• Christiaan Quyn

Quyn Capital Annual Letter 2021

Annual letter for 2021 to our partners at Quyn Capital.


“The successful investor is usually an individual who is inherently interested in business problems.” - Philip Fisher
 

Introduction


This year marks the second year in which the Covid-19 pandemic continued to disrupt economies and livelihoods. It has been another extraordinary year, where variants of Covid-19 continued to wreak havoc around the world despite the rollout of vaccines.


While Central Banks around the world took extraordinary measures to curtail the contraction in economic activity, the situation in Sri Lanka took a turn for the worst in 2021.


Unlike most of the rest of the world, Sri Lanka is in a severe economic crisis. The Sri Lankan Rupee has depreciated sharply against the US Dollar, imports have been curtailed and essential food is being rationed under a state of emergency. The impact has been devastating to a variety of businesses and the livelihood of many individuals has been severely impacted. Sri Lanka is facing what is called a ‘Balance of Payments’ crisis. To understand the severity of the crisis, let me try to avoid the jargon and try to explain the crisis.


Sri Lanka’s economic crisis of 2021


Let us begin with the fact that Sri Lanka runs twin deficits, a budget deficit and the other a current account deficit. The former means that the government spends more money to run the public sector than it receives in revenues (taxes), the latter means that Sri Lanka spends more on importing goods than it does on exporting goods out of the country. To the dismay of our Sri Lankan teachers who always lecture us on living within our means, the government of Sri Lanka has always resorted to borrowings to make up the deficit. However, unlike us the government has special powers, it has the ability to print local money.


At the end of 2020, Sri Lanka’s debt to GDP ratio was 101%. This means that the country’s entire public debt exceeds what the country was able to produce in 2020. What we want to pay attention to is about 44% of that debt, which is in foreign currency, because Uncle Sam has not given us the ability to print USD, we’ve got to come up with the money or restructure that debt.


Between 2021 and 2025, it is estimated Sri Lanka requires USD 4–5 billion annually to meet its foreign debt obligations. Sri Lanka’s current reserves are estimated to be around USD 2.8 billion (September 2021). Sri Lanka is in the midst of a perfect storm, with depleted reserves and insufficient revenues, coupled with a pandemic-induced collapse of significant sources of foreign income like tourism earnings. Hence, it does not take an economist to realize that the government faces immense difficulties in servicing its foreign debt. This is the heart of the crisis in Sri Lanka.


A year filled with choices between misery & disaster for authorities


While it may be easy for us to judge the decisions made by the government and the relevant authorities, we must understand that the choices they face are extraordinarily difficult, and with the removal of hindsight, are very difficult to predict without constant and lingering doubt.


What is obvious is that Sri Lanka is going through an extraordinary period in its post-independence history. A once in a lifetime pandemic brought upon a severe economic crisis that has ruined thousands of people’s lives. This disastrous health crisis has killed over 10,000 people, all while collapsing the entire healthcare system.


We do not know how this is all going to play out


In 2020 the economy contracted by a staggering 3.6%. In May 2021, the rapid escalation of new cases and deaths, likely caused by the Delta variant, put pressure on the authorities to initiate further lockdowns in order to slow the spread of the virus. Naturally, this dampened economic activity. No one can really know what is going to happen with any certainty.


Here we come to an important point. We think of ourselves as partners engaged in a private partnership as business people. Prudent and pragmatic business people do not try to predict the important but unknowable — macroeconomics.


I was highly skeptical of optimistic forecasts by a variety of ‘prominent economists’ that projected high rates of growth and rapid recovery last year. I reflected that skepticism in a memo titled ‘Living through history’, which outlined that it was silly to make any form of macroeconomic projections. It turned out almost all of those forecasts were wrong and needed to be revised. If those forecasters were wrong last year, why should we pay any attention to them now?


Hence, we do not pay attention to any economic forecasts, we focus instead on the micro-economics of the businesses we own and a deep understanding of their business models.


The threat of inflation and depreciation of the Sri Lankan Rupee


Something that has been on my mind this year has been the threat of inflation on the Sri Lankan Rupee. Inflation, despite being a macroeconomics phenomenon that is futile to predict is unfortunately of huge significance to our gains in the partnership.


An easy way to understand all the talk about inflation is by asking the question — ‘Has there been a real loss of purchasing power in the Sri Lankan Rupee? If I bought x amount of goods a year ago for Rs. 5000 from the grocery store, if I make the same trip today, can I buy the same quantity of goods with the same amount of money?’


The answer is no. On average, the same basket of foods would roughly cost you about 11% more. Average inflation has increased by 10% thereby seriously impacting the purchasing power of the Sri Lankan Rupee. Meanwhile, a Sri Lankan Rupee has depreciated against a US Dollar by about 10% (September 2021). Increasing the cost of US Dollar-denominated debt and imports.


Although the rapid rise of inflation over the course of the year has been alarming, historically, inflation is not a new phenomenon in Sri Lanka. Former Deputy Governor of the Central Bank W. A. Wijewardne in a brilliant article authored last year noted, that between 1952 and 2020, income needed to increase by about 12,000 times to maintain the same purchasing power. To put it into simpler terms, a Rupee in 1952 is worth less than 1 cent today.


So 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. Hence, it is imperative that we not just need to beat the medium to long fixed deposit rate, but also the rate of inflation. It is only then we achieve a real growth of capital that does not see a deterioration in purchasing power.


Currently, there seems to be a multitude of factors at play that have further added to inflation in 2021 that I believe are too theoretical and academic to be of any interest to our partners, instead, let me explore the implications of inflation on the allocation of capital and the businesses we own in our partnership. I believe this is important to understand and central to our principles outlined when each of you joined the partnership.


Capital allocation in 2021 — tackling the possibility of further Rupee depreciation and reflecting on the crisis and economic recession


As mentioned before my job as the general partner in our partnership job isn’t to forecast macroeconomic factors such as GDP growth or inflation. Neither is it to figure out how everything is going to work out for the Sri Lankan economy or Sri Lankan Rupee. I have no special insight into the value of gold or any foreign currency (neither do I plan on acquiring any insights on the matter either).


As laid out in our principles when each of you joined the partnership, my job is to buy good businesses at great prices that can continue to make a good return for us as long-term shareholders despite the vicissitudes of life.


Keeping that in mind, I want to be prepared for any eventuality, including high inflation and a prolonged economic recession or depression. Here’s how I thought about it this year.


Tackling inflation


To quote Warren Buffett, inflation is the ‘giant tapeworm of corporate earnings’. It could have devastating consequences for certain types of businesses and industries. Let me give you an example. If the general level of prices is forced upwards, businesses that can not force those price increases on to customers without a lowering of sales volume, while suffering an increase in capital expenditure or cost of goods is bound to face extreme difficulties in sustaining its previous levels of profitability in an inflationary environment. Many manufacturers in industries such as Tea Plantations may face this challenge if they are unable to raise the prices of their products, while their capital expenditures on manufacturing equipment may increase.


To minimize the effects of the above, my focus is to deeply understand the business model of the companies we want to buy to ensure we do not own any companies that can potentially fall into this difficulty. Here are a few ways we try to achieve this


  • A focus on business with high returns on capital employed: Warren Buffett describes the ideal business as one that ‘that earns very high returns on capital and that keeps using lots of capital at those high returns’. These businesses require low amounts of capital expenditure and generate large amounts of cash on the assets employed.

  • A focus on businesses that have pricing power: Owning businesses that have the ability to raise prices on their products without needing to say a prayer the night before are the types of businesses we want to own. Some businesses are able to do this due to a wide variety of competitive factors from brand name to the essential nature of the product they sell.

This is not a full-proof strategy to combat inflation. It is one, however, that I am most comfortable with and makes the most sense to me. Fortunately, we own wonderful businesses that contain both of the characteristics described above.


It is one thing however to find and understand such great businesses, it is another to get an opportunity to purchase such wonderful businesses at fair or bargain prices that make for a good long-term investment. This is why all the negative headlines and the economic crisis of 2021 make it a great time to be a long-term value investor in Sri Lanka.


Speculative frenzy in the market


Despite the deterioration of the economic conditions of the country, the capital market in the country seems to have attracted a variety of new participants this year. While current interest rates are historically low, daily turnover and trading reached historically high levels. Meanwhile over Rs. 60 Bn has been raised via IPOs. There also seem to be speculative valuations in the market not based on any intrinsic value of the underlying business. However, such excesses have also created opportunities as many wonderful companies are ignored and do not attract the attention of short-term speculators.


We also need not be concerned about average opinion and attention-grabbing headlines. In fact, the attention-grabbing negative headlines have enormously benefitted us by discounting wonderful businesses to sometimes even bargain prices. This has been enormously beneficial to the performance of the partnership.


The speculative atmosphere of the public influencing the indexes this year does not change our principles and attitudes to how we want to invest. This year has given us another opportunity to buy more of what we already own at a discount and buy a few more wonderful companies at fair prices.


Our results


For 2021 our partnership has not done better than the general market and but it has outperformed the current 5-year risk-free rate (5.6%). The total return on the general market index (ATR) has advanced by about 79% in 12 months to 15,366. While the total return on the S&P SL20 index (STR) has increased by 62% to 6627. This is highly unusual as the compounded annual growth rate of the ASPI and S&P SL20 over the last 5 years has been 9.66% and 0.82% respectively.


According to the latest data available, most equity-based unit trusts and mutual funds did beat the 5-year risk-free rate from January to October this year, according to the Unit Trust Association of Sri Lanka. It is also interesting to note that the total amount of funds has increased as well.


Indexes in Sri Lanka 2021
Source: JB Securities, Nov 30th, 2021

Our partnership with dividends re-invested amounts to a return of 9.83% for the year. A modest gain relative to previous years.


Quyn Capital 2021 results vs index benchmarks
Quyn Capital Results vs Benchmarks from 01/01/2020 to 30/11/2020

Interpretation of results


There are a few reasons for this performance. This includes the fact that we raised funds this year and that we have paid extra caution to avoid the speculative overvalued stocks.

Our concentrated portfolio is comprised of a few high-quality businesses we understand very well. Once again this year, we had an opportunity not just to buy more of what we own at much greater discounts, but also to add to the portfolio with a few more high-quality businesses.


Hence our performance does not reflect the performance of the broader indexes. Instead our value-based purchases this year continue to remain undervalued, with the current price roughly reflecting about 50% of the underlying value over the long term. Setting the stage for an exciting future as our businesses start to operate in a post-Covid-19 world.


Conclusion


Many ask if the events of the pandemic seem to have brought about a permanent change to the Sri Lankan economy. Given this large disruptive uncertainty, coupled with Sri Lanka’s economic crisis, one may ask why invest in Sri Lanka in the first place?


To answer that question, I certainly don’t think all businesses can be treated the same way. Intelligent investing is about value and price. For many of the wonderful businesses we own, I think current market prices do not reflect real intrinsic value. Much of the disruption to the economy may certainly be here to stay but I believe not all businesses will be affected equally.


This is because our businesses have real competitive advantages, strong financial balance sheets, and high-quality management. Past records of earnings and growth over decades are a better gauge of what they are capable of in the future and not the pandemic-influenced 2020/21 results.


Covid-19 is an unusual event (to say the least). However, there is reason to believe the worst of the pandemic is over. The over 60% vaccination rate (2 doses — November 2021) is a great achievement for the country. I look forward to observing how this plays out next year.


Hence, my focus will continue to be on a deep understanding of the economic characteristics of the businesses we intend to buy and own. Our partnership results over the long term will be directly tied to the performance of the businesses we own. We can only make money if our businesses can continue to make money, survive and prosper in the future.


This is an exciting prospect because the businesses we own are creating good profits for us today but look even better poised for the future.


 

I have disclosed as much of my philosophy and thinking as may be imparted without talking of individual issues. If there are any questions, I would welcome hearing from you.


References


A large number of facts have been derived from the material listed below.



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