Jeetay Annual Letter 2003-04

Dear friends,

Our first yearly audited investment results*are as follows

Year 2003-04JeetaySensexRelative Performance
June 7- Sep 733.4%33.1% 
Sep 7 - Dec737.0%16.7% 
Dec 7 - Mar 7-6.1%15% 
Mar 7 - June 75.3%-17% 
Cumulative80.8%48.0%32.8%

A bull market is the stock market equivalent of grade inflation which makes even dunces look clever. The numbers achieved will with near-certainty never be repeated and it would be folly to benchmark future returns in the market on these numbers. The test so far has been easy but going ahead will be far more challenging.

Over short periods of time, Mr. Market is a capricious examiner – rather than feeling elated, we’ve wondering if we are doing something wrong by being graded so liberally by Mr. Market. So we would like to take you through the philosophy that guides our investment decision-making.

The Philosopher’s Stone and Margin of Safety

Plato in “The Republic” teasingly averred on the adoption of a kind of fairy tale - the myth, taught to everyone, that God fashioned men so that gold was put in the composition of rulers; a lesser metal, brass, in the auxiliaries; and mere iron and bronze in the farmers and other workers. Everyone would know his intrinsic worth and would remain in a state of contentment in where he is. There would thus be an end to social strife. Plato would have been vexed when looking at Mr. Market where bronze is sometimes sold as gold and brass as iron and where price and fashion rather than intrinsic value and analysis rule.

Constant strife seems to favor activity. A person can however stay on the same spot by standing still or walking on a treadmill. On many occasions, in investing, it pays to be inactive.

Between walking on a treadmill and standing still, we would prefer to stand still.

The elements propounded by the ancient Greeks like Empedocles, Plato and Aristotle consisted of earth, air, fire and water each imbued by two contending opposite qualities (hot and cold, dry and moist) by which they could be interconnected. All of investing is made up of just two elements – price and value and on many occasions they are never connected by Mr. Market. The Greek philosophers who reduced all matter to the four elements – a sort of predilection for “first principles” did it for a very practical purpose – things change and they wanted to understand those transformations. All of investing is an embodiment of this return to first principles — where is change happening and what would it lead to? The classical elements were representative of the different physical states that matter can adopt. For instance, earth represented not just soil or rocks, but all solids. The Greeks thus saw elements as types, not to be too closely identified with particular substances. In value investing too, when you look at price as an element, you look at the market and when you look at value, you look at the fundamentals of the company.

The central tenet of alchemy, which in the old days, provided the theoretical basis for metallurgy, was that if metals could indeed be interconverted one to another in the bowels of the earth, perhaps the alchemist could find a method to accelerate the process artificially and make gold from base metals. In value investing, price is the great equalizer and sometimes equates lead and gold and so can turn lead to gold. The Holy Grail of alchemy, the Philosopher’s Stone, is the smallest quantity of which can transform base metals to gold. In their endless quest for the Philosopher’s Stone, alchemists burnt, distilled, melted and condensed all manners of substances. The Philosopher’s Stone in value investing is the “margin of safety”, the gap between price and value and the larger the amount, the higher the odds of finding gold in the markets.

A single element can show very different characteristics depending on what it is combined with. Chlorine is a corrosive, poisonous gas; combined with sodium in table salt, it is completely harmless. Portfolio construction too similarly combines volatile risky assets into what should be a savory combination.

When the depth of a river is measured or the number of ants in a colony, the measurement does not reveal anything about the fundamental constitution of the system. Studying market prices is just like this – they do not reveal anything about intrinsic value. The elements are classified in the periodic table, which any student of chemistry is familiar with, not according to their color, but according to their atomic weights. If a periodic table of investing was ever devised, the system of classification would rationally be based not on market prices, but on intrinsic value.

When scientists see structure, they believe that there is an ordering principle for it. What brings order in investing is the principle of intrinsic value – the future free cash flows of an asset discounted to the present.

We would like to, however, caution potential investors on some of the risks associated with our investment approach and our past year returns.

1. In extended bull markets, we will almost certainly underperform. We would be reluctant to hold on to  positions that have crossed intrinsic worth, no matter how tempting the short-term price action may look. This may mean being in cash, if necessary, for long periods of time. We will never take the risk of a permanent loss of capital which playing a short-term momentum game may imply. We would rather look foolish, than foolishly play a game we do not understand and would not be successful in.

2. We do not believe that one year is a meaningful representation of investment skill. We would at a minimum, look at five years to gauge the successful application of investment principles. However we would be monitoring our performance on a year-on-year basis. Please take this year’s performance at best as indicative and not representative of what is in store in the future.

3. We do not give any guarantee of performance. The only guarantee that we can give is that we will diligently and faithfully apply the time-tested principles of value investing in the construction and maintenance of your portfolio. We do not promise to get you richer quickly, but to protect your capital in real terms and earn a reasonable rate of return.

Case Studies

As a rule we don’t publicly disclose names of companies. However, to illustrate our investment methodology very briefly, the following are some case studies of companies we invested in the last one year.

1. A manufacturer of drilling equipment was available at less than cash on balance sheet, no debt, a normalized P/E multiple of 4 and was likely to grow its earnings at double digit rates for the next three years. At the price at which we bought in, we got the business for free. In the last four months we have been holding this stock, even as the BSE Sensex has returned a negative 17%, this company has appreciated by 50%.

2. A leading Indian ink manufacturer had set up a plant in the US which ran through some initial teething problems. On an EV/Sales basis, the business was quoting at near its historical lows. The operating leverage in the business was large and it was the lowest cost producer in the world. We sold our investment in 3 months and earned a return of 136% compared to the BSE Sensex which returned 19% during the same period.

3. A leading manufacturer of compressors which was quoted at a price to free cash of less than 4. The company had no debt and was AAA rated. The market was pricing it at worse than a risky bond even though the earnings looked set to grow. Its peers, even though strategically not as well placed, were quoted at a relative premium. When we sold the stock 7 months later, the stock had appreciated 100% compared to the Sensex’s 0.6%.

Even if we are stuck with the most severe case of Alzheimer’s we will never forget Warren Buffett’s two fundamental rules of investing:

1. Rule number one: Don’t lose capital
2. Rule number two: Don’t forget rule number one

We are not in this game to hit the quickest century in the shortest period of time, but to hit the quickest century with the least amount of risk.

Portfolio Management Scheme (PMS)

We have received SEBI permission for the Portfolio Management Scheme (PMS). Should you be interested in knowing more about our schemes, please contact us at:

Tel no: 0091-22-22181985 / 22181986
Email: chetan@jeetay.com

The surplus funds of Jeetay Investments Private Limited are invested in the portfolio management scheme and all the profits will be ploughed back into investment in the PMS. We will be eating our own cooking. So look out for the occasional burp.

Our back office and reports will be in the hands of our close friend, Mr. Abhay Bhagat who is a leading chartered accountant. Knowing Abhaybhai’s integrity and diligence, we know that part of the operations is in very safe hands.

Chetan Parikh
Director

July 02, 2004