Ambit Coffee Can 2017

STRATEGY

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November 2017

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The Coffee Can Portfolio 2017 Research Analysts Prashant Mittal, CFA [email protected] Tel: +91 22 3043 3218

Aadesh Mehta, CFA [email protected] Tel: +91 22 3043 3239

Sudheer Guntupalli [email protected] Tel: +91 22 3043 3203

Pankaj Agarwal, CFA [email protected] [email protected] Tel: +91 22 3043 3206

Abhishek Ranganathan, CFA [email protected] Tel: +91 22 3043 3085

Ashvin Shetty, CFA [email protected] Tel: +91 22 3043 3285

Nikhil Pillai [email protected] Tel: +91 22 3043 3265

Strategy

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) Astral Poly (NOT RATED)

……………………………………………………..113 ………………………………………………………..121

Dr Lal PathLabs (NOT RATED) …………………………………………………..129 Cera Sanitaryware (NOT RATED) ………………………………………………135 REPCO Home Finance (NOT RATED) ………………………………………….141

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Page 2

Strategy THEMATIC

November 17, 2017

The Coffee Can Portfolio 2017

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.

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

Coffee Can Portfolios have consistently outperformed the Sensex 2000 2001

All-cap CCP (start) 500 600

All-cap CCP (end) 3,831 9,802

CAGR return 22.6% 32.2%

Outperformance relative to Sensex 6.6% 11.7%

2002 2003

800 900

7,709 10,175

25.4% 27.4%

5.1% 7.2%

2004 2005

1,000 900

16,849 6,643

32.6% 22.1%

12.7% 6.0%

2006 2007

1,000 1,500

6,376 9,027

20.4% 19.6%

9.0% 10.3%

2008 2009

1,100 1,100

6,759 6,510

21.4% 23.7%

9.6% 11.5%

2010 2011

700 1,400

3,167 3,558

22.8% 15.8%

12.1% 4.7%

2012 2013

2,200 1,800

7,502 6,608

25.7% 34.8%

11.1% 19.8%

2014 2015

1,600 2,000

2,902 2,841

22.1% 19.0%

14.6% 5.7%

2016

1,700

2,142

26.0%

-2.5%

Kick-off year

Source: Bloomberg, Ambit Capital research. Note: Full 10 year TSR (Total Shareholder Return) calculation is done for the periods from 2000 – 2007 (starting 30th June). For periods after 2007, TSR calculation is performed till 7th November 2017 ( this is excluding live portfolios for 2014, 2015 & 2016 for which CAGR returns and absolute returns have been calculated since these portfolios were launched in Nov ’14, Nov'15 and Nov ’16 respectively).

Research Analyst Prashant Mittal, CFA +91 22 3043 3218 [email protected]

[email protected]

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 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):

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Strategy Exhibit 1: A combination of superior RoCE and revenue growth is a winner in the Indian context* 12.0%

Average outperformance: 10-year CAGR 9.6%

10.0% 8.0%

6.7%

6.0% 4.1% 4.0% 2.0% 0.0% Superior on sales growth

Superior on RoCE

Superior on Both

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 3035%. 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):

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Strategy Exhibit 2: Share price CAGR returns over 10-year periods for CCP with and without rebalancing 20002010

2001- 2002- 2003- 2004- 20052011 2012 2013 2014 2015

20062016

2007- Median 2017 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 0.8% 5.9% 0.4% 8.4% 12.0% 6.9% 7.2% 6.2% 3.7% with 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-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 50% = 1 Yr

Standard Deviation

40%

Staying invested for longer period improves median returns for Sensex whilst reducing risk

30%

20%

Sensex Coffee Can Portfolios

1 Yr

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

3 Yr

3 Yr

5 Yr 10%

5 Yr

10 Yr

10 Yr

0% 8% -10%

13%

18%

23%

28%

Returns (median)

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

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Page 6

Strategy 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.

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Page 7

Strategy Exhibit 4: Summary of the 2017 Coffee Can Portfolio Company

Ticker

Mcap ($mn)

HDFC Bank

HCL Technologies

Lupin

HDFCB IN

HCLT IN

LPC IN

LIC Housing Fin. LICHF IN

72,487

19,272

Free Float ADV-6m Greatness Mcap (Median) Accounting Score Ambit Decile Stance ($mn) ($mn) (%) 53,641

7,516

31.0

18.1

N/A

D2

N/A

92%

Comments

P/E

P/B

RoCE*

FY17

FY18E

FY17

FY18E

FY17

SELL

Credible execution track record driving consistent high earnings growth while maintaining asset quality

31.9

26.6

5.2

4.6

1.8

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

14.8

20.6

2.8

2.5

13.3

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

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

86.2

69.5

34.5

28.4

41.7

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

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

34.6

26.6

6.9

5.9

21.4

62.9

50.3

10.7

9.0

16.8

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.

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

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Page 8

Strategy

Company

Ticker

Mcap ($mn)

Dr Lal Pathlabs

Cera Sanitwaryware

DLPL IN

CRS IN

REPCO Repco Home Fin IN

1,026

684

550

Free Float ADV-6m Greatness Mcap (Median) Accounting Score Ambit Decile Stance ($mn) ($mn) (%)

123

308

341

0.9

0.2

1.8

D2

D6

N/A

75%

54%

N/A

Comments

P/E

P/B

RoCE*

FY17

FY18E

FY17

FY18E

FY17

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

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

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

Source: Bloomberg, Capitaline, Ambit Capital Research. Note: *RoA for BFSI stocks. Market cap data as of 07 Nov’17.

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Page 9

Strategy

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.

Robert Kirby of Capital Guardian introduced the concept of ‘Coffee Can Portfolio’ in 1984

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: 

Four factors work in favour of the 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 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%.

Firstly, the probability of generating positive returns increases disproportionately with increase in holding horizons

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 disproportionately with increase in holding horizon

in

India

increases

Probability of gains

100% 90% 80% 70% 60% 50% 1 Hour

1 Day

1 Week

1 Month Years

1 Year

10 Year 100 Years

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

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Page 10

Strategy 

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.

Secondly, compounding results in a natural rebalancing of winners and losers in a portfolio

Exhibit 6: A hypothetical portfolio with 50% strike rate and symmetry around positive and negative returns 10-year CAGR

600 500

Stock A

26%

Stock B

-26%

Portfolio

17.6%

400 300 200 100 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 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.”

Thirdly, by its design, the CCP is indifferent to short-term trends, sectors, themes, and approaches such as chasing earnings or momentum

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Strategy 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

Share price (in Rs)

25,000 20,000 CAGR 4.2%

CAGR 2.6%

15,000 10,000 5,000

CAGR 0.7%

Sep-17

Sep-16

Mar-17

Mar-16

Sep-15

Mar-15

Sep-14

Mar-14

Sep-13

Mar-13

Sep-12

Mar-12

Sep-11

Mar-11

Sep-10

Mar-10

Sep-09

Mar-09

Sep-08

Mar-08

Sep-07

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 market1. 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 returns2. 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) [email protected] November 17, 2017

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Page 12

Strategy 

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 Finally, churn has a significant generated CAGR returns of 19.7%. This implies ~8.6% of the final corpus impact on overall portfolio (~US$52mn in value terms) is lost to churn over the ten-year period. Thus, a returns 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.

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Strategy

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.

We start with the basic investing principles for our stock selection

Exhibit 8: A combination of superior RoCE and revenue growth is a winner in the Indian context* 12.0%

Average outperformance: 10-year CAGR 9.6%

10.0% 8.0%

6.7%

6.0% 4.1% 4.0% 2.0% 0.0% Superior on sales growth

Superior on RoCE

Superior on Both

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 Stocks with superior RoCE have exceed the cost of capital. RoCE, therefore, is of utmost importance in assessing a outperformed their peers over the firm’s performance. Our empirical work on the share price performance of Indian last ten-year period 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%. [email protected]

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Page 14

Strategy Why 15%? The weighted average cost of capital (before taxes) for Indian 15% RoCE is the minimum return companies is around 13-14% (assuming an equal mix of debt and equity; ~11% required to beat the cost of capital cost of debt and ~15% cost of equity). Adding the risk-free rate (7.5-8% in India) 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 Very few listed companies manage nominal GDP growth rate has averaged 14% over the past ten years (FY07-17). A to achieve a sales growth that firm operating in India should, therefore, be able to deliver sales growth of at matches India’s nominal GDP least 14% per annum. However, very few listed companies (only 6 out of the growth rate of 15% ~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 We use RoE of 16% and loan equity over return on assets because it is a fairer measure of the bank’s ability to growth of 15% as filters to screen generate higher income efficiently on a given equity capital base over time. BFSI stocks 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- We use a market-cap threshold of cap threshold of `1bn. India is the least liquid among the world’s 15 largest equity `1bn 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.

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Page 15

Strategy 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 risk-adjusted returns; i.e. returns in excess of the riskfree 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.

We back-test the framework and the results are revealing

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%

1,700 2,142 26.0% -2.5% 800 969 21.1% -7.4% 2016 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).

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Page 16

Strategy 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 largecap 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.

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

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* 2000

All-cap CCP (start) 500

All-cap CCP (end) 3,831

CAGR return 22.6%

Outperformance relative to BSE200 5.1%

Large-cap CCP (start) 400

Large-cap CCP (end) 3,338

CAGR Outperformance return relative to BSE200 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%

1,700 2,142 26.0% -6.3% 800 969 21.1% -11.1% 2016 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 Portfolio too are deployed in the Coffee Can Portfolio for the year 2001. The results from the analysis have been summarised in exhibit below: [email protected]

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Strategy Exhibit 11: Portfolio returns assuming constant fund inflows every year Weight in the portfolio (%): Total stocks

Portfolio IRR

Sensex IRR

Alpha (Portfolio vs Sensex)

100.00

29.7%

21.4%

8.3%

17.79

100.00

29.5%

21.0%

8.5%

20.30

100.00

25.1%

16.9%

8.2%

24.29

21.05

100.00

23.3%

15.1%

8.1%

53.88

17.50

28.63

100.00

25.6%

15.7%

9.9%

49.15

18.10

32.76

100.00

21.6%

13.5%

8.1%

Top 5 stocks

Next 5 stocks

Remaining stocks

Overall

30

62.33

23.70

13.96

2001-11

31

57.78

24.44

2002-12

36

53.14

26.56

2003-13

46

54.65

2004-14

48

2005-15

50

2000-10

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 (%): Top 5

Next 5

Others

Overall

Portfolio IRR

Sensex IRR

Alpha (Portfolio vs Sensex)

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

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November 17, 2017

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Page 18

Strategy

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%

2001

600

2,409

32.1%

0.9%

400

925

18.2%

4.2%

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

2004

1,000

3,904

33.2%

1.3%

600

3,089

38.8%

6.9%

31.3%

6.3%

500

1,769

28.8%

3.8%

2005

900

2006

1,000

2,525

22.9%

1.8%

500

1,606

26.3%

5.2%

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, IndSwift and Munjal Showa). We repeat this exercise for the periods of 2001-11, 200212, 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:

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Strategy Exhibit 14: Performance of the Coffee Can Portfolios under the two scenarios Scenario 1

Scenario 2

Growth of `99 CAGR returns for invested at the start the portfolio of the period* 22.6% 759

Phase 2000-10

Scenario 1 vs Scenario 2 Excess CAGR Loss of terminal returns under portfolio value Scenario 1 under Scenario 2 -0.2% 1%

Growth of `99 CAGR returns for invested at the start the portfolio of the period* 22.7% 769

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

Average

25.3%

22.1%

2.2%

-17%

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.

Our analysis suggests for the Coffee Can construct to play its magic, the CCP should be left untouched for a decade

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 Avg : 13%

No. of observations

10 Yr investment horizon +1SD 120

80

40

-1SD

Avg :17%

-1SD

1 Yr investment horizon

+1SD

10 Yr horizon has a fat right tail

1 Yr horizon has a fat left tail

0 -50%

-30%

-10%

10%

30%

50%

70%

90%

110%

130%

150%

BSE100 returns (in %) 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.

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Strategy

Median

distributions

Standard deviation

14%

Sharpe (using median) 40%

2.5

11%

The region which showcases ‘free lunch’ – i.e. returns and risk move in favourable direction together

10% 9%

20% 15% 10%

Sharpe ratio

25%

1

3

5

7

9

11

13

15

17

35% 30% 25%

1.5

20% 1.0

15% 10%

0.5

5%

5%

0%

8%

40%

2.0 Standard Deviation

30% 12%

Standard deviation

The ‘sweet spot’ of investment horizon

35%

13% Returns (annualised)

Exhibit 17: For the Nifty, the sweet spot of risk-adjusted returns is reached around the fifteen-year mark

Standard deviation

Exhibit 16: For the Nifty, the returns ‘normalize’ as the time horizon increases

0%

-

19

1

Years Source: Bloomberg, Ambit Capital Research Note: The returns have been computed on a daily rolling basis for the Nifty50 index since July 1990

3

5

7

9

11 13 Years

15

17

19

Source: Bloomberg, Ambit Capital Research Note: The returns have been computed on a daily rolling basis for the Nifty50 index since July 1990

We take this analysis further and showcase that how 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 CCP) for the long term, the risk-adjusted profile improves even further. Exhibit 18: Combining ‘patience’ in investing with ‘quality’ of investing (using Sensex as proxy for market) is the holy grail 50% =

Standard Deviation

1 Yr

Staying invested for longer period improves median returns for Sensex whilst reducing risk

40%

30%

20%

Sensex Coffee Can Portfolios

1 Yr

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

3 Yr

3 Yr

5 Yr 10%

5 Yr

10 Yr

10 Yr 0% 8% -10%

13%

18%

23%

28%

Returns (median)

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

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Strategy Exhibit 19: Combining ‘patience’ in investing with ‘quality’ of investing (using BSE200 as proxy for market) is the holy grail 50%

BSE200 index Staying invested for a longer period improves median returns for BSE200 whilst reducing risk

Standard Deviation

40%

Coffee Can Portfolios

1 Yr

1 Yr 30% Combining patience with quality (through CCP) further improves riskadjusted returns

3 Yr

20%

3 Yr

5 Yr

10%

5 Yr 10 Yr

10 Yr

0% 8% -10%

13%

18%

23%

28%

Returns (median)

Source: Bloomberg, Ambit Capital Research Note: The returns have been computed since Jun’94 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

These results are clearly spectacular and vindicate the rationale of long-term investing. However, any smart investor would think that these results are an ‘effect’ rather than a ‘cause’. In other words, these results are obtained by performing a critical task i.e. selecting quality companies and holding on to them for long term. So then how does one identify such quality companies? To capture that point we’d like to direct investors’ attention to our 02 Nov’15 dated note “The Coffee Can Portfolio.. the coffee works”, where we identified the common traits of those quality franchises that have made way to Coffee Can portfolios maximum number of times (referred to as “Winners amongst winners” in the note). Three traits in particular stood out with respect to such companies - (a) obsessive focus on the core franchise instead of being distracted by short-term gambles outside the core segment; (b) relentless deepening of competitive moats and; (c) sensible capital allocation i.e., refraining from large bets and returning excess cash to shareholders. These traits manifest themselves in the form of high and stable earnings growth trajectory for such companies. In the very same note mentioned in the paragraph above, we also compared the capital allocation profiles (i.e. sources and uses of cash) of the “Winners amongst winners” vs. the market (using Nifty as a proxy in that case). As can be clearly seen in the charts below, the propensity of using internal cash (i.e. cash from operations) is much higher for a typical CCP company vs. a typical company in the market index. This in turn implies lower use of debt and resultantly lower leverage for such companies.

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Strategy Exhibit 20: Nifty companies rely more on debt…

3%

Exhibit 21: ...as compared to “Winners amongst winners” 1%

5%

CFO

5%

CFO

5%

Debt Raised

5%

7% Debt Raised

Equity issued

Equity issued

53%

34%

Net cash used

Net cash used 82%

Dividend and Interest received

Dividend and Interest received

Source: AceEquity, Ambit Capital Research Note: Exhibit above reproduced from our 02 November 2015 thematic: “The Coffee Can Portfolio…the coffee works!” without changes. Data pertains to the FY05-15 period

Source: AceEquity, Ambit Capital Research Note: Exhibit above reproduced from our 02 November 2015 thematic: “The Coffee Can Portfolio…the coffee works!” without changes. Data pertains to the FY05-15 period

Exhibit 22: Nifty companies pay lower dividends…

Exhibit 23: ...while “Winners amongst winners” are more shareholder friendly on dividends

Net capex and investments

1% 9%

Net capex and investments

5% 5%

Debt Repayment

11%

Debt Repayment 48%

Interest paid

7% 54% 18%

Interest paid

37% Dividend paid

Dividend paid

Others

Others 2%

Source: AceEquity, Ambit Capital Research Note: Exhibit above reproduced from our 02 November 2015 thematic: “The Coffee Can Portfolio…the coffee works!” without changes. Data pertains to the FY05-15 period

3%

Source: AceEquity, Ambit Capital Research Note: Exhibit above reproduced from our 02 November 2015 thematic: “The Coffee Can Portfolio…the coffee works!” without changes. Data pertains to the FY05-15 period

Now for any Coffee Can company to keep growing at more than 10% year after year, it will need to find new ‘value accreting’ opportunities especially as it grows bigger in size. Given the sharp focus of such companies on maintaining their competitive moats, these companies do so (i.e. invest in new opportunities) without letting go of their return on capital. This characteristic allows a typical Coffee Can company to maintain a steady earnings growth trajectory. These two facets (lower use of leverage and growing whilst maintaining high RoCE), are what separates a typical Coffee Can firm from a typical firm in the market. Whilst the latter might make use of leverage to fund its growth aspirations (even if its value diluting in nature), a Coffee Can firm maintains a high benchmark for its capital allocation decisions. It achieves high growth but not at the cost of return on capital. Lower use of leverage in turn allows for lower earnings (and consequently stock) volatility during turn in credit cycles. The effect of such a focused business practice for these companies is visible in anecdotal evidence of impressive growth in earnings and lower stock price volatility. The exhibit below clearly showcases how the EPS CAGR of the CCP portfolios has beaten the EPS CAGR for BSE200 index in 14 out of 17 instances.

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Strategy Exhibit 24: The Coffee Can Portfolios have seen higher EPS growth versus the BSE200 index in 14 out of 17 instances 30% CCP

EPS growth (CAGR)

25%

BSE200

20% 15% 10% 5%

FY16-17

FY15-17

FY14-17

FY13-17

FY12-17

FY11-17

FY10-17

FY09-17

FY08-17

FY07-17

FY06-16

FY05-15

FY04-14

FY03-13

FY02-12

-5%

FY01-11

FY00-10

0%

-10% Source: Bloomberg, Capitaline, Ambit Capital research.

Also, a typical completed CCP (one that has run its entire course of 10 years) has seen much lower drawdown vs. the BSE 200 index. As an example, we present below the trajectory of Rs100 invested in BSE200 index and the Coffee Can portfolio beginning in Jun’00. The returns and drawdown profiles for rest of the completed Coffee Cans portfolios (i.e. the ones starting in 2001 to 2007) are given in Appendix 4. Exhibit 25: Coffee Can Portfolios suffer much lower drawdowns than the BSE200 index 70%

900

50%

500 30%

300 100

10%

-100

-10%

-300

-30%

-500 -50%

-700 -900

Maximum drawdown

Portfolio values (Rs)

700

CCP - Max DD (RHS) BSE200 Max DD (RHS) CCP (LHS)

BSE200 (LHS)

Jun-10

Jan-10

Aug-09

Mar-09

Oct-08

May-08

Dec-07

Jul-07

Feb-07

Sep-06

Apr-06

Nov-05

Jun-05

Jan-05

Aug-04

Mar-04

Oct-03

May-03

Dec-02

Jul-02

Feb-02

Sep-01

Apr-01

Nov-00

Jun-00

-70%

Source: Bloomberg, Ambit Capital research. Note: The maximum drawdown is calculated as drop in value from the peak to the period concerned. For example, in Nov’08 the maximum drawdown of 59.5% denotes a drop in value of 59.5% in BSE200 index from the peak achieved in Nov’07

The importance of this point with respect to the relative performance of CCP vis-à-vis the aggregate market index can be gauged through a simple example. Let’s say you invest Rs100 in two stocks each – A and B. Investment in Stock A goes to Rs50 in a year while the one in stock B goes to Rs80 during a downturn. Now for Stock A to make back the initial investment of Rs100, it will need return of 100% (50* (1+ 100%) = 100) while stock B will need a return of 25% (80* (1+25%) = 100). What this essentially implies is that in any long enough holding horizon with intermittent periods of sharp correction, stock A will need to provide much better returns than stock B to be able to beat the latter in end. This extreme divergence in risk (captured through propensity of drawdown) is what allows quality companies with low drawdown (like Stock B in above example) to keep compounding robustly even with modest returns year after year and result in a substantial corpus at the end of ten years. At the same time, the aggregate market [email protected]

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Strategy index (like Stock A in the above example) on the back of a higher and more prolonged drawdown is unable to garner equivalent overall returns even with some intermittent periods of sharply high returns. This lesser ‘risk’ as captured by lower price correction and resultantly lesser required return to claw back initial investment is an important reason why the stocks in a typical CCP tend to outperform aggregate market indices on a long-term basis. Combining the lower drawdown aspect with higher EPS growth trajectory for CCP results in best of both worlds – a high stock price appreciation trajectory (on the back of high earnings growth which as we showed in our 29 Apr’15 note, “Can value investors make money in India”, is a primary determinant of long term returns) and lower stock price volatility on the back of lower leverage. These two factors in combination lead to Coffee Can portfolios outperforming the broader market year after year.

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Strategy

Today’s Coffee Can for 2017-2027 Introducing the Coffee Can candidates for 2017-2027 We screened India’s listed universe of non-BFSI stocks with a market capitalisation of more than `1bn that have delivered 10% sales growth and 15% RoCE (pre-tax) every year for the past year. The list is mentioned in the exhibit below. Exhibit 26: The shortlisted firms with superior RoCE (pre-tax) and sales growth over the last ten years (FY07-17) Share price performance (ten-year CAGR rel. to Sensex) (%)

Mcap (US$bn)

FY18 P/E

HCLT IN

20%

19.0

13.9

Lupin

LPC IN

28%

5.9

21.2

Page Industries

PAG IN

48%

3.9

76.5

Amara Raja Batteries

AMRJ IN

44%

1.9

25.1

Superior on both

Ticker

HCL Technologies

Abbott India

BOOT IN

25%

1.5

26.4

Astral Poly

ASTRA IN

52%

1.4

50.6

Dr Lal Pathlabs

DLPL IN

N/A

1.1

39.6

Cera Sanitary.

CRS IN

48%

0.7

37.7

Coffee Can 2017-2027 continues to feature some of India’s mostsuccessful franchises as well as the most-compelling investment themes

Source: Bloomberg, Capitaline, Ambit Capital research; Note: Share price performance has been measured over a ten-year period (i.e. 31 March 2007 to 31 March 2017). In case of firms with a shorter listing history, the performance has been measured over the shorter period (not less than 3 years). * Market-cap as on 7th November 2017. Dr. Lal PathLabs was not listed throughout the ten-year period and hence the financial data used is based on Draft Red Herring Prospectus as provided by Capitaline, for periods prior to its IPO.

From our previous Coffee Can Portfolio, stocks like Asian Paints, Britannia, Cadila, eClerx, Axis Bank and Relaxo do not find a place in this year’s Coffee Can. The only new addition this year is Abbott India. We run a similar filter for India’s listed BFSI stocks with a market-cap of more than `1bn and: (a) an RoE of 16%; and (b) loan growth of 15% for every consecutive year Only 5 BFSI stocks meet our screening filters for the past ten years. The firms clearing this filter are shown in the exhibit below. Exhibit 27: The very short list of the BFSI firms with superior RoE and loan book growth (over FY07-17)

HDFC Bank

HDFCB IN

Share price performance (Ten year CAGR rel. to Sensex) (%) 22%

72.6

26.7

LIC Housing Finance

LICHF IN

36%

4.5

14.3

GRUH Finance

GRHF IN

40%

2.7

50.1

Repco Home Finance

REPCO IN

15%

0.5

17.2

Muthoot Capital Serv

MTCS IN

25%

0.1

24.0

Superior on both

Ticker

Mcap US$bn)

FY18 P/E

Source: Bloomberg, Capitaline, Ambit Capital research; Note: Share price performance has been measured over a ten-year period (i.e. 31 March 2007 to 31 March 2017). In case of firms with a shorter listing history, the performance has been measured over the shorter period (not less than 3 years). *Market-cap as on 7th November 2017. Repco Home Finance was not listed throughout the ten-year period and hence the financial data used is based on Draft Red Herring Prospectus as provided by Capitaline, for periods prior to its IPO.

From the above list, we exclude Muthoot Capital Services due to its size and liquidity. It is striking that this year we have a very short list of stocks that pass our filters – only 8 non-BFSI stocks and only 5 BFSI stocks. The last time the Coffee Can Portfolio had so few stocks was in 2011.

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Strategy Exhibit 28: Stocks that featured in the CCP last year but did not make it to this year’s iteration of the CCP Company

Reasons for exclusion

Asian Paints delivered a sales growth of 7.6% in FY17 (using IND-AS numbers for FY16 and FY17); hence does not clear the Coffee Can filter on ten consecutive years of sales growth in excess of 10% Britannia delivered a sales growth of 7.8% in FY17 (using IND-AS numbers for FY16 and FY17); hence does not clear the Coffee Can filter on ten consecutive years of sales Britannia Inds. growth in excess of 10% Cadila's sales have been flat in FY17 (using IND-AS numbers for FY16 and FY17); hence does not clear the Coffee Can filter on ten consecutive years of sales growth in excess of Cadila Health. 10% Relaxo Footwear delivered a sales growth of ~1.6% in FY17 (using IND-AS numbers for Relaxo Footwear FY16 and FY17); hence does not clear the Coffee Can filter on ten consecutive years of sales growth in excess of 10% eClerx delivered a sales growth of ~1.2% in FY17 (using IND-AS numbers for FY16 and FY17); hence does not clear the Coffee Can filter on ten consecutive years of sales eClerx Services growth in excess of 10% Axis Bank delivered a loan book growth of ~10.1% in FY17 (using IND-AS numbers for FY16 and FY17) and an RoE of ~6.8% (using IND-AS numbers for FY16 and FY17); Axis Bank hence does not clear the Coffee Can filter on ten consecutive years of loan book growth of 15% and RoE in excess of 16% .

Asian Paints

Source: Company filings, Ambit Capital research

Having identified the Coffee Can stocks for this year’s iteration of the Coffee Can In the ensuing sections we evaluate Portfolio, in the ensuing sections we will evaluate each of the companies forming part the stocks that feature in this year’s CCP using John Kay’s IBAS of our Coffee Can Portfolio using John Kay’s IBAS framework. framework John Kay’s IBAS framework has been discussed in greater details in Appendix 3: John Kay’s IBAS Framework.

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Strategy

Performance of ‘live’ Coffee Can portfolios We launched our maiden Coffee Can portfolio on 17 November 2014 titled “The Indian Coffee Can Portfolio”, We followed this up with two more portfolios revealed in 2015 and 2016 under notes titled “The Coffee Can Portfolio…the coffee works!” and “The Coffee Can Portfolio 2016” respectively.

We have launched three Coffee Can portfolios beginning Nov’14

Whilst the whole premise of our Coffee Can Portfolio is based on holding the portfolio stocks for a period of 10 years without being perturbed by the short-term fluctuations in the share prices, a look at the performance of these portfolios suggests that two out of these three portfolios have done extremely well vs. the Sensex. Also, the pattern of returns in these three portfolios highlight that the benefit from Coffee Can portfolios is realized when you hold them for longer periods The Coffee Can Portfolio launched in 2014 has generated total returns of 22% (on a CAGR basis) vs total CAGR returns of 8% for the benchmark Sensex index since initiation. The Coffee Can Portfolio launched in 2015 has generated total CAGR returns of 19% vs total CAGR returns of 13% for the benchmark Sensex index since initiation. The Coffee Can Portfolio launched in 2016 has generated total CAGR returns of 26% vs total CAGR returns of 29% for the benchmark Sensex index since initiation.

The 2014 and 2015 portfolios have done extremely well vs the Sensex index

Exhibit 29: Performance of the 2014 Coffee Can Portfolio since initiation Company Date from/to

Value at start (`)

Value at end (`)

Total return CAGR

14-Nov-14

07 Nov 17

ITC

100

114

5%

Asian Paints

100

174

20%

Godrej Consumer

100

204

27%

Marico

100

195

25%

Ipca Labs.

100

81

-7%

Berger Paints

100

198

26%

Page Industries

100

217

30%

Balkrishna Inds

100

275

40%

eClerx Services

100

135

10%

Mayur Uniquote

100

113

4%

V-Guard Inds.

100

344

51%

HCL Technologies

100

117

5%

HDFC Bank

100

200

26%

Axis Bank

100

114

4%

City Union Bank

100

205

27%

GRUH Finance

100

218

30%

1,600

2,902

22%

100

124

8%

Portfolio* Sensex Outperformance

14.6% Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at start of `1,600 denotes an equal allocation of `100 in each stock at the start of the period. Portfolio price at the end is the value of the portfolio at the end of the period (07 Nov’17). Thus, for this period, the value of the portfolio rose from `1,600 at the start to `2,902 at the end.

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Strategy Exhibit 30: Performance of the 2015 Coffee Can Portfolio since initiation Company

Value at start (`)

Value at end (`)

01-Nov-15

07-Nov-17

HCL Technologies

100

106

3%

ITC

100

124

11%

Lupin

100

45

-33%

Asian Paints

100

140

18%

Cadila Health.

100

121

10%

Britannia Inds.

100

146

20%

Marico

100

166

28%

GlaxoSmith C H L

100

93

-4%

Colgate-Palm.

100

111

5%

Amara Raja Batt.

100

76

-13%

Page Industries

100

148

21%

Berger Paints

100

159

26%

eClerx Services

100

93

-3%

Astral Poly

100

185

36%

V-Guard Inds.

100

347

85%

Cera Sanitary.

100

176

32%

HDFC Bank

100

168

29%

Axis Bank

100

113

6%

LIC Housing Fin.

100

128

13%

GRUH Finance

100

197

40%

2,000

2,841

19%

100

129

13%

Date from/to

Portfolio* Sensex

Total return CAGR

Outperformance

5.7% Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at start of `2,000 denotes an equal allocation of `100 in each stock at the start of the period. Portfolio price at the end is the value of the portfolio at the end of the period (07 Nov’17). Thus, for this period, the value of the portfolio rose from `2,000 at the start to `2,841 at the end.

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Strategy Exhibit 31: Performance of the 2016 Coffee Can Portfolio since initiation Company

Value at start (`)

Value at end (`)

16-Nov-16

07-Nov-17

Total return CAGR

Asian Paints

100

123

23%

HCL Technologies

100

115

15%

Lupin

100

62

-38%

Britannia Inds.

100

156

56%

Cadila Health.

100

134

34%

Amara Raja Batt.

100

73

-27%

Page Industries

100

158

58%

eClerx Services

100

92

-8%

Astral Poly

100

192

92%

Cera Sanitary.

100

168

68%

Relaxo Footwear

100

141

41%

HDFC Bank

100

148

48%

Axis Bank

100

113

13%

LIC Housing Fin.

100

118

18%

GRUH Finance

100

170

70%

Dr Lal Pathlabs

100

73

-27%

Date from/to

Repco Home Fin Portfolio Sensex

100

107

7%

1,700

2,142

26%

100

129

29%

Outperformance

-2.5%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at start of `1,700 denotes an equal allocation of `100 in each stock at the start of the period. Portfolio price at end is the value of the portfolio at the end of the period (07 Nov’17). Thus, for this period, the value of the portfolio rose from `1,700 at the start to `2,142 at the end.

Should investors rebalance the Coffee Can portfolios for the years 2014, 2015 and 2016? With 6 out of last year’s 17 stocks not featuring in this year’s Coffee Can Portfolio, the obvious question one would ask is whether to rebalance the earlier Coffee Can Portfolio (initiated in 2016) to include the stocks figuring in this year’s iteration. To answer that question, we point investors to our 02 November 2015 thematic: “The Coffee Can Portfolio…the coffee works!” In our 02 November 2015 note, we compared the results of a “buy and hold” strategy vs an annual rebalancing strategy of the Coffee Can Portfolio over six ten-year iterations starting year 2000.

We advise investors to refrain from rebalancing the Coffee Can portfolios

The updated results from our analysis have been reproduced in exhibit below. Exhibit 32: Share price CAGR returns over 10-year periods for CCP with and without rebalancing 20002010

2001- 2002- 2003- 2004- 20052011 2012 2013 2014 2015

20062016

2007- Median 2017 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 0.8% 5.9% 0.4% 8.4% 12.0% 6.9% 7.2% 6.2% 3.7% with 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.

As can be seen in the exhibit above, the Coffee Can approach without rebalancing has outperformed with rebalancing approach on all eight occasions. The median CAGR for CCP without rebalancing over these six iterations was 21.5% vs 17.8% for CCP with rebalancing. These results reaffirm the advantage of the “buy and hold” approach over an annual rebalancing approach. [email protected]

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Appendix 1: How the Coffee Can is different to our other portfolio constructs "Forever is a good holding period." – Warren Buffett Over the years, we have developed various portfolio constructions for investors based on their outlook. We have summarised these below: ‘Good and Clean’ (G&C): We began this portfolio in 2011. The G&C portfolios are constructed each quarter using: (i) a battery of financial tests based on the previous fiscal year’s data; and (ii) our forensic accounting model. Each G&C portfolio typically runs for a quarter before we revise it. Thus, we believe this portfolio is ideal for investors aiming to beat benchmarks over the short term. The methodology is: 

Within each sector, we first identify firms that do well on our ‘greatness’ and ‘accounting’ frameworks;



We then overlay our macro outlook and valuation filters to identify sectors which are placed favourably; and



The sector-level champions from step 1 (for the sectors identified in step 2) constitute our G&C portfolio.

Our G&C portfolio is ideal for investors aiming to beat benchmarks over the short term

Please click here for the latest G&C portfolio published on September 02, 2015. Ten-bagger: We first unveiled this portfolio - built using our ‘greatness’ framework in January 2012. (See our 19th January 2012 note - ‘Tomorrow’s ten baggers’ - for the framework behind this construct note; click here for the note.) This framework studies a firm’s structural strengths by focusing not on absolutes but rather on improvements over a period of time and the consistency of those improvements. A basic sketch of the underlying process behind the making of a great firm has been recaptured in Exhibit below. Exhibit 33: The ‘greatness’ framework a. Investment (gross block)

The ten-bagger framework studies a firm's structural strength and focuses on improvements over a period of time and the consistency of those improvements

b. Conversion of investment to sales (asset turnover, sales)

c. Pricing discipline (PBIT margin)

e. Cash generation (CFO)

d. Balance sheet discipline (D/E, cash ratio)

Source: Ambit Capital Research

We rank the BSE500 universe of firms (excluding financial services firms and excluding firms with insufficient data) on our ’greatness‘ score, which consists of six equally weighted headings – investments, conversion to sales, pricing discipline, balance sheet discipline, cash generation and EPS improvement, and return ratio improvement. Under each of these six headings, we further look at two kinds of improvements:

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Strategy 

Percentage improvements in performance over FY14-16 vs FY11-13; and



Consistency in performance over FY11-16 i.e. improvements adjusted for underlying volatility in financial data

A complete list of factors that are considered whilst quantifying greatness has been mentioned in Exhibit below. Exhibit 34: Factors used for quantifying greatness Head 1 Investments 2 Conversion to sales

3 Pricing discipline 4 Balance sheet discipline

5

Cash generation and PAT improvement

6 Return ratio improvement

Criteria a.

Above-median gross block increase (FY14-16 over FY11-13)*

b.

Above-median gross block increase to standard deviation

a. b. c.

Improvement in asset turnover (FY14-16 over FY11-13)* Positive improvement in asset turnover adjusted for standard deviation Above-median sales increase (FY14-16 over FY11-13)*

d.

Above-median sales increase to standard deviation

a.

Above-median PBIT margin increase FY14-16 over FY11-13)*

b.

Above-median PBIT margin increase to standard deviation

a.

Below-median debt-equity decline (FY14-16 over FY11-13)*

b.

Below-median debt-equity decline to standard deviation

c.

Above-median cash ratio increase (FY14-16 over FY11-13)*

d.

Above-median cash ratio increase to standard deviation

a.

Above-median CFO increase (FY14-16 over FY11-13)*

b.

Above-median CFO increase to standard deviation

c.

Above-median adj. PAT increase (FY14-16 over FY11-13)*

d.

Above-median adj. PAT increase to standard deviation

a.

Improvement in RoE (FY14-16 over FY11-13)*

b.

Positive improvement in RoE adjusted for standard deviation

c.

Improvement in RoCE (FY14-16 over FY11-13)*

d.

Positive improvement in RoCE adjusted for standard deviation

Source: Ambit Capital research; Note: * Rather than comparing one annual endpoint to another annual endpoint (say, FY11 to FY16), we prefer to average the data out over FY11-13 and compare that to the averaged data over FY14-16. This gives a more consistent picture of performance (as opposed to simply comparing FY11 to FY16).

The ten-bagger portfolio focuses on structural plays that are financially strong firms (with credible management teams) and remain consistent performers on a crosscyclical basis. Companies are identified based on their relentless improvement in financial performance over long periods of time (usually, six years). This portfolio is ideal for conventional buy-and-hold investors with a 1-3 year horizon. Adding the Coffee Can for long-term investors with a ten-year outlook To this suite of portfolios, we now add the Coffee Can which is ideal for long-term investors with a ten-year outlook. In the table below, we summarise our portfolio recommendations for investors. Exhibit 35: Our suite of Portfolios for investors looking to invest in India Type of Investor

Recommended Ambit Portfolio

Short-term investor with quarterly performance focus

Good and Clean Portfolio

Conventional buy-and-hold investor with 1-3 year horizon

Ten-Bagger Portfolio

Long-term investor with ten-year outlook Source: Ambit Capital Research

Coffee Can Portfolio

Returns over recommended time period The 19 instalments of our ‘Good & Clean’ portfolios over the last six years have delivered a staggering 3.1% alpha on a CAGR basis The six iterations of our ten-baggers portfolios have generated over 10.7% alpha over the past six years Average alpha of 8.6% over eight- to ten-year iterations

The Coffee Can Portfolio is ideal for long-term investors with a tenyear outlook

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Appendix 2: Performance of last 14 back tested Coffee Can portfolios Period 1: 2000-2010 (6.6% alpha relative to the Sensex; 22.6% per annum absolute returns) All-cap portfolio stocks: NIIT, Cipla, Hero MotoCorp, Swaraj Engines, HDFC Large-cap portfolio stocks: NIIT, Cipla, Hero MotoCorp, HDFC In the first iteration, both versions of the CCP outperformed the benchmark. Whilst the all-cap CCP delivered a 22.6% return (6.6% alpha to the Sensex), the large-cap portfolio delivered a 20.6% return (7.6% alpha to the Sensex). The maximum drawdown for both the portfolios in this period was also less than the maximum drawdown for the Sensex. Exhibit 36: First iteration summary 2000-2010*

All-cap CCP

Large-cap CCP

Sensex

CAGR returns

22.6%

23.6%

16.0%

Maximum drawdown**

-35%

-30%

-56%

Excess returns

0.42

0.53

0.14

Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2000. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from December 2007 to December 2008 for the all-cap CCP, large-cap CCP and for the Sensex.

The five stocks that constituted the first iteration of the Coffee Can Portfolio consisted of one IT company, one pharma company, one BFSI company and two companies from the automobile/auto-ancillary sector. These were NIIT, Cipla, Hero MotoCorp HDFC Ltd and Swaraj Engines. The star performers during this period were Hero MotoCorp and HDFC which proved to be a ten-bagger whilst NIIT collapsed ~74% in this period. Exhibit 37: Portfolio performance during the first iteration Value at start (Rs)

Value at end (Rs)

30-Jun-00

30-Jun-10

NIIT

100

26

-13%

Cipla

100

531

18%

Hero Motocorp

100

1,499

31%

Swaraj Engines

100

493

17%

HDFC

100

1,283

29%

Portfolio

500

3,831

23%

Sensex

100

441

Company Date from/to

Outperformance

Total return CAGR

Hero Motocorp and HDFC were the star performers, whilst NIIT was the laggard in Period 1

16% 6.6%

Source: Bloomberg, Ambit Capital research. Note: *Portfolio price at the start of Rs500 denotes an equal allocation of Rs100 in each stock at the start of the period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs500 at the start to Rs3,831 at the end.

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Strategy Exhibit 38: Hero and HDFC rose exponentially whilst NIIT collapsed in 2000-2010

Value of stock in portfolio (in Rs)

4,500 4,000 3,500 Swaraj Engines

3,000 2,500

Hero Motocorp

2,000

Cipla

1,500

NIIT

1,000

HDFC

500 Value at start

Vaue at end

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs500 at the start to Rs3,831 at the end.

Period 2: 2001-2011 (11.7% alpha relative to the Sensex; 32.2% per annum absolute returns) All-cap portfolio stocks: Cipla, Hero MotoCorp, Apollo Hospitals, Roofit Industries, HDFC Ltd and LIC Housing Finance Large-cap portfolio stocks: Cipla, Hero MotoCorp and HDFC Ltd Both versions of the CCP performed well during the second iteration as well, beating the Sensex. The all-cap and large-cap CCP gave an impressive alpha of 11.7% and 7.8% respectively for this iteration. The portfolio was remarkably steady as compared to the maximum drawdown, delivering an excess return of 0.66-0.72x. Exhibit 39: Second iteration summary 2001-2011*

All-cap CCP

Large-cap CCP

Sensex

CAGR returns

32.2%

28.3%

20.5%

Maximum drawdown**

-34%

-31%

-56%

Excess returns

0.72

0.66

0.23

Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 29 June 2001. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from December 2007 to November 2008 for the all-cap CCP and the large-cap CCP and December 2007 to February 2009 for the Sensex.

During the second iteration, the Coffee Can Portfolio consisted of six stocks with three repeats (Cipla, Hero MotoCorp and HDFC from Period 1) and three new entries (Apollo Hospitals, Roofit Industries and LIC Housing Finance). During this period, note that one of the stocks in the portfolio, Roofit Industries, was delisted during 20012011. Despite this, the portfolio performed admirably. The star performer was LIC Housing Finance that delivered 46.7x returns whilst Cipla was a laggard at 3.0x. Exhibit 40: Portfolio performance during the second iteration Company Date from/to Cipla Hero Motocorp Apollo Hospitals Roofit Inds. HDFC LIC Housing Fin. Portfolio Sensex Outperformance

Value at start (Rs) 30-Jun-01 100 100 100 100 100 100 600 100

Value at end (Rs) 30-Jun-11 396 1,985 1,409 4 1,242 4,767 9,802 646

Total return CAGR

LIC Housing Finance was the star performer delivering ~47x total returns in Period 2

15% 35% 30% -27% 29% 47% 32% 20% 11.7%

Source: Bloomberg, Ambit Capital research. Note: Value at start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs600 at the start to Rs9,802 at the end.

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Strategy Exhibit 41: LIC Housing Finance’s performance during 2001-2011 was stellar Value of stock in portfolio (in Rs)

12,000 10,000 LIC Housing Fin. 8,000

HDFC

6,000

Roofit Inds. Apollo Hospitals

4,000

Hero Motocorp

2,000

Cipla

Value at start

Vaue at end

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs600 at the start to Rs9,802 at the end.

Period 3: 2002-2012 (5.1% alpha to the Sensex; 25.4% per annum absolute returns) All-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Container Corporation of India, Gujarat Gas, Aurobindo Pharma, HDFC Ltd and LIC Housing Finance Large-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Container Corporation of India, HDFC Ltd During the third iteration, the Coffee Can delivered an alpha of 5.1% whilst the large-cap Coffee Can delivered an alpha of 3.3%. Both versions of the Coffee Can performed well during maximum drawdown as well, delivering excess returns of 0.43x-0.49x. Exhibit 42: Third iteration summary 2002-2012*

All-cap CCP

Large-cap CCP

Sensex

CAGR returns

25.4%

23.7%

20.3%

Maximum drawdown**

-41%

-32%

-56%

Excess returns

0.43

0.49

0.22

Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 28 June 2002. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from December 2007 to November 2008 for the all-cap CCP, December 2007 to December 2008 for the large-cap CCP and December 2007 to February 2009 for the Sensex.

The number of stocks making it to the 2002 edition of the Coffee Can Portfolio was much higher than the previous two iterations. A total of eight stocks qualified to be part of the Coffee Can Portfolio in the third iteration. Cipla, Hero MotoCorp, HDFC Ltd and LIC Housing were repeated yet again whilst the other four stocks were Infosys, Container Corporation, Gujarat Gas and Aurobindo Pharma.

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Strategy Exhibit 43: Portfolio performance during the third iteration Value at start (Rs) 30-Jun-02

Company Date from/to

Value at end (Rs) 30-Jun-12

Total return CAGR

Infosys

100

706

22%

Hero Motocorp

100

1,038

26%

Cipla

100

461

16%

Container Corp.

100

740

22%

Guj Gas Company

100

763

23%

Aurobindo Pharma

100

505

18%

HDFC

100

1,237

29%

LIC Housing Fin.

100

2,260

37%

Portfolio

800

7,709

25%

Sensex

100

637

20%

Outperformance

5.1%

Source: Bloomberg, Ambit Capital research. Note: *Portfolio price at the start of Rs800 denotes an equal allocation of Rs100 in each stock at the start of the period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs800 at the start to Rs7,709 at the end.

Exhibit 44: Portfolio’s outperformance was led by LIC Housing Finance once again Value of stock in portfolio (in Rs)

9,000 8,000

LIC Housing Fin.

7,000

HDFC

6,000

Aurobindo Pharma

5,000

Guj Gas Company

4,000

Container Corpn.

3,000

Cipla

2,000

Hero Motocorp

1,000

Infosys

Value at start

Vaue at end

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs800 at the start to Rs7,709 at the end.

Period 4: 2003-2013 (7.2% alpha to the Sensex; 27.4% per annum absolute returns) All-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Sun Pharma, Container Corporation of India, Gujarat Gas, Aurobindo Pharma, HDFC Ltd, LIC Housing Finance Large-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Container Corporation of India, Sun Pharma and HDFC Ltd Whilst the all-cap version of the Portfolio delivered a 7.2% alpha, the large-cap version gave a higher 9% alpha in the fourth iteration. In a maximum drawdown situation, both versions remained steady and beat the Sensex, thereby delivering excess returns of 0.62-.0.77x. Exhibit 45: Fourth iteration summary 2003-2013*

All-cap CCP

Large-cap CCP

Sensex

CAGR returns

27.4%

29.2%

20.2%

Maximum drawdown**

-31%

-28%

-56%

Excess returns

0.62

0.77

0.22

Sun Pharma powered through to be the best-performing stock in Period 4

Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2003. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from December 2007 to November 2008 for the all-cap CCP, December 2007 to December 2008 for the large-cap CCP and December 2007 to February 2009 for the Sensex.

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Strategy Barring one addition (Sun Pharma), the Coffee Can Portfolio in its fourth iteration was the same as that in the third iteration. Performance was driven by Sun Pharma’s stellar performance. However, the performance of the large-cap version was better than the all-cap version of the Coffee Can Portfolio. Exhibit 46: Portfolio performance during the fourth iteration Value at start (Rs)

Value at end (Rs)

30-Jun-03

30-Jun-13

Infosys

100

713

22%

Cipla

100

710

22%

Hero Motocorp

100

958

25%

Sun Pharma.Inds.

100

3,381

42%

Container Corpn.

100

736

22%

Aurobindo Pharma

100

528

18%

Guj Gas Company

100

518

18%

HDFC

100

1,292

29%

LIC Housing Fin.

100

1,338

30%

Portfolio

900

10,175

27%

Sensex

100

631

Company Date from/to

Total return CAGR

Outperformance

20% 7.2%

Source: Bloomberg, Ambit Capital research. Note: *Portfolio price at the start of Rs900 denotes an equal allocation of Rs100 in each stock at the start of the period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs900 at the start to Rs10,175 at the end.

Exhibit 47: Sun Pharma delivered a stellar performance in Period 4 Value of stock in portfolio (in Rs)

12,000

LIC Housing Fin.

10,000

HDFC Guj Gas Company

8,000

Aurobindo Pharma 6,000

Container Corpn.

4,000

Sun Pharma.Inds. Hero Motocorp

2,000

Cipla Value at start

Vaue at end

Infosys

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs900 at the start to Rs10,175 at the end.

Period 5: 2004-2014 (12.7% alpha to the Sensex; 32.6% per annum absolute returns) All-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Container Corporation of India, Gujarat Gas, Alok Industries, Munjal Showa and Havells India, HDFC Ltd and LIC Housing Finance Large-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Container Corporation of India and HDFC Ltd The fifth iteration of our Coffee Can Portfolio yielded a whopping 12.7% alpha over the Sensex. The portfolio was equally divided between large-caps and midcaps/small-caps. The higher share of the mid-caps/small-caps vs earlier iterations was instrumental in delivering higher alpha during this period.

The CCP delivered a whopping 12.7% to the Sensex, in Period 5

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Strategy Exhibit 48: Fifth iteration summary 2004-2014*

All-cap CCP

Large-cap CCP

Sensex

CAGR returns

32.6%

22.1%

19.9%

Maximum drawdown**

-62%

-31%

-56%

Excess returns

0.40

0.45

0.21

Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2004. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from December 2007 to November 2008 for the all-cap CCP, December 2007 to December 2008 for the large-cap CCP and December 2007 to February 2009 for the Sensex.

The performance amongst the mid-cap/small-cap stocks was extreme: Whilst Havells delivered ~96.7x returns, Alok Industries delivered -60% by the end of the iteration. Given the phenomenal performance by Havells during the period, the performance of the large-cap portfolio (22.1% CAGR) lagged that of the all-cap portfolio (32.6% CAGR). Exhibit 49: Portfolio performance during the fifth iteration Value at start (Rs)

Value at end (Rs)

30-Jun-04

30-Jun-14

Infosys

100

547

19%

Hero Motocorp

100

710

22%

Cipla

100

561

19%

Container Corpn.

100

738

22%

Guj Gas Company

100

1,199

28%

Alok Inds.

100

40

-9%

Munjal Showa

100

627

20%

Havells India

100

9,764

58%

HDFC

100

1,123

27%

LIC Housing Fin.

100

1,540

31%

1,000

16,849

33%

100

616

Company Date from/to

Portfolio Sensex

Total return CAGR

Outperformance

Extreme price performance among mid-cap/small-cap stocks sets apart Period 5 from the earlier iterations of the CCP

20% 12.7%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at the start of Rs1,000 denotes an equal allocation of Rs100 in each stock at the start of the period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,000 at the start to Rs16,849 at the end.

Exhibit 50: Havells India was the star performer in Period 5 Value of stock in portfolio (in Rs)

18,000

LIC Housing Fin.

16,000

HDFC

14,000

Havells India

12,000

Munjal Showa

10,000

Alok Inds.

8,000

Guj Gas Company

6,000 4,000

Container Corpn.

2,000

Cipla Hero Motocorp

Value at start

Vaue at end

Infosys

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,000 at the start to Rs16,849 at the end.

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Period 6: 2005-2015 (6.0% alpha to the Sensex; 22.1% per annum absolute returns) All-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Container Corporation of India, Geometric, Havells India, Ind-Swift, Munjal Showa and HDFC Ltd Large-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Container Corporation of India and HDFC Ltd In the sixth iteration, our Coffee Can Portfolio again outperformed the Sensex with an alpha of 6.0%. The large-cap version also outperformed the Sensex with an alpha of 3.4%. In this period, while the all-cap version generated a higher alpha than the large-cap version on an absolute basis on a risk-adjusted basis, large-cap version beat all-cap version mainly on account of lower maximum drawdown (excess return of 0.41x for large-cap vs. 0.26x for all-cap). Both versions, however, continued to perform better than Sensex on risk-adjusted basis as well. Exhibit 51: Sixth iteration summary 2005-2015*

All-cap CCP

Large-cap CCP

Sensex

CAGR returns

22.1%

19.5%

16.1%

Maximum drawdown**

-54%

-28%

-56%

Excess returns

0.26

0.41

0.15

Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2005. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from December 2007 to February 2009 for the all-cap CCP and Sensex; and from December 2007 to December 2008 for the large-cap CCP.

The extreme price performance among mid-cap/small-cap stocks continued during this iteration as well: Havells’ delivered ~30.6x returns whilst Ind-Swift delivered -92% returns by the end of the iteration.

Extreme price performance among mid-cap/small-cap stocks continued in period 6

Exhibit 52: Portfolio performance during the sixth iteration Value at start (Rs)

Value at end (Rs)

30-Jun-05

30-Jun-15

Infosys

100

394

15%

Hero Motocorp

100

607

20%

Cipla

100

529

18%

Container Corpn.

100

612

20%

Geometric

100

121

2%

Havells India

100

3,155

41%

Ind-Swift

100

8

-22%

Munjal Showa

100

391

15%

HDFC

100

827

24%

Portfolio

900

6,643

22%

Sensex

100

446

Company Date from/to

Outperformance

Total return CAGR

16% 6.0%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at the start of Rs900 denotes an equal allocation of Rs100 in each stock at the start of the period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs900 at the start to Rs6,643 at the end.

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Strategy Exhibit 53: Havells India continued being the star performer in sixth iteration as well

Value of stock in portfolio (in Rs)

7,000 HDFC

6,000

Munjal Showa 5,000

Ind-Swift

4,000

Havells India Geometric

3,000

Container Corpn. 2,000

Cipla

1,000

Hero Motocorp Infosys

Value at start

Vaue at end

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs900 at the start to Rs6,643 at the end.

Period 7: 2006-2016 (8.9% alpha to the Sensex; 20.3% per annum absolute returns) All-cap portfolio stocks: Infosys, Cipla, Hero MotoCorp, Container Corporation of India, Geometric, Havells India, Suprajit Engineering, Munjal Showa, HDFC Ltd and HDFC Bank Large-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Container Corporation of India, HDFC Ltd and HDFC Bank In the seventh iteration, our Coffee Can Portfolio has again outperformed the Sensex with an alpha of 8.9%. The large-cap version has also outperformed the Sensex with an alpha of 5.7%. On a risk-adjusted basis, as well, both versions beat the Sensex with excess return of 0.25-0.28x vs. 0.06x for the Sensex. Exhibit 54: Seventh iteration summary 2006-2016*

All-cap CCP

Large-cap CCP

Sensex

CAGR returns

20.3%

17.1%

11.4%

Maximum drawdown**

-49%

-33%

-56%

Excess returns

0.25

0.28

0.06

Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2006. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from December 2007 to February 2009 for the all-cap CCP and Sensex; and from December 2007 to November 2008 for the large-cap CCP.

Mid-cap/small-cap stocks again outperformed in this period with Havells and Suprajit Engineering’s stock price rising by 13.4x and 11.9x respectively.

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Strategy Exhibit 55: Portfolio performance during the seventh iteration Value at start (Rs)

Value at end (Rs)

30-Jun-06

30-Jun-16

Infosys

100

361

14%

Cipla

100

248

10%

Hero Motocorp

100

551

19%

Container Corpn.

100

342

13%

Havells India

100

1,441

31%

Geometric

100

296

11%

Munjal Showa

100

431

16%

Suprajit Engg.

100

1,291

29%

HDFC

100

622

20%

Company Date from/to

HDFC Bank Portfolio Sensex

Total return CAGR

100

794

23%

1,000

6,376

20%

100

294

Outperformance

11% 8.9%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at the start of Rs1,000 denotes an equal allocation of Rs100 in each stock at the start of the period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,000 at the start to Rs6,376 at the end

Exhibit 56: Mid-caps outperform the large-caps in the seventh iteration Value of stock in portfolio (in Rs)

7,000

HDFC Bank

6,000

HDFC

5,000

Suprajit Engg.

4,000

Munjal Showa Geometric

3,000

Havells India

2,000

Container Corpn.

1,000

Hero Motocorp Cipla

Value at start

Vaue at end

Infosys

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,000 at the start to Rs6,376 at the end.

Period 8: 2007-2017 (10.3% alpha to the Sensex; 19.6% per annum absolute returns) All-cap portfolio stocks: Infosys, Wipro, Cipla, Tech Mahindra, Hindalco, Hero MotoCorp, Container Corporation of India, Asian Paints, Havells India, Geometric, Aftek, Munjal Showa, Suprajit Engineering, HDFC Ltd and HDFC Bank Large-cap portfolio stocks: Infosys, Wipro, Cipla, Tech Mahindra, Hindalco, Hero MotoCorp, Container Corporation of India, Asian Paints, HDFD Ltd and HDFC Bank In the eighth iteration, our Coffee Can Portfolio continued its outperformance versus the Sensex both on an absolute and risk-adjusted basis.

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Strategy Exhibit 57: Eighth iteration summary 2007-2017*

All-cap CCP

Large-cap CCP

Sensex

CAGR returns

19.6%

16.7%

9.3%

Maximum drawdown**

-53%

-39%

-56%

Excess returns

0.22

0.22

0.02

Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2007. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from December 2007 to February 2009 for the all-cap CCP, large-cap CCP and for the Sensex.

In this iteration, amongst large-caps, Asian Paints led the charge with almost 14.2x returns. Extreme movements were seen in mid-cap stocks again with stocks like Suprajit Engineering delivering almost 24x returns whereas Aftek delivered -96% returns. Exhibit 58: Portfolio performance during the eighth iteration Value at start (Rs) 30-Jun-07

Value at end (Rs) 30-Jun-17

Total return CAGR

Infosys

100

235

9%

Wipro

100

212

8%

Cipla

100

284

11%

Tech Mahindra

100

119

2%

Hindalco Inds.

100

145

4%

Hero Motocorp

100

739

22%

Container Corpn.

100

211

8%

Asian Paints

100

1,521

31%

Havells India

100

1,055

27%

Geometric

100

243

9%

Aftek

100

4

-28%

Munjal Showa

100

564

19%

Suprajit Engg.

100

2,472

38%

HDFC

100

449

16%

HDFC Bank

100

774

23%

1,500

9,027

20%

100

244

Company Date from/to

Portfolio Sensex Outperformance

9% 10.3%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at start of Rs1500 denotes an equal allocation of Rs100 in each stock at the start of the period. Portfolio price at end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1500 at the start to Rs9,027 at the end

Exhibit 59: Asian Paints was the star performer in the eighth iteration

Value of stock in portfolio (in Rs)

10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 Value at start

Vaue at end

HDFC Bank HDFC Suprajit Engg. Munjal Showa Aftek Geometric Havells India Asian Paints Container Corpn. Hero Motocorp Hindalco Inds. Tech Mahindra Cipla Wipro Infosys

Source: Bloomberg, Ambit Capital research. Note: Value at start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,500 at the start to Rs9,027 at the end.

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Strategy

Period 9: 2008-Present (9.6% alpha to the Sensex; 21.4% per annum absolute returns) All-cap portfolio stocks: Infosys, Wipro, Cipla, Asian Paints, Tech Mahindra, Havells India, Automotive Axles, Geometric, HDFC Ltd, HDFC Bank and Punjab National Bank Large-cap portfolio stocks: Infosys, Wipro, Cipla, Asian Paints, Tech Mahindra, HDFC Ltd, HDFC Bank and Punjab National Bank Our ninth iteration that begins in June 2008 is also outperforming the Sensex with an alpha of 9.6%. The large-cap version also beats the Sensex with an alpha of 7%. The large-cap version on account of lower drawdown has the higher risk-adjusted return at 0.29x vs. 0.28x for all-cap version and 0.10x for the Sensex. Exhibit 60: Ninth iteration summary 2008-2017*

All-cap CCP

Large-cap CCP

Sensex

CAGR returns

21.4%

18.8%

11.8%

Maximum drawdown**

-48%

-38%

-39%

Excess returns

0.28

0.29

0.10

Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2008. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from July 2008 to February 2009 for the all-cap CCP, large-cap CCP and for the Sensex.

Both large-caps and mid-caps shared the outperformance during this iteration with Asian Paints and HDFC Bank delivering ~10x and 8.7x returns respectively whilst Havells India is continuing its dream run with 15.2x returns. Exhibit 61: Portfolio performance during the ninth iteration Company Date from/to

Value at start (Rs)

Value at end (Rs)

Total return CAGR

30-Jun-08

07-Nov-17

Infosys

100

265

11%

Wipro

100

289

12%

Cipla

100

305

13%

Asian Paints

100

1,097

29%

Tech Mahindra

100

293

12%

Havells India

100

1,621

35%

Automotive Axles

100

467

18%

Geometric

100

643

22%

HDFC

100

506

19%

HDFC Bank

100

967

27%

Punjab Natl.Bank

100

306

13%

1,100

6,759

21%

100

285

Portfolio Sensex Outperformance

12% 9.6%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at the start of Rs1,100 denotes an equal allocation of Rs100 in each stock at the start of the period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,100 at the start to Rs6,759 until 7thNov’17.

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Strategy Exhibit 62: Large-caps and mid-caps shared outperformance in this iteration

Value of stock in portfolio (in Rs)

8,000

Punjab Natl.Bank

7,000

HDFC Bank

6,000

HDFC

5,000

Geometric Automotive Axles

4,000

Havells India

3,000

Tech Mahindra

2,000

Asian Paints

1,000

Cipla Wipro

Value at start

Vaue at end

Infosys

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,100 at the start to Rs6,759 until 7thNov’17.

Period 10: 2009-Present (11.5% alpha to the Sensex; 23.7% per annum absolute returns) All-cap portfolio stocks: Infosys, Wipro, Jindal Steel, Cipla, Asian Paints, Oracle Financial Services, Tech Mahindra, Motherson Sumi, HDFC Ltd, HDFC Bank and Punjab National Bank Large-cap portfolio stocks: Infosys, Wipro, Jindal Steel, Cipla, Asian Paints, Oracle Financial Services, HDFD Ltd, HDFC Bank and Punjab National Bank In the iteration beginning in 2009, both all-cap and large-cap CCP beat Sensex comprehensively again with alpha of 11.5% and 5.6% respectively. On a riskadjusted basis as well they gave a stable performance with excess returns of 0.53x0.74x. Exhibit 63: Tenth iteration summary 2009-2017*

All-cap CCP

Large-cap CCP

Sensex

CAGR returns

23.7%

17.8%

12.2%

Maximum drawdown**

-21%

-19%

-24%

Excess returns

0.74

0.53

0.18

Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2009. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from July 2015 to February 2016 for the all-cap CCP; and December 2010 to December 2011 for the large-cap CCP and Sensex.

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Strategy Motherson Sumi was the star performer in this iteration with the stock price rising ~26x during this period. Exhibit 64: Portfolio performance during the tenth iteration Value at start (Rs)

Value at end (Rs)

30-Jun-09

07-Nov-17

Infosys

100

255

12%

Wipro

100

333

15%

Jindal Steel

100

40

-11%

Cipla

100

252

12%

Asian Paints

100

1,044

32%

Oracle Fin.Serv.

100

375

17%

Tech Mahindra

100

281

13%

Motherson Sumi

100

2,695

48%

HDFC Bank

100

648

25%

HDFC

100

424

19%

Company Date from/to

Punjab Natl.Bank Portfolio Sensex

Total return CAGR

100

164

6%

1,100

6,510

24%

100

261

Outperformance

12% 11.5%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at the start of Rs1,100 denotes an equal allocation of Rs100 in each stock at the start of the period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,100 at the start to Rs6,510 until 7thNov’17.

Value of stock in portfolio (in Rs)

Exhibit 65: Motherson Sumi was the star performer in this iteration 7,000

Punjab Natl.Bank

6,000

HDFC HDFC Bank

5,000

Motherson Sumi Tech Mahindra

4,000

Oracle Fin.Serv.

3,000

Asian Paints

2,000

Cipla

1,000

Jindal Steel Wipro

Value at start

Vaue at end

Infosys

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,100 at the start to Rs6,510 until 7thNov’17.

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Strategy

Period 11: 2010-Present (12.1% alpha to the Sensex; 22.8% per annum absolute returns) All-cap portfolio stocks: Asian Paints, Amar Remedies, Motherson Sumi, Tulip Telecom, HDFC Bank, Punjab National Bank and Dewan Housing Finance Large-cap portfolio stocks: Asian Paints, HDFC Bank and Punjab National Bank In this iteration, our Coffee Can Portfolio outperformed the Sensex with an alpha of 12.1%. The large-cap version also beat the Sensex with an alpha of 9.2%, but on account of a lower maximum drawdown has the higher risk-adjusted return at 0.59x vs. 0.57x for all-cap version and 0.11x for the Sensex. Exhibit 66: Eleventh iteration summary 2010-2017*

All-cap CCP

Large-cap CCP

Sensex

CAGR returns

22.8%

19.8%

10.6%

Maximum drawdown**

-26%

-20%

-24%

Excess returns

0.57

0.59

0.11

Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2010. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from October 2010 to August 2013 for the all-cap CCP; June 2011 to December 2011 for the large-cap CCP and December 2010 to December 2011 for the Sensex.

The performance of the portfolio in this iteration was led by Motherson Sumi (~12.7x returns). In spite of suspension of trading in two of the constituent stocks through the period (Amar Remedies and Tulip Telecom), the portfolio gave a stellar performance with ~23% CAGR returns. Exhibit 67: Portfolio performance during the eleventh iteration Company Date from/to

Value at start (Rs)

Value at end (Rs)

30-Jun-10

07-Nov-17

Total return CAGR

Amar Remedies

100

8

-29%

Asian Paints

100

532

25%

Motherson Sumi

100

1,378

43%

Tulip Telecom

100

1

-47%

HDFC Bank

100

501

24%

Punjab Natl.Bank

100

104

1%

Dewan Hsg. Fin.

100

643

29%

Portfolio

700

3,167

23%

Sensex

100

211

11%

Outperformance

12.1%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at the start of Rs700 denotes an equal allocation of Rs100 in each stock at the start of the period. Data for Amar Remedies and Tulip Telecom is not available because the companies were suspended during this period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs700 at the start to Rs3,167 until 7thNov’17.

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Strategy Exhibit 68: Motherson Sumi again was the star performer in this iteration

Value of stock in portfolio (in Rs)

3,500 3,000

Dewan Hsg. Fin.

2,500

Punjab Natl.Bank

2,000

HDFC Bank

1,500

Tulip Telecom Motherson Sumi

1,000

Asian Paints 500

Amar Remedies

Value at start

Vaue at end

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs700 at the start to Rs3,167 until 7thNov’17. Data for Amar Remedies and Tulip Telecom is not available because the companies were delisted during this period.

Period 12: 2011-Present (4.7% alpha to the Sensex; 15.8% per annum absolute returns) All-cap portfolio stocks: ITC, Asian Paints, Motherson Sumi, Ipca, Tulip Telecom, Zylog Systems, Pratibha industries, Unity Infra, Amar Remedies, Setco Automotive, HDFC Bank, Punjab National Bank, Dewan Housing and City Union Bank Large-cap portfolio stocks: ITC, Asian Paints, HDFC Bank and Punjab National Bank In the twelfth iteration also the Coffee Can portfolio is outperforming the Sensex with an alpha of 4.7%. The large-cap version continued its outperformance in this iteration as well, beating both the all-cap version and the Sensex on both absolute and riskadjusted return measures. Exhibit 69: Twelfth iteration summary 2011-2017*

All-cap CCP

Large-cap CCP

Sensex

CAGR returns

15.8%

16.8%

11.1%

Maximum drawdown**

-27%

-16%

-21%

Excess returns

0.29

0.56

0.15

Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2011. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from April 2012 to August 2013 for the all-cap CCP, July 2011 to December 2011 for the large-cap CCP and February 2015 to February 2016 for the Sensex.

Extreme price performance among mid-cap/small-cap stocks was seen during this iteration. Motherson Sumi’s stock price rose 7.8x during this period whilst Zylog Systems lost 98% of its value.

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Strategy Exhibit 70: Portfolio performance during the twelfth iteration Value at start (Rs)

Value at end (Rs)

30-Jun-11

07-Nov-17

ITC

100

219

13%

Asian Paints

100

380

23%

Motherson Sumi

100

881

41%

Ipca Labs.

100

165

8%

Tulip Telecom

100

1

-52%

Zylog Systems

100

2

-46%

Pratibha Inds.

100

15

-26%

Unity Infra.

100

10

-30%

Amar Remedies

100

6

-36%

Setco Automotive

100

219

13%

HDFC Bank

100

380

23%

Punjab Natl.Bank

100

97

0%

Dewan Hsg. Fin.

100

669

35%

City Union Bank

100

514

29%

1,400

3,558

16%

100

195

11%

Company Date from/to

Portfolio Sensex Outperformance

Total return CAGR

4.7%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at the start of Rs1,400 denotes an equal allocation of Rs100 in each stock at the start of the period. Data for Amar Remedies and Tulip Telecom is not available because the companies were suspended during this period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,400 at the start to Rs3,558 until 7thNov’17. Data for Amar Remedies and Tulip Telecom is not available because the companies were suspended during this period.

Exhibit 71: Extreme price performance was seen in mid/small-caps in this iteration Value of stock in portfolio (in Rs)

4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 Value at start

Vaue at end

City Union Bank Dewan Hsg. Fin. Punjab Natl.Bank HDFC Bank Setco Automotive Amar Remedies Unity Infra. Pratibha Inds. Zylog Systems Tulip Telecom Ipca Labs. Motherson Sumi Asian Paints ITC

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,400 at the start to Rs3,558 until 7thNov’17. Data for Amar Remedies and Tulip Telecom is not available because the companies were suspended during this period

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Strategy

Period 13: 2012- Present (11.1% alpha to the Sensex; 25.7% per annum absolute returns) All-cap portfolio stocks: ITC, Asian Paints, Marico, Opto Circuits, Ipca Labs, Berger paints, Page Industries, Balkrishna Industries, Grindwell Norton, Zylog Systems, Tecpro Systems, Pratibha Industries, Astral Poly Technik, Amar Remedies, Unity Infra, Setco Automotive, HDFC Bank, Axis Bank, Punjab National Bank, Allahabad Bank, Dewan Housing and City Union Bank Large-cap portfolio stocks: ITC, Asian Paints, HDFC Bank, Axis Bank and Punjab National Bank In the iteration beginning June 2012, the all-cap version again came to the fore, beating both the Sensex and the large-cap CCP on both absolute basis and riskadjusted basis. Exhibit 72: Thirteenth iteration summary 2012-2017* CAGR returns Maximum drawdown** Excess returns

All-cap CCP 25.7% -21% 0.84

Large-cap CCP 18.0% -23% 0.43

Sensex 14.6% -21% 0.32

Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2012. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from December 2012 to August 2013 for the all-cap CCP, May 2013 to August 2013 for the large-cap CCP and from February 2015 to February 2016 for the Sensex.

With 22 companies making the cut in this iteration, this was the biggest Coffee Can portfolio in terms of number of constituent companies. Astral Poly Technik was the star performer in this iteration with ~16.3x increase in the stock price. Zylog Systems and Tecpro Systems, on the other hand, lost almost their entire value with a drop of 99% and 97% in their stock price. Exhibit 73: Portfolio performance during the thirteenth iteration Company Date from/to ITC Asian Paints Marico Opto Circuits Ipca Labs. Berger Paints Page Industries Balkrishna Inds Grindwell Norton Zylog Systems Tecpro Systems Pratibha Inds. Astral Poly Amar Remedies Unity Infra. Setco Automotive HDFC Bank Axis Bank Punjab Natl.Bank Allahabad Bank Dewan Hsg. Fin. City Union Bank Portfolio Sensex Outperformance

Value at start (Rs) 30-Jun-12 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 2,200 100

Value at end (Rs) 07-Nov-17 169 308 368 5 156 530 747 762 416 1 3 17 1,729 5 14 160 336 273 128 58 885 432 7,502 208

Total return CAGR 10% 23% 28% -43% 9% 36% 46% 46% 30% -56% -49% -28% 70% -44% -30% 9% 25% 21% 5% -10% 50% 31% 26% 15% 11.1%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at the start of Rs2,200 denotes an equal allocation of Rs100 in each stock at the start of the period. Data for Amar Remedies is not available because the company was suspended during this period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs2,200 at the start to Rs7,502 until 7thNov’17.

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Strategy Exhibit 74: Astral Poly Technik outperformed other stocks in this iteration City Union Bank Dewan Hsg. Fin. Allahabad Bank Punjab Natl.Bank Axis Bank HDFC Bank Setco Automotive Unity Infra. Amar Remedies Astral Poly Pratibha Inds. Tecpro Systems Zylog Systems Grindwell Norton Balkrishna Inds Page Industries Berger Paints Ipca Labs. Opto Circuits Marico Asian Paints ITC

Value of stock in portfolio (in Rs)

8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 Value at start

Vaue at end

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs2,200 at the start to Rs7,502 until 7thNov’17.

Period 14: 2013- Present (19.8% alpha to the Sensex; 34.8% per annum absolute returns) All-cap portfolio stocks: ITC, HCL Technologies, Asian Paints, Marico, Berger Paints, Ipca, Page Industries, Balkrishna Industries, Solar Industries, Astral Poly Technik, Pratibha Industries, Unity Infra, Sarla Performance Fibers, HDFC Bank, Axis Bank, Indian Bank, City Union Bank and Dewan Housing Large-cap portfolio stocks: ITC, HCL Tech, Asian Paints, Marico, HDFC Bank, Axis Bank This iteration beginning in June 2013 has given the best results thus far with a whopping return of 34.8% on a CAGR basis. Sensex over the same period has generated a CAGR of 14.9% whereas the large-cap portfolio has generated a CAGR of 22.5%. Exhibit 75: Fourteenth iteration summary 2013-2017*

All-cap CCP

Large-cap CCP

Sensex

CAGR returns

34.8%

22.5%

14.9%

Maximum drawdown**

-19%

-12%

-21%

Excess returns

1.40

1.21

0.34

Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2013. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from December 2015 to February 2016 for the all-cap CCP, from July 2015 to February 2016 for the large-cap CCP and from February 2015 to February 2016 for the Sensex.

Mid-cap stocks led the performance of the profile in this iteration with some of the stocks prices rising 3-4 times since the beginning of this portfolio in June 2013. These stocks included names like Balkrishna Industries, Dewan Housing Finance, Astral Poly Technik, Solar Industries and Page Industries. Unity Infraprojects, Pratibha Industries and Ipca Labs on the other hand are amongst stocks that lost value in this period.

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Strategy Exhibit 76: Portfolio performance during the fourteenth iteration Value at start (Rs)

Value at end (Rs)

30-Jun-13

07-Nov-17

ITC

100

132

7%

HCL Technologies

100

248

23%

Asian Paints

100

256

24%

Marico

100

324

31%

Berger Paints

100

313

30%

Ipca Labs.

100

85

-4%

Page Industries

100

519

46%

Balkrishna Inds

100

935

67%

Solar Inds.

100

590

50%

Astral Poly

100

693

56%

Pratibha Inds.

100

28

-25%

Unity Infra.

100

25

-27%

Sarla Performance

100

394

37%

HDFC Bank

100

281

27%

Axis Bank

100

209

18%

Indian Bank

100

346

33%

City Union Bank

100

340

32%

Dewan Hsg. Fin.

100

889

65%

1,800

6,608

35%

100

183

Company Date from/to

Portfolio Sensex Outperformance

Total return CAGR

15% 19.8%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at the start of Rs1,800 denotes an equal allocation of Rs100 in each stock at the start of the period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,800 at the start to Rs6,608 until 7thNov’17.

Exhibit 77: Mid-caps led the charge in this iteration generating most of portfolio value Value of stock in portfolio (in Rs)

7,000 6,000 5,000 4,000 3,000 2,000 1,000 Value at start

Vaue at end

Dewan Hsg. Fin. City Union Bank Indian Bank Axis Bank HDFC Bank Sarla Performanc Unity Infra. Pratibha Inds. Astral Poly Solar Inds. Balkrishna Inds Page Industries Ipca Labs. Berger Paints Marico Asian Paints HCL Technologies ITC

Source: Bloomberg, Ambit Capital research. Note: Value at start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,800 at the start to Rs6,608 until 7thNov’17.

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Strategy

Appendix 3: John Kay’s IBAS framework “I don’t want an easy business for competitors. I want a business with a moat around it. I want a very valuable castle in the middle and I want the duke who is in charge of that castle to be very honest and hardworking and able. Then I want a moat around that castle. The moat can be various things. The moat around our auto insurance business, GEICO, is low cost.” – Warren Buffett “I always try and spend the last few minutes… to touch on a competitor, or a company they do business with, such as a supplier or a customer. Although not all managements will talk about other companies, when they do, it can be very revealing. The ultimate commendation is when a company talks positively about a competitor. I always put a strong weight on such a view.” – Anthony Bolton, the legendary fund manager who ran the Fidelity Special Situations fund Sustainable competitive advantages allow firms to add more value than their rivals and to continue doing so over long periods of time. But where do these competitive advantages come from? And why is it that certain firms seem to have more of these advantages than others?

Sustainable competitive advantages allow firms to add value and continue doing so over long periods

In his 1993 book, ‘Foundations of Corporate Success’, John Kay, the British economist and Financial Times columnist, wrote more comprehensibly and clearly about this than any other business guru. John states that “sustainable competitive advantage is what helps a firm ensure that the value that it adds cannot be competed away by its rivals”. He goes on to state that sustainable competitive advantages can come from two sources: distinctive capabilities or strategic assets. Whilst strategic assets can be in the form of intellectual property (patents and proprietary know-how), legal rights (licenses and concessions) or a natural monopoly, the distinctive capabilities are more intangible in nature. Distinctive capabilities, says Kay, are those relationships that a firm has with its customers, suppliers or employees, which cannot be replicated by other competing firms and which allow the firm to generate more value additions than its competitors. He further divides distinctive capabilities into three categories: 

Brands and reputation



Architecture



Innovation

Let us delve into these in more detail, as understanding them is at the core of understanding the strength of a company’s franchise.

John Kay’s framework focusses on ‘Innovation’, ‘Brands’, ‘Architecture’ and ‘Strategic Assets’ as sources of sustainable competitive advantage

Brands and reputation "A product can be quickly outdated, but a successful brand is timeless." – Stephen King, American novelist, author & TV Producer In many markets, product quality, in spite of being an important driver of the purchase decision, can only be ascertained by a long-term experience of using that product. Examples of such products are insurance policies and healthcare. In many other markets, the ticket price of the product is high; hence, consumers are only able to assess the quality of the product only after they have parted with their cash. A few examples of such products would be cars and high-end TVs.

“A product can be quickly outdated, but a successful brand is timeless”

In both these markets, customers use the strength of the company’s reputation as a proxy for the quality of the product or the service. For example, we gravitate towards the best hospital in town for critical surgery and we tend to prefer world-class brands whilst buying expensive home entertainment equipment. Since the reputation for such high-end services or expensive electronics takes many years to build, reputation tends to be difficult and costly to create. This in turn makes it a very powerful source for a competitive advantage. [email protected]

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Strategy For products that we use daily, we tend to be generally aware of the strength of a firm’s brand. In more niche products or B2B products (e.g. industrial cables, mining equipment, municipal water purification, and semiconductors), investors often do not have first-hand knowledge of the key brands in the relevant market. In such instances, to assess the strength of the brand, they turn to:  

Brand recognition surveys conducted by the trade press. The length of the warranties offered by the firm (the longer the warranties, the more unequivocal the statement it makes about the firm’s brand). The amount of time the firm has been in that market (egg. “Established 1905” is a fairly credible way of telling the world that since you have been in business for over a century, your product must have something distinctive about it). How much the firm spends on its marketing and publicity (a large marketing spend figure, relative to the firm’s revenues, is usually a reassuring sign). How much of a price premium the firm is able to charge vis-a-vis its peers.



 

One way to appreciate the power of brands and reputation to generate sustained profits and, hence, shareholder returns is to look at how India’s most-trusted brands, according to an annual Economic Times survey, have fared over the last decade. As can be seen in the table below, over the past decade, the listed companies with the most powerful brands have comfortably beaten the most widely acknowledged frontline stock market index by a comfortable margin on revenues, earnings and share price movement. Exhibit 78: Performance of listed companies with the most-trusted brands #

Company

Trusted Brands*

1

ColgatePalmolive

Colgate (1)

2

Hindustan Unilever

3

Nestle

4 5

Clinic Plus (4), Lifebuoy (10), Rin (12), Surf (13), Lux (14), Ponds, etc Maggi (9), Nestle Milk Chocolate (62), etc

GSK Horlicks (16) Consumer Bharti Airtel Airtel (18) Average for the listed companies with the top 5 brands For the index, Nifty

10-year Growth (FY04-14) (% CAGR)** Revenues

EPS

Share price***

14

17

27

10

8

15

15

16

23

15

21

33

33

18

15

18

16

22

12

13

14

Listed companies with the mosttrusted brands have beaten the benchmark index on revenues, earnings and share price performance

Source: Economic Times and Ambit Capital analysis using Bloomberg data. Note: * Figures in brackets indicate the rank in the 2012 Economic Times ‘brand equity’ survey to find the 100 most-trusted brands in India. ** The FY14 data is based on Bloomberg consensus as on 7 April 2014. *** Share price performance has been measured from Mar-04 to Mar-14

Architecture “A dream you dream alone is only a dream. A dream you dream together is reality.” – John Lennon ‘Architecture’ refers to the network of contracts, formal and informal, that a firm has with its employees, suppliers and customers. Thus, architecture would include the formal employment contracts that a firm has with its employees and it would also include the more informal obligation it has to provide ongoing training to its employees. Similarly, architecture would include the firm’s legal obligation to pay its suppliers on time and its more informal obligation to warn its suppliers in advance if it were planning to cut production in three months.

‘Architecture’ refers to the network of contracts, formal and informal, that a firm has with its employees, suppliers and customers

Such architecture is most often found in firms with a distinctive organisational style or ethos, because such firms tend to have a well-organised and long-established set of processes or routines for doing business. So, for example, if you have ever taken a home loan in India, you will find a marked difference in the speed and professionalism with which HDFC processes a home loan application as compared to other lenders. The HDFC branch manager asks the applicant more specific questions than other lenders do and this home loan provider’s due diligence on the applicant and the property appears to be done more swiftly and thoroughly than most other lenders in India. [email protected]

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Strategy So, how can an investor assess whether the firm they are scrutinising has architecture or not? In fact, whilst investors will often not know the exact processes or procedures of the firm in question, they can assess whether a firm has such processes and procedures by gauging the: 

extent to which the employees of the firm co-operate with each other across various departments and locations.



rate of staff attrition (sometimes given in the Annual Report).



extent to which the staff in different parts of the firm give the same message when asked the same question.



extent to which the firm is able to generate innovations in its products or services or production processes on an ongoing basis.

At the core of successful architecture is co-operation (within teams, across various teams in a firm and between a firm and its suppliers) and sharing (of ideas, information, customer insights and, ultimately, rewards). Built properly, architecture allows a firm with ordinary people to produce extraordinary results.

HDFC and GCMMF are the most striking demonstrations of architecture in India

Perhaps the most striking demonstration of architecture in India is the unlisted nonprofit agricultural co-operative, Gujarat Cooperative Milk Marketing Federation Ltd (GCMMF), better known to millions of Indians as ‘Amul’. With its roots stretching back to India’s freedom movement, GCMMF was founded by the legendary Verghese Kurien in 1973. This farmer’s co-operative generated revenues of `137bn (around US$2.1bn) in FY13, thus making it significantly larger than its main private sector competitor, Nestle (FY13 revenues of `91bn or around US$1.5bn). Furthermore, GCMMF’s revenues have grown over the past five years by 21% as opposed to Nestle’s 16% over the same period. In fact, GCMMF’s revenue growth is markedly superior to the vast majority of the top Indian brands shown in Exhibit 92. GCMMF’s daily milk procurement of 13 million litres from over 16,000 village milk co-operative societies (which include 3.2 million milk producer members) has become legendary. The way GCMMF aggregates the milk produced by over 3 million families into the village co-operative dairy and then further aggregates that into the district co-operative which in turn feeds into the mother dairy has been studied by numerous management experts. Not only does the GCMMF possess impressive logistical skills, its marketing acumen is comparable to that of the multinational giants cited in the table shown above: In key FMCG product categories such as butter, cheese and packaged milk, Amul has been the longstanding market leader in the face of sustained efforts by the multinationals to break its dominance. GCMMF is also India’s largest exporter of dairy products. So how does GCMMF do it? How does it give a fair deal to farmers, its management team (which includes the alumnus from India’s best business schools), its 5,000 dealers, its 1 million retailers and its hundreds of millions of customers? Although numerous case studies have been written on GCMMF, at the core of this cooperative’s success appears to be: (a) its 50-year old brand with its distinctive imagery of the little girl in the polka red dotted dress; (b) the idea of a fair deal for the small farmer and the linked idea of the disintermediation of the unfair middle man; and (c) the spirit of Indian nationalism in an industry dominated by globe girdling for-profit corporates. Innovation “Learning is not compulsory … neither is survival.” – W Edwards Deming, American statistician, professor, author. The world’s most famous prize for manufacturing excellence is named after him. "Innovation distinguishes between a leader and a follower." –

Steve Jobs

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Strategy Whilst innovation is often talked about as a source of competitive advantage, especially in the Technology and Pharmaceutical sectors, it is actually the most tenuous source of sustainable competitive advantage as: 

Innovation is expensive.



Innovation is uncertain - the innovation process tends to be a ‘hit or miss’.



Innovation is hard to manage due to the random nature of the process.

Whilst most talked about, ‘Innovation’ is also the most tenuous source of sustainable competitive advantage…

Furthermore, even when the expensive innovation process yields a commercially useful result, the benefits can be competed away, as other firms replicate the innovator and/or employees who have driven the innovation process tend to extract the benefits of innovation through higher compensation. In fact, innovation is more powerful when it is twinned with the two other distinctive capabilities we have described above – reputation and architecture. Apple is the most celebrated example of a contemporary firm which has clearly built a reputation for innovation (think of the slew of products from Apple over the past decade which first changed how we access music, then changed how we perceive our phones and finally, how we use our personal computers). Strategic assets In contrast to the three distinctive capabilities discussed above, strategic assets are easier to identify as sources of competitive advantages. Such assets can come in different guises: 

   



…’strategic assets’ on the other hand are easier to identify

Intellectual property i.e. patents or proprietary know-how (e.g. the recipe for Coke’s famous syrup which is a closely held secret and kept in the company’s museum in Atlanta, Georgia); Licences and regulatory permissions to provide a certain service to the public, e.g., telecom, power, gas or public transport; Access to natural resources such as coal or iron-ore mines; Political contacts either at the national, state or city level; Sunk costs incurred by the first mover which result in other potential competitors deciding to stay away from that market e.g. given that there already is a Mumbai-Pune highway operated by IRB, it does not make sense for anyone else to set up a competing road; and Natural monopolies i.e. sectors or markets which accommodate only one or two firms; for example, the market for supplying power in Mumbai is restricted to one firm, Tata Power.

Whilst strategic assets can come in different forms, all of them result in a lower per unit cost of production for the firm owning the asset relative to its competitors. For example, Tata Steel’s decades-old access to coal and iron-ore from its captive mines allows it to make more money per tonne of steel produced than any other steel manufacturer in India. According to Ambit Capital’s analysts, on a tonne of steel produced, Tata Steel earns `45,000 vs `39,000 for SAIL and `38,000 for JSW Steel.

Access to captive coal and iron ore results in more money per tonne of steel for Tata Steel vs its competitors due to lower cost of production

Unsurprisingly therefore among the top-50 companies by market cap in India since the Nifty was launched in 1995, there is only one conglomerate – Tata Sons - which has had three companies which have been in the index more or less throughout this period i.e., Tata Power, Tata Steel and Tata Motors. Upon closer examination, the Tatas are an almost text book case of how to build businesses which, without being the most innovative players in town, combine architecture and brands to great effect, thereby creating robust sources of sustainable competitive advantages. The group seems to have created at least three specific mechanisms to ensure that these sources of competitive advantage endure:

The Tatas have combined architecture with brand to create robust sources of sustainable competitive advantages

Firstly, Tata Sons, an unlisted company (owned by several philanthropic trusts endowed by members of the Tata family), is the promoter of the major operating Tata companies and holds significant shareholdings in these companies. Tata Sons’ patient, long-term orientation in terms of building large and robust businesses gradually has played a major role in the stability of the listed Tata businesses. [email protected]

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Strategy Secondly, Tata Quality Management Services (TQMS), a division of Tata Sons, assists Tata companies in their business excellence initiatives through the Tata Business Excellence Model, Management of Business Ethics and the Tata Code of Conduct. TQMS, quite literally, provides the architecture to harmonise practices in various parts of the Tata empire. Thirdly, Tata Sons is also the owner of the Tata name and several Tata trademarks, which are registered in India and around the world. These are used by various Tata companies under a license from Tata Sons as part of their corporate name and/or in relation to their products and services. The terms of use of the group mark and logo by Tata companies are governed by the Brand Equity and Business Promotion Agreement entered into between Tata Sons and Tata companies.

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Strategy

Appendix 4 The exhibits below highlight how the maximum drawdown for the completed Coffee Can portfolios (beginning every year from 2001 to 2007) has been lower than the BSE 200 index.

70%

1,500

50%

1,000

30%

500

10%

0 -10%

-500

-30%

-1,000

BSE200 Max DD (RHS) CCP (LHS)

BSE200 (LHS)

Jun-11

Jan-11

Aug-10

Mar-10

Oct-09

Dec-08

May-09

Jul-08

Feb-08

Sep-07

Apr-07

Nov-06

Jun-06

Jan-06

Aug-05

Mar-05

Oct-04

May-04

Dec-03

Jul-03

Feb-03

-70% Sep-02

-2,000 Apr-02

-50% Jun-01

-1,500

CCP- Max DD (RHS)

Maximum drawdown

2,000

Nov-01

Portfolio value (Rs)

Exhibit 79: Coffee Can Portfolio (2001) suffered much lower drawdowns than the BSE200 index

Source: Bloomberg, Ambit Capital Research Note: The maximum drawdown is calculated as drop in value from the peak to the period concerned. For example in Nov’08 the maximum drawdown of 59.5% denotes a drop in value of 59.5% in BSE200 index from the peak achieved in Nov’07

Exhibit 80: Coffee Can Portfolio(2002) suffered much lower drawdowns than the BSE200 index

Portfolio value (Rs)

50%

750

30% 250

10%

-250

-10% -30%

-750

-50% -70% Jun-12

Jan-12

Aug-11

Mar-11

Oct-10

May-10

Dec-09

Jul-09

Feb-09

Sep-08

Apr-08

Nov-07

Jun-07

Jan-07

Aug-06

Mar-06

Oct-05

May-05

Dec-04

Jul-04

Feb-04

Sep-03

Apr-03

Nov-02

Jun-02

-1,250

Maximum drawdown

70%

1,250

CCP - Max DD (RHS) BSE200 Max DD (RHS) CCP (LHS)

BSE200 (LHS)

Source: Bloomberg, Ambit Capital Research Note: The maximum drawdown is calculated as drop in value from the peak to the period concerned. For example in Nov’08 the maximum drawdown of 59.5% denotes a drop in value of 59.5% in BSE200 index from the peak achieved in Nov’07.

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Strategy

70%

1,000

50% 30%

500

10% 0 -10% -500

-30%

CCP - Max DD (RHS) BSE200 - Max DD (RHS) CCP (LHS)

BSE200 (LHS)

Jun-13

Jan-13

Aug-12

Mar-12

Oct-11

May-11

Dec-10

Jul-10

Feb-10

Sep-09

Apr-09

Jun-08

Nov-08

Jan-08

Aug-07

Mar-07

Oct-06

Dec-05

May-06

Jul-05

Feb-05

-70% Apr-04

-1,500 Sep-04

-50% Nov-03

-1,000

Maximum drawdown

1,500

Jun-03

Portfolio value (Rs)

Exhibit 81: Coffee Can Portfolio(2003) suffered much lower drawdowns than the BSE200 index

Source: Bloomberg, Ambit Capital Research Note: The maximum drawdown is calculated as drop in value from the peak to the period concerned. For example in Nov’08 the maximum drawdown of 59.5% denotes a drop in value of 59.5% in BSE200 index from the peak achieved in Nov’07

Jun-14

Jan-14

Aug-13

Mar-13

Oct-12

May-12

Dec-11

Jul-11

Feb-11

Maximum drawdown

-70% Apr-10

-1,800 Sep-10

-50% Nov-09

-1,300 Jun-09

-30%

Jan-09

-800

Aug-08

-10%

Oct-07

-300

Mar-08

10%

May-07

200

Jul-06

30%

Dec-06

700

Feb-06

50%

Apr-05

1,200

Sep-05

70%

Nov-04

1,700

Jun-04

Portfolio value (Rs)

Exhibit 82: Coffee Can Portfolio (2004) suffered equivalent drawdown to BSE200 index

CCPMax DD (RHS) BSE200 Max DD (RHS) CCP (LHS) BSE200 (LHS)

Source: Bloomberg, Ambit Capital Research Note: The maximum drawdown is calculated as drop in value from the peak to the period concerned. For example in Nov’08 the maximum drawdown of 59.5% denotes a drop in value of 59.5% in BSE200 index from the peak achieved in Nov’07.

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Strategy Exhibit 83: Coffee Can Portfolio (2005) suffered lower drawdowns than the BSE200 index 70%

900

50%

500 30%

300 100

10%

-100

-10%

-300

-30%

-500

Maximum drawdown

Portfolio value (Rs)

700

-50%

-700

CCP - Max DD (RHS) BSE200 Max DD (RHS) CCP (LHS)

BSE200 (LHS)

-70% Jun-15

Jan-15

Aug-14

Mar-14

Oct-13

May-13

Dec-12

Jul-12

Feb-12

Sep-11

Apr-11

Nov-10

Jun-10

Jan-10

Aug-09

Mar-09

Oct-08

May-08

Dec-07

Jul-07

Feb-07

Sep-06

Apr-06

Jun-05

Nov-05

-900

Source: Bloomberg, Ambit Capital Research Note: The maximum drawdown is calculated as drop in value from the peak to the period concerned. For example in Nov’08 the maximum drawdown of 59.5% denotes a drop in value of 59.5% in BSE200 index from the peak achieved in Nov’07.

70%

700

50%

500 30%

300 100

10%

-100

-10%

-300

-30%

-500

CCP- Max DD (RHS) BSE200 Max DD (RHS) CCP (LHS)

BSE200 (LHS)

Jun-16

Jan-16

Aug-15

Mar-15

Oct-14

May-14

Dec-13

Jul-13

Feb-13

Sep-12

Apr-12

Nov-11

Jun-11

Jan-11

Aug-10

Mar-10

Oct-09

May-09

Dec-08

Jul-08

Feb-08

-70% Sep-07

-900 Apr-07

-50% Nov-06

-700

Maximum drawdown

900

Jun-06

Portfolio value (Rs)

Exhibit 84: Coffee Can Portfolio (2006) suffered much lower drawdowns than the BSE200 index

Source: Bloomberg, Ambit Capital Research Note: The maximum drawdown is calculated as drop in value from the peak to the period concerned. For example in Nov’08 the maximum drawdown of 59.5% denotes a drop in value of 59.5% in BSE200 index from the peak achieved in Nov’07.

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Strategy

Jun-17

Jan-17

Aug-16

Mar-16

Oct-15

May-15

Dec-14

Jul-14

Feb-14

Maximum drawdown

-70% Sep-13

-700 Apr-13

-50% Nov-12

-500 Jun-12

-30%

Jan-12

-300

Aug-11

-10%

Mar-11

-100

Oct-10

10%

May-10

100

Dec-09

30%

Jul-09

300

Feb-09

50%

Sep-08

500

Apr-08

70%

Nov-07

700

Jun-07

Portfolio value (Rs)

Exhibit 85: Coffee Can Portfolio(2007) suffered much lower drawdowns than the BSE200 index

CCP- Max DD (RHS) BSE200 Max DD (RHS) CCP (LHS)

BSE200 (LHS)

Source: Bloomberg, Ambit Capital Research Note: The maximum drawdown is calculated as drop in value from the peak to the period concerned. For example in Nov’08 the maximum drawdown of 59.5% denotes a drop in value of 59.5% in BSE200 index from the peak achieved in Nov’07.

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HDFC Bank SELL HDFCB IN EQUITY

Sustainability is key

BFSI

Flags Accounting: Predictability: Earnings Momentum:

GREEN GREEN GREEN

Performance 155 130 105

HDFC Bank

Sensex

Strong execution is in its DNA HDFC Bank focused on two key principles in its business – building a stable and low-cost liability base and winning clients by offering unique solutions (e.g. technology-led capture of capital market floats). The bank has taken a long-term approach to protect margins and asset quality rather than aggressive, near-term growth (e.g. avoided project finance-led growth). Superior profitability has allowed HDFC Bank to sustain its capital position through internal profit generation without undue dilution of shareholders’ fund. The bank has made two acquisitions but its recent focus has been on organic growth through accelerated branch network expansion on a pan-India basis.

Source: Bloomberg, Ambit Capital research

Going beyond IBAS framework A risk-averse culture and ability to use technology (systems and processes) to create a unique offering have been key differentiators. Despite a relatively low advertising budget and lack of celebrity endorsements, a high brand recall is a testimony of the bank’s strengths. HDFC Bank is known for its focus on systems and processes, which has helped it in terms of business continuity. The bank’s key strategic asset is its low-cost funding franchise (cost of funds of 5.2% vs peer average of ~5.7%), which has helped it effectively compete with other banks without taking higher asset quality risks. Valuations leave little margin of safety Despite the weak macro environment, the bank has done well in terms of superior loan growth (currently at 22% vs ~7% for the banking system) and maintaining strong NIM (currently 4.3%). However, bank faced some asset quality hiccups in recent times. Thus, with our expectation of a slowdown in loan growth for private banks due to recapitalisation of PSU banks, pressure on NIM given weak CASA growth, and pick-up in delinquencies in retail/SME loans, we do not expect a pick-up in EPS growth from current levels. HDFC Bank is trading at 23.6x FY19E P/E and 4.1x FY19E P/B, ~50% premium to peers.

Research Analysts Pankaj Agarwal, CFA Tel: +91 22 3043 3206 [email protected] Ravi Singh Tel: +91 22 3043 3181 [email protected] Rahil Shah Tel: +91 22 3043 3217 [email protected]

[email protected] 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.

Nov-17

Sep-17

Aug-17

Jun-17

80 May-17

Established in 1994, HDFC Bank is India’s largest private sector bank in terms of assets with ~6.7% market share (in loans). HDFC Bank has differentiated itself from peers through strategic focus on retail assets and liabilities. Retail loans and retail deposits form ~68% and ~79% of loans and deposits respectively. This has helped the bank deliver superior NIM (5-year average of ~4.3%) compared to peers. Robust risk management and processes have helped the bank maintain its asset quality (average credit cost of 70bps in the past 5 years), helping deliver average RoE of ~19.4% in the last 5 years. A stable management team and use of technology since inception have facilitated the consistent performance.

`4,708/US$72.9 `2,969/US$46.0 `1,822 `1,330 27

Mar-17

Banking on retail bank and technology

Mcap (bn): 3M ADV (mn): CMP: TP (12 mths): Downside (%):

Feb-17

Changes to this position: STABLE

Recommendation

Dec-16

HDFC Bank has since inception focused on building a granular retail franchise on both sides of the balance sheet. It has maintained a conservative approach to lending (gross NPA of 1.26%). With a stable management team at the helm, the bank was able to expand its retail offering on a pan-India basis and fill gaps in its corporate banking offering. However, despite EPS growth slowing to 19% in the last two years (vs a decade of >25% EPS growth), valuation multiples expanded. Valuations are at ~50% premium to peers. This leaves little margin of safety especially as the external environment is still not conducive for banks. Remain SELLers with TP of Rs1,330 (2.9x FY19E BVPS). Competitive position: STRONG

November 17, 2017

Nov-16

STRATEGY NOTE

HDFC Bank Exhibit 1: HDFC Bank loan book is diversifying towards retail Home

Vehicle

Other retail

Non-retail

RoE (RHS)

40%

10%

20%

5%

0%

0%

FY13

FY14

FY15

FY16

FY17

1HFY18*

792

989

1,258

1,600

1,954

2,397

3,030

3,655

4,646

5,546

6,049

FY14

FY12

FY13

FY11

FY12

FY10

FY11

FY09

FY10

FY08

FY09

1HFY18

15%

FY17

60%

FY16

20%

FY15

80%

FY08

25%

FY07

100%

Source: Company, Ambit Capital research

Exhibit 2: Key financial parameters over the last decade Loan book (Rs mn) Loan book growth (%)

36.1%

24.9%

27.3%

27.1%

22.2%

22.7%

26.4%

20.6%

27.1%

19.4%

22.3%

Operating profits (Rs mn)

41,975

51,790

64,297

77,254

93,906

114,276

143,601

174,045

213,635

257,324

153,379

Net profits (Rs mn)

17,221

22,449

29,487

39,264

51,671

67,263

84,784

102,159

122,962

145,496

80,449

EPS (Rs)

8.1

10.6

12.9

16.9

22.0

28.3

35.3

42.1

48.6

56.8

31.3

Gross NPAs (%)

1.81%

1.95%

1.43%

1.05%

1.01%

0.97%

0.98%

0.93%

0.94%

1.05%

1.26%

Net NPAs (%)

0.66%

0.63%

0.31%

0.19%

0.18%

0.20%

0.27%

0.25%

0.28%

0.33%

0.43%

Tier 1 (%)

10.2%

10.6%

13.3%

12.2%

11.6%

11.1%

11.8%

13.7%

13.2%

12.8%

13.3%

ROA (%)

1.28%

1.31%

1.45%

1.57%

1.68%

1.82%

1.90%

1.89%

1.85%

1.81%

1.79%

ROE (%)

16.7%

16.1%

16.1%

16.7%

18.7%

20.3%

21.3%

19.4%

18.3%

17.9%

17.3%

Source: Company, Ambit Capital research. Note: *1HFY18 operating profits, net profits and EPS numbers not annualized

Exhibit 3: The key things to note from evolution Time period

1994-1999

2000-2008

2009-Present

Phase

A corporate bank with a difference

Building the retail bank

Reaching the hinterland and taking on Silicon Valley

Key developments



The initial management team was built mostly by hiring young bankers from foreign banks like Citibank, Bank of America and HSBC.



The bank focused on raising low-cost liabilities, finding gaps in the existing offerings of competing banks, capturing transactional and cash management business from the corporates rather than lending money to them.



The bank implemented a fully integrated online banking automation system as compared to other popular offline systems which were used by other competitors.



In FY04, the bank struck a deal with its parent company (HDFC) to become a distributor of HDFC’s home loans for a fee of 0.7% of the loan and the right to buy back 70% of the loans originated by it.



Extensive focus on retail loans allowed the bank to post a retail loan book CAGR of 67% over FY00-08 and contributed 57% of the loan book by FY08.



Focused on selling third-party products and acquiring point-of-sale terminals.



HDFC Bank acquired Centurion Bank of Punjab (CBOP) in May 2008. CBOP was one-fifth of HDFC Bank in terms of balance sheet and half in terms of branches.



HDFC Bank focused on improving rural foot prints. The bank set up dedicated desks at semi-urban and rural branches to cater to agriculture loans.



HDFC Bank started a major push towards ‘digital banking’. Various initiatives like PayZapp wallet, loans in ten seconds, etc. were launched.

Source: Ambit Capital research

[email protected] November 17, 2017

Ambit Capital Pvt. Ltd.

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HDFC Bank Exhibit 4: Competitive mapping of HDFC Bank with other comparable peers Loan book

Loan CAGR (FY13-17)

CASA

NIMs

RoE

Net NPAs

Tier I

15,711

12.6%

44.6%

2.6%

7.0%

3.71%

10.4%

HDFC Bank

5,546

23.2%

48.0%

4.4%

17.9%

0.33%

12.8%

ICICI Bank

4,642

12.8%

50.4%

3.2%

10.3%

5.43%

14.4%

Axis Bank

3,731

17.1%

51.4%

3.5%

6.8%

2.31%

11.9%

Kotak Mahindra Bank

1,361

28.3%

44.0%

4.3%

13.2%

1.26%

15.9%

IndusInd Bank

1,131

26.4%

36.9%

4.0%

15.3%

0.39%

14.7%

Company (Rs bn, FY17) State Bank of India

Source: Company, Ambit Capital research

Exhibit 5: Mapping HDFC Bank and its peers on IBAS Company

Innovation

Brand Architecture

Strategic asset

Overall rank

Comments

HDFC Bank

The bank scores highly on all parameters: Innovation (origin as an upstart bank, transaction banking, technology-led solution, capital markets strategy to capture floats, forays in rural and digital banking); brand (wide geographical and demographical reach); architecture (little churn in senior management, highly focused on systems and processes, meeting unmet demands of customers); and strategic assets (wide branch network, large and sticky retail deposits franchise, strong asset quality and a good capital raising track record)

ICICI Bank

The bank has mixed scores on IBAS: Innovation (present across all segments of financial services, pioneer in using technology); brand (wide geographical and demographical reach, but marred by negative asset quality cycles); architecture (cyclical ups and downs on growth and asset quality has impacted the quality of engagement with employees and customers); and strategic assets (wide branch network, large and sticky retail deposits franchise, leading franchises in most financial services businesses)

Axis Bank

The bank scores highly on most parameters: Innovation (evolution of the bank’s retail liabilities, retail assets, DCM business, SME banking and wholesale banking in high quality leading franchises); brand (wide geographical and demographical reach; successful transition from a quasiPSU brand to new-age banking brand); architecture (strong and independent board, an employee-friendly environment and a flexible culture open to changes with track record of seamlessly re-orienting under three leaders with different management styles); and strategic assets (bestin-class franchise in areas of transaction banking, such as cash management, payments, business banking and government businesses, wide branch network, large and sticky retail deposits franchise).

Kotak Mahindra Bank

The bank scores highly on most parameters: Innovation (evolution from an NBFC to a universal financial services conglomerate); brand (strong brand but with limited reach, received a fill up from ING Vysya Bank acquisition); architecture (conservative corporate culture with high focus on costs and risk pricing, even at the cost of growth); and strategic assets (leading franchises in number of lending and non-lending financial service businesses).

IndusInd Bank

The bank has mixed scores on IBAS: Innovation (overhauling of entire corporate banking, and launching and scaling up of retail products under new management); brand (strong niche brand in vehicle finance and other niche segments, yet to evolve into a prominent high-street brand); architecture (strong and well-knit senior management team; strong longterm relationship-based customer connect in vehicle finance); and strategic assets (unmatched differentiated vehicle finance franchise, structured midmarket corporate banking franchise, rapidly expanding branch network).

State Bank of India

The bank has mixed scores on IBAS: Innovation (has built presence across all segments of financial services businesses over the long term, but constraints linked with being PSU bank limit rapid innovations and adopting best practices from peers); brand (wide geographical and demographical reach, but underwhelming perception for standards of customer service); architecture (poor alignment of employee-reward programme with commercial success of the bank, HR practices are not comparable with private sector peers); and strategic assets (wide branch network, large and sticky retail deposits franchise and leading franchises in most financial services businesses).

Source: Company, Ambit Capital research; Note:

- Strong;

- Relatively Strong;

- Average;

- Relatively weak.

[email protected] November 17, 2017

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HDFC Bank Exhibit 6: Loan book growth has been stable at ~22% with improvement in NIM Loan growth

Exhibit 7: Due to efficiencies in operations, RoA of the bank has improved over the years

Net interest margins (RHS)

RoA

4.8%

45% 40% 35% 30% 25% 20% 15% 10% 5% 0%

4.5%

RoE (RHS)

2.0%

25% 20%

1.5%

15%

1.0% 0.5%

0% 1HFY18

FY17

FY16

FY15

FY14

FY13

FY12

FY11

FY10

FY09

FY07

FY17

5%

0.0%

1HFY18

FY16

FY15

FY14

FY13

FY12

FY11

FY10

FY09

FY08

FY07

4.0%

10%

FY08

4.3%

13.3% 1HFY18

12.8%

11.8% FY14

FY17

11.1% FY13

13.2%

11.6% FY12

12.2%

Tier 1

FY11

FY10

10.6% FY09

FY07

10.2%

16% 14% 12% 10% 8% 6% 4% 2% 0%

1HFY18

FY17

0% FY16

20%

0.0% FY15

0.5% FY14

40%

FY13

1.0%

FY12

60%

FY11

1.5%

FY10

80%

FY09

2.0%

FY08

100%

FY07

2.5%

FY08

Provision coverage ratio (RHS)

8.8%

Gross NPAs

FY16

Exhibit 9: Tier-1 ratio has been strong over the years 13.7%

Exhibit 8: Gross NPAs have increased in recent years

FY15

Source: Company, Ambit Capital research; Ratios are annualised for 1HFY18

13.3%

Source: Company, Ambit Capital research

Source: Company, Ambit Capital research

Source: Company, Ambit Capital research

Exhibit 10: HDFC Bank is trading at a premium to its historical multiples

Exhibit 11: HDFC Bank has outperformed BSE Bankex by ~5x

6

600 500

5

400

4

300 200

3

100

2

Oct-17

Mar-17

Aug-16

Jan-16

Jun-15

Nov-14

Apr-14

Feb-13

Sep-13

Jul-12

Dec-11

May-11

Oct-10

Mar-10

Aug-09

HDFC Bank

Avg. PB

Source: Bloomberg, Company, Ambit Capital research

Jan-09

Jun-08

Oct-17

Jan-17

Apr-16

Jul-15

Oct-14

Jan-14

Apr-13

Jul-12

Oct-11

Jan-11

Apr-10

Jul-09

Oct-08

Jan-08

Apr-07

Jul-06

Oct-05

PB

Nov-07

0

Sensex Index

Source: Bloomberg, Company, Ambit Capital research

Exhibit 12: Explanation for our flags Segment

Score

Accounting

GREEN

Predictability

GREEN

Earnings momentum

GREEN

Comments Similar to all other Indian private sector banks, HDFC Bank uses intrinsic value of stock option to account ESOP expense. However, the bank disclosed that if Black Scholes model-based fair valuation was used, net profit would be adjusted lower by average ~8% over FY14-17. The bank has one of the best track records of long-term profitability. It has delivered on the guidance with very little room in variation. Consensus EPS estimates for FY18 and FY19 have been reduced by 3% each in past one year. We expect 19% EPS CAGR over FY17-20E.

Source: Ambit Capital research [email protected]

November 17, 2017

Ambit Capital Pvt. Ltd.

Page 64

HDFC Bank Balance sheet Year to March (Rs mn) Networth Deposits

FY16

FY17

FY18E

FY19E

FY20E

726,778

894,624

1,027,228

1,185,413

1,376,621

5,464,242

6,436,397

7,723,676

9,268,411

11,122,093

Borrowings

849,690

740,289

838,150

950,031

1,078,003

Other Liabilities

367,251

567,093

652,157

749,981

862,478

7,407,961

8,638,402

10,241,211

12,153,837

14,439,195

389,188

489,521

583,968

696,921

832,028

Investments

1,958,363

2,144,633

2,564,538

3,067,475

3,669,912

Advances

4,645,940

5,545,682

6,644,634

7,964,685

9,550,659

Other Assets

414,470

458,566

448,071

424,756

386,596

Total Assets

7,407,961

8,638,402

10,241,211

12,153,837

14,439,195

Total Liabilities Cash & Balances with RBI & Banks

Source: Company, Ambit Capital research

Income statement Year to March (Rs mn)

FY16

FY17

FY18E

FY19E

FY20E

Interest Income

602,214

693,060

788,275

935,476

1,114,852

Interest Expense

326,299

361,667

397,194

473,570

564,879

Net Interest Income

275,915

331,392

391,081

461,907

549,974

Total Non-Interest Income

107,517

122,965

142,395

159,519

181,635

Total Income

383,432

454,357

533,476

621,426

731,609

Total Operating Expenses

169,797

197,033

221,542

253,025

288,873

57,022

64,837

69,515

78,195

87,818

Employees expenses Other Operating Expenses

112,775

132,197

152,026

174,830

201,055

Pre Provisioning Profits

213,635

257,324

311,934

368,401

442,736

Provisions

27,256

35,933

48,804

54,508

63,316

PBT

186,379

221,391

263,131

313,893

379,420

Tax

63,417

75,894

90,203

107,605

130,068

122,962

145,496

172,928

206,288

249,352

FY16

FY17

FY18E

FY19E

FY20E

85.0%

86.2%

86.0%

85.9%

85.9%

PAT Source: Company, Ambit Capital research

Key ratios Year to March (Rs mn) Credit-Deposit (%) Cost/Income ratio (%) Gross NPA (Rs mn) Gross NPA (%)

44.3%

43.4%

41.5%

40.7%

39.5%

43,928

58,857

87,002

97,483

111,688

0.94%

1.05%

1.30%

1.21%

1.16%

13,204

18,440

30,451

34,119

39,091

Net NPA (%)

0.28%

0.33%

0.46%

0.43%

0.41%

Provision coverage (%)

69.9%

68.7%

65.0%

65.0%

65.0%

NIMs (%)

4.40%

4.37%

4.35%

4.29%

4.27%

Tier-1 capital ratio (%)

13.2%

12.8%

12.5%

12.3%

12.2%

Net NPA (Rs mn)

Source: Company, Ambit Capital research

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HDFC Bank Du-pont analysis Year to March

FY16

FY17

FY18E

FY19E

FY20E

NII / Assets (%)

4.1%

4.1%

4.1%

4.1%

4.1%

Other income / Assets (%)

1.6%

1.5%

1.5%

1.4%

1.4%

Total Income / Assets (%)

5.8%

5.7%

5.7%

5.5%

5.5%

Cost to Assets (%)

2.6%

2.5%

2.3%

2.3%

2.2%

PPP / Assets (%)

3.2%

3.2%

3.3%

3.3%

3.3%

Provisions / Assets (%)

0.4%

0.4%

0.5%

0.5%

0.5%

PBT / Assets (%)

2.8%

2.8%

2.8%

2.8%

2.9%

Tax Rate (%)

34.0%

34.3%

34.3%

34.3%

34.3%

ROA (%)

1.85%

1.81%

1.83%

1.84%

1.88%

Leverage

9.9

9.9

9.8

10.1

10.4

18.3%

17.9%

18.0%

18.6%

19.5%

Year to March

FY16

FY17

FY18E

FY19E

FY20E

EPS (Rs)

48.6

56.8

67.0

79.3

95.1

EPS growth (%)

16%

17%

18%

18%

20%

ROE (%) Source: Company, Ambit Capital research

Valuation

BVPS (Rs)

287.5

349.1

397.8

455.5

524.9

P/E (x)

38.4

32.9

27.9

23.6

19.6

P/BV (x)

6.49

5.35

4.69

4.10

3.56

Source: Company, Ambit Capital research

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HCL Technologies SELL November 17, 2017

HCLT IN EQUITY

Mcap (bn): 3M ADV (mn): CMP: TP (12 mths): Downside (%):

Flags Accounting: Predictability: Earnings Momentum:

GREEN GREEN AMBER

Performance

HCL Tech.

Sensex

Source: Bloomberg, Ambit Capital research

HCLT’s forensic score analysis

Second only to TCS on our IBAS framework HCLT has consistently innovated (3/4) to lower its cost structure. It has been able to deliver average EBIT margin of 19% (FY07-17) despite offering 30-40% cost savings to clients on each deal renewal and steady wage inflation though helped by depreciation of INR vs USD. HCLT scores well (3/4) on brand as it occupies a high client mind-share (source: third-party industry reports) as well as good reputation among employees, reflected in lower attrition (16% vs peer median of 18%). HCLT’s decent positioning on architecture (3/4) and strategic assets (3/4) reflects strong sales architecture built over years and client connect. Competitive positioning is dwindling with the IP acquisition spree Over the last two years, HCLT started aggressively investing in IP deals by partnering with global product majors like IBM. These deals relate to products approaching end of life, and we reckon their IRRs to be in low double digits. Besides the risk of continuous reinvestments on upgrade of these products, HCLT is also exposed to the risk of wasted management bandwidth. A service line centric organization structure adds to the risks. Valuations at 13x one-year forward P/E are not enticing enough given the above risks.

Source: Ambit ‘HAWK’, Ambit Capital research

HCLT’s greatness score analysis

S

A bit ‘HAWK’ A bit C

it l

h

Research Analyst Sudheer Guntupalli +91 22 3043 3203 [email protected]

[email protected] 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.

Nov-17

Sep-17

Aug-17

Jun-17

May-17

140 130 120 110 100 90 80

Rode the IMS wave, now well-positioned for IoT HCLT began as the R&D division of HCL Enterprise, which had developed an indigenous microcomputer in 1978. The inherited culture is a key ingredient of its success in outsourced engineering services (#1 in India, top-5 globally). Over 1996-2003, HCL formed a JV with Perot Systems which gave it access to highvalue US clients. It missed out on the “Y2K bug” boom because management thought it was temporary low-end work. However, since then, two large bets paid off. It pioneered offshore delivery of IMS in 2003-04 (38% of FY17 revenues, no.2 globally after IBM) and acquired Axon in 2009 (gave it relationships with CXOs in large organizations). Its next big bet is IoT, which would require it to build on capabilities in IMS and engineering services.

Rs1,241/US$19 Rs1,377/US$21 Rs870 Rs750 14%

Mar-17

One of the better performing large Indian IT services companies Since the GFC, performance of top firms has diverged with capital allocation, portfolio mix, operational excellence and management quality. HCLT has been one of the better performers on these metrics driven by bold bets on IMS and Axon that have paid off, strong capabilities in IMS and an excellent sales effort driven by Vineet Nayar (CEO over 2007-13). Over the past 10 years, HCLT’s revenue has posted 19% CAGR (USD, vs 17% for larger peers) and 23% CAGR (INR, vs 21% for larger peers).

Recommendation

Feb-17

HCLT’s discerning bets on Infrastructure Management Services (IMS) and engineering services (ES) have enabled it to deliver FY07-17 revenue CAGR of 19% (USD) vs. 17% for larger peers. Strong capabilities in these segments also position it well for the upcoming Internet-of-Things era. The company has had a stellar capital allocation track record (FY07-17 average RoE of 26%, its large acquisition of Axon has been successful). However, with 13 acquisitions in the past 24 months, we are concerned about a potential value-destructive deal, especially given the string of IP deals related to end-of-life products and low double-digit estimated IRRs. Current valuation of 13x one-year forward P/E does not offer adequate margin of safety. HCLT remains our top SELL in IT services. Competitive position: STRONG Changes to this position: STABLE

Technology

Dec-16

On a slippery slope

Nov-16

STRATEGY NOTE

HCL Technologies Exhibit 1: Evolution of HCL Technologies

Cloud / IoT

Software services

Infrastructure services

Engineering and R&D services

ROCE* (RHS)

50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% FY17

FY15

FY14

FY13

FY12

FY11

FY10

FY09

FY08

FY07

IMS & ES ramp up

FY16

6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500

BPO

Source: Ambit Capital research, company

Exhibit 2: Key financial parameters over the last decade (Rs mn)

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

FY17

1,763

2,078

2,574

3,320

4,035

4,539

5,180

5,822

6,235

6,975

39%

18%

24%

29%

22%

12%

14%

12%

7%

12%

13,732

9,787

12,156

14,361

21,014

36,313

57,138

73,209

73,365

84,325

Revenues ($ mn) Revenue growth (%) Net profits EPS CFO

13.4

7.3

8.9

10.3

15.0

25.8

40.4

51.9

51.9

59.7

15,282

21,272

11,811

14,584

18,493

27,096

63,481

55,422

71,067

94,010

CFO-EBITDA

1.1

1.0

0.5

0.6

0.5

0.5

0.8

0.6

0.8

0.9

8,786

17,507

6,864

7,353

10,021

22,490

57,527

44,110

61,310

60,988

-

0.70

0.42

0.31

0.20

0.11

0.05

0.02

0.03

0.02

RoE (%)

26%

18%

21%

19%

22%

29%

35%

35%

29%

27%

ROCE* (%)

26%

27%

20%

24%

31%

41%

46%

40%

38%

36%

FCF Debt equity (x)

Source: Company, Ambit Capital research. Note: *This is pre-tax RoCE which includes interest and dividend income along with EBIT in the numerator and total capital including cash in the denominator.

Exhibit 3: The key things to note from evolution Time period

Phase

Key developments

FY07-15

IMS and ES ramp up

FY15-

Cloud/IoT

 HCLT grew its revenues faster than peers because of IMS & ES  To remain insulated from cloud disruption and build on IoT capabilities

Source: Ambit Capital research, company

Exhibit 4: Competitive mapping of HCLT, TCS, Infosys, Wipro & TechM Company

Sub-Segment positioning

FY17 revenue ($)

Revenue CAGR FY10-17

Industry market share

EBITDA margin (FY17)

Pre-tax ROCE (FY17)

Pre-tax CFO/EBITDA (FY10-17)

Capex/CFO (FY10-16)

TCS

2

17,575

12%

38%

27%

53%

93%

16%

Infosys

4

10,208

11%

22%

27%

35%

97%

31%

Wipro

3

7,705

8%

16%

21%

23%

94%

26%

HCLT

1

6,975

15%

15%

22%

38%

84%

20%

TechM

NA

4,351

24%

9%

14%

29%

67%

56%

Source: Company, Ambit Capital research

[email protected] November 17, 2017

Ambit Capital Pvt. Ltd.

Page 68

HCL Technologies Exhibit 5: Mapping HCLT and peers on our IBAS framework Company

Innovation

Reputation

Architecture

Strategic asset

Overall rank Comments

TCS

Overall, TCS ranks on top of our IBAS framework. It has constantly innovated in areas of offshoring, pyramid correction, code re-use and moving up the value chain in terms of IT services (which is also reflected in its industry leading EBIT margin 26.5%, FY17). TCS developed the reputation of a “value for money” vendor which makes it a preferred choice of clients especially for annuity kind of Run The Business (RTB) projects. It also has the reputation of an employee friendly organization which is reflected in its low attrition rate (15%, FY17). Focus on delivery, unique organizational structure driving margin expansion makes TCS score well on architecture aspect. Client connects ($50mn clients = 78 which is almost 2x of the nearest competitor), make it rank well on strategic assets aspect.

Infosys

Infosys ranks second on our IBAS framework along with HCLT. The company scores well in areas of offshoring, pyramid correction, code re-use which is reflected in its high EBIT margins (24%, FY17). However, it could not establish a niche for itself in any particular vertical or service line which makes it an average scorer on reputation aspect. It lags well behind TCS in terms of its organizational structure (issues regarding placement of consulting practise in hierarchy) and strategic assets (client connects).

Wipro

Wipro lags behind other four big players on (overall score of ¼) on our IBAS framework. Wipro is not as successful as TCS/Infosys in terms of pyramiding, code re-use which is also reflected in its lower EBIT margin (19.5%, FY17). Though the company has been at the forefront of adopting new technologies, it could not scale them up (and hence given away market leadership to HCLT in IMS). Strategic assets (client connects) are not strong (as in the case of TCS or Infosys) as it used to rotate relationship managers every 18 months. Wipro runs a silo-ed organizational structure which lacks vertical based selling experience. These factors make the company score low on architecture and strategic assets.

HCLT

HCLT ranks second on our IBAS framework along with Infosys. The company maintained decent margins (20%, FY17) and ROCE (22%, FY17) by keeping utilization (84%) high, pyramid correction and code re-use. The company has built a strong reputation of being among top-2 IMS vendors globally (ahead of all Indian peers) and top-5 ES vendors (ahead of all Indian peers) globally which makes it score well on Reputation. The company has built the architecture of an aggressive sales led organization with client relationships in IMS and ES become strategic assets to cross sell other services.

TechM

Though the current EBIT margins of TechM are significantly lower than its peers (11%, FY17), this cannot be interpreted as weakness of the company in terms of offshoring, pyramid correction and code re-use. Margins of the company have taken a hit because of recent acquisitions like LCC (normalized margin is 19.4% in FY14). The company has built the reputation of being the strongest player in telecom segment (ahead of all Indian peers). The company also has the DNA of successful growth derived in inorganic route and marquee clients especially in telecom segment. Overall, the company fits into above average bucket on IBAS framework.

Source: Company, Ambit Capital research

[email protected] November 17, 2017

Ambit Capital Pvt. Ltd.

Page 69

HCL Technologies Exhibit 6: Sources of cash over the last 10 years (FY07-17)

Exhibit 7: Uses of cash over the last 10 years (FY07-17)

4%

7%

16% 33% 60% 80%

CFO

Asset sale

Cash Flow from Financing

Dividend

Capex

Acquisitions

Source: Company, Ambit Capital research

Source: Company, Ambit Capital research

Exhibit 8: One year forward P/E evolution

Exhibit 9: HCLT’s share price performance vs Sensex

18

180 160

16

140 120

14

100

12

80

Avg

Source: Company, Ambit Capital research

HCLT IN

Oct-17

Sep-17

Aug-17

Jul-17

Jun-17

May-17

Apr-17

Mar-17

Feb-17

Jan-17

Dec-16

Oct-17

Apr-17

Oct-16

Apr-16

Oct-15

Apr-15

Oct-14

Apr-14

Oct-13

Apr-13

Oct-12

Apr-12

Oct-11

P/E

Nov-16

60

10

SENSEX

Source: Company, Ambit Capital research

Exhibit 10: Explanation for our flags Segment Accounting Predictability Earnings momentum

Score

Comments

GREEN

Our proprietary forensic accounting tool Hawk places HCL Tech in ‘Zone of safety’ in terms of Accounting policies.

GREEN

The management issues annual guidance and earnings surprises over the past eight quarters have averaged less than 5%.

AMBER Bloomberg shows multiple downgrades to consensus numbers in last 8 weeks.

Source: Ambit Capital research

Exhibit 11: Forensic score evolution

Exhibit 12: Greatness score evolution

Source: Ambit ‘HAWK’, Ambit Capital research

Source: Ambit ‘HAWK’, Ambit Capital research

[email protected] November 17, 2017

Ambit Capital Pvt. Ltd.

Page 70

HCL Technologies Balance sheet (consolidated)* Rs bn Net Worth Other Liabilities

FY16

FY17

FY18E

FY19E

FY20E

277

345

350

395

442

22

18

18

18

18

Capital Employed

300

363

368

414

460

Net Block

106

166

179

186

193

Other Non-current Assets

40

40

35

35

35

247

272

266

315

368

Debtors

76

85

93

101

112

Unbilled revenues

30

26

28

30

33

Cash & Bank Balance

117

131

114

149

184

Other Current Assets

24

31

31

34

38

Current Liab. & Prov

94

115

112

122

135

Curr. Assets

Net Current Assets

153

158

154

193

232

Application of Funds

300

363

368

414

460

FY16

FY17

FY18E

FY19E

FY20E

6,235

6,975

7,775

8,492

9,431

Growth

7.1%

11.9%

11.5%

9.2%

11.1%

Revenue

409

466

501

548

608

Cost of goods sold

Source: Company, Ambit Capital research

Income statement (consolidated)* Rs bn Revenue (US$ mn)

275

316

343

393

446

SG&A expanses

52

55

58

57

65

EBITDA

88

103

109

106

106

Depreciation EBIT EBIT Margin

6

8

9

8

9

82

94

100

98

97

20%

20%

20%

18%

16%

Other Income

10

9

10

10

12

PBT

92

104

110

108

109

Tax

19

19

22

22

22

Reported PAT

73

84

88

86

87

Diluted Adj EPS

52

60

61

60

61

Source: Company, Ambit Capital research

[email protected] November 17, 2017

Ambit Capital Pvt. Ltd.

Page 71

HCL Technologies Cash flow statement (consolidated)* Rs bn

FY16

FY17

FY18E

FY19E

FY20E

Net Income

73.4

84.3

87.5

85.8

86.9

Depreciation

5.7

8.3

9.1

7.8

8.9

CF from Operations

73.5

93.8

96.6

93.6

95.8

Cash for Working Capital

(2.4)

0.2

(7.7)

(3.7)

(4.8)

Net Operating CF

71.1

94.0

88.9

89.9

91.0

Net Purchase of FA

(9.8)

(33.0)

(13.6)

(15.0)

(16.7)

Acquisitions

(179.2)

(144.2)

178.1

5.9

7.9

Others

(33.1)

(10.4)

11.5

0.4

0.5

Net Cash from Invest.

(42.8)

(43.4)

(2.2)

(14.6)

(16.1)

Proceeds from Equity & other

0.0

-

-

-

-

Dividend Payments

(33.7)

(40.6)

(33.8)

(40.3)

(40.3)

Cash Flow from Fin.

(28.4)

(44.4)

(67.7)

(40.3)

(40.3)

61.3

61.0

75.2

74.9

74.3

103.6

119.5

126.1

114.4

149.4

(0.1)

6.2

19.0

35.0

34.6

FY16

FY17

FY18E

FY19E

FY20E

P/E

17.5

15.2

14.9

15.2

15.0

EV/EBITDA

13.5

11.5

10.8

11.2

11.1

2.9

2.5

2.4

2.2

1.9

14.4

12.5

11.8

12.1

12.2

4.6

3.7

3.7

3.2

2.9

2.4%

2.6%

1.8%

2.6%

2.6%

RoE

29%

27%

25%

23%

21%

RoCE

24%

23%

22%

19%

17%

ROIC

39%

37%

33%

30%

28%

Receivable days (Days)

95

87

87

87

87

Fixed Asset Turnover (x)

4.3

3.4

2.9

3.0

3.2

Free Cash Flow Opening cash balance Net Cash Flow Source: Company, Ambit Capital research

Ratio analysis (consolidated)* Valuation (x)

EV/Sales EV/NOPAT Price/Book Value Dividend Yield (%) Return Ratios (%)

Turnover Ratios

Source: Company, Ambit Capital research

[email protected] November 17, 2017

Ambit Capital Pvt. Ltd.

Page 72

Lupin NOT RATED LPC IN EQUITY

Legacy under threat?

Healthcare

From India to USA; journey from weak product portfolio to complex one Until FY07, Lupin had an India-heavy revenue profile with product portfolio in slow-growing acute therapies. Management realised changing trends in Indian pharma consumption and switched to lifestyle disease chronic products that grew faster than IPM. Similarly, in the US, management realised product-specific opportunities and capitalised during FY13-16 (US revenue CAGR of 23%). Lupin’s capability to adapt to changing environments has led to margin/RoCE expansion. While peers focused on acquisitions to grow, Lupin primarily grew organically. Early entry into the Japanese market is an advantage over peers. Ranks 2nd on sector framework; needs to improve on innovation Focus has been on creating strategic assets through investment in Japan, presence in complex generics in the USA and de-risking of the US business through multiple USFDA-approved facilities to strengthen its business mix. Lupin has a credible branded franchise in India with a broad-based product portfolio (Top 10 brands contribute only 20% of revenue). Limited key man risk is led by decentralised decision making. Scope to improve MR productivity in India and higher investments in biosimilars, NCEs and NDDS (innovation) can improve comparative standing.

Flags Accounting: Predictability: Earnings Momentum:

RED AMBER RED

Performance 150 130 110 90 70

Lupin

Sensex

Source: Bloomberg, Ambit Capital research

Lupin’s forensic score analysis

Source: Ambit ‘HAWK’, Ambit Capital research

Lupin’s greatness score analysis

Source: Ambit ‘HAWK’, Ambit Capital research

Valuations will take time to rerate At current valuation of 17x FY19E consensus earnings, there is scope for a rerating emerging from: a) receding concerns in the USA (2HFY19E), b) wellentrenched management, c) strong balance sheet, and d) excellence in execution. However, the recent warning letter, uncertainty around launches and pricing in the US will delay a rerating. Near-term catalysts to watch for are: (a) gTobi and gTamiflu launches in 4QFY18; (b) Prevacid ODT, Coreg CR and gLialda launches in FY19; and (c) further cost efficiencies. [email protected] 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.

Nov-17

Sep-17

Aug-17

Jun-17

50 May-17

Lupin has championed the art of business evolution (from plain oral solids to complex generics) without compromising on profitability and stakeholder interests. Lupin transitioned from anti-TB company (more than 50% of revenues in FY06) to higher-growth CVS/Diabetes/CNS, resulting in revenue CAGR of 23% over FY07-17. In the USA, Lupin evolved its revenue profile from plain oral solids to filing for complex generics. Revenue per ANDA improved from US$3.7mn in FY08 to US$6.5mn in FY16. Over the past couple of years, Lupin’s investments in the USA have come to the fore as it has added differentiated products and expect them to materialise in the medium term, but this is now getting delayed because of the warning letter.

`374/US$5.7 `2,259/US$35 `827 n.a. n.a.

Mar-17

Vision to move from oral solids to complex generics materialises

Mcap (bn): 3M ADV (mn): CMP: TP (12 mths): Upside (%):

Feb-17

Changes to this position: STABLE

Recommendation

Dec-16

Lupin transitioned from API to plain oral solids to complex generics due to management’s vision/agility in tapping the changing dynamics. We had considered Lupin as one of the biggest beneficiaries of GDUFA given presence in complex generics and pipeline of ~150 ANDAs. However, the US business is coming under pressure because of price pressure in the base business due to channel consolidation in the US and repetitive quality issues at its facilities delaying product approvals. However, India’s faster than IPM growth driven by higher composition of chronic therapies and first-mover advantage in Japan will provide support to earnings albeit with some margin decline. Reduction in R&D, underperformance of Gavis acquisition and limited investments in innovation are emerging structural challenges. Stock trades at 17x FY19 consensus earnings, which is at a marginal discount to peers. Competitive position: STRONG

November 17, 2016

Nov-16

STRATEGY NOTE

Lupin

` Bn

Exhibit 1: Evolution of Lupin

200 180 160 140 120 100 80 60 40 20 -

Making inroads in the US business led by launch of plain oral solids; enetering chronic space in India.

Indian business driven growth with India contributing 60% of overall revenues

FY05

FY06

FY07

FY08

India

FY09

FY10

US generics

FY11

FY12

Benefits of patent cliff with Lupin launching limited competiion products in the US market

FY13

Others (RoW , API)

FY14

FY15

FY16

45% 40% 35% 30% 25% 20% 15% 10% 5% 0%

FY17

RoCE (RHS)

Source: Company and Ambit Capital research. Note: RoCE is pre-tax RoCE.

Exhibit 2: Strong growth and RoCE over the past decade but a sharp decline in RoCE in FY17 (Rs mn) Revenues Revenue growth (%)

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

FY17

28,917

38,666

48,708

58,190

70,829

96,413

112,866

127,700

142,555

174,943

44%

34%

26%

19%

22%

36%

17%

13%

12%

23%

4,083

5,015

6,816

8,626

8,677

13,142

18,364

24,032

22,607

25,575

9.9

12.1

15.3

19.3

19.4

29.4

41.0

53.5

50.2

56.6

2,585

4,695

6,764

7,980

5,600

12,510

20,039

27,331

(3,824)

41,148

59%

78%

86%

88%

60%

79%

92%

102%

21%

117%

FCF

241

1,308

72

7,990

549

7,097

14,787

18,655

(61,639)

15,141

Gross debt equity (x)

0.94

0.86

0.44

0.35

0.41

0.22

0.09

0.06

0.64

0.59

RoE (%)

38%

37%

34%

29%

24%

29%

30%

30%

23%

21%

ROCE* (%)

25%

24%

26%

24%

23%

31%

38%

37%

23%

18%

Net profits EPS CFO Pre tax CFO/EBITDA

Source: Company, Ambit Capital research. Note: *This is pre-tax RoCE which includes interest and dividend income along with EBIT in the numerator and total capital including cash in the denominator.

Exhibit 3: The key things to note from evolution Time period

Phase

Key developments

 Lupin derived 60% of its revenues from its Indian business comprising primarily of anti-TB portfolio (contributing 50% of the Indian business).  Within its Indian business, the company relied on acute portfolio which is a low-margin business (consolidated Indian business drives FY05-FY07 EBITDA margins