Quyn Capital Annual Letter 2023
Annual letter for 2023 to our partners at Quyn Capital. For the period ended 31st of December 2023.
Results
To 31st of December 2023,
The figures above are unaudited and presented on a cumulative basis with and without performance fees. Additionally, the presented results are compared against relevant benchmarks. Please note however that the JB Equity Fund, S&P SL20, and ASPI are shown only from January 2023 to the end of November 2023 because the December results are not out yet.
The effect of the performance noted above is the value of a Sri Lankan Rupee invested in the partnership at inception would now be worth around Rs. 1.97 before performance fees and Rs. 1.74 after fees. A similar amount invested in the S&P SL20 index mentioned above would be worth around Rs. 1.33 and if one had put a Rupee in a local 5-year bank fixed deposit it would be worth about Rs. 1.50 in the same period.
*Note: The reporting period was changed this year from November 30th to December 31st each year so that comparisons to benchmarks could be made much easier given that The Unit Trust Association of Sri Lanka Performance Summary reports use the 31st of December as the end period each year and those numbers can now easily be compared to our results as well.
Introduction
This year marks a gain in market values that outdoes the decline experienced in last year’s results. Last year, Sri Lanka witnessed an economic crisis of historical proportions, and by year-end, equity investors of all stripes experienced panic and painful declines.
Despite the gain in market values, what really matters to me is the gain in real business value. There are a few good things to report in this year’s letter. Starting with Sri Lanka’s undertaking of painstaking reforms that could aid growth for our businesses in the years to come, another is the fact that many of the businesses we own recovered their momentum and seem to occupy greater competitive positions as they emerge from the crisis.
In the following sections, I will discuss how each of our businesses dealt with the crisis, separating the non-financial businesses from the financial businesses.
How our non-financial businesses are dealing in a nation in crisis
Our non-financial investments include some of Sri Lanka’s most profitable manufacturing, retail, and real estate businesses. Many of these businesses are positioned well for a high inflationary & recessionary environment. Below, I’ll talk about why each of them can survive and prosper despite the crisis, without naming any of these businesses specifically.
For the main manufacturing business, it continues to hold significant brand and pricing power, while also enjoying a significant lack of competitor products. Meanwhile, the economics of the business enables it to maintain a return on capital employed in the business at over 100%. This means the profits of the business in just one year provide a total return on investment needed to keep the business running. In other words, it gushes cash. Despite the crisis, its earnings power seems to have increased last year. It is a truly exceptional business with a long-term track record bought at a fair price. This year we were able to buy a little bit more at much lower prices.
Meanwhile, the retail business has maintained earnings power that has kept up with food inflation. This is because of the essential nature of the business. It is constantly lowering prices for better merchandise and benefits from the lack of a convenient alternative in traditional retail for the middle and upper-middle-income population of the country. These lower prices are enabled through a model called scale-economics-shared where the business reduces profit margins & lowers costs through size and scale and shares those savings with customers to generate more volumes (revenue) and scale that allows for it to reduce profit margins again in a virtuous cycle, ultimately increasing total net profit through volume growth. It is an exceptional business led by world-class management with tremendous growth potential, purchased in 2022 during the midst of the crisis at a large discount to private value.
Our investment in the real estate business shows good promise as well. Despite the threats of remote working and competition for premium commercial real estate, the business operates one of the best-known commercial properties in the country. The current inflationary crisis makes the business even more valuable because it was constructed with US Dollar-denominated costs incurred years ago that would cost significantly more today. Hence, the asset is more valuable and if constructed today, would need to demand higher rents in order to earn a return on investment equivalent to the past (something our competitors face). Additionally, it was bought at a significant discount to property value while the prospect for growth remained good. At the time of purchase in 2020, the business included an additional development of multiple residential towers, about 800,000 sq. ft of commercial real estate, and shopping mall space, all of which were not accounted for in the market capitalization at the time.
How our financial businesses are dealing with the economic crisis
Last year we spoke about the risk of dilution. In summary, dilution risk occurs when companies issue equity at less than the firm's worth. This year, that risk did not come to pass (yet!) as no big banks we owned raised equity and some opted for debentures instead. However, the magnitude of the crisis last year and its impact on businesses like banking should certainly create doubt about our original analysis and the valuation of the business.
Financial businesses are riskier businesses to value and own because of the inherent leverage present in them. Liabilities like deposits or insurance contracts usually exceed shareholder’s capital by many multiples, hence, you need to keep a close eye on risk and understand if these businesses are managed exceptionally well in order to prevent the total wiping out of shareholder’s capital in the case of a severe crisis, like the one we just experienced.
Financial businesses in Sri Lanka have had to deal with a combination of some serious challenges which include: the Sri Lankan sovereign debt default, a severe shortage of foreign currency, an economy in recession and growing unemployment, a deteriorating loan book, high inflation and a sudden rise in interest rates. Each of these factors impacts the business and the combination of them creates a potent mix that can deeply stress any financial institution. Sri Lanka was deeply fortunate not to experience a financial panic during the worst of the crisis.
This uncertainty created large discounts in market value for all financial businesses, but the exact implications of the sovereign debt crisis and the debt default of the government of Sri Lanka were extremely difficult to predict. This was the most difficult factor to consider in my current assessment of the business and hence, I could not value the business relative to the possible risks involved. We simply held on, deploying extra capital into other opportunities we understood. Market values steadily recovered, given the subsequent economic recovery and the government’s decision to not let banking sector assets be impacted by the domestic debt restructuring plan.
Sri Lankan financial institutions are not out of the danger zone just yet. It is likely to take many years till the deteriorating loan book recovers, while the government has much to fix with its debt and state-owned enterprises.
Total Panic in 2022
“Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true.” — Charlie Munger quoting Demosthenes
The consequences of the economic crisis last year resulted in widespread fear, which then turned into a panic and a large decline in market values. Once fear engulfed the market, investors began to only think about worst-case scenarios, leaving no room to think about any possible value in the market. Logic, history, and time-honored norms were dismissed, and replaced by thoughts of a total collapse of the country.
The Sri Lankan economy did collapse, it was a painful and difficult period for everyone in the country. But did that mean it was rational to think that there was no need for any sense of optimism about the future? Were all of Sri Lanka’s most profitable businesses going to go bust? Was there never going to be any sort of recovery? With hindsight, we can now see that this was not true. Fear was overdone as a concern and it prevented investors from taking constructive action when they should.
Our ability to hold a different viewpoint to the common consensus and act differently to the market is because our partnership adhered to a core set of principles. Those principles were based on Ben Graham’s core investing principles, which contrary to popular sentiment amongst most financial analysts in the country, provide us with a sound intellectual framework that has proved enormously beneficial to all partners.
This is why I insisted that all partners sign and accept the ground rules of the partnership in 2020, in order to help prepare us for the uncertainties of the future and stay the course. But let’s explore what these principles mean and why they have worked for us.
The ‘value investing’ principles
“There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.”
— Warren Buffett, The Super Investors of Graham-and-Doddsville, 1984
Benjamin Graham was an intellectual powerhouse who is commonly known as the author of the popular investing classic ‘The Intelligent Investor”. Born in 1894, the “Dean of Wall Street” created and conceptualized the “value” school of investing. More than 80 years after its creation, Ben Graham’s principles have been profitably applied by some of the best investors in the world. Warren Buffett has famously said that “no one ever became poor by reading Graham.”
However, in Sri Lanka, many leading Sri Lankan investment houses and media outlets would like you to think that this approach is out of date. They argue that Sri Lanka is different from other global markets. That the Sri Lankan market does not recognize value, that it is too ‘volatile’, that it is too ‘risky’, and that no one has ‘made money’ by looking into business fundamentals.
The implication is that everyone should speculate by focusing on the future price of the stock, not the value of the business, and those who are not up for this game should put their money into bank deposits or real estate. But this is not true, good principles are not restricted by geographical boundaries and the adherence to Ben Graham’s value investing principles has given us an adequate rate of return this year.
Why has value investing worked for us in Sri Lanka? Because we joined the village of Graham and Doddsville.
Warren Buffett beautifully explains why value investing works. In May 1984, in a speech to the Colombia Business School to celebrate the 50th anniversary of his mentors Benjamin Graham & David Dodd’s seminal book “Security Analysis,” Warren Buffett laid out why value investing works in a speech titled “The Super Investors of Graham-and-Doddsville.”
In the speech, Warren Buffett highlights a group of highly successful long-term investors whose successful long-term record can be proved by the adherence to a series of principles taught by mentor Ben Graham. The principles are as follows:
- These investors were always buying the business and not the stock, they were businessmen buying businesses
- They all exploited the difference between the market value of the business and their estimation of the intrinsic value of the business, in other words, their focus was on price and value
- They adhered to the ‘margin of safety’ principle, in other words, they are trying to buy businesses for less than what they are worth, like buying Dollar bills for 40 cents
Maintaining a strict adherence to these principles, which were written in the United States in the 1930s, has turned out to be a good strategy in Sri Lanka almost 90 years later. Ben Graham’s core idea of simply conducting good business valuation work and buying companies at below their net worth (conservatively calculated), transcends geographical boundaries and time.
Reading and practicing our Graham & Dodd in Sri Lanka has allowed us to prosper, and I count myself a happy follower of the intellectual village of Graham-and-Doddsville. The speech is a Warren Buffett masterclass and I highly recommend reading it on the Colombia Business School website. I have included it in the references at the end of this letter.
But as much as I would like to think that the gains seen this year were of my own making, this is not true, most businesses were able to bounce back due to the recovery in the economy this year. And all credit must go to the actions of the central bank governor and his team.
The amazing job done by the governor in halting the rise of inflation
Nandalal Weerasinghe, a career central banker, was appointed Central Bank Governor in April 2022 amidst inflation running at its fastest pace in Asia while the Sri Lankan currency’s depreciation was amongst the worst in the world.
The governor understood the assignment, and within a few days of his appointment, he increased interest rates by a whopping 7% in one day. He followed that up by making a number of sound but difficult policy decisions that enabled the Sri Lankan economy to recover. Sri Lanka’s overall inflation peaked in September 2022 at 73.3% and food inflation increased to 85.8%. A year later, inflation in August 2023 determined by the National Consumer Price Index (NCPI) decreased to 2.1% on a year-on-year basis. An outstanding achievement.
In a country dominated by political corruption, and a bloated inefficient public system, Governor Nandalal has proved that all hope is not lost for Sri Lanka. He came out of retirement to serve his country in the most remarkable fashion and today, every Sri Lankan’s Rupees are able to keep their purchasing power due to his leadership. He deserves our praise, for many of our businesses would be doing a lot worse if not for the difficult decisions taken by the CBSL under his leadership in 2022.
Setting a high bar and staying the course
While our principles never change — they are timeless — the analysis of our businesses is subject to change depending on a number of factors. Some businesses are going to be harder hit due to the crisis and as discussed in the evaluation of our businesses, we stayed away from financial businesses given the uncertainty and inability to understand all the risks in 2023.
This year we added nothing new to our portfolio and simply reinvested in our existing portfolio at lower prices. No new businesses were added simply because I couldn’t generate any good new ideas. All new ideas are continually measured against present ideas and we will not purchase any new business if we are not getting more value than we already have in our current portfolio. This has resulted in limited activity this year and has led to larger concentrations in our existing portfolio.
This sort of concentration produced the wide unpleasant short-term swing we saw in the portfolio last year. Personally, I am unbothered by these short-term swings and I am willing to concentrate on my best ideas in exchange for the best long-term compounding rate possible (incurred at the lowest possible risk of capital loss). Given that high bar, it is hard to develop replacement ideas and we came up with nothing during the remainder of the year despite some lower stock prices, which should have been conducive to finding new opportunities. This brings me to another point.
I am doubtful that the bargains seen over the last few years may repeat any time soon. Of course, anything can happen in markets, but I think the prices of the past are unlikely to be repeated. On a more positive note, during those times, the hard psychological and analytical work was done and I believe the partnership is now filled with future capital gains. The output will come in time, we just have to be patient. This may be completely at odds with conventional wisdom, but the best thing to do now is to do nothing and wait for the companies we own to capitalize on the advantages they have created. But if an opportunity presents itself, I am ready to act as necessary.
I want to thank our partners who stayed the course during this difficult period. As always, I value your confidence in my abilities and your patience in staying the course when it truly matters the most.
References
- “Warren Buffett’s Ground Rules: Words of Wisdom from the Partnership Letters of the World’s Greatest Investor” by Jeremy C. Miller
- The Super Investors of Graham-and-Doddsville by Warren Buffett: link
- https://www.ft.lk/front-page/Inflation-declines-to-2-1-in-August/44-753250
- https://www.reuters.com/article/sri-lanka-crisis-economy-idUSB8N2UZ014
- New Governor appointed: https://www.themorning.lk/articles/197372
