Quarter 2, 2013. - WILLOW INVESTMENT MANAGEMENT, LLC.
The Rupee with its 10% drop over the quarter admittedly took us by surprise. It now holds the enviable spot of being the worst performing Asian currency for the quarter. If the "macro-pundits" are to be believed then "We ain't seen nothing yet" and the Rupee is basically doomed. After all, the tapering signals from US Fed, policy inaction in India, election season and a high current account deficit (CAD) all point that way. Well, we are not so sure. We can think of several reasons why Rupee should be stronger. For instance gold, oil and several other commodities that make up majority of our import bill, are getting cheaper. The government is approving infrastructure projects in the earnest ($2bln just this last month). CAD itself at 3.6% was much better than expected. However, our arguments only add to the din of expert nonsense you hear all over the financial media. We cannot predict the direction of Indian Rupee with much certainty and we don't think the pundits can either. Although fully aware of the macro risks to our portfolio we try not to base our decisions on things we cannot predict nor control.
As mentioned, small and mid cap stocks make up most of our portfolio. This is direct result of the massive chasm that currently exists between small and large cap valuations. Marquee companies in hot sectors such as IT services and FMCG are trading at all time high valuations, reminiscent of the tech multiples of early 2000s and the real estate multiples of 2006-07. On the other hand several promising small and mid caps are available at throwaway prices. This cannot last indefinitely. Despite our small cap bias our performance so far has tracked the better performing large cap indices. We expect this trend to continue. Moreover, as the performance gap between the small and large companies closes we should benefit disproportionately. Most importantly, the operating performance of our portfolio companies remains strong. If this trend continues, and we expect it will, soon enough the market should catch up and reward us amply. Meanwhile, the short-term volatility we suffer seems like a fair price to pay for long run performance.
Our plan of attack going forward remains the same, only difference being an increased emphasis on management capability. Large companies with monopoly like economics can be run by sub-par management but can nevertheless achieve above par results. For most others, including the kinds we own currently, the quality of management makes or breaks the business.
A good example of a recent investment based largely on valuation and management capability is Capital First Limited. CAPF is a medium sized specialty finance company that lends to individuals and small companies. These loans are secured against houses, land, gold, autos etc. The business is rather simple as in you borrow cheaply and lend at highest possible rates while keeping your expenses low and making sure that you don't to deadbeats. CAPF until recently was a part of the Future Group, which is run by Kishore Biyani, a bona fide Indian rags-to-riches-to-not-so-riches story. Like many of his counterparts, Mr. Biyani overextended himself to finance his company's explosive growth and then ran into problems as the economy slowed. In order to pay down his debts he recently sold some of his languishing non-core assets including Future Capital Holdings (now Capital First). In mid 2012 the majority ownership of CAPF was transferred to Warburg Pincus, a leading US Private Equity firm. Also, post transaction CAPF's CEO V. Vaidyanathan aka Vaidy ended up owning 10% of the company. The new owners quickly infused $20mm in tier 1 capital, off-loaded problematic loans, cleaned house, re-branded the company and put a sensible growth plan in place. As we did our own due diligence it became clear to us that market's assessment of CAPF was likely way off the mark.
While there is nothing special about CAPF's specialty finance business there were a two factors that made it a compelling investment. One was the low valuation that reflected CAPF's tainted past rather than the present or the future. The new company looks nothing like the old one but the market doesn't realize this yet. The second factor was the new ownership. Having a reputed private equity as a majority shareholder has some serious advantages for us. First off all, we can be absolutely certain of management integrity and corporate governance. Secondly, we know that our incentives are completely aligned with controlling shareholders. A private Equity strategy has one overarching goal: to sell their portfolio company at a profit. As Warburg runs, monitors, improves, promotes and ultimately sells its investment we stand to gain alongside them. Finally, the CEO has his fortune tied to the same goal and has a stellar track record of running big finance companies. We fully expect Warburg and Vaidy to succeed in their efforts. Not willing to leave anything to chance we made sure that we buy our stock at a lower price than Warburg did.
In conclusion, we admit that these are tough times for Indian markets and the Indian Rupee. However, over the last 20 years or so, or ever since India started on its liberalization drive, there have been countless such moments. More often than not such times present excellent investment opportunities that require patient capital and good temperament. We hope we possess both but we'll let time be the final arbiter. It will be our pleasure to discuss any part of this letter or other investment related issues with you in more detail so please reach out at will.