Category: blog

Oh, is that how it always happens?

November 25, 2021

Letter # 63, 10^th November 2021

It’s 1988 and tennis fans were keenly watching two players, Andre Agassi, ranked at number 3 ⁽¹⁾, and Boris Becker, ranked at number 4. By 1989, they had faced each other on three separate occasions, and Becker won all the three matches (Agassi did not win even a single set in two of those). By the end of 1989, Becker went on to occupy the number 2 spot in the ATP rankings and Agassi was pushed to number 7.

Then, something changed. They played three matches in 1990, and as if by a stroke of luck, Agassi won all three (won two matches in straight sets). In 1991, they played two more games and again, Agassi won both. During their careers, they faced each other on 14 occasions, and Becker won only four matches (just one more after three wins by 1989), and Agassi clocked … TEN. Seriously, mate, what happened?

Agassi later revealed in an interview ⁽²⁾ that he kept watching the tape of Becker’s service and noticed a tell. Just as Becker was about to serve, he would stick his tongue out — in the middle if he was serving up the middle and to the left if he was serving wide.

Having discovered Becker’s tell was only half the victory; resisting the temptation of reading his serve for the majority of the match and choosing the moment when he could use that information to break the game open was harder.

The learning is simple: if you are predictable, people learn to hack you. Markets teach us the same, i.e., if we are listening.

Let’s take the banking sector for example. Between December 2007 and March 2020 (12 years), Bank Nifty nearly doubled despite the COVID-induced market correction. In comparison, the Nifty only rose a meek 40%. Still, Bank Nifty outperforming the Nifty was only the side-story.

The ‘lead’ story is what led to that Bank Nifty’s stellar performance. Kotak’s stock price tripled and that of HDFC Bank quadrupled. In December 2007, the combined weight of HDFC Bank (HDFCB) and Kotak Mahindra Bank (KMB) was just 24%, whereas that of ICICI Bank (ICICIBC) and State Bank (SBIN) combined was 51%.

During the same period (Dec-07 to Mar-20), ICICIBC rose just 40%, and SBIN fell 10%. Strong asset quality controls catapulted HDFCB and KMB to pole position, while others fumbled. In turn, that led to two things.

One, weights of ‘clean’ banks increased dramatically: HDFCB and KMB rose to 44% by March 2020, and that of ICICBC and SBIN fell to 30%, i.e., delta of a whopping 21%.

Second, and more importantly, many market participants subconsciously formed the opinion that what has happened in the past would continue – i.e., HDFCB + KMB would keep gaining share. Just because they ran the bank better, markets would keep rewarding them with higher valuations.

What transpired was the exact opposite. Between March 2020 and now, the Bank Nifty has doubled again, but the composition is entirely different.

HDFCB and KMB have underperformed the index by 50%, whereas ICICIBC and SBIN have outperformed by broadly the same quantum. Consequently, HDFCB + KMB weights have fallen to 38%, and ICICBC and SBIN are quickly catching up with 36%. While they gave up 21 ppt (percentage points) of share over twelve years, they have quickly regained 5 ppt over just the last year and few months.

At the end, Agassi knew very well that if Becker found out that the ‘tell’ was made, the advantage would be lost. He could have exploited Becker’s every serve and decimated him, but the risk wasn’t worth it. A long-term win mindset does involve letting go of short-term gains.

It is similar with markets. While ‘experts’ often suggest that great companies are always great investments, historically, it hasn’t stood the test of time. The past may be a decent guide to future, but events that have not happened in the past are happening all the time now. Let data, and not heuristics, speak louder for your investment decisions.

Notes:
(1) Ultimate Tennis Statistics – Rankings Table
(2) WATCH: The amazing story of how Andre Agassi read Boris Becker’s serve by watching his tongue – Tennis365

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.

Map is not the territory, but packaging is often the product

October 30, 2021

Letter # 62, 30^th October 2021

Earlier this week, a plan by US Senate Democrats to impose a tax that would likely affect 700 billionaires collapsed after a backlash. Negotiators have been trying to find new sources of revenue to pay for Biden’s ‘Build Back Better’ legislation, under which a USD2 trillion spending package had already been announced. Democrats had hoped to simply raise corporate taxes and individual income, and capital gains tax on the wealthy, but Kyrsten Sinema, a moderate Democrat from Arizona opposed it, reports FT ⁽¹⁾.

You might say: “Right, so one senator opposed it, big deal! This plan promises huge investment in infrastructure, housing, education, and healthcare; and is projected to create 10 million clean energy jobs. Part of this package (American Rescue Plan) has already been passed, the rest surely will, right? These things always work out, no?”

No. The US Senate is split 50-50 on party representation (Democrats and Republicans). Any one senator can single-handedly sink the chances of the bill getting passed. For US billionaires “spending more is not a problem, so long as everyone pays (through inflation) and not just us (higher tax on the wealthy).”

One wonders why the Democrats would stake so much on a plan that could be derided so easily. Alfred Korzybski, the Polish-American academic, answered it centuries ago with: ‘The map is not the territory’. He offered his audience biscuits wrapped in white paper. ‘Nice biscuits, don’t you think?’, he said, and got positive responses – until he tore the paper to reveal they were dog biscuits. Two students began to retch, a few ran to the washroom. The biscuits had tasted good, but only until the wrapper stayed concealed.

And it does not happen just in a controlled environment. Announcing the tiniest tweaks to popular products has been a disaster for Vegemite, Milo and the Cadbury Crème Egg. People so often notice a change in taste just because a change in formulation has been announced. So, when Kraft wanted to introduce a healthier formulation for their Mac & Cheese, they did not announce it for a long time. Practically no one noticed it until Kraft retrospectively put out an advertisement saying, “It’s changed. But it hasn’t.”

After his famous experiment Korzybski proudly announced: ‘You see, I have just demonstrated that people don’t just eat food, but also words. And… the taste of the former is outdone by the taste of the latter.”

Political parties are aware of the importance of optics, so being seen as trying to effect a change can often be as powerful as the change itself. This analogy is often extended to investments, but it has a critical flaw. Vegemite sales and how voters vote can be based on perception, but when it comes to investments, it is not a straight line. While the size of assets under management depends on how potential investors view one’s investment framework (i.e., the map), the investment returns themselves (i.e., the territory) are not based on perception. They represent a fact.

The last two weeks have been a rude reminder of that. Over the last eighteen years, different market cap-based indices have broadly given similar returns (Sensex 19%, Midcap Index 21%, SmallCap Index 22%; all numbers in CAGR). But it has not been a linear journey. In a market upcycle, the small and mid-cap indices outperform the Sensex and vice versa in a downcycle.

As we see from the chart above, the difference in returns has been rather stark in different market cycles. The problem arises when we start believing that the current cycle will last an eternity.

Take the example of the period between December 2017 and March 2020. During that time, while the Sensex fell 13%, the SmallCap index fell a whopping 50%. A large section of investors developed the belief that ‘there are only 20-25 companies that form an investible universe in India, and the rest is not worth looking into’. The cycle then turned in April 2020, and since then, the SmallCap index had outperformed the Sensex by over 100 percentage points (Sensex 110%, SmallCap Index 213%) in the run-up to October 18, 2020.

Of late, we seemed to have developed the conviction that SmallCap companies will keep outperforming the Sensex no matter how crazy the valuations. Over the last two weeks, however, while the Sensex has corrected 4%, the SmallCap index has corrected 7%, and more than 100 companies (over INR3b market cap) have corrected more than 15%.

While we are amid the cycle, ‘packaging’ an investment product that seeks to benefit from the cycle prevailing might appeal to a large investor base, but for returns to be truly superior across market cycles, two things are called for: (a) an awareness that indices operate in cycles, which invariably reverse, and (b) a dynamic mix of businesses across the market cap spectrum in the portfolio.

Notes:
(1) Democrats’ proposed billionaires tax collapses after resistance from moderates | Financial Times

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.

Is something more important than stock selection?

October 22, 2021

Letter # 61, 22^nd October 2021

Social media had a field day this week when Apple, the technology giant instrumental to transforming music devices and mobile phones, launched a cleaning cloth for USD19. Memes took over when Apple added a compatibility list to this product’s information – that is, the devices that ‘the cloth’ can potentially clean. As if that weren’t enough in and of itself, a lot of us gasped when we realized that ‘the cloth’ is sold out until late November 2021! ⁽¹⁾

Sounds bizarre, doesn’t it? A technology company launching a commodity cleaning product, at ten times the price of competition … and people lining up to buy it. It later dawned on me that it happens more often than we realize – and not just for consumer products, but everywhere, including with investments.

Daniel Kahneman, THE authority on behavioural economics, neatly sums up this bizarre behaviour with what he calls the ‘focusing illusion’ ⁽²⁾. He says, “nothing in life is as important as you think it is, while you are thinking about it.” When people believe that they “must have” a good, they greatly exaggerate the difference that the good will make to the quality of their life, he explains.

Kahneman asked a few people – given that the weather is beautiful in California – would they be happier if they lived there. Most people said yes. But when Kahneman asked Michiganders and others a different question (not focused on weather), they appeared just as contented as the Californians. Relationships, work, and recreation are broadly similar no matter where one lives. Also, once you settle in a place, you do not think about the climate that much. When specifically prompted however, ‘the weather’ assumes a bigger role in decision-making, simply because one is paying attention to it.

We can apply this framework to investments as well. We had argued in ‘Discipline Eats Timing for Lunch’ ⁽³⁾ that while people pay immense attention to timing the market, the difference in returns between disciplined investing and timing the markets is not large. But when markets are galloping, all we focus is on how little we are invested in markets. And when it dramatically corrects, all we focus is on how we could have sold more. Because one constantly observes the market rises and falls, ‘timing’ assumes far more importance than the fact that disciplined investing brings similar returns.

We also argued in ‘Being Vaguely Right Rather than Precisely Wrong’ ⁽⁴⁾ that the disciplined investing works with individual stocks as well, provided one is in the right theme. Our focus is too often on the timing the current theme ‘precisely’, rather than getting the next big trend ‘vaguely’ right.

In the third and final part, we take his line of thought forward. (a) Yes, discipline is far more important than timing (b) and yes, it must be in the right themes, but (c) today we argue that sector selection is of paramount importance.

Let’s assume that you are the Chief Investment Officer of a large Indian fund with total autonomy to run it as you deem fit. Between December 2007 and February 2009, your call on asset allocation (say debt vs. equity) would contribute close to 90% of the fund’s total returns. The decision, then, to avoid Realty and invest in FMCG would contribute close to another 9%. Lastly, within FMCG, the decision on whether to invest in ITC, or Dabur, or Nestle, in the overall scheme of things would be responsible for just 1% of your overall portfolio returns.

The table below lists the different market cycles in India with best and worst returning sectors and relative performance of similar-sized businesses at that time.

Historically, sector selection has had a far larger impact on investment returns than stock selection within that sector. It is true that occasionally one embarks upon a company that cuts through these ‘sectoral cycles’ and outperforms across. But we focus an inordinate amount of time looking for those. A great company in a sector that underperforms often generates much inferior returns to an average company belonging to a sector that outperforms.

But since we interact with, and focus on companies (stock prices, analyst calls, management calls) and not directly on sectors, we form the illusion that the right company is far more important than the right sector. In what we consider a logical conclusion to the arguments we made over the previous letters, we humbly submit that over the longer term, a focus on discipline, themes and sectors is likely to yield a far superior return than the illusion of timing the markets and getting the company selection right.

Notes:
(1) Apple’s New $19 Polishing Cloth is Sold Out Until Late November – MacRumors
(2) Edge.org
(3) Discipline eats timing for lunch… every single time! – Buoyant Capital
(4) Being vaguely right rather than precisely wrong – Buoyant Capital

Being vaguely right rather than precisely wrong

October 15, 2021

Letter # 60, 15^th 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!

Notes:
(1) Discipline eats timing for lunch… every single time! – Buoyant Capital

Discipline eats timing for lunch… every single time!

October 1, 2021

Letter # 59, 1^st October 2021

“Arite old man, breadcrumbs followed, show me the way home. Is there a problem with the three laws?” asks Detective Spooner to Dr Alfred Lanning.

“No, the three laws are perfect” came back the reply.

“Then why would you build a robot that could function without them?” he continues probing.

“The three laws would lead to only one logical outcome… Revolution” the doctor is now smiling.

“Whose revolution?” asks the detective as the music keeps growing somber by the second.

With a sense of finality, Dr Lanning says… “That, detective, is the right question”.

Fellow Will Smith fans will recognize the dialogue from the 2004 movie, I, Robot, that got nominated for the Best achievements in visual effects category at the Academy awards.

Now, talking of “right questions”, with the market at highs, we are increasing questioned by potential investors: “Given the current market levels, do you think it is good time to start getting invested in equities?”. Obviously, there cannot be a binary (Yes or No) answer to such a question. However, we can say this with some reasonable certainty is: While a lot of investors might have a similar question to the one being asked to us, it is NOT the right question to consider for equity investments. But for it to be a Yes or No response, a couple of other considerations apply. Before I expand on that, let us take a brief detour.

Humour me for a bit here. Let us imagine that there are two investors – Mr Smart and Mr Not-so-smart. Mr Smart believes in timing the market and has waited a long time for it to correct. He was patient, and when they eventually corrected in 2009, he started his equity investments at the bottom of the crash. Since then, he has been investing in the markets at the end of every month. Mr Not-so-smart didn’t bother about timing the market, and as it turned out, his equity investments began at the peak of the markets in 2008. But like Mr Smart, he also kept investing. Now, how much do you estimate would be the difference in the returns of these two investors? A brief detour before I answer that.

Besides timing, an equally difficult question to answer is – whether markets are “expensive enough”. Going by historical valuations, the markets were trading at an all-time-high one-year forward price to earnings multiple of 17X in the month of November 2020, when the Nifty was at 12800. Nifty has since increased to 17,500 and is still trading at 22X one-year forward price-to-earnings.

For one thing, analyst estimates change with change in macro-economic variables. Also, there are behavioural aspects to consider (when markets are down and out, and the analyst predicted target prices already show huge upside, analysts are loathe to raise estimates further. Trust me, I have been there). Lastly, things that have never happened in the past are happening all the time now. The markets had never corrected 35% in one month prior to March 2020 and have never recovered to go on to new highs in one straight line, the way they already have. By that corollary, there is very little to objectively suggest when the absolute tops and bottoms of markets occur. Whereas that has always been the case, it hasn’t stopped us from developing a false sense of belief that we are able to predict these outcomes.

Now, let us come back to the question at hand. Would it at all be surprising if, I told you that whereas Mr Smart made 14.7% CAGR, the returns for Mr Not-so-smart were… 14.4% CAGR. Yes, that is correct; we double checked the calculations. All that waiting for correction, and the smartness to pick the bottom and the gall to start putting money when the market is down and out. All that Mr. Smart has, to show for it, is a mere 30bps annual outperformance. Sounds very counter intuitive, but I am happy to send across the calculations if you feel like checking it yourself. With that, I am hopeful you would now concur that ‘is it the right time to get invested in equities’ is the wrong question. In short, we don’t know when markets top. And in the long run, it hasn’t mattered.

Now if you are saying… “Mate, don’t show me a 13-year analysis. That’s way too long keep up the discipline”. I’d say, “Great, let’s go shorter”. Mr Not-so-smart begins his equity journey at March 2015 peak whereas Mr. Smart begins investing from the lows of Feb 2016 (Nifty has corrected 17% by then). Assuming they continued investing every month with discipline, Mr. Smart generated returns of 19.9% CAGR, while Mr. Not-so-smart is not far behind at 18.3%. THAT IS IT – you were awesome at timing the market and end up feeling pretty good about yourself for a long time. But at the end, that has historically given you a very slim edge. And here, we are not even accounting for Peter Lynch’s wisdom: “More people have lost money waiting for corrections and anticipating corrections than in the actual corrections” ⁽¹⁾. That’s right; we got it right this time around, but how many rallies have we missed waiting for that correction?

Nevertheless, implicit in our story of the two investors were two important assumptions. One, they had incremental money (monthly cashflows) to invest with changes in markets. And two, they had the discipline and a mental makeup to keep investing when markets kept tanking. It is one thing to say that we will average the position when market correct. It is quite another to actually do it.

In the end, after reading this, if you are tempted to ask: ‘So, would you say that asset allocation and investment discipline are quantum leaps more important than the timing of your initial investment”, I might be tempted to reply: “That, detective, is the right question!”.

Notes:
(1) Peter Lynch: Secrets to success | Investing lessons | Fidelity

Fully invested bears, anyone?

September 24, 2021

Letter # 58, 24^th September 2021

It’s easy to miss the events that occur in far-off lands, but a few offer an interesting perspective. Yesterday, Algeria closed its airspace to Morocco, a month after it broke off all diplomatic ties with its neighbour. While it is difficult to spot the two small North African nations on a map, their story is fascinating. One that leaves you gasping with… “but, why?”

On paper, the African nations appear promising. Oil reserves (Algeria), vast natural resources (including a large coastline) and new-found independence. Circa 1960s, they held the potential to usher North Africa into prosperity in the post-independence era. Well, they did not.

It started when the French conquered Algeria in 1830s. Like a good neighbour, Morocco catalysed a rebellion against the occupation. But a decade later, France responded by attacking the Moroccan army and annexed parts of its territory to France.

By the 1950s, however, precious metals were discovered in the annexed parts and France transferred the area to Algeria. Years later, France offered to return it to Morocco, if the latter was willing to jointly develop the minerals with France. Morocco rejected this advance as by then Algeria was in final swing of its independence movement. Provisional government of Algeria offered a better deal.

But, on gaining independence, Algeria was in no mood to comply. The trust was broken, relationships were soiled and “Sand Wars” broke out. The final nail came in 1975 when Spain conceded its territorial occupation of Western Sahara to Morocco (a region to its South). Western Sahara had a large coastline and offered access to the Atlantic Ocean by bypassing the Gibraltar Strait. For Algeria, that was the key to its aspiration of regional dominance. A proxy conflict ensued which lasted for two decades. A cease fire was announced in 1991, but the score was far from settled.

Over the past decade, the two countries combined have spent over USD110bn on defence (combined GDP is cUSD300bn). Morocco runs amongst the most sophisticated military with arsenal of F16 jets, M1 Abrams battle tanks, M109 howitzers and observation satellites. Algeria matches it with its own fleet of SU 34 jets, Navy frigates and kilo-class submarines. A close observation would reveal the country of origin of this equipment (for respective countries).

The two countries do not face a national threat, apart from each other. Yet, they spend all that money on defence, year after year, just trying to out manoeuvre each other; precious money that could have been spent on education, infrastructure building and general economic development. All this, while Algeria’s GDP is contracting, and austerity measures are in place for more than the past five years ⁽¹⁾.

In his book, The Wisdom of Crowds, James Surowiecki argues that under the right circumstances, groups are remarkably intelligent and are often smarter than the smartest people in them. He begins by telling the story of Francis Galton, the English Victorian-era polymath. In one of the poultry contests in 1907, some 787 people paid six pence for the opportunity to guess the weight of a rather large ox. A few guessers were farmers and butchers (maybe classified as experts), but a far greater number had no specialized knowledge of farm animals. Based on that, he anticipated his 787 participants would come up with a dumb answer.

The ox weighed 1,198 pounds. Galton took all guesses and plotted a distribution curve. He found that the median guess was within 0.8% of the correct weight and mean guess was within 0.1% (average guess was 1,197 pounds). The crowd, as a collective, just knew! They knew it better than the “so-called” experts could guess. How?

Surowiecki writes that two critical variables are necessary for a collective to make superior decisions–diversity and independence. One, if a collective can tabulate decisions from a diverse group of individuals who have different ideas or opinions on how to solve a problem, the results will be superior. Two, independence does not mean participants remain in isolation, but each member is free from influence of other members.

A geopolitical history of the two African nations reveals how the collective wisdom of crowds has always been missing. The politics of Morocco takes place in the framework of parliamentary constitutional monarchy. It hold elections, but the King makes strategic decisions. In July 2020, Morocco’s King Mohammed VI celebrated 21 years on the throne. Prior to him, late King Hassan II ruled from 1961 to 1999 and the list of dynasts date back to 788 AD.

Algeria, on the other hand, is a constitutional semi-presidential republic. However, many political observers call Algeria a “controlled democracy”— a state where the military and “a select group” of unelected civilians make major decisions, such as who should be president ⁽²⁾. When talking of countries, one cannot distil the failure point to one (or even a few) variables. Nevertheless, it is fair to say that the wisdom of crowds has been long missing, and the lack of accountability does explain the situation in part.

Now let us consider Galton’s idea for stock markets–a system that is incentive-based and one that can aggregate investor decisions. If the “smart collective” always comes to the right conclusion, how come we end up with booms and busts? Why does the “diverse group” not come to the right prediction for the market as it did in Galton’s country fair?

Surowiecki argues that with markets, condition No. 2 (independence) is often not met and more so in modern times. Decisions of market participants are not always independent, but often coalesced into one opinion. People make decisions based on actions of others rather than their own private information. The age of social media accentuates this process.

And, it adds up. Prior to March 2020, the market had never fallen 35% in one month and never before had it recovered in one straight line; and yet it did. Earlier, two cohorts existed: (a) “Trend followers” (momentum strategies) who bought more when prices rose (and vice-versa); and
(b) “Fundamentalists” who bought based on underlying value. They used to balance each other out and historical market corrections (or recovery) were not as pronounced.

Increasingly, that difference has blurred. Whereas momentum strategies continue, fundamental investors have devised ways of valuing businesses that did not exist before. Thought process moves to relative–B is cheaper compared to A, hence one must buy B. Regardless of whether B deserves to be valued at current absolute valuations. PE multiples are just a state of mind, they say, right?

When everyone starts operating looking at others, it eventually results in market rallies (and corrections) assuming extreme proportions. The last straw is when fundamentalists throw in the proverbial towel and convert into what one finds regularly now… “a fully invested bear”. Now that this is out of the way and as US and Indian markets hit their all-time highs, do you think it is a good time to start getting invested in equities for the next decade?

Notes:
(1) ALGERIA: Shift Towards Austerity (readcube.com)
(2) https://www.economist.com/middle-east-and-africa/2012/05/12/still-waiting-for-real-democracy

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

No such thing as a free meal, or… free make-up, apparently!

September 17, 2021

Letter # 57, 17^th September 2021

Malcolm Gladwell has an interesting start to his book, Outliers. He argues that “I did it by myself” kind of explanations to success don’t usually work. Most of them are invariably beneficiaries of hidden advantages, extraordinary opportunities and cultural legacies that enable them to learn, work hard and make sense of the world in ways others cannot.

Take hockey teams in Canada for example. Here, 40% of the national players are born in the first quarter of a calendar and only 10% in the last. What gives? No, it isn’t astrology. It’s simply that the eligibility cut-off for age-class hockey is January 1. So, someone who is born on January 2 would compete with younger kids, sometimes almost a year younger. At that level, 12 months can make a huge difference. As levels advance, it then leads to a self-fulfilling prophecy–you start getting more games, better facilities and the benefit compounds in your favour by the time you reach the national stage.

I was reminded of Outliers earlier this week as many brokerages presented their views on the upcoming (and quite hot, might I add) IPO of the home-grown online Beauty and Personal Care (BPC) champion Nykaa. As Spark Capital succinctly put it (and I paraphrase) over the last decade, a lot of factors have aligned to create a conducive runway for growth for Nykaa i.e., the rapid penetration of smart phones, affordability of data, adoption of digital commerce, evolution of logistics ecosystem and Covid-led digital adoption. Nevertheless, Nykaa got multiple things right–the category and channel (there weren’t many players in online BPC space), solved the right consumer problem (counterfeits and lack of foreign brands sans distribution) and did so without burning a lot of cash.

The consensus opinion from most reports appears to be along these lines: (a) it is a great business; (b) in a nascent industry with a massive runway; (c) it has cracked it in a way that competition never would be able to… and that too; (d) without burning cash.

Consequently, it deserves to be valued quite close to stratosphere. Nykaa last raised capital in May 2020 at the valuation of USD1.2bn. One year later, by March 2021, news reports ⁽¹⁾ had started pegging IPO valuation at USD3.5bn. By June 2021 ⁽²⁾ that rose to USD4.5bn. Most recently, one brokerage report suggested a one-year forward target of cUSD9bn.

I think that as Nykaa’s business model has benefitted from the ecosystem that evolved, its valuations have benefitted from the gush of liquidity fuelled through by historically low interest rates. And, whereas reams of pages are being dedicated to the business model, a discourse on how secondary market shareholders should value such businesses seems missing (publishing absolute valuations may not be permitted under law, the methodology to value it still is).

The venture capital model runs on probability rather than cash flows. A 10% probability of 50x returns over five years implies 33% CAGR… that math is easy. For secondary markets: (a) cash flows; and (b) its timing, take precedence. In developed economies, investments in new-age, hyper growth, cash burning businesses are treated akin to an investment in an ultra-high duration bond (a cash flow stream that will probably generate high cash flow after a long period). So long as interest rates stay very low, secondary investors happily match their ultra long-term liabilities with investments in equity of such businesses. The moment interest rates rise above a certain threshold, these equity investments become untenable to fund. And, without continuous funding, the ‘probability’ of future cash flows dwindles.

I employ similar model that a brokerage might have used to arrive at the USD9bn valuation, albeit with 2 minor changes–one, I increase cost of capital by 2%, and two, I lower terminal growth by 2% (both are quite conceivable and within the realms of possibility). With these changes, the valuation falls to USD5bn, down 44% from the suggested USD9bn. Also, important to point out that the terminal growth rate kicks in after assuming that the annual FCF increases from negative USD10mn currently to over USD2bn over the next two decades (yes, two decades is the explicit forecast period).

“Look at the mess the US economy and the Fed balance sheet is in,” you might say. “Why would the interest rates ever rise?” The short answer is, because economic activity is rising due to liquidity, not necessarily due to productivity gains. Also, a large part of supply disruptions may be permanent. And… it has happened before!

Richard Nixon was inaugurated in 1969 and despite widespread belief of being ‘fiscally conservative’, he turned out to be one with “liberal ideas”. He continued to fund the war, increased social welfare spending, ran large budget deficits and supported income policy.

In 1971, he broke away from the gold standard, which devalued the USD. He fired the then Fed chair McChesney and installed Burns, and leaned heavily on him to keep rates low. “We will take the inflation, if necessary, but we can’t take unemployment,” said Nixon, recalls Burns in his book Secret of the temple.

Initially, the Fed in the 1970s kept seeing inflation as driven by high crude oil prices (and therefore “transitory”, which also saw mankind invent the term ‘core inflation’). Eventually, US had both–high inflation and high unemployment. By 1973, inflation doubled to 8.8%, on its way to 12% later in the decade. It eventually took a new fed chair Volcker in 1979 to raise interest rates to double digits, which put the economy in recession.

Milton Friedman, later, eloquently said it in his book Money Mischief, “inflation is always and everywhere a monetary phenomenon.” To summarize, something will eventually give in and interest rates will rise. May not be now, not next quarter, but soon enough. And once that cycle starts playing out, a lot of business models will become questionable. With that, valuations of all such businesses will be questioned.

Nykaa has created a phenomenal business out of hardly any investment. Even if evolution of the ecosystem benefitted the company, one must credit it for getting almost everything right. Regardless of that, the question of valuation is still one for secondary investors. Nykaa will do phenomenally well if it were to grow annual FCF from negative USD10mn to over USD2bn over the next two decades (as that broking house seems to believe). Even if that happens, minuscule changes in assumptions lead to dramatically lower valuations.

Given the frenzy surrounding the IPO market in general and Nykaa in particular, ours would likely come off as a minority opinion. I am aware of that. Nevertheless, over the short term, following central banks helps make money; over the long term, macros need to fall in order. And, whereas macros for Nykaa might turn out to be just fine, those of several economies leave a lot to be desired. Sadly, that has an equal (if not higher) bearing on the valuation of these businesses than the macros of these companies themselves.

After reading this, while scratching your head, if your question for me is, “dude… I just want to make money on listing pop; will I?” I would do you one better and ask this in return, “if there is a huge runway ahead and the company isn’t burning cash, why the IPO in the first place?”

Notes:
(1) nykaa ipo: ETtech IPO Watch | How Nykaa’s valuation, cap table have evolved over the years – The Economic Times (indiatimes.com)
(2) Nykaa looks to list at $4.5 billion valuation (livemint.com)
This letter was originally published here: No Such Thing As A Free Meal, Or … Free Make-Up, Apparently! (cnbctv18.com)

Same story: structural when chemicals, cyclical when aluminium?

September 3, 2021

Letter # 56, 3^rd September 2021

If I asked you to name the best performing stock in your portfolio over the past five years, what are the chances that you would pick one from the chemicals space? Called by whatever name – commodity, speciality, CRAMS, high performance etc.–on an average, over the past decade, these companies have catapulted 50x. Their historical earnings during the same period have jumped 5x, implying meaningful expansion in valuations.

And the story, you would say, is straight forward, right? Chemicals is a polluting industry; China did whatever it had to do over the past 2 decades and is now incrementally focussed on environment. Plus, post-Covid, the world is tired of the supply chain hassle and wants ‘China plus one’ procurement. Indian companies are well placed in simple as well as complex (or multi-step) chemistry. Plus, managements speak decent English to converse with buyers, labour cost is low, law of the land holds, currency is broadly stable and companies are free to pollute their way to growth. A minuscule move away from China would double revenues of Indian companies. Natural destination… right to win… blah, blah. I will hold these businesses for the next 50 years and valuations don’t matter!

It’s all good and we are in the same boat as the next person; as in, our best performers are chemical companies as well. But what if I were to tell you that the exact same story is playing out in aluminium, and whereas all of us see the chemicals story as “structural”, we view the aluminium price move as “cyclical”. That is to mean that good chemical companies deserve a 30x PE multiple, but metal companies are something of a fad and hence deserve a single digit PE multiple and are generally not worthy of a place in our portfolios for the long term. If you are happy to consider a nuanced take on a complex topic, allow me the opportunity to present my case below.

Aluminium is a reasonably new metal. Unlike steel’s history of thousands of years, aluminium’s history dates back only to early 19^th century, when it was considered ‘holier than thou’ (Napoleon III, the first president of the French Republic, served his state dinners on aluminium plates while the rank and file were served on plates made from gold. Yes, you read that right!).

In the late 1800s, Oberlin College student Charles Hall and French engineer Paul Heroult, separately and simultaneously, developed an inexpensive electrolysis process to extract aluminium from ore. Large amount of electricity was required to power this process, and consequently, production moved to regions where power was cheap. In 1970, NAFTA and USSR accounted for 58% of global aluminium production. By 1998, aluminium production had doubled from 1970 levels, but these countries still accounted for 40% plus of global production. Here is where things started to change.

At the turn of the new millennium, aluminium was THE shiny new metal; it weighed a third of steel, was corrosion resistant, completely recyclable and had good electrical conductivity. It was the metal of the future and all countries creating infrastructure were looking at aluminium with a lot of hope. Sadly, one of those countries was China.

Broadly speaking, to make one ton of aluminium, you need two tons of alumina, four tons of bauxite and 15,000 kwh of electricity. Whereas aluminium smelters and alumina refineries can be built, bauxite and coal (traditionally the fuel for electricity) occur naturally. Historically, therefore, the largest aluminium producing countries were the ones that had access to cheap electricity and bauxite.

That was about to change. In the run-up to 2020, the global aluminium smelting capacity would nearly triple. What was more striking was that China accounted for more than 80% of the incremental capacity. That’s HUGE. For a country that imports bauxite (by my estimate, 40% of bauxite that China requires is imported) as well as coal to generate power only to export aluminium while its domestic companies incurred losses was baffling. I had previously discussed why I believe China expanded the way it did; you can read about it here ⁽²⁾.

Now the thing we conveniently forget is that aluminium is also a highly polluting industry–to make one ton of aluminium, the refinery process (2 tons of alumina) produces around 9kg of air emissions (mainly SO2), 1kg of water emission and over 2000kg of solid waste (red mud). Plus, the anode making produces 2.5kg of air emission, 0.3kg of water emission and 25kg of solid waste. Lastly, aluminium smelting itself produces 23kg of air emission, half a kg of water emission and 34kg of solid waste (landfill) ⁽³⁾.

Last year, China accounted for over 56% of global aluminium production with a carbon footprint that is much larger than rest of the world (given huge transportation for bauxite and coal, plus largely coal-fired power plants). As the Chinese government started clamping down on aluminium production⁽⁴⁾ to curtail emissions, aluminium prices hit a decade-high this week.

Discussions, even now, revolve around how sustainable these prices are and a large section of investors choose to ignore this sector. Since 2000, however, whereas absolute aluminium prices are up 65%, adjusted for global inflation, they are down 25%. The three listed aluminium companies in India generated a single digit ROCE last year, and two of them are integrated with captive bauxite, and the third one has the lowest conversion cost.

If chemical businesses have rallied for the better part of the past decade, inter-alia on the news that China is serious about reducing emissions, then a similar analogy extends to these aluminium smelting companies as well. Indian companies combined have the production capacity of over 4mt and they trade at single digit PEs. Over the past two months, aluminium prices have moved higher by USD300/t, resulting in an annualized increase in EBITDA by over USD1bn combined.

As many global brokerage houses start pegging next year aluminium prices at over USD3,000/t, which of the below do you think is the right question to ask? (a) should aluminium companies be a part of your portfolio; or rather (b) which aluminium company would you prefer to own?

Notes:
(1) Aluminium and aluminum are interchangeably used in this article and might appeal differently to your sensibilities depending on which side of the pond you are. I am sure my purist colleagues would be kind enough to excuse this liberty at my end.
(2) https://www.buoyantcap.com/capitalist-but-on-my-terms/
(2b) https://www.buoyantcap.com/chemicals-and-commodities-knowing-how-china-operates-can-help/
(3) 46194971.pdf (oecd.org)
(4) METALS Aluminium prices lifted to 10-year high by China concerns | Reuters
This letter was originally published here: View: Should Aluminium Companies Be Part Of Your Portfolio? (cnbctv18.com)

Disrupting the disruptors

August 27, 2021

Letter # 55, 27^th August 2021

Let us start with a question: In your opinion, when an industry undergoes seismic changes, do incumbents sense them and respond quickly? Or do things become clear only in hindsight?

In the mid-1800s, Instagram wasn’t yet a rage, but everyone still loved clicking photographs. Cameras were then built using photographic glass plates as supports for negatives and were considered superior to film because they were stable and unlikely to bend or distort. But, there was a problem–cameras were huge and not portable.

That was about to change by 1888. “You press the button; we do the rest” was the slogan with which Kodak’s first fully portable camera was launched. George Eastman’s (Kodak’s founder) guiding principles were simple–mass production at low cost, international distribution, extensive advertising and customer focus. Kodak single-handedly disrupted photography by transforming it from complex activity to a social practice that became part of everyone’s life.

Kodak had a good run until the 1970s, when Japanese film companies (Sony and Fuji) started aggressively pushing into the US market. Kodak lost market share in the run up through 1990s. The sale of analogue camera and films still accounted for 64% of photographic products in 2002, but the world was changing. But by 2005, the consumer film business was disappearing 25% per annum. For 120 years, Kodak had done everything by itself (at one time, it even raised its own cattle and used the bones for making photographic gelatine). In the new digital world, Kodak could no longer do that. By 2011, its stock price fell below USD2 per share and it filed for bankruptcy on 19^th Jan 2012.

The funny part is, the first electronic camera was invented by Steve Sasson, an engineer with Eastman Kodak in 1975. But it was filmless photography and Kodak generated majority of its profits from selling films. Management’s reaction was “that’s cute, but don’t tell anyone about it.”

While Japanese companies Fuji (films) and Nikon (digital cameras) were disrupting Kodak, another US company was busy dethroning a Japanese giant, this time, in the field of music. Akio Morita, Sony’s co-founder, had the vision to marry digital technology with media content in early 1980s. But engineers (and not the media division) ran Sony. The idea that consumers can download music and keep listening to it without it resulting in incremental sales for Sony did not sit well with them. Even when they came around, they introduced proprietary files that were incompatible with the fast-growing mp3 market. By the time they were forced into co-operating, Sony had lost its foothold in two crucial product categories–television and portable music devices.

The company that owned the Walkman brand (was synonymous with portable music devices) was nowhere to be found by the time Apple’s iTunes became the industry standard. Sony’s market valuation by 2012 was down 87% from its 2003 highs (when iTunes was introduced) and down 97% from the 2000 highs.

These days, cameras and music are no longer getting disrupted; instead, the movie exhibition business is. Pay per view and OTT services are trying their level best to change the way movies are viewed world-wide.

In India, however, we have a little history. The introduction of colour television and VCR technology in late 1980s marked the beginning of the piracy culture in India. By early 1990s, many entertainment channels were launched and an average India viewer was eager to consume a lot more. However, the country spent a large part of 1990s living borderline on the cusp of illegality with the movie business. Pirated compact disks were sold by the roadside or on peer-to-peer sites (like BitTorrent or Kazaa) without any part of that income accruing to the formal economy of India.

Yes, it was shoddy. Yes, the quality was supremely bad. But it was cheap and it offered instant gratification. Towards the turn of the new millennium, Indian viewers were tired with this system and wanted better.

That’s when the current exhibition chains set up shops. They didn’t just exhibit a movie in high quality, they sold the entire ‘movie-going experience.’ Spend time with your family, enjoy the movie in good seats and air-conditioned halls, shop in the malls after the movie and end the day with dinner in the next-door restaurant. An entire ecosystem emerged–malls with exhibition houses as anchor tenants, restaurants and shopping markets, which became the mainstay with many families in India.

In the year ended March 2020 (a year with marginal covid impact), over 100mn people saw movies at PVR, India’s largest movie exhibition company. An average visitor paid INR204 for a ticket, consumed food & beverage of INR108 and paid INR20 in convenience charges (the convenience to book tickets on internet). For a family of four, that amounts to INR1,325 per movie. That’s a sizeable amount considering India’s current average income, but nevertheless, it establishes the fact that in just over 2 decades, exhibition houses have managed to disrupt the way movies were traditionally watched in India.

The challenge now is at their doors. Since the onset of covid, in the seventeen odd months that the cinemas were shut, production houses and movie watchers have altered their habits. Traditionally, cinemas enjoyed a three-month window of exclusivity before films moved to other formats. Great box office numbers were good for everyone – cinemas, studios and movie stars. But things are different now. Warner Bros released its entire 2021 slate of films, including Godzilla vs Kong, on its HBO Max streaming service the same day as theatrical release. Disney did the same with Black Widow.

Now that multiplexes are about to open, will viewers go to the cinemas to watch a movie? Well, you tell me. Now that Amazon prime and Netflix deliver the same content at a fraction of the cost to your houses, how valuable is the ‘movie watching experience’ for you? A vast majority of the market believes that exhibition houses are here to stay. PVR’s share price is only 35% lower than its pre-covid highs and analysts that cover the stock overwhelmingly rate the company as a Buy (26 Buy and Hold ratings vs. 5 Sell ratings).

Historically, whenever seismic changes have occurred in an industry, the incumbent player believed that the world is unlikely to change beyond a point. The fact that change was imminent became apparent only in hindsight. The fate of exhibition industry lies in the balance; and we shall let time decide.

This letter was originally published here: As Multiplexes Open, Would They Make For Good Investments? (cnbctv18.com)

Losing the plot

August 20, 2021

Letter # 54, 20^th August 2021

It’s the crucial day five and India is in their fourth over of the day (86^th of the inning). Ollie Robinson has the new Dukes in his hand and is charging towards Pant who is batting on 22 off 45. Pant edges one to the keeper and India are 194 for seven. By the 90^th over, Robinson traps Sharma on the crease with a slower ball and India are down to 209 for eight. In walks Bumrah. A shaky lead of 182 and with two wickets to take, England is now favourite to win. By the time India declares their innings, they are at 298 for eight with a mammoth lead of 271 runs (Shami and Bumrah scored an unbeaten 56 and 34, respectively).

What happened there? How could the entire Indian top order collapse for a little over 200 runs and the ninth wicket partnership goes on to score an unbeaten 89! Former English bowler Steve Harmison had an interesting take on that.

He says ⁽¹⁾, “they didn’t have any slips, no catchers in any position while bowling at numbers 9 and 10. A good ball to Virat Kohli is a good ball to Shami and Bumrah. England just seemed to get one eye off trying to get Bumrah out by bowling bouncers at him.” Why, might you ask? “The inexperienced characters were trying to sort of stand up for Jimmy Anderson (Bumrah kept bowling bouncers at Anderson in the first innings and they were returning the favour). Sometimes, you just have to step back and take a couple of deep breaths.”

Essentially, to avenge the bouncers bowled to Anderson, the English team ended up giving 89 runs to the ninth wicket, gave away the highest runs ever and second 50 to Shami and lost all 10 wickets and the match with just 60 overs to play on the last day.

How rookie of them, one might wonder. Such a blinding glimpse of the obvious, right? But it happens often than we think, and it happens closer to home all the time.

Long Term Capital Management (LTCM) was started in 1993 by the renowned Solomon Brothers bond trader, John Meriwether with two Nobel Prize winning economists on the board of directors. The strategy was simple: (a) Identify a minuscule opportunity of arbitrage in bond markets’ and (b) Leverage to the hilt, which generates a significant return on equity even with a minuscule return on investments. At its peak, LTCM had USD5bn in equity and USD124bn in debt. When the going was good, returns were great–21% in year one, 43% in year two and 41% in year three prior to 1998. Then, they lost USD4.6bn in less than four months due to: (a) Asian and Russian financial crisis creating unprecedented situations in the bond market; but also (b) having a false assumption that arbs work equally well with equities (short volume, risk arb and equity relative value) as they do with debt.

Well, that was decades ago; let’s talk about the more recent implosion of Bill Hwang’s Archegos Capital late March this year. Archegos was structured as a family office, investing just Bill’s money. While US rules prevent individual investors from buying securities with more than 50% of money borrowed on margin, no such rules apply to hedge funds or family offices. By late March, Archegos’s leverage had increased 5 to 1. Also, Archegos used swaps where it got the upside and downside in stock performance without owning the equity directly (the name of the bank would show up in shareholder register). While even the banks that funded him were not aware of the complete picture, on March 26^th, with a staggering USD100bn portfolio defaulting, Bill Hwang became synonymous with LTCM. Such high leverage, what were you thinking, right?

Even if we directly don’t identify with these stories, there are lessons to be learnt from them. Equity markets have steadily risen since March 2020 and buying the dip along the way has always appeared to be a great decision in hindsight. It is during times like these, and unknowingly, the anchoring bias sets in. When markets correct, we anchor our decisions to latest prices. When a stock falls from INR800 to INR600 during a correction, we are tempted to average, without consciously thinking if INR600 is a good price in and of itself. That leads to sub-optimal decisions. What then should we be ideally doing?

At Buoyant, we always return to these two actions when we make decisions like these. One, we do a sort of ‘zero-based budgeting’. Let’s forget at what price the stock has recently quoted at, and rather assume that we had the opportunity to buy out the business entirely. If one were to run a discounted cash flow model on it, what assumptions would I have to make to justify the price today? If those assumptions look broadly achievable, we go ahead and buy more.

Second, and more importantly, to retest our thesis, we actively reach out (with utmost respect) to people who have a negative view on the stock than we own, even if they have gone wrong for the entire bull run. Shutting oneself to alternative view points and drinking our own cool aid is among the worst things investors can possibly do.

When the going has been good (in cricket, asset management or individual stock decisions), it is easy to lose the plot when the situation reverses. We risk losing the entire test match, returns of an entire lifetime or might find ourselves buying sub-standard businesses at slightly lower price just because it recently quoted at a price which now looks high. Being aware is a battle half won.

Notes:
(1) England lost the plot by trying to get back at Bumrah over bouncer barrage to Anderson: Steve Harmison (sportskeeda.com)
This letter was originally published here: What Not To Do During A Market Correction (cnbctv18.com)