Preferred Way to Reduce Risk in a Rising Market


“Risk means more things can happen than will happen”

-Elroy Dimson


In a rising market, most investment/ trading styles do well despite overpaying. For, money gushing into any asset class can raise its price irrespective of underlying value. Prudence and safety are needless, even penalised during such times. But like most good things, such good runs – even if they extend over a long time – eventually reverse. Waking up to build controls after such reversal is too late.

Portfolio safety is like a car’s seat belt. Both are minor irritants in good times, but life-saving during accidents. Just as it is prudent to always wear seat belts tolerating minor discomfort, it is important to control risk in portfolios even in good times tolerating lower relative returns.

Our preferred way to reduce risk in the portfolio is to buy a diversified set of good companies cheaply and hold them till they remain good and don’t get super expensive. Yes, there is an inherent conflict in this goal. Markets have become more efficient and everyone is trying to do the same. So good companies donot come cheap. Mostly. But there are two pockets where mispricings are common. First is temporary hardships either in the world, country, sector or company during which even good companies get traded at throw away prices. And second is smaller companies which are not so well tracked and/ or are less liquid and can remain mispriced.

Doing the above is easy in theory but difficult in practice. We need to exercise discipline and have safety margin in all the three components – (a) diversified uncorrelated positions, (b) good companies, and (c) reasonable valuations.

And while doing the above, there are bouts of luck and mistakes. Many times, probable outcomes don’t happen and/ or improbable outcomes happen. Often we get good outcomes beyond our expectations due to plain good luck. These times call for humility and trimming positions that get super expensive. Conversely despite doing the right thing our positions can fall. If there is no material deterioration in underlying fundamentals, these are times not for despondency or self-pity, but raising our bets. Lastly, we make mistakes; they are normal in a pursuit of higher than risk-free returns. When we make mistakes, mention of their account precedes that of achievements so that we don’t lose the lessons.

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Focus on Intrinsic Value


“What do you see, son”? Asked Guru Dronacharya. “Only the bird’s eye, Sir”, replied Arjun.

-the Mahabharat

We all have grown up listening to this Mahabharat  story on importance of focus. Whether its archery or investing, great achievements demand undivided focus. The bird’s eye equivalent in long term investing that demands undivided focus is company’s intrinsic value (or economic worth, in simpler terms). For, only that can help us decide if a company is undervalued or overvalued versus its stock price. Everything else, is noise.

To recall, a company’s intrinsic value is the present value of its future free cash flows. Two broad components of intrinsic value calculation are (1) future free cash flows (i.e. cash earnings less investments) and (2) future interest rates to discount those cashflows to their present values (aka discount rates).

Assessing intrinsic value, thus, requires looking into the future – for both cash flows and discount rates. Unlike Arjun’s bird in the Mahabharat that is still and clearly visible, intrinsic value is therefore a moving and hazy bird.

Future cashflows: Either due to their nature or our current ignorance, we cannot imagine future cash flows of most of the companies. It’s futile to even attempt their intrinsic value calculations. For, in archery parlance, we cannot even see the bird. Nonetheless, there is a sub set of companies where we can. Mostly these companies provide essential, under-penetrated or non-substitutable products/ services competitively and are run by able and honest management. They are expected to see reasonable revenue growth and high returns on capital. Here is where we limit ourselves looking.

Future interest rates: For intrinsic value purposes we are concerned, not with interest rates of next quarter or year, but with long term future interest rates. Just as assuming very low long term future interest rates is mistaken (last 10 years), so is assuming very high long term interest rates (temptation today). We need to assume moderate interest rates over long term in our intrinsic value assessment. Given that 30-yr Indian government securities are yielding around 7% today (2024), 4% is too low, and 15% too high for discount rate. Anywhere between 10%-12% sounds okay, today.

We need to place all incoming information in above backdrop. Discipline to limit ourselves to sound companies and focus on their intrinsic values that correctly embeds future cashflows and long term future interest rates will allow us to ignore noise and take right investment actions.

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7 key learnings from 10 years of Compound Everyday Capital

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.

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The right discount rate

Intrinsic value of any asset is the present value of its future free cashflows discounted at an appropriate discount rate. The appropriate discount rate should be the realistic return that one expects from investing in that asset. Such expectation is shaped by returns on risk free instruments of similar maturity.

An equity share is a long dated asset, good ones are perpetual. Many great companies are in existence for over 100 years (For eg. Coca Cola, Unilever, P&G etc). In India, the longest dated risk free instrument is the 30 year government bonds. Their current (2024) yields are 7%. Given that equities are riskier and longer dated than this, we need to add some spread to this. Indian equity discount rates, thus, should be above 7% currently, but how much above is a matter of judgement.

Financial theory tries to use past volatility to arrive at this number and involves needless mathematical jugglery. We use a 10% discount rate for quality businesses and keep raising this for lesser ones. Mind you, present values are very sensitive to discount rates. A fall of 1% in discount rates, raises the present value of a 30 year cashflow stream growing at 5% annually by around 11%-13%. Without mathematical acrobatics, our practice is to use a high discount rate. If the business looks fairly valued leave alone cheap at that rate, we become interested.

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Understanding impact of inflation on intrinsic values

While exact causes and future trajectory of inflation are neither easy nor interesting topics to discuss, the impact inflation has on businesses, valuations and investment opportunities is real and therefore deserves your investment attention

Intrinsic value of a business is present value of its future free-cash-flows (cash profits less investments) discounted at an expected reasonable rate of return. Inflation can adversely affect all the three elements of this value equation – (1) profits, (2) investments in working capital & fixed assets and (3) expected reasonable rate of return (aka cost of capital).

Profits – When revenues fail to increase as fast as costs during inflation, profitability suffers. There are two antidotes to this– (a) raise prices, and/or (b) control costs. There are many nuances to each of them.

Companies that sell unsubstitutable necessities such as staples, utilities etc. can raise prices without material effect on volumes. Inflation raises output prices for commodity producing companies (steel, copper, aluminium, oil etc.), but the benefits are temporary due to cyclicity – higher prices reduce demand and/or attract new supply that cool prices. For lenders, interest rates on loans are reset faster than cost of deposits and supports margins. Industries with low spare capacity can raise prices in near term without materially affecting volumes. On the other side, often regulatory caps on pricing can become a deterrent. If end consumers are seeing strain on their budgets, they will try to delay, substitute or downtrend. However, companies serving higher income consumers may be hit less.

On cost side, companies with high operating margins can maintain absolute profits without large increase in output prices during inflation. Illustration: if revenue is 100, operating cost is 30, then operating profit is 70 (and operating margin 70%). If costs rise by 10% to 33, just a 3% rise in sales price to 103 can protect absolute operating profits of 70. Whereas if the operating margins are 30%, a 7% rise in sales prices will be needed.  Continuing on costs, companies with high operating leverage (high fixed costs) can see rise in margins with rise in volumes (rise in fixed costs is slower than rise in volumes and improves margins). Lastly, a lower cost player can breakeven when others in the industry bleed and can get stronger as competition dwindle.

Finally, if inflation leads to rise in interest rates or currency depreciation, companies with high debt or imports can see sharp rise in their interest and forex cost, that can further hurt profits.

Investments – Working capital and capital expenditure (capex) rise with inflation. Rising input prices increase investments in inventory, and rising output prices increase receivables. Some of this is negated by rise in payables. Dominant companies who can keep low inventories, receive dues faster from customers and delay payment to vendors can keep working capital low. Capex heavy businesses are worst hit during inflation. Maintenance or new capex rise in line with inflation. The rise has to be paid out of profits and this reduces free cash that can distributed to shareholders. Capex and working capital light businesses are best saved during inflation. Services are generally less investment intensive than goods. Companies where large capex is already done will also be less affected by inflation.

Discount Rate: Central banks usually raise interest rates to control inflation. This raises the hurdle rate that risky investments like equities should deliver. A higher discount rate reduces present value of future cashflows. There is no running away from this for any company, but loss making companies with back ended cashflows are hit more. Higher discount rates should make us wary of paying high multiples even for strong companies. Keeping other things constant, what was deemed fair at 30x earnings during low inflationary period can become expensive during high inflation.

For a given company, the net effect of inflation on all three variables – profits, investments and discount rate – need to be studied together to understand its investment merit. High points on profitability and/or investments may be nullified by low points due to high valuations. Moreover, short term effects need to be separated from longer term effects. Pricing tailwinds for many commodity producers may be cyclical. Stronger companies may sacrifice margins in near term to capture market share from weaker ones. In short, assessing impact of inflation on intrinsic value is little messy and we need to err on the side of caution. This means accepting that the sub set of companies whose intrinsic values may rise during inflation is very small.

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Return is visible. Risk is not

Unlike investment return, there are no full proof quantitative measures of investment risk. Risk can only be qualitatively judged. It’s like driving a vehicle. One can choose between safe and rash driving. Driving at 100 kmph can be both rash and safe depending on type of vehicle, road and traffic. Similarly, a 20% return can be both safe and risky depending on the buying price. An expensive buy can get more expensive and generate that 20% return. At the same time a cheaper stock can get reasonably priced and generate 20% return. Former is risky, latter is less so.

Assessment of investment performance is incomplete if the focus is only on returns and not risks. The best way to reduce investment risk is to invest within one’s circle of competence and not to overpay.

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Buy High. Sell Low. Repeat. Go Broke

Nothing is as financially ruinous as consistently buying high and selling low. Yet we see it happening all the time. Ignorance, emotions, and miss-selling interact with each other to powerfully induce this folly.

Without a sense of a company’s worth, it is impossible to judge whether its share price is high or low. Assessing that worth requires understanding of underlying business and many investors donot have time, interest or ability to do it. Price trend is generally used as a substitute for this ignorance about intrinsic value. Companies seeing price rising are considered as good and vice versa. When more people believe in this momentum, it becomes a self-fulfilling prophecy. Ignorance encourages buying assets that are rising.

Nothing intoxicates human mind as rising prices. Rising prices trigger emotions of envy, FOMO (fear of missing out) and greed. Those sitting on side-lines get interested. And those making money feel invincible and take more risks even on leverage.

Times of rising markets is business-season for many “experts” – distributors, advisers, brokers, merchant bankers etc. Sadly, financial incentives of almost all “experts” are linked to selling financial products – stocks, mutual funds, IPOs, insurance policies – and not good outcomes for investors. This leads to miss-selling. Mutual funds, life insurers and capital raising companies paid over INR 37,000cr (rough conservative estimate) worth of commissions in 2021 to these “experts”. This was paid without any linkage to the buyers’ returns from the financial products sold.

When willingness to buy during rising prices is met by advice that pays the advisor for selling expensive products, it creates a powerful force to buy high.

The same story reverses when prices fall. In absence of sense of intrinsic value most investors fail to assess whether paper losses are temporary or permanent. Momentum and emotions trigger a rush for the door. And those “experts” who peddled the products during rising prices either disappear or are not heard.

Here’s a crude antidote to this: When past returns of an asset class are high, ignore all temptations and “expert advice” of even higher returns. Conversely, when past returns of an asset class are low or even negative, ignore anything that stops you from investing. Lastly, when taking help from “experts”, see that they are remunerated for results, not selling products. When you get a call from a life insurance agent, just hang up!

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Low interest rates = Low future equity returns (lessons from 2010-2020)

Low interest rates have been often cited as a justification for higher equity valuations. When fixed income instruments are yielding 0%-2% in the developed world, investors flock to riskier assets in search of higher returns and equities benefit from this lack of investible opportunities.

However, a corollary to this is lower future equity returns. If investors believe that lower interest rates offer arbitrage benefit to equities and bid up equity prices, this act should reduce the arbitrage and make future returns of all asset classes converge. In other words, if interest rates of 1% around the world pushes money towards equities, future returns from equities will not be different from 1%. Many investors do not take this into account.

Secondly, there is an implicit assumption that interest rate will remain so low forever. If that’s not the case and rates do rise, they will hit a long tenured asset harder. A 10 year bond falls more in % terms than a 1 year bond for a same rise in interest rates. And equities are perpetual assets. If interest rates do rise, equities are going to fall substantially more.

While everyone’s happy that lower interest rates and abundant capital supports rising equity prices, here’s an outcome that many investing carelessly today may not like: low equity returns if interest rates remain low; and negative equity returns if interest rate increase even marginally. When prices are bid up aggressively – heads you lose, tails you lose too!

The one safeguard against this is to buy equities assuming that interest rates are already high and leave some margin of safety.

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Underperforming in a rising market

One needs to guard against the desire to be a top performer at all times. Markets are not always rational and often go through bubbles. The most popular sectors during bubbles trade at exorbitant valuations and see a rise in their weights in benchmark indices. A top quartile performance during those times can be obtained only by going overweight on popular sectors. And what’s popular is seldom cheap – tech in 1999, infra and real estate in 2007, quality/ growth in 2020 and PSUs/Defense/ Railways in 2024.

Other things remaining constant, an underperformance versus the benchmark is a leading indicator of risk reduction during buoyant times.

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Test match Vs T20 match

10 Overs, 40 runs, 0 wickets. How’s this for a first innings cricket match score? You will rightly ask – What’s the format of this game? It’s a bad score for a twenty-twenty (T20) match, average score for a one day (ODI) match and a decent score for a test match. And if it’s indeed a test match with bouncy pitch, overcast conditions and the best bowling unit in the world – you will say it’s a fantastic score.

In cricket and in investing, it’s impossible and, even, unfair to judge a score without knowing what format of the game it is. What’s good for T20 may be bad for test matches. What’s good for momentum trading may be bad for long term investing.

We are playing a test match and not a T20. The key to success – both in test match batting and long term investing – is to leave or defend the balls that are risky. And, hit only when the ball is in the sweet zone.

This investing sweet zone for us is buying sustainable businesses, run by able and honest management, at reasonable prices. And so long the ball is not in this zone – either the business and/or management and/or price are bad, we wait, and wait and wait. For that juicy half volley or full toss right in our zone. They normally come.

T20s are more popular than test matches. Similarly, short term investment horizon and momentum based trading are more common than long term horizon and value oriented investing. Popular attention is focussed on what’s going to happen next day, week or month in markets. This should not let us forget that we are playing a different game

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