Investment Process, Investment Psychology

Test match Vs T20 match

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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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Investment Psychology, Market Cycles

Envy, FOMO and Greed

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It’s agonisingly difficult to stay on sidelines as stock prices rally. Every day’s rise, calculable from daily prices, reminds of returns forgone. And, if friends, family and neighbours are gloating about it on social media, the chance of staying cautious amidst rising prices is close to nil.

Envy and fear of missing out (FOMO) are evolutionary emotions that supported survival of human beings. It propelled our hunter forefathers into action and ensured that they were not staying behind in the survival queue.  So is greed. There were survival benefits in over eating or storing excess food or accumulating things beyond immediate need. We inherited these emotions as their legacy.

Envy and FOMO pushes those staying on sidelines to participate in a rising market, often at the top. And greed pushes those who are making money to continue chasing rising prices often on leverage (trade on borrowed money/ margin). This fuels feel good emotions and a feedback loop. Sadly, financial history shows that what cannot go on forever, will stop someday. While good for survival; envy, FOMO and greed are hazardous during investing.

You will be attracted to narratives about how things are different these times and time to make money is now. The origins of these narratives are often from those who get their payday selling part or full of assets/ companies. When someone comes to you with a deal, check how is he/she getting remunerated.

Most of the times, most of the prices donot go in one direction. What’s wise at one price, is foolish at another. Plan of buying assets in hope of passing it on to a greater fool can backfire when supply of greater fools run out and one ends up holding the can.

The only antidote against succumbing to envy, FOMO and greed in investing is a sense of intrinsic value and discipline to wait if prices donot leave a sufficient margin of safety against bad luck or error. Both of these – sense of intrinsic value and discipline – come from an understanding of underlying assets/ businesses. Avoid poor businesses &/or poor managements &/or poor prices. And one can avoid many mistakes.

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Investment Process, Value Investing

Temporary Hardships

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Good businesses seldom trade at bargain prices.  However some times, very rarely, they are struck by adversity that hurts earnings. In our experience the immediate price reaction to any sudden negative development for good business is mostly negative. If on a calm analysis we can conclude that the hardships are temporary and less impactful than the price has discounted, such bloopers can be a good opportunity to pick good businesses at good prices.

The obvious mistake that can be made is to misjudge permanent hardship as temporary, and structural headwinds as cyclical shifts. The only antidote against making this mistake is a sound understanding of the business and its industry.

MCX fell 84% in 2013 when NSEL fiasco came to light. Muthoot Finance fell 63% in 2013 after gold prices fell 20% and RBI imposed 60% LTV requirement. Inox Leisure fell 36% in 2018 when a PIL was filed to allow outside food. Canfin Homes fell 65% in 2018 after Canara Bank failed to sell its 30% stake at its desired price and IL&FS default further affected sentiments towards non-bank lenders. These were temporary hardships where we remained invested and/or added further and have been rewarded well.

Dish TV fell 80% due to Jio aggression and OTT popularity. DB Corp too fell 80% despite high cash generation and growing in circulation due to threat from internet. These are permanent hardships and we had to exit at par in former and loss in latter.

So long as demand continues to remain robust, business debt free or has access to capital, raw material or end product prices are cyclical, and remedial measures remain in control of management, the hardships are temporary.

However if there is challenge to long term sustainability of demand, or new technology brings in better and/or cheaper solutions hardships are permanent.

Curiously temporary hardships have higher visibility, permanent hardships are less noisy. Management and media miss the latter or hope it to be temporary. Nonetheless, ability to distinguish between the two can be profitable. Wherever prices misjudge the hardship to be permanent, it can be a good buying opportunity.

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Corporate Governance, Frauds

Honesty is the best policy

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25x earnings are much better than 1x stealing

– Ashish Dhawan

You would have heard of stories in past about stocks falling 60-99% in a month after governance issues were uncovered in many large and reputed companies. Many frauds are unearthed when debts can’t be rolled over and credit crisis often does that.

There is a fine line between ambition and foolishness. Capitalism is brutal and business failures common. However under influence of greed and ego many cross the fine line and resort to lying and theft. Sooner or later the misdeed is called out and punishment is severe – imprisonment, impoverishment, fleeing, or in rare cases self-harm. Given the extent of loss of wealth, credibility, and good night’s sleep, it bears asking whether all that is really worth it. 

Tolerance towards corporate malfeasance is at its lowest today and that is a good milestone for Indian stock markets. SEBI’s whistle blower framework has made it more difficult for promoters to keep their misdeeds under wraps. The difficulty and cost of misdeed has risen. At the same time, thankfully, markets are ready to reward corporate governance with premium multiples. It is clearly visible that it pays to be honest.

We hope that promoters take a leaf out of these cases of wealth and reputation destruction and understand that it is their selfish interest to respect minority shareholders and behave responsibly. 

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Investment Process

Behaviour as an edge

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“What’s not going to change in next 10 years?”

-Jeff Bezos

Internet, AI, securities regulations and entry of talented individuals have blunted the erstwhile investment edge offered by better information and better analyses. Rational behaviour – buying below intrinsic value and selling above it irrespective of short term noise – still remains a sustainable source of investment edge. That’s because institutional compulsions and human emotions & biases force participants to eschew this rationality and create mispricing. These two factors will not materially change in next 10 years. 

Institutional Compulsion: Investment behaviour of fund managers at investment institutions is driven by minimising career risk. Their jobs, promotions and bonuses depend on increasing the assets under management (AUM) which in turn depends on matching or beating their benchmarks net of fees on quarterly basis. Often unconventional and/ or concentrated stock picks cannot offer this guarantee. Therefore most of them construct ‘index aware’ portfolios – euphemism for mimicking benchmark indices. Many companies that are out of index donot find buyers and remain mispriced. Rising interest in Index Funds/ETFs (passive funds that mimic benchmarks fully without any human discretion) will further aggravate this anomaly. Further, redemptions or regulations force fund managers to sell stocks irrespective of value. In past SEBI reclassification in mutual funds drove lot of money out of mid and small caps to large caps irrespective of fundamental merit. 

Human emotions & biases: While good for hunting, gathering and surviving, evolution has ill prepared us to do well in investing. Fear and greed were mental shortcuts that helped our hunter forefathers survive. They ran when there were rustlings in the bushes (fear). And, they overate/ stored whenever food was in excess (greed). These genes are passed on to us as their legacy. Price fall triggers the same fear. Risk aversion rises and future projections get grim. No price is too low. Conversely price rise engenders same greed. Risk taking rises and future projections get rosy. No price is too high. Behavioural Finance has demonstrated that we are not perfectly rational. We are susceptible to heuristics and cognitive biases.

Behaviour Edge: Knowing above, following offers us a sustainable investment edge:

  1. Operating only in businesses that we honestly understand and having a sense of their intrinsic values.
  2. Remaining humbly aware of multiple possibilities including our folly and therefore buying with a margin of safety.
  3. Understanding that (a) intrinsic values are less volatile than price, and (b) emotions revert to mean.
  4. Raising money and/ or investing only when prices make sense (is harder than seems) and willingness to hold cash when opportunities are thin. Our incentive structure supports this behaviour.

Rational Money: A fund’s behaviour is derived from its investors’ behaviour. We may, thanks to above reasons, find bargain securities and buy. Prices however may continue to fall even after that despite fundamentals remaining intact. Interim NAV performance may look poor. If investors panic and withdraw on those times, the paper loss will be converted to actual loss and all our behavioural astuteness will amount to nothing. A fund manager can be only as rational as the money she manages.

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Investment Psychology, Market Cycles

Volatility and Bargains (reminder during bear markets)

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The key to discovering bargains is an understanding of value/ worth of a business. Prices often over or undershoot conservatively assessed value for various reasons. Future uncertainty and over reaction to continuing developments is one of the sources of this volatility.

Since the launch of the BSE Sensex in 1986, India has witnessed five events of seismic proportions – the 1991 Economic Liberalisation, the 1997-98 Asian Crisis, the 2000 dot-com bubble, the 2008 sub-prime crisis and the 2020 Covid-19 pandemic. Market movements during each of those times were characterised by very high volatility – rising and falling over 50% in short term. Even after these upheavals the Sensex has compounded by 16%  annually (including dividends) in the last 32 years.

One key factor in climbing these walls of worries has been human tendency to fight, survive, adapt and prosper. The need to keep improving one’s life conditions amidst all hardships will always exist – more so in India today as it stands at under 2500$ per capita GDP. So long India remains a democratic nation and a free market economy, good businesses that can cater to the demand of a prospering India profitably will prosper.  All we have to do is buy sensibly without overpaying. Volatile periods will be an opportunity to do just that.

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Market Cycles

Smallcap meltdown of 2018

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Non fundamental events aggravated the panic in broader markets in last nine months of 2018. Since January 2018, NSE Nifty 50 grew by 4% where as mid and small caps represented by NSE Midcap 100 and NSE Small cap 100 fell by 19% and 32% respectively. The mid and small caps have had a dream run over large caps in 5 years ending 2017– compounding at around 20% (Nifty midcap 100 and small cap 100 full indices) annually till Dec 2017, higher than NSE Nifty’s 12% p.a. And a correction was natural. Four non-fundamental reasons magnified the fall:

First, In October 2017, SEBI released a circular on re-categorisation and rationalisation of Mutual Funds Scheme. To oversimplify, it barred large and mid cap schemes from investing in small caps. By current SEBI definition small caps are over 60% of actively traded companies on the NSE. Mutual funds were compelled to sell these stocks amidst narrowing liquidity that amplified the fall.

Second, the SEBI came out with an ASM list (Additional Surveillance Measure) to curb volatility in prices of some small and mid cap stocks. Ironically, exactly the opposite happened. The measure inter alia required 100% margin for trading in these stocks. Significant liquidity dried post this announcement and further accentuated the fall. The ASM list is not a vote on fundamentals of the company. One of our stocks that was included in ASM offered us attractive opportunity to add.

Third, in April 2018, NSE announced changes to NSE Midcap 100 constituents whereby 46 of 100 stocks of the then mid cap index were excluded from index. This is significantly large number. Many mutual funds that mimic index, sold these excluded stocks causing corrections.

And lastly fourth, in late September as an overreaction to loan default event at an infrastructure NBFC (IL&FS) (non banking finance company) , there was a scare in the entire NBFCs space including housing finance about asset liability mismatch (crudely, debt repayable being higher than collections on advances) and stocks fell over 40% in a day. In a second order effect, many mid caps became small cap necessitating sell offs from large cap and midcap mutual fund schemes (first reason above).

Value often emerges when everything gets painted by same fear brush. We eagerly became counterparty to this non-fundamental based selling. While such price corrections do cause temporary pain, they also give one of the best times for a discerning stock picker.

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Business Analysis

Lending Business 101

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At its core, a lending business has three main profit impacting activities: (a) borrowing, (b) lending and (c) recovering the principal with interest. In theory, the best lender is someone who can borrow at lowest rates, lend at highest rates and recover all with interest. In practice, this is an impossible combination especially the latter two activities because lending rates and asset quality usually are inversely related.

High interest rates are usually charged to high risk borrowers or asset classes wherein chances of default are high. In practice, a good lender is someone who has discipline in underwriting and willingness to walk away if he is not remunerated for the risk assumed. Owing to incentive-structures that drive growth at any cost, very few lenders pass this test.

Another hallmark of a good lender is access to a diversified, granular base of low cost deposits. Concentration in deposit base increases risk of run on the lender. That coupled with concentration in loan book has been recipe for bank closures world over in past. Only a lender with trust and wide distribution network can command a low cost and diversified deposit base.

In lending, liabilities are the real assets and assets are real liabilities.

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Investment Process, Investment Psychology

Humility & Conviction

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Psychology plays an important role in investing. A crucial component of investment psychology is the delicate balance between humility and conviction. In investing, we deal with future. Assessment of future outcomes and their probabilities requires humility – acknowledgment of the fact that we may not know everything and what we know may turn out to be wrong.  Just humility will, however, lead to nowhere. Even after factoring in the possibilities of being ignorant and wrong, if Mr. Market provides an opportunity, we got to be ready to act with conviction.

The importance of this delicate balance between humility and conviction should shape one’s investment behavior.

Humility translates into various aspects of investment process namely – conservative assessment of value, investing with a margin of safety, diversifying, willingness to hold cash and sit tight when opportunities abate. To gain conviction, one needs to understand the underlying business, have a long term orientation and bet strongly when odds are in favour.

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Business Analysis, Macroeconomics

Earnings and Multiples Cycle

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One of the few constants in realm of investing is that most of the variables – interest rates, commodity prices, and profit margins – move in cycles and not straight rising/ falling lines. In addition to demand and supply dynamics, human emotions especially greed and fear play a contributing role in creation, sustenance and reversal of cycles. When things go well, greed fuels the rise of a cycle and when things do not go well, fear exacerbates the fall.

A corollary to existence of cycles is the tendency of these variables to revert to mean. Of specific interest to us is the position of earnings and multiples assigned to the earnings in that cycle. Not only profits revert to mean, the multiples that market is willing to pay for the earnings also revert to mean. In a downwards earnings curve, markets – dictated by emotions-  often assume that bad times will continue and assign lower multiple resulting in double down effect on prices. And, vice versa in good times. If our belief is that earnings will revert to mean, we can be reasonably sure that multiples too will revert to mean.

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