Ambit Coffee Can 2017

Research Analysts

The Coffee Can Portfolio 2017

Prashant Mittal, CFA [email protected] Tel: +91 22 3043 3218

November 2017

STRATEGY

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Quality Premium

Aadesh Mehta, CFA [email protected] Tel: +91 22 3043 3239 Sudheer Guntupalli [email protected] Tel: +91 22 3043 3203 Nikhil Pillai [email protected] Tel: +91 22 3043 3265

CONTENTS

The Coffee Can Portfolio 2017 ………3

Executive Summary ……….4

The case for a Coffee Can Portfolio ……….10

Framework and results from back-tests ………..14

Patience with Quality is the Holy Grail ………19

Today’s Coffee Can for 2017-2027 ……….26

Performance of ‘live’ Coffee Can portfolios ………28

Appendix 1: How the Coffee Can is different to our ……….31

other portfolio constructs

Appendix 2: Performance of last 14 back tested Coffee Can portfolios …….33

Appendix 3: John Kay’s IBAS framework ……….52

Appendix 4 ……….57

COMPANIES

HDFC Bank (SELL) ………61

HCL Technologies (SELL) ……….67

Lupin (NOT RATED) ………..73

LIC Housing Finance (SELL) ………81

Page Industries (BUY) ………..87

GRUH Finance (NOT RATED) ………..101

Amara Raja (NOT RATED) ……….107

Abbott India (NOT RATED) ………..113

Astral Poly (NOT RATED) ………..121

Dr Lal PathLabs (NOT RATED) ………..129

Cera Sanitaryware (NOT RATED) ………135

REPCO Home Finance (NOT RATED) ……….141

THEMATIC

November 17, 2017

Strategy

Coffee Can Portfolio 2017

Company Name Ambit Stance HDFC Bank Our stance: SELL Mcap (US$ bn): 72.6 ADV - 6m (US$ mn): 40.1 HCL Technologies Our stance: SELL Mcap (US$ bn): 19 ADV - 6m (US$ mn): 23.1 Lupin Our stance: NR

Mcap (US$ bn): 5.9 ADV - 6m (US$ mn): 36.5 LIC Housing Fin. Our stance: SELL Mcap (US$ bn): 4.5 ADV - 6m (US$ mn): 19.3 Page Industries Our stance: BUY Mcap (US$ bn): 3.9 ADV - 6m (US$ mn): 4.4 GRUH Finance Our stance: NR Mcap (US$ bn): 2.7 ADV - 6m (US$ mn): 2 Amara Raja Batt. Our stance: NR Mcap (US$ bn): 1.9 ADV - 6m (US$ mn): 6.5 Abbott India Our stance: NR Mcap (US$ bn): 1.5 ADV - 6m (US$ mn): 0.3 Astral Poly Our stance: NR Mcap (US$ bn): 1.4 ADV - 6m (US$ mn): 0.9 Dr Lal Pathlabs Our stance: NR Mcap (US$ bn): 1.1 ADV - 6m (US$ mn): 1.9 Cera Sanitaryware Our stance: NR Mcap (US$ bn): 0.7 ADV - 6m (US$ mn): 0.4 Repco Home Fin Our stance: NR Mcap (US$ bn): 0.5 ADV - 6m (US$ mn): 2.4

Source: Bloomberg, Ambit Capital Research

Research Analyst

Prashant Mittal, CFA

The Coffee Can Portfolio 2017

In this year’s Coffee Can thematic, we highlight how combining ‘patience’

(of staying invested in Indian stocks) with ‘quality’ (offered by the Coffee

Can companies) is the holy grail of investing. We show that holding a

Coffee Can Portfolio (CCP) untouched for 10 years generates the best

returns with minimal risk. The 2017 Coffee Can portfolio contains familiar

names like HDFC Bank, HCL Tech., Lupin, Page, Astral, Cera and LIC

Housing - with Abbott India being the new entrant this year.

The case for a Coffee Can Portfolio

The Coffee Can construct hinges on investing in high-quality franchises (which

have a superior track record of financial performance over the preceding decade)

for a very long period of time – a decade to be precise. The virtues of such a

construct include: (a) significantly raising the probability of making returns; (b)

reducing transaction costs by avoiding churn; (c) allowing the power of

compounding to work its magic; and (d) removing the negatives of “noise”.

Back-tests prove the potential of the CCP to beat the benchmark

Both on a live basis as well as in back-tests, 16 out of 17 iterations of the Coffee

Can Portfolio have handsomely outperformed the Sensex as well as broader

market indices, such as the BSE200 index. Further, for investors who seek

deployment of fresh funds received every year, we showcase how the IRR

achieved from investing fresh inflows in the subsequent year’s Coffee Can

portfolio is almost 9% higher vis-à-vis the Sensex index.

‘Patience’ with ‘Quality’ is the holy grail of investing

In last year’s (

hyperlink)

Coffee Can report we highlighted that even as Coffee

Can Portfolios (CCP) beat the Sensex over a shorter duration of five years, the

alpha is much higher if you stay put for a longer duration of 10 years. We analyze

this point and highlight how combining the ‘patience’ of staying invested in Indian

markets (which improves risk-adjusted returns as the holding period increases)

with ‘quality’ of investments generates the best returns with least risk.

Today’s Coffee Can for 2017-2027

Six stocks from the previous CCP do not make it to this year’s portfolio: Asian

Paints, Britannia, Cadila, eClerx, Axis Bank & Relaxo. The fresh addition to this

year’s portfolio is Abbott India. Whilst we do not advocate annual rebalancing of

the portfolio, clients interested in 2017 CCP should refer to exhibit on the right.

Kick-off year All-cap CCP (start) All-cap CCP (end) CAGR return Outperformance relative to Sensex 2000 500 3,831 22.6% 6.6% 2001 600 9,802 32.2% 11.7% 2002 800 7,709 25.4% 5.1% 2003 900 10,175 27.4% 7.2% 2004 1,000 16,849 32.6% 12.7% 2005 900 6,643 22.1% 6.0% 2006 1,000 6,376 20.4% 9.0% 2007 1,500 9,027 19.6% 10.3% 2008 1,100 6,759 21.4% 9.6% 2009 1,100 6,510 23.7% 11.5% 2010 700 3,167 22.8% 12.1% 2011 1,400 3,558 15.8% 4.7% 2012 2,200 7,502 25.7% 11.1% 2013 1,800 6,608 34.8% 19.8% 2014 1,600 2,902 22.1% 14.6% 2015 2,000 2,841 19.0% 5.7% 2016 1,700 2,142 26.0% -2.5%

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 January 2008

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 Page Industries’ 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.

Note that research 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*

Source: Bloomberg, Ambit Capital research. Note:*The universe is 2007’s BSE200 firms (ex-financials); performance relative to the BSE200 Index; the chart is based on price data from 31 March 2007 to 31 March 2017. The red bars denote the 10-year 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 17 years. Results from our back-test suggest that in 16 out of 17 iterations, the

Coffee Can portfolios have 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, 16

out of 17 iterations of the Coffee Can portfolios still beat the benchmark BSE200

index quite comprehensively.

Performance of the live Coffee Can Portfolio launched in form 2014-16

We launched our maiden 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 two more Coffee Can Portfolios in 02 November 2015

thematic:

“The Coffee Can Portfolio…the coffee works!

” and 17 November’16

thematic:

“The Coffee Can Portfolio 2016”

Since publication in November 2014, the first Coffee Can Portfolio has generated

total returns of 22% (on a CAGR basis) vs total returns of 8% for the benchmark

Sensex index since initiation. The Coffee Can Portfolio launched in 2015 has

generated total returns (CAGR) of 19% vs total returns of 13% for the benchmark

Sensex index since initiation. The Coffee Can Portfolio launched in 2016 has

generated total returns (CAGR) of 26% vs total returns of 29% for the benchmark

Sensex index since initiation.

That said, from one CCP to the next, 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, 2015 and 2016 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 ~3.7% points (on a median basis; in CAGR

terms, see exhibit below):

4.1% 6.7% 9.6% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0%

Superior on sales growth Superior on RoCE Superior on Both

Exhibit 2: Share price CAGR returns over 10-year periods for CCP with and without rebalancing 2000- 2010 2001-2011 2002-2012 2003-2013 2004-2014 2005-2015 2006-2016 2007-2017 Median CAGR CCP without rebalancing 19.3% 28.5% 22.4% 25.4% 30.8% 20.5% 18.4% 18.9% 21.5% CCP with rebalancing 18.5% 22.6% 22.0% 17.0% 18.7% 13.5% 11.2% 12.7% 17.8%

Difference (w/o minus

with rebalancing) 0.8% 5.9% 0.4% 8.4% 12.0% 6.9% 7.2% 6.2% 3.7%

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-year period starting from June of the first year and ending with June of the last year.

Patience with Quality is the Holy Grail of investing

While we have advocated a minimum holding period of ten years for the Coffee Can

Portfolio to realize its true potential, 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 in 15 out of the last 17 iterations, the Coffee

Can Portfolio handsomely outperformed the benchmark Sensex index over a shorter

time horizon (i.e. five years). However, that does not imply that investors should shift

to a duration of five years for their investments. Our analysis suggests for the Coffee

Can construct to work its magic, the portfolio should be left untouched for a decade.

A portfolio at the end of, say, 5 years (and rolling over funds from the exiting stocks

to 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.

We analyze this point further by combining analysis, covered in our 22 Dec’16 note

‘The peculiar distribution of equity returns in India’

and 25 Jan’17 note

‘The free lunch

in Indian equities’

with the results for Coffee Can portfolios. In these notes we

highlighted how the risk-adjusted returns pattern in India is clearly in favour holding

on for periods of more than 5 years. However, once you combine patience with

‘quality’ – something that we proxy using our Coffee Can portfolios, the risk-adjusted

returns are even better. The exhibits below highlight how the risk-adjusted returns

improve for the market (median returns improves while standard deviation declines)

as one moves towards longer holding horizons. Further, if one was to hold on to

‘quality’ companies (as in the CCP) the risk-adjusted profile improves further.

Exhibit 3: Combining ‘Patience’ with ‘Quality’ of investing (using Sensex as proxy for market) is the holy grail

Source: Bloomberg, Ambit Capital Research Note: The returns have been computed since Jan’86 for the Sensex and since Jun’00 for the CCP on a weekly rolling basis. For the CCP, every June we shift to the new portfolio being launched that year

1 Yr 3 Yr 5 Yr 10 Yr 1 Yr 3 Yr 5 Yr 10 Yr -10% 0% 10% 20% 30% 40% 50% 8% 13% 18% 23% 28% S ta n d a rd D e v ia ti o n Returns (median) = Sensex

Coffee Can Portfolios Staying invested for

longer period improves median returns for Sensex whilst reducing risk

Combining patience with quality (through CCP) further improves risk-adjusted returns

Today’s Coffee Can Portfolio for 2017-27

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 summarized in the exhibit on the next page. 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.

Exhibit 4: Summary of the 2017 Coffee Can Portfolio

Company Ticker Mcap

Free Float Mcap ADV-6m (Median) Accounting Decile Greatness Score Ambit Stance Comments P/E P/B RoCE*

($mn) ($mn) ($mn) (%) FY17 FY18E FY17 FY18E FY17

HDFC Bank HDFCB

IN 72,487 53,641 31.0 N/A N/A SELL

Credible execution track record driving consistent high earnings

growth while maintaining asset quality 31.9 26.6 5.2 4.6 1.8

HCL

Technologies HCLT IN 19,272 7,516 18.1 D2 92% SELL

We see the competitive advantages built by the company in IMS & ES at risk because of its recent aggression into end of life IP products. In addition, service line oriented organization structure is a key negative

14.6 14.0 3.8 3.3 27.7

Lupin LPC IN 5,849 3,100 26.0 D9 92% NR

Lupin has championed the art of business evolution (from plain oral solids to complex generics) without compromising on profitability and stakeholder interests. However, now the company is facing threats in US business because of quality issues at facilities delaying launches and channel consolidation in USA leading to base business erosion. India and Japan offer some support though

14.8 20.6 2.8 2.5 13.3

LIC Housing Fin. LICHF IN 4,545 2,727 17.6 N/A N/A SELL

LIC’s support is key strategic asset. But earnings momentum would decline due to moderating real estate prices, competitive headwinds and asset quality risks

15.2 14.3 2.6 2.3 1.4

Page Industries PAG IN 3,532 1,731 3.1 D1 79% BUY

Page can grow at 24% CAGR over the next decade led by women’s innerwear, leisurewear and kidswear. Disciplined category selection (only knits), tough to displace shelf space and brand sweating will only boost dominance. Valuation of 55x FY19E EPS only partly captures blend of Hanes-like dominance and high/visible growth ramp

86.2 69.5 34.5 28.4 41.7

GRUH Finance GRHF IN 2,684 1,101 1.7 N/A N/A NR Best play in affordable housing due to innovative credit scoring,

strong local knowledge and support of the parent HDFC 58.6 49.0 15.6 13.5 2.4

Amara Raja Batt. AMRJ IN 1,790 859 4.9 D4 67% NR

Emerged as credible competitor to Exide driven by cost/technological advantages. However, market share gains to slow down as Exide wakes up from its complacent past

24.3 23.0 4.5 3.9 19.7

Abbott India BOOT IN 1,471 368 0.2 D1 83% NR

Abbott trading at a 10-15% discount to peers is justified due to no novel product launches, over dependence on legacy business and compromised minority interest. Excess cash on the books of the parent and lack of focus in building the business, we believe multiples signal a likely delisting candidate.

34.6 26.6 6.9 5.9 21.4

Astral Poly ASTRA IN 1,400 560 0.5 D1 42% NR

Over last decade Astral’s sales and EPS has grown at 35% and 31% CAGR and can grow at similar rate over the next decade as the company builds on its brand and architecture to become an ace building materials brand from a premium pipes brand

62.9 50.3 10.7 9.0 16.8

Company Ticker Mcap Free Float Mcap ADV-6m (Median) Accounting Decile Greatness Score Ambit Stance Comments P/E P/B RoCE*

($mn) ($mn) ($mn) (%) FY17 FY18E FY17 FY18E FY17

Dr Lal Pathlabs DLPL IN 1,026 123 0.9 D2 75% NR

Sales growth of mid-to-high teens with steady margins and return ratios will continue led by investment in growth in the form of reference and satellite labs, expanding the test palette and reasonable price hikes. Stock’s valuation at 35x FY19E consensus P/E is justified given that Dr Lal combines the higher growth potential of the consumer discretionary sector at the economics of the consumer staples sector.

43.0 38.6 10.1 8.3 26.5

Cera

Sanitwaryware CRS IN 684 308 0.2 D6 54% NR

Cera’s high RoCE (Median FY13-FY17: 29%) despite increasing competition keeps its valuations elevated. Improving product portfolio, increasing presence in premium and mass market and the launch of home upgrade division can strengthen the brand and growth rates

45.7 37.7 8.6 7.2 18.4

Repco Home Fin REPCO

IN 550 341 1.8 N/A N/A NR

Strong positioning in affordable housing in South India due to local area knowledge and an innovative origination strategy. However a weak rating profile implies that competitive advantages are moderate

19.6 17.3 3.1 2.7 2.4

The case for a Coffee Can Portfolio

The Coffee Can approach to portfolio construction

We introduced our maiden 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 (ideally for ten years or more). To recap the origins of this

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 Portfolio’

likening the approach to the Wild West, when Americans, before the widespread

advent of banks, saved their valuables in a Coffee Can and kept it under a mattress.

Why does the approach work?

The simplicity of the Coffee Can approach to portfolio construction rests in four

factors that work in favour of longer investment horizons at the portfolio level:



Higher probability of returns over the long term: As is well understood,

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

CAGR basis, whilst the standard deviation of returns has been ~29%. Now using

these values of returns and standard deviation and assuming a normal

distribution of returns (a simplifying assumption), the probability of generating

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 5: Probability of gains from equity investing in India increases

disproportionately with increase in holding horizon

Source: Bloomberg, Ambit Capital research. Note: This chart has been inspired by similar work done by Michael Mauboussin in the Western context.

50% 60% 70% 80% 90% 100%

1 Hour 1 Day 1 Week 1 Month 1 Year 10 Year 100 Years

P ro b a b il it y o f g a in s Years

Robert Kirby of Capital Guardian

introduced the concept of ‘Coffee

Can Portfolio’ in 1984

Four factors work in favour of the

Coffee Can approach to portfolio

construction

Firstly,

the

probability

of

generating

positive

returns

increases disproportionately with

increase in holding horizons



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

horizon. As time progresses, stock B declines to irrelevance while the portfolio

value starts converging to the value of holding in stock A. Even with the assumed

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 6: A hypothetical portfolio with 50% strike rate and symmetry around positive and negative returns

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” (2

_{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

fundamentals of your investment so you can rightly observe when prices have

moved above or below your company’s intrinsic value. It is the same lesson

preached by Ben Graham and Warren Buffett. But all too often, deep-rooted

psychological issues outweigh this commonsensical advice. It is easy to say we

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.”

Secondly, compounding results in a

natural rebalancing of winners and

losers in a portfolio

Thirdly, by its design, the CCP is

indifferent to short-term trends,

sectors, themes, and approaches

such as chasing earnings or

momentum

As an example, we highlight how, over the long term, Page Industries’ stock price

has withstood short-term disappointments to eventually compound at an

impressive 30% CAGR since Mar’07.

Exhibit 7: Page’s stock has compounded at an impressive 30% CAGR since Mar’07

Source: Bloomberg, Ambit Capital research.

However, the chart shown above also highlights that over the past 10 years, there

have been several extended time periods when Page’s share price has not gone

anywhere – such as from Mar’07 to Mar’09, Jan’15 to Jan’16 and May’16 to

May’17. In spite of remaining flat over these periods, Page has performed so well

in the remaining six years that the 10-year CAGR for the stock is 30%. At its

simplest, this is why the concept of investing for longer time horizons works –

once you have identified a great franchise and you have the ability to hold on it

for a long period time, there is no point trying to be too precise about timing your

entry or your exit. As soon as you try to time that entry/exit, you run the risk of

“noise” rather than fundamentals driving our investment decisions.

To further demonstrate how ‘churn’ and ‘turn’ destroy ‘return’, we quote again

from ‘Investing: The Last Liberal Art’ by Hagstrom. In this book, the author refers

to an interesting experiment conducted by a behavioural economist at the

University of California. We reproduce the extract below:

“In 1997, Terence Odean, a behavioral economist at the University of California,

published a paper titled Why do Investors Trade Too Much? To answer his question,

he reviewed the performance of 10,000 anonymous investors.

Over a seven-year period (1987-1993), Odean tracked 97,483 trades among ten

thousand randomly selected accounts of a major discount brokerage. The first thing

he learned was that the investors sold and repurchased almost 80 percent of their

portfolios each year (78 percent turnover ratio). Then he compared the portfolios to

the market average over three different time periods (4 months, 1 year and 2

years). In every case, he found two amazing trends: (1) the stocks that the investors

bought consistently trailed the market, and (2) the stocks that they sold actually

beat the market

_.

Odean wanted to look deeper, so he next examined the trading behavior and

performance results of 6,465 households. In a paper titled, “Trading Is Hazardous

to Your Wealth” (2000), Odean, along with Brad Barber, professor of finance at

University of California, Davis, compared the records of people who traded

frequently versus people who traded less often. They found that, on average, the

most active traders had the poorest results, while those who traded the least earned

the highest returns

_{. The implication here is that people who might have suffered}

the most from myopic loss aversion and acted upon it by selling stocks did less well

– much less well – than those who were able to resist the natural impulse and

instead hold their ground.“

1 _{Terence Odean, “Do investors trade too much?”, American Economic Review (December}

1999)

2 _{Terence Odean and Brad Barber, "Trading Is Hazardous to Your Wealth: The Common Stock}

Investment Performance of Individual Investors," Journal of Finance 55, no. 2 (April 2000) 5,000 10,000 15,000 20,000 25,000 M a r-0 7 S e p -0 7 M a r-0 8 S e p -0 8 M a r-0 9 S e p -0 9 M a r-1 0 S e p -1 0 M a r-1 1 S e p -1 1 M a r-1 2 S e p -1 2 M a r-1 3 S e p -1 3 M a r-1 4 S e p -1 4 M a r-1 5 S e p -1 5 M a r-1 6 S e p -1 6 M a r-1 7 S e p -1 7 S h a re p ri ce ( in R s) CAGR 2.6% CAGR 4.2% CAGR 0.7% [email protected]



No churn: Finally, by holding a portfolio of stocks for over ten years, a fund

manager resists the temptation to buy/sell in the short term. With no churn, this

approach reduces transaction costs which add to the overall portfolio

performance over the long term. We illustrate this with an example below.

Assume that you invest US$100mn in a hypothetical portfolio on 30 June 2007.

Assume further that you churn this portfolio by 50% per annum (implying that a

typical position is held for two years) and this portfolio compounds at the rate of

Sensex Index. Assuming a total price impact cost and brokerage cost of 100bps

for every trade done over a ten-year period, this portfolio would generate CAGR

returns of 18.6%. Left untouched, however, the same portfolio would have

generated CAGR returns of 19.7%. This implies ~8.6% of the final corpus

(~US$52mn in value terms) is lost to churn over the ten-year period. Thus, a

US$100mn portfolio that would have grown to US$602mn over the ten-year

period (30 June 2007 - 30 June 2017) in effect grows to US$550mn due to high

churn.

Having built the case for a Coffee Can construct, in the next section we discuss the

framework we use to identify stocks for the Coffee Can Portfolio.

Finally, churn has a significant

impact on overall portfolio

returns

Framework and results from back-tests

In the world of investing, a number of quantitative (or rules based) approaches have

been devised for portfolio construction. For example, Joel Greenblatt’s ‘Magic

Formula’ and Joseph Piotroski’s ‘F-score’ screener are some of the well-known

approaches that can be used for portfolio construction. Even at Ambit, we use our

proprietary ‘greatness’ framework to identify quality franchises that have consistently

been showing an improvement in their financial performance over a six-year period.

[Note: We have now made both our proprietary ‘greatness’ and ‘accounting’

frameworks available for access to our clients using ‘

HAWK

’. Please contact your sales

representative if you are yet to receive your login credentials for access to the ‘HAWK’

platform.]

That said, whilst there are multiple rule-based approaches for portfolio construction,

most of these rule-based approaches usually require a periodic rebalance of the

portfolio. Thus, by virtue of limitations in their very construct they become less useful

for making designing a Coffee Can portfolio.

We, therefore, start with the basic principles of investing for our stock selection in a

Coffee Can portfolio. At the very basic level, a company doing well would mean that

it is profitable and is growing. The twin filters of growth and profitability, in our view,

are sufficient to assess the success of a franchise. Our tests of stock selection,

therefore, center around a long-term track record of delivery on revenue growth and

strong RoCE.

Exhibit 8: A combination of superior RoCE and revenue growth is a winner in the Indian context*

Source: Bloomberg, Ambit Capital research. Note:*The universe is 2007’s BSE200 firms (ex-financials); performance relative to the BSE200 Index; the chart is based on price data from 31 March 2007 to 31 March 2017. 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.

The twin filters of Coffee Can

We use RoCE (pre-tax) and revenue growth as the filters for selecting Coffee Can

stocks. Details are given below:



Pre-tax return on capital employed of 15% for each of the last ten years

Why pre-tax RoCE? Whilst management teams have a natural desire for growth

and scale, growth creates shareholder value only when the returns on capital

exceed the cost of capital. RoCE, therefore, is of utmost importance in assessing a

firm’s performance. Our empirical work on the share price performance of Indian

companies also supports the primacy of RoCE as a share price driver (see the

exhibit above). As shown in the exhibit above, BSE200 firms (ex-BFSI) with

superior revenue growth (in the top quartile) during the 10-year period over

FY07-17 outperformed the BSE200 Index by 4.1% on a CAGR basis. However,

firms with a superior RoCE growth gave a higher outperformance of 6.7%. The

best outperformance during this period was given by firms that were superior on

both revenue growth and RoCE at 9.6%.

4.1% 6.7% 9.6% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0%

Superior on sales growth Superior on RoCE Superior on Both

Average outperformance: 10-year CAGR

We start with the basic investing

principles for our stock selection

Stocks with superior RoCE have

outperformed their peers over the

last ten-year period

Why 15%? The weighted average cost of capital (before taxes) for Indian

companies is around 13-14% (assuming an equal mix of debt and equity; ~11%

cost of debt and ~15% cost of equity). Adding the risk-free rate (7.5-8% in India)

and an equity risk premium of 6-6.5% too gives a cost of capital broadly in that

range. The equity risk premium, in turn, is calculated as 4% (the long-term US

equity risk premium) plus 250bps to account for India’s rating (BBB- as per S&P).

We, thus, use 15% as a minimum because we believe that that is the bare

minimum return required to beat the cost of capital which for the vast majority of

listed companies is at least 14%.

Further, from our earlier discussions, we note that over the past 30 years, the

Sensex has delivered returns of around 15% per annum, validating our point of

view that 15% is a sensible figure to use as a minimum RoCE (pre-tax) criteria.



Revenue growth of 10% every year for each of the last ten years: India’s

nominal GDP growth rate has averaged 14% over the past ten years (FY07-17). A

firm operating in India should, therefore, be able to deliver sales growth of at

least 14% per annum. However, very few listed companies (only 6 out of the

~1512 firms run under our screen), have managed to achieve this! Therefore, we

reduce this filter rate modestly to 10%; i.e. we look for companies that have

delivered revenue growth of 10% per annum every year for ten consecutive years.

In summary, our filters focus on a minimum pre-tax RoCE of 15% or more and sales

growth of 10% for more over ten consecutive years.

Note: Given the recent accounting standard change from Indian GAAP to IND-AS, to

calculate the parameters above for FY16-17 we have used corresponding IND-AS

numbers.

For Financial Services stocks, we modify the filters on RoE and sales growth

as follows:



Return on equity of 16% for each of the last ten years: We prefer return on

equity over return on assets because it is a fairer measure of the bank’s ability to

generate higher income efficiently on a given equity capital base over time.

We use 16% as a minimum because we believe that is the bare minimum return

required to meet the cost of equity for Indian lenders (for the vast majority of

Indian lenders, cost of equity is at least 15%).



Loan growth of 15% every year for each of the last ten years: We believe

loan growth of 15% is an indication of a bank’s ability to lend over business

cycles. Strong lenders ride the downcycle better as competitive advantages

surrounding their origination, appraisal and collection process ensure that they

continue their growth profitably either through market-share improvements or

upping the ante in sectors which are resilient during a downturn.

Finally, for all the stocks considered for the Coffee Can Portfolio, we put a

market-cap threshold of `1bn. India is the least liquid among the world’s 15 largest equity

markets. Thus, for institutional clients, we believe a market capitalisation of `1bn is

the bare minimum to take a position in the stock. Stocks smaller than this tend to be

illiquid and create high impact costs.

Note that whilst these twin filters of revenue growth and RoCE may appear simplistic

in nature, our approach consciously does not look for candidates with the highest

growth and highest RoCE, as reversion to mean is an accepted fact in corporate life.

Instead, we base our selection on a system of guard rails which helps us assess which

firms have what it takes to protect themselves and march ahead through good as well

as bad times. This approach is also different to that taken in our other portfolio

constructs that focus on comparatively shorter holding periods, where we are more

focused on directional progress. More details on these can be found in the Appendix

1: How the Coffee Can is different to our other portfolio constructs.

15% RoCE is the minimum return

required to beat the cost of capital

in India

Very few listed companies manage

to achieve a sales growth that

matches India’s nominal GDP

growth rate of 15%

We use RoE of 16% and loan

growth of 15% as filters to screen

BFSI stocks

We use a market-cap threshold of

`1bn

Results from back- testing the Coffee Can portfolios

Having built a case for the Coffee Can construct and a framework for identifying

these Coffee Can stocks, we now discuss results from our back-testing of the

framework.

Using the twin filters of growth and profitability discussed in the previous section, we

ran back-tests of the CCP over the last seventeen years (i.e. portfolios initiated

annually from 2000 to 2016), including eight portfolios that have run their entire

course of ten-years (2000-2010, 2001-2011, 2002-2012, 2003-2013, 2004-2014,

2005-2015, 2006-2016 and 2007-2017) and nine portfolios (starting 2007) which

have not yet completed their 10 years. We also show the performance of a separate

‘large-cap CCP’ consisting solely of stocks that were in the top-100 stocks by market

cap (at the start of the period under consideration).

We have also stress-tested these results for maximum drawdown to test the strength

of the portfolio during periods of market volatility:



First, we calculate CAGR returns for each of the 17 portfolios and the

Sensex/BSE200 index;



Next, we compute the maximum drawdown (defined as the maximum drop in

cumulative returns from the highest peak to the lowest subsequent trough); and



Finally, we calculate the adjusted returns; i.e. returns in excess of the

risk-free rate (assumed at 8%, comparable to the last ten year average 10-yr

Government bond yield of 7.8%) divided by the absolute maximum drawdown.

Performance of the previous Coffee Can portfolios vs Sensex using total

shareholder returns

In the exhibit below, we have shown the performance of each of the preceding 17

Coffee Can portfolios vs Sensex using the total shareholder returns (i.e. assuming

that dividends are reinvested back into the same stock on the ex-dividend date).

We summarise the results of each of these 17 iterations in the table below. For

details on the portfolio constituents, please refer to the Appendix 2.

Exhibit 9: Back-testing results of 17 iterations of the Coffee Can Portfolio (vs Sensex) using total shareholder returns Kick-off year* All-cap CCP (start) All-cap CCP (end) CAGR return Outperformance relative to Sensex Large-cap CCP (start) Large-cap CCP (end) CAGR return Outperformance relative to Sensex 2000 500 3,831 22.6% 6.6% 400 3,338 23.6% 7.6% 2001 600 9,802 32.2% 11.7% 300 3,622 28.3% 7.8% 2002 800 7,709 25.4% 5.1% 500 4,182 23.7% 3.3% 2003 900 10,175 27.4% 7.2% 600 7,791 29.2% 9.0% 2004 1,000 16,849 32.6% 12.7% 500 3,679 22.1% 2.1% 2005 900 6,643 22.1% 6.0% 500 2,968 19.5% 3.4% 2006 1,000 6,376 20.4% 9.0% 600 2,918 17.1% 5.7% 2007 1,500 9,027 19.6% 10.3% 1,000 4,690 16.7% 7.4% 2008 1,100 6,759 21.4% 9.6% 800 4,028 18.8% 7.0% 2009 1,100 6,510 23.7% 11.5% 900 3,534 17.8% 5.6% 2010 700 3,167 22.8% 12.1% 300 1,138 19.8% 9.2% 2011 1,400 3,558 15.8% 4.7% 400 1,076 16.8% 5.8% 2012 2,200 7,502 25.7% 11.1% 500 1,214 18.0% 3.4% 2013 1,800 6,608 34.8% 19.8% 600 1,451 22.5% 7.5% 2014 1,600 2,902 22.1% 14.6% 700 1,118 17.0% 9.5% 2015 2,000 2,841 19.0% 5.7% 1,200 1,460 10.2% -3.1% 2016 1,700 2,142 26.0% -2.5% 800 969 21.1% -7.4%

Source: Bloomberg, Capitaline, Ambit Capital research. Note: Portfolio at start denotes an equal allocation of `100 for the stocks qualifying to be in the CCP for

that year. *The Portfolio kicks off on 30th _{June of every year. CAGR returns for all the portfolios since 2012 have been calculated until 07 Nov’17 (except for the live}

portfolios for the years 2014, 2015 and 2016 for which CAGR returns and absolute returns have been calculated since these portfolios were launched in November each year).

We back-test the framework and

the results are revealing

The results are revealing and can be summarised as follows:



16 out of 17 CCPs comprehensively outperformed the benchmark Sensex

index.



Even the sub-set of the CCP, i.e. the

large-cap

version of the CCP has been

successful in beating the Sensex on 15 out of 17 occasions.



On a risk-adjusted basis (where we define risk as maximum drawdown), 16 out of

17 iterations of the

all-cap portfolio

and 15 out of 17 iterations of the

large-cap portfolio have outperformed

the Sensex.



The

large-cap versions

of the CCP have outperformed the all-cap versions

in

2000, 2003 and 2011 (both on an absolute basis as well as risk-adjusted basis).

In the other versions, however, the all-cap version of the CCP has delivered

superior returns as compared to the respective large-cap versions on an absolute

basis.

Performance of the previous Coffee Can portfolios vs BSE200 index using

total shareholder returns

In the exhibit below, we now plot the performance of these portfolios vs broader

market indices, such as the BSE200 index. The results, however, remain the same

with 16 out of 17 all-cap Coffee Can portfolios and 15 out of 17 large-cap Coffee

Can portfolios managing to beat the benchmark BSE200 index comprehensively.

Exhibit 10: Back-testing results of 16 iterations of the Coffee Can Portfolio (vs BSE200 index) Kick-off year* All-cap CCP (start) All-cap CCP (end) CAGR return Outperformance relative to BSE200 Large-cap CCP (start) Large-cap CCP (end) CAGR return Outperformance relative to BSE200 2000 500 3,831 22.6% 5.1% 400 3,338 23.6% 6.1% 2001 600 9,802 32.2% 9.8% 300 3,622 28.3% 5.9% 2002 800 7,709 25.4% 4.9% 500 4,182 23.7% 3.2% 2003 900 10,175 27.4% 7.7% 600 7,791 29.2% 9.5% 2004 1,000 16,849 32.6% 13.4% 500 3,679 22.1% 2.8% 2005 900 6,643 22.1% 6.2% 500 2,968 19.5% 3.6% 2006 1,000 6,376 20.4% 8.1% 600 2,918 17.1% 4.9% 2007 1,500 9,027 19.6% 9.4% 1,000 4,690 16.7% 6.5% 2008 1,100 6,759 21.4% 8.3% 800 4,028 18.8% 5.7% 2009 1,100 6,510 23.7% 10.1% 900 3,534 17.8% 4.1% 2010 700 3,167 22.8% 11.1% 300 1,138 19.8% 8.2% 2011 1,400 3,558 15.8% 2.9% 400 1,076 16.8% 4.0% 2012 2,200 7,502 25.7% 8.9% 500 1,214 18.0% 1.2% 2013 1,800 6,608 34.8% 16.4% 600 1,451 22.5% 4.1% 2014 1,600 2,902 22.1% 10.8% 700 1,118 17.0% 5.7% 2015 2,000 2,841 19.0% 2.0% 1,200 1,460 10.2% -6.8% 2016 1,700 2,142 26.0% -6.3% 800 969 21.1% -11.1%

Source: Bloomberg, Capitaline, Ambit Capital research. Note: Portfolio at start denotes an equal allocation of `100 for the stocks qualifying to be in the CCP for

that year. *The Portfolio kicks off on 30th _{June of every year. CAGR returns for all the portfolios since 2012 have been calculated until 07 Nov’17 (except for the live}

portfolios for the years 2014, 2015 and 2016 for which CAGR returns and absolute returns have been calculated since these portfolios were launched in November each year).

How should investors deploy fresh capital received every year?

Given the long-term “buy and hold” approach advocated by the Coffee Can it is only

natural that investors wonder about the approach to be followed for fresh fund

deployment that are received every year. We discussed this point in detail in our last

years’ Coffee Can report

“The Coffee Can Portfolio 2016”

dated 17 Nov’16.

Specifically we took into account two scenarios:

a) The fresh inflows every year are assumed to remain constant and are deployed in

next year Coffee Can portfolio. So for instance, after starting a Coffee Can

portfolio in Jun’00 with `100, when an investor receives `100 more in Jun ’01,

these funds are deployed in the Coffee Can Portfolio for the year 2001 (and

allowed to compound over the remaining 9 years of the initial Coffee Can). Any

dividends that were declared by any of the stocks in the initial Coffee Can

17 iterations of the CCP that we

initiated from 2000 to 2016 prove

the potential of the CCP to beat the

Sensex and the BSE200

Exhibit 11: Portfolio returns assuming constant fund inflows every year

Total stocks

Weight in the portfolio (%):

Portfolio IRR Sensex IRR Alpha (Portfolio vs Sensex) Top 5 stocks Next 5 stocks Remaining

stocks Overall 2000-10 30 62.33 23.70 13.96 100.00 29.7% 21.4% 8.3% 2001-11 31 57.78 24.44 17.79 100.00 29.5% 21.0% 8.5% 2002-12 36 53.14 26.56 20.30 100.00 25.1% 16.9% 8.2% 2003-13 46 54.65 24.29 21.05 100.00 23.3% 15.1% 8.1% 2004-14 48 53.88 17.50 28.63 100.00 25.6% 15.7% 9.9% 2005-15 50 49.15 18.10 32.76 100.00 21.6% 13.5% 8.1% 2006-16 57 46.48 15.66 37.86 100.00 19.9% 10.2% 9.7% Average 43 53.92 21.46 24.62 100.00 25.0% 16.3% 8.7% Median 46 53.88 23.70 21.05 100.00 25.1% 15.7% 8.3%

Source: Bloomberg, Ambit Capital research. Note: In the exhibit above we have assumed that the fresh fund inflows every year remain constant (i.e. Rs100 each

year). Exhibit reproduced without any changes from our 17 Nov’16 report “The Coffee Can Portfolio 2016”.

One can clearly gauge from the table above that not only has each of the portfolios

delivered healthy IRR (average IRR for the seven portfolios is ~25.0%), each of the

portfolios has quite comprehensively beaten the benchmark Sensex index (with an

average outperformance of ~8.7%).

b) The fresh fund inflows every year are assumed to grow at 20% each year over the

10-year life of a particular Coffee Can Portfolio. Here we assume that after

starting Coffee Can portfolio in Jun’00 with `100, when an investor receives `100

more in Jun ’01, the investor receives fresh inflows of `120 (i.e. a 20% increase

over the `100 received in Jun ’00), which is then invested in the Coffee Can

Portfolio for the year 2001 and is then allowed to compound over the remaining

9 years of the initial Coffee Can. Here again we assume that any dividends that

were declared by any of the stocks in the initial Coffee Can Portfolio are deployed

in the Coffee Can Portfolio for the year 2001.

The exhibit below summarises the results from our analysis.

Exhibit 12: Portfolio returns assuming fund inflows grow at 20% every year

Total stocks Weight in the portfolio (%): Portfolio IRR Sensex IRR Alpha (Portfolio

vs Sensex)

Top 5 Next 5 Others Overall

2000-10 30 55.29 23.94 20.77 100.00 29.9% 21.4% 8.4% 2001-11 31 49.65 25.15 25.20 100.00 28.3% 19.7% 8.5% 2002-12 36 45.04 25.26 29.70 100.00 23.4% 14.3% 9.1% 2003-13 46 48.16 21.75 30.09 100.00 20.4% 13.0% 7.4% 2004-14 48 45.94 15.40 38.66 100.00 24.8% 15.3% 9.6% 2005-15 50 41.37 16.58 42.05 100.00 22.4% 13.5% 8.9% 2006-16 57 38.40 16.54 45.06 100.00 20.1% 9.9% 10.2% Average 43 46.26 20.66 33.07 100.00 24.2% 15.3% 8.9% Median 46 45.94 21.75 30.09 100.00 23.4% 14.3% 8.9%

Source: Bloomberg, Ambit Capital research Note: In the exhibit above we have assumed that the fresh fund inflows every year increase by 20% (i.e. Rs100 at the

start of year 1, Rs120 at the start of year 2, and so on) Exhibit reproduced without any changes from our 17 Nov’16 report “The Coffee Can Portfolio 2016”.

In this case too, portfolio IRR remains healthy at ~24.2% (vs ~15.3% for the Sensex

index).

We believe the exhibits above bring out a very important aspect of the Coffee Can

construct; which is, 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.

Under both the scenarios, the

portfolio continues to generate

healthy IRRs vs the Sensex index

Patience with Quality is the Holy Grail

In last years’ Coffee Can report,

“The Coffee Can Portfolio 2016”

dated 17 Nov’16,

we’d also discussed briefly how the returns as well as risk profile for the Coffee Can

Portfolio are over a shorter time horizon. In that context, we determined the

performance of Coffee Can portfolios over shorter time horizon of five years and as

the results in exhibit below showcase, even over shorter time horizons, 15 out of 17

CCPs has outperformed the benchmark Sensex index

Exhibit 13: Performance of the previous 17 iterations of the Coffee Can Portfolio over a 5-year period Kick-off year* All-cap CCP (start) All-cap CCP (end) CAGR return Outperformance relative to Sensex Large-cap CCP (start) Large-cap CCP (end) CAGR return Outperformance relative to Sensex 2000 500 1,150 18.1% 4.1% 400 925 18.2% 4.2% 2001 600 2,409 32.1% 0.9% 300 1,320 34.5% 3.3% 2002 800 4,006 38.0% -0.5% 500 2,667 39.8% 1.3% 2003 900 3,771 33.2% 1.3% 600 3,089 38.8% 6.9% 2004 1,000 3,904 31.3% 6.3% 500 1,769 28.8% 3.8% 2005 900 2,525 22.9% 1.8% 500 1,606 26.3% 5.2% 2006 1,000 2,029 15.2% 1.0% 600 1,458 19.4% 5.2% 2007 1,500 2,685 12.3% 7.5% 1,000 1,968 14.5% 9.7% 2008 1,100 2,670 19.4% 10.7% 800 1,875 18.6% 9.8% 2009 1,100 3,529 26.3% 12.5% 900 2,203 19.6% 5.8% 2010 700 1,764 20.3% 9.4% 300 708 18.7% 7.8% 2011 1,400 2,335 10.8% 0.4% 400 828 15.6% 5.2% 2012 2,200 6,651 24.8% 8.9% 500 1,165 18.4% 2.5% 2013 1,800 6,608 34.8% 16.4% 600 1,451 22.5% 4.1% 2014 1,600 2,902 22.1% 10.8% 700 1,118 17.0% 5.7% 2015 2,000 2,841 42.1% 4.8% 1,200 1,460 21.7% -15.5% 2016 1,600 2,069 29.3% -2.9% 800 969 21.1% -11.1%

Source: Bloomberg, Capitaline, Ambit Capital research. Note: Portfolio at start denotes an equal allocation of `100 for the stocks qualifying to be in the CCP for

that year. *The Portfolio kicks off on 30th _{June of every year. CAGR returns for all the portfolios since 2012 have been calculated until 07 Nov’17 (except for the live}

portfolios for the years 2014, 2015 and 2016 for which CAGR returns and absolute returns have been calculated since these portfolios were launched in November each year).

While this result might lead investors to wonder why then should they keep their

money locked in for 10 years instead of five, our subsequent analysis in the report

pointed towards how results are materially better in the former case. Specifically, we

compared two scenarios,

Scenario 1- Each of the eight (2000, 2001, 2002, 2003, 2004, 2005, 2006, 2007]

completed Coffee Can portfolios are left untouched for a decade.

Scenario 2- Each of these eight (2000, 2001, 2002, 2003, 2004, 2005, 2006, 2007]

Coffee Can portfolios is allowed to compound for the first 5 years of the life of the

portfolio. At the end of year 5, the portfolio value of stocks that does not clear our

Coffee Can filters in year 5 is equally allocated to the fresh stocks that meet the

Coffee Can criteria in year 5. So, for example, from the Coffee Can Portfolio for the

year 2000, Cipla, Hero MotoCorp and HDFC continued to meet the Coffee Can

thresholds in 2005. NIIT and Swaraj Engines, however, failed to meet the Coffee Can

criteria in 2005. Hence, we allocate the portfolio value of NIIT and Swaraj Engines at

the end of year 5 equally to all the fresh stocks that meet our Coffee Can thresholds

in 2005 (in this case: Infosys, Container Corporation, Geometric, Havells India,

Ind-Swift and Munjal Showa). We repeat this exercise for the periods of 2001-11,

2002-12, 2003-13, 2004-14, 2005-15, 2006-16 and 2007-17.

In both the scenarios we assume a total price impact cost plus brokerage cost of

100bps for every trade done over the ten-year period. The portfolio attributes under

each of the two scenarios discussed above can be seen in exhibit below:

Exhibit 14: Performance of the Coffee Can Portfolios under the two scenarios

Phase

Scenario 1 Scenario 2 Scenario 1 vs Scenario 2

CAGR returns for the portfolio

Growth of `99 invested at the start of the period*

CAGR returns for the portfolio

Growth of `99 invested at the start of the period* Excess CAGR returns under Scenario 1 Loss of terminal portfolio value under Scenario 2 2000-10 22.6% 759 22.7% 769 -0.2% 1% 2001-11 32.2% 1,617 24.9% 913 7.4% -44% 2002-12 25.4% 954 23.3% 803 2.2% -16% 2003-13 27.4% 1,119 25.7% 976 1.8% -13% 2004-14 32.6% 1,668 28.5% 1,222 4.1% -27% 2005-15 22.1% 731 21.3% 686 0.8% -6% 2006-16 20.4% 631 13.3% 344 7.1% -45% 2007-17 19.6% 596 17.5% 496 2.2% -17% Average 25.3% 22.1% 3.2% -21%

Source: Bloomberg, Ambit Capital research. Note: *After considering Rs1 in terms of brokerage and price impact cost.

The results from our analysis showcase how in seven out of eight iterations, the

portfolio value at the end of year 10 is higher if the initial Coffee Can Portfolio is kept

untouched for the decade. The more astounding thing to note is that in two of the

iterations (i.e. 2001-11 and 2006-16), the portfolio value at the end of year 10 is

lower by 44% and 45% respectively if an investor decides to churn the portfolio in

year 5.

This analysis yet again brings out the point that for the Coffee Can construct to

deliver its magic, the portfolio should be left untouched for the decade. A shorter

time horizon does not allow the power of compounding to work its magic.

Combining patience with quality generates best risk-adjusted returns

In this version of our annual Coffee Can thematic, we decided to further explore the

point on why someone should stick to investing for the long term with Coffee Can

companies. Tying up funds for 10 years is by no means an easy task and a large

majority of investors need to showcase good returns over shorter duration too in light

of extreme competition in the fund management industry. To analyze the

performance of a typical Coffee Can portfolio over durations less than 10 years then,

we first direct investors’ attention towards our 22 Dec’16 dated note

‘The peculiar

distribution of equity returns in India’

and 25 Jan’17 dated note

‘To get the free lunch

in Indian equities’

where we had highlighted how the risk-adjusted returns pattern in

India is clearly in favour holding on for periods of more than 5 years. The exhibits

below clearly showcase how patience with respect to investments serves investors the

best.

Exhibit 15: The BSE100’s returns over a 10-year investment horizon are most likely to beat the risk-free rate

Source: Bloomberg, Ambit Capital Research. Note: Period under consideration is from April 1991 – December 2016. Avg refers to the average. The red dotted lines represent the average, average +1standard deviation, and average -1standard deviation for the 1-year investment horizon and the black dotted lines represent the average, average +1standard deviation, and average -1standard deviation for the 10-year investment horizon.

-1SD Avg : 13% +1SD Avg :17% +1SD -1SD 0 40 80 120 -50% -30% -10% 10% 30% 50% 70% 90% 110% 130% 150% N o . o f o b se rv a ti o n s

BSE100 returns (in %)

10 Yr investment horizon 1 Yr investment horizon

1 Yr horizon has a fat left tail

10 Yr horizon has a fat right tail

Our analysis suggests for the

Coffee Can construct to play its

magic, the CCP should be left

untouched for a decade