- Wealth PMS (50L+)
FY22 was a good year for the CM Focused portfolio, up 36.7%, while the Nifty 50 advanced by 19%.
In this post, we’ll break down the CM Focused Portfolio’s performance and get into the underlying portfolio management process.
The chart shows the cumulative performance of the CM Focused Portfolio starting Jan 2019.
Reading this chart: ₹100 invested on day 1 in Jan 2019 be worth ₹208/- in Focused vis-a-vis 162/- and 160/- in Nifty 50 and CNX 500, respectively, at the end of April 2022
Since its peak in October 2021, the NIFTY is down -9%. In comparison, CM Focused is down by -6.6%. This was achievable because we increased our cash allocation up to 35% by Nov 2021. More on this later. This is in line with how we’d like the portfolio to outperform by a little, both when markets are up and when markets fall. Do this over a few years, enabling significant outperformance versus the benchmark.
CM Focused is up by 1.1% in Apr 2022 and down -0.9% YTD on recent performance. Nifty 50, on the other hand, is down -1.3% in Apr 2022 and up by -1.2% YTD.
This puts CM Focused in the top 15 percentile of all Flexi & Multi cap mutual funds in the last year.
Reading this chart: Annualised Returns, higher the better, Volatility: lower the better, and Maximum Drawdown: lesser the better.
The better way to visualise returns is to look at rolling returns. The chart below shows 1-year rolling returns, i.e. the 1-year returns as of any given date. If that green line stays above the grey lines more or less consistently, it’ll be a job well done.
The chart shows 1-year rolling returns from Jan 2020.
In a nutshell, CM Focused is a fundamentally picked portfolio of companies with the potential for significant earnings growth over the next 3 to 5 years and trading at reasonable valuations. What follows is meant to offer more context on how we think about managing the CM Focused portfolio.
First a recent story that shook the Global Hedge Fund Industry.
A story of human biases, leveraged punts and egoistic bets. This is the story of Gabe Plotkin.
Gabe Plotkin was with Steven Cohen’s SAC Capital before starting Melvin Capital in 2014. The fund at its peak managed over $12 billion and generated an envious 30% CAGR from 2014 to 2020.
Melvin Capital was short on GameStop (an offline gaming retailer) since 2014. Things were great until they weren’t. A group of Reddit users launched a war against these Hedge funds and started buying GameStop stock. This pushed the stock up by 2500% in Jan 2021. Melvin had lost 54.5%, or roughly $6.8 billion, by the end of the same month.
One year, Two bailouts & a thousand memes later…
Gabe Plotkin went back to his investors and (kind off) said, “Guys, your portfolio is down 50%. It is difficult for me to bring it back to the previous highs. Furthermore, I am losing on my performance fee. Let’s do one thing. Here is your money. Take it back and re-invest in my new fund. By doing this, I don’t have the baggage of under-performance and can charge a hefty performance fee. We good?”
Needless to say, there was a backlash among the investors & the hedge fund community. He immediately realized his mistake and backed off.
Gabe is undoubtedly one of the sharper minds on Wall-street. Yet, the extreme pressure of underperformance, drawdowns, and misaligned incentives impacted. The urge to be right always, setting the bar too high, being fixated on a particular outcome etc., are a few ways smart people manage to shoot themselves in the foot. There are lessons to learn from the tale of Melvin Capital.
What are the vulnerabilities when managing a portfolio? What can we do to minimise them, get around them and more importantly, survive them and give ourselves a better chance to win in the long run?
Big losses compound investors’ irrational behaviour. You & I are no different. We need a framework to deal with such scenarios while managing portfolios:
Avoiding huge drawdowns
Minimising “big” losses is more important than maximising gains. Huge drawdowns are painful in the short term and create a dent in long-term returns.
For example, assume the following table in which you had two years of similar returns, and in the third year, you are down by the same percentage. You will notice that the best CAGR was by someone who generated 30% for two years and -30% in the third year, compared to 70% for two years and -70% in year 3.
So we scale up and down while building our positions. This gives us the flexibility to upsize & downsize the allocations as per the company’s growth prospects. It also allows us to move to cash as per market conditions.
We don’t preach Buy & Hold forever. High-growth companies command high PEs, but markets quickly derate such stocks when growth moderates. So we keep an eye on the technicals and have a “soft Stop-Loss” in place for every holding. “Soft” means stocks breaking down trigger a review even if nothing fundamental has changed. For instance, a stock breaking down in an otherwise steady market could signify that some bad news is around the corner.
Of course, this doesn’t mean we avoid all drawdowns. Drawdowns and pullbacks are a necessary part of equity investing. We strive to avoid deep drawdowns that are hard to come back from.
During market panic situations, even the best investors fail to react rationally and get carried away by their emotions. This often leads to forced selling at the lowest possible prices. In such scenarios, we refrain from taking rushed action. We wait for the market to stabilize and assess the situation.
Here are three examples in the last year where we stayed put during the market chaos:
Scenario 1: Russia-Ukraine war
Russia fired its first missile on Ukraine on Feb 24th, 2022. A day later, we sent a note to our subscribers about our action plan if things go south. We analyzed three possible scenarios and took each day as it came. A month later, the World had moved on. All the major indices like Nifty 50, Dow Jone, FTSE etc., have recovered from their Feb 2022 lows.
*Our slack communication to our subscribers about the Russia-Ukraine War and our plan of action
Scenario 2: A wild beast named IRCTC
We entered IRCTC in Apr 2021, considering the favourable valuations and growth triggers like additional Capex in Rail Neer, Internet ticketing to reach 80% from the current 72% and venturing into air ticket & bus booking portal. However, in Oct 2021, the stock was in the news for all the wrong reasons. While the markets may be wrong in valuing a PSU, the government did its job perfectly by messing it up. It levied profit share on convenience fees on a day when the stock went ex-split. Only to revert a day later.
In two days, the stock was down 31%. We trimmed our position to half & waited for the panic to settle down. We fully exited the stock in Nov 2021 once the panic had subsided. Overall, the holding returned 155% returns in less than a year.
Scenario 3: Zomato failed to deliver
We entered Zomato in July 2021 with an allocation of 3%. However, within a few months, things looked iffy. They invested in start-ups like Curefit and Shiprocket and entered the BNPL segment. The market didn’t like these developments, and the stock was under continuous pressure. In Jan 2022, on the back of a global-tech sell off, the stock had seen a drop of -30% within three days. We waited for things to stabilize and exited at Rs 92/- with a loss of -32%. The stock continued its downward trajectory and is currently trading at Rs 66/-.
In Oct 2021, as markets were getting weak, we initially raised our cash levels to 20% & took it to 35% in mid-November, as opportunities were hard to come by. This tactical allocation between equity & cash will help us navigate volatility in the markets and invest when the opportunity arises. Cash will continue to be a defensive and sometimes offensive position in the portfolio.
In FY22, the CM Focused portfolio was up by 36.7%, while the Nifty was up 19%, with an alpha of 17.7%. These returns were on the back of holding around 20% cash for several months of the year.
A value stock turned into a growth story.
BSE generated a significant part of our alpha. We entered BSE when it was at a market cap of 2750 Cr with a cash & cash equivalents of ~1600 Cr. Our initial SOTP suggested a valuation of 5600 Cr. We partially booked profits in Aug 2021 & Mar 2022, as we allocate no more than 12% of the portfolio on a single stock. The stock is 3x from our initial purchase and a doubler on the average buy price. We continue to hold the stock in our portfolio.
A 10 bagger called Alkyl Amines
We added Alkyl Amines in Oct 2019 it went on to go up 10x. Revenues grew by 26% and PAT by 60%. While the company was delivering on earnings, the PE also expanded from 17 to 63 during the same time. These valuations for a chemical company seemed overly optimistic. We had seen an expansion in margins on the back of lower RM costs during the same time. In Q1FY22, the company had reported a historically high operating margin of 38% and PAT margin of 26%. We expected that these margins were not sustainable and started to decrease our stock allocation.
In Apr 2021, we initially bought down our allocation from 6.6% to 3%. And exited fully in Aug 2021. The stock was up 90% in FY22 (till our exit), contributing to our alpha.
A company taking market share from the leader
In Feb 2021, we added POLYCAB, an FMEG (Fast-Moving Electrical Goods) player in its growth phase. The company is one of the strong players in the wires & cables segment. Revenue growth has been phenomenal in the last three years. The FMEG market is estimated to be ~80,000 Cr; the company has a market share of 12% in the wires and cables segment. We bought the stock as part of the theme of shifting from unorganised to organised and raising brand value. We bought it at a reasonable valuation of 19 times EV. The next leg of growth comes from exports and Government initiatives. The stock is up by 75% in FY22 and around 80% from our initial purchase, contributing to overall alpha.
But, Markets have been generous
We can list down another three reasons stating why we generated alpha, but that only means we are ignoring the power of markets in general and liquidity in particular. Post-Covid, the market had seen the rally of its decade. It started in Apr 2020 and continued until Oct 2021 (probably, by looking at current market conditions). The wave had lifted every boat in its way. Ours included.
However, things have been back to the basics in the last six months. The froth is gone. Markets like these are a real test for any portfolio strategy. How we perform in the next year is what matters the most.
*A wall quote in our office
While CM Focused has a few multi-baggers in our kitty, we have our fair share of laggards, mistakes of commission & omission. Let’s look at our missteps in FY22, what went wrong, and our learnings from them:
Buying Zomato & Nykaa:
As discussed above, we bought into Zomato & Nykaa, considering the theme of new-age tech disruptors and the execution capabilities of the founders. But soon after the IPO, Zomato invested in areas like grocery delivery (investments in Blinkit), health (Cure fit) etc. We realized our mistake and exited both Zomato & Nykaa at a loss of 32% & -22%, respectively.
Staying away from financials
We exited Manappuram Finance in June 2021 and, since then, have stayed away from financials. We expected post-Covid book cleaning to happen over a period of three to four quarters and predicted an increase in NPAs. However, the banks & NBFCs came out of stress safe and sound. The businesses are back, and the asset quality has gone to pre-Covid levels. Even though we were closely tracking this sector and aware of the ongoing changes, we couldn’t go ahead with a Buy recommendation on a few names we liked. This error of omission might have cost us a few percentage points of alpha in our portfolio.
Increased weightage of the company at the wrong time
We hold a platform-based product company that generates 400 Cr free cash flow every year and needs zero Capex to grow. Since then, it has been part of our portfolio from Apr 2020 and has been up 25%. In Dec 2021, the stock had corrected as much as -32% from its recent highs. The business & valuation looked attractive. We increased our allocation from 4.8% to 7%. The stock is further down -17% since then. While we can’t predict the short term moves, we could have waited for the stock to show some reversal before increasing our allocation.
We mainly focus on sectors that we understand the most. Our circle of competence lies mainly within IT, FMCG, Financials, Pharma, Chemicals, Auto, and select Industrials. On the other hand, we try to stay away from sectors like Steel, Infra, Capital goods, Airlines, etc., where the earnings predictability is low.
This will continue to be our strategy for FY23 unless we see some drastic change in fundamentals or growth prospects of any particular sector.
We are currently holding 30% cash in our Focused portfolio. Please note that the cash is a residual value of our portfolio. Meaning that we will move to cash if we don’t find enough opportunities in the market.
We are waiting for our fat pitch. If we swing in FOMO, we may be locked in for low returns. But if we let go of all the ideas, there is no assurance that the next will be more attractive. Hence we are trying to find a balance between the two.
We are constantly in search of new ideas and also looking to increase our allocation in our recent additions. The idea is to reduce cash in a phased manner instead of deploying it in one go. Hopefully, the ongoing market correction may throw some opportunities at us to deploy our cash back into the market.
With the unscheduled rate hike by the RBI this week, it is now official that interest rates are now on their way up. In the US, the Fed raised by 0.5%. Only a matter of time before other central banks follow suit.
Interest rates act as gravity for equity markets. As money becomes expensive, corporates will get less keen on Capex led growth. This, followed by higher raw material costs for the companies, reduce margins further. On the consumer side of the story, discretionary spending comes down.
FIIs inflow may get impacted as local debt becomes more attractive for them. This could be followed by a slowdown in corporate earnings—A double whammy situation for a domestic equity investor.
But if we try to zoom out a little and think long-term, all these uncertainties are of meagre importance. This is not the first-rate hike nor the first market correction. We look at the current volatility as an opportunity to buy some great businesses and be part of their growth story in the long run.
I’ll conclude with a quote from one of my favourite fund managers, Paul Tudor Jones.
We are aware not to go overboard by last year’s returns and keep our foot on the ground while hunting for the next big opportunity. Dear Mr Market, Bring it on.
We recently launched our Focused portfolio on Smallcase. The constituents & weights remain the same as the premium portfolio. If you are already a premium member, you no need to subscribe to Focused Smallcase.
But if you are looking to build a portfolio of strong businesses which are in their high growth trajectory, please go ahead and check the details on the Smallcase website.