
P Passionate and Driven
R Realistic but aggression
E Efficient Capital Allocator
S Skin in the game
S Strong governance and Risk Management
Disclaimer
Investments in the securities markets, and especially in options, are speculative and involve substantial risk. All investments under the portfolios are subject to market and other related risks and there is no assurance or guarantee that the value of or return on investments will always be accretive, it could depreciate to an unpredictable extent. For more information about various types of risk factors, please click here.
This newsletter is meant for general reading purpose only and is not meant to serve as a professional guide for the readers. This newsletter does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. The recommendations, if any, made herein are expression of views and/or opinions and should not be deemed or construed to be neither advice for the purpose of purchase or sale of any security, (as defined under section 2(h) of securities Contracts (Regulation) Act.1956,
This newsletter has been prepared based on publicly available information, internally developed data and other sources believed to be reliable. Carnelian Asset Advisor Pvt. Ltd. (Carnelian), Sponsor, the Trustees or any of their respective directors, employees, associates, or representatives (“entities & their associates”) do not assume any responsibility for, or warrant the authenticity, accuracy, completeness, adequacy, and reliability of such information. Whilst no action has been solicited based upon the information provided herein; due care has been taken to ensure that the facts are accurate, and opinions given are fair and reasonable. This information is not intended to be an offer or solicitation for the purchase or sale of any financial product or instrument. This material is for your private information only and same in full or any part thereof should not be construed as our recommendation to buy or sell securities or invitation to subscribe our Portfolio Services, Advisory Services or funds managed by us. Recipients of this information are advised to rely on their own analysis, interpretations & investigations. Readers are also advised to seek independent professional advice order to arrive at an informed investment decision. Carnelian, entities & their associates shall not be liable for any direct, indirect, special, incidental, consequential, punitive, or exemplary damages, including loss of profits, arising in any way from the information contained in this material. Entities & their associates including persons involved in the preparation or issuance of this material may from time to time have long or short positions in and buy or sell the securities there of, of company(ies)/ specific economic sectors mentioned herein and as such not a recommendation to buy, sell or hold any such securities. investments are subject to market risks, read all related documents carefully. Any redistribution of the Firm’s Newsletters or e-mails, without the written consent of the Firm, is strictly prohibited.
Disclosure of Performance Figures: Performance related information provided in the newsletter or email is not verified by SEBI. Past Performance are not indicative of future performance. Reader should not assume or expect that future performance of any investment or strategy will be profitable or equal to historical or anticipated performance levels. Further note that w.e.f. April 2020 onwards,
1. Firm Level Performance figures given herein above calculated on Time Weighted Rate of Return (TWRR) basis is combined performance of all the portfolios of all Investment approaches managed by Portfolio Manager as required by SEBI (PM) Regulations 2020.
2. Investment approach specific Performance figures given herein calculated on Time Weighted Rate of Return (TWRR) basis is combined performance of all the portfolios of that specific Investment approach managed by Portfolio Manager as required by SEBI (PM) Regulations 2020.
Registrations: Carnelian Asset Advisor Pvt. Ltd. (“Carnelian”) is a SEBI registered Portfolio Manager (SEBI Reg. No. INP000006387) and Investment Advisor (SEBI Reg. No. INA000015792). Carnelian is also an Investment Manger to Carnelian Capital Compounder Fund – I, which is a SEBI registered Category III Alternative Investment Fund (AIF) (SEBI Reg. No. IN/AIF3/18-19/0642). For more information, visit us at www.carneliancapital.co.in .
Risk Factors
All investments under the portfolio of any Strategy, Investment approach, advisor or Alternative Investment Fund’s are subject to market and other related risks and there is no assurance or guarantee that the value of or return on investments will always be accretive, it could depreciate to an unpredictable extent.
i. Investments in securities are subject to market risks which include price fluctuation risks. There is no assurance or guarantee that the objectives of any of the portfolio will be achieved. The investments may not be suited to all categories of investors. In achieving objectives of the portfolio, the investments made in securities could be subject to diversification risk being exposure to limited sectors.
ii. The names of the portfolio, strategy or investment approach or fund do not in any manner indicate their prospects or returns. The performance in the equity portfolios may be adversely affected by the performance of individual companies, changes in the market place and industry specific and macro-economic factors.
iii. The debt investments and other fixed income securities may be subject to Interest rate risk, credit risk, and reinvestment risk Liquidity in these investments may be affected by trading volumes, settlement periods and transfer procedures.
iv. The past performance of the Portfolio Manager, Fund or Investment Advisor does not indicate its future performance. Investors are not being offered any guaranteed returns.
v. Investments in equity run the risk of volatility, high valuation, obsolescence and low liquidity. Mid-cap and low-priced stocks may suffer from low liquidity.
vi. Portfolio’s using derivative / futures and options products are affected by risks different from those associated with stock and bonds. Such products are highly leveraged instruments and their use requires a high degree of skill, diligence and expertise. Small price movements in the underlying security may have a large impact on the value of derivatives and futures and options. Some of the risks relate to mis-pricing or the improper valuation of derivatives and futures and options and the inability to correlate the positions with underlying assets, rates and indices. Also, the derivatives and futures and options market is nascent in India.
vii. As and when the Investment Manager, Investment Advisor or Portfolio Manager trades in the derivatives market, there are risk factors and issues concerning the use of derivatives that investors should understand. Derivative products are specialized instruments that require investment techniques and risk analysis different from those associated with stocks and bonds. The use of a derivative requires an understanding not only of the underlying interest but also of the derivative instrument itself.
Derivatives require the maintenance of adequate controls to monitor the transactions entered into, the ability to assess the risk that a derivative adds to the portfolio and the ability to forecast price rate movement correctly. There is a possibility that a loss may be sustained by the portfolio as a result of the failure of another party (usually referred to as the “counter party”) to comply with the terms of the derivatives contract. Other risks in using derivatives include the risk of mispricing or improper valuation of derivatives and the inability of derivatives to correlate perfectly with underlying assets, rates and indices.
Thus, derivatives are highly leveraged instruments. Even a small price movement in the underlying security could have a large impact on their value. Also, the market for derivative instruments is nascent in India.
viii. In the normal course of business, circumstances may arise that could result in the interest of Carnelian Asset Advisors Pvt Ltd conflicting with that of its affiliates / group entities where Carnelian Asset Advisors Pvt Ltd makes best efforts to ensure that such conflicts of interest are identified and managed and that clients’ interests are protected. Carnelian Asset Advisors Pvt Ltd shall ensure fair treatment to all clients while providing unbiased services and render high standards of services and shall also ensure to put the client’s interest above all.
Carnelian Asset Advisors Pvt Ltd and its group companies have policies and procedures in place to control the flow and use of nonpublic information and employees’ personal account trading. Where appropriate and reasonably achievable, Carnelian Asset Advisors Pvt Ltd segregates the activities of staff working in areas where conflicts of interest may arise.
ix. In the case of stock lending, risks relate to the defaults from counter parties with regards to securities lent and the corporate benefits accruing thereon, inadequacy of the collateral and settlement risks. The Portfolio Manager is not responsible or liable for any loss resulting from the operations of the portfolios.
x. The Investment Manager, Investment Advisor or Portfolio Manager may invest in the shares, debt, deposits and other financial instruments except other than mutual funds units of group companies with prior consent of the Client which shall be obtained in writing. The investment in shares of group companies will be governed by arm’s length relationship.
xi. Investors are not being offered any guaranteed or assured return/s i.e., either of Principal or appreciation on any of the portfolio under any circumstances.
xii. The liquidity of the any Investments is inherently restricted by trading volumes in the securities in which it invests.
xiii. The Investment Manager, Investment Advisor or Portfolio Manager may, considering the overall level of risk of the portfolio/fund/client, invest in lower rated/unrated securities offering higher yield. This may increase the risk of the portfolio/fund. Such investments shall be subject to the scope of investments as laid down in the applicable Contribution Agreements, Client Agreement, Public Placement Memorandum, Disclosure Documents or any amendments thereof.
xiv. The Investment Manager, Investment Advisor or Portfolio Manager may, subject to authorization by the Client in writing, participate in securities lending. The Investment Manager, Investment Advisor or Portfolio Manager may not be able to sell/lend out securities, which can lead to temporary illiquidity. There are risks inherent in securities lending, including the risk of failure of the other party, in this case the approved intermediary to comply with the terms of the agreement. Such failure can result in a possible loss of rights to the collateral, the inability of the Approved Intermediary to return the securities deposited by the lender and the possible loss of corporate benefit accruing thereon.
xv. In achieving objectives of the portfolio, the investments made in securities could be subject to diversification risk due to exposure to limited sectors.
xvi. Any act, omission or commission of the Investment Manager, Investment Advisor or Portfolio Manager under relevant agreement will be solely at the risk of the client and the Investment Manager, Investment Advisor or Portfolio Manager will not be liable for any act, omission or commission taken or failure to act save and except on the ground of malaise, fraud, conflict of interest or gross negligence, willful default and/or fraud of the Investment Manager, Investment Advisor or Portfolio Manager.
xvii. The Client undertakes all responsibilities and agrees to bear all risks arising out of refusal by a Company or Corporation for whatever reasons, to register the transfer of any of the Securities in respect of the Client’s account. The Securities which are so purchased and refused to be transferred in the name of the Client or the Portfolio Manager/Fund, as stated herein above, by the Company or Corporation concerned, will be sold by the Investment Manager, Investment Advisor or Portfolio Manager, at the best available market rate, at the risk and responsibility of the Client concerned.
Tel: 91 – 22-6691 4023/24 | www.carneliancapital.co.in| Email ID: swati@carneliancapital.co.in
B-1405, One BKC, Bandra Kurla Complex, Bandra (E), Mumbai – 400 051.