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Historical context to China’s crackdown; where does India fit?

July 30, 2021

Letter # 52, 30^th July 2021

We could be accused of indulging our vanity, but still we are going to say this: it gives us immense pleasure to announce this 52^nd weekly letter, marking the first anniversary of us publishing every Friday. It has been an enriching experience–a lot of learnings along the way and fruitful interactions with many of you post the publication (the brickbats and bouquets are appreciated in equal measure) make us look forward to the weekends. Onto this week then!

The last week saw a sharp contrast between established tech companies reporting record profits and new age tech businesses losing billions of dollars following the crackdown by China. But July 2021 also marked the 100^th year of the founding of the Communist Party of China (CPC) and a brief peek into their past might surprise a few–starting with the fact that it wasn’t the de-facto heir to modern China. Rising decibel level of China’s activity in the Taiwan strait amidst US navy leadership continued belief that China will take control of Taiwan soon, makes for interesting times. More on that in a bit, now a brief history of how the CPC got here.

Following the collapse of the Qing dynasty (1644 – 1912), it was chaos in China. By 1923, the Kuomintang (KMT) emerged as the principal party in China. Buoyed by Soviet Union’s support, KMT agreed to cooperate with the Chinese Communist Party (CCP) to form the First United Front. But, after the death of KMT’s founder in 1925, it split into left and right wings; the left wing aligned with the CCP. By 1927, CCP and KMT were in an all-out war, pretty much till 1949 (with a brief armistice during the second Sino-Japanese war, 1937-1945). The two Chinese parties fought the Japan war differently—while the KMT preferred conventional warfare, the CPC opted for guerrilla tactics.

The end of war saw CCP’s ambitions take wider wings. Based on the terms dictated by the US, Japan was asked to unconditionally surrender to KMT (and not to CCP). In the eyes of the US, KMT, and not CCP, was the heir apparent to modern China. Despite over USD4bn in post-war aid from the US, the war had left KMT significantly weaker. CCP’s membership, meanwhile, was rising dramatically – and it went for the kill. Mao Zedong proclaimed the founding of People Republic of China on 1^st October 1949. By then, the CCP had suffered 1.3mn combat casualties, but the same number for KMT was over 7.5mn! CCP systematically pushed out the KMT government from its capital in Nanjing to Guangzhou, then to Chengdu, and later across to the strait to Taiwan by December 1949.

Since then, the CPC has kept an iron grip on China. As Richard McGregor writes in his book, The Party: “the Party has made sure it keeps a lock-hold on the state; the three pillars of its survival strategy are–control of personnel, propaganda and the People’s Liberation Army.” The Party has a central committee (300 members), which reports into the politburo (about 25 members), which then reports into the sanctum sanctorum – the standing committee (5-11 members; currently 7). Since 1949, there have been five heads of the Party, Mao Zedong (1949 – 1976), Deng Xiaoping (1976 – 1990), Jiang Zemen (1990 – 2002), Hu Jintao (2002 -2012) and Xi Jinping (since 2013).

China adopted the Soviet model of Red Army, but under Deng, it judged that the arms race had brought down Communism in Moscow and that is how Hu’s confidant, Zheng Bijian, describes the ‘peaceful rise’ of China. Under the radar, until you gain the size. Operative word being: ‘UNTIL’.

Now that China has the size, it is time to let ambitions fly. Adm. Phil Davidson (US Indo-Pacific command, 2018-2021) ⁽¹⁾, and his successor Adm. John Aquilino (since March 2021) ⁽²⁾ have separately testified that “we have seen aggressive actions [by China] earlier than we had anticipated, whether be on Indian borders or in Hong Kong or against the Uyghurs.” Aquilino believes that China considers establishing full control over Taiwan as its ‘number one priority’.

Life appears to have come a full circle – Japan surrendered to the same KMT that is now relegated to being the opposition of a much smaller Taiwan–a country the US believes will be attacked by China within the next six years.

In the early 1980s, China had devised the ‘one country, two systems’ approach to regain control over Hong Kong and Macau; Taiwan unification was next in line. Geopolitical analyst Shrivan Neftchi in his Caspian Reports says, “Beijing has used economic isolation and political interference to coerce reunification.” Eventually, China cut ties with Taiwan in 2016 after election of pro-independence forces and increased military activity in the Taiwan strait.

China, with USD250bn defence budget, significantly outspends Taiwan’s USD11bn, but given that Japan and US will back Taiwan in a war, the playing field is levelled. An all-out war, therefore, may not be the solution. What is possible, however, is that China begins a hybrid warfare – stop short of shooting and subdue the foe through fear and exhaustion, says Shrivan, which can be decisive if performed well. China’s Airforce breaches Taiwan airspace routinely. Last year, Taiwan had scrambled its air force nearly 3,000 times against China, costing it over USD900mn. And the tempo is rising. The number of Chinese vessels entering Taiwan controlled waters stood at 2 in 2017; by 2020, it had risen to nearly 4,000!

China can keep salami-slicing Taiwan and not go for an all-out war until it is desperate for approval back home. As Richard writes, “state sovereignty, territorial integrity and economic development are all priorities of the state, but all are subordinate to the need to keep the Party in power.” The crackdown on education sector is essentially China playing to the galleries (domestic middle class) by keeping education, healthcare and real estate costs down, while pandering to the communist agenda (serving middle class at the expense of billionaire founders and venture capitalists).

Geopolitically, India is not new to China’s tactics, and recent skirmishes at its borders suggest that India is up for the task. But financially, India might need to up its game if it intends to benefit from the massive business that ‘China plus one’ strategy brings.

PLI is a step in the right direction here, but the size of many Indian businesses is still a fraction of China and Indian corporates are wary of taking on more debt to fund growth. While extending a significant helping hand to corporates would help India seize the moment, the political pliability of it is questionable. Tactical deal-making with new partners (say for Indian textiles industry with Europe, for the GSP+ status) could help as well.

From the markets’ standpoint, it would be a stretch to believe that investors that lost money in the Chinese crackdown would automatically shift that exposure to India. India still does not have the size and an even stricter capital convertibility. The ‘Rupee risk’ investment will have to compete for that international investors’ pie and the best strategy to ensure that it comes to India is by strengthening the core (helping business grow, signing on more trade deals, bolstering the economy), rather than looking for quick fixes.

Notes:
(1) Davidson: China Could Try to Take Control of Taiwan In ‘Next Six Years’ – USNI News
(2) Chinese threat to Taiwan ‘closer to us than most think,’ top U.S. admiral says | CTV News
The story was originally published here: Historical Context To China’S Crackdown; Where Does India Fit? (cnbctv18.com)

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.

“Davids” beat “Goliaths” more often than we know

July 23, 2021

Letter # 51, 23^rd July 2021

Equity markets have a way of surprising us. Yes, they did fall more than they arithmetically should have during covid. But there is another undercurrent that is often missed– the 2-plus years’ underperformance of small-cap stocks ended with the market’s bottoming. Since April 2020 till as of writing this letter, while the Sensex has jumped 79%, the BSE Small-cap Index has catapulted 175%. If that sounds like a lot, let me tell you that by historical standards, it’s NOT. But, more on that when we return from this brief detour; one that involves the story of David and Goliath.

While the biblical account of this story is rather well known, I shall still briefly summarize it. As per the Book of Samuel, Israelites were in a standoff for over 40 days with Philistines at the valley of Elah. They eventually decided to settle it based on the outcome of a single fight (less bloodshed that way). Goliath (appearing for Philistines) was a six-footed giant and came bearing heavy armour and many weapons; he was expecting a hand-to-hand combat. David (appearing for Israelites) had a rather small frame and came to the fight with no armour and just a stick, a few stones and a sling. As soon as the fight began, instead of engaging in a close encounter, David hurled a stone at the only part of Goliath’s body not covered with armour (the centre of his forehead), instantly killing him.

While this is interesting, Malcom Gladwell in his book David and Goliath has a more nuanced take on how this story translates into today’s life. He explores two ideas: one, that all what we consider valuable in our world arises out of these lopsided conflicts because the act of facing overwhelming odds produces greatness and beauty. And second, we consistently misread such conflicts. What appear as weaknesses often translate into great sources of strengths; and in that, the fact of being an underdog transforms people in ways we often fail to appreciate. It is a fascinating read, which provides a template of sorts for defeating giants. Let me share a story from the book.

The story of Vivek Ranadive, an MIT graduate who grew up playing cricket, but had to later coach his daughter (12-year old) Anjali’s team at basketball. Initially, he thought that basketball is a mindless game. Team A scores and immediately retreats to its side of the court and team B dribbles the ball from its side of court to A’s side. The length of court is 90 feet, but majority of the game is played in just 24 feet! Only occasionally, teams played ‘full court press’, i.e., contest their opponent’s attempts to advance the ball.

It was rare, but Ranadive had a problem–his girls weren’t tall, couldn’t shoot, weren’t adept at dribbling and there wasn’t a lot of time to teach these skills. He knew that if they played in the conventional way, they were sure to lose. But then Ranadive wasn’t the one to give up easily (he went to study at the MIT in the 1970s–during that time, RBI had to approve the use of forex for studies of individual students. If he could get RBI to bend, how difficult could this be).

Ranadive’s strategy was built around two deadlines that must be met. First, when a team scores, a player from the other team takes the ball outside the play area and has five seconds to pass it on to a teammate in the court. If the team can’t make it in five seconds, the other team gains possession of the ball. Normally it is not a problem since the other team always retreats to its side of the court. The second deadline was to advance the ball across mid-point to the other team’s side within 10 seconds.

Ranadive’s girls decided to play it man-to-man defence (shadow your opponent) and made sure the other team was unable to pass the ball from outside the court. Eventually, the other team missed both its deadlines. This is still ‘little league’ of basketball and 12-year old girls, known to play a certain way, didn’t know how to cope with this unorthodox strategy. Ranadive made sure that his girls were better trained; they had to survive the ‘full court press’ for the entire game. With this little innovation, Anjali’s team managed to reach the nationals despite their known inabilities. They changed the traditional rules of how the game was played, just like David changed the rules of engagement.

Malcom also mentions the story of Lawrence of Arabia’s conquest of Aqaba and how they took on the Turks from the direction where they least expected. I think India’s final assault on Tiger hill during the Kargil war was also based on similar strategy.

Now coming back to markets. Before the onset of the Covid-triggered market fall (and during the time when small caps were underperforming i.e., December 2017 to March 2020), a section of investors (professional and otherwise) had formed this opinion that “large companies will keep getting larger and at the expense of smaller companies.” That meant that the investible universe in India had come to be narrowly defined as a few companies, beyond which investments were considered pariah. That made sense, right? After all, look at small-cap stocks getting decimated for more than 2 years now. It didn’t matter that history stated otherwise, and therefore, these investors were arguably not ready for what was coming.

See the exhibit below; the relative 100ppt outperformance since April 2020 by small caps is the lowest on record since the inception of these indices in April 2003.

Five distinct upcycles are apparent since these indices were formed; and the small-cap index has beaten the Sensex every time. Of course, the opposite is true in downcycles, but it is the net result that should count, right? Any guesses on what that is?

Over the past five years, traditional way of doing business has been disrupted. Banking AQR in 2015, Demonetisation in 2016, GST in 2017, NBFC crisis in 2018 and Covid pandemic in 2020, among others, have made it rather difficult for a lot of smaller companies to compete with larger ones. However, the resilience of Indian entrepreneurship has managed to find ways to stay relevant and be counted when the time comes. The net result: Since April 2003, the BSE Small-cap Index is up close to 30x compared to Sensex rising just 18x. In India, the “Davids” certainly have been beating the “Goliaths” more often than we know.

This letter was originally published here: Smallcaps Vs Sensex: “Davids” Beat “Goliaths” More Often Than We Know (cnbctv18.com)

Inflation might not have the answers, learnings lay elsewhere

July 16, 2021

Letter # 50, 16^th July 2021

Hey mate, your team lost to mine at our favourite sport last night ⁽¹⁾; time for you to treat everyone to dinner. How about Saturday?

Umm… I owe dinner, I agree. But can’t we do it on Friday? You see, I am on a tight leash here.

What? Are you suggesting that you can afford a meal on Friday, but not on Saturday?

Precisely! Prices on Saturday are twice that of Friday.

Oh, how about Sunday? People go to work on Monday; not that many go out dining on a Sunday and restaurants know that, correct?

Not really. Cheque on Sunday is twice that of Saturday. And, on Monday, it is twice that of Sunday.

Come on mate. You have got to be kidding me.

Midway, you might have caught on that I was referring to what could have been an actual conversation in Zimbabwe, circa 2009. At the height of hyperinflation in 2009, it was so difficult to measure inflation that the Zimbabwean government stopped filling out official statistics. Hanke and Kwok ⁽²⁾ estimate the peak month of inflation stood at 79.6 billion percent per month or 89.7 sextillion percent year-on-year in November 2008. Or, put another way… prices were rising roughly 131% every day!

That might appear a while ago, but the debate rages on. Data published earlier this week showed that US consumer prices rose by 5.4% in June 2021, at a faster pace than 2008. Data published this Wednesday also showed that UK inflation hit 2.5% in the same period, its highest level since 2018.

The same day, Fed chair Jay Powell fended off a barrage of questions from the US Congress as he sought to ease concerns over the Federal Reserve’s response to surging US inflation. “I know that people are very worried about inflation. We hear that loud and clear from everybody,” said Powell. But added that, “we do believe that these things will come down of their own accord as the economy reopens – it would be a mistake to act prematurely.” The 10-year Treasury note traded 6 basis points lower post the testimony and equity markets rallied.

While newspapers and social media feeds are inundated with posts consisting of views from people on either side of the aisle (those who believe inflation is transitory or otherwise), Ha Joon Chang has quite a different take on this in his book Bad Samaritans.

He writes that during the 1960s and 1970s, Brazil’s average inflation rate was 42% per year. Despite that, Brazil was one of the fastest-growing economies in the world for those two decades (per capital income rose 4.5% p.a.). Even Korea, during its “miracle years”, was growing per capita income at 7% per year, while continuing to have inflation at the rate closer to 20% p.a.

Chang, of course, doesn’t argue that all inflation is good: Argentina’s 20,000% inflation during the 1990s, Germany in the early 1920s and Zimbabwe’s above are unquestionably bad. It hampers long-range planning, thereby making investment decisions difficult to execute, which in turn impacts jobs and economic growth. But, in moderation, inflation could be a good thing–something that neo-monetary policy experts completely dismiss.

The post-apartheid Africa National Congress regime in 1994 announced that it would pursue an IMF-styled macro-economic policy (so as not to scare away investors) and kept real interest rates high (10-12%), which kept inflation rate low (6.3%). But, this was achieved at a huge cost on jobs and growth. Chang concludes that when rich countries get into recession, they usually relax monetary policy and increase budget deficits. When the same thing happens to developing countries, the “Bad Samaritans”, through the IMF, force them to raise interest levels and balance their budgets (stark contrast of Korea in 1997 vs. Sweden in the early 1990s).

Now, let’s bring attention back home; do we know whether India’s inflation (CPI at 6.3%, WPI at 12.9%) is transitory or not? What we do know is that India sits on an all-time-high food grain stock (food and beverage form 46% weight in CPI), that housing (10% weight) inflation is absent and pick up in vaccination and supply-side easing could bring in incremental supplies. While rising commodity prices (incl. oil) and bad monsoons pose risk to this, beyond that, we don’t really know.

But the fun part is, we don’t need to have a great handle on inflation; learnings might lay elsewhere. Historically (since we have data – 1991), equity markets have been ok with inflation rates up to 8%, a bit worried till 12% and nervous beyond 12%. But more importantly, during extreme times, central banks have historically been reasonably tolerant of inflation. Between 1940 and 1952 (World War 2 periphery), US inflation reached double digits on three separate occasions (1942, 1947 and 1952). Debt to GDP crossed 100% in 1947 and infrastructure to GDP stood at a mammoth 1.6%. However, during all these periods, US bond yields hardly changed.

While the jury is still out on whether Covid zone qualifies as “extreme times”, the reluctance of central banks to act (raise interest rates) in the face of record borrowings by governments and rising inflation does provide an opportunity to get invested appropriately, i.e., in companies that own hard assets, preferably ones that have moderate levels of debt. Ever wondered why those infrastructure, real estate and commodity stocks in your portfolio have been having a stellar run lately.

Notes:
(1) I could have used the example of Italy and England, but I fear that it might be too soon to joke about it!
(2) cato123448v26n2_2up.q
(3) The letter was originally published here: Inflation Might Not Have The Answers, Learnings Lay Elsewhere (cnbctv18.com)

Capitalist… but on my terms!

July 9, 2021

Letter # 49, 9^th July 2021

July 2 was a typical Friday evening for most companies, save one. The Cyberspace Administration of China (CAC) warned Didi Chuxing (Didi; China’s answer to ride-hailing app Uber and Lyft) that in one hour it would publicly be ordered to stop signing new users ⁽¹⁾. Didi was subsequently also asked to remove its app from app stores in China as it had violated laws on collection and use of personal data. By Tuesday, CAC announced that it would tighten regulations over companies listing abroad, especially, over cross-border transfers of sensitive information. Prior to this, CAC had never invoked the ‘cyber security review process’ introduced just over a year ago.

FT states that according to procedure, companies should volunteer for a review of their procurement and supply chain if their operations are of critical importance to national infrastructure. If Didi ‘voluntarily’ submitted for clearance, it would come as a surprise that it chose not to wait for the clearance before proceeding with the USD4.4bn IPO, which got listed just a couple of days before the crackdown. Didi’s ADR is since down more than 27% from highs and now trades below its IPO price i.e., over USD20bn in lost shareholder value in less than one week.

Chances are that you have already read all about it. While CAC’s action could have surprised a few, it would not have surprised Nian Guang Jiu. Richard McGregor writes about Nian and the way China operates in his book, The Party: The secret world of China’s communist rulers.

Nian was first jailed in 1963 for engaging in illegal speculation, i.e., running a private food stall in his hometown Wuhu in Anhui. During the Cultural Revolution, a few years later, his capitalist rap sheet alone was enough to put him behind bars again.

When freed in the late 1970s, Nian opened a shop selling roasted sunflower seeds. He did not have a good education while growing up and was nicknamed the ‘fool’. He chose to name his product Idiot Seeds. Within a few years, Nian had a thriving business with more than 100 employees.

This success got the Anhui party chiefs petrified, who thought that they might be committing political error by allowing Idiot Seeds to flourish. They sent a report to Beijing asking whether they should shut the shop down, which eventually landed on Deng Xiaoping’s ⁽²⁾ desk in 1984. Soon after, Deng replied that, “in keeping with wild economic experimentation he was encouraging at the time, closing a business might make people think the open-door policy had changed.” Nian’s Anhui Fool Group (no typo) survived. But, by 2008 when Richard met him, he had morphed from a subversive capitalist into a state-sponsored business celebrity, parroting official propaganda.

Richard writes that after coming to power in 1949, the Party closed private businesses and confiscated their assets. The suspicion harboured towards entrepreneurs lingered long after Deng’s market reforms in the late 1970s. When Jiang Zemin ⁽²⁾ allowed entrepreneurs to join the Party in 2001, it created a rare public split among the Party’s leadership.

The Party’s distrust of private sector was never about money, nor the flagrant contradiction between individual wealth and Marxist pantheons. Everyone agreed on the need to turn profits. The real issue for the Party was the threat that foreign and local private sector might become its political rival. The unprecedented partnership between a Communist party and capitalist business holds; it remains an uneasy, unstable and unholy alliance, but an alliance, nonetheless, writes Richard. The book published more than a decade ago makes a lot of sense in the current context.

And, there are more stories. China National Petroleum Corp (PetroChina) is best described as the ExxonMobil of China. Paul Schapiro of Goldman Sachs wrote this around the time when PetroChina was gearing up for listing: “The best way to describe PetroChina was that it was the Ministry of Petroleum.” But, as it was getting repackaged to be sold off to foreign shareholders, PetroChina shed close to 1mn jobs and the Ministry of Petroleum disappeared altogether, leaving the company with little direct oversight from the government. When capitalism is the need of the hour, communism can clearly wait! That and oh yes, there was a subtle difference–PetroChina was getting listed in the mainland and in Hong Kong, not in the US.

As Richard Baum, another China scholar, puts it, “state sovereignty, territorial integrity and economic development are all priorities of the state; but all are subordinate to the need to keep the Party in power.” If the Party fears that foreign or local private sector might become a political threat, they will be reined in. And, if the Party fears that Chinese entities wanting to list in the US would have to share audit files with US regulators, then the whole process of US listing could be stifled.

You can very well be a capitalist operating in my country, BUT it must be on my terms is the thinly-veiled message. Or as Richard so succinctly puts it, “the Party is like God. He is everywhere. You just cannot see him.”

In comparison, another IPO will likely list this month, but in India. What started as Foodiebay in 2008, later rebranded as Zomato, would likely list for over USD10bn! A truly home-grown company with orders per month approaching 55mn and transacting users likely to cross over 14mn, started just as restaurant listing business, and entered food delivery as late as in 2016. But now, of its USD394m consolidated revenue, 82% comes from food delivery, 14% from dining out and the balance is contributed by classifieds and loyalty programme.

The second largest shareholder in Zomato, at 16.5% pre-money, is Ant Financial. Ant Financial (or Ant Group as it is now known) is an affiliate company of China’s Alibaba Group. India, just a year ago, had an acrimonious altercation with China at its north-eastern border, which resulted in public outcry calling for banning China manufactured products in India.

Whereas India has done nothing to stifle the IPO of a company that has a large holding from a Chinese company, readers would recall that it is the same Ant Financial whose IPO (in China and Hong Kong exchanges) was suspended in November last year citing ‘possible failure to meet disclosure requirements.’ Reasons could have been different then, but the message was the same: You can be a capitalist operating in my country, but IT MUST BE ON MY TERMS!

This behaviour has several implications for India, both business wise and for equity markets. Superior operating efficiencies have enabled China to become the manufacturing hub of the world; it’s difficult to entirely replace it. But, increasingly, businesses have started to realise how China operates and are looking to diversify; hence, the ‘China plus one’ strategy. Industries (like chemicals and textiles) in India are already benefitting from this. India benefits by having a superior and predictable regulatory environment. Increasingly, the Government of India is realising the benefits of lending a helping hand to several industries (hence the PLI schemes).

What has started with ‘China plus one’ for business procurement, will likely soon extend to the financial realm as well. Though the size of Indian businesses is much smaller compared to Chinese businesses, domestic demand in India is still high. Financial investment from foreign players (via FDI, FPI, etc.) should dramatically increase in India over time.

Notes:
(1) Didi caught as China and US battle over data | Financial Times (ft.com)
(2) CPC leadership history: 1949 to 1976 – Mao Zedong, 1976 to 1990 – Dang Xiaoping, 1990 to 2002 – Jiang Zemin, 2002 to 2012 – Hu Jintao, 2013 to now – Xi Jinping

How much paper supply is too much?

July 2, 2021

Letter # 48, 2^nd July 2021

What if you had the power to make rules that companies wanting to list on the bourses must follow? How would you design those rules? If it were me, and since I am very pro retail shareholders, I would have something along these lines…

If the company has never issued shares before, the IPO must be at face value.
If the company did issue capital before, I (and I alone) will fix the premium that it would be allowed to charge based on MY assessment of: (a) trends of shares of similar companies already listed; (b) value of shares based on the company’s profit-making capacity; (c) future prospects; and (d) present and future dividend paying capacity.
While at it, I might also prescribe a minimum investment in the offer by the promoter group. Well, throw in minimum investment by directors as well.

Did I hear you say, “have you lost it, already?” If so, let me convince you that’s not the case, and offer you a trip down memory lane.

The Controller of Capital Issues (or CCI) was set up in 1943 and established as a statute in 1947. CCI’s permission was mandatory for capital issuance of any sort (equity, preference, debentures). The whimsical rules I list above, were, in fact, the law of the land until SEBI was set up in 1992. SEBI did away with arbitrary pricing methods and companies were allowed to raise money at will and at a price that companies thought was fair.

Relaxation in raising money in India was also accompanied by Indian government allowing companies to raise money abroad and Global Depository Receipts (GDR) became the preferred route. The Indian economy had just been liberalized and growth had started galloping to almost 7.4% by 1994. Other Asian economies were also starting to show some resilience (the Asian tigers) and the common perception was that the growth in India will outstrip that of its Asian peers.

Suddenly, every business needed vast amount of capital to prepare for the future. With ability to raise capital getting relaxed and foreign capital suddenly becoming available, raising money through the GDR route reached a level of frenzy, which later gave way to domestic IPO frenzy.

Domestic offerings ⁽¹⁾: From 1989 through 1992, some 14 companies used to IPO every month. Between 1992 and 1996, that number increased to a whopping 84 companies per month. In the run up to the market peak in Feb 1995, 145 issues were opened for subscriptions in just the month of Jan 1995, followed by 78 subscriptions in Feb 1995.

Phew! Those were good times. Now, let’s jettison back to the current time, i.e., now. Remember our What IF series–one where we answer unusual and fun questions with lots of data. One such question that we received was, “look, India Inc. is raising so much money through IPOs, FPOs, OFSs, QIPs etc. What IF there was a way to correlate that behaviour with market cycles?”

Well, that’s an interesting and pertinent question, and it was fun trying to come up with a suitable answer. Like our previous notes, we divided the past two decades in three cycles: start of the cycle (2009, 2016), middle of the cycle (2012, 2015 and 2019) and peak of the cycle (2008, 2010 and 2018). We then dug up data on all issuances and juxtaposed the total to overall market-cap of India Inc. (absolute numbers don’t mean much, given the inflation and rising market participation).

The exhibit above narrates a decent story. The start of the cycle is characterised by two things:
(1) the amount raised is between 10bps and 40bps of the total market-cap of all listed stocks; and
(2) the size of individual IPOs, is small. By the middle of the cycle, the range moves up marginally (20-50bps), but the size of issuances increases; larger companies are now tapping the market. Lastly, when the cycle has peaked in the past, cumulative issuances have ballooned (more than 1ppt), but more characteristically, it turns into the season of Mega IPOs.

Now, just because it has historically followed a pattern, we won’t go so far to suggest that it will recur. But come to think of it, markets do follow the laws of economics. Given the limited demand for financial assets at any given point, an incremental large supply of paper would act to shift the equilibrium of market pricing to a lower level in the coming period.

But, behavioural aspects are important too, and that is where the euphoria that engulfs certain IPOs is noteworthy. I remember the Reliance Power IPO (I used to work for one of the bankers to the issue at the time). India hadn’t gone completely digital back then and applications had to be submitted in person. On the last day of application, people queued up for 3 floors and beyond the gate of the building to submit forms. You had to be there to feel it; it was surreal!

Retail shareholders, as a cohort, have come a long way since then. Their sustained investments amidst Covid correction last year, despite FII selling, demonstrated that they have arrived. We are neither arguing that the current period’s 80bps of issuances (close to peak of the cycle) imply we are nearing a peak, nor that the lack of mega IPOs suggests that we might not be there yet.

What we do however point to is that our compilation of previous data points (inverted valuation pyramid structure, % of stocks hitting 52-week high etc.) is indicative of the rising complacency in the market. And, history has not been kind to people who have dramatically increased risk at a time when selling a stock almost always makes one look foolish the next day and buying the dip almost always makes one look smart.

Notes:
(1) PRIME,Your Gateway to Indian Primary Capital Market (primedatabase.com)
The letter was originally published here: India Inc Is Raising A Lot Of Money; What Does History Suggest? (cnbctv18.com)

Edges: Some go to the keeper, some go all the way

June 25, 2021

Letter # 47, 25 June 2021

It’s the 4^th of February 2021 and India is taking on England at Chennai, India. The visiting team is in top form, which is on total display in the first test. Skipper Joe Root piles on a double century in the first innings itself, helping his team put up 578 on board. The game was already half won when India failed to surpass 350 in reply. England beat India by a mammoth 227 runs… and that too, on India’s turf!

Old story, did you scoff? “Didn’t you see India lose the World Test Championship finals just a couple of days back, huh?” Sadly, I did. But then, what’s the fun in bringing that up!

What however is fun, is this question: with England having won the first test against India back in Feb 2021, which team, would you reckon, was statistically the most likely to qualify for the finals against New Zealand (had already qualified). India, or England?

As it turns out, neither! England only had a 25% probability of qualifying, which was still better than India’s chances at 17%. Well, it was Australia with a whopping 42% probability (it would have qualified had the series been drawn 2-2 or 1-1, or had England won 2-1, 2-0, 1-0).

As we take solace from the fact that while India lost, its presence in that competition itself was a low probability event; something more surprising strikes – how does a country like New Zealand become the World Test Champion? Come to think of it, it’s a country with hardly any population, no domestic tournaments of repute and a minuscule cricketing budget.

New Zealand’s population is about 5mn, less than half of Mumbai and a fifth of its neighbour Australia. It has about six domestic teams, but there is just one competition for first-class, one-day, and twenty20. In 2010, New Zealand Cricket announced ⁽¹⁾ that it had signed a business deal with USA-Cricket Association and that it would go and play a certain number of games in the US. Yeah, that’s right, in the US. Until that time, I wasn’t aware that they played professional cricket in the US.

New Zealand’s batting coach from 2007 to 2009 ⁽²⁾, Mark O’Neill, said this, “in Sydney there are 20 first grade teams, each club has five grades. To get to first grade you’ve got to be a friggin’ good player and once you get there the competition is very, very fierce. Unfortunately, it’s not the same standard [in New Zealand].” They appear to have come a long way in just about a decade, haven’t they?

The fact that New Zealand managed to win despite these odds – leaving stronger teams like Australia (that has an impeccable domestic circuit), England (a team in top form all through the past two years), South Africa (a nation of athletes) behind, and eventually beating a team whose budget is arguably multiple times their budget – is truly praiseworthy. Their soft-spoken skipper Kane Williamson deserves a little (if not a lot) of credit for piecing together this fine unit.

And, talking of superlative cricketing teams that manage to pull off the extraordinary, let’s move to inspiring corporate teams that managed to do the same. Classified advertisements in newspapers was a boring business in the 1990s. The world was moving ‘online’ and with that, they began the journey.

In March 1997, Sanjeev Bikhchandani launched naukri.com (under the company Info Edge or INFOE). Job listings that used to happen in newspapers were the first to move over to the internet. Matrimonial came next. In Sept 2004, INFOE acquired Jeevansathi.com.

By the time INFOE came up for listing in 2006, it was still a ‘classifieds’ business which was “helping people and business meet.” INFOE IPO-d at an adjusted (for 2 bonuses) price of INR80/share. Today, at over INR60,000 crore in market cap, INFOE is a serious contender for Nifty inclusion ⁽³⁾. How did the company do it?

The business was decent, but managements’ vision was exceptional. A re-reading of its annual reports is still an absolute delight. It becomes evident that INFOE was ahead of curve by almost 5 years on seismic changes in the industry ⁽⁴⁾. In 2010, the company decided not to spend beyond its means for naukri.com, when capital was readily available as it would entail “high cash flow risks”. And yet, it did acquire 50% stake in Zomato in 2011, which did grow by investing ahead of revenue. Even when 80% of the business was Naukri.com, INFOE declared in 2011 that it wanted to become the “leaders in the internet space.”

By 2013, INFOE removed this tagline from its presentation: “Helping people and business meet”, which gave way to “India’s leading online company.” Since then, it has continued to invest in several start-up businesses, in promoters it trusts and areas that it is familiar with. INFOE has acknowledged that mistakes are part of business and has been happy to cut losses when warranted (99labels.com).

INFOE has a bit of a Berkshire feel to it. In 2015, the company scaled down its PPT materially, not in terms of reporting, but in terms of accoutrements. It started presenting in a plain white background, with no logo or shiny colours – just information. Also, we still carry fond memories of INFOE being among those few companies where top managements have found it ‘ok’ to disagree with one another in investor meetings… but have always preferred to speak their minds.

As INFOE expands into yet another category (by launching AIF in 2020) and seriously knocks on Nifty’s doors, we are happy to take lessons from it as well as the Kiwi team that resources could be limited, but imagination really isn’t!

Notes:
(1) USA and New Zealand sign deal to promote cricket (espncricinfo.com)
(2) Cricket: The Aussie with hard words for our top order – NZ Herald
(3) https://www.financialexpress.com/market/dmarts-avenue-supermart-naukri-coms-info-edge-shares-may-enter-nifty-50-soon-indian-oil-may-exit/2276688/
(4) Info Edge (India) Limited
The story was originally published here: https://www.cnbctv18.com/market/stocks/info-edge-share-price-some-go-to-the-keeper-some-go-all-the-way-9779851.htm

Haven’t seen anything yet, or have we?

June 18, 2021

Letter # 46, 18 June 2021

Imagine that you wanted to buy a subscription to your favourite magazine. Which of the following options are you most likely to opt for? (a) Web-only service priced at USD59/year; (b) Print only subscription priced at USD125/year; or (c) Print and web subscription priced at USD125/year.

Well, if you chose option c, you are in great company. In his book, Predictably Irrational, Dan Ariely asked the same question to 100 students at MIT’s Sloan School of Management, and 84% chose option c. They obviously saw the advantage of print plus web over the print only offer.

However, if you are confused with the presence of option b altogether, you have a point too. Two options priced the same, but one with visibly inferior value proposition is a no brainer, right? After all, who in their right minds would choose option b. And, come to think of it, which ‘rational’ publication would even make such an offer?

Dan deals with the subject of ‘relativity’ in a nuanced manner in his book. He has worked for long in the field of behavioural economics and makes this fundamental observation: “most people do not know what they want, unless they see it in context. We not only tend to compare things with one another, but also focus on comparing things that are easily comparable – and avoid comparing things that cannot be compared easily.”

Marketers have understood this all along. New York Times ran a story ⁽¹⁾ about Gregg Rapp, a restaurant consultant who specializes in the pricing for menus at restaurants. He suggests that restaurants often use “decoys”. For example, they place a really expensive item at the top of the menu, so that the other dishes look more reasonably priced; research shows that diners tend to order neither the most nor the least expensive item, drifting towards the middle. Thus, by creating an expensive dish on the menu, a restaurant can lure customers into ordering the second most expensive choice (which is engineered to deliver a high profit margin).

To prove his point, Dan ran the same problem by his students after removing option b from the choices above. Since no student had chosen option b in the first place, the end outcome should be the same, right? (i.e., 84% students would still go with print + web subscription). However, when presented with just option a and c, 64% students chose option a–totally contrary to their earlier choice. Dan concludes that because our minds understand, with absolute clarity, that option c is better than option b, it sub-consciously becomes the best of the three alternatives as well (i.e., we no longer consciously evaluate whether option c is better than option a also).

And come to think of it, it isn’t limited to choosing web subscriptions; it impacts us in our everyday lives. How often have we found ourselves looking at a business more favourably just because its peer is trading at twice the valuation? How often do we sit back and evaluate whether the implicit assumptions that come with high valuations are even achievable?

Last week ⁽²⁾ we introduced our ‘What If’ series – our attempt to answer crazy and fun financial questions that can be answered only with lots of data. We had urged readers to send us some of their questions and received many; thank you for sending them.

Among the questions received, one was: “Markets are hitting highs every day; What IF there was a way to tell if this looks more like 2004 or 2008”? Just so we are on the same page, market rally started somewhere in 2004 and peaked in 2008 (Sensex rose 3x and small-cap index 7x).

Well, it is an interesting question, and whereas there are no right answers, there are several fun ways to investigate it. Several factors are at play here–global economic cycle, domestic corporate and earning cycle, valuation cycles etc.). While several brokerage houses have published a lot of analysis on how valuations (PE, EV/E, PB etc.) have behaved at different points, we found the following analysis particularly insightful.

We divided the past two decades into three ⁽³⁾ cycles: (a) Years 2004, 2009 and 2016 as ‘start of the cycle’; (b) Years 2010 and 2015 as ‘middle of cycle’; and (c) Years 2008 and 2018 as ‘peak of the cycle’. For all years, we compared the (a) total stocks traded during the given period against (b) the stocks that traded within 5% of their 52-week highs. We then juxtaposed it with the situation today.

Historically, at the start of a cycle, on average, 6% stocks have been close to their 52-week highs. In the middle of the cycle, that number inches up, but only marginally, to 8%. At the peak of the cycle, on average, 29% of all stocks that got traded on those days traded within 5% of their 52-week highs. That number, for this week was at 23% ⁽⁴⁾.

While this may not be a conclusive data set to predict market tops in and of itself, when looked at in conjunction with several other factors ^{(5) and (6)}, it does behove us to tread with caution. It is rather easy at such junctures to be caught up in ‘relative behaviour’ – i.e., comparing our portfolio’s performance with several anecdotes of circuit-hitting stocks and getting the feeling of having missed out. In such moments, one might look to “catch up” by increasing the risk on portfolio, while historically it has precisely been the time that one should have been doing the exact opposite.

PS: If you are wondering which “irrational” publication was smart enough to include that decoy choice that we mentioned in paragraph one, it was The Economist. Well, it was fun trying to answer this question, please do send across more, if you have them.

Notes:
(1) Restaurants Use Menu Psychology to Entice Diners – The New York Times (nytimes.com)
(2) What IF – Buoyant Capital
(3) Data chosen for 5 day average as follows: For 2004 cycle, data is for 30^th Aug to 3^rd Sept 2004 and so on for the rest of them. 2008 cycle: 30^th Dec 2007 to 4^th Jan 2008; 2009 cycle: 10^th May to 15^th May 2009; 2010 cycle: 1^st Nov to 5^th Nov 2010; 2015 cycle: 23^rd Feb to 28^th Feb 2015; 2016 cycle: 12^th Jun to 17^th Jun; 2018 cycle: 8^th Jan to 12^th Jan 2018 and Now: 11^th Jun to 15^th Jun 20216
(4) As of 15^th June 2021
(5) Arguments matter, but stories sell better – Buoyant Capital
(5) https://www.buoyantcap.com/what-if/
This letter was originally published here: Treading Markets With Caution: Not Falling For ‘Relative Behaviour’ Trap (cnbctv18.com)

What IF

June 11, 2021

Letter # 45, 11 June 2021

Imagine you had a magic wand, which gave you the amazing power to time the market with complete accuracy, but with a small glitch—you can only trade indices (not individual stocks) and must always stay invested. Over the past two decades, how much do you think the magic wand would have been worth? i.e. how high would the returns have been had you sold at top and bought at bottom? For context, the Sensex has returned 14% CAGR and BSE Small-cap index 16% CAGR since 2003. A brief detour before we return to answer this.

Randall Munroe studied until the age of 22; first at a high school that specialized in mathematics and science, and graduated with a degree in physics. It was like a dream come true when Langley Research Centre, NASA, hired him as a programmer and roboticist. However, in 2006, NASA ‘ran out of money’ ⁽¹⁾ to rehire him and had to let him go within a year.

On the basis on what I wrote above, would you be surprised to read this bio of Randall in Wikipedia: Randall Munroe is an American cartoonist, author, and engineer.” That’s right… 15 years later, he is a “cartoonist” first, “author” later, and the education that landed him the NASA job, last!

Randall went on to write an extremely successful blog titled xkcd (not an acronym) that bore the tagline ‘A webcomic of romance, sarcasm, math and language’. His webcomic had already started garnering 70 million hits a month by October 2007.

He also wrote a blog titled ‘what if’, where he answered totally absurd questions regarding math and physics. Questions like, ‘what if… the earth stopped spinning, but the atmosphere retained its velocity’ or ‘what if… I took a swim in a typical spent nuclear fuel pool; how long can I safely stay at the surface?’ or ‘what if… everyone on earth aimed a laser pointer at moon at the same time, would it change its colour?’

While the questions are absurd, Randall’s answers are well researched, nuanced, and profound. In 2014, he published a collection of some of the questions in a book titled ‘What if’, which reached the top of New York Times bestsellers list within a month and got featured as the ‘Amazon Best Book of the Month’. Randall also has a tremendous sense of humour, which makes his book an informative as well as a fun read for people of all ages. Do give it a shot.

I am trying to follow in Randall’s footsteps by taking up random questions in finance that can be answered with tons of data.

And, the answer to the magic wand question is, a whopping 31.4%! Yes, that is what the magic wand was worth. You would have invested in the Sensex between December 2003 and June 2004, December 2007 and February 2009, October 2010 and December 2011, and December 2017 and March 2020 (and long Small-cap index all the other times).

The elephant in the room however is…we don’t really have a magic wand, do we? But we have the next best thing–the benefit of hindsight.

So, let’s formulate this. We start with buying one index (say small cap) and hold it till it outperforms the other (Sensex) by certain percentage points. Once it does, we swap (sell small cap and buy Sensex), and repeat. We need to optimise for just one variable–that outperformance number at which we will flip and switch.

Assuming we switched after 20% outperformance, the strategy would have generated 18% CAGR– higher than individual returns of Sensex or the Small-cap index, but a far cry from the ‘magic wand’ number. The chart below gives the returns that one would have generated under different thresholds of outperformance. As we can see, the closest we could get to the magic wand number is by switching out when the outperformance hits 80% (i.e., we do not sell small cap until it outperforms Sensex by 80%, and vice-versa).

This exercise highlights a few important aspects: (a) The market operates in cycles. There are times when large caps outperform mid and small caps, and vice-versa. Over the past 2 decades, there have been 9 distinct cycles of reversals. While we are in a cycle, it appears as if things will likely never reverse (small-cap cycle now or large-cap cycle between December 2017 and March 2020), but historically, the cycle has always, invariably, and inevitably, reversed.

(b) For a portfolio to outperform over a longer period, a judicious mix of large, mid and small cap businesses is essential. Even with a suboptimal switch (after 20% outperformance), returns have been higher than either the Sensex or the Small-cap index. Our recency bias prevents us from noticing the cyclical nature of the ‘trend’ that is ongoing for a few years – say between December 2017 and March 2020, the small-cap index underperformed ferociously (down 50% vs. 13% for Sensex). So marketing geniuses came up with heuristics like ‘there are only 20-25 investible stocks in India’, ‘buy strong growth, high ROE large caps, and they will generate strong returns forever’ etc. Even professional money managers had given in, when large caps formed more than 75% of allocation in many multi-cap mutual funds (90% in a few cases).

(c) At the cost of repetition from my previous letters, there are no fixed formulae that allow one to generate superior long-term returns. A cycle has reversed within 5 months (December 2003-May 2004) and has, at times, sustained for years (May 2004 to December 2007). An upcycle has generated 70% outperformance (April 2003 to December 2003) as well as 330% outperformance (May 2004 to December 2007). A down cycle has generated 9% underperformance (December 2003-May 2004) as well as 37% underperformance (December 2017-March 2020).

The idea behind this exercise is one, to have fun with data (like Randall does) and two, to be aware that like the previous cycle (of large caps outperforming) has not lasted, the current cycle (of small caps outperforming) will also eventually change. I would have told you when, but then…I am missing my magic wand!

PS: I intend to make ‘What IF’ a routine part of my writing. Do write back to me if you have some crazy fun financial questions that can be answered only if you have tons of data (we already do!). Also, remember the model where switching at 80% outperformance generated the highest returns? In that cycle, today, we are already at 60% outperformance by small caps!

Notes:
(1) Many news things, some overdue – xkcd
This letter was originally published here: Small caps outperforming Large caps big time; what does history suggest? – cnbctv18.com

Formulae don’t work; here is why

June 4, 2021

Letter # 44, 4 June 2021

The year is 1988 and tennis fans are keenly watching two players – Andre Agassi, ranked No. 3 ⁽¹⁾, and Boris Becker, ranked No. 4. By 1989, they would face each other on three separate occasions and Becker would win all the three matches (Agassi did not win even one set in two matches). By the end of 1989, Becker went on to occupy No. 2 spot on ATP rankings and Agassi was pushed to No. 7.

Then… something snapped. They played three matches in 1990, and as if by a stroke of luck, Agassi won all three (won 2 matches in straight sets). In 1991, they played two more games, and again, Agassi won both. Over the course of their careers, they faced each other on 14 occasions, and Becker managed to win only 4 matches or just one more after three wins by 1989, and Agassi won 10! What happened there? A brief detour before we go there.

In the fall of 1948, most of the newly arrived post-grad math students at Princeton University were cocky, but one was even cockier, writes Jonathan Aldred in License to be Bad. Still in his twenties, he made an appointment to see Einstein to discuss a few things. The meeting lasted an hour, at the end of which, Einstein grunted, “you’d better study some more physics, young man.” That young man was John Nash, who later went on to win the Nobel prize for his contribution to ‘game theory’. Initially, Nash had to face lot of criticism and was about to give up, until his PhD supervisor decided to present Nash’s thesis in the form of a story.

Two members of a criminal gang are imprisoned separately and cannot communicate with each other. The police have enough evidence to convict both of a minor crime, but not the major one that they suspect them of having committed. They offer both the following deal: “confess and implicate your partner; you receive immunity from prosecution, while your partner gets 10 years.” If both stay silent, both get two years for the minor crime. The dilemma for both prisoners is, if the other speaks out, I get 10 years, and he gets a free pass and vice versa. The best course of action, obviously, is to stay silent. But the question is, should I take the deal first, under the assumption that the other will take it first?

In 1950, no one had an inkling that the Prisoner’s Dilemma would later become the most influential game in game theory and was widely practised in the nuclear arms race between the US and USSR. In 1955, however, the philosopher Bertrand Russell took the game theory forward (in context of nuclear disarmament) by publicizing a game called Chicken. Imagine US and USSR are rival hot-blooded drivers, speeding towards each other down the middle of a long, straight road. If neither moves out of the way (‘chickens out’), both will die. If one chickens, both survive; but the one who moves out earns the everlasting contempt of his rival.

Coming back to Agassi vs. Becker. 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 his tell was only half the victory; resisting the temptation of reading his serve for majority of the match and rather choosing the moment when he could use that information to break the game open was harder.

Now, what do tennis and game theory have to do with investments? Over the course of the past few months⁽³⁾, I have vehemently argued (with data) that in markets there are no formulae (buy high growth companies that generate strong return ratios or avoid commodities of PSU stocks etc.) that allow the portfolio to outperform across market cycles. I have also written that historical data does not support the several myths–a portfolio always outperforms if you buy leaders, buy companies with highest ROCEs, buy only large-cap businesses or small-cap business etc.

The reason that a fixed formula cannot work is because the very knowledge of its existence will make the formula worthless. Let’s assume that everyone starts believing that say… buying “high growth strong return ratio companies” will result in outperformance at all times, and they start buying. While demand for shares of such companies rises, supply remains limited; as a result, their stock prices catapult swiftly over a short period of time.

At certain point, new investors realize that these businesses are quoting at stratospheric valuations (earnings can rise only so much) and decide to wait. Now, if earnings growth is cyclical and starts shrinking, stock prices will collapse (Nifty 50 in 1970s, tech bubble in early 2000s). If earnings rise at a steady pace, the stock price stops rising for multiple years till the valuations start looking decent again (Coca Cola, Walmart, Hindustan Uniliver and Colgate between 1998 and 2010). Investors are in a constant state of Prisoner’s Dilemma–do I keep buying under the assumption that everyone still believes that this formula works? And, if I ‘chicken out’ while everyone else continues to believe the theory, I stand to miss out.

Agassi knew that if Becker found out the ‘tell’ was made, the advantage would be lost. He could have decimated Becker by exploiting the tell on every serve; but, apparently, that was still too large a risk to take. He chose to use it just for those crucial moments.

Now take RenTec for example. The firm founded by Jim Simons, which has generated 66% returns (pre-fees)–exceptional returns– between 1988 and 2018. They did manage to build something akin to a formula (albeit not a fixed one, but one that was ever evolving based on new information) to beat the market across cycles. RenTec used to charge 5% fixed fee and 44% performance fees (highest fees ever in the asset management business) and yet, when they found that the strategy is not scalable enough, they stopped running clients’ money altogether (they just ran their own money).

Now, compare that to the “free advice” you get from self-proclaimed market experts on how doing a, b or c will get the job done. While the narrative is important on how decisions are made, the narrative that a few fixed sure shot formulae help a portfolio outperform the market on all occasions have neither worked in the past and are unlikely to work in the future.

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
(3) All historical letters one can find here: blog – Buoyant Capital
The letter was originally published here: In investing and life, change is the only constant – cnbctv18.com

Letting the facts interrupt a good story

May 28, 2021

Letter # 43, 28 May 2021

Over years of investing in equity markets, have you amassed a few sets of rules and formulae that have always turned profits for you? That ONE formula that always seems to work? How about buying companies that have the highest return ratios? Or investing in leaders of a sector? Something that just works, irrespective of market cycles!

Adam Grant, in his book, Think Again makes remarkably interesting points on the matter. This story from him will help set the context.

In 1949, a massive fire had engulfed the forest around the Missouri river, with flames stretching as high as 30 feet. After a while, it became evident to the smokejumpers that fighting was no longer an option, and they will have to run for their lives. But the fire was catching up on them fast and it was an uphill climb. That’s when Wagner Dodge did something that baffled others.

Instead of outrunning the fire, he took a matchbox and burnt the grass around him. He then dampened a towel and lay face down for fifteen minutes in the vacant space as the fire raged directly above him. Essentially, he had taken away the fuel that a fire needs to keep going. This method did not make sense to the crew, which chose to follow the textbook. Tragically, twelve smokejumpers perished. They were taught to douse a fire, not to start one.

While that was sad, what was bizarre was that bodies of a few smokejumpers were found with their equipment still on them. A backpack, 25-pound chainsaw and other tools. While trying to outrun a fire, in an uphill climb, why would they not simply ditch the equipment? One firefighter later explained that discarding your tools doesn’t just require you to unlearn habits and disregard instincts, but it’s perceived as admitting failure and shedding part of your identity. You don’t fight a fire with bodies and bare hands; you fight it with tools, which become a part of your existence.

Adam insists that we don’t just hesitate to rethink our answers, we hesitate at the very idea of rethinking. Seth Stephens-Davidowitz carries this concept further in his book Everybody lies. In 2013, a reddish-brown horse (no. 85) was among the 152 horses being auctioned in upstate New York. The horse’s current owner was an Egyptian beer magnate, Ahmed Zayat, who wanted to sell no. 85 and buy other horses. To help him, Ahmed had hired a team of experts – a small firm called EQB, headed by Jeff Seder.

After a few days of evaluating, Seder’s team told Ahmed that they were unable to recommend any horse to buy in this auction, but had a near-desperate plea–he cannot, ABSOLUTELY POSTIVELY cannot, sell horse no. 85! Thankfully, Ahmed paid heed and retained the horse (later renamed American Pharoah). American Pharoah went on to become the first horse in more than three decades to win the Triple Crown! What did Seder know that apparently no one did?

Historically, people had believed that the best way to predict horses’ success was to analyse their pedigree. Being a horse expert meant being able to rattle off about the horse’s father, mother, grandparents, siblings, etc.

However, Seder (a Harvard grad) found that pedigree wasn’t a consistent predictor of a successful race horse. He was more interested in data and started collecting it, for years on. He measured the size of horses’ nostrils; he did EKGs to examine their hearts and cut the limbs off dead horses to measure the volume of their twitch muscle. He grabbed a shovel to determine if the size of a horse’s excrement had any correlation to its wins (had it lost a lot of weight before a race?). He then got his big first break when he decided to measure the size of their internal organs. Since technology didn’t exist back then, he created his own portable ultrasound. The results were remarkable. He found that the size of a horse’s heart, especially the left ventricle, was a massive predictor of a horse’s success – the single most important variable.

At the New York auction, of the horses on offer that day, No. 85 was 56^th percentile on height, 61^st percentile on weight, 70^th percentile on pedigree, but a whopping 99.6^th percentile on left ventricle. The data screamed that no. 85 was one in ten thousand or even one in a million horse.

Now let’s come back to the question I had asked at the start of this letter: can you think of that one winning formula that has always helped you generate a profitable investment? Earlier this month ⁽¹⁾, I had argued that boiling down an investment framework to bite-sized rules has historically not worked. Today, let us look at a similar euphemism: “Buy businesses that generate strong return ratios, and they will continue to outperform the markets forever,” they say.

Whereas it is obvious that one would not want to invest in businesses that cannot earn their cost of capital. However, I humbly submit that historical return ratios are of little help as sole predictors of investment returns. The chart below is the frequency distribution of the stock returns of 674 companies (with market cap above INR5bn and those that have a 10-year share price history). We took the average of return on capital employed (ROCE) between 2007 and 2010 (so that one year does not have an outlier effect) and compared their stock returns over the next decade (2011 to 2021). As the chart indicates, returns aren’t materially different across ROCE buckets.

Data indicate that you cannot predict future returns based on historical return ratios of businesses. How then, you might wonder, could the high ROCE fallacy have started? I believe some expert would have looked at stocks that have done well over the last decade and studied common traits – say, all had great return ratios a decade back. He then would have concluded that buying businesses with great return ratios results in superior investment returns.

However, we miss the huge survivorship bias here. Humour me for a bit. One could look at all the successful companies, compare their traits and conclude that ‘all of them are successful because they took outsized risks.’ Fair observation. However, there are companies that took outsized risks and perished on account of an unfavourable outcome. Unfortunately, they are no longer part of the universe you are analysing (because they went bankrupt). If you think that no one does that, I can list two books that were written explicitly stating that, and they sold more than 4m copies!

Similarly, businesses that returned superior investment returns may have a common trait–they generate superior return ratios. However: (a) all businesses that generated strong returns ratios a decade ago did NOT result in superior stock returns; and (b) there is a subset of stocks that delivered superior investment returns, but were NOT generating high return ratios a decade ago.

We should be cautious in what we choose to believe in as it becomes an unshakeable part of our investment framework (like smokejumpers clinging to their equipment). Adam concludes that ‘once we accept the story as true, we rarely bother to question it.’ The more we rely on data, rather than narratives, the better off we are in the long run. Reducing an investment framework to bite-sized rules sounds interesting in meetings and webinars; their efficacy in long-term cross-cycle investment returns is sadly rather poor.

Notes:
(1) Heuristics help open doors, but are bad for investments – Buoyant Capital
This letter was originally published here: Higher return ratios lead to superior returns? Think again… – cnbctv18.com