Blog – Page 4 – Cedcapital

Honesty is the best policy

July 12, 2024 No Comments

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.

Investment Process

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.

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