Ambit Coffee Can Portfolio(Nov 16)

160 Pages·2016·4.65 MB·English

by  Karan Khanna

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:[phone]
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% [phone]
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% [phone]
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% [phone]
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
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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
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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
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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
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 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