Quyn Capital Annual Letter 2022
Annual letter for 2022 to our partners at Quyn Capital.
Introduction
The year 2022 was another historic year for Sri Lanka, again for all the wrong reasons. In last year’s annual letter I wrote about the foreign exchange crisis and it turned out I was rather optimistic, as the crisis ended up being significantly worse.
The causes of the crisis have been well documented, you can read more about what got us here by following the work of some prominent media outlets (I will post links to their articles at the end of this letter). The focus of this letter is instead going to be on how to think about the crisis, the damage to the businesses we own caused by the crisis, and how we can emerge from the crisis.
Let’s start with some basics on the economy.
Understanding what GDP really means
You may have heard the term GDP being thrown around, a measure commonly used to track overall economic performance. GDP or real gross domestic product is the total value of goods and services produced in the country adjusted for inflation. You want to think of it as the number of goods and services an economy produces in a certain period of time. It also includes the amount of income the country earned.
Sri Lanka produced about $68 Billion in 2012. Since 2012, Sri Lanka has grown GDP between 2–4 percent per year over the last 10 years, to produce about $83 Billion in 2021. In order for the economy’s productive capacity to grow over this time, more workers were employed, investments in machines and other equipment were made (for those workers to use) and sophisticated technology was also added. So this is a very real amount of value added to the overall economy that affects many people’s lives in Sri Lanka. Now, economists argue about the total value added to the overall economy during this period, however, most agree at least some real value has been added to the economy. All of this has now been impacted due to the economic crisis.
The consequences of large negative GDP growth due to the crisis
In August earlier this year, Central Bank Governor Dr. Nandalal Weerasinghe projected an 8% decline in total GDP this year. Meanwhile, the Sri Lankan Rupee rapidly depreciated by about 90% against the US Dollar. That is a large amount and significant enough to indicate that this economic crisis is one of the most severe in our history.
Since many of you already feel the consequences of the depreciation of the Sri Lankan Rupee (we all share the horror of looking at our latest grocery bills), I will instead expand upon why that negative 8% in GDP growth is of significance.
An 8% decline in GDP growth means Sri Lanka will roughly be unable to produce about $6.6 Billion in output for 2022 that it could have produced just a few years before. That is a huge amount. To put it differently, think about MAS Holdings, one of Sri Lanka’s largest companies produces about $2 Billion in revenue per year and employs about 76,000 people in Sri Lanka alone. The company is responsible for a large portion of Sri Lanka’s foreign exchange income. The decline is equivalent to over 3 companies of the size of MAS completely shutting down for the year. A truly shocking prospect.
These aren’t some imaginary or paper losses, we are talking about products that could have been manufactured but weren’t, wages, profits, and crucially foreign exchange that could have been earned but never came to fruition, resulting in average people being unable to pay rent or bear the cost of food. That is $6.6 Billion Dollars that won’t come back soon.
The fallout from the severe economic crisis
Despite predicting that the government of Sri Lanka would not be able to service its debt payments in 2021, I did not think through what a collapse in the economy due to a foreign currency shortage would really look like. As the cost of living doubled, the country was unable to import a wide variety of essential items such as medicines and food. Sri Lanka also faced a total shortage of fuel, with lines at the fuel stations stretching for many miles.
Unfortunately for the partnership, my inability to hold a more defensive posture resulted in us holding less cash at hand, which inevitably resulted in an inability for me to have deployed as much cash as I would have liked during a very opportunistic period. A combination of economic deterioration, political upheaval, and panic brought about large declines in the market values of businesses we already own and some new businesses at bargain prices. It was another rare opportunity to buy some of Sri Lanka’s best businesses at large discounts to private business value.
We could roughly only deploy about 10% of our assets in cash during this time, a fraction of what I would have liked to have deployed during this period.
Additionally, I need to convey that I underestimated a lot of what was to transpire this year, the outbreak of war in Europe, the effects of inflation on many reserve currencies, the Sri Lankan debt crisis, etc. However, it was mostly the devastating effects of the latter that would turn out to have serious consequences on some of the businesses we own. In previous letters I have mentioned that I am not in the business of predicting macroeconomic events, however, this year’s poor results in the partnership’s returns are of my own making.
Below, I elaborate on why this is the case.
Dilution risk for financial institutions
Dilution risk occurs when companies issue equity at less than the firm is worth. This risk is always with us but is most pernicious at stock market troughs. It is also more common amongst financial firms, as marked-to-market figures may influence the calculation of loan losses. Hence regulatory requirements require the raising of capital during the most pessimistic of times.
As some of you may know our partnership has about 25% of our assets in some of Sri Lanka’s largest financial institutions. Here’s how dilution risk can affect them.
In 2018, Commercial Bank, under normal market conditions, I reckon was roughly worth about Rs. 120 Bn, divided by 1m shares (1,027,479,888) or Rs. 120 per share.
In March 2020, we bought the business at around Rs. 55 Bn, or Rs. 55 per share, thinking we were getting a Rupee for less than 45c. But the firm in June 2020 raised 115.2m new shares at Rs. 80 to fund Covid-19 induced losses.
As an estimate, if Commercial Bank experiences Rs. 20 Bn worth of losses, the intrinsic value per share, adjusting for the losses, falls from Rs. 120 per share to Rs. 100 per share. Under this scenario, purchases made at Rs. 55, thought to be at 45c on a Rupee of value, turn out to be 55c on the Rupee.
You might say, that is not too bad, Commercial Bank is a market leader with very high-quality management, low costs, and entrenched competitive advantages. The firm also raised the money in USD, a valuable currency as the country faces a dollar shortage, and raised it from the IMF, a valuable partner over the long term.
But it gets worse for another smaller bank in our portfolio — NDB.
In 2018, NDB, under normal market conditions, was roughly worth (according to my estimates) about Rs. 50 Bn, divided by 221 million shares at Rs. 200 per share.
In November 2019, we bought the business at around Rs. 21 Bn, or Rs. 98 per share, thinking we were getting a Rupee for less than 50c.
However, to fund Covid-19-induced stresses and losses, the firm in June 2021 raised 106m new shares at Rs. 75 per share (via a rights issue) and 17.7m new shares at Rs. 82.5 per share (via a private placement). In total that amounts to about Rs. 9.4 Bn.
As an estimate, if NDB experiences Rs. 10 Bn worth of losses, the intrinsic value per share, adjusting for the losses, falls from Rs. 200 per share to Rs. 160 per share. Under this scenario, purchases made at Rs. 98, thought to be at 50c on a Rupee of value, turn out to be 61c on the Rupee.
Dilution risk accelerates as the share price declines: if the firm raises the same amount of new capital at a lower price per share, then the intrinsic value after the capital raising falls. This was the case with NDB, as a low price of Rs. 75 per share valued the entire business at Rs. 17 Bn, less than the total retained earnings of the business (Rs. 20 Bn) but it was a premium relative to the market price of Rs. 65 per share at the time.
We did have an opportunity to protect ourselves from this risk by participating in the rights issue, but we felt that there were much better businesses, with better returns on capital and selling at greater discounts that warranted the use of our capital at the time.
It may turn out that an intrinsic value of Rs. 40 Bn for the business or Rs. 160 per share may turn out to be wrong or may take much longer to materialize than estimated. I have reasons to doubt my original analysis and I take full responsibility for this decision. This error is entirely my fault as I underestimated the full scale of the pandemic & the economic crisis that followed in 2022. It does not necessarily mean however that we will suffer any significant losses as the total size of the position is less than 2% of assets under management. We have some margin of safety (I think the business is run by prudent professional bankers) and we will be patient, as current market prices are not a reflection of a fair valuation of the business, hence, we have no intention to sell.
On average our holding period for a business is 7 years, hence, I am eagerly going to watch how the business performs over the years and keep a keen eye on further dilution due to the raising of capital at depressed market valuations that is likely to occur during this difficult period.
Real results for owners of businesses in Sri Lanka today
In last year’s report, I elaborated that in order to generate real gains in our capital, our real rate of return must be considered after the deduction of inflation over the same period. As excited as I presume many of you are on the topic of inflation, I won’t be repeating it, instead, I’ll elaborate on the real effect of inflation on the owners of businesses in 2022.
Today, the figure for year-on-year inflation is around the 70% mark which means that Sri Lanka is experiencing hyperinflation. Even for a business that earns 20% on equity (very few businesses are consistently able to achieve these returns), current inflation rates have turned all positive returns earned into negative returns for all owners. In other words, even if all returns were paid in cash and not taxed at all, it would still leave owners with about 50% less purchasing power than they had at the start of the year. All despite the company not having spent a single Rupee of earnings.
At present inflation rates, almost all business owners should expect no real long-term return from the average Sri Lankan publicly listed business, even if these individuals reinvest the entire after-tax proceeds from all dividends they receive. The average return on equity of publicly listed Sri Lankan businesses is fully offset by the implicit tax on capital levied by inflation.
Additionally, keep in mind that returns to equity are likely to be subjected to further deterioration as proposed explicit taxes are levied on corporate income, dividends, and capital gains.
As mentioned last year, we have no solution to this problem except for being extremely selective about the economic characteristics of the businesses we purchase. I alluded to the characteristics that help these businesses survive and grow despite the enormous pressures of inflation in my last letter. Thankfully, many of the businesses we own share these characteristics and are in a strong position to survive & grow despite a high inflationary & recessionary environment.
However, we would be best served by the Central Bank working hard to maintain stable prices and on that front Central Bank Governor Dr. Nandalal Weerasinghe seems to have clearly understood the threat of hyperinflation and is making meaningful progress in combating it. In my opinion, he is really serving the country by doing the difficult job of trying to maintain the value of the Rupee and combat inflation even if that means the economy goes through an unpopular high-interest rate period.
Our results
This year has been the worst performance of our fund. Our partnership with dividends re-invested amounts to a return of -18.41% for the year. The first negative year we have experienced in the history of the partnership.
In relation to the overall market indexes, our partnership has not done as badly as the general market but underperforms the current 5-year risk-free rate paid annually (14.5%) by a wide margin.
In 2022 the total return on the general market index (ATR) declined by about 22% in 12 months to 11,780. While the total return on the S&P SL20 index (STR) has declined by 26% to 4,999.
We mentioned last year that the unusually high returns of the index were not in line with 5-year trends and that turned out to be correct. Due to the declines experienced this year, the ASPI and S&P SL20 show a 5-year compounded annual growth rate of 5.39% and -7.85% respectively.
The table below shows how this year has been the worst performance of our fund. The partnership with dividends re-invested amounts to a return of -18.41% for the year.
Interpretation of results
Despite the large overall decline in the general market, I alone am solely responsible for the performance of the fund this year.
Our portfolio is concentrated on a few high-quality businesses, all of which have seen declines in market value. Some of them even improved earnings this year, however, they couldn’t avoid the general decline in market value. As the economic crisis unfolded, a combination of hyperinflation, panic, and high-interest rates took government treasury bills from 5% to 25% in the span of a year. All of these factors likely had an influence on market values.
However, nothing I have seen so far suggests that these businesses have seen long-term economic value destroyed, hence, with the cash received through dividends we purchased more of what we own and one additional business. Despite the overwhelming pessimism, it is my job to ensure we purchase as much value as we can get for every Rupee in the partnership and stay the course.
I am of the opinion that current market values do not reflect the economic reality of the businesses we own in our portfolio. Instead, our value-based purchases continue to remain attractive purchases, with large discounts on intrinsic value.
My thoughts on a historic year — Sri Lanka’s 2022 economic crisis is our moment of truth
In his brilliant book ‘Upheaval’, author Jared Diamond talks about how a crisis can be thought of as a moment of truth for a nation: a turning point, when conditions before and after that “moment” are “much more” different from one another than before and after “most” other moments.
The magnitude of the economic crisis in Sri Lanka brought about a series of events that make it clear that the nation is unlikely to revert back to the previous coping methods for our economic problems. Successfully resolving the crisis this time requires real economic reform and change. The extent of that change is yet to be decided, but it will determine if the success of solving the crisis may be partial or inadequate and if the problems will return.
One optimistic note I noted this year was the fact that despite the painful depreciation of the Sri Lankan Rupee, it has now made our currency cheaper relative to other comparable currencies, which in turn makes producing our exports cheaper, as wages are paid in local currency remain the same while US Dollar income has doubled in value.
This provides an incentive to get businesses in Sri Lanka to focus on earning Dollars, given the enormous earnings power relative to local wages incurred. This movement towards globally competitive export-oriented firms is what Sri Lanka needs to put it back on the GDP growth track.
Conclusion — Staying the course
When many of you joined the partnership in 2020, I insisted on periods of evaluation that require a minimum of 3 to 5 years in the partnership. Despite the difficult results this year, I urge you to stay the course. My personal net worth makes up a large portion of the fund and I am not going anywhere. I believe that over the long term, the market values of the businesses we own will reflect their true economic net worth.
Ben Graham, the author of ‘The Intelligent Investor’, famously said that an investor is neither right or wrong because others agreed or disagreed with him; he is right because his facts and analysis are right. Despite the depressed market values experienced during the year 2022, I continue to remain optimistic about the businesses we own due to their economic characteristics and competitive advantages.
Hence, I believe our facts and analysis continue to hold and that our partnership’s record over the long term will reflect the economics of the businesses we own. We will continue to maintain our holdings and stay the course, so long as these economic fundamentals continue to last.
I have disclosed as much of my philosophy and thinking as may be imparted while also talking about a few individual investments made in the past this year. If there are any questions, I would welcome hearing from you.
References
- https://www.ft.lk/front-page/CB-projects-economy-to-contract-by-over-8-in-2022/44-738879
- https://www.cbsl.gov.lk/en/news/inflation-in-august-2022-ncpi
- https://www.masholdings.com/who-we-are/
- https://www.ifc.org/wps/wcm/connect/523681dc-b9d7-4fce-8113-ea4a86c1e006/IFC+SheWorks+-+MAS.pdf?MOD=AJPERES&CVID=nnVcSOA
- https://www.ft.lk/top-story/Low-inflation-first-interest-rate-later-CBSL/26-740752
- Upheaval: Turning Points for Nations in Crisis by Jared Diamond (available here)
On Sri Lanka’s economic collapse
