June 2024 / Q1 FY25

Market Outlook

The chatter around valuations remains subjective and questionable. While the markets have been on a roll, earnings growth has also been very buoyant, thereby still keeping the overall valuation under check. We have spoken about our thoughts on valuations in our March 2024 and December 2023 newsletters and don’t see much change in the genre of companies we’re usually focused on. Our simple belief is that markets, in the longer term, will reward companies that deliver consistent earnings. We prefer to look at valuations in the context of those earnings.

Amidst the markets making new highs and the valuation banter — which we have discussed in the past and which largely remains beyond our control — this time around we choose instead to share our learnings in investing over the last 12 years since we set up Equitree. We sincerely hope that these learnings will act as a guiding lighthouse to navigate the volatile waters / anxiety with respect to investing in markets, at all points in time.

01Key Learnings from 12 Years of Equitree

1ABorrowed Conviction Never Works

Investing in the market based on “tips” and “recommendations” from “friends” and “friends-of-friends” has been long prevalent in the market. This has further accentuated now with the ease of digital technology. The FOMO (fear of missing out) and greed of making a fast buck generally make people cave in. While these do work in a bull market, it has been empirically proven that this generally haunts back as the market cycle turns.

Investors also tend to do herd investing or shadow investing, which again ends up with similar results over a long period of time. While people tend to follow marquee investors, what one doesn’t understand is that risk profiling of each investor is different and holding tenure can also be different for different investors — eventually leading to significantly different outcomes.

At Equitree, we practice independent thinking and prefer focusing within our circle of competence to mitigate potential disasters. Our ground-up approach to investing gives us the conviction to invest in businesses with a long-term approach rather than chasing shallow “momentum” / “herds” / “flavor of the market” themes. This helps us even more during market downturns, where we can take more informed decisions on our holdings rather than panic-sell.

When following the herd, your result can be as good as the herd, but if one needs a different outcome, one needs to challenge and have a completely different and independent approach.

1BRight Position Sizing Leads to Financial Liberty

Getting an investment decision right is only half the battle won. In investing, what is more relevant is how much money one makes when one gets it right, and how much one loses when one gets it wrong — and this is where right position sizing becomes extremely important.

Investing with “borrowed conviction” substantially hinders investors’ ability to do right position sizing. That’s where even with a supposedly good investment, wealth creation seldom happens.

Anecdote: Benjamin Graham and GEICO

In 1948, Benjamin Graham — often hailed as the “Father of Value Investing” — made a pivotal decision that diverged from his own teachings, resulting in one of the most remarkable investment successes of his career[3]. Graham, typically an advocate for diversification who rarely allocated more than 5% to a single holding, identified a deep-value opportunity that compelled him to break his own rules.

He deployed an unprecedented 25% of his partnership fund’s AUM into this single investment and, for the first time, allowed the position to run contrary to his usually strict valuation methods. The magnitude of the decision’s success is staggering: Graham’s $712,500 investment for 50% of GEICO grew to over $400 million in just 25 years — a phenomenal 550+ bagger return[3].

While one might argue this was an anomaly or attribute it partly to luck, it was ultimately Graham’s conviction and willingness to make a calculated deviation from his standard approach that led to this extraordinary outcome.

At Equitree, while we maintain a discipline to not invest more than 10% of original capital in a single stock, we don’t unnecessarily over-diversify either. We look to build a concentrated portfolio of 12–15 high-quality businesses based on our deep conviction, and meaningfully deploy capital in each of them. Once invested, we believe in letting our winners run and harnessing the power of compounding rather than unnecessarily cutting positions just because the value has gone up as a percentage of the portfolio.

1CPatience — The Chinese Bamboo Tree Principle

Like any plant, growth of the Chinese Bamboo Tree requires the staples: water, fertile soil, and sunshine. However, its growth journey is very different from most other flora. In its first year, we see no visible signs of activity. In the second year, again, no growth above the soil. The third, the fourth — still nothing. But finally, in the fifth year, we see phenomenal growth of about 80 feet in just six weeks.

Patience — a virtue most commonly ignored in the markets — in effect remains the quintessential quality in outsized wealth creation from investing. This principle in our field has been coined as “asymmetrical payoff.”

In investing, businesses seldom function in a linear manner. One does get caught on the wrong side of the cycle, face prolonged headwinds, or encounter sudden unforeseen events. This impacts stock prices in the short term and may go through extreme volatility — akin to no growth seen in a Chinese Bamboo for the initial years. However, if the business fundamentals remain strong through these headwinds, probability is that such strong businesses come back with a bang — achieving the 80-foot growth.

Time and again, our biggest winners have put our resolve to the test. Yet we’ve discovered that blending patience with well-founded conviction is the magic formula. This aligns with microcap investor Ian Cassel’s “ugly duckling” theory[4], which suggests that the most promising investments often start as overlooked or underappreciated companies. Just as the ugly duckling transforms into a beautiful swan, these seemingly unattractive investments can blossom into remarkable performers over time.

1DStaggered Investing vs Dollar Cost Averaging (SIP)

In micro-caps and small-caps, we’re often hit by erratic price action — in both the upside and the downside. Doing a standard SIP at a fixed interval generally does not augur well for microcap investing, as the erratic price behaviour may lead to disproportionate exuberance or makes one continuously buy the pessimism. For incremental capital allocation, one rather needs to understand the reasons for either of the price actions based on business fundamentals, instead of adopting a fixed time-interval-based investing.

At Equitree, staggered buying involves deploying a decent amount as base capital into our portfolio, while always maintaining some cash. This allows us to understand the business cycles better and build positions accordingly based on execution of the business as well as market volatility.

1EWhen to Exit

This question is perhaps the most pertinent question an investor must ask or deal with on multiple fronts. The beauty of it is that nobody is always right; as long as we win more than we lose, it leads to substantial wealth creation over time.

Most investors tend to either exit at marginal profits, or hold loss-making companies in the hope of a revival, as cutting losses becomes extremely difficult psychologically. The other extreme is to follow a strict “stop-loss” strategy, where one books losses if a stock drops 20–30% only to realise that it rises back as a phoenix.

At Equitree, we follow a well-defined exit strategy. We would look to exit our investment only if any of the following situations arise:

02Two 30-Baggers, Two Lessons

2AShakti Pumps — The Reward of Independent Conviction

We’ve been buying into this business since 2017, when the company was in complete oblivion. Most market men had either not heard about the company or didn’t have much confidence in the management. Nonetheless, we did our ground-up research, and based on our conviction, stuck our neck out.

During the journey, our conviction got tested numerous times — and every time, we would go back to the roots to get a reconfirmation of the same. Gladly, our conviction has played out beautifully — the investment turning out to be a 30-bagger for us[5], and now the market is awakening to this and buying in the optimism.

Five separate drawdowns, including two of 60%+, would have shaken out anyone investing on borrowed conviction. We held — because the ground-up reconfirmation kept telling us the business was getting stronger, not weaker.

2BHBL Power — The Reward of Patience

This company had the first-mover advantage for a niche product, however got plagued by delay in approvals from the government. Once the commercial orders started kicking in, it gave the company a first-mover advantage in the industry. The improved execution and product mix led to a complete change in the numbers of the company, which led to a re-rating for the company — making it a ~30-bagger for us[6].

First buy at ₹20 (~2018); still holding at ₹620 (mid-2024). The interim was 5 years of stagnated growth: regulatory hurdles, supply chain inefficiencies, fluctuating profit margins. The eventual turnaround came from increased batteries and defence demand, streamlined operations and supply chain, and investment in R&D and strategic alliances.

03Budget 2024 — Our Two Cents

The budget for 2024–2025 was broadly in line with our expectations. Despite a coalition government in place — which increased expectations of the budget being more “populist” and drifting away from the erstwhile focus on infra spend — it was pleasant to see that the government has not given in to any of these pressures.

The focus on infrastructure spending continues with a ~16% growth in capex[7]. With that, it was heartening to see the government being cognizant of fiscal prudence and maintaining fiscal deficit at 4.9% of GDP, which should help in improving India’s sovereign rating as well.

Indeed, there was a negative surprise for the capital markets in the form of tax-rate hikes — from 10% to 12.5% for LTCG and 15% to 20% for STCG. We believe this may have a short-term sentimental impact rather than any long-term fundamental impact.

From our perspective, being long-term and less-frequent churners, the ability to stay invested and defer taxes helps in compounding that capital too — which materially reduces the impact of taxes on the eventual returns.

04What Are We Doing Currently?

Our portfolio companies have reported 29% growth in PAT for FY24. Business visibility for most of our companies continues to be very good, and we expect FY25 as well to register ~30% growth — poising us for some interesting times ahead.

Despite the stock price performance during the last quarter and year, our portfolio still trades at a median PE multiple of 21.5× FY25 PAT. This makes us extremely comfortable holding the portfolio.

We are cognizant of froth in valuations in some parts of the market. The pace at which markets have been hitting new highs owing to burgeoning domestic liquidity, potential regulatory measures to curb the volumes in F&O, curbing margin funding by taking around 1,000 companies out from the allowable list of securities for margin[8], and geopolitical issues — are some of the issues which may have an impact on the market in the near term. We believe these issues may bring about a 5–7% correction in the indices and around 15–20% in small and mid caps. Individual stocks may of course behave differently based on earnings growth and valuations.

Based on this, we have been reviewing the portfolio very closely on business developments and valuation. In line with that, we have partially booked profit in one of our portfolio companies and have pared down holding in another where, despite good operational performance, reported profit is suffering due to a change in accounting policy.

We continue to find interesting opportunities which fit our parameters and have added a new company to the portfolio — which we believe could be an emerging leader in the consumer durables space.

Please feel free to reach out to us for any feedback or further information.

Sources

01

PMS Bazaar — Equitree Capital ranked the 4th-best-performing PMS for the June 2024 quarter (Q1 FY25).

02

Nuvama Custodian Services; Equitree Capital internal performance and NAV records (June 30, 2024). Returns are TWRR, net of fees and expenses, and not verified by any regulatory authority/SEBI.

03

Benjamin Graham investing in GEICO (1948): 25% partnership-fund allocation; $712,500 stake in 50% of GEICO compounded to over $400 million in 25 years (550+ bagger). Sourced from Graham biographical accounts and partnership records.

04

Ian Cassel — “Intelligent Fanatics” / “Ugly Duckling” theory of microcap investing (MicroCapClub).

05

Shakti Pumps (India) Ltd. (NSE: SHAKTIPUMP) — TradingView price history (2017–2024); first buy ₹150, all-time high ₹4,739 (July 2024).

06

HBL Power Systems Ltd. (NSE: HBLPOWER) — TradingView price history (2018–2024); first buy ₹20, holding at ₹620 (mid-2024).

07

Union Budget 2024–2025; Prabhudas Lilladher; Equitree Capital — sectoral and capex breakdown of central-government budget; fiscal deficit set at 4.9% of GDP.

08

SEBI circular — Removal of ~1,000 companies from the list of securities approved for margin funding; tightening of derivatives and SME IPO norms.