Ambit Capital - Strategy - Can 'Value' Investors Make Money In India (Thematic).pdf

STRATEGY

Analysts:

Can value investors make money in India?

Gaurav Mehta, CFA

Karan Khanna

[email protected]: +91 22 3043 3255

[email protected]: +91 22 3043 3251

April 2015

M E T H DT O

M A D N E S

Strategy

April 29, 2015 Ambit Capital Pvt. Ltd. Page 2

CONTENTS

Can value" investors make money in India?................................................ 3

Value versus quality................................................................................. 4

Value delivers over shorter time-frames. 5

The value premium dissipates over longer horizons 7

Decomposition of the value premium. 8

Are value and quality mutually exclusive? .10

Why long term?......................................................................................... 12

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

Can value investors make money in India? In this note we address the age-old debate on value vs quality. Whilst value delivers over shorter time frames (a year or less), the value premium tends towards zero over longer time frames, say 10 years. This is because whilst valuations dominate short-term performance, earnings growth dominates over longer time frames. Earnings growth, in turn, is the weakest for the cheapest stocks. Further, value and quality are not mutually exclusive; we highlight a few high-quality companies trading at reasonable valuations from our Coffee Can Portfolio (CCP) and ten-bagger portfolios.

The value vs quality debate Our investment approach centers on investing in quality businesses for the long term; our Ten-bagger and Coffee Can portfolios are both modeled on this philosophy. Further, we have tilted towards being agnostic to valuations in these portfolios, as we believe that after screening for quality, adding a further valuation filter does not enhance performance. Yet at the same time, the existence of a value premium has been well documented, especially in the Western context. In this note, we address this disconnect between the two approaches: value and quality. Value delivers over shorter time frames of around a year Analysing the performance of quintiles based on P/E suggests that low P/E works well, thus supporting the existence of value premium. The performance of value is best over a one-year holding horizon and the premium dissipates as the holding horizons increase. Moreover, earnings growth remains weak for the cheaper quintiles, suggesting that it is a rerating in valuation multiples that drives the near-term outperformance for value stocks. and the value premium dissipates over longer-term horizons The link between beginning period valuations and stock returns becomes weaker over long time frames and approaches zero on a ten-year basis. Thus, whilst valuations play an important role in driving stock returns in the near term, in the long run it is the underlying trajectory of fundamentals that drives returns, with valuations tending towards irrelevance. Thus, value stocks, with poor earnings growth, do not deliver over longer holding horizons. However, value and quality are not mutually exclusive Stocks become expensive for several reasons such as investors betting on a revival. Similarly, good companies may go out of favour due to near-term concerns and may become cheap. Thus, quality and value should not be seen as mutually exclusive groups. In fact, a distribution of firms with RoCEs of >15% suggests that such firms are uniformly distributed across P/E quintiles (like the distribution of our Ten-bagger and Coffee Can firms too). Combining value and quality, on the other hand, should thus improve returns further.

THEMATIC April 29, 2015

Strategy

High-quality companies from our model portfolios trading at reasonable valuations

Ticker Company name Trailing

P/E Part of which portfolio?

TCS IN TCS 24.5 Ten-baggers

ITC IN ITC 28.6 Coffee-can; Ten-baggers

HDFCB IN HDFC Bank 24.0 Coffee-can

COAL IN Coal India 17.4 Ten-baggers

TTMT IN Tata Motors 10.3 Ten-baggers

HCLT IN HCL Tech 17.2 Coffee-can; Ten-baggers

AXSB IN Axis Bank 18.1 Coffee-can

IDEA IN Idea Cellular 22.6 Ten-baggers

TRP IN Torrent Pharma. 23.8 Ten-baggers

MRF IN MRF 14.1 Ten-baggers

MTCL IN Mindtree 19.4 Ten-baggers

IPCA IN Ipca Labs. 21.7 Coffee-can; Ten-baggers

BIL IN Balkrishna Inds. 15.1 Coffee-can

CUBK IN City Union Bank 13.1 Coffee-can

PSYS IN Persistent Sys 19.1 Ten-baggers

ECLX IN eClerx Services 19.8

Coffee-can; Ten-baggers

FNXC IN Finolex Cables

19.3 Ten-baggers

SF IN Sundram Fasten.

27.2 Ten-baggers

GDPL IN Gateway Distr.

22.2 Ten-baggers

VST IN VST Inds. 17.3 Ten-baggers

MUNI IN Mayur Uniquoters

22.4

Coffee-can

Source: Bloomberg, Ambit Capital research. Note: These are stocks from our model ten-baggers and Coffee Can portfolios that fall in Q3, Q4 or Q5 on trailing P/E

Analyst Details

Gaurav Mehta, CFA +91 22 3043 3255

[email protected]

Karan Khanna

+91 22 3043 3251

[email protected]

The value premium dissipates in India as holding horizons increase

Source: Company, Ambit Capital research. Note: Value premium is the excess returns for the cheapest quintile on trailing P/E vs the average returns for the remaining four quintiles

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Value vs quality The debate on what matters more, value or quality, has always been a hotly contested one, and has gained more prominence recently, given the sharp share price correction in many of the expensive, good-quality names.

Our preferred investment approach traditionally has been to invest in Good & Clean companies, which implies investing in firms with high corporate governance standards and an efficient capital allocation track record. Our Coffee Can and ten-bagger portfolios have been modeled on this approach (click here for our 17 November 2014 note on the Coffee Can Portfolio and here for our 5 January 2015 note on Tenbaggers 4.0). In creating these portfolios, we have been agnostic to valuations, as beginning period valuations do not stay as relevant in shaping long-term returns, after having been already screened for quality.

In our 20 November 2014 note, Role of valuations in long-term investment success, we had shown that the five Coffee Can portfolios from 2000 to 2004 had gone on to beat the Sensex over the subsequent ten years in spite of higher beginning P/Es.

Exhibit 1: Coffee Can portfolios beat the Sensex in spite of higher beginning period valuations CAGR returns for ten-year period starting

CCP All-cap returns

Sensex returns

Beginning-period Sensex P/E

Beginning-period CCP P/E

30 June 2000 30 June 2010 16.7% 14.1% 22.7 31.8

29 June 2001 30 June 2011 21.7% 18.5% 16.9 20.1

28 June 2002 29 June 2012 19.0% 18.3% 14.2 16.0

30 June 2003 28 June 2013 25.1% 18.3% 11.7 12.9

30 June 2004 30 June 2014 31.6% 18.1% 12.5 13.5

Source: Bloomberg, Ambit Capital research

Another plot that we have often used to illustrate this point on valuations is displayed in Exhibit 2 below. This exhibit plots FY04 valuations as measured by P/E vs ten-year relative returns over FY04-14 for the BSE200 universe of firms.

The value of the R-squared makes the story self-explanatory. A zero for this value indicates that the beginning-period valuations do not play any meaningful role in explaining stock returns over the next ten years.

Exhibit 2: Data over FY04-14 suggests beginning period valuations do not materially influence investment returns over longer time frames

Source: Ambit Capital research; Note: FY04-14 returns here are stock returns relative to Sensex. Trailing P/E has been restricted to 100.

Whilst our approach of sticking to quality irrespective of valuations has worked so far (in both back-tested and live portfolio performances), there is ample literature available, especially in the developed world context, to suggest that value investing does deliver outperformance. Thus, in this note, we address this disconnect between the two approaches: value and quality.

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In this note we address the age-old debate on value vs quality

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AdminTypewriterNote 1: But for stocks where beginning valuation are so high that even in blue sky scenario, returns for next 10 years basis is below 10% should be avoided

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AdminTypewriterSee note 1

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AdminTypewriterSee note 1 plus higher the valuation, lower the subsequent returns holds true. But sticking to quality ensures that there is no permanent loss of capital....One might needs to lower his hurdle rate to stick to quality....

Strategy


Value delivers over shorter time frames To test the performance of value investing in India historically, we begin by defining value as stocks trading at cheap valuations (as measured by trailing P/E). The market (i.e. BSE200 Index) is divided into five quintiles based on the trailing P/E multiple, and performance is measured over the subsequent year with an annual rebalance of the portfolio over the last 15 years. (The portfolio rebalance is done as of the end of March every year with the prevailing share price on that day and the preceding Financial Years earnings.)

The rolling one-year returns for quintiles constructed using beginning period P/E suggests that a low P/E strategy indeed works very well over shorter time frames. Using average returns, whilst the most-expensive quintile (i.e. Q1) has delivered CAGR returns of 10% over the last 15 years, the cheapest quintile on P/E (i.e. Q5) has managed to deliver CAGR returns of ~22%. We see this as strong evidence in favour of the existence of a value premium.

Exhibit 3: Rolling one-year performance of P/E quintiles (with Q5 being the cheapest quintile) over the last 15 years (average basis)*

Source: Bloomberg, Ambit Capital research. Note: The portfolio rebalance is done on 31st May every year. Stocks with trailing P/Es above 100 have been excluded from the universe. Performance for the latest year has been updated till 27 April 2015.

The premium continues to exist even if we use median returns instead of average returns, suggesting this value premium is not the result of a few outliers. On a median basis, whilst the cheapest quintile has delivered CAGR returns of ~14%, the most expensive quintile has delivered CAGR returns of ~6%. This translates into a performance differential of ~8% for Q5 vs Q1 on a CAGR basis.

Exhibit 4: Rolling one-year performance of P/E quintiles over the last 15 years (median basis) *

Source: Bloomberg, Ambit Capital research. Note: The portfolio rebalance is done on 31st May every year. Stocks with trailing P/Es above 100 have been excluded from the universe. Performance for the latest year has been updated till 27 April 2015.

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Rolling one-year returns for quintiles constructed using trailing P/E suggests value delivers over time frames such as a year

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AdminTypewriterFrequent churning improves returns drastically in cheap quality stocks and reduces return drastically in high quality stocks. Buy & Hold works for high quality, whereas for cheap quality one needs to get both entry and exit right.

Strategy


Thus, it is evident from the discussion above that over shorter time frames, a value-oriented strategy seems to have worked well historically. However, as can also be seen very clearly from these two exhibits, performance of value has a degree of cyclicality to it. In the past four years, the Q5 worm seems to have stagnated even as Q1 has continued to rise. This is in line with our previous work on the subject (see here) that value delivers in periods of conducive macro but does not when the macro turns challenging.

The idea of the current work, however, is to assess the performance of value on a very long-term, cross-cyclical basis. In that context, at least over a one-year holding horizon, value has delivered in the past 15 years. Whether or not does the value premium continue to exist for longer holding periods (say 3, 5 and 10 years) is what we address in the next section.

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The value premium dissipates over longer horizons As discussed in the previous section, there seems to be evidence of the existence of a significant value premium on a one-year basis. In this section of the note we analyse whether or not the value premium remains over longer time frames as well.

Exhibit 5 below shows the average returns for the quintiles constructed using beginning period valuations over different time horizons for the last 15 years.

Exhibit 5: Performance of value over different time horizons

Quintiles based on beginning P/E

Subsequent returns


Q1 8.3% 10.5% 12.5% 13.2% 13.6% 13.3%

Q2 14.4% 14.5% 15.4% 16.7% 17.7% 17.1%

Q3 12.7% 13.6% 15.3% 15.2% 15.8% 13.3%

Q4 13.0% 12.3% 12.6% 13.6% 13.5% 11.4%

Q5 16.8% 16.3% 15.9% 15.0% 14.1% 9.4%

average (Q1-Q4) 12.1% 12.7% 14.0% 14.7% 15.2% 13.8% Value premium (Q5 minus average) 4.7% 3.5% 2.0% 0.3% -1.0% -4.4%

Source: Bloomberg, Ambit Capital research. Note: stock returns for a quintile at any point in time are on a median basis; quintiles returns have then been averaged over time. Stocks with trailing P/Es above 100 have been excluded from the universe.

An analysis of the returns for these quintiles over longer time frames suggests that whilst the value quintile continues to outperform, as can also be seen in Exhibit 6 below, the value premium dissipates over longer holding horizons.

Exhibit 6: The value premium dissipates as holding horizons increase

Source: Bloomberg, Ambit Capital research. Note: stock returns for a quintile at any point in time are on a median basis; quintiles returns have then been averaged over time. Stocks with trailing P/Es above 100 have been excluded from the universe.

Thus, whilst value works well over shorter time frames, the link between beginning period valuations and stock returns gets weaker over long time frames and approaches zero on a ten-year basis. This also explains the zero R-Squared thrown up by a regression of beginning valuations and the subsequent ten-year returns in Exhibit 2 (page 4).

One direct conclusion from this analysis is that whilst valuations play an important role (P/E in this case) in driving stock returns in the near term, it is the underlying trajectory of fundamentals (earnings in this case) that drives returns in the long run, with valuations tending towards irrelevance. We explore this point in the next section.

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Decomposition of the value premium That returns are significantly affected by valuations in the near term but are driven by fundamental performance in the long term seems to the key learning from the findings of the previous section. We will shortly demonstrate this with actual numbers at the stock level for the five P/E-based quintiles, but before that going through a deconstruction of returns at the index level into these two components - valuation change and earnings growth - is equally enlightening.

As is evident from Exhibit 7 below, on a YoY basis, valuation rerating has been the single biggest driver of Sensex returns. In contrast, over longer time horizons, Sensex returns have largely been driven by earnings compounding. The 15% CAGR returns delivered by Sensex has broadly mirrored its earnings growth over the same time horizon (see Exhibit 8 below).

Exhibit 7: Whilst P/E seems to be a bigger driver of Sensex returns over shorter time frames

Source: Ace Equity, Ambit Capital research. Note: Both Sensex returns and change in P/E have been calculated on a yearly basis starting from Dec 90.

Exhibit 8: Sensex returns have mirrored EPS growth over long periods

Source: Ace Equity, Ambit Capital research. Note: Both Sensex and Sensex EPS have been rebased to 100 at the beginning of Jan 91.

Thus, over the long term, returns mirror earnings growth even as they are primarily driven by valuation changes in the shorter term, at the index level.

Coming back to stocks, a decomposition of returns of the P/E quintiles is shown in Exhibits 9 and 10 below. Even as earnings growth stays weakest for Q5 and strongest for Q1, Q5 still manages to outperform over shorter time frames primarily owing to a valuation rerating (vs a derating for Q1) over shorter time frames.

Over longer time horizons, however, the valuation rerating that explains the value premium becomes much smaller in magnitude in comparison to earnings growth. Further, earnings that become much more important over longer time horizons are significantly inferior for the value quintile vs the other quintiles (see Exhibit 9 below). As a result, the premium that value enjoys on a one-year basis gradually tapers off over time.

Exhibit 9: Even as earnings growth is weakest for Q5 and strongest for Q1

Quintiles based on beg. P/E

Subsequent earnings growth


Q1 34.7% 27.7% 25.5% 23.3% 21.3% 17.6%

Q2 21.1% 18.6% 17.7% 17.6% 17.5% 16.4%

Q3 12.0% 11.6% 12.7% 12.5% 12.5% 12.0%

Q4 2.7% 6.4% 6.8% 9.4% 9.9% 12.7%

Q5 -1.5% 3.0% 5.6% 6.4% 6.9% 7.0%

average (Q1-Q4) 17.6% 16.1% 15.7% 15.7% 15.3% 14.7%

Q5 minus average -19.2% -13.1% -10.1% -9.3% -8.4% -7.7%


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Whilst returns are primarily driven by valuation changes over shorter time frames

earnings become much more important over longer time horizons

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Exhibit 10: valuation changes ensure better returns for Q5 over shorter time frames

Quintiles based on beg. P/E

Subsequent earnings multiple change


Q1 -18.4% -13.7% -10.0% -7.3% -4.5% -1.0%

Q2 -7.7% -2.1% -1.5% 0.2% 1.3% 2.1%

Q3 1.0% 3.6% 3.9% 4.8% 4.6% 3.4%

Q4 16.6% 12.1% 12.1% 9.9% 8.9% 3.8%

Q5 23.9% 18.9% 16.1% 14.4% 13.6% 6.9%

average (Q1-Q4) -2.1% 0.0% 1.1% 1.9% 2.5% 2.1%

Q5 minus average 26.1% 18.9% 15.0% 12.5% 11.1% 4.9%

Source: Bloomberg, Ambit Capital research.

Given that investing in high-quality franchises with strong longer-term outlooks has traditionally been the cornerstone of our investment philosophy, it is encouraging to see that earnings growth - and not valuations - is a more important driver of investment returns over the long term.

A backtest of the returns from our Coffee Can Portfolios corroborates this finding. As is evident from Exhibit 11 below, the ten-year returns of these portfolios have more or less converged to the earnings growth over the period with valuations (i.e. P/E expansion) becoming almost irrelevant.

Exhibit 11: CCP return decomposition shows that earnings growth is the biggest driver of portfolio returns Iteration Run-period Total returns P/E expansion Earnings growth

2000 30 June 2000 30 June 2010 16.7% -5.7% 23.7%

2001 29 June 2001 30 June 2011 21.7% 2.7% 18.6%

2002 28 June 2002 29 June 2012 19.0% 0.7% 18.2%

2003 30 June 2003 28 June 2013 25.1% 3.5% 20.9%

2004 30 June 2004 30 June 2014 31.6% 3.9% 26.6%

Average 22.8% 1.0% 21.6%


However, before we conclude this discussion, there are two points that need to be elaborated upon.

a) Are value and quality mutually exclusive?

Whilst everything boils down to earnings growth in the long term, does value working over shorter time frames in turn imply that quality does not deliver over such horizons?

b) Why long term?

Why do we place so much emphasis on long-term investing? After all, as Keynes famously said, in the long term we are all dead.

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Are value and quality mutually exclusive? Given that value works well over intermediate time frames, one could conclude that quality does not over such time frames. More generally, there is a tendency to equate value with low quality and vice versa.

This view gets further enforcement from the fact that forward-looking earnings growth for Q5 stays much weaker vs Q1, suggesting that Q5 indeed comprises low-quality stocks. However, it is important to note that growth in accounting earnings is not in itself a conclusive evidence of quality (a company like Arshiya for example showed stellar EPS growth of ~35% over FY07-12; however, Arshiya does not qualify on Ambits Good & Clean criteria by any stretch of the imagination).

Using RoCE as another dimension of quality, we tabulate the distribution of firms with RoCEs of more than 15% across the five P/E quintiles in Exhibit 12. First, contrasting the performance of firms in these quintiles with RoCEs of more than 15% with that of the full quintile clearly suggests that superior RoCE leads to superior performance.

More importantly, the distribution of quality (defined as firms with RoCE greater than 15%) across the five quintiles is more or less uniform, with concentration in Q1 not being materially higher versus other quintiles.

Exhibit 12: RoCE distribution in the P/E quintiles

% of firms

with RoCE>15%

Median returns [over May 00-May 15]

for all firms in the quintile

Median returns [May 00-May 15]

for firms with RoCE>15%

Q1 55% 4.9% 9.8%

Q2 68% 12.4% 13.3%

Q3 64% 8.0% 10.6%

Q4 62% 8.7% 10.8%

Q5 62% 14.0% 17.4%

Source: Bloomberg, Ambit Capital research. Note: Universe is BSE200 index rebalanced annually. Performance has been measured over May 00 May 15.

Similarly, a distribution of our ten-bagger and CCP firms across the five quintiles has been displayed in Exhibit 13 below. Given the stringent quality filters that we use to construct these portfolios, one would expect these stocks to be trading at expensive valuations (and hence dominate Q1), especially given that quality has performed so well over the last few years.

Yet, what is evident from the exhibit below is that these portfolios are again uniformly spread across the first four P/E quintiles (very few of these firms lie in Q5, the lowest P/E quintile).

Exhibit 13: Distribution of our ten-bagger and CCP firms across the five P/E quintiles

Q1 Q2 Q3 Q4 Q5 Total

Ten-baggers 23% 23% 37% 13% 3% 100%

Coffee-can portfolio 25% 19% 31% 25% 0% 100%

Source: Bloomberg, Ambit Capital research. Note: This is the distribution of our Ten-baggers 4.0 portfolio published on 05 January 2015 and our Coffee-can portfolio published on 17 November 2015 using trailing P/E as on 23 April 2015.

Similarly the distribution of our first three ten-bagger portfolios, published once every year for the last three years, across the five P/E quintiles (basis the trailing multiples at the time of publication of the respective portfolios) is shown in Exhibit 14 below. Here too the distribution is relatively uniform, especially in the first four quintiles, suggesting there is no undue concentration of these stocks in Q1.

Distribution of high RoCE firms across the five quintiles is more or less uniform

Even our ten-bagger and CCP firms are uniformly spread across the first four P/E quintiles


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AdminTypewriterEven in low PE multiple, quality [ROCE > 15%] wins...

AdminTypewriterBad quality companies generally have lower PE, but all low PE companies are not bad. Same for high PE...

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Exhibit 14: Distribution of our first three ten-bagger portfolios across the five P/E quintiles

Q1 Q2 Q3 Q4 Q5 Total

Ten-baggers 1.0* 25% 38% 25% 8% 4% 100%

Ten-baggers 2.0 30% 30% 23% 10% 7% 100%

Ten-baggers 3.0 33% 23% 30% 10% 3% 100%

Source: Bloomberg, Ambit Capital research. Note: This is the distribution of the first three iterations of our Ten-baggers portfolio published on 19 January 2012, 14 January 2013 and 26 November 2013 using trailing P/E as on date of publication. *excludes Tata Power as the company made losses on a trailing twelve month basis.

In conclusion, stocks may become expensive for several reasons like investors betting on a revival in the economy in general or a turnaround for a company in particular. Similarly good-quality companies may go out of favour due to near-term concerns and may become cheap. Therefore, quality and value should not be seen as mutually exclusive groups. This also helps reconcile why our ten-bagger portfolios have continued to deliver each year even as the findings of this research piece suggest that value works well over time frames such as a year. Combining value and quality, on the other hand, wherever possible, should improve returns further.

In that context, several quality companies that comprise our Coffee Can and ten-bagger 4.0 portfolios are also trading at reasonable valuations. This short list of (CCP and ten-bagger) firms that fall in Q3, Q4 or Q5 on trailing P/E currently is shown in Exhibit 15 below.

Exhibit 15: High-quality companies from our model portfolios trading at reasonable valuations

Ticker Company name Mcap (US$ mn) 6M ADV

(US$ mn) Trailing

P/E Quintile on

trailing earnings Features in which

Ambit portfolio?

TCS IN TCS 77,309 51.9 24.5 Q3 Ten-baggers

ITC IN ITC 42,801 53.6 28.6 Q3 Coffee-can; Ten-baggers

HDFCB IN HDFC Bank 39,831 32.6 24 Q3 Coffee-can

COAL IN Coal India 37,210 26.0 17.4 Q4 Ten-baggers

TTMT IN Tata Motors 26,418 42.7 10.3 Q5 Ten-baggers

HCLT IN HCL Tech 19,357 36.8 17.2 Q4 Coffee-can; Ten-baggers

AXSB IN Axis Bank 20,074 51.0 18.1 Q4 Coffee-can

IDEA IN Idea Cellular 10,919 16.6 22.6 Q3 Ten-baggers

TRP IN Torrent Pharma. 3,188 1.8 23.8 Q3 Ten-baggers

MRF IN MRF 2,504 9.8 14.1 Q4 Ten-baggers

MTCL IN Mindtree 1,551 4.4 19.4 Q3 Ten-baggers

IPCA IN Ipca Labs. 1,277 4.3 21.7 Q3 Coffee-can; Ten-baggers

BIL IN Balkrishna Inds. 1,130 2.0 15.1 Q4 Coffee-can

CUBK IN City Union Bank 869 1.4 13.1 Q4 Coffee-can

PSYS IN Persistent Sys 894 2.5 19.1 Q3 Ten-baggers

ECLX IN eClerx Services 760 1.3 19.8 Q3 Coffee-can; Ten-baggers

FNXC IN Finolex Cables 666 1.4 19.3 Q3 Ten-baggers

SF IN Sundram Fasten. 595 0.7 27.2 Q3 Ten-baggers

GDPL IN Gateway Distr. 622 2.2 22.2 Q3 Ten-baggers

VST IN VST Inds. 408 0.2 17.3 Q4 Ten-baggers

MUNI IN Mayur Uniquoters 299 0.5 22.4 Q3 Coffee-can

Source: Bloomberg, Ambit Capital research. Note: Universe for the purpose of arriving at the quintile on trailing valuations is BSE500 index as of Oct 14.

Combining value with quality should help improve returns further



AdminTypewriterHigher PE Is not equal to qualityalways, but vice-versa is true in LT

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Why long term? Equities, given the inherent volatility, are usually touted as a long-term asset class. This makes sense at an intuitive level - whilst the Sensex has returned over 15% CAGR returns over the last 25 years, there have been intermittent periods of unusually high drawdowns. For example, in 2007, an investor entering the market near the market peak would have lost over 60% of value in less than twelve months of investing. Thus, whilst over longer time horizons, the odds of profiting from equity investments are very high, the same cannot be said of shorter time frames.

In his book, More than you know, Michael Mauboussin illustrates this concept using simple math in the context of US equities. We use that illustration and apply it in the context of Indian equities here.

We note that the Sensexs returns over the past 30 years have been 16% on a CAGR basis, whilst the standard deviation of returns has been ~29%. Now using these values of returns and standard deviation and assuming a normal distribution of returns (a simplifying assumption), the probability of generating positive returns over a one-day time horizon works out to ~51.2%.

As the time horizon increases, the probability of generating positive returns goes up. The probability of generating positive returns goes up to ~70% if the time horizon increases to one year; the probability tends towards 100% if the time horizon is increased to 10 years (see Exhibit 16 below).

Exhibit 16: Probability of gains from equity investing in India increase disproportionately with increase in holding horizons

Source: Bloomberg, Ambit Capital research. Note: This chart has been inspired by similar work done by Michael Mauboussin in the Western context.

In addition to a disproportionately higher probability of profit, three other factors work in favour of longer investment horizons at the portfolio level:

(a) No churn: By holding a portfolio of stocks for over ten years, the investor resists the temptation to buy/sell in the short term. With no churn, this approach reduces transaction costs which add to the overall portfolio performance over the long term.

(b) Power of compounding: Holding a stock for long periods allows the power of compounding to play out. As a result, winning stocks gain disproportionately and start dominating portfolio returns while losing stocks fade away to irrelevance. Thus, even with modest strike rates, investors improve their portfolio returns by holding stocks for the long term.

(c) Neutralising the negatives of noise: Investing over longer time horizons is also an effective way of killing noise that interferes with the investment process. Consider for example, how over the long term Lupins investors have had to withstand short-term disappointments to eventually compound at an impressive 33% CAGR since Jan 04 (see Exhibit 17 below).

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The probability of generating positive returns increases disproportionately with increase in holding horizons

No churn, power of compounding and neutralising the negatives of noise are other factors that work in favour of longer investment horizons

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AdminTypewriterNo Churn once quality bought at fair price, unless even in blue sky scenario returns less than 10%

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Exhibit 17: Lupins stock price has compounded at an impressive 33% CAGR since Jan 04


The chart shown above highlights that over the past 11 years, there are several extended time periods when Lupins share price has not gone anywhere such as from Jan 04 to Mar08 and from Jun10 to Jan12. In spite of remaining flat over these periods, Lupin has performed so well in the remaining six years that the 11-year CAGR of the share price is 33%. At its simplest, this is why the concept of investing for longer time horizons works once you have identified a great franchise and you have the ability to hold on it for a long period time, there is no point trying to be too precise about timing your entry or your exit. As soon as we try to time that entry/exit, we run the risk of noise rather than fundamentals driving our investment decisions.

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Lupin's share price

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Institutional Equities Team Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 [email protected]

Research

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E&C = Engineering & Construction

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Explanation of Investment Rating

Investment Rating Expected return (over 12-month)

BUY >10%

SELL

Documents

Ambit Capital - Strategy - Can 'Value' Investors Make Money In India (Thematic).pdf