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STRATEGY November 2016 Year 1 Year 10 The Coffee Can Portfolio 2016 Research Analysts: KaranKhanna,CFA RakshitRanjan,CFA SagarRastogi AnujBansal [email protected] [email protected] [email protected] [email protected] Tel:+912230433251 AadeshMehta,CFA PareshDave,CFA AshvinShetty,CFA NitinBhasin [email protected] [email protected] [email protected] [email protected] PrashantMittal,CFA RaviSingh AbhishekRanganathan,CFA NikhilPillai [email protected] [email protected] [email protected] [email protected] Strategy CONTENTS SECTOR The Coffee Can Portfolio 2016 …………………………………………………….3 Executive Summary ……………………………………………………………………4 The case for a Coffee Can portfolio ……………………………………………….9 A framework for constructing the Indian Coffee Can portfolio ……………….13 Does the approach work? Results from our back-testing ……………………..15 Performance of the Coffee Can portfolios launched in ……………………….18 2014 and 2015 Optimal way to deploy fresh funds each year ………………………………….21 The ideal life of a Coffee Can portfolio ……………………………………….…24 Today’s Coffee Can for 2016-2026 ……………………………………………..26 Appendix 1: How the Coffee Can is different to our …………………………131 other portfolio constructs Appendix 2: Performance of the 14 back-tested ……………………………..133 Coffee Can portfolios Appendix 3: John Kay’s IBAS Framework ……………………………………..150 COMPANIES HDFC Bank (SELL): Flawless execution …………………………………………..27 Axis Bank (BUY): A strong core ……………………………………………………33 HCL Technologies (BUY): Set to surf the IoT wave ……………………………..39 Asian Paints (BUY): A legend built over several decades ……………………..45 Lupin (BUY): Dukes have castellated the fort …………………………………...51 Cadila (BUY): Inches make champions ………………………………………….57 Britannia (SELL): On a steady growth path ……………………………………...63 LIC Housing Finance (SELL): The old lady of housing finance ………………..69 Page Industries (BUY): ‘Inner’ Strength ………………………………………….75 Amara Raja Batteries (SELL): Competitive edge under threat ………………..81 GRUH Finance (NOT RATED): Will it stand the test of time? …………………89 Dr Lal PathLabs (NOT RATED): Long-term growth path ……………………….95 eClerx (SELL): No room for error ………………………………………………..101 Astral Poly (NOT RATED): A ‘fanatic’ challenger ………………………………107 Relaxo Footwears (NOT RATED): The nimble footed giant …………………113 REPCO Home Finance (NOT RATED): Swimming against the tide …………119 Cera Sanitaryware (NOT RATED): A super-efficient Superbrand …………..125 November 17, 2016 Ambit Capital Pvt. Ltd. Page 2 Strategy THEMATIC November 17, 2016 The Coffee Can Portfolio 2016 The Indian Coffee Can Portfolio 2016 In this annual update of our coffee can portfolio, we further augment the HDFC Bank Our stance: SELL case for this unique construct. The previous editions of the coffee can Mcap (US$ bn): 47.6 ADV - 6m (US$ mn): 25.9 portfolio (CCP) have done remarkably well, with 18.4% outperformance Axis Bank Our stance: BUY and 9.6% outperformance (in CAGR terms) for the two iterations since Mcap (US$ bn): 17.5 ADV - 6m (US$ mn): 85.8 publication in Nov ’14 and Nov ’15 respectively. That said, our analysis HCL Technologies Our stance: BUY suggests for the true potential of the coffee can construct to play out, the portfolio should be left untouched for a decade. Asian Paints, HDFC Mcap (US$ bn): 16.6 ADV - 6m (US$ mn): 27.4 Bank, Page and Astral are some prominent stocks that again appear in Asian Paints Our stance: BUY this year’s portfolio. Relaxo, Repco and Dr Lal are the new entrants. Mcap (US$ bn): 15.2 ADV - 6m (US$ mn): 17.6 The case for a Coffee Can Portfolio Lupin Our stance: BUY The coffee can construct hinges on investing in high quality franchises (which Mcap (US$ bn): 10.4 ADV - 6m (US$ mn): 30.1 have a superior track record of financial performance over the preceding decade) Cadila Health. Our stance: BUY for a very long period of time – a decade to be precise. The virtues of such a Mcap (US$ bn): 5.9 ADV - 6m (US$ mn): 5.1 construct include: (a) significantly raising the probability of making returns; (b) reducing costs by avoiding churn; (c) allowing the po wer of compounding to work Britannia Inds. Our stance: SELL its magic; and (d) removing the negatives of “noise”. Mcap (US$ bn): 5.6 ADV - 6m (US$ mn): 10.0 Back-tests prove the potential of the CCP to beat the benchmark LIC Housing Fin. Our stance: SELL Both on a live basis as well as in back-tests, the previous 16 iterations of the Mcap (US$ bn): 4.0 ADV - 6m (US$ mn): 18.1 Coffee Can Portfolio have handsomely outperformed the Sensex as well as Page Industries Our stance: BUY broader market indices, such as the BSE200 index. Further, on a total returns Mcap (US$ bn): 2.7 ADV - 6m (US$ mn): 2.4 basis (i.e. including dividends), the Coffee Can Portfolio’s returns are +1% to +3.7% points higher than the returns under a share price only scenario. Amara Raja Batt. Our stance: SELL Mcap (US$ bn): 2.6 ADV - 6m (US$ mn): 5.0 True potential of the CCP is realised over the long term Whilst the portfolio continues to do well even over a shorter duration (say, five GRUH Finance Our stance: NR years), terminating it at the end of year 5 (and investing the proceeds in the CCP Mcap (US$ bn): 1.7 ADV - 6m (US$ mn): 1.5 for year 5) results in a loss of potential alpha of ~3.3% points (in CAGR terms). Dr Lal PathLabs Our stance: NR That said, in case the need for fresh deployment of funds arises, we also Mcap (US$ bn): 1.5 ADV - 6m (US$ mn): 1.8 showcase that doing so in successive coffee can iterations also leads to benchmark-beating returns (8-9% excess IRRS under various scenarios). eClerx Services Our stance: SELL Mcap (US$ bn): 0.9 ADV - 6m (US$ mn): 1.0 Today’s Coffee Can for 2016-2026 Six stocks from the previous CCP do not make it to this year’s portfolio: ITC, Astral Poly Our stance: NR Marico, GSK Consumer, Colgate Palmolive, Berger and V-Guard Inds. Mcap (US$ bn): 0.8 ADV - 6m (US$ mn): 0.4 Fresh additions to this years’ portfolio are Relaxo, Repco and Dr. Lal Relaxo Footwear Our stance: NR PathLabs. Whilst we do not advocate annual rebalancing of the portfolio, clients Mcap (US$ bn): 0.7 ADV - 6m (US$ mn): 0.2 who are interested in the 2016 CCP should refer to the exhibit on the right. Repco Home Fin Our stance: NR Sixteen iterations of the Coffee Can Portfolio have outperformed the Sensex Mcap (US$ bn): 0.6 ADV - 6m (US$ mn): 1.0 Kick-off All-cap All-cap CAGR Outperformance year* CCP (start) CCP (end) return relative to Sensex Cera Sanitary. Our stance: NR 2000 500 3,831 22.6% 6.6% Mcap (US$ bn): 0.5 ADV - 6m (US$ mn): 0.6 2001 600 9,802 32.2% 11.7% Source: Bloomberg, Ambit Capital research. Note: Mcap as of 2002 800 7,709 25.4% 5.1% 15 November 2016 2003 900 10,175 27.4% 7.2% R esearch Analysts 2004 1,000 16,849 32.6% 12.7% 2005 900 6,643 22.1% 6.0% Karan Khanna, CFA 2006 1,000 6,376 20.4% 9.0% +91 22 3043 3251 2007 1,500 7,828 19.5% 10.8% [email protected] 2008 1,100 5,724 22.1% 11.2% 2009 1,100 4,843 22.7% 11.5% Nitin Bhasin 2010 700 2,042 18.7% 9.5% +91 22 3043 3241 2011 1,400 2,550 12.1% 2.7% [email protected] 2012 2,200 5,356 23.3% 9.9% 2013 1,800 4,762 34.8% 21.4% Prashant Mittal, CFA 2014 1,600 2,331 22.2% 21.0% +91 22 3043 3218 2015 2,000 2,387 19.3% 13.4% [email protected] Source: Bloomberg, Ambit Capital research. Note: *Returns for 10 year-period from 2000-2006 (starting 30th June); CAGR returns for portfolios since 2007 until 30th Sep’16 (except for live portfolios for 2014 and 2015 for which CAGR returns and absolute returns have been calculated since these portfolios were launched in Nov ’15 and Nov ’16 respectively). 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. Strategy Executive Summary The case for a Coffee Can Portfolio We first introduced the Coffee Can Portfolio in our 17 November 2014 thematic: “The Indian Coffee Can Portfolio” for investors who have the ability to hold stocks for very long periods of time (i.e. for ten years or more). The coffee can construct essentially hinges on investing in quality franchises with superior long-term historical track records of financial performance over longer periods of time. We believe at the portfolio level, there are four factors that work in favour of the coffee can construct. These are:  Higher probability of returns over the long term: Over longer periods of time (for example, the last 30 years), the Sensex has returned ~15% CAGR. That said there have been intermittent periods of unusually high drawdowns. For example, an investor entering the market near the peak in early Jan ‘08 would have lost over 60% of value in just about fourteen 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 horizons.  A longer time horizon allows the power of compounding to work its magic: Holding a portfolio of stocks for periods as long as 10 years or more allows the power of compounding to play out its magic. Over the longer term, the portfolio gets dominated by the winning stocks whilst underperforming stocks keep declining and eventually become inconsequential. Thus, the positive contribution of the winners disproportionately outweighs the negative contribution of the losers to eventually help the portfolio compound handsomely.  Neutralising the negatives of “noise”: Empirically, investing and holding for the long term has been the most effective way of killing ‘noise’ that interferes with the investment process. Using Lupin’s illustration in the note we show that one of the reasons the coffee can construct works well is because the ability to hold on to a great franchise for a long period of time allows you to let fundamentals drive your investment decision rather than “noise.”  No churn: Finally, the coffee can construct allows an investor to hold a portfolio of stocks for over 10 years without any churn. With no churn, the coffee can approach reduces transaction costs which add to the overall portfolio performance over the long term. Laying a framework for constructing the Indian Coffee Can Portfolio To identify stocks for our Coffee Can Portfolio, we start with the basic principles of investing. At the very basic level, a company doing well would mean that it is profitable and is growing. These twin filters of growth and profitability, in our view, are sufficient to assess the success of a franchise. We, therefore, select stocks with a long-term track record of delivery on revenue growth and RoCE. For financial services stocks, we modify these filters slightly and look for a long-term track record of delivery on loan book growth and RoE. November 17, 2016 Ambit Capital Pvt. Ltd. Page 4 Strategy Note that even our work suggests a combination of superior RoCE and revenue growth has been a winner in the Indian context (see exhibit 1 below): Exhibit 1: A combination of superior RoCE and revenue growth is a winner in the Indian context* Average outperformance, 10-year CAGR 12.0% 11.1% 10.0% 8.0% 6.0% 4.9% 4.0% 2.6% 2.0% 0.0% Superior on Revenue Superior on RoCE Superior on both growth Source: Bloomberg, Ambit Capital research. Note: * The universe is 2006’s BSE200 firms (ex-financials); performance relative to the BSE200 Index; the chart is based on price data from 31 March 2006 to 31 March 2016. The red bars denote the 10-yr share price performance of top quartile stocks on revenue growth, RoCE as well as a combination of both from the BSE200 universe. For the Coffee Can Portfolio, we therefore look for firms that have delivered a minimum pre-tax RoCE of 15% or more and sales growth of at least 10% or more over ten consecutive years. For financial services stocks, we seek to identify firms that have delivered a minimum RoE of 16% and loan book growth of at least 10% or more for ten consecutive years. Back-test proves the potential of the coffee can construct to beat the benchmark Using the filters discussed above, we run back-tests of the framework for each of the last 16 years. Results from our back-test suggest that each of the previous 16 coffee can portfolios has comprehensively outperformed the benchmark Sensex index both on an absolute as well as on a risk-adjusted basis. Further, even if we were to use broader market indices, such as the BSE200 index, each of the previous sixteen iterations of the coffee can portfolios still beat the benchmark BSE200 index quite comprehensively. Performance of the live Coffee Can Portfolio launched in 2014 and 2015 We launched the first Coffee Can Portfolio for investors in our 17 November 2014 thematic: “The Indian Coffee Can Portfolio” (to be held from 2014-2024). We followed this up with the second Coffee Can Portfolio that was launched in our 02 November 2015 thematic: “The Coffee Can Portfolio…the coffee works!” Since publication in November 2014, the first Coffee Can Portfolio has generated total CAGR returns of 17.6% vs total CAGR returns of -0.8% for the benchmark Sensex index. Similarly, the second Coffee Can Portfolio that was launched in 2015 has generated total CAGR returns of 11.7% vs total CAGR returns of 2.1% for the benchmark Sensex index since initiation. That said both these portfolios have witnessed a churn of 30-35%. With reasonably high levels of churn, the obvious question one would ask is whether to rebalance the 2014 and 2015 portfolios to include stocks that feature in this year’s iteration? We advise investors to refrain from rebalancing the coffee can portfolios. A Coffee Can Portfolio that is rebalanced every year underperforms the Coffee Can Portfolio that is left untouched for a decade by ~5.3% points (on a median basis; in CAGR terms, see exhibit 2 below): November 17, 2016 Ambit Capital Pvt. Ltd. Page 5 Strategy Exhibit 2: Share price CAGR returns over 10-year period for CCP with and without rebalancing 2000- 2001- 2002- 2003- 2004- 2005- Median 2010 2011 2012 2013 2014 2015 CAGR CCP without rebalancing 19.3% 28.5% 22.4% 25.4% 30.8% 20.5% 23.9% CCP with rebalancing 18.5% 22.6% 22.0% 17.0% 18.7% 13.5% 18.6% Difference (w/o minus with 0.8% 5.9% 0.4% 8.4% 12.0% 6.9% 5.3% rebalancing) Source: Bloomberg, Ambit Capital Research Note: Dates refer to the first year and last year of the ten-year holding period. Performance has been measured over a 10-yr period starting from June of the first year and ending with June of the last year. This exhibit has been reproduced without any changes from our 02 November 2015 thematic: “The Coffee Can Portfolio…the coffee works!” An optimal way to deploy fresh funds each year The coffee can construct advocates the “buy and hold” approach. That said one of the challenges investors face is how to deploy the fresh fund inflows that are received every year. Here we evaluate two scenarios: (1) where the fresh fund inflows that are received every year are assumed to remain constant; and (2) where the fresh fund inflows that are received every year are assumed to increase by 20% each year. We further assume that every year as an investor receives fresh fund inflows, these funds are deployed in the Coffee Can Portfolio for that particular year. Our analysis suggests that under both the scenarios, the IRR for the Coffee Can Portfolio is significantly higher than the IRR for Sensex. Further, whilst the number of stocks in the portfolio are high (~43 stocks on an average for the seven completed coffee can portfolios), the top ~23% of the stocks comprise 65-75% of the total portfolio value by the end of year 10 under both the scenarios. We believe this brings out a very important aspect of the coffee can construct which is that allowing the power of compounding to work its magic is a much more important driver of long-term returns than the most ideal stock selection itself. Thus, even whilst the number of stocks in the portfolios is fairly high, over time the losing stocks become insignificant while the portfolio returns are gradually dominated by the winners. An ideal life of a Coffee Can Portfolio Historically, we have advocated a minimum holding period of ten years for the Coffee Can Portfolio as we believe that the benefits of the coffee can construct can only be realised by investing in quality franchises with a superior long-term track record of financial performance, over longer periods of time. That said one of the questions several investors have asked us is “how do the returns as well as risk profile fare over a shorter period of time (such as five years)?” Results from our analysis reveal that each of the previous sixteen iterations of the Coffee Can Portfolio has handsomely outperformed the benchmark Sensex index over a shorter time horizon (i.e. five years). So, given the outperformance even over a shorter time period, would the investor be better off if he terminates the Coffee Can Portfolio at the end of 5 years instead of 10 years? Our analysis suggests for the coffee can construct to work its magic, the portfolio should be left untouched for the decade. Whilst the Coffee Can Portfolio over a shorter time horizon does indeed outperform the benchmark Sensex index, terminating the portfolio at the end of, say, 5 years (and investing the funds from the exiting stocks in fresh stocks that make it to the Coffee Can Portfolio in year five) results in ~3.3% points lower alpha for the portfolio vs keeping the portfolio untouched for a decade. November 17, 2016 Ambit Capital Pvt. Ltd. Page 6 Strategy Today’s coffee can for 2016-26 Having discussed the virtues of the coffee can construct and establishing the ideal life for a Coffee Can Portfolio, we screen the entire spectrum of listed companies with market-cap greater than `1bn using our twin filters of growth and profitability. The list of firms that makes it to this year’s edition of our Coffee Can Portfolio has been summarised in exhibit 3 below. The coffee can continues to feature some of India’s most successful franchises as well as the most-compelling investment themes. Using John Kay’s IBAS (Innovation, Brand, Architecture and Strategic Assets) framework, we evaluate these companies in the ensuing sections of the note. Appendix 3 of the note gives you more colour regarding John Kay’s IBAS framework and Ambit’s bestselling book, The Unusual Billionaires, gives you details regarding just how successful the coffee can companies have been over years. November 17, 2016 Ambit Capital Pvt. Ltd. Page 7 Strategy Exhibit 3: Summary of the 2016 Coffee Can Portfolio Free Float ADV-6m Greatness Company Ticker Mcap Mcap (Median) Accounting Score Ambit Comments P/E P/B RoCE* Decile Stance ($mn) ($mn) ($mn) (%) FY16 FY17E FY16 FY17E FY16 Credible execution track record driving consistent high earnings HDFC Bank HDFCB IN 47,610 35,232 23.2 N/A N/A SELL 25.6 21.5 4.4 3.8 1.9 growth while maintaining asset quality Despite facing asset quality stress, capability to generate strong Axis Bank AXSB IN 17,489 11,368 68.3 N/A N/A BUY 13.9 28.2 2.2 2.1 1.7 operating profits provides comfort Set to capitalise on competitive advantages in IMS and ES to build HCL Tech. HCLT IN 16,641 6,490 20.6 D2 92% BUY 19.7 13.7 4.1 3.4 34.2 a strong IOT offering Deserve high valuation due to a) resilient repainting cycle in weak Asian Paints APNT IN 15,151 7,121 15.0 D1 50% BUY macro, b) greater pricing power and c) ability to successfully drive 58.4 47.3 18.0 15.1 47.2 transition to value added services in home improvement category Ability to adapt to changing environment and be successful is the Lupin LPC IN 10,365 5,493 22.7 D6 100% BUY 30.3 23.1 6.3 5.1 24.6 secret sauce to Lupin Early investments in innovation like biosimilars, NCEs/NDDS are Cadila Health. CDH IN 5,907 1,477 3.8 D5 46% BUY 25.8 25.0 7.3 6.0 29.0 provide competitive edge in EMs/regulated markets Will play on the width of the portfolio and leverage its cost Britannia Inds. BRIT IN 5,633 2,760 8.0 D2 83% SELL 46.5 39.2 21.2 15.9 71.9 efficiencies vs peers LIC’s support is key strategic asset. But earnings momentum LIC Housing Fin. LICHF IN 3,987 2,392 15.0 N/A N/A SELL should decline due to declining real estate prices and competitive 15.9 12.4 2.9 2.4 1.4 headwinds. Will grow due a) aspirational brand b) in-house manufacturing Page Inds. PAG IN 2,702 1,324 2.0 D3 88% BUY 77.3 61.0 35.6 27.7 54.7 and c) control on distribution channel Low cost advantage with Johnson Controls' parentage to continue Amara Raja Batt. AMRJ IN 2,552 1,225 3.9 D3 83% SELL driving market share gains market share gains albeit at lower 34.7 29.8 8.1 6.7 35.8 pace than before Best play in affordable housing due to innovative credit scoring, GRUH Finance GRHF IN 1,705 699 0.8 N/A N/A NR 46.6 38.6 13.6 11.3 2.4 strong local knowledge and support of the parent HDFC Set to enjoy long growth ramp driven by market share gains from Dr Lal Pathlabs DLPL IN 1,477 177 0.7 N/A N/A NR unorganised, acquisitions and socio economic tailwinds driving 73.8 59.1 19.3 15.2 31.5 penetration Competitive advantage a thing of past as regulatory driven eClerx Services ECLX IN 874 437 0.4 D2 42% SELL 15.9 15.2 5.3 4.5 51.5 challenges in BFSI and rise of automation threaten business model Transitioning from a pipes manufacturer to a larger building Astral Poly ASTRA IN 758 303 0.2 D1 58% NR materials franchise; capitalising the brand recall and replicating its 49.8 35.6 6.5 5.6 18.2 architecture to become a challenger brand in adhesives Focus on brand building and premiumisation provide Relaxo the Relaxo Footwear RLXF IN 727 182 0.1 D1 92% NR pricing power in a value offering without compromising on volume 40.2 36.3 10.1 DNA 29.7 growth Strong positioning in affordable housing due to local area Repco Home Fin. REPCO IN 626 388 0.6 N/A N/A NR 27.7 22.0 4.4 3.7 2.2 knowledge and an innovative origination strategy Second largest in scale but the most profitable sanitaryware Cera Sanitary. CRS IN 490 221 0.2 D5 67% NR manufacturer. With competition rising, Cera has plugged gaps in 39.1 30.5 7.7 6.4 25.1 its product portfolio, now catering to all market segments Source: Bloomberg, Capitaline, Ambit Capital Research. Note: *RoA for BFSI stocks. Mcap data as of 15 November 2016. November 17, 2016 Ambit Capital Pvt. Ltd. Page 8 Strategy The case for a Coffee Can Portfolio The coffee can approach to portfolio construction In our 17 November 2014 thematic: “The Indian Coffee Can Portfolio”, we introduced the Coffee Can Portfolio for investors who have the ability to hold stocks for very long periods of time (for ten years or more). For investors who are not familiar with the coffee can construct, the term ‘coffee can’ was coined by Robert G Kirby of Capital Guardian, who in his 1984 note (click here for the note) narrated an incident involving his client’s husband who had purchased stocks recommended by Kirby in US$5000 denomination each but did not ever sell anything from the portfolio. This process led to enormous wealth creation for the client over a period of about 10 years mainly on account of one position transforming to a jumbo holding worth over US$800,000 which came from a zillion shares of Xerox. Impressed by this approach of ‘buy and forget’ followed by this gentleman, Kirby coined the term ‘Coffee Can Robert Kirby of Capital Guardian Portfolio’ - the concept harkens back to the Wild West, when Americans, before the introduced the concept of ‘Coffee widespread advent of banks, saved their valuables in a coffee can and kept it under a Can Portfolio’ in 1984 mattress. Why does the approach work? The simplicity of the coffee can approach to portfolio construction rests in four factors Four factors work in favour of the that work in favour of longer investment horizons at the portfolio level: Coffee Can approach to portfolio  Higher probability of returns over the long term: As is well understood, construction equities as an asset class are prone to extreme movements in the short term. For example, whilst the Sensex has returned ~15% CAGR returns over the last 30 years, there have been intermittent periods of unusually high drawdowns. In Jan ‘08, for instance, an investor entering the market near the peak in January would have lost over 60% of value in just about fourteen 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 Sensex’s returns over the past 30 years have been ~14% on a Firstly, the probability of CAGR basis, whilst the standard deviation of returns has been ~29%. Now using generating positive returns these values of returns and standard deviation and assuming a normal increases disproportionately with distribution of returns (a simplifying assumption), the probability of generating increase in holding horizons positive returns over a one-day time horizon works out to ~51.1%. Note, however, that as the time horizon increases, the probability of generating positive returns goes up. The probability of generating positive returns goes up to ~68% if the time horizon increases to one year; the probability tends towards 100% if the time horizon is increased to 10 years (see Exhibit 4 below). Exhibit 4: Probability of gains from equity investing in India increases disproportionately with increase in holding horizon 100% s n ai 90% g of 80% y t bili 70% a b o 60% r P 50% 1 Hour 1 Day 1 Week 1 Month 1 Year 10 Year 100 Years Years Source: Bloomberg, Ambit Capital research. Note: This chart has been inspired by similar work done by Michael Mauboussin in the Western context. November 17, 2016 Ambit Capital Pvt. Ltd. Page 9 Strategy  Power of compounding: Holding a portfolio of stocks for periods as long as 10 years or more allows the power of compounding to play out its magic. Over the longer term, the portfolio comes to be dominated by the winning stocks whilst losing stocks keep declining to eventually become inconsequential. Thus, the positive contribution of the winners disproportionately outweighs the negative contribution of losers to eventually help the portfolio compound handsomely. We elaborate the power of this powerful phenomenon in much greater details in the ensuing sections of the note as well as Appendix 2 (Performance of the 14 back-tested Coffee Can Portfolio) using historical case studies. We will illustrate the point using simple mathematics here. Let’s consider a hypothetical portfolio that consists only of two stocks. One of these stocks, stock A, grows at 26% per annum whilst the other, say stock B, declines at the same rate, i.e. at 26% per annum. Overall, not only do we assume a 50-50 strike rate, we also assume symmetry around the magnitude of positive and negative returns generated by the winner and the loser respectively. In Exhibit 5 below, we track the progress of this portfolio over a 10-year holding Secondly, compounding results in a horizon. As time progresses, stock B declines to irrelevance while the portfolio natural rebalancing of winners and value starts converging to the value of holding in stock A. Even with the assumed losers in a portfolio 50% strike rate with symmetry around the magnitude of winning and losing returns, the portfolio compounds at a healthy 17.6% per annum over this 10-year period, a pretty healthy rate of return. This example demonstrates how powerful compounding can be for investor portfolios if only sufficient time is allowed for it to work its magic. Exhibit 5: A hypothetical portfolio with 50% strike rate and symmetry around positive and negative returns 600 10 yr CAGR 500 Stock A 26% 400 300 Stock B -26% 200 Portfolio 17.6% 100 0 0 1 2 3 4 5 6 7 8 9 10 Source: Ambit Capital research  Neutralising the negatives of “noise”: Empirically, investing and holding for the long term have been the most effective way of killing ‘noise’ that interferes with the investment process. This has also been corroborated by Robert G. Hagstrom in his recent book, “Investing – The Last Liberal Art” (2nd edition, 2013). In this book, the author talks about the “chaotic environment, with so much rumour, miscalculation, and bad information swirling”. Such an environment was labelled “noise” by Fischer Black, the inventor of the Black-Scholes formula. Hagstrom goes on to say: “Is there a solution for noise in the market? Can we distinguish between noise prices and fundamental prices? The obvious answer is to know the economic Thirdly, by its design, the CCP is fundamentals of your investment so you can rightly observe when prices have indifferent to short-term trends, moved above or below your company’s intrinsic value. It is the same lesson sectors, themes, and approaches preached by Ben Graham and Warren Buffett. But all too often, deep-rooted such as chasing earnings or psychological issues outweigh this commonsensical advice. It is easy to say we momentum should ignore noise in the market but quite another thing to master the psychological effects of that noise. What investors need is a process that allows them to reduce the noise, which then makes it easier to make rational decisions.” November 17, 2016 Ambit Capital Pvt. Ltd. Page 10

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