Carnelian Update - “Max”imising Magic;Process or outcome?

Greetings from Team Carnelian.

Hope you and your family are safe through the second wave hitting.

Many of you who have been following us must be aware of our MCO framework. We have received many requests seeking a case study of our magic portfolio to get insights into our approach. So, in this newsletter we would like to present a case study from our “Magic Basket” wherein our process is designed to capture a structurally sound business facing temporary challenges and valuation dislocation, thereby capturing both earnings growth and valuation rerating, in turn creating Magic for investors.

Along this framework we bought Max Financials (holding company of Max Life) as a part of our Magic Basket.

Why did we buy?

1. Max life is an incredible business we would love to own.

2. Short term dislocation and perception gap led to the stock trading at a significant discount to peers, despite strong business fundamentals.

We love such situations where if post our research, we are satisfied that the dislocation is temporary, business is great and we understand the catalyst in the medium-term horizon.

Why we like Max Life Insurance business….?

Max life is the 4th largest life insurance company built by the Max group over last 20 years. During this period of 20 years, it has consistently delivered and outperformed industry leaders on every parameter an insurance business (product, persistency, productivity) should be measured.

How did they do this? Max and New York life (JV partner) both were unknown brands in India in financial services compared to their competition like ICICI, SBI, HDFC etc. Max chose to take a difficult path right from the beginning - to go after long term sustainable business rather than chasing market share (“Delayed Gratification”). Max has hired and cultivated one of the best leadership teams, constituted a truly independent Board with members of global repute and hired a professional CEO – independent of promoters.

Max executed their chosen strategy very well – infact in most of our private interactions, even competition has admired and acknowledged them and their work. Max Life was the company HDFC Life, another player we admire, wanted to buy out owing to its business quality. “Deepak Parekh commented in 2017 that HDFC Life will pay premium to Max Life for its quality products.”

What were these strategic choices?

Product mix: Products of insurance industry can be broadly categorized into 2 buckets:

1. Traditional

- PAR and protection (primary purpose is selling cover for life, hence structural in nature)

2. Non traditional

- Non-PAR (offers guaranteed returns but prone to interest rate cycles and carries balance sheet risk)

- ULIP (offers market linked returns – akin to mutual fund, prone to market cycle)

Building traditional business requires significant upfront investments and hence can be a drag in the initial years, however it is more sustainable as compared to ULIPs which is cyclical. Non-PAR business sustenance is a function of interest rate cycle and carries a balance sheet risk, hence requires suitable hedging/risk management tools.

Max consciously chose to build the business with a focus on PAR portfolio and did a great job at it. Max’s PAR AUM @ INR 42K crores is the second highest next only to behemoth LIC, and much higher than industry leaders like HDFC Life, SBI Life. This clearly demonstrates the quality of business Max has built.

Max’s share in ULIP was significantly lower than peers….

The above data clearly demonstrates Max’s focus on building a long-term business franchisee vs chasing short term market share… one of the attributes we closely track.

Many small Innovations, which became a culture; “Right culture” gave them “Right to win”:

It did many firsts in the industry and continues to do, which became an industry practice or table stake at a later stage. But the culture of staying ahead of curve is what differentiated Max.

- Max could offer highly competitive pricing for its protection products owing to its data intelligence. When everyone was looking at overall data and data science was unheard of in early 2000s, it started capturing data at a granular level. For e.g., it started a pin code level of risk analysis. This granular risk analysis practice helped them to avoid risky business, reduce claim ratio and offer pricing which competition couldn’t. This gave them a big edge to win customer and build agency channel.

- It started to settle claims in 48 hours which helped them gain customer trust.

- Max was the first in the industry to start Free Look period to the customers which later became a norm. Customers were given full freedom to surrender the policy and get full refund during free look period.

- Max started a practice of giving the customer a call after he/she was sold a policy by channel to explain the policy benefits and confirm if he/she was happy to go ahead with the policy to ensure customer understood and the product has not been mis-sold. The customer could opt for a refund if he/she desired. This led to sharp increase in persistency as mis-selling reduced and product suitability was ensured. This has now become an industry practice.

- Max invested heavily in building a proprietary agency distribution channel just like LIC. But most interestingly it invested heavily into “agent training”, ensuring their agent quality was far better than others. Agents of Max were trained to understand customer needs and risk profile first before recommending the product. Well trained agents armed with best products resulted into highest productivity in the industry.

- Max has also invested heavily in building digital capability which gave them edge when the country went into lock down.

- Max Life has also built industry leading HR practises and incentive system to motivate their employees. Max Life at rank 24 is the only life insurance company to be amongst India's top 100 great places to work.( 2020) – as per survey by GPTW.

Our deep insight comes from looking at these seemingly miniscule steps which have helped Max built a solid franchisee over the years to build a sustainable growth business. It is so solid that even post pandemic Max had outperformance of 11% (Max grew by 4% in comparison to Industry which de-grew by 7%).

What is the outcome of the chosen strategy?

Market share - It is only the growth mindset and culture inculcated right from inception that has helped Max become the 4th largest insurance player. Max Life’ New Business Premium has grown at 18% over the last five years and further, it has been able to improve its market share from 9.30% to 10.6% (of private sector) in last 5 years.

Highest Persistency in the industry, a very strong parameter of customer satisfaction and profitability.

Max’s consistent persistency @ 85% is much higher than peers like Bajaj, Aditya Birla etc. (70% - 75%) and in lines with large bank backed insurance companies. Higher persistency means low customer attrition leading to higher embedded value and return ratios (ROEV).

Highest Agent productivity

What was the dislocation?

Despite superior business fundamentals, the stock was trading at a steep discount (60-70%) to its peers as well as to its intrinsic value.

What was worrying the market? Around 50% of Max’ Business was generated through Axis Banca channel and the market was worried of discontinuation of this channel should the regulator not approve Axis buying into Max’ equity stake. Promoter leverage was another issue worrying the market. Any forced liquidation of stock could cause serious MTM losses.

Our Hypothesis: Market was ignoring the fact that the agency relationship with Axis will continue irrespective of the outcome of the deal indicating limited downside should the equity deal not go through. The distribution business of Max contributed significant fee-based income for Axis, hence discontinuation was unlikely. It was important for both sides. Moreover, there was a reasonable probability of large upside on conclusion of Axis’ equity deal, which will render this relationship permanent. We did our homework and found that both sides were committed to continue agency deal as well equity deal and it was only a matter of time. We didn’t mind waiting because the underlying business was growing well. When the underlying business does well despite some overhang of corporate action, we smell an opportunity and don’t mind waiting patiently. It is the patient & prepared Investor who wins over investor who worry with everyday news flow reported by press.

Outcome: Approval of Axis deal has resulted in significant unwinding of discount; Thereby delivering 105% return since June 2019. Moreover, we believe that the compounding engine will continue for a fairly long period owing to large opportunity size and concentrated market share amongst few players, with Max being one of them. Axis partnership under the guidance of Amitabh Chaudhry, man behind creation of HDFC life, can only open up new vista of growth.

What’s heartening is when you invest into a great business run by a great management facing temporary dislocation, once the dislocation is over, the compounding engine is still at work, as depicted into our graph.

We see Max continuing to be a part of our portfolio.

Though outcome of Max has turned in our favor due to the unfolding of a magic event (approval of Axis equity deal), however what excites us is not the outcome but the process which we followed in the stock selection. We have built multiple scenarios around the risk-reward metrics and our stock selection was not solely dependent on unfolding of the magic event. We will continue to pursue the MCO framework and Carnelian multi step stock selection process (MRFG, CLEAR and PIU) involving numerous filters instead of just focusing on the outcome.

This also goes well with one of our core principles – “Excellence in inputs precedes outcome”.

We will continue sharing both successful and not so successful stories of our MCO framework in the forthcoming newsletters. While successful stories will motivate us, the not so successful stories will help us improve our process. We believe this will be a continuous process.

Lastly our two bits on the current markets

We have shared a lot about our long-term view on the economy through our past letters (Lollapalooza & 7 major trends). We continue to remain very bullish on India’s long-term prospects.

Second wave of Covid-19, rising interest rate fears, high markets expectations are likely to keep markets in a narrow range with a possibility of 5-7% correction. We will be unfazed by this and will recommend investors to use this as an opportunity to increase allocation to Indian Equities. No other asset class will beat this over a 5 years period.

Happy investing & happy reading.

Disclaimer: This newsletter is meant for general reading purpose only and is not meant to serve as a professional guide for the readers. This newletter does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. The recommendations, if any, made herein are expression of views and/or opinions and should not be deemed or construed to be neither advice for the purpose of purchase or sale of any security, (as defined under section 2(h) of securities Contracts (Regulation) Act.1956,

This document has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Carnelian Asset Advisor Pvt. Ltd. (Carnelian), Sponsor, the Trustees or any of their respective directors, employees, associates or representatives (“entities & their associates”) do not assume any responsibility for, or warrant the authenticity, accuracy, completeness, adequacy and reliability of such information. Whilst no action has been solicited based upon the information provided herein; due care has been taken to ensure that the facts are accurate and opinions given are fair and reasonable. This information is not intended to be an offer or solicitation for the purchase or sale of any financial product or instrument. Recipients of this information are advised to rely on their own analysis, interpretations & investigations. Readers are also advised to seek independent professional advice order to arrive at an informed investment decision. Carnelian, entities & their associates shall not be liable for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including loss of profits, arising in any way from the information contained in this material. Entities & their associates including persons involved in the preparation or issuance of this material may from time to time have long or short positions in and buy or sell the securities there of, of company(ies)/ specific economic sectors mentioned herein and as such not a recommendation to buy, sell or hold any such securities. investments are subject to market risks, read all related documents carefully.

Carnelian Asset Advisor Pvt. Ltd. (“Carnelian”) is a SEBI registered Portfolio Manager (SEBI Reg. No. INP000006387) and Investment Advisor (SEBI Reg. No. INA000015792). Carnelian is also an Investment Manger to Carnelian Capital Compounder Fund – I, which is a SEBI registered Category III Alterntive Investment Fund (AIF) (SEBI Reg. No. IN/AIF3/18-19/0642).

For more information, visit us at www.carneliancapital.co.in.