Government policies and regulations have a material impact on business growth and profitability. Research has shown that business/ capitalism friendly policies add to general national prosperity. Take for instance the 1991 Economic Liberalisation in India. That single decision has altered the trajectory of wealth creation by Indian businesses. Respect for trade, commerce, enterprise and property rights has been a common source of wealth creation across multiple countries including Switzerland, Singapore, America, Japan, and to a limited extent, even China.

It is not surprising that Indian markets are cheering the expectation of the Modi government’s relection in the forthcoming elections. Over last 10 years, the Modi government has spearheaded many notable reforms including GST, reduction of corporate income taxes, speeding up infrastructure spends, fostering digitalisation through JAM – Jandhan, Aadhar and Mobile – trinity and promoting Make in India to name a few.

While the impact of policies on business growth is clear, the near term impact on the markets is less so. Two key challenges are (a) double counting and (b) impact of other factors:

Often, expected election outcomes already get baked into prices. Expecting a further rise when markets have already risen can be a double counting error.

Also, politics is not the only factor that affects markets. Global interest rates (falling interest rates since 2008 to 2022), global economic cycle (Chinese commodity boom in 2003-2007), geo political issues (Kargil war, 9/11, Ukraine-Russia war), technological changes (internet in 2010s and AI currently), demographics etc. all can have multiplicative or countervailing effect on markets.

Here are few examples of how correlation between elections and stock market is messy:

After rising 3x post Economic Liberalisation of July 1991, (partly due to the Harshad Mehta scam), the BSE Sensex remained flat for next 11 years even as the benefits of Liberalisation continued. There was the Asian crisis, Pokhran nuclear test (leading to global sanctions), and the Kargil War all in between.

In the 2004 elections, there were high expectations of the BJP-led government’s re-election under Mr. Atal Bihari Vajpayee. We all remember the optimistic “India Shining” campaign. Contrary to expectations, the Congress-led United Progressive Alliance (UPA) won, initially leading to a 14% drop in the Nifty Index over the month following the election. However, the market was up 24% next year due to the Chinese commodity boom.

Or, take the 2009 elections, when Sensex was up 81% for the full year on re-election of The UPA’s government with a stronger coalition. How much of this was due to UPA re-election and how much a recovery from steep fall the previous year due to the Global Financial Crisis, is difficult to segregate.

In summary, it is not very easy to pinpoint election outcome’s exact and solitary impact on stock markets both in near term and longer term. This is because not only do prices bake in expectations, but there are other factors at play too.

Our approach is taking election outcomes as one of the many inputs into assessment of a company’s economic worth and comparing that worth with prices. Election outcomes stack lower than many other more important inputs like size of opportunity, competitive advantage, management quality etc in the pecking order. While there may be some businesses that directly benefit from who is in the power (infra, mining, defence, capital goods etc), economic cadence of businesses that we like (not many in the above list) are not materially affected by who’s in charge of the country so long as capitalism and free enterprise flourish.

असतो मा सद्गमय। तमसो मा ज्योतिर्गमय। मृत्योर्मामृतं गमय ॥

(May we move from untruth to truth, darkness to light, and mortality to immortality.)

– Brihadaranyaka Upanishad

Truth: There are only a few eternal truths in investing. Some of them include: (a) Stocks are not pieces of paper, they represent partial ownership in live businesses. (b) The value of a business (and therefore stocks) is the present value of cash that can be taken out of the business over its life. That depends on opportunity size, competitive advantage and management quality. And, (c) Risk stems from acting without understanding this value and/ or paying above the conservatively assessed value. The closer our actions are to these truths, the better our long term performance will be.

Light: Returns lie in the future. However, future is uncertain and dark. Only an intellectually honest understanding of a business can shine light on its character and help predict its future. While perfect understanding of a business is impossible, honest working understanding of key variables is sufficient. Mistakes occur when we think we understand a business when actually we don’t. Hence there is need for humility, sceptic mindset and use of common sense, forensics, and triangulations. Unless proved otherwise, every incoming information about a company needs to be doubted. Keeping our hypothesis always in question and seeking to invalidate our most loved beliefs can allow us to move towards light.

Another aspect of darkness is our biases and emotions that prevent us from seeing the light. Greed, envy, fear of losing or missing out, overconfidence, and hubris obstruct the light of rationality. While these biases and emotions have evolutionary importance, they become counterproductive while investing. It may sound funny, but the first impulse is usually wrong in investing and it would be safe to act opposite to it. Being greedy when fearful, for example. Yes it is difficult to go against our evolutionary programming, but staying aware of our emotions and biases can take us towards right action. 

Immortality: Being a custodian of wealth that is going to be useful not only for the current but even future generations, we need to think in terms of decades instead of quarters. Our first objective as investors should, therefore, be to avoid mortal mistakes, financial ruin and permanent loss of capital. Focus on risk should precede expectation of riches. This requires preference for sustainability and repeatability.

Prices often rise in short term due non-fundamental reasons including narrative, liquidity and news flow; many times against fundamental reality. While riding such rise due to luck or design looks temptingly doable, it is not sustainable (at least for us) and may eventually reverse. In longer run, paying below carefully assessed fundamental value is the only way we understand to sustainable returns.

Lastly, when assessing value or behaving, we should remember that most things – high growth, high margins, success and failure are impermanent. Prices move from being expensive to being cheap and vice versa. By retaining equanimity and behaving counter-cyclically, we can use these swings to our advantage.

In summary, we have to keep moving towards and sticking to a process that is based on eternal truths, intellectual honesty and sustainability.

Surgeons, pilots and many critical professionals have saved lives using checklists. In last 12 years, our investment checklist has evolved after being battle tested with real life wins and losses. Here’s that checklist summarised into five key hurdles/ questions that every company we own or wish to own has to pass:

First and the biggest hurdle is that we must be able to independently understand the business. This involves understanding how the business makes money and why do consumers demand its product/ services. Due to complexity of the business or our own ignorance, many businesses are not able to pass through this screen. No understanding, no conviction, no investment case. Time, reading and thinking help us improve understanding of new or existing businesses.

The second key question that we ask is how large is the opportunity size. A company that is serving an essential product/ service with no threat of substitution and has low penetration can be said to have a long runway (for example demat accounts, air conditioners, health insurance etc). A definite disruption threat is a key risk to avoid.

Long runway, however, in itself is not enough. The business should have some inherent competitive advantage that allows it to tap the runway profitably. Competitive advantage allows the company to protect profits from competition or regulations. Low cost, network effects, patent/ license/ copyright, switching costs, consumer habits, culture etc. can be some of the sources of competitive advantage. Without competitive advantage, growth does not create shareholder value. This is an area where we spend a lot of time. High returns on capital hints presence of an advantage in the past. We probe the causes and durability of such high returns. It is important not to mistake cyclical tailwind/ headwind as competitive advantage/ disadvantage.

The fourth and the most difficult filter is management quality. We look at the past actions of management around three areas. First is execution track record i.e. ability to create distribution, human resource, and supply chain capabilities that allows it to maintain or grow its market share. Second is capital allocation i.e. investing incremental earnings on return accretive projects or in absence, returning them back to shareholders in best possible way. Last is treatment of minority shareholders as evident from accounting quality, embezzlement, remuneration and skin in the game.

The last but important hurdle is valuation. For core equity positions, valuation alone is useless unless the company passes all the four hurdles above. Our preferred method to value is to see what growth and margin assumptions are built into current price versus (a) past and (b) our conservative imagination of its future. Often a company that passes the above four tests does not come cheap. While quality demands paying up, paying any price can be a mistake. We need to wait for temporary hardships or size discount (smaller companies can remain mispriced due to lack of attention from larger investors) that can create mispricings.

Despite failing to pass one or more of the above five hurdles, a company’s stock may do temporarily well. An 80 P/E stock may go to 100P/E; stock of a company in a new long runway sector but no entry barrier may rise in initial euphoria; temporary tailwinds may be mistaken for enduring advantage etc. But if the truth around the five steps hold, weak thesis gets its due punishment. Conversely, a company passing through all the five hurdles sooner or later gets it due reward. Keeping the investing bar high and executing all five of them with discipline and margin of safety is the key to minimise investment mistakes and improve long term returns. Funnily, the five hurdle process eventually works because it does not always work

Journey is the destination

We completed 10 years at Compound Everyday Capital in 2022 and shared seven of our key learnings with our investors:

1. Risk > Return: In our initial days while we thought we were risk conscious, our primary focus was on returns. We didn’t know that we didn’t know. Despite taking risks that we were unaware of, we did well due to luck. The wrong lessons led to mistakes, heartburn and learning. The learning is that risk management and capital protection should be the primary goal of investing. And the simplest way to reduce risk in equity investing is not to overpay after doing proper valuation work that incorporates quality of business and management, uncertainty, cyclicity, possibility of being wrong and base rates. Putting risk first, however, is not as easy as it sounds. For, in a rising market a risk based investment approach will feel like what insurance premium feels until there is an accident – a needless cost. However over the longer term this risk focused approach, like insurance, will avoid large drawdowns and come out better even if it lags in interim.

2. Seek to invalidate: Evolution has ill prepared human mind for investing. Emotions, while good for surviving in the savannah, work counter-productively in investing. In past, ego and confirmation bias had stopped us from rejecting our delusions. We were caught trying to justify low valuations without looking at perils. If we had worked on an idea, it started looking good to our mind -ego. We selectively looked at positives to justify holding – confirmation bias. Bruised ego, we learnt painfully, is better than burnt pockets. Today when we get a new idea, our first reaction is to try to actively kill it. Our initial research focuses on searching for evidences that proves that the bet is subpar and therefore not worth spending more time. Only if we find ourselves unable to actively kill an idea, we move ahead with it but try to remain ready to ditch if thesis doesn’t unfold as we though. Care is needed not to take this too far, for it can foster cynicism and inactivity. It’s a difficult balance to achieve, but we are trying. On balance, this approach has saved us on more occasions than leading us astray.

3. Two key risks – Poor Management, Disrupted Business: We have made a handful of mistakes that tick this box. Management that, in past, has not allocated capital well, not has executed well, has not adopted conservative accounting or has not treated minority investors well are clear red flags. Similarly when we find evidence that a business is definitely disrupted or if the new technology weakens a company’s competitive positioning, we are worried. In both these cases, we avoid/exit irrespective how mouth-watering surface valuations look. They are mostly traps.

4. Temporary hardships are good: Often the type of company that we like – exceptional business run by able and honest management – is what everyone likes as well. This means most of them are well tracked and efficiently priced most of the time. However temporary setbacks in either the company, sector, country or the world engenders fear which breaks their efficient pricing mechanism. These are the only times when exceptional businesses can be found at exceptional prices. Benefitting from temporary hardships requires preparation and waiting. Preparation for understanding the right companies, and waiting for temporary hardships. Caution, however, is needed to ensure that the hardships are indeed temporary and not permanent.

5. Most things are cyclical: In investing, like in life, good times are followed by bad and vice versa. Demand, supply, growth, margins and multiples go through cycles and mean revert. Peak growth, peak margins and peak multiples often occur in life of a company. During such times, FOMO (fear of missing out), accolades, media narratives and halo effect can tempt one to give in and enter at wrong times. Opposite happens when cycle reverses. Awareness of cycles, therefore, is a good way to profit from them.

6. Expanding circle of competence: Doing proper valuation work is the bed rock of risk based investing. We cannot assess whether a company is over or under valued unless we have an opinion about its intrinsic value. Forming this opinion requires good understanding of a company – it’s business model, size of opportunity, competitive position, key drivers etc. It’s usually safe to skip an idea if we cannot understand the business and if it falls outside our circle of competence – which happens often with us. While this discipline is important, what makes our work both engaging and challenging at the same time is the efforts required to expand this circle of competence one company at a time. Larger the circle, larger is the fishing pond.

7. Smart Diversification: All returns lie in the future, but the future is unknowable. Despite best efforts, rapid technological change, uncertainty, ignorance and mistakes will remain investing challenges. Too much concentration can raise risks. To provide for these risks, we need humility in sizing our bets and diversifying intelligently. An intelligently diversified portfolio is one where constituent securities donot always move in one direction and thus lend resilience across multiple adverse scenarios over longer term. Care, conversely, is also needed not to over-diversify else winners will not move the needle.