The prediction problem

Letter # 25, 15 January 2021

“Well mate, I think I might enjoy lunch at home tomorrow,” gloated Glen McGrath, noted Australian bowler from the commentary box, on day 4 of the third cricket test match between India and Australia, suggesting that India would be bowled out before lunch on day 5. “Australia are 310 ahead at the moment, but I honestly think India won’t make even 200 in the second innings,” surmised Ricky Ponting, widely considered the most successful test captain in international cricket history.

However, what followed on day 5 demonstrated the monumental resolve of the Indian cricket team to bat through the day and force a draw as two Indian batsmen (Vihari and Ashwin) batted a staggering 48 overs on the last day. Since day 4, Australia was the only team looking for a win; the Indian cricket team treated the draw as a successful outcome (Ashwin even carried one of the stumps with him as a souvenir).

While this rekindles fond memories of another Indian cricketer Gautam Gambhir, who batted for 72 overs (close to 11 hours) in 2009 (Ind vs. NZ, 2nd test played at Napier, NZ) and close to 31 overs in 2011 (Ind vs. SA, 3rd test played at Cape Town, SA) to force a draw on international soil, the latest Ind vs. Aus. test brings an even more interesting aspect to fore–one that deals with failure of prediction.

Nate Silver, the founder of FiveThirtyEight.com, deals with this subject beautifully in his book The Signal and the Noise. Nate shot into the limelight after he accurately predicted the outcome of 49 (of 50) states in the 2008 US presidential election and the winner of all 35 senate seats. Originally a Chicago economics grad, Nate was working with KPMG as a transfer-pricing consultant when he created a predictive system for baseball (Pecota), which later helped him with his electoral predictions (his website is named after the 538 electoral college votes).

In the era of big data, one would presume that we are getting better at making predictions. But according to Nate, huge quantum of data is as much a problem as a solution. More data does not always result in better predictive abilities as much of the information could be just noise which distracts us from the truth. Besides, more data could lead to us forming spurious correlations, while falsely raising confidence instead of being cautious about overfitting and uncertainty. Blindly trusting models and creating huge leverage was one of the reasons that led to the global financial crisis in 2008; “some predictions may not fail as often as simpler ones, but when they fail, they fail badly,” writes Nate.

Nate also differentiates between fields where more data can lead to better predictions. Weather forecasting has dramatically improved with the introduction of super computers, but similar impact in economic or political forecasting is not visible. While ‘risk’ is something you can put a price on (you know the odds and can count it ahead of time), ‘uncertainty’ is a risk that is hard to measure; you might be acutely concerned about it, but have no idea how many of them are there or when they might strike.

In December 2007, economists in the Wall Street Journal’s forecasting panel predicted only 38% likelihood of a recession over the next year. This was surprising because data would later reveal that the economy was already in recession at the time. Nate sums it well, “we need to stop and admit it: we have a prediction problem. We love to predict things – and we aren’t very good at it.”

And there is no better time to talk about predictions than the present as many brokerage houses will put out their annual forecasts for 2021 at a time when markets are at their historic highs. Flush with liquidity, Indian markets are trading at a record valuation multiple and investors often ask, is the rally done?

We do not profess to know the answer, but going by the historical precedent, the rally should have been done a long back. But then, what forms part of ‘historical precedent’ today also happened for the first time at some point in the past. As a corollary, something ‘new’ that happens this time around will form part of historical precedence when we evaluate a few years down the line.

Analyst forecasts assume that F22 is going to be a normal year. As per historical precedent (as the chart below indicates), we had reached the peak (bubble) January 2008 valuations on 11th November 2020 itself (when Nifty was at 12700). As of writing this letter, we are already up 15% from that level. Is it different this time around? We don’t know! The 35% drawdown in Index had not happened before March 2020 and a V-shaped recovery has no precedent in history either. But then, history is made by a dominant role played by surprising events that have wide-scale implications.

Having said that, in our view, not being able to predict (whether the rally is done or not) is not the same as being unable to position the portfolio effectively. Like we have argued in the past (link) for a portfolio strategy to be effective–it needs to evolve with time and there cannot be ‘one strategy to beat the markets all the time.’

Disclaimers:
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.

Genius, is it?

Letter # 24, 8 January 2021

We often encounter our destiny on the very path we take to dodge it. 2021 has begun with a bang, and with a degree of frenzy that many would have thought was impossible during mid-2020. Also, last week, India’s Central Drugs and Standards Committee (CDSCO) formally approved coronavirus vaccines from two companies: (a) Bharat Biotech’s Covaxin; and (b) Serum Institute of India’s (SII) Covishied. SII was chosen by Oxford University and its partner AstraZeneca to manufacture vaccines (1).

While how the Oxford vaccine works is relatively simple to understand, what we are more interested in knowing is how it developed one in such record time – 10 months versus previous best of 4 years it took for the mumps vaccines in 1967 and the average vaccine development time of 10-15 years (2).

First, a few over-simplified steps on how the Oxford vaccine is supposed to work. They take a virus that causes common cold in chimpanzees. This virus is then genetically modified so that it cannot infect humans (hence, safe for children and elderlies). The coronavirus spike protein is then printed on this virus and injected into humans. When the vaccine enters human cells, it induces an immune response, priming the immune system to attack the coronavirus if it later infects the body.

Now for the fun part. In early hours of 11th Jan 2020, Prof. Teresa Lambe of Oxford University received the genetic code for the novel coronavirus shared on the worldwide web by scientists in China. She got to work straight away, still in her pajamas, and was glued to her laptop for the next 2 days. By Monday morning, she was ready with the template for a new experimental coronavirus vaccine. She basically designed the vaccine in 48 hours! (3).

This might seem like a stroke of genius, but it wasn’t JUST that. Oxford has been working on this delivery mechanism for an extremely long time. It had used similar technique for malaria vaccine development, the first field trial results of which were published in 2015 (4) . But as of December 2020, final human trials (5) are yet to be completed. cAd3-EBO Z, the vaccine for Ebola, was also developed using the same route, wherein phase 1 clinical trials were held as early as in September 2014. Because a lot of hard work was already put into the delivery mechanism, developing a solution to this problem (Covid vaccine) in such a record time (10 months versus minimum 10 years average) appears a stroke of genius.

And, speaking of geniuses, why should just the vaccine master chefs be entitled to the tag! Markets have a way of tricking us into believing that all of us have become genius stock-pickers off-late. Over the past three months, the broader Sensex Index is up 22%, but mid- and small-cap indices are up around 28%. Better still are those 191 companies that have returned over 50% and the 36 companies have doubled in price, all within a matter of just 3 months.

That is not to say that the pace of the rally isn’t scary. The scars of backlash after every major rally are still fresh in our memories. In just the past half decade, we saw RBI conducting AQR on banks in 2015, demonetisation in 2016, GST implementation glitches in 2017, the NBFC crisis in 2018 and the Covid pandemic in 2020. This has shrunk the market cycle from 3-5 years into a much smaller shock-based yo-yo. After every cycle, consumption-based themes have been the first to recover and that sector seemed to have become a “go-to” sector for most professional investors. The past 3 months, however, have lifted all boats where excesses in a few sectors or performance of different market-capitalisation indices have evened out in one clean swoop.

Whereas short-term rallies and corrections have become a way of life for most of us, it is the Financial Times’ (FT story) story on the top 100 companies by equity value added that piqued our interest. The sheer size and speed with which these companies have grown is staggering. Majority of the businesses are delivering new technological solutions or traditional products through better technology. The only company to make an appearance from India is Reliance Industries.

Despite all the frenzy over the past 3 months, the lone appearance that India makes on the global scene is at number 89 in top-100. The short boom-bust cycle over the past 5 years has got us so focused on ‘buying companies with predictable cash flows and paying anything for it’ that we have forgotten what the long-term change could bring us. Could India demand its legitimate role in the new world order (she was too young during the Bretton Woods era)? Could India drive the next round of technological developments? How about the next big thing in infrastructure or pharmaceuticals or being the global hub for manufacturing?

While it will be our endeavour to look out for pitfalls when (and not if) the current exuberance subsides, it will equally be our zest to find the next company from India that could make it on that FT list a few years down the line. As always, we continue to believe that like the ecology, an investment framework has to keep evolving: (a) it needs a balance of cyclicals in the portfolio (link); (b) it needs a judicious mix of sectors in the portfolio (link); and (c) generally, it needs a flexible investment approach that is willing to learn (linklinklinklinklink).

With that we wish all our readers a Happy New Year. We intend to keep our date with you every week in 2021.

Notes:
(1) Serum to apply for licence to manufacture Oxford vaccine in a week, says CEO Adar Poonawalla – Health News , Firstpost
(2) What’s the Fastest a Vaccine Has Been Made in Modern Medicine? (nautil.us)
(3) Oxford-AstraZeneca vaccine: Bogus reports, accidental finds – the story of the jab – BBC News
(4) New Malaria vaccine shows promise in field trial | University of Oxford
(5) Team behind Oxford Covid jab start final stage of malaria vaccine trials | Malaria | The Guardian

(6) Vaccines against Ebola Virus disease — Oxford Vaccine Group

Disclaimers:
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.

Absence of evidence, zero accountability and flummoxing promotion

Letter # 23, 18 December 2020

The fundamental difference between truth and fiction is that fiction must always make sense. Let’s compare the following two events:

One: This Monday, Stefan Lofven, Sweden’s Prime Minister, said that the country had underestimated the likelihood of a second Covid wave, reports the NYT (1). As of writing this letter, Sweden has reported close to 350,000 cases and over 7,800 deaths due to coronavirus. Its deaths per million of population, at 770, is over 7x the average of its Nordic neighbours. Around 3,000 nurses have quit their jobs this calendar year and Stockholm reported that ICU capacity has hit 99%, and that Sweden will be forced to send Covid patients to Finland (2).

Two: It’s that time of the year when mountains are clad in slow and the ski season is upon us. But, it’s also corona time; hence, France, Italy and Germany have shut their ski areas till January. Austria opens on 24th December with severe restrictions in place. Sweden opened its ski lifts last week.

Sweden has always been an outlier through the pandemic; it has kept bars, schools, movie theatres and gyms largely open. Its chief concern was that everyone being holed up at home could lead to depression and suicides. Ander Tignell, the state epidemiologist, in an interview in October 2020, hoped that the spread of immunity would help the country get through the fall.

It could well have been just a case of a strategy that didn’t work; a costly mistake, but an honest one. Afterall, under Swedish law, the government isn’t allowed to force people to stay at home (yes, they are thinking of an emergency law that will give it the power of lockdowns (1)). Where it gets outlandish is on two accounts.

First, face masks aren’t recommended in Sweden because the Public Health Authority says there isn’t enough evidence that they work (3). 170 countries around the world recommend using masks; using them has no side effects. Hence, citing absence of evidence for not using them is inexplicable.

Second, Sweden’s “health experts” were so confident of their approach that they were schooling other countries. Prof. Johan Giesecke (Tignell’s predecessor and co-thinker (4)), in an interaction with an Indian politician said, “in India, you will do more harm than good with strict lockdown measures.” And that, “it is a very mild disease. 99% infected people will have very less or no symptoms (5).”  Had India followed his advice, cases in India (extrapolating Sweden’s numbers) would have been closer to 73mn (versus 10mn currently) and deaths at 700,000 (144,000 currently). And this is without considering India’s higher population density and its inferior public health services (the curve is not just linear then; it gets exponential in accounting for these two conditions). Arguably, cases in India may have been underreported, but hiding deaths of this magnitude would have been difficult. While India, thankfully, chose not to pay heed to such “experts”, it brings two issues into focus.

First, as Nasim Taleb writes in his book, Skin in the game, that while in the past people of rank or status were those who took risks and those were the ones to face the downside for their actions. Today we are witnessing the opposite of such heroes: bureaucrats, bankers and academicians with too much power and no real downside or accountability. At no point in history so many non-risk-takers have exerted so much control. This rings true for many industries, including asset management (we have written about it before link). In our view, fund managers and sales teams must be compelled to have equity exposure to funds in which they ask investors to invest in. For us, if we don’t put our money where our mouth is, we don’t deserve your time, let alone your money.

Second, no matter how strong your conviction, a rigid straitjacket framework seldom works. Over the past two years (and until a few months back), markets seemed to have gravitated towards the theory that ‘a good company is a great investment at ANY price’. Such companies will keep getting bigger at the expense of smaller ones, and as such, large market-cap companies will continue to outperform small sized ones. However, charts below indicate the opposite.

Over the past 17 years, total returns for Sensex, BSE Mid-cap and BSE Small-cap indices have been similar, but they have rarely moved in tandem; there have been years when the Sensex outperformed the other two indices and vice-versa. Instead of a formulated straitjacket that large caps are the only investible universe, we have found that taking advantage of such market mispricing helps us generate superior alpha over time.

In the end, even as Sweden is working extremely hard to contain the Covid situation, the same Prof. Johan Giesecke (Tignell’s co-thinker, proponent of herd-immunity and one in those interactions with an Indian politician) has been promoted by the WHO as the vice-chair of the Strategic and Technical Advisory Group on Infectious Hazards (6). If this doesn’t increase our collective faith in total and urgent need for having ‘skin in the game’ in all walks of life, we don’t know what will.

Notes:
(1) In Sweden, Infections and Calls for a Lockdown Are Rising – The New York Times (nytimes.com)
(2) Is the second wave overloading Sweden’s intensive care units? – The Local
(3) Covid-19: Sweden Rejects Face Masks as Cases Soar, ICU Beds Fill Up – Bloomberg
(4) Sweden’s “herd immunity” policy produces disaster – World Socialist Web Site (wsws.org)
(5) India will ruin its economy very quickly if it had severe lockdown, Swedish health expert tells Rahul Gandhi (freepressjournal.in)
(6) Sweden’s ‘Herd Immunity’ Mastermind Gets Promoted by WHO (newsweek.com)

Jailing short sellers, capital returns and long-run cycles

Letter # 22, 11 December 2020

Do you remember the time when the stock market was looked upon as a barometer of the overall economy? In meteorology, a barometer measures the change in atmospheric pressure to predict a coming storm. By analogy, the market, through its participants’ collective wisdom, is supposed to predict the coming changes in the economic activity of a nation. There are some obvious limitations to both, ones that come with making predictions. But whereas the immutable laws of physics (and those alone) guide a meteorological barometer, a stock market is not guided by just laws of economics (demand and supply of capital); there are multiple variables at play as it is and regulators are now often choosing to add further randomness to the pile, like the short-selling ban.

South Korea’s market regulator, yesterday, declared that it will jail and levy hefty fines on traders who illegally bet against stocks of companies, reports the Financial Times (1). The short-selling ban rule was initially imposed after the KOSPI plunged 8% on March 13th (as covid hit markets globally) and was set to be in place till September 2020. It was later extended in August 2020 for another six months till March 2021 citing fresh wave of covid-19 (2).

South Korea’s benchmark KOSPI now trades more than 20% higher than the pre-covid highs and has risen close to 90% from March 2020 lows. When the ban was extended in August, the benchmark, having risen 60% from lows, was already trading above pre-covid level. Amidst this, total deposits at brokerage accounts of Korean retail investors have catapulted from USD25bn in February 2020 to over USD57bn in November 2020. Trying to protect retail shareholders from unmanageable price fall is one thing, extending it when markets have fully recovered is quite another. In our view, this creates a disequilibrium in the demand-supply dynamic. History stands testimony that such experiments do not end well (bread lines before the breakdown of the Soviet Union).

There are institutions that create this disequilibrium and then there are others that formulate a strategy to benefit from it. One example of the latter is Marathon Asset Management–opportunistic investor in global credit and fixed income markets. Instead of looking at simple ‘growth’ and ‘value’ distinction, Marathon focuses on capital cycles to identify businesses that can deliver superior returns.

The book, Capital Returns – investing through the capital cycle, is a collection of reports written by investment professionals at Marathon. They essentially view everything in terms of cycles and whenever a target company stands to benefit or get impacted by changes in cycles within that industry, they move in. The book itself contains several real-life examples of multiple industries and jots down the thought process of the investment professionals. It’s a fascinating read.

Analysing Marathon’s thought process got us reflecting on how, off late, the Indian economy and markets seem to be having their fair share of cycles. Prior to the GFC in 2008, economic cycles used to be fairly long (around five years). Since then, however, we have already witnessed seven mini-cycles, with several disruptions along the way, especially in India, and particularly over the past five years (Banking AQR in 2015,  Demonetisation in 2016, GST implementation in 2017, NBFC crisis in 2018 and covid pandemic in 2020).

During that time, a predominant share of banking loans was extended to the retail sector and private consumption contributed bulk of the incremental GDP. Consumption-driven themes, therefore, have had the largest investor mindshare as they, during the downturn, fell the least and bounced back the fastest during recovery.

While the consumption theme has the largest recall, it’s not the only theme that has outperformed. A look at the table below might surprise a few readers. Each new cycle has produced a different set of sectors that outperform and those that don’t.

While stock market cycles are shorter, the broader economic cycles take much longer to change. The RBI survey on aggregate capacity utilisation has stayed below the 75% mark for majority part of the past five years (it had steadily started increasing before the pandemic hit). With: (a) material rise in government’s capital spending; and (b) newly announced production-linked incentives for various industries starting to take effect, that could change over the course of the next few years.

Since building high-intensity infrastructure and capacities take years, it would start reflecting in fiscal statistics (IIP, GDP) as well as surveys (RBI publications) only at a much later stage. In the meantime, investment frameworks that suffer from recency bias and work on formulated straitjacket approach will have a much difficult time picking up the change in the larger narrative. Consider the table below, which looks at two broad cycles over the past 17 years. Several sectors witnessed a complete reversal of performance versus the broader market. IT, FMCG, Healthcare and Auto, which had underperformed during 2003-07, completely reversed their performance during 2007-20, whereas Capital Goods, Metals and Oil & Gas, which had outperformed during the first cycle, underperformed heavily in the second one.

As with our previous letters (link, link, link, link, link), we reiterate our view that one cannot expect a unitary investment framework to deliver superior investment returns across all market cycles. While the recency bias (expecting what has happened over the past five years will continue to happen over the next five) is a serious one to overcome, generating superior returns over the long term calls for one to look beyond recent trends.

Notes:
(1) South Korea threatens to jail short sellers under new rules | Financial Times (ft.com)
(2) South Korea Extends Ban on Short-Selling Amid Virus Flareup – Bloomberg

Disclaimers:
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.

Morphed images, galloping prices and cyclicals

A to C: Ok, I have been discussing your potential role in the origin of coronavirus with my friends in the US, Germany and France (1a).

C to A: Oh, and I was under the impression that you are my friend. I feel betrayed and won’t buy meat from you anymore (1b).

A to C: What! How is that done? I will impose duties on the silicon metal that you were sending my way (1c).

C to A: Ok then, no barley for me (1d).

A to C: Wow, you want a fight? Here it is; no more zinc coated steel, reinforcing bars, copper tubes or hot rolled coils (1e).

C to A: Ok, no cotton, timber or wine for me (1f). And just to add insult to injury, I will tweet a morphed picture of your soldiers doing bad things in Afghanistan (1g). I know it’s totally incorrect, but we anyways don’t let our citizens see twitter (not that we owe them an answer or anything), but it definitely will be embarrassing for you (2).

A to C: Well, that went downhill quickly. You should be ‘utterly ashamed’. Say Sorry (1h).

And instead of tendering an apology to Australia, China’s foreign ministry spokesperson Hua Chunying responded that Australia should feel ashamed of its acts in Afghanistan. From the sequence of events above, it might appear that Australia is the aggrieved party and China the bully. And yet, Australia has ‘patiently sought’ to address tensions in the relationship and wanted direct discussion with ministers.

That is because Australia has a lot at stake. It sends over USD150bn worth of goods and services–roughly 7% of its GDP–to China each year. 40% of these exports are iron ore, 10% coal and ~8% education (China’s students coming over to study). In comparison, China’s exports to Australia are only ~USD50bn, accounting for a minuscule percentage of its GDP. Clearly, China has the edge on economic grounds.

Among other things (weak USD against other currencies, rising liquidity, higher demand and cyclically tight supply), the rising strain in the relationship between Australia and China is leading to commodity prices soaring to levels not seen in the past seven years. Iron ore prices have risen to USD133 per ton (from recent lows to USD75/t in Mar20 and USD40/t in Jan-16). Copper prices have rallied 65% since Mar-20, zinc 52% and aluminium 43%. For many of these commodities, China has imported raw material only to export finished goods back at a price that does not make sense for a lot of international players (we had discussed this at length here: link). Continued tension with Australia could result in China losing access to cheap raw materials, which in turn is likely to trigger a supply crunch not witnessed for a while now.

Investing life would have been easier had things been that simple. For example, Australia is dependent on China as it exports USD60bn worth of iron ore to the latter, but 60% of China’s iron ore requirements come from Australia (~600mn tons each year). China has been trying hard to replace that for a while now and its overtures in Simandou (interiors of Guinea, Western Africa) have been to that effect.

Nevertheless, that site will require billions of dollars to develop, which includes building a 700km rail link to port. Optimistic estimates peg project completion in five years, but a few in the mining industry put it at 10 years. In the short term, China could look to Brazil as an alternate source (currently supplies 20% of its requirement), but at the current juncture that’s not a priority as it is busy battling corona virus. Eventually, economics solves all puzzles. If you want peace, make nations trade-a corollary to Frédéric Bastiat’s quote, “when goods do not cross borders, soldiers will,”-and commodity prices will sober down once China and Australia become BFF again and as activity slows towards the start of the Chinese new year.

In the meantime, however, the NSE Metals Index has risen c35% over the past month compared to c11% returns in NSE Nifty (and is now outperforming the Nifty even on calendar year to date basis). When you boil it down to individual companies, it is starker. Over the past 13 years, India’s oldest and amongst the most respected private steel companies Tata Steel has delivered near zero returns. Nonetheless, in bouts, it has been stellar – returning over 250% thrice (in the same period and up 50% in just the past month). This brings us to the bigger question, how important are cyclicals in one’s portfolio? Have investors, over the past few years, given undue importance to structural growth stories at the cost of cyclical businesses?

We have argued several times in the past (link, link, link, link) that one cannot expect a unitary investment framework (buy good companies at any price or only buy companies with RoE higher than X% and margins higher than Y%, don’t buy PSU businesses, don’t buy commodity businesses, etc.) to deliver superior investment returns over a longer horizon. If there was one (or even a few) investing hack(s) to beat the market, it (they) would have been discovered over the past 90 years of institutional investment history.

In our investment framework, we essentially deploy a judicious mix of strategies, which involves sizeable exposure to these cyclical businesses (not just commodities like metals and cement, but long-term cyclicals like commercial vehicles). By design, we have no ambition to buy those businesses at their absolute bottom and sell them at the absolute top of cycle. And still we have realised that exposure to cyclicals generates superior returns versus not having them in the portfolio.

Notes:
(1) Timelines: (a) 21 April 2020 (b) 11 May 2020 (c) 13 May 2020 (d) 18 May 2020 (e) 30 June to 27 July 2020 (f) 16 Oct to 20 Nov 2020 (g) this week (h) 30 Nov 2020
(2) Australian soldiers are facing an inquiry over possible war crimes in Afghanistan: https://www.theguardian.com/australia-news/2020/nov/26/australian-soldiers-sent-show-cause-notices-after-afghanistan-war-crimes-report

Disclaimers
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.

Hand of god, no ‘rules’ rules and effectiveness trumps efficiency

It’s the 1986 World Cup quarter final and Argentina is playing England. Had you judged the game based on its boring first half, you would not have believed how the action-packed second half scripted the game in to the annals of history. In the 51st minute, Diego Maradona was playing a ‘one-two’ with his teammate Valdano, but the English defender Hodge miscued his clearance into the penalty area and the ball looped up. The English goalkeeper Shilton came off his line to clear the ball, but Maradona, already charging ahead, leapt in the air and slotted the goal with his left hand. English players complained, but the referee could not see what had happened and allowed the goal to stand. Diego later remarked in the press conference that ‘the goal was scored a little with Maradona’s head and a little with hand of god.’ 

Within just 4 minutes of the ‘hand of god’ goal came the ‘goal of century’. Maradona took the possession of the ball, in his team’s half of the centreline, and single-handedly beat the whole English defence and drilled the game’s second goal. Years later, in 2002, this goal was voted as the greatest goal of all time. Argentina went on to beat Belgium 2-0 in the semis and West Germany 3-2 in the finals to lift the cup.

The surprising thing, however, is that for most of his career Maradona played in teams that had no superstars. The Napoli squad (a city where Diego is still revered as deity), with which he conquered Italian soccer, didn’t have any A list names. When he signed up for the club in 1984, club Napoli had never won the Italian league. His diminutive frame notwithstanding, Maradona was instrumental in Argentina’s superlative World Cup performance in 1986, 1990 and 1994. Even as the current crop awaits the news of Ronaldo and Messi playing alongside in a testimonial match, for those of us who grew up in the 1980s,  ‘El pibe de oro’ (the golden boy) and Black pearl (Pele) would always remain technically the best to have kicked the ball. We join millions of Maradona fans this week to bid adieu to the greatest player of all time.

We switch from people, on to organizations that do things differently. Erin Meyer and Reed Hastings draw on hundreds of interviews with current and past employees to write their book, No Rules Rules, about the culture at Netflix.

In his previous venture at Pure Software, Reed had tried to create rules and establish processes every time employees made a mistake. In Netflix, he wanted to promote flexibility, employee freedom and innovation instead of error prevention and strict adherence to rules. He built an exceptional talent pool and then asked the employees to openly voice opinions and feedback with positive intent. The book contains a lot of interesting reads, especially about feedback loops, but what stuck with us were the policies or rather lack thereof.

In the ‘no vacation policy’, employees could take as many breaks as they required, and for Netflix the biggest innovations happened while people were on breaks. But for the policy to be truly implemented, leaders must model big vacation talking. Yes, you read that right. Not only should the leaders take vacations, but they should openly talk about them because there should be no room for ‘soft limits’ in any department. While unlimited holidays are easy to implement, boundaries for acceptable behaviour were defined as: (a) always act in the best interest of the company; (b) never do anything that makes it harder for others to achieve their goals; and (c) do whatever you can to achieve your own goals. Even more surprising was the ‘no expense policy’. All policies related to expenses were removed, but employees had to: (a) spend money as if it was their own; and (b) act in the best interest of Netflix.

The driving principles at Netflix are: (a) Hire the best; (b) Trust employees openly and ask them to trust others. (c) Keep improving the collective talent density. The thought process behind these is that if you have good employees thinking about how to improve the organization, they are more likely to be an asset to the firm compared to a tightly controlled average bunch of people who are worried about rules, hierarchy and speaking their mind.

Most organizations aim to become efficient (tick off more items per day, reach out to more leads, process more applications and so on). But as Netflix suggests, for human beings, ‘effectiveness’ trumps ‘efficiency’. This, we believe, applies to the investment process as well.

Many a times, investment managers formulate an investment process just because it has worked well in the past (say, best company is a great investment at any price or never to buy PSU stocks and so on). Rigid adherence to the investment process implies that even when it is leading to bad outcomes, one resists disassociating from it. In short, the process becomes a part of who the investment manager is.

Contrast this with the thought process that determines the actions of one of the biggest investors Warren Buffet. In his 1992 shareholder letter, he writes, “investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it,” adding that he, “participated in this foolishness,” when he bet on US Air in 1989. And yet, Berkshire became among the largest shareholders in the big 4 airlines in the last year. Similarly, Berkshire has always shied away from investing in technology companies, but its largest investment by value today is Apple and it is the largest shareholder of IBM.

As we had argued in our previous letters (link, link), having an investment framework is good, but rigidly defining a process is unlikely to work over the long term. If there were defined rules in investing that could beat the market, then it is likely that over the past 90 odd years of institutional investing, those rules would have been discovered and negated (because everyone would follow that same rule, the alpha would disappear). By all means, stick to the process, stick to the framework, but stay open to change; it might not be as illogical as it sounds.

Beyond economics, 23 things and beyond just the price

“No nation was ever ruined by trade, even seemingly the most disadvantageous,” said Benjamin Franklin, one of the founding fathers of the United States of America in 1774 (1). In the past week, India certainly paid no heed to that as it continued to stay away from the RCEP, originally negotiated between 16 countries – ASEAN members (10 countries) and their FTA partners (Australia, China, Korea, Japan, New Zealand and India). Touted as the largest regional trading agreement to date (member countries account for a  third of global GDP and 40% of global trade), the stated purpose of RCEP was to make it easier for products and services of one country to be available across others.

India had decided to exit the discussions in November 2019 over ‘significant outstanding issues’ which it has ‘consistently’ raised during negotiations. The Minister for External Affairs commented that India’s stance was based on ‘clear eyed calculation’ and that no pact was better than a ‘bad agreement’ (2). While India ships 20% of its total exports to RCEP nations, imports from them account for 34%. Combined, these countries accounted for USD105bn (of USD184bn or 57%) of India’s trade deficit in 2019.

In our opinion, the economics of the transaction did not work for India. It harbours the ambition of expanding manufacturing (through Make in India); initial focus being on import substitution, but eventual aim is to export to the rest of the world. RCEP entailed inadequate provisions to check surge in imports and was, therefore, unpalatable to India. But to certain observers, (2) the ongoing clash with China made India wary (hence, its refusal to join the BRI as well) of entering any agreement. Afterall, India’s decision to stay away might have considerations beyond just the economics of the transaction.

23 things: On the economics of free trade, however, Ha-Joon Chang, a South Korean economist (currently at University of Cambridge, England) has fabulous views, aptly covered in his book 23 Things They Don’t Tell You About Capitalism. In a theoretically profound book, Chang, while not hitting out at capitalism per se, has gone on to bust several myths which have become sort of ‘given’ in the world of developmental economics.

Chang contrasts two countries. Country A, until two decades ago was highly protectionist, with average industrial tariff of 30% plus. It restricts cross-border flow of capital, has a highly regulated banking sector and numerous restrictions on foreign ownership of assets. Foreign firms are discriminated against through differential taxation. ‘A’ conducts no elections, is riddled with corruption and has opaque property (incl. IP) rights. It has a large number of state-owned entities that make huge losses.

Country B’s trade policy has literally been the most protectionist in the world in the past few decades, with average industrial tariff of 40-55%. Majority of the population cannot vote, corruption is rampant and political parties sell government jobs to their financial backers. It has not recruited a single civil servant through the competitive process. Record of government loan defaults worries foreign investors. Especially in banking, foreigners cannot become directors, its IP rights record is patchy, at best.

It might not be a huge surprise that country A is China around the year 2000; but, not many would have guessed that country B is US around 1880s. Despite all ‘supposed’ anti-developmental policies, China was the world’s fastest growing economy for three decades until 2010, and so was the United States in the 1880s.

Unlike Ben Franklin (USD100 bill carries his face), the thoughts of other US leaders on protectionism are interesting. Alexander Hamilton, the then Treasury Secretary (USD10 bill carries his face) submitted a report to the Congress in 1790s arguing that industries in their infancy need to be protected and nurtured by the government before they can stand on their feet. On the USD5 bill appears Ab Lincoln, who in defiance of British pressure on the Unites States to adopt free trade, had opined that “within 200 years, when America has gotten out of protection all that it can offer, it too will adopt free trade.” Funnily enough, Britain itself adopted free trade only towards 1860s when its industrial dominance was absolute. Before that, Robert Walpole (who ran the country between 1721 and 1742) was the original architect of the infant industry argument that Alex Hamilton followed.

Chang concludes by stating that free-trade and free-market policies have rarely worked. Most rich countries did not use such policies when they were developing countries, while these policies have slowed down growth and increased income inequality in developing countries.

Beyond just the price: Now, foreign policy and macro data in general are fun to track and one might get it right once in a while too. But, in our experience, consistently mining macro data as an investment edge does not work. For us, bottom-up earnings cycle analysis combined with a top-down sectoral allocation view seems to generate best results.

A topic that seldom comes across in conversation with seasoned investors is the feedback mechanism. For example, we were once asked how different investment returns would look had we not exited an investment. Although the question has merits, we admittedly chose not to track it.

In our July 2018 memo (link here, pg. 8-9), we had argued that markets are notoriously bad at giving feedback and as investment managers we need not be unemotional, but rather inversely emotional (worried when others are not). Consequently, on several occasions, we have taken the decision to sell an investment because our investment thesis did not play out (despite markets still being positive on the name, we were long: link here). There have often been occasions where we decided to sell an investment just because our investments in a business exceeded our comfort zone of either its trading liquidity on the bourses or regarding the weight of the investment in the fund.

In the end, just as Chang professes, India’s decision to not join the RCEP may have been based on considerations ‘beyond just the economics’. Similarly, for us, there are often times when the decision to sell an investment has considerations which are ‘beyond just the price’. It allows us to stay inversely emotional, which, to us, is far more valuable.

Notes:
(1) https://www.wto.org/english/forums_e/public_forum14_e/theme_e.pdf
(2) https://indianexpress.com/article/explained/explained-the-china-factor-and-indias-strategic-thinking-on-rcep-7053813/

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Poll forecasting, Kelly criterion and mean reversion

If you are even half interested in electoral politics, you have been in for a treat over the past fortnight. India’s third-most populous state’s election of Chief Minister (by casting c42m votes) and the United States’ election of President (c150m votes) (1) had a common thread: the eventual outcome was hugely different from the polled outcome. While Biden’s pre-election lead of 8.0ppt (2) turned out much higher than actual lead of 3.3ppt, NDA’s final seat tally was 29% higher than exit poll estimates.

The fact that they got it wrong is NOT of too much interest to us; that happens all the time when working with small sample sizes. What’s interesting, however, is how the small changes in initial assumptions drove large changes in the outcome. India Today – Axis poll (one that we rate highly, both on analysis and integrity) had pencilled-in 80 off 243 for the ruling coalition, whereas the actual seat count was 125 (56% higher). In a refreshing admission of mistake (3), Axis conjectured that it missed the mark, inter alia, as overall female turnout was 5% more than male, which swung the election. Reiterating for the sake of emphasis–a 5% swing in roughly half the voters led to 56% higher seats for one side!

One might think that’s outlandish, but we had written about this phenomenon in our August 2020 letter (link here) while describing Ed Lorenz’s Chaos Theory and how tiny changes in the initial condition lead to dramatically different outcomes. Today, we argue that when dealing with chaos theory (for e.g., investments in the banking sector), a mean reversion model often serves as a better guide than a probability-based model.

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Kelly criterion: Remember the 2008 hit film 21 in which hotshot MIT grads bring Las Vegas casinos down on their knees? That was a real-life story, the inspiration of which lay with Ed. Oakley Thorp, a mathematics professor and blackjack player, who developed the concept around counting cards in the late 1950s.

Ed’s technique, in turn, was based on what is called the Kelly criterion, which provides a mathematical way to determine the optimal size of: (a) bets if you are gambling; or (b) asset allocation if running a portfolio. It is expressed as ‘2p – 1 = x’ or 2x the probability of winning minus 1 equals the percentage of one’s bankroll that should be bet (probability of winning is 55%, bet 10%; probability increases to 70%, bet 40% and so on). Ed used this technique to great effect in blackjack, estimating the probability based on whether high cards were dealt to players or they were in the hand with the dealer, sufficiently altering his betting positions.

Mean reversion: Many authors argue that the skills required to excel at investments and poker/blackjack are similar. Robert G Hagstorm writes in his book, Investing: The last liberal art, that over the years, the Kelly criterion has become a part of the mainstream investment theory. Some believe Warren Buffett as well as Bill Gross use Kelly methods in managing their portfolios. Another author William Poundstone wrote a book, Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street, arguing how both are inter-related.

For us, there is a subtle, but important, difference. Outcomes are finite in gambling. For example, let’s imagine you enter into a wager with a friend that with one roll of dice you will get 6. Straight odds are one in 6 or a 16% probability. But then, suppose your friend rolls the dice again, quickly covers with hand, peeks and says, I can tell you it’s an even number. With this new information, you can recalculate the odds to 33%. While you were considering placing the bet, your friend says, “and it is not a 4,” and you can bump the probability up to 50%!

Assessing that probability in equity investment framework is quite another thing. Consider this NBFC which predominantly finances used commercial vehicles. In a conversation with us last week, they mentioned that their collection efficiency for October was 95% plus. This high number was surprising, given that their book comprises customers which have been severely impacted by the pandemic (6% are taxi operators, plus not all freight movement is back to normal). We couldn’t help but ask the reasons behind their book behaving so well.

One reason that stood out was that their current book had seasoned rather unexpectedly. The ILFS crisis in 2018 meant exceedingly small addition to the number of customers over the past two years. And, as old customers kept paying their EMIs, their loan to value fell to a level that it didn’t make sense for them to default. Obviously, 75% customers are owner-drivers (who will want to retain their livelihood and hence will not default) also helped.

Now, this is the same stock that fell 66% in less than a month in March 2020 and has risen 36% over the past month. How easy do you think it is to correctly calculate the probability of loss in this NBFC’s book at the peak of the pandemic? If calculating probability is reasonably difficult, Kelly criterion is of little help for equity investing. Instead, we find ourselves seldomly relying on mean reversion. In another one such letter (link here), we were baffled by the highest underperformance of the banking sector on record yet, and had noted the following: Now that we are in the midst of the highest relative under performance ever seen in the banking sector, only time will tell whether it is the case of another ‘myopic loss aversion’ by investors or ‘this time, it’s really different!’

As half of that underperformance got reversed over just a few months, we are getting increasingly convinced that a mean reversion model works as a better guide than a probabilistic model, especially in dealing with sectors where small changes in assumptions trigger large changes in outcomes.

Note:
(1) US election of next President is subject to the outcome of the pending legal cases
(2) https://www.bbc.com/news/election-us-2020-53657174
(3) https://twitter.com/PradeepGuptaAMI/status/1326490915502952448?s=20

SaaS, one who has never sinned, and tech valuations

Mate, instead of doing business of EUR28.2bn (mid point) in 2020, as we had guided in April, we now believe we will be able to do only EUR27.5bn (again, mid point), down just 2.3%. We cool, right?

Sorry sir, you take our relationship for granted. This is simply not done.

But wait, that’s not all. We have a ‘cloud computing’ division. We shall ramp it up to EUR22.0bn by 2025 from just EUR1.9bn in 3QC20. You happy now?

Oh, that’s even worse. Obviously, there simply cannot be that much business to go by. You sell licenses now, which brings immediate $$$ (ok, EUR in this case). You start selling your software as a service (SaaS), you cannibalise your own business.

Oh, come on, be reasonable.

Sorry. In my eyes, the value of your business drops by EUR33bn TODAY; down 21% in one day.

What? That’s ridiculous. Hold on, I am buying. Almost EUR250m worth (note 1)

Well, that’s not gonna cut it, now. Over the next five days, we shall value you a further 7.5%, down another EUR6.5bn.

If they could speak, in my mind, this is how the dialogue between Mr. Market and SAP must have transpired in the week of October 23, 2020. SAP is a German multinational software company, known especially for its ERP. It is Europe’s largest software company by revenue and third-largest publicly traded software company in the world.

One who hasn’t sinned multiple times: Now, this is a true-blue market darling we are talking about. Over the past eighteen years, the stock is up over 13x. In early 2000s, managing enterprise resources was done through messy proprietary systems host to each country, region and/or local flavours. Today, we cannot fully fathom the enormity of the task to consolidate those statements at the end of each accounting period, let alone make all the data available for the purpose of managerial analysis. The thought of one integrated system that functions across the entire organisation was entirely utopian back then.

And, that is what SAP accomplished; and the markets loved it for that. So, what changed? Nassim Taleb summarises it in his book Antifragile – that for nature to be antifragile, organisms need to die. A system that sacrifices fragile units makes itself stronger to shocks. The fragility of every start-up is necessary for the economy to be antifragile. For e.g., individual restaurants are fragile–they compete and some shut down. But that is what makes the entire business of ‘eating out’ robust–it has survived the test of time.

Technology business is similar. History is littered with businesses that we thought were worth a lot at the time. Take Blockbuster (worth USD8bn in 1994), Palm Inc., (USD50bn in 2003), Alta Vista, Pebble, Vertu, Jawbone and many more that went bankrupt. Not to forget iconic companies like Blackberry (USD80bn in 2008) or Nokia that got sold at cents to a dollar on peak valuations.

Taleb says that this is where learning from mistakes of others benefits the rest of us, and, sadly, not them. Had the Titanic not had that famous accident, as fatal as it was, we would have kept building larger and larger ocean liners with inferior material and the next disaster would have been even more tragic.

So, whereas technology has kept changing over the past two decades, businesses and corporations that have survived are the ones which have learned to adapt. Take IBM for example; it was into consumer hardware, servers, services and even software, and despite giving up multiple lines of businesses over the past decade, it continues to remain diversified. Similar is the case of HP and Xerox (if one includes all the demergers). Or as Taleb puts it, “my characterization of a loser is someone who, after making a mistake, doesn’t introspect, doesn’t exploit it, feels embarrassed rather than enriched with new information, and tries to explain why he made the mistake rather than moving on.” For Taleb, “he who has never sinned is less reliable than he who has only sinned once. And some who has made plenty of errors (though never the same error more than once) is more reliable than someone who has never made any.”

Tech investing: The entire SAP episode brings the discord in tech investing to the fore. Tech investing is hard because: (a) technology changes at a reasonable clip; and (b) the narrative around technology in and of itself is changing as well. Over the past two decades, Apple Inc., has traded at 10x forward earnings multiples thrice and at 40x forward earnings multiples as well.

The narrative at higher multiples argues for technology to become all pervasive and it assumes that a company can deliver strong growth for an extended period. And the strong cash flow it generates will be ploughed back into R&D and/or returned via buybacks and dividends. At low multiples, the narrative changes to unpredictability of the technology and ability of companies to survive the technology shift.

To us, SAP willing to reinvent itself based on changing market conditions is a sign of maturity. The management putting its own money where its mouth is (instead of investing shareholders’ money for buyback) reflects skin in the game (a concept we deeply believe in). It’s quite possible that SAP’s latest gambit falls short of target, but in our view, history will be kinder to SAP than Mr. Market.

Note
1: SAP executives and officials increase in stakes: Christian Klein, CEO – EUR204k, Luka Mucic, CFO – EUR75k, Juergen Mueller, CTO – EUR24k, Hasso Plattner, Chairman – EUR248,535k, Raif Zeiger, Board member – EUR 25k, Lars Lamade, Board member – EUR 20k

Disclaimers
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.

A ‘wow’ business model, The Party, and what China exports

I am not sure what surprises us more, the revelation in the Journal of Biomechanics(1) that a common ant can lift 5,000 times its weight or the fact that the largest IPO till date has stopped taking orders from big investors a day sooner than planned(2)! Jack Ma’s Ant Group Co. is scheduled to raise USD34.5bn and plans to get listed on November 5, 2020. For the IPO, that is most likely to pip Saudi Aramco’s USD26bn record, has already seen retail portion oversubscribed 870x at Shanghai, and Bloomberg reports that mom-and-pop shops in Hong Kong are taking 20x leverage to supercharge their bets.(2)

Ant’s business is interesting. What accounted for more than half the revenue three years ago (Alipay – payments bank), today is just a hook for the real business (credit lending, wealth management and insurance distribution). Alipay’s volumes are staggering (close to USD4tn of total payment value compared to cUSD5tn for MasterCard and cUSD9tn for Visa), but low margins (at c10bps,) translate into transaction take rates that are just 5bps versus say 230bps for Paypal. Hence, little money is made in this business.

But that’s what makes fintech fun; using payments bank to understand consumer behaviour and making money elsewhere. Where, you might ask? Well, last year, Ant disbursed close to 16 consumer loans per second. Not impressed? How about USD300bn loans in one year? Put that into context–it is 22% of what the entire Indian banking system disbursed by ONE company, in ONE year! The best part is, Ant does not take any underwriting risk, the partner banks do (there are a 100 of those); it just gets a fee for sourcing the loan. The company has also tied up with 170 asset managers in the wealth management business, where it manages 680mn users with over USD500bn in AUM. Similar story with insurance distribution; with just a ‘sideline insurance agency licence’, about 107mn people have joined Ant’s health insurance plan and it accounts for 13% of the online premia market. So how much money does the company make? Well, for 3QCY20, it clocked USD6.8bn revenue and USD4.0bn gross margin –a growth of 50% and 75% year-on-year, respectively. That’s just…WOW!

The Party: While Ant’s business model looks stellar, how China’s capitalist corporations co-exist with a communist ideology is even more fascinating. Richard McGregor writes in his book, The Party: The secret world of China’s communist rulers, that Hu’s displacement of Jiang (in 2002) was not only the first peaceful handover in China since the 1949 revolution, which was notable in itself, but also the first in any major communist country. The roots of The Communist Party of China (CPC) were laid with a civil war in division of territory in 1949 as a unitary one-party sovereign state with Mao Zedong as its founding father.

The CPC has a central committee (c370 members), which acts as a kind of enlarged Board of Directors. The committee selects the Politburo (25 members), which in turn selects the Standing Committee (the sanctum sanctorum; currently seven members). The Politburo’s overriding priority lies in securing the CPC’s grip on the state, the economy, the civil service, the military, police, education, social organisation and the media. The Party keeps a lock-hold on state through three pillars: (A) Companies: Within all companies, there is a separate ‘Party Committee’ which has superseded the Board of Directors on occasions. (B) Personnel: The Organisation department maintains files on top-level officials in the public sector and appointments are announced without any accompanying explanation. In 2009, heads of three state airlines were rotated overnight to rival firms to keep competition in check. (C) Army: The People’s Liberation Army was formed in 1927 as a military wing of a revolutionary party, and its key mission now is to ensure that CPC stays in power.

What China exports: Steve Cheung, a Chicago-trained economist, had said, “the Chinese had to deal with corruption, a D-grade judicial system, controls over freedom of speech & beliefs, education & health care which were neither public nor private, exchange controls, inconsistent policies and tens of thousands of riots.” It is surprising that the economy grew nearly at 10% CAGR for three decades. Or maybe it did so because of it!

Lack of political compulsions enables China to operate at levels that do not seem possible for most other countries. For example, prior to China becoming the largest manufacturer of aluminium in the world, it was widely believed that countries with cheap cost of power (since 40% of aluminium smelting cost is energy costs) will have the largest production capacity (e.g., Russia, Canada, Dubai). However, by 2015, China was not only importing key raw materials (bauxite and alumina), but also fuel (coal to generate power), only to export aluminium back to the rest of the world; that too at a price where 30% of global production was losing money. But so was the largest aluminium company in China, Chalco, for four years.

Well, building large-scale infrastructure calls for large quantities of base commodities (steel, cement, including aluminium).  It is my surmise that had China imported all the aluminium it needed from the rest of the world, the eventual cost of building the infrastructure would have been much higher than the cumulative losses incurred by Chalco over many years. The fact that minority shareholders in Chalco, who might not think that huge losses for multiple years is a great idea, apparently did not factor in the equation. The fact that it disrupted economics elsewhere in the world was of little consequence either. A few projects that were commercialised in India (third-largest aluminium producer after China and Russia) during that time faced difficulties as well. This situation was corrected once different economies (starting with EU, then US and now India as well) started deploying trade barriers (duties, import embargoes, etc.) to help their respective domestic industries.

The belief that standalone unit economics (without state intervention) have little relevance in China has kept us wary of investing in businesses where prices are determined at a global level (commodities, textiles, chemicals, among others), and China is a large exporter in that commodity. Over the past few years, however, some businesses have done phenomenally well where either China has decided to vacate the space (chemicals, citing pollution reasons) or were forced to create some space due to clients’ compulsion to diversify their sourcing strategy (specialty chemicals, textiles and EMS). We certainly hope that this trend continues.