Letter # 60, 15th October 2021
‘In theory, there is no difference between theory and practice. In practice, there is’ said Yogi Berra. This statement captures the conundrum of asset managers operating in today’s environment; especially the ones that have witnessed how previous market cycles have ended.
Growing up, we were taught how to make decisions under conditions of perfect certainty. ‘Assuming a world with no frictions (taxes and impact cost), the capital asset pricing model predicts that the value of the asset should be X, based on how things have happened in the past (normal distribution)’. As soon as we leave our universities, we realize that (a) events that are taking place now have never happened before and (b) a vast majority of our decisions will be made with either a missing vital fact or statistic, forcing us to make decisions in uncertainty.
If you are a frequent traveller taking flights at odd hours, it is likely that you may have grown unfond of GPS devices. While reaching an airport, we do not need a route with the fastest average journey, as much as we need one with lowest variance in journey time. It is better to take a route that takes 10 mins more versus the one where you might reach either 10 mins sooner, or possibly 40 mins later. With critical things, the ‘least-bad-worst case scenario’ matters more than the mean. We are in such a time for equity markets.
Two weeks back, in our note ‘Discipline eats timing for lunch’ we pointed out (1) that the difference in returns of a recurring investment for a Nifty investor, with best timing and one with no timing, is a miniscule 40bps over the long term. Multiple investors asked us whether that holds true for individual stocks as well. Therein, we found an interesting pattern.
Yes, the thesis broadly holds true for individual stocks as well. Let us take the case of Bajaj Finance. At the peak of 2007 bull market, it traded at INR42.6/share. By 2009, it corrected 87% (to INR5.6/share). Assuming you managed to buy the entire quantity that you wanted at rock bottom prices, your returns would have been 77% CAGR – fabulous! However, had you started buying at the peak, but continued to invest each month, your SIP returns would have still been 63% XIRR. Difference in returns is more than the 40bps we saw with Nifty, but it is not too bad either.
We replicate this exercise for stocks across different sectors in the table below. While an equal weighted portfolio would have corrected an average 57% from peak to bottom, one’s ability to time the market would have resulted in just 500bps of difference in returns. Stocks more than halve, and perfect timing is hardly worth breaking a sweat over, right? Absolutely right, but with a caveat. Sit tight, the fun has just begun.
Whereas timing hardly mattered, something else altogether made the difference. The list that you see above is the list of companies that survived and prospered; and not the list of companies that were the best performing ones in the run up to the market highs (in 2008). The table below presents the select few companies that were part of BSE500 Index as of January 2008.
For all the best performing companies of 2008 (barring one), the highs were not crossed even a decade later. Whereas timing did not matter for companies in table one, for companies in table two, a disciplined systematic investment approach would have summarily failed. The vital difference? STOCK SELECTION.
When markets are in a tearing hurry to reach higher levels, they are happy to discount earnings 5-10-20 years out – and investors are happy to chug along. When the tide turns, realization dawns, and often it is too late to course correct.
So, what does one do at junctures like these? I do not proclaim to have the answer, but the litmus test for us is – if the stock falls 25% in the market correction (at which juncture – the facts will change, stories and narratives around the stock will change and the conviction of the entire street will come into question), what are we more likely to do with that stock – (a) buy more, or (b) sell and run away to a ‘safer stock’. A portfolio of companies where answer is ‘a’ above (or, Portfolio A) will likely result in superior returns over longer term, while avoiding sleepless nights until the ‘longer term’ arrives. Portfolio A might even be worth giving up the excess returns in the run up to market highs; for – we might as well be vaguely right than be precisely wrong!
Information in this letter is not intended to be, nor should it be construed as investment, tax or legal advice, or an offer to sell, or a solicitation of any offer to make investments with Buoyant Capital. Prospective investors should rely solely on Disclosure Document filed with SEBI. Any description involving investment examples, statistical analysis or investment strategies are provided for illustration purposes only – and will not apply in all situations and may be changed at the discretion of principal officer. Certain information has been provided and/or based on third-party sources and although believed to be reliable, has not been independently verified; the investment managers make no express warranty as to its completeness or accuracy, nor can it accept responsibility for errors appearing herein.