Equity Midas

Subscriber Update - Feb '22

Dear Subscriber,


Welcome to the third issue of Equity Midas Capital’s Subscriber Update.  


Q3-IY2021-22 (IY = Investment Year, Q3 = Dec 2021 – Feb 2022) began with a promise of normalcy and ended with the worst fears of a war being realized. 

With the severity of Covid cases under control (though the numbers were high), there was strong hope that we are moving towards the pre-2020 world order.  Markets shared the same enthusiasm till mid-Jan. The situation changed soon after.


Once the FYQ3 results started coming thru, the gap between the expectations and actual performance started becoming clear. Stocks which has run-up based on fairy-tales, were no longer as charmed. For stocks to maintain their value, operating performance should match the embedded expectations. If that does not happen, the correction is swift and many a times extreme. Newly listed technology companies and other Covid beneficiaries were not able to keep up with those expectations and saw big correction.


EVM portfolio was not spared as well. Many of the portfolio stocks had run-up before the results. Unfortunately some companies were not able to deliver on the margins due to high input costs. This prompted a steep correction in the prices.


We cover the margin pressure aspect in detail in the Operating Performance section.


On to some positive news, we published our first smallcase this quarter. Strength Of Nifty50 is now available on smallcase. You can access it here.

 

Note: We publish these letters every 3 months, in the first week of September, December, March and June.  This also allows us to collate & analyse the results published for the previous quarter and include the same here.

Portfolio Performance

As on Feb 28, 2022, average holding period of our recommendations has been 9 months. We have now completed 75% of the recommended holding period. By the time we write the next edition of our investor letter, we would have sold off stocks we purchased in Tranche 1 & 2 (April 30, 2021).
This quarter promised much higher returns but we closed much lower. They did however out-performed their respective benchmarks. Focus returns are still better than Feast returns but we expect the situation to reverse in the coming quarter.

Unrealised Returns, As On Feb 28, 2022 (before fees & taxes, including dividends) (For Current Returns, please click here
PORTFOLIONUMBER OF STOCKSTOTAL RETURNS (%)BENCHMARKBENCHMARK RETURNS (%)AVG HOLDING PERIOD
FOCUS (LARGE & MID CAP)914.03NIFTY 2008.579 MONTHS
FEAST (ALL CAP)3411.93NIFTY 5008.669 MONTHS

The graphs below show the daily performance of Focus and Feast in comparison with their respecting benchmarks, till Feb 28, 2022.

Key Observations

  • Large & Mid cap companies showed a drop in returns while small caps delivered positive returns for this quarter.
  • Lower expectations from small caps helped to deliver this positive returns, even when the operating performance was not good as compared to YoY and QoQ data.
  • Highest impact of input cost inflation was seen among the commodity companies within the portfolio.
  • Some laggards despite corporate actions like buy-back offer continued their down-turn due to very poor results.
  • Operational performance remains the key the stock returns.
  • As shown in the next section, stocks that have met or beaten the expectations have delivered superior returns. The basic tenet of EVM remains intact.
  • Overall the model portfolio performance trend is in-line with the market performance with a positive bias.

Operating Performance Analysis - EVM View

As we did in the previous edition of our letter, we have distributed the portfolio companies based on the expectations achieved by third quarter.

In a typical year by Q2, anything above 65-70% of expected performance is good performance. This year though, with Q1 numbers impacted due to Covid, judging this number is a bit difficult. Different companies were impacted differently.

So to review the performance of the companies we created four quadrants.

Quadrant 1 – Poor Performance (< 40% of expected performance achieved by Q2)
Quadrant 2 – Adequate Performance (40% to 60% of expected performance achieved by Q2)
Quadrant 3 – Good Performance (60%-75% of expected performance achieved by Q2)
Quadrant 4 – Excellent Performance (>75% of expected performance achieved by Q2)

Based on this grouping here is how we see the results:

QUADRANTCOUNT OF COMPANIESRETURNS
18-13.36
288.23
31014.37
4837.89
Grand Total3411.93

As seen from the table above, returns generated by companies in Quadrant 3 and Quadrant 4 are much better as compared to companies in Quadrant 1 and 2. This is in line with the model expectations.

Quadrant 1 companies have performed poorly on operating parameters and that is reflected in stock price performance. 

High number of companies in quadrant 1 and 2 is a cause of worry. We need to refine that part of the model will determines the potential of the companies to meet expected performance. If we are able to better that aspect, the returns can be improved by a big margin.

 

Margin Pressures Analysis

 

As seen in this quarter’s results, many companies while delivering on sales/revenue growth showed a drop in earnings. This happened due to input cost pressures which resulted in steep margin drop.


There are two aspects for such a margin drop. First, the time lag between the input cost increase and the eventual passing it on to the customer. This transition period usually shows a drop in margins but is recovered soon after. It is a temporary effect and the market also appraises the situation quickly and the stock prices recover fast.

 

Second, there are situations where cost increases cannot be passed on to the customers (at least in the near future). Such companies may not recover their market prices anytime soon. Prices move only when there are definite signs of margin improvement. Commodity cycles are typical example of such scenarios.

 

It is very difficult to predict which company will fall in which category. Instead, having a diversified portfolio like EVM Feast is a definite positive.
Increasing inflation is a bad sign for the markets.


This (Ukraine – Russia) war has had an impact on commodity prices (metals, oil, gas, etc.). Most of them are at multi-year highs.
Increasing interest rates are further expected to impact inflation.


State elections have meant that fuel cost increase has not been passed on. Post March 10th, after the state elections are done, a steep increase in fuel prices is expected which will fuel inflation as well. 

Investor Queries

Q1. With many companies not meeting the expectations, is there a change in the model that is warranted?

Ans: Getting any quantitative model 100% right all the time is impossible. The variables that impact a company performance and hence its market performance are far too many to include them all in any model. What we do is approximate what we believe are the most critical and whose historical data shows a correlation with the company operating performance.

Historically our test results have given us close to 70% correct results, i.e. 70% of companies in the portfolio have been able to meet or beat the expectations (i.e. delivered >90% of expected performance). This year, based on the results thus far, that number seems difficult to achieve. With the last quarter numbers still pending, there is always the possibility but we do realise that it will tough.

This part of the model is something we work on thru out the year. This is an effort that will never reach its conclusion. At the same time, any changes that we make needs to be thoroughly tested. With every bad company identified, there is a tendency to over-fit the model to filter that company out. What might work in hindsight may not work in the future. This is a pitfall of building quantitative models based on historical data. Models that work in hindsight always seems more intelligent.

So, while we acknowledge the need to better the model, it is not a easy task by any means. We have made minor changes and are in testing phase. Hopefully they will be ready for release for the FY2022-23 portfolio.

 

 

Q2. Explain your “Sell” philosophy. When do we sell the current holdings?

Ans: As an investor in equity markets, I have been very clear on my own “sell” philosophy. I sell only when one of these two conditions have come true:

1. I need the money to spend. Why else do we make money if we cannot use it to spend on our needs and wants?

2. I have identified a new better opportunity to invest.

 

A third exception condition always exists and that is if the company I have invested in in involved in some fraud.

So I exited either to spend or re-invest. I never really exited the markets to keep the money idle waiting for a market crash or because the valuations are high or any other reason.

There was a problem with this though.

 

As I was following the traditional approach of fundamental analysis then, point 2 always seemed true. As soon as I invested in some company, there used to few others that cropped up seeming to be much better opportunities that the one I had identified just a few months back. Basic human nature of “grass is always greener on the other-side” applied here. 

When I set out to design an investment approach/model, I started with a set of principles. One of the key principles was to use my “sell” philosophy as it is. This means that in EVM, we sell when:

1. Investor need the cash to spend (this is entirely the investor’s decision).

2. We recommend a sell when we have identified next year’s portfolio companies. 

 

Since we cannot identify the next set of companies to invest before the next years results are out, it gives us exactly 1 year of holding period there by giving us the benefit of lower Long Term Capital Gains (LTCG) tax rates. SI we followed First In First out approach to ensure that all our transactions benefitted from the LTCG benefit.

This also means that we never really exit the market and hence we never time the market as well.

We may miss a few opportunities to exit early or double down on the investments when the market gives an opportunity, but quantitative approach means we do not recommend what we cannot back test. Many decisions on early exit or increasing the investment amount are gut feelings and we surely would never want our gut to get involved in our investments.

 

 

 

Current Affairs

Strength Of Nifty50 (SON50) is now available on Smallcase.

I recommend SON50 for those of you who want to enjoy the low volatility and security of top 50 listed companies in India but at the same time, generate slightly better returns than the index itself. 

The charges for SON50 are 1200 INR for an year’s subscription. The idea is to keep the changes as low as the ETF alternatives or even lower. Since the portfolio constituents are mega cap companies, liquidity will never be a problem. Only after completing 1 year on the smallcase platform will we start actively marketing the product. Till then, you, our subscribers and readers are our only ambasaddors.

 

 US Portfolio

 

 We have been working on launching the US portfolio for quite some time. Now with the new NSE platform being launched, it will be even easier to invest in US companies. 
With situations like war becoming a reality, distributing your assets in multiple countries is also good for risk management.
Unfortunately, we have not been able to get it right as yet. We have decided to postpone the launch of the US portfolio till Feb 2023.
 

Chef's Corner - The IPO Rush

I get this question from a lot of people. Do you invest in IPOs? Do you suggest we apply for XYZ IPO?
IPOs are considered to be “safe” for some odd reason. It is considered as a bargain. I believe that happens because of two reasons:

1. Excellent marketing effort by the company and lead managers

2. Participation by some big investors (pre-IPO) which makes everything look very legitimate

3.  The “new”ness of the opportunity.

 

Unfortunately. we do not consider IPOs as a good investment vehicle. IPOs are floated to either raise money (to fund growth or to repay debt)  or to provide exit to existing owners. In both the situations, the current owners will want to raise the money at the best possible valuation at the best possible time. IPO are hence usually planned after a streak of great performances by the company and the market. 

nfortunately for us investors, while it is good if the Company make money,  we benefit only if the market values is more than the price we paid for it. Hence unless and until you know how the market values the company it is not prudent to take any position.
 

 

Thank you & Regards,
Ashish Arole
Equity Midas Capital
equitymidas.com
 
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Research Analyst Role

We are SEBI registered Research Analyst and not Investment Advisors. This means our expertise lies in researching and analysing stocks and giving our views/recommendations on those stocks. In our case, we publish them as recommendations.

 

An Investment Adviser on the other hand, works with you to plan your overall finances after understanding your financial goals. The advice offered by an Investment Adviser is personalised as against our recommendations which do not change based on individual financial situation/goals. Simply put, our recommendations are not personalised advice; it is the output of our research.

Unlike a PMS or a Mutual Fund, we are not involved in the actual trading of stocks. The actual buying and selling of the portfolio stocks is done by the subscriber himself/herself using their own trading and demat accounts.

Our service to subscribers is limited to giving access to the recommendations.

Value Investing

Investing is simple, buy low, sell high & make profit.  The core focus of investing, hence, has always been to identify stocks valued lower than their intrinsic value.

Any financial asset can be valued based on the expected returns (earnings, cash flow, dividends, etc.) in the future. These future returns when discounted at the expected rate of return (also called as discount rate)  yield us present value (or the intrinsic value) of the asset. Consider every company as a returns yielding machine. If you can forecast the expected returns, you can determine the present value. If the present value is higher than the market value, it is valued low and is a candidate for buying.

Value Investing is always a contrarian approach. Many great investors including Warren Buffett, Charlie Munger, Benjamín Graham, Peter Lynch, have their own interpretations of value investing but all of them have this trait in common. Value Investing is a game of patience, once you make your move, you have to trust the market to correct its mistake and re-value the stock to its appropriate level.

Even when the company maintains or betters it performance subsequently, it might take a few weeks to few years for the market to revalue the company. However, once you find such a company, which you bought at a relatively low price and which continues to deliver on its operational performance, you probably never need to sell such a wonderful asset! While value investing is perfectly correct in theory, its implementation in practice is much more complicated.

Predicting the future is no mean game. Even the people managing and running the business won’t be able to make correct predictions. The solution is Margin Of Safety.  Margin of Safety gives you the leeway to be wrong on the predictions but yet be right on making gains.

Rating Rationale

  • Our BUY Recommendations are the output of our proprietary quantitative model, Expectations Value Model (EVM). EVM combines financial performance, market expectations, and quantitative assessments to determine stock recommendations. To know more about the model, please visit: https://equitymidas.com/philosophy/
  • We divide the stocks in two sets viz. Large & Mid Caps and Small Caps. Top 6 companies as determined by EVM,from each sets, are given as our recommendations.
  • EVM can only be run after the annual results are declared i.e. on last day of May every year. Our BUY recommendations are hence released typically on 31st May (except when 31st May is a weekend/holiday)
  • When the next set of BUY recommendations are available, we simultaneously give SELL recommendations for the previous year’s BUY recommendations. In other words, we re-balance the recommendations once a year. Essentially, SELL recommendations only mean that the next set of BUY recommendations have been identified.
  • These are key tenets of EVM:
    1. Operational performance of the companies should be rewarded by the market, historically.
    2.  Market expectations are within the reach of the company for the next year.
    3. Company is fundamentally sound with good interest coverage.
    4. Rank the company based on valuations and probability of meeting the expectations.
  • Since EVM is run every year, the typical holding period for our recommendations is 1 year but few stocks may re-appear in our next year’s BUY recommendations.
  • We do not have any price targets.
Rating/Recommendation
Interpretation
BUYStocks identified by EVM with potential to deliver good returns (as a group) over the next twelve months. Total expected return includes dividend yields.

DO NOTE:
EVM being a quantitaitve model, has been backtested for the set of recommendations it genrates and not for performance of individual stock. Potentially, the variation in returns of individual stocks can be very high. We do not have target prices of target returns for our recommendations.
SELLHolding period of 1 year has been completed and new set of opportunities have been identified by EVM.

EVM Guidelines for Operating Performance Classification

EVM states that the market performance of any stock is closely correlated to the underlying company’s expected operating performance. Every quarter we analyse the operating performance of the recommended stocks against the expectations calculated by EVM.

 

We rank the recommendations based on the operating performance and group them in 4 quadrants based on expectations achieved in that quarter. Here is how we group them:

 

 

QUADRANT CLASSIFICATION PER EXPECTATIONS ACHIEVED (%) EVERY QUARTER
Quarter 1Quarter 2Quarter 3Quarter 4
Quadrant 1<=20<=40<=60<=80
Quadrant 2>20 & <22.5>40 & <45>60 & <67.5>80 & <90
Quadrant 3>22.5 & < 25>45 & < 50>67.5 & < 75>90 & < 100
Quadrant 4>25>50>75>100

According to EVM, the group meeting the expectations for that quarter should deliver better than market returns.