Annual Letter to Stakeholders

2015-2016

Dear Investors,

In the midst of challenging global economic environment, it was a difficult year for investors. The
year was marked by the steep decline in oil prices, a downward adjustment in Chinese
currency, fed lift off, failed monsoon in India and heavy bulwark by the government to put the
economy back on track, but we ended last year on a satisfactory note. Our performance is as
below:

Portfolio Performance Vallum India Discovery BSE S&P Mid Cap

1 Year (March Year 2015-16) 26.7% 0.25%
CAGR Since Incept. (Oct 11) 40.6% 13.2%

*returns of the model portfolio, return over 1 year are annualized; return for the individual investor will differ based on entry horizon and portfolio
construction.

Our strategy for stock selection and portfolio construction remains the same - invest in mid-
market companies or business turnarounds and make sizable bets. Our rationale is simple –
these two pools attract fewer investors and equity value is mispriced. This adequately
compensates us for illiquidity, volatility, and concentration risk. We diversify ourselves in 20-22
opportunities available across sectors, companies, usually an individual opportunity with sales
of more than Rs 500 crs p.a. We have no threshold of market capitalization before making the
investment and fewer is merrier for us. The key thing to differentiate or think about is
distinguishing between the fundamentals of the business and the expectations built into the
price. Those are two separate things. What we’re looking for is not necessarily the best
companies. We are looking for mispriced companies that meet our checklists. So, a distinction
between expectations and fundamentals would be the root or core of the process. With some
difficulties, we have overcome confirmation bias and are ready to be investors for one full
business cycle. The primary objective of this annual letter is to discuss the results of our
portfolio companies and our goal is to explain the long-term investment philosophy behind the
selection process for the companies in our portfolio. Over the short term, the stock market can
be irrational and unpredictable, however, over the long term, the market adequately reflects the
intrinsic value of companies. If the stock selection process is sound and rational, investment
returns will eventually follow. Through this letter, we aim to give you the information required to
understand this process. You will hopefully notice we are transparent and comprehensive in our
discussion.

***

Our two-year-old investments in oncology focused pharmaceutical companies are progressing

well. The company has recently received US FDA for API plant and is awaiting the nod for a
formulation plant. The sales will kick off in the US markets once regulatory approval is received.
The packaging company is expanding its franchise to newer areas like pesticides, industrial
goods including the sensational FMCG launches of Ayurveda guru. The agrochemical company
business witnessed slow down due to global weather-related issues leading to slow-moving

1 Vallum Capital Advisors, SEBI Registered Investment Advisers.

 Annual Letter to Stakeholders
2015-2016

products and a declining pipeline of inventory in the business. A better monsoon in India and
favourable weather for agriculture is likely to change the future course. Our investment in the
company engaged in the rice business is intact and the company is progressing well on product
value migration. This year, earnings of value added steel company were positively impacted by
renewed thrust on investment by railways. However, the general economic conditions were not
very conducive and industrial activity was muted.

Last year, I wrote to you about our investment in home textile companies, which has benefited
from long-term favourable structural changes in the global home textile market. The company
has performed well much beyond our expectation and generated a superlative return in short
investment horizon. We forecasted reasonable uptake in bed linen business, with improving
financial position, but were surprised with high expanding margins. We underappreciated the
role of room night sales progress of Air BNB. It sold approx 70 mn room nights in 2015 up from
12 mn room nights in 2012, a 5x increase and the positive impact it has created on global bed
linen markets. The understanding of the convergence of technology and its impact on
mainstream businesses will be a milestone in investing business for many of us. In my investing
career of over 16 years, I have not seen an investment turning 11x, in 18-month holding period.
Our internal risk management system has alluded us to pare our exposure and we deployed this
money in other opportunities. This has also reminded me about the role of luck in investing. We
follow the same process while investing in companies but the outcomes for a few can be very
surprising.

Middle market investing is also fraught with higher investment risk. The risk of an unproven
track record of promoter intent towards minority, shorter history of corporate governance,
companies susceptible to business environment changes, technological changes, sometimes
political alignment (specific to India) weak second line of management, small funnel of product
dependence exists in some companies. We aim for companies that are less susceptible to this
risk and are able to mitigate specific risks as they progress in their business. Let me also give
you a glimpse of how we are navigating through these challenges. We have invested a lot of
time in putting up together a process, a proprietary framework on stock selection over these
years. I also call this mental mapping. This has two-fold benefits; bring more objectivity and
contain our individual biases, ensuring that rigidity does not compromise our investing acumen.
While investing, we navigate through these challenges, balancing risk and rewards based on
our experience. Let me share with you how we had a tough time dealing with the unique
situation of an investee company where its parent company had passed a resolution to sell a
land parcel to its subsidiary, in which we are invested. This uncalled move was vehemently
resisted by us during shareholding voting. Though our investment is not under threat, due to
very strong underlying business, it has led to a bitter taste for us.

In the middle market or turnaround investing, investors must recognize they need to have long
investment review horizon, not only the holding horizon. The mismatch between both has often
led to the mediocre performance of investment managers. As we expand our investor base, we
ensure that we have communicated this to each one of you in detail.

2 Vallum Capital Advisors, SEBI Registered Investment Advisers.

 Annual Letter to Stakeholders
2015-2016

This year, Transformer businesses have attracted our attention. It neatly fits in our investment
thesis of a damsel in distress. The excess capacity build over the last few years has resulted in
the industry is barely generating a positive economic return, working at 50% utilization and 10-
15% of peak EBDITA/unit. The seriousness of the government to turnaround the ailing power
sector has the potential to change the fortune of this industry. We made three investments in
chemicals sectors, one in fluorine chemistry, aspiring to be a leader in the world in its chosen
field, the second in dyes and dyes intermediate business, and lastly in a company in amines
business. The sector is also playing on the transition of China from investment to consumption-
led economy, upsurge in labor wages and the fight against air & water pollution. Curbing
pollution is irreversible and the cost of conducting business has increased for chemical
companies operating out of China. For years, the basic chemical product prices have seen the
price deflation due to oversupply from China. This will change with changing priorities of the
nation and we feel our investee companies will be a beneficiary. Investors have a distaste for
companies that have no strong brand, intellectual property rights or deals in commodity
products and sometimes, they overpay for the aforementioned attributes. Our experience
suggests that every business goes through a cycle and a careful analysis gives the opportunity
to make superlative returns in some business cycles. The dye company was generating a
reasonable return on equity in down cycle of the product prices when we invested. As I write to
you, I gather that the product prices have shot up significantly on the back of stringent pollution
control norms in China. One of the overlooked investing parameters has been less time devoted
to the supply side dynamic in the industry. We have benefitted significantly on many occasions
by studying supply side dynamics as much as demand projection.

During the year, we made our first investment in Auto ancillary business. The company makes
gear shifters and a variety of other products. The business is well diversified across two
wheelers to four wheelers and caters to a wide breadth of customers. The company has entered
various joint ventures to improve product profile, up gradation and reasonably priced. Such
companies have the capacity to lead the ever-changing technological need of customers. The
second generation management is very impressive and has the capacity to create sustainable
shareholder value over a period of time. Before closing, we have made an investment in
consumer electrical solution company with a formidable brand in domestic markets and has also
achieved a leadership position in the export of its products. I have even mentioned in my earlier
notes that the industrial brands will become valuable over a period of time and we believe it is
better to own an industrial brand v/s apparel brand, considering the valuation difference.

***

As we discussed, last time, we have stayed away from public sector banks and this was the
year of reckoning when the value trap played out. We do not foresee an immediate revival of the
banking sector due to the shrinking requirement of capital (working and long term) by
customers. Our diligent central bank ensures that monetary transmission is passed with no
leakage due to banking inefficiency. Valuation of banking stock may see an occasional bounce
but underlying business metrics and stress of real estate sector is yet to surface in the banking
sector. The reoccurrence of the banking crises highlights the need for strong self-induced check
& balances in institutional mechanisms. The solution lies in making the dividend compulsory,

3 Vallum Capital Advisors, SEBI Registered Investment Advisers.

 Annual Letter to Stakeholders
2015-2016

which would discourage overstatement of earnings, encouraging short selling in capital markets
by promoting stock lending and borrowing mechanism, sound whistle blower policy, fixing the
liability of rating agencies which are supposed to take care of investor interest not issuer and
selection of auditors and independent directors by a lottery system. This will align the interests
of a diverse set of participants, giving early warning signals to those concerned and
strengthening capital markets.

***

As we move towards completion of five years of existence of Vallum, myself and our team
would like to express our deep gratitude for being partners with us in this blissful journey. It is
imperative for us to not only select good companies for our portfolios but also to remain
outstanding stewards of your capital. We remain very positive about good long-term prospects
of our economy and would emphasise that investors should judge the process implemented by
the current government to improve prospects of the economy rather outcome on their way, but
not yet there.

Manish Bhandari

April 2016
manish.bhandari@vallum.in
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A note on Portfolio construction and Performance computation: Money Advised is on the basis of master model portfolio and
sub portfolio within the same based on individual entry point. The return is not comparable with Mutual fund, as they follow master
portfolio approach, with no segregation at the point of entry. The illustration of performance is of fully deployed portfolio, not of client
weighted portfolio return as each will have variation in portfolio.

4 Vallum Capital Advisors, SEBI Registered Investment Advisers.