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CY 2023: The Current Year Should Give Us Volatility & Drawdowns To Deploy Capital

Updated: Apr 6, 2023

PMSTimes & ITUS Capital

Humans are known to be extrapolating engines – we like certainty, predictability and translate the same into our investment patterns. It’s important to realize that our core behavior as humans tends to in most cases be detrimental to what is needed in the markets where it’s important to be comfortable with volatility, negativity, and risk-reward.

In September 2022, the markets were pricing in robust consumer growth, a decadal theme for manufacturing to scale in India, and a potential de-coupling of risk between India and the global economies. It was around this time that we had written a note to our investors highlighting the risk-reward of building a new portfolio at the time and had spoken about being cautious in our allocations and maintaining a higher-than-normal cash balance. So, what changed for us?

Markets are a function of three factors – growth (which is specific to the company and the industry), liquidity (which is a function of Central banks and the broad interest rate regime we are in), and valuation (which gives a sense of the downside if we are wrong). As an investor, I expect at least two of the three to be in our favour for us to create a sustainable portfolio that generates a high teens IRR for the investor ( which is the core premise around which investors allocate capital to us in the public equities market).

When we wrote on being cautious back in October 2022, it was a time when growth was robust, however, we saw liquidity conditions both in India and globally tighten alongside valuations not being in our favour. This prompted us to be cautious capital allocation and we were selective around how we wanted to deploy new capital.

Going into 1QCY23, we continue to maintain that the current year should give us volatility and drawdowns to deploy capital. We do not see liquidity conditions ease soon and maintain that interest rates will stay elevated through the course of the year.

We should continue to see high inflation (though the rate of change of inflation may drop), which means the Central banks should not have strong reasons to cut rates. In this global backdrop, it’s imperative that portfolios are built around strong cash flows and where margin of safety is adequate on the downside ( with comfort on valuations).

As humans, we tend to take comfort in numbers – so it’s important I spend time quantifying what I wrote above.

In terms of the growth, our portfolio has seen a cash flow growth of 22.5% over the last 1 year alongside gross margin expansion by 2% over the same period. These are healthy trends that I would like to see in the portfolio companies we own for our clients. In the base case growth rate, we forecast from here ( at current valuations), I see a portfolio level IRR at 16.5% - I would expect this to be closer to 20% for us to deploy capital aggressively. It is this comfort in valuations that I expect before we become aggressive in ramping up our portfolio for clients this year. This is reflected in the higher-than-normal cash balance we maintain across clients.

No decision comes without a certain consequence – as the saying goes, the above decision to maintain discipline also means that we as a fund can underperform in the short term if markets go higher (Markets can always be irrational longer than you think – just because we do not find a valuation comfort does not mean that markets need not go up).

However, as a portfolio manager – we have always maintained that our role has two functions – buy good businesses with headroom for growth and at the right valuation. If the latter means, that we must be patient, it is imperative that we do the same. This is something we have always stood for over the last 6 years.

Finally, with the liquidity environment being tight, we maintain that the volatility in CY23 will be high, giving the disciplined capital allocator opportunities to deploy capital this year.

We maintain that CY23 will be a year of constructing portfolios whose benefit (in terms of

shareholder IRR) should be seen in the subsequent two years.

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