Bay Capital 5th Anniversary Letter to Investors

September 11th, 2019

‘Tempus Fugit’ –

The Latin phrase translated to mean “Time Flies” is what we are reminded of as we look back on the last five years of the fund. The fund as conceived by us is a culmination of the collective learnings that we have had investing in India over time.

The founding principles, approach and strategy that we are anchored to are, we believe, resilient enough to navigate through the periods of stress and volatility that we are as likely to experience going forward as we have seen over the last five years (be it during demonetization or GST implementation or the recent NBFC crisis).

This resilience is reflected in many ways in our performance numbers since inception. Our outperformance when compared to the MSCI India Index now stands at an annualised 9.4% since August 2014. In the past 60 months, the fund has been up 41 months and down only 19 months. The same number for the MSCI India Index is 33 up months and 27 down months.

As we laid out the strategy for the fund and how the India story could be captured, one aspect that we focused on is – what not to do. This discipline has helped us navigate through the minefield of bad businesses that we see in the Indian investment landscape today – highly leveraged companies, promoter and sponsor groups with lax governance standards, sub-standard business models and in some cases all of these combined into one potent cocktail!

One of the most significant highlights is that, we have attempted to stay the course and be true to our guiding principles. These are to identify businesses which are judicious and stellar allocators of capital, which have no leverage or low levels of debt, which have significant competitive edges either in the nature of brands, distribution, technology or all of these and above all have impeccable governance standards. Many a times, we have seen investment managers experience “style drift” over time – we are cognizant of this and remain disciplined in our approach to prevent this from happening.

Since inception, the three key aspects of our strategy have been –

1. Bottom up and Depth versus Width
Our focus has always been on investing in outstanding businesses that have the attributes we have highlighted above. Of all these, capital allocation would be the single most important factor that drives our decision making. This ensures that our funneling process cuts out more than 80% of the “noise” and our focus is then on the 20% that makes up the high-quality businesses out there. This focus along with our ability to spend 9-12 months working on a new investment allows us to go as deep as necessary to understand the business and how it can shape up over a decade.

This disciplined investment approach is clearly reflected in our returns and outperformance. Up to 90% of our outperformance when measured against the MSCI India, can be attributed to our stock selection abilities. Similarly, sticking to our ‘what not to own’ list and avoiding cyclicals like utilities, materials and capital-intensive industrial businesses has worked in our favour in this volatile market.

As investors, we often look for ways to constructively engage with our investee businesses, as also with prospective investees, to present our differentiated insights to them. Some of the interesting, value added and fun research projects we have done over the years are –

(i) We had written letters to the management of all the portfolio names to discuss what we look for in our investee business, how we evaluate culture, what we like about the business and also highlighted areas of concern. We received overwhelmingly positive responses and we will continue to engage with them constructively.

(ii) We presented our learnings from the CAGNY conference (the marquee global consumer conference in the US) to several of our investee businesses.

(iii) We presented to the founder and senior management team of a large value retailer (a prospective investee business) on their operating strategy and potential opportunity size in the context of similar businesses globally.

(iv) We represented our concerns around the compensation structure of an investee business, which we believed was leading to sub-optimal capital allocation decisions (subsequently taken up very seriously by management).

(v) We attended the Berkshire Annual Meeting in Omaha and have heard first-hand the words of wisdom from the wizards of investing.

(vi) We were invited by one of our investee company to present to their entire senior management team on how we, as long-term shareholders, view and evaluate their business.

2. Low Turnover, Buy and Hold approach to compound returns over time
A metric that we quite proudly like to share is our annual turnover number of 7.6%* since inception and our average holding period of 45 months (excluding 2019 stock additions).

In our third anniversary letter, we mentioned owning 8 out of the 10 businesses that were bought within the first month of launching the fund. Moreover, we had not traded on 500 of the 750 trading days in the first three years. A quick check back at these as we complete 5 years and we are happy to report that we still hold 8 out of the 10 original businesses that we first bought in the portfolio and our trading stats (no trading on > 60% of the days), continues to be viewed with dismay by our brokers.

The ability of a business to compound earnings (and therefore shareholder returns) over long periods is often under-appreciated. The ability to generate free cash flow and allocate capital judiciously and profitably are the hallmarks of these businesses. Therefore, the cumulative cash of our 8 “Day 1” portfolio companies of $ 6 bn (June 2019), is a phenomenal number to our mind. These “Day 1” businesses have compounded earnings at ~15% CAGR and have an average ROCE of ~40%. The average total shareholder returns of these 8 businesses is ~15% in USD terms. (*as on August 2019)

3. Devil’s Advocate Programme
One of our key strengths, we believe, is our ability to look for areas of risk and for ways to mitigate that risk as we invest in our underlying portfolio businesses. The devil’s advocate program has been an important aspect of this risk mitigation exercise.

In a strategy like ours, especially in the names that we own for some time, it is quite easy to fall in love with our businesses, with a feeling of complacency easily setting in. We are cognizant of the fact that complacency and hubris are the killers of many a business and we would not want ourselves to be in that position, ever. Therefore, our devil’s advocate programme aims to keep us grounded to look for potential red flags and to use that actively to drive interactions with company managements. Some of these contra cases have been extremely effective in us NOT doing something and thereby has prevented us from being buffeted by some of the problems that we are seeing around us in a variety of businesses.

If all of the above had to be condensed into one “variable”, it would perhaps be “process”. While we are cognizant of process not becoming a rigid straitjacket around what we do, our thinking about process is best described by Michael Mauboussin, the acclaimed author and one of the most creative minds on Wall Street. In talking about investment decisions and outcomes, he says ultimately investing is decision making with incomplete information based on probabilistic outcomes. In order to ensure good outcomes, it becomes important to arrive at good decisions and this is possible through a focus on good processes.

To illustrate this, he highlights the case of his friend playing blackjack in Las Vegas, when the person sitting next to his friend is dealt a 17. If one is familiar with standard blackjack strategy, one might believe that the right thing to do is to sit on a 17. But this man asked for a hit. The dealer revealed a 4, making his hand. For good measure, the dealer said, “good hit, sir.”

This in essence is bad process leading to a good outcome; but if one were to (mistakenly) pursue that strategy over time, one is sure to get wiped out . Hence, the need to focus on the process and decision making and over time, the decisions and the outcomes will turn out to be more favourable.

Going Wrong for the Right Reason and Going Wrong for the Wrong Reason We consider ourselves fortunate to have avoided some of the “blow-ups” of businesses, we have being seeing recently. Our single minded focus on capital preservation means that we are ok not owning the next “great” stock that goes up 3x in 3 years, but we will feel terrible if we end up owning a name that falls 50% on account of bad governance or gross mismanagement in general or that we bought a bad business. In other words, we are ok to go wrong for the “right” reason (thesis not playing out as anticipated, external dislocation, Government policies, strategic errors of capital mis-allocation by our investee businesses) but we would not want to go wrong for the “wrong” reason (investing in businesses which are fundamentally flawed, are bad allocators of capital or have toxic cultures).

We will not let our eye of the ball on this dynamic. As we think about it, the key question to ask ourselves is not “was this decision bad” but more importantly “was this the right decision when it was made”. While ultimately outcomes matter, in probabilistic situations, process in many ways addresses this.

We have been very fortunate to have had the support of our investors who have believed in our approach, the strategy and our view that long-term compounding returns is what matters.

We hope that our portfolio businesses will continue to do what they are doing, even after a decade. More recently, a heartening trend that we have been observing, is that businesses are recognising the need to be more agile and more responsive to the impulses from their broader operating environments. Therefore, while we would expect these businesses to be doing the same things, they would be doing this in a better, sharper and more effective manner. This would go a long way in ensuring that their moats are not only maintained, but also strengthened and compounding returns accrue to us as shareholders in the business.

We are appreciative of our investors and associates for their wonderful continuing support over the last five years. The most important thing to say on reaching the five-year mark is a big thank you for reposing your faith in us. We look forward to further strengthening these relationships and to building new ones!

Posted by Siddharth Mehta, Founder & CIO