Q2 2024-25 Letter – East Green PMS

Dear Investor,

As we end the second quarter of this financial year, certain headwinds appear to have come on the horizon. The usual question of ‘Is it a good time to invest’ is on the lips of many investors. Let us try to answer this question by looking at various data points.

Domestic concerns:
- Valuation on the higher side (trailing PE ratio for Nifty is ~23.5x, higher than its three-year median of 22x)
- There are concerns about a potential slowdown in earnings growth in the next few quarters. This is partly due to a high base in the last year. Any shift in investor sentiment due to this will require careful monitoring and will impact various sectors differently.
- Rural consumption has been subdued for many quarters. Although there are some signs of recovery, particularly with good monsoons, we will need to monitor earnings and other data before coming to any conclusions.

Global dynamics:
- With some weakness finally showing up in the American labour market, the Fed has begun its much-anticipated rate cuts. For some years now, analysts have been predicting a recession in the US economy. Recessions typically come close to the beginning of rate cuts and so historical data suggests that one is due very soon. Although, for now, the US market indices are making fresh highs!
- In this quarter, we also saw the unwinding of the yen carry trade. This increased volatility globally for some days. Although this was temporary, this points to the possibility of similar risks on the horizon for the markets.

These immediate concerns are counterbalanced by several long-term positives for the Indian economy and equity market:

Domestic investor participation – Retail investor participation continues to grow, with a record number of new demat accounts getting opened and steady inflows into mutual funds through SIPs.
Economic tailwinds – India is amongst the fastest growing economies in the world and is expected to remain so in the immediate future as well.
Government reforms and initiatives – The government’s continued focus on infrastructure development and PLI (Production Linked Incentive) schemes is expected to boost capital expenditure.
Demographic dividend – India’s young, growing workforce continues to be a long-term positive for economic growth and domestic consumption.
Good health of financial system – India is probably the best placed major economy right now in terms of the health of its financial system with record low NPAs.
China plus one – India could be one of the beneficiaries of global supply chains de-risking from China.

While we remain mindful of near-term challenges, these positive factors reinforce our conviction in the long-term potential of the Indian stock market.

Market implications and investment strategy in current conditions

The combination of domestic growth/valuation concerns and global uncertainty may lead to increased market volatility in the near term.

In such a situation, investors typically resort to one or many of these strategies:

Sector rotation: Shift allocation to defensive sectors (e.g. consumer staples) and to businesses less dependent on external factors or exports.
Focus on quality: Buy companies with very strong balance sheets and cash flows.
Strict risk management: Diversify across sectors and market caps.
Asset allocation changes: Reduction in portfolio allocation to equities.

However, pre-empting market conditions comes with its own opportunity costs. There is always the temptation of wanting to perfectly time the market, but even seasoned investors struggle with this. The combined psychology of all participants drives the market and human decision making, by its very nature, cannot be perfect. As investors, our job should be to analyse dispassionately, manage risk and above all listen to what the market is saying. However, our own behavioural biases come in the way of conducting this objective analysis. Let us see some behavioural biases involved in wanting to time the market:

Overconfidence Bias (I saw on the news; the market is frothy!): Many investors overestimate their ability to predict market movements. However, consistently timing the market is nearly impossible, even for experienced professionals.
Recency Bias (Market has run up too much in the last few months!): The tendency to place too much importance on recent events can lead investors to make decisions based on short-term market performance, potentially missing out on long-term growth opportunities.
Anchoring (Nifty cannot go beyond 24,000 so quickly!): Fixating on a specific price point or past market high can prevent investors from recognizing value in current market conditions.

This brings us to the earlier point about opportunity costs. Investors fail to realise the hidden cost of waiting. Perhaps the most significant and often overlooked aspect of trying to time the market is the opportunity cost of waiting for a correction. Historical data provides a compelling case against this strategy. Studies have shown that the potential gains from investing during market corrections are often dwarfed by the returns missed while waiting on the sidelines. For instance, an analysis of any market index over several decades reveals that missing just the 10 best days in the market would have reduced overall returns by nearly half compared to staying fully invested. This effect is even more pronounced in rapidly growing markets like India, where the opportunity cost of missing strong market days can be substantial.

To counter these biases, we advocate for:

Systematic Investing: Regular, planned investments help avoid the pitfalls of trying to time the market.
Diversification: A well-diversified portfolio can help manage risk and reduce the impact of market volatility.
Long-term Perspective: Focusing on long-term financial goals rather than short-term market fluctuations.
Emotional Discipline: Making investment decisions based on thorough analysis and predetermined strategies, not on emotions or market noise.

Remember, time in the market is often more crucial than timing the market. Historical data consistently shows that staying invested through market cycles tends to yield better results than attempting to time entries and exits.

From the perspective of the Indian market, even though near-term challenges exist, the long-term growth potential remains strong supported by favourable demographics and ongoing structural reforms. The current market conditions may provide an opportunity for patient investors to build positions in fundamentally strong companies.

In light of these developments, our investment approach remains disciplined yet adaptive. We continue to focus on companies with strong fundamentals, sustainable business models, and the ability to navigate economic cycles. While we acknowledge the short-term uncertainties, we remain committed to capitalising on India’s long-term growth story.

For investors, times like these underscore the importance of a well-thought-out, diversified investment strategy aligned with individual risk tolerances and financial goals. While market volatility can be unsettling, it’s crucial to maintain a long-term perspective and avoid reactive decisions based on short-term market movements.

Agile Strategy Performance

East Green’s Agile strategy has delivered a return of 37.1% (annualised, post fee and expenses) since its inception in July 2023. Over the same period, the return for S&P BSE 500 TRI was 36.7% and for Nifty 50 TRI it was 27.4%. The Sharpe ratio in this period was 1.90 and the Sortino ratio was 2.08, implying a superior return on a risk adjusted basis.

Note: East Green return numbers mentioned here are time weighted and are calculated net of all fees and expenses. These have not been verified by SEBI. Additionally, performance of individual client portfolios may differ during the period.

Agile Portfolio Overview

At the end of this quarter, the sectors with highest allocation were industrials (continuing capex), other financials (increasing participation in capital markets) and NBFCs (credit upcycle). Sectoral allocation keeps getting dynamically adjusted as needed.

Note: Individual portfolios may differ depending on time of investment and subsequent capital addition/withdrawals

Key changes to the portfolio this quarter:

Trimmed position in a pharmaceutical company when the stock price ran up quickly this quarter; exited it completely when details of a US FDA observation got released.
Added a diagnostic company to the portfolio. The company is primarily focused on radiology and gets most of its revenue from Southern India. It has aggressive growth plans and has one of the best margins and ROCE in the industry. The stabilisation of prices in the diagnostic market is an overall positive for the entire sector.
Exited the two textile companies when successive quarterly earnings failed to deliver on the expectation of growth rebound.
Initiated position in a newly listed e-commerce player which is dominant in a niche segment. It has aggressive growth plans and is also displaying a continuous improvement in profitability.
Added a couple of companies in the renewable energy segment. They have very attractive order books and with the continued push by the government in the power sector, the growth prospects for both appear strong.
Initiated position in a newly listed NBFC with a strong management track record and listing at an attractive valuation.

Quant Strategy Performance

Our Quant strategy, which was initiated in May 2024, has delivered a return of 16.6% (post fee and expenses) vs 16.4% for S&P BSE 500 TRI and 15.8% for Nifty 50 TRI in the same period. The Sharpe ratio for the strategy during this period was 1.32 and the Sortino ratio was 1.30. Since this is a new strategy and new investors have been adding capital through the quarter, the actual returns in investor portfolios would be higher than in the reported numbers which has a drag because of initial capital additions being proportionately high as a % of the AuM.

Quant Portfolio Overview

July and August were massively outperforming periods for Quant portfolio. However, the month of September was a period of underperformance.

The entire quarter was characterised by a stable market regime, which provided a favourable environment for our approach. Volatility stayed low, except a short period of high volatility due to the yen carry trade unwinding. However, that didn’t trigger our risk-off signals, and we did not reduce allocation in equities.

Despite overall stability, we observed significant sector movements. Our overweight in PSU/railways/defence sectors proved beneficial in earlier months but dragged down the return in September. The model has since then exited them and moved into industrials and energy.

As happens in the normal course of business, certain metrics and parameters were tweaked and the portfolio remains fully invested in equities as of 30th September, showcasing the health of Indian markets. However, things might change in the near future. Looking ahead, we remain vigilant for potential regime shifts while confident in our strategy’s adaptive capabilities.

Market Outlook and Way Ahead

There have been multiple sources of volatility in the past few months. Elections, budget, conflicts, yen carry trade unwinding, uncertainty around US Fed actions, Chinese stimulus, and so on. The Indian stock market has taken all these in its stride and continued to stay strong. At the time of writing this, we are seeing incessant FII selling, and the indices have understandably corrected as well. The extent of correction from the top (~6% for Nifty), however, is minor for the scale of FII exits ($10 billion in October at the time of writing).

The overall growth trajectory of the Indian economy and the rise of domestic flows into equities (through funds and directly) are responsible for this unprecedented strength. This doesn’t mean that we cannot have deeper corrections in the immediate future or that there are no risks in the market right now. Those would be very wrong conclusions to draw. What is clear, though, is the confidence of the investor community in India’s growth prospects. In that sense, we as investors in Indian equities, are fortunate to have this once in a generation opportunity in front of us. Going back to where we started this letter, it is imperative that we do not lose sight of this long-term picture due to near term fluctuations. It is advisable to stay invested, maintain discipline and not try to pre-empt the market. This is exactly what we intend to do at East Green!

Best Regards,

East Green Advisors LLP

Disclaimer/Disclosure:

This document is issued by East Green Advisors LLP [East Green PMS]. This document has been prepared and issued on the basis of internal data, publicly available information, and other sources believed to be reliable. The purpose of this letter is to provide general information about the market and the house view of East Green Advisors LLP. It is produced for information purposes only and should not be construed as investment advice to any party. It does not constitute a prospectus or offer document or an offer or solicitation to buy any securities or other investment. All opinions, figures, charts/graphs, estimates, and data included in this document are as of the date of issuance and are subject to change without notice. While utmost care has been exercised while preparing this document, East Green PMS does not guarantee the absolute accuracy of the information provided and disclaims all liabilities, losses, and damages arising out of the use of this information. The statements contained herein may include forward-looking statements that are based on our current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance, or events to differ materially from those expressed or implied in such statements. Readers shall be fully responsible and liable for any decision taken on the basis of this document. Investments in securities are subject to market and other risks. East Green PMS does not offer any guaranteed or assured returns. Please read the disclosure document carefully before investing. Past performance should not be taken as an indication or guarantee of future performance. Additionally, the performance data mentioned here has not been verified by SEBI.