Monthly Newsletter

February 2018

February, 2018 Ambit Asset Management. Page 1

 Monthly Newsletter

Macro overview
Beginning of volatility but not end of uptrend

Global equity markets have been characterized by an unusual calm over the last several years. Volatility has stayed
artificially low helped by extremely low interest rates and easy money conditions across the globe. This trend however is
changing rapidly over the past few months. Yields globally have been on the rise, with US 10-year bond yields now at a
four year high of 2.82%. The good news is that this rise in yields owes its roots to an improving global economy.
Economic data from the US, Europe and increasingly emerging markets has been encouraging. (IMF now forecasts 2018
and 2019 global GDP growth at 3.9% vs. 3.7% in 2017 and 20bps higher than its October 2017 forecast).
Exhibit 1: Equity volatility stayed artificially suppressed in Exhibit 2: …but yields have spurted over the past year led
recent years due to unprecedented low interest rates… by improving economic environment

45 4 Increase (bps) in 10 YR Bond yield Since June 2016

40 3
35 3
30 2 UK
25 2
20 1
Germany
15 1
10 0
Oct-14
Sep-11
Feb-12
Aug-12
Jan-13
Jun-13
Nov-13
Apr-14
Sep-14
Feb-13
Jul-13
Dec-13
May-14

Mar-15
Aug-15
Jan-16
Jun-16
Nov-16

US

- 50 100 150
India VIX US Vix US 10YR Bond % (RHS)
US Germany UK

Source: Bloomberg Source: Bloomberg

Improving economic activity is good news for corporate earnings. Especially for corporate India, earnings have stayed
suppressed for the last decade or so and now with disruption around demonetization and GST behind, and positives of
the reform process likely to benefit the organized, listed company universe, we believe earnings are turning the corner.
We therefore believe that equity markets are now moving away from being liquidity supported towards
being earnings driven. The flip side of this however is that as economy improves, liquidity environment will keep
getting tighter, which in our view will act to increase volatility in equity markets across the globe.

Net net, we think investors should brace for more volatility going ahead even as market trend should stay up. This could
be similar to the 2004-2007 period in Indian equities, where earnings were strong and yet liquidity kept getting tighter
leading to a strong bull market but with very high volatility. Even as the Nifty registered a 37% CAGR during that period,
there were 22 episodes of over 5% intermittent correction and 7 episodes of over 10% correction, with 2 episodes even
extending beyond 20% decline.

Exhibit 3: Despite significant volatility (see drawdowns), Exhibit 4: …helped by healthy earnings growth even as
Nifty delivered strong returns during FY04-07… liquidity kept getting tighter globally

100% 5,000 40% 6%

80% 30% 5%
4,000
60% 20%
3,000 4%
40%
10%
20% 3%
2,000 0%
0%
FY01
FY02
FY03
FY04
FY05
FY06
FY07
FY08
FY09
FY10
FY11
FY12
FY13
FY14
FY15
FY16
FY17

2%
1,000 -10%
-20%
-20% 1%
-40% -
Sep-04 Jul-05 May-06 Mar-07 -30% 0%

Nifty drawdown Nifty (RHS)

Sensex EPS growth 10 YR US Bond yield

Source: Bloomberg , Ambit Source: Bloomberg, Ambit

February, 2018 Ambit Asset Management. Page 2

 Monthly Newsletter

Ambit Good & Clean

Ambit's Good & Clean strategy provides long only equity exposure to Indian businesses that have an impeccable track
record of clean accounting, good governance, and efficient capital allocation. Ambit’s proprietary ‘forensic accounting’
framework helps weed out firms with poor quality accounts while our proprietary ‘greatness’ framework helps identify
efficient capital allocators with a holistic approach to consistent growth. Our focus has been to deliver superior risk-
adjusted returns with as much focus on lower portfolio drawdown as on return generation. Some salient features of the
Good & Clean strategy are as follows:
 Process oriented approach to investing: Typically starting at the largest 500 Indian companies, Ambit's proprietary
frameworks for assessing accounting quality and efficacy of capital allocation help narrow down the investible universe
to a much smaller subset. This shorter universe is then evaluated on bottom-up fundamentals to create a concentrated
portfolio of no more than 20 companies at any time.
 Long-term horizon and low churn: Our holding horizons for investee companies are 3-5 years and even longer with
annual churn not exceeding 15-20% in a year. The long-term orientation essentially means investing in companies that
have the potential to sustainably compound earnings, with this earnings compounding acting as the primary driver of
investment returns over long periods.
 Low drawdowns: The focus on clean accounting and governance, prudent capital allocation, and structural earnings
compounding allow participation in long-term return generation while also ensuring low drawdowns in periods of equity
market declines.

Look beyond the headline performance of January 2018

After the strong last quarter of CY17, CY18 begun on a weak note for us. While the performance in the month of
January has not done justice to what investors expect from us, we think that it was a very atypical month in more ways
than one:
 What went on at the headline index level wasn’t representative of what was happening in broader markets and
concealed the actual state of the market. Even as large cap indices surged, most stocks were down. For instance,
about two thirds of the BSE500 companies yielded negative returns (even as that index moved up 2.3%), with half of
them losing 3.2% or more.
 Moreover, the slim minority of stocks that surged, were actually laggards of the previous year (CY2017). On the
other hand, the better performers of CY2017 declined through the month (as seen in the exhibit below– Quintile 1
(top 20%) and Quintile 2 (next 20%) that generated the best returns in Jan’18 had the lowest returns in CY17.
Exhibit 5: The best return generating companies (BSE 500) in January 2018 have been amongst the worst performers in
CY17

BSE 500 constituents relative outperformance: CY17 vs 1M ending ending Jan'18

10%
1M outperformance (Jan'18)

Q1 (Best Jan 18
(relative to BSE 500)

5%
Performers)
0%
-10% -5% Q2 0% 5% 10% 15% 20%
Q3
-5%
Q4
-10%

-15%
Q5 (Worst Jan18
performer)
-20%
CY17 Share outperformance (relative to BSE 500)
Source: Ambit Capital, Bloomberg

Overall, we think Jan’18 was a very unusual month and shouldn’t be taken as representative of anything by long term
investors. Further, portfolio companies that have reported so far have seen healthy revenue growth and strong earnings
in 3QFY18 as shown in the exhibit below. We therefore don't believe that anything has fundamentally changed for our
portfolio stocks, and hope to recover fast enough. As already highlighted earlier, volatility will stay and investors who
look through it will be handsomely rewarded by markets.

February, 2018 Ambit Asset Management. Page 3

 Monthly Newsletter

Exhibit 6: G&C portfolio stocks* have witnessed healthy financial performance in 3QFY18
Average Median
Growth
YoY QoQ YoY QoQ
Revenue 15% 4% 12% 4%
EBITDA 15% 8% 16% 13%
EBITDA margin (basis points) 33bps 72bps 48bps 48bps
PBT 22% 15% 24% 11%
PAT 22% 17% 20% 12%
Source: Company, Bloomberg Note* The performance above reflects the 3QFY18 results of eight stocks constituting ~50% of G&C portfolio weight

Portfolio update – No significant changes

We have made no major changes to the portfolio in the past month. The company that we had last invested in last
quarter and where we continue to add is a leading player in an NBFC space. The company is evolving from an
LCV/used-CV financier to a credible challenger in other auto segments (cars, MUVs, 2Ws, used vehicles) through the
deployment of cutting-edge technology to reduce costs and adoption of "portfolio" approach to evaluate its employees.
This has not only helped it grow faster than the underlying market but also helped in improving margins.

On a sectoral basis, consumption companies, lenders and light manufacturing exporters comprise a bulk of our portfolio.
Some firms that do well on our process include the world’s second-largest manufacturer (and catching up fast with the
global leader) of high chrome mill internals, country’s leading and the most profitable branded innerwear company, a
specialty chemicals company that is the global leader (and by a large margin) in its key molecules, amongst others. We
believe most of these businesses will keep compounding at growth rates north of 20% for the next several years without
taking any undue risks in the process.

Exhibit 7: Returns of our Good & Clean strategy

Returns (%) Apr15 May15 Jun15 Jul15 Aug15 Sep15 Oct15 Nov15 Dec15 Jan16 Feb16 Mar16 FY16
G&C (4.8) 3.9 (2.6) 3.0 0.3 (1.1) 1.1 1.7 (0.8) (3.8) (8.7) 11.4 (1.8)
Nifty (6.8) 3.1 (0.8) 2.0 (6.6) (0.3) 1.5 (1.6) 0.1 (4.8) (7.6) 10.8 (11.2)
Returns (%) Apr16 May16 Jun16 Jul16 Aug16 Sep16 Oct16 Nov16 Dec16 Jan17 Feb17 Mar17 FY17
G&C 4.3 3.5 1.1 4.1 2.8 (0.8) 3.2 (6.2) (1.0) 6.3 2.2 3.9 25.2
Nifty 1.4 4.0 1.6 4.2 1.7 (2.0) 0.2 (4.7) (0.5) 4.6 3.7 3.3 18.5
Returns (%) Apr17 May17 Jun17 Jul17 Aug17 Sep17 Oct17 Nov17 Dec17 Jan18 FY18
G&C 3.2 0.8 1.4 1.0 (2.8) 0.8 4.8 2.8 5.3 (3.8) 13.9
Nifty 1.4 3.4 (1.0) 5.8 (1.6) (1.3) 5.6 (1.1) 3.0 4.7 20.2
Source: Bloomberg, Ambit. Portfolio inception date is Mar12, 2015. Returns for Mar’15 have been merged with Apr’16 and the same adjustment has been
made to index returns. Returns as of 31st January, 2018

Exhibit 8: Returns of our Good & Clean strategy

30
25.2
25
20.2
18.5
20
13.9
15
10
5
0
-5 FY16 (1.8) FY17 FY18

-10
-15 (11.2)
Nifty Good & Clean
th st
Source: Ambit Capital, Bloomberg. *Date of inception= 12 March 2015. Returns as of 31 January, 2018

February, 2018 Ambit Asset Management. Page 4

 Monthly Newsletter

Ambit Coffee Can

How punchy can the P/E multiple of a ‘great’ company be?
When it comes to investing in stock markets, greatness is defined as ‘the ability of a company to grow whilst
sustaining its moats over long periods of time’. Such great companies have repeatable and defensible earnings with
significant competitive advantages that defend their superior returns from the unrelenting assault of the competitors. Given
the consistent track record of such rare companies, their share prices ought to trade at higher multiples - but how much?

A large proportion of investors and financial analysts use short-cut methods to value companies. Some of these include
using 3/5/10-year historical average P/E or P/B multiples to arrive at the absolute valuation or using PEG (i.e. the ratio P/E
divided by expected earnings growth of a stock) ratios to identify overvaluation or undervaluation relative to peers. All
these methods anchor themselves either to historical valuations or to peers’ performances, which becomes an unjustified
comparison since it ignores two key aspects of ‘great’ businesses:
Firstly, valuation multiples or PEG ratios draw comparisons based only on their earnings trajectories whilst ignoring the
amount of capital reinvestment required to sustain that earnings trajectory. For instance let us assume that two companies
X and Y have the same earnings trajectories when A reinvests only 25% of its cash back into the business while B reinvests
50% of cash back into the business. Company A, which requires lower degree of capital reinvestment to deliver the same
earnings growth, deserves a higher valuation than B, since A leaves higher free cash flows in the hands of the
shareholders by generating a higher return on capital employed.
Secondly, PEG ratios or P/E multiples do NOT adequately capture the longevity of a franchise. For instance, let us assume
that two companies X and Y have the same capital investment and cash generation for the next 5 years. However, while X
can sustain its competitive advantages for 10 years, Y can sustain its competitive advantages for 20 years. In this case, Y
deserves a higher P/E multiple than X despite delivering the same set of financials over the next 5 years.
A Discounted Cash Flows based valuation best captures both, longevity as well as capital efficiency of great companies.
So how punchy can the fair value of a ‘great’ company be? Let us assume that an investor has identified a company
ABC which will deliver the following financial performance:
 Sustain an ROCE (Returns on Capital Employed) of 35% for the next 20 years (from 2018 to 2038); and
 Maintain a dividend payout ratio of 30% i.e. it reinvests the balance 70% earnings in the business and generates 35%
ROCE on this incremental capital employed.
Let us also assume that, thanks to the popular theory of ‘mean reversion’, in 2038 Company ABC will trade at the current
market average P/E multiple of 20x. This is possible if in 2037 there is no visibility of another 20-year runway for growth.
Now the big question is – “At what P/E multiple in 2018 will this company deliver market average returns over the
next 20 years?” The following points and the exhibit below show the result of this exercise for Company ABC:

 The BSE Sensex has delivered 11% CAGR over the past 25 years. So let’s assume 11% CAGR to be the likely market
return over the next 20 years.
 If the said company’s P/E multiple in 2018 is 210x (yes, you read that right, 210!) then this company will deliver 11%
compounded annualised returns over the next 20 years assuming a steady decline in its P/E to 20x by 2038.
 If, more realistically, ABC is available for investment at 50x P/E in 2018, then it will deliver 19.5% share price CAGR
over the next 20 years even as the company’s P/E declines from 50x in 2018 to 20x in 2038.
Exhibit 9: Conviction on fundamentals will give healthy returns even with high entry P/E
Earnings Capital Reinvestment of 20-year investment
Year Earnings ROCE P/E
growth Employed Earnings CAGR
0 100 286 35% 70% 50
1 125 24.5% 356 35% 70% 49
2 155 24.5% 443 35% 70% 47
3 193 24.5% 551 35% 70% 46
18 5,165 24.5% 14,756 35% 70% 23
19 6,430 24.5% 18,372 35% 70% 22
20 8,005 24.5% 22,873 35% 70% 20 19.5%
Source: Bloomberg, Ambit Capital; ROCE = Returns on Capital Employed

February, 2018 Ambit Asset Management. Page 5

 Monthly Newsletter

While the analysis discussed above makes theoretical sense, we highlight two practical examples where investing in great
companies at punchy valuations has been the right decision even as these valuations have significantly de-rated thereafter.
Example 1 - Asian Paints, 1994-2004: On 31st March 1994, Asian Paints was trading at a P/E multiple (trailing) of 38x
when the Sensex was trading at a P/E multiple of 47x. After a decade, by 31st March 2004, Asian Paints’ P/E multiple de-
rated to 20x as Sensex’s P/E multiple de-rated to 19x. Despite this de-rating, an investment in Asian Paints at 38x P/E
multiple in 1994 would have grown at 12% CAGR (excl dividend) till 2004, when Sensex delivered only 4% CAGR over the
same time period. This was because Asian Paints maintained an average ROCE of 32% with an average rate of
reinvestment of earnings being 54% over these 10 years (see exhibits on the left below). Moreover, as highlighted in the
exhibit on the right below, the period of 1994-2004 was not the only period when Asian Paints maintained a healthy
ROCE and capital reinvestment rate. It has had such stellar track record of consistency for more than seven decades in a
row!
Exhibit 10: Asian Paints’ share price Exhibit 11: Asian Paints’ fundamentals Exhibit 12: Asian Paints’ 70 years of
(1994-04) (1994-04) consistency

600 Retained Earnings % Revenue (CAGR for Prev. 10 years)

Share Price Pre-Tax ROCE %
500 P/E 70%
PBT/Capital Employed (LHS)
EPS 50% 20%
400 60% PBT Margin (RHS)
40%
300 50% 15%

200 30%
40%
10%
100 30% 20%
- 5%
20% 10%
1994
1995
1995
1996
1997
1998
1999
2000
2000
2001
2002
2003
2004

1994
1995
1995
1996
1997
1998
1999
2000
2000
2001
2002
2003
2004
0% 0%
1962 1972 1982 1995 2002 2012

Source: Bloomberg, Ambit Capital Source: Company, Ambit Capital Source: Company, Ambit Capital

Example 2 - Walmart, 1983-1996: On 30th December 1983, well-known retailer Walmart’s stock was trading at a P/E
multiple of 56x when S&P500 Index was trading at a P/E multiple of 12x. By 30th December 1996, Walmart’s P/E had
shrunk to only 17x whilst S&P500 Index’s P/E had risen to 19x. Despite this de-rating in its P/E multiple, Walmart delivered
a share price CAGR of 19% from 1983 to 1996 when S&P500 Index delivered a CAGR of 12% over the same period. This
stellar share price performance was delivered by Walmart despite its P/E multiple reducing to a third because the firm
maintained an ROCE of 34% whilst reinvesting on average, 87% of its annual cash flows back into the business.

February, 2018 Ambit Asset Management. Page 6

 Monthly Newsletter

Performance update – Ambit’s Coffee Can PMS

Exhibit below shows the performance of Ambit’s Coffee Can PMS. The portfolio comprises 11 stocks of high quality
companies, spread across Financials, Home Building Materials, Consumer Discretionary and Consumer Staples. There has
been no change in the list of holdings (i.e. zero churn) since inception. Since Ambit’s Coffee Can Philosophy seeks only
great franchises which can sustain their competitive advantages over long time period, our high conviction in the longevity
and capital reinvestment requirements of our portfolio companies implies that we continue to advise investors to buy such
great franchises even though our view is that fundamentals do NOT fully support current valuations of the broader market.

Exhibit 13: Ambit’s Coffee Can PMS performance update (as on 31st January 2018)

30%
Coffee Can PMS Nifty 50 25.2%
25% 23.0%
20%

15%

10%
5.8% 5.6% 3.9% 5.4% 4.7%
4.0% 3.4% 3.3% 3.0%
5% 2.3% 2.9% 2.3% 1.9% 2.2%
1.4% 0.9% -1.0%
-1.0% -1.6% -2.7%
0%
Mar'17* April'17 May'17 Jun'17 Jul'17 Aug'17 Sep'17 Oct'17 Nov'17 Dec'17 Jan'18 Since
-5% -1.2% -1.3% Inception

Source: Ambit Capital, Bloomberg. *Date of inception= 6th March 2017

February, 2018 Ambit Asset Management. Page 7

 Monthly Newsletter

Ambit Risk Optimizer

Ambit Risk Optimizer PMS is a low risk offering that seeks to generate superior risk-adjusted returns by optimizing asset
allocation to three common asset classes: Equity, Gold and Government Bonds. The fund uses a proprietary framework
to decide allocations to these assets, typically in inverse proportion to their risk profiles. The product seeks to enhance
debt returns without materially enhancing the risk profile. Basis empirical analysis, typical returns expectation should be
about 2.5%-3% better than bonds on a cross-cycle basis, which translates to about 10% net per annum, with a risk
profile similar to that of bonds. On most risk measures like standard deviation, maximum drawdown or worst 12 month
returns, the portfolio is expected to be similar to bonds.

Since going live eleven months ago, the portfolio has been on track to deliver 9% annualized returns, net of expenses.
More importantly, there hasn’t been any material drawdown so far. This is in spite of the fact that the asset class that is
the largest exposure of the fund, i.e. government bonds, has not done well during this period thanks to a continued
surge in bond yields. The low-risk nature of the product arises from diversification benefits achieved through the
combination of gold, equities and bonds. For example, even as bonds have continued to suffer past few months while
gold has broadly been sideways, a surge in equities has made sure that the product returns have stayed positive. On the
other hand, in the months of August and September, equities were down in each of those months but gold did well to
again ensure a decent outing for the product.

In the current investment environment, where investors grapple with lofty equity market valuations on one hand and
rising bond yields on the other, a process-oriented approach to asset allocation like the risk optimizer approach which
ensures low drawdown risk offers a prudent solution in our view.

Allocations
Allocations are a function of risk profiles of the three assets relative to each other (greater allocation to less risky asset
classes). However, basis history, 50-80% has been the indicative range of bonds, 10-35% on gold and 10-30% on
equities.

The current model allocation is bonds ~57%, equities ~24% and gold 20%.

Exhibit 14: Ambit’s Risk Optimizer performance update (as on 31st January 2017)

20
18.1 18.1
18
16 15.2

14
11.8
12
Returns, %

9.7 9.3
10 8.5
8.2
8 7.3 7.1

6 5.3
4.0
4
1.5 1.5 1.27
2 0.98 0.68 0.61 0.44 0.81 0.33 0.59
0 0
0
Mar'17 Apr'17 May'17 Jun'17 Jul'17 Aug'17 Sep'17 Oct'17 Nov'17 Dec'17 Jan'18 Since
Inception
Absolute Annualized *

Source: Ambit Capital. *Date of inception= 28thFeb 2017

February, 2018 Ambit Asset Management. Page 8

 Monthly Newsletter

Disclaimer
Ambit Capital Private Limited (“Ambit”) is a registered Portfolio Manager with Securities and Exchange Board of India vide registration
.number INP000002221.

This presentation / newsletter / report is strictly for information and illustrative purposes only and should not be considered to be an offer, or solicitation
of an offer, to buy or sell any securities or to enter into any Portfolio Management agreements. This presentation / newsletter / report is prepared by
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You are expected to take into consideration all the risk factors including financial conditions, Risk-Return profile, tax consequences, etc. You
understand that the past performance or name of the portfolio or any similar product do not in any manner indicate surety of performance of such
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Ambit does not guarantee the future performance or any level of performance relating to any products of Ambit or any other third party service
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Further Ambit shall not be liable for any loss which may have arisen by wrong or misleading instructions given by you whether orally or in writing.

February, 2018 Ambit Asset Management. Page 9