Behaviour as an edge

July 12, 2024 No Comments

“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:

Operating only in businesses that we honestly understand and having a sense of their intrinsic values.
Remaining humbly aware of multiple possibilities including our folly and therefore buying with a margin of safety.
Understanding that (a) intrinsic values are less volatile than price, and (b) emotions revert to mean.
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.

Investment Psychology, Market Cycles

Volatility and Bargains (reminder during bear markets)

July 12, 2024 No Comments

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.

Market Cycles

Smallcap meltdown of 2018

July 12, 2024 No Comments

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.

Business Analysis

Lending Business 101

July 12, 2024 No Comments

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.

Investment Process, Investment Psychology

Humility & Conviction

July 12, 2024 No Comments

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.

Business Analysis, Macroeconomics

Earnings and Multiples Cycle

July 12, 2024 No Comments

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.

Investment Psychology

Overcoming Fear

July 12, 2024 No Comments

If there is one thing that can get in the way of our shared path of wealth creation, it is fear. And if there is one thing that will collectively make us better investors, it is overcoming fear. It is during the darkest hour of fear that greatest bargains are found. And during those times our greatest mistake would be selling instead of buying or holding.

The main cause of fear is that normally when stocks are falling, everything else is falling too including cash and confidence. There are no landmarks or shady trees to take shelter under. Investors would take out money from stocks to meet other expenses/ liabilities. We cannot be fearless just by deciding not to be fearful. We need antidote that works.

The only antidote to fear from price fall is to PREPARE FOR BAD TIMES; to arrange our affairs in such a manner that we are not hard pressed for cash during recessions.

Investment Mistake, Investment Psychology

Difficulties of Being in a Bull Market

July 12, 2024 No Comments

“I don’t predict future. I understand human nature”

-Lord Krishna to Arjun in The Mahabharata

Thanks to our genetic wiring; envy, greed and fear (of losing out) are three primary human emotions every bull market stimulates. We acknowledge usefulness of these human emotions. Emotions including envy, greed and fear have been instrumental in human survival and superiority over other species since life’s origin. Being envious forced us to compete and improve. Being greedy made us accumulate and overcome scarcity. And, being fearful triggered the fight/ flight responses necessary for survival. These emotions therefore, with generations, are so etched into human consciousness that they operate automatically and indiscretionally, including, in a bull market. Unfortunately, going by financial markets’ history, these emotions when drive actions, lead to bubbles and crashes.

Focus, however, has to be on business value all the time; especially during bullish times. During bullish phases, envy, fear of losing out and greed sets in. Prices get higher and opportunities reduce. By not chasing momentum, a careful investor is bound to see temporary and reversible periods of underperformance. Being patient is never easy, especially if your neighbour is getting richer in a bull market. But this is exactly what one needs to try to do! This approach is better than chasing hot stocks and burning fingers in next correction. A thoughtful investment approach focuses at least as much on risk as on return. Whenever it has been easy to make money in equity markets, it has been even easier to lose it. Earning 16% for 10 years each will leave one with more money than earning 20% in 9 years each and losing 15% in the 10^th.

Business Analysis

Disruption: “AND” Vs “OR”

July 12, 2024 No Comments

Disruption is one of the biggest threat to a business and its stock price. Disrupted or soon to be disrupted businesses optically look cheap but are in fact value traps because the businesses are expected to decline as new technology/ way of doing things takes hold. Recall the cases of newspapers, film camera, feature phones etc.

In most cases future disruption is clearly visible. But in some cases it is hazy, even unfounded. This haziness can be a breeding ground for bargains. Often it is feared that existing way of doing business will completely end and new way will take hold. It is framed as an “OR” problem. Newspaper or online news, film camera or digital camera, feature phone or smart phone. But in many minority of cases the question may not be of “OR” but of “AND”. The new and old may co-exist. Or, the incumbents may adapt and be able to offer new products as well. Internal combustion engine (ICE) auto-companies may, for example, transition to electric vehicles (EVs). Physical newspapers may transition to digital versions. Whenever disruption threat is overplayed, it can create mispricings.

Care, however, needs to be taken to see whether the “AND” phenomenon is actually supportive to industry structure and profitable growth. Returning to the example of ICE vs EV auto companies, while incumbents may migrate to EV, it is not clear which company will win. Also given inputs to battery packs are still not indigenously made, margins and returns on capital are uncertain.

Few “And vs Or” questions are easy to solve, few are not. But whenever all questions are painted with the same fear brush, they can create mispricings.

Investment Psychology, Quarterly Update

Letter to Investors – Jun’24 – Extracts

July 6, 2024 No Comments

EXECUTIVE SUMMARY

- Trailing twelve months’ earnings of underlying portfolio companies grew by 46%.
- NAV grew by 8.9% YTD with 78% funds invested in equity positions. Balance 22% is parked in liquid/ arbitrage funds.
- Solving dilemma of investing in a one-way rising market.
- We added further to an existing position to make it a major position (>=5% weight).
- Lessons from manias and panics of last 400 years.
- Stance: Cautious

Dear Fellow Investors,

Broader markets remain expensive…

Markets continue their one way up-march and valuations in most of the pockets remain stretched. We look at two valuation ratios – price to sales and price to book – to show the extent of over-valuation. Price to sales indicates the ratio of market capitalisation of a company to its net sales. Price to book ratio compares the market capitalisation of the company to its net worth (or book value).

We are choosing these two ratios over the popular price to earnings (P/E) ratio because the denominator of P/E – earnings – can be influenced by cycles or extraordinary/ non-operating items and can be misleading. For eg., earnings of Banks, Oil and Gas companies and Public Sector Undertakings (PSUs) are at cyclical high today and their P/E look low. Sales and book values, instead, are more stable and can capture the extent of over/ under valuation better.

Price to Sales: Over 100 of the top 750 companies currently trade at price to sales of over 10x (versus an average of 25 companies in last 20 years) and over 220 companies trade at price to sales of over 5x (versus an average of 85 in last 20 years). Median price to sales ratio of top 750 companies is at 3.5x versus 20-year average of 1.1x.

Price to book: Price to book ratio shows the stark over-valuation in small and mid-size companies. Nifty Midcap 100 and Nifty Smallcap 100 indices trade at 5x and 4.4x price to book ratios, higher by 100% and 153% over their decadal median. Nifty Midcap index is near its past peak of 2008. For the smallcap index, the P/B is twice of 2018 level. 2018 saw the previous smallcap bubble from where the index fell 20% in following 6 months.

…But we don’t know what will pause/ reverse the rally…

In 1996 when the NASDAQ was at 1300, Alan Greenspan (the US Federal Reserve Board chairman), said that the U.S. stock market was irrationally exuberant. NASDAQ kept going up for next 4 years to 5000 (>4x). And then crashed 80%.

Alan Greenspan was not wrong. Just early. Markets can remain irrational for longer than one can remain prudent.

Like every time before, it is difficult to predict the nature and timing of events that can trigger market meltdown today especially in India. The political, macroeconomic and microeconomic situation in India remains robust. Retail investors have balanced the volatility caused by foreign flows. However, we should not forget that inability to imagine the trigger doesnot mean we can avoid one. When valuations are high, margin of safety low, and the world interlinked to the extent as it is today, smallest adverse events can cause default, credit contraction, foreign exchange fluctuation, war or pandemic. In fact, these have been the triggers for past crashes.

So, what do we do….

How do we solve for this dilemma? We continue to stick to reasonably priced quality companies. In most bubbles including current one, there remain some pockets that are of good quality and are not as exuberant. We have been adding weights there (shared in this and past letters). Once our target weights are allocated to these positions, we park the balance in liquid/ arbitrage funds. On selling side, we will tolerate moderate overvaluations. We will trim gradually if overvaluation is very high.

This strategy, like every other strategy, is not full proof. If the markets were to crash tomorrow, our stocks will fall too. We have, with great care and discipline, built a quality portfolio which is reasonably priced. It is our belief, and history is a testament that such quality portfolio built at reasonable price will be first to recover. Moreover, our high spare cash will be useful in buying further. And if there is no crash, our incremental deployment will slow down due to lack of opportunities, cash reserves will build up, existing positions will continue to benefit and we may trim super expensive positions. STANCE: Cautious.

A. PERFORMANCE

A1. Statutory PMS Performance Disclosure

Portfolio	YTD FY25	FY24	FY23	FY22	FY 21	FY 20*	Since Inception*	Outper-formance	Cash Bal.
CED Long Term Focused Value (PMS)	8.9%	29.2%	-4.3%	14.9%	48.5%	-9.5%	16.0%		22.0%
S&P BSE 500 TRI (includes dividends)	NA^	40.2%	-0.9%	22.3%	78.6%	-23.4%	NA^	NA^	NIL
*From Jul 24, 2019; Since inception performance is annualised; Note: As required by SEBI, the returns are calculated on time weighted average (NAV) basis. The returns are NET OF ALL EXPENSES AND FEES. The returns pertain to ENTIRE portfolio of our one and only strategy. Individual investor returns may vary from above owing to different investment dates. Annual returns are audited but not verified by SEBI. W.e.f. April 01, 2023 SEBI requires use of any one from Nifty50, BSE500 or MSEI SX40 as a benchmark. We have chosen BSE500 as our benchmark as it best captures our multi-cap stance. ^BSE has stopped sharing index values for time being.

Persisting with the discipline

We continue to focus on risk with a complete blind eye to quarterly returns in today’s heady times. This involves double checking our thesis every day, saying no to poor quality or expensive ideas and investing in acceptable positions gradually and fearfully.

Such has been the velocity of the markets currently that stocks that we have rejected due to subpar quality and/ or high price continue to rise relentlessly. The immediate emotional reaction, naturally, is of missing out. However, thanks to our direct and vicarious experiences, we have learnt to ignore these first impulses that the market like current one triggers.

A2. Underlying business performance

Past Twelve Months	Earnings per unit (EPU)²	FY 2024 EPU (expected)

Mar 2024	8.6¹	8.5-9.5³
(guidance was –>)	(7.5-8.5)
Dec 2023 (Previous Quarter)	8.0
Mar 2023 (Previous Year)	5.9
Annual Change	45.8%
CAGR since inception (Jun 2019)	15%
¹Last four quarters ending Dec 2023. Results of Mar quarter are declared by May only. ² EPU = Total normalised earnings accruing to the aggregate portfolio divided by units outstanding. ³Please note: the forward earnings per unit (EPU) are conservative estimates of our expectation of future earnings of underlying companies. In past we have been wrong – often by wide margin – in our estimates and there is a risk that we are wrong about the forward EPU reported to you above.

Trailing Earnings: We had revised the Earnings Per Unit guidance for FY24 to Rs 7.5-8.5 last quarter. That was due to sale of two positions where earnings were at cyclical high. Actual trailing earnings per share for FY24 came in at Rs 8.6, marginally above the upper range of the guidance. Trailing twelve months Earnings Per Unit (EPU) of underlying companies, grew by 46% (including effects of cash equivalents that earn ~6%).

1-Yr Forward Earnings: We introduce FY25 forward earnings per unit guidance at Rs 8.5-9.5.

A3. Underlying portfolio parameters

Jun 2024	Trailing P/E	Forward P/E	Portfolio RoIC	Portfolio Turnover¹
CED LTFV (PMS)	24.5x	22.0x-24.5x	34.0%³	Nil
BSE 500	26.2x²	–	15.5%²	–
¹ ‘sale of equity shares’ divided by ‘average portfolio value’ during the year to date period. ²Source: BSE. ³Portfolio Return on Invested Capital (RoIC) is on core equity positions. For BSE we share the RoE (Return on Equity)

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

We continue to hold the arbitrage position in equity and preference shares of Music Broadcast (Radio City). The position remains in the money currently. There were no mistakes to report in this period.

B2. MAJOR PORTFOLIO CHANGES

Bought: We added to an existing position . It is now a 5% position (major position).

Sold: We did not sell anything in the reporting period.

B4. FLOWS AND SENTIMENTS

500x leverage in Weekly Options

India has seen sharp surge in derivatives volumes in last few years. India’s derivatives volumes accounted for over 80% of global derivatives volumes in April 2024. Last quarter, the average daily notional options volume of Nifty 50 contract in India (at 1.64trn$/ day) crossed that of US S&P 500 contract (1.44trn$/day). In fact, derivatives volumes are 400x of equity cash volumes in India, an all-time high both in India and the world.

The main contributor for this surge is weekly expiring options, also known as, zero-day options.

Option premium usually falls as time to maturity falls. Therefore zero-day option – that expires on the same day as bought – costs roughly one tenth of a traditional monthly-expiry options. One Nifty-50 zero-day option allows a buyer to have an exposure worth Rs 5 lacs by paying an option premium of just Rs 1,000 – a 500x leverage.

A 500x leverage magnifies gains and losses by 500 times. A 1% change in Nifty 50 can turn Rs 1000 into Rs 6000. Conversely even a 0.2% fall in Nifty-50 can wipe out the premium. Surprisingly, this leverage which has grown manifold remains uncaptured in periodic debt statistics – money supply, gross advances, debt to GDP etc.

For newer traders that have seen rising prices and low volatility, weekly options have been the goose that lays golden eggs. But in reality, these speculative instruments are more like collecting pennies on a busy highway, or living in a rent-free home in a high-seismic zone. Once the prices start falling, most of the retail traders will incur capital losses.

—–

Taking Temperature

We use some qualitative indicator to take the temperature of markets and get hints of where are we in the cycle.

Retail and HNI investors continue to chase past performance. Capital market flows remain extremely buoyant as evident from multiple data points:

In last twelve months, of the INR 2.3 trn that flew into equity mutual funds (MF), over 50% went into smallcap, midcap and thematic funds which were already very expense. A sizable part of these MF inflows came from new fund offers (NFOs). NFOs are launched when the theme has already done well. No surprise that around 60% of NFOs have underperformed their benchmarks in last 3 years.
IPO pipeline (Hyundai, OLA Electric, Bajaj Housing etc.) is indicating 2024 will again record near all-time high collections.
SME IPOs continue to break records in terms of number of issues, extent of oversubscription, amount raised and listing pops. Versus Rs. 4900cr in CY2023, SME IPOs have already raised Rs. 3600cr in first half of CY2024. Also, the SME IPO index is up 250% in last 12 months! Most of the underlying companies have ordinary businesses and unknown corporate governance history.
Promoters and insiders continue to offload their stakes and cash out at loft vallations. Over 440 promoters have sold stakes worth Rs 62,000 cr in the first half of CY2024, highest since 2019.

Another interesting data point to look at is Skyscraper construction. The underlying theory is that many of the iconic skyscrapers of past have coincided with top of financial cycle. The Empire State Building in New York City was started in 1929. The Petronas Twin Towers in Kuala Lumpur were started in 1993. The Jailing Tower in Shanghai was started in 1995. Burj Khalifa was finished at the height of the market collapse in Dubai. In India, Imperial I &II (840ft each), the then tallest buildings, were built in Mumbai in 2010. Over 30 skyscrapers (600ft+ height) have been completed in last 3 years in Mumbai. Construction of even taller buildings (Ocean Power 1&2 1086ft, Aaradhya Avaan, 1000ft high) are underway right now.

C. OTHER THOUGHTS

Manias and Panics – Lessons from last 400 years

“I can calculate the movement of stars, but not the madness of men.”

Sir Issac Newton (after losing money in the South Sea Bubble, 1720)

Financial bubbles and crashes have been a frequent occurrence throughout the recorded world history. Almost all have led to bankruptcies, job losses, and financial distress. If meltdown of bubbles is so painful, why can’t we stop them? Won’t it be better if prices remain etched to the financial worth of underlying securities/ assets, and owners earned the natural yields of those assets?

We scanned over 10 episodes of bubbles and crashes of last 400 years – including Tulip Mania of 1636, the Great Depression of 1929, the Dot Com bubble of 1999, the Sub-prime crisis of 2008 etc – to try and understand the causes of bubbles and crashes. The objective was to pull out/ revise lessons that today’s enthusiastic investors can learn from and avoid similar mental and financial toil.

Initial Rational Source: In almost all the bubbles of last 400 years, one or more of the following were the initial source(s) of economic exuberance:

SN	Initial Rational Sources	Examples
1	Inventions/ Productivity growth	o US 1920s (railways, radio, automobiles), o US Tech Bubble 1990s (internet)
2	Expansion of credit, excessive leverage, easy money, low interest rates	o Japanese Real Estate 1980s, o US Subprime Crisis 2000s, o Global Venture Capital boom 2015-2022
3	Globalisation, exports, cheap currency	o Japanese Real Estate 1980s, o South East Asia 1990s, o China 2000s
4	Economic Reforms/ Liberalisation	o Mexico 1980s, o US abandoning the Gold Standard 1970s, o India Harshad Mehta episode 1990s
5	Monopolies	o South Sea Bubble 1720, o Mississippi Bubble 1720

Most of the above measures were taken in pursuit of progress and economic well-being. And most of these measures were justified reasons for imagining a brighter future. They did improve lives and general wealth.

Wealth Effect: Anticipation of higher demand and growth due to above initial events leads to rise in asset prices. Banks get comfortable lending funds against security of these inflating assets. Raising money through equities become cheaper. Easy availability of both debt and equity capital at low cost of capital encourages capital investments and job creation. This raises incomes and thereafter consumption. The wealth effect thus feeds itself.

Greater Fool Theory: What turns initial optimism into euphoria and bubble is the over estimation of brighter future, animal spirits and emotional outburst of greed, envy and fear of missing out (FOMO). Wealth effect leads to general sense of prosperity. It triggers envy and FOMO among sideliners. Prices start to detach from underlying reality. People buy in the hope that others may buy from them at even higher price – the Greater Fool Theory. Indian smallcaps, midcaps and a few sectors seem to be going through this stage currently.

Timing the top: Sadly, sooner or later the supply of greater fools run out. Some external event happens that makes prices to first stop rising and then start falling. Those not able to service debt or expenses are forced to liquidate falling assets. Gradually greed turns to fear and wisdom of crowds turns into stampede of folly. If we try to pick clues about being able to time the peaks, we will return disappointed. For, there is no upper range of time in months when a bubble pops. However, sooner or later, it does pop. Following have been one or more common crash triggers/ escalators of the past:

SN	Crash Triggers/ Escalators	Examples
1	Frauds or Swindles	o Enron/ Worldcom During US Tech Bubble 1990s, o Satyam, India 2008
2	Default or Bankruptcies	o US Maring Debt 1920s, o South East Asian Crisis 1997, o Lehman Brothers 2008, o IL&FS default 2018
3	Contraction of credit or money supply	o Japanese Real Estate 1980s, o US Tech Bubble 1990s
4	Geo-Politics, Terrorism, War	o Yom Kippur War and Oil Crisis 1973, o 9/11 Attack 2001
5	Natural Calamities including Pandemics	o Spanish Flu, 1918, o Covid -19, 2020

Saviour: Primary protection against emotional follies of envy, greed, fear of missing out and overconfidence in an overheated market is to remember what Benjamin Graham and Warren Buffett said about bubbles and human nature –

“The investor’s chief problem, and even his worst enemy, is likely to be himself”

“Be fearful when others are greedy”

***

As always, gratitude for your trust and patience. Kindly do share your thoughts, if any. Your feedback helps us improve our services to you!

Kind regards,

Team Compound Everyday Capital

Sumit Sarda, Surbhi Kabra Sarda, Punit Patni, Arpit Parmar, Sanjana Sukhtankar and Anand Parashar

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Disclaimer: Compound Everyday Capital Management LLP is SEBI registered Portfolio Manager with registration number INP 000006633. Past performance is not necessarily indicative of future results. All information provided herein is for informational purposes only and should not be deemed as a recommendation to buy or sell securities. This transmission is confidential and may not be redistributed without the express written consent of Compound Everyday Capital Management LLP and does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product. Reference to an index does not imply that the firm will achieve returns, volatility, or other results similar to the index.

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