“Ratings, cultural parasitism, and What were you thinking?”
Dear Sire, would you be so kind as to spend cUSD3.5b in advertisements, each year might I add, to reach 762mn viewers, of which, about 220 odd million tune in for prime-time TV watching (1).
Sure, but how should I decide where to advertise?
Sir, we have an excellent well-document process where we measure watermarked channels based on a sample of about 44,000 households (2).
That’s great, but don’t you think the sample size is just too low, especially considering that the ad spend per sample is huge; won’t it create incentives for manipulation?
But sir, this is a huge improvement over the last system. Back then, TAM only had about 2,000 meters and their competition INTAM used to report diametrically opposite ratings.
So, what happened to INTAM?
Well, TAM acquired it! (3)
Alright, but with such advancements in digital technology, there has got to be a better way, right? What about all the DTH and internet TV users—there are almost 125mn of those! Aren’t they a better sample size (4)?
May be sir, but how can we invade the viewers’ privacy!
If the Target Rating Point (TRP) scandal this week wasn’t on your radar, the above dialogue aptly summarizes it. A large part (if not all) of the INR270bn odd television ad revenue is decided based on the data captured by those 44,000 meters. Given that a network earns close to 70% of its revenue from ads (balance 30% from subscriptions), these ratings become currency for survival. Unlike election exit polls (also relying on a small sample size), which purely seek to entertain, TRP decides where ad spends will be directed. Politics and the facts of the case aside, to us, these details are intriguing.
Cultural parasitism and belief bias: Given the intellectual firepower housed within top spenders in the advertisement market, one wonders as to why a more scientific decision-making model has not emerged yet. The best approach is a totalitarian one—i.e., get the actual viewership data. Here, technology has advanced, but not everyone in India can afford to install a system that communicates two ways (signal sent to households and households relaying it back). In its absence, one would have wished for a large enough sample size. A 0.02% sample size (44,000 samples of c200mn households with a television set at home (5)) is dramatically low to be a representative.
This TRP system has stayed pervasive, in part, because of what’s called cultural parasitism, and in part, due to belief biases.
Cultural parasitism happens when an ideology parasitizes the mind and changes the host’s behaviour. This is then passed on to others. Therefore, a successful ideology (the only kind we hear about) is not configured to be true; it is configured to be easily transmitted and believed. In context of the issue at hand: “Following TAM (and its successor BARC) ratings is how things have always been done. When I joined freshly from B-school, my seniors did it like that, and we are simply following.”
In belief bias, an argument that we would have normally rejected for being idiotic seems perfectly logical just because it leads to a conclusion that we approve of. Or we judge the argument not by how strongly ‘it’ supports the conclusion, but how strongly ‘we’ support the conclusion. In our case, people who really have the power to make the change and improve the system are happy with how things currently are. Why improve something that is already working in your favour?
What were you thinking was the iconic line by Scott McNealy, erstwhile CEO of Sun Microsystems. Sun, the darling of the stock market during the dot-com bubble in early 2000s, hit valuation of 10x revenue. Scott had this to say, “at 10x revenue, to give you a 10-year payback, I have to pay you 100% of revenue for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at USD64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”
Cultural parasitism had engulfed the investment community during the end of the 20th century. It had changed the behaviour of not just investors in tech stocks, but almost everyone started believing a certain hypothesis. Sun was later acquired by Oracle at a fraction of peak valuations. This leaves us wondering as to how much of cultural parasitism already infects us in the current bull market. The ideology of ‘buying what is improving at any price’ seems to be transmitting easily these days. It started during the lockdown with Healthcare and FMCG, which have underperformed markets since. It later moved on to rural-focused stocks, and most recently it seems to have moved to technology stocks in India. Rotations in sectoral performance have always been a part of our markets, but the relatively extremity seen in the market’s behaviour these days is more recent.
Resources:
(1) https://www.livemint.com/industry/media/tv-records-762-million-viewers-per-week-in-2019-despite-nto-barc-study-11584735703190.html
(2) https://www.barcindia.co.in/technology#datacollectionprocess
(3) https://timesofindia.indiatimes.com/business/india-business/TAM-Intam-to-merge-TV-rating-services/articleshow/1293872190.cms
(4) https://indianexpress.com/article/opinion/columns/tv-fake-trp-barc-ratings-s-y-quraishi-6718823/
(5) https://www.financialexpress.com/industry/number-of-homes-with-tv-sets-grows-by-7-5-to-197-million-says-barc/1259631/
Human genome, viral mutations and evolving investment framework
If you grew up in the 1980s, the acronym ‘ACTG’ is bound to evoke fond memories of the then newly launched Maruti 800 (bonus points if you spelt it as ‘Air Conditioned, Tinted Glass‘). And, unless you took evolutionary biology in grad school, it is less likely that you expanded it to ‘Adenine, Cytosine, Thymine and Guanine’—the four types of bases found in a DNA molecule. Back in the eighties, neither tinted glasses on cars were banned, nor had the human genome been mapped. In this letter, we take lessons from human genetics and viral mutations to hypothesize why a constant, fixed principle-based investment framework (including passive investing) is likely to fail over the long term.
The Human Genome Project was launched in 1990; it mapped and sequenced the entire human genome (c22,300 genes) for the first time (by 2003). If that doesn’t sound like a lot, consider this—the human body contains c100tn cells with a nucleus; the latter houses two complete sets of the human genome (one from each parent)—close to 3.1bn base pairs! The whole thing was printed in 2012, which if read at the rate of one word per second for eight hours a day, would require 100 years to complete, and yet it fits inside a nucleus of a tiny cell that can easily rest on the head of a pin.
Now, the gene can photocopy (replication) as well as read (translation) itself. But when it replicates, mistakes are made—a letter or paragraph is missed out or gets inserted at the wrong place. This is mutation—human beings accumulate about 100 mutations a generation.
Viral mutation: Viruses, on the other hand, mutate much faster. Just because they technically aren’t a living thing (they need a host to reproduce), doesn’t mean they are spared evolutionary pressures. While on the one hand they must evade the human immune system fighting them off, on the other they must make sure that the host survives long enough for them to reproduce. Take the case of HIV that causes AIDS. It can produce billions of copies of itself each day, while commonly committing errors, which creates mutations in its genetic code (their large population and short 52-hour lifecycle certainly helps).
Often, the human immune system fails to eradicate the virus and cure isn’t available (current status in HIV). In that case, drugs are administered that block their replication by inhibiting key viral enzymes. The drug will initially reduce the viral load for the patient, but the virus will randomly mutate. Now, we have a virus with resistance mutation which will reproduce despite the presence of drugs, and the entire new population will be drug resistant. When HIV started evolving around the drug, virologists started treating it through highly active antiretroviral therapy (HAART), where a cocktail of drugs was administered at the same time, which brought the virus under reasonable control.
Evolving investment framework: Over a long enough timeframe, the principles of asset management are like a mutating gene structure. If generating alpha is the virus we are after, any strategy that aims to capture it will work initially, until the goal post is shifted to something else, and a new strategy is required to tackle it. This essentially implies that a fixed rule-based theory to generate alpha (for example, just buying higher RoE companies at whatever the valuation or buying just the leaders in their respective fields) will have a limited shelf life in finding success.
And, given how well these strategies have worked over the past few years, the reverse may currently appear unfathomable. But history is littered with examples of such failed strategies, that had worked for a bit and haven’t since. For example, from c1928 until c1958, the preferred strategy was to use the spread between earning and bond yield as an investment consideration. Earnings yield on stocks generally exceeded the yield on long-term US government bonds, usually by a substantial margin, and when they narrowed, one switched. Since 1958, however, that relationship has completely broken down and this strategy would have underperformed for the past six decades.
Then came the 1990s. Long-Term Capital Management (LTCM) generated massive assets by arbitraging bond yields. Historically, bond yields had always behaved in a certain manner and LTCM’s complex models had generated stupendous results year after year; so much so, that they had to refuse incremental capital and had, in fact, returned capital even to investors that didn’t ask for it. At its peak, they managed over USD126bn in assets with just USD4.6bn in equity (rest was leverage). The equity got wiped off in the Russian Financial Crisis and the fund had to be bailed out by the Federal Reserve. On the board of LTCM were two Nobel laureates—Myron Scholes and Robert Merton. Acclaimed financial journalist Roger Lowenstein describes the crisis beautifully in his book, When genius failed.
Lately, Renaissance Technologies (or RenTec) is one of the most successful quant-based funds, founded in 1982 by James Simons, an award-winning mathematician and former Cold War code breaker. RenTec’s flagship Medallion Fund has returned 66% CAGR over 30-years from 1998 to 2018, totalling trading gains of over USD100bn (yes, those figures are correct!). In his book about Jim The man who solved the market, Gregory Zuckerman made an interesting observation, “we’re right 50.75% of the time. But we’re 100% right 50.75% of the time. You can make billions that way.” At RenTec, while quant-based models make decisions and trades, the models themselves are continuously evolving based on the feedback loop from the 150 researchers and programmers who work at the fund.
We would like to end this with the belief that when everything else is evolving, why shouldn’t your investment strategy. Investment strategies that are stuck on one fixed paradigm will stop working; the only question before us is, not if, but when? For us, there is no such thing as ‘one strategy to beat the markets all the time!’
Overnight successes, inexplicable prodigies and tiger cubs
“Sorry guys, I am late,” was a totally non-contextual tweet that got over a hundred thousand likes. The previous one from the same gentleman was two years ago and had barely scraped through to a few hundred. What changed or is this how the proverbial overnight success looks like?
Chances are high that the name Rahul Tewatia has popped up on your timeline sometime in the past week. In case it has not, he is a batsman with the Rajasthan Royals-a team with a cricketing league in India. He shot to the limelight as he led his team to victory in a limited 20 over match. Chasing an extremely high total, he was painfully slow to start, scoring just 17 off 23 balls, at which point, several experts had summarily written him off (a few had advised the team to retire him). What followed was an extraordinary display of batting skill as he hit six of the next seven balls for sixes, securing victory for his team and an ‘overnight success’ tag for himself.
Well, this puts the tweet in context–late to start his aggressive innings, late to find recognition (at 27 years of age) or late to return to twitter. But no, this is no case of ‘overnight success’. In a beautiful article written for ESPN (link below – resource 1), Sidharth Monga dwells on Rahul’s struggles, offering a deep insight into his psyche. “Bro, you need to fight for what you are owed,” was his retort when mocked by a team mate about, “who asks for recognition from the coach himself?”
Inexplicable prodigies: This was a story of struggles, but there’s something called ‘natural talent’, right? K. Anders Ericsson writes in his book ‘Peak’ that, “I have made it a hobby to investigate stories of such prodigies and I can report with confidence that I have never found a convincing case of anyone developing extraordinary abilities without intense and extended practice.”
Case in point is Wolfgang Mozart, arguably the ultimate example of an inexplicable prodigy, who accomplished so much at such a young age that he must have been born with something extra. But dig deeper and you find that his father, Leopold, began Mozart’s training at an incredibly young age of four and trained him with stupendous vigour. In the book, Ericsson also raises questions on Mozart’s composition skills. Several compositions credited to Mozart, in fact, carry an imprint of Leopold’s handwriting or as musicologists eventually realised, they were all based on relatively unknown sonatas written by others.
Perfect pitch: Conjectures, no matter how professionally researched, are not convincing in disproving a thesis. So let us look at a case of a perfect pitch-a talent widely believed to be a genetic gift. Perfect pitch is the ability to recognise a musical note with total accuracy–for example, one hears a note and correctly identifies it as an ‘E flat’ below the middle C. It is exceptionally rare–only one in about 10,000 people have it, and even among professional musicians, it is not common. Beethoven had it, Brahms did not; Sinatra had it, Miles David did not. Among the recent crop, Charlie Puth has often demonstrated perfect pitch. You either have it or you don’t, it can’t be acquired, goes the common rhetoric.
However, Japanese psychologist Ayako Sakakibara debunked this theory. He recruited 24 children between the ages of two and six and put them through a month’s training course, giving them four or five short training sessions per day. While a few of the children developed perfect pitch in less than a year, others took as long as a year and a half. But, by the end of the experiment, every single one of the 24 kids developed perfect pitch. Ayako demonstrated that with enough practice, almost any ‘talent’ can be acquired.
Tiger cubs: That is all good with music and cricket, but doesn’t our business entail a much more complex mix of art and science? Maybe, but a similar thing was attempted in trading as well. In 1983, Richard Dennis and William Eckhardt, legendary commodity traders, held the turtle experiment. Dennis believed that anyone could be taught to trade. He devised a short training programme and placed an ad in the Wall Street Journal to recruit students. Thousands applied, but only 14 were selected based on binary answers to be given to a set of questions.
He called his student traders “turtles” based on a turtle farm that he had seen in Singapore. The experiment was extremely successful, and the first two groups of students were estimated to have earned USD175mn over the next five years. And, it was not restricted to mere trading, many fund managers and analysts working with Julian Robertson’s hedge fund Tiger Management branched out on their own and did very well (known widely as Tiger Cubs). Add to it the funds that he seeded with this own money (the Tiger Seeds); cumulatively, the Tiger family tree now manages over USD230bn in assets across hundreds of funds.
Fund performance: If skills can be acquired and all you need is enough practice, what explains the recent underperformance of active fund management to benchmarks? Well frankly, we do not profess to know the exact answer, but we have a hypothesis. The frantic rise in competition in the asset management industry has constantly narrowed the time periods when performance is judged. Sales teams compare daily NAVs and annual rankings across funds to judge who is better. People have given up the rat race of employment, just to be ensnared into the rat race of beating other people’s returns.
The need to get it right every single day, day after day, leads to extremely sub-optimal decisions, in our view. This attitude, over time, results in portfolios that increasingly look remarkably similar to benchmarks; and a fund has expenses (annual fees, trading commissions, etc.) that a benchmark does not. Change the period of comparison to cross-cycle evaluation (one cyclical top to another or one bottom to another), which could be a few months, a few quarters or a few years, and we will find a totally changed mindset, ready to take decisions which are more rewarding in the long term.
Resources:
(1) https://www.espncricinfo.com/story/_/id/29989908/rr-v-kxip-ipl-2020-rahul-tewatia-romance-struggle
Get your wings, pour your heart and ride!
“Let’s replace Coca-Cola as the largest non-alcobev company in the world; do you have suggestions?” muses Rory Sutherland, Vice Chairman of one of the largest ad agencies in the world, Ogilvy, in his book Alchemy. If not in a particularly mischievous mood, an acceptable answer to him would be along these lines, “we need a drink that tastes nicer than Coke, costs less than Coke and comes in a really big bottle so people get great value for money.”
The right answer, nevertheless, was, “hey, let’s try marketing a really expensive drink that comes in a tiny can and tastes kind of disgusting?” And ‘disgusting’ was not his opinion; the response to a market survey for this product was near unanimous anger; one of the participants said, “I wouldn’t drink this piss if you paid me to.” And yet, Red Bull managed to sell 7.5b cans in 2019 and generates enough money to fund F1 & NASCAR racing teams on the side! And, of course, it has given ‘wings’ to millions of people.
Rory, in his fabulous book, goes on to explain how a bunch of ideas, that no sane person would have invested a penny in, have gone to change the world. Imagine someone pitching the following ideas to you:
1: What people really need is a cool vacuum cleaner; it doesn’t matter if it costs four times its competition. (Dyson)
2: … and the best part of all this is that people will write the entire thing for free. (Wikipedia)
3: I confidently predict that the great enduring fashion of the next century will be a coarse, uncomfortable fabric which fades unpleasantly and which takes ages to dry. As of now, however, it is only popular with labourers. (Levis)
4: We will force people to choose between only three or four items. (McDonalds)
Pour your heart: Speaking of doing things the illogical way, think of this almost USD100b market-cap corporation that was built on the premise that people will buy this product from its stores by paying multiple times of what it costs them to make it at home, almost every single day.
Starbucks was a ground coffee merchant for a decade before it began serving coffee as a drink. Howard Schultz writes in his book Pour your heart into it that he tramped the streets of Seattle for a year giving presentation s to investors; of the 242 people he approached, 217 rejected his proposition outright, “coffee is not a growth industry,” he was told.
Schultz struggled to raise the USD4m he paid to buy Starbucks from its previous owners. He then changed the way people drank coffee – ‘one person, one cup, one neighbourhood at a time’ as the company’s mission statement says. For a dollar to two more, they could have a real sensory experience; his aim was to ‘blend coffee with romance’, creating a warm and enjoyable environment where along with coffee, you could listen to a bit of jazz or ponder life’s questions, thereby creating ‘a third place’ that was neither work nor home. Today, Starbucks operates at over 30,000 locations worldwide in more than 70 countries.
The opposite of a good idea: The human brain finds it difficult to comprehend (as to why such ideas succeed), in part because it is conditioned to look at a problem from a logical standpoint. Highly educated people don’t merely use logic; it is ingrained in their identity—it’s who they become.
A product is likely to sell because either not many people own it, so it must be good or lots of people own it, so it must be good—and both can co-exist. While in physics, the opposite of a good idea is generally a bad idea, in life the opposite of a good idea can be a very good idea, and both opposites often work.
Bikes: Now for an inspirational story that’s home grown and this one is as cultish as it gets—bikes! The brand Bullet was initially manufactured by Royal Enfield (before it dissolved in 1971) and is now owned by Eicher Motors. It has outlived peers such as Jawa Motors’ Yezdi and Escorts’ Rajdoot.
A series of bad decisions in the 1970s and 1980s had riddled the company with lots of debt with business es spanning across trucks, busses, tractors, footwear and garments. This went on until 2006, when the current CEO Siddhartha Lal initiated an apocalyptic fire sale that saw Eicher divest all but the motorcycle and truck divisions.
The motorcycle initially appealed to buyers because one could endlessly tinker with it (yes, that was the charm!). Nevertheless, Eicher started investing real money into its bikes; the electric start grew more reliable and fuel injection & transmission were revamped. This has started to pay off over the past five years as Eicher has generated operating margin of close to 30%—miles ahead of the competition. It hasn’t come without its fair share of mistakes, but from selling mere ~300,000 units in 2015, the company sold over 800,000 units in 2019 (pre-covid year), and now Jay Leno owns one and so does Billy Joel.
We started with a bunch of ideas that changed the way business was always done; let us end with ideas that changed the world (especially given that November 3 is so close). Irrational people can often be more powerful than the rational ones, arguably because their threats appear more convincing. “I will build the wall and make Mexico pay for it,” was a far more compelling argument (well, at least to voters) compared to the four years of congressional infighting to bring jobs back to the United States. They say, if you are totally predictable, people will find a way to hack you; but a little bit illogical and you end up giving ‘wings’ to the world while owning a F1 team, building USD100b corporation , promoting the best performing auto business or living in the White House.
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.
Ant colonies, self-organized criticality and small-caps
18 September, 2020
A lot has already been written about the recent SEBI order on multi-cap mutual funds (announced on 11th Sept); and we do not intend to belabour the topic further. To us, the market reaction to this directive is far more interesting. It brings us to examine as to how the collective decision-making works in ‘complex adaptive systems’ and how our investment strategy should reflect that. The complexity at work here is: (a) variables for the fund house: merge scheme, or buy and comply, (b) variables for SEBI: extend time to comply, allow flexi cap as a new category, (c) variables for retail/HNI: pre-empt mutual funds and buy now, or sell on possible rallies. We use the analogy of ant-colonies to see how the system adapts to it.
Ant colonies: Ant colonies demonstrate a fascinating example of the concept of self-organization—a process where a structure appears in the system that does not have a central authority that imposes its will by pre-planning (and we submit that markets operate in a similar fashion, the recent overpowering role of respective central banks, notwithstanding). When ants go foraging for food, they initially spread out in many different directions; in a pretty random manner. However, once they locate the food, they return to the nest while laying down the pheromone trail. Whenever one ant finds the shortest path, its quicker return and multiple trips intensifies the concentration of pheromones along that path. Other ants, then, choose the path with the strongest concentration of pheromones, thereby solidifying the path further. This means that a few ants end up working more than others, but their behaviour is directed to the survival of the colony, rather than the survival of any individual ant. This is how the collective behaviour of an ant colony finds an optimal solution, to a very basic problem.
Since the SEBI order, the BSE Small cap index is up 5.1% in one week versus 0.5% returned by the Sensex. This is despite the largest mutual fund (in the impacted category) publicly announcing that they are averse to buying the small cap stocks just to meet the requirements in this order. To us, this is the markets’ collective behaviour finding an optimal solution, and while important, SEBI’s order is not solely responsible for such market behaviour. The example below will clarify further.
Self-organized criticality: Whenever a large-scale event occurs, it is a human tendency to gravitate towards one specific, easily identifiable cause, as being the sole responsible factor. However, numerous scientists have pointed out that large-scale events are not necessarily the result of a single large event, but rather the unfolding of many smaller events that create an avalanche-like effect. Per Bak, a Danish theoretical physicist, explained this beautifully, as he developed the ‘self-organized criticality’—a holistic theory of how such systems behave.
Imagine an apparatus that drops a single grain of sand on a large flat table. Initially, sand spreads across the table and begins to form a slight pile. As the grains rest, one on top of another, the pile starts rising—forming a slope on either side. Eventually, the pile of sand cannot grow any higher. At this point, the sand starts trickling down the slope at a faster pace than the pace at which the grains are added on the top, creating sort of an avalanche. At its highest level, the sand pile is in a state of criticality—on the verge of becoming unstable. The last grain did not create the avalanche; the system was unstable, in a state of criticality and waiting for trigger for the eventuality (avalanche, in this case) to manifest.
Small cap Index: Over the last seventeen years through March-2020, the CAGR in returns of Sensex, Midcap and Small cap indices are 14.5%, 15.3% and 15.0% respectively—there is hardly anything to choose between them. And yet, as the table below shows, the difference in annual returns has been extremely stark.
Over the last two years, the markets seemed to have gravitated towards the theory that ‘a good company is a great investment at ANY price’. Whereas, well-managed companies, operating in sectors that have sizeable moats, are certainly good businesses to own; but for us, for them to be great investments that generate superlative returns on a cross-cycle basis, the price paid must be right as well. Historically, we have witnessed great companies delivering near ZERO returns when the initial price paid was simply too high (Coca-Cola, 1998-2016, EPS doubled during that time; IBM, 1999-2010, EPS tripled during that time; Hindustan Unilever, 1999-2010, EPS doubled; Colgate 1994-2009, EPS quadrupled).
Between Jan-2018 and the SEBI order, the small-cap index had underperformed the Sensex by c30%. In the past, indices have mean-reverted based on their earnings and valuation cycles. The SEBI order, then, was just the last grain in the metaphorical sand-pile of the market which had reached a self-organized criticality, and the collective behaviour of the market participants led to the outcome that we saw during the last week. It has happened previously, and we will not be surprised if it recurs. As we have previously written—whatever is intrinsically unsustainable, will find out a way to not sustain.
Check out, but don’t leave; A show about nothing and Symphony
“You can check-out any time you like, but you can never leave!” If you grew up listening to the 70s rock, chances are that you would have immediately replayed the guitar solo in your head, performed by Don Felder and Joe Walsh (on their Fender Strat and ’59 Les Paul Starburst). Eagles released Hotel California in 1976 and it went on to sell 32 million copies worldwide and was ranked as one of the greatest albums of all times and also won a Grammy.
This is the story we know. What isn’t discussed as widely is how this song broke a large number of the then established rules. One, the song was more than six minutes long (commercial songs, then and even now, are not longer than three and a half minutes). Two, it stopped in the middle and restarted (contrary to generally accepted norm that energy is supposed to build up at all times). Three, it had a minute and half of guitar solo (never done before). And lastly, the song has very unusual chromatic chord progression and sudden shift from minor key in the verse to a dominant major key in the chorus (a shenanigan that would invite censure from music theory teachers even today).
A show about nothing: When the first Seinfeld script was submitted, executives didn’t know what to do with it. NBC executive Warren Littlefield said, “it didn’t sound like anything else on TV. There was no historical precedent.” The author of the initial report on the Seinfeld pilot felt it bordered somewhere between ‘weak’ and ‘moderate’. Test audiences’ reaction to the pilot was that it lacked the community feeling of Cheers, family dynamics of The Cosby Show and relatability of ALF.
We all know how Seinfeld, often described as ‘a show about nothing’, went on to run for nine seasons and 180 episodes (for equal number of years from 1989 to 1998). It features among the best television shows of all times in publications such as Entertainment Weekly, Rolling Stone and TV Guide.
Original entrepreneurs: Like rock bands and television series, there are a lot of ‘non-conformists’ in the corporate world as well who have changed the way business has been done traditionally. And, a few such businesses are part of Buoyant Capital’s fund. But today we want to talk about Symphony Limited (Symphony). Over the previous decade, Symphony’s share price has compounded 15x, a return of 31% CAGR, truly a superlative number.
Unlike most companies in the white goods segment, Symphony has not built multiple factories, nor does it have a finger in every pie of the sector. A single-product company, it devotes its energy and resources to what it does best—making air coolers. Its asset-light model has enabled the company to generate average RoE of close to 50% over the previous decade, and it has even paid out over 60% of cash generated from operations via dividends (including distribution tax).
Symphony owes its genesis to the company’s promoter Mr. Achal Bakeri finding existing products an ‘eyesore’. As he comes from a family of real estate developers and having faced the problem of collections, Mr. Bakeri has ensured that Symphony is cautious in extending credit; its working capital has been less than 24 days on average for the past five years.
What’s commendable is that Symphony was willing to learn from its mistakes. The company had started diversifying into other products (geysers, washing machines, among others) around 1995. Unfortunately, it underestimated the competition in these categories, which pushed the company into bankruptcy in 2003. Symphony emerged out of bankruptcy in 2009 with a clearer focus and an improved resolve that has catapulted it to the top position in the air cooler market. Now, it has deepened penetration in the domestic market and also made multiple acquisitions in international markets abiding by the same ethos—huge respect for capital, asset-light model and sticking to what it does best.
There are numerous examples of how history has been created by believers—studio executives have passed on hits ranging from Star Wars to E.T. to Pulp Fiction and publishers have rejected The Chronicles of Narnia, The Diary of Anne Frank, Gone With The Wind, Lord of the Rings and even Harry Potter. We often wonder how songs that broke all the rules went on to become chart busters and shows about nothing ruled TV for a large part of 1990s. To us, it largely boils down to people: (a) not afraid to think differently; and (b) willing to take the risk everything for what they believe in.
In the case of Hotel California, Don Henley—Eagles’ lead singer and drummer (by the way, it’s incredibility difficult to play drums and sing)—told the record company, “to release it as it is, or not at all.” In the case of Seinfeld, it was Rick Ludwin who made it happen and in the case of Symphony it was Mr. Bakeri willing to walk on a different path.
Disclaimers
Information in this letter is not intended to be, nor should it be construed as investment, tax or legal advice, or an offer to sell, or a solicitation of any offer to make investments with Buoyant Capital. Prospective investors should rely solely on Disclosure Document filed with SEBI. Any description involving investment examples, statistical analysis or investment strategies are provided for illustration purposes only – and will not apply in all situations and may be changed at the discretion of principal officer. Certain information has been provided and/or based on third-party sources and although believed to be reliable, has not been independently verified; the investment managers make no express warranty as to its completeness or accuracy, nor can it accept responsibility for errors appearing herein.
A magical over, the wrong running back and Resulting
The year is 1993 and Eden Gardens, Kolkata, is hosting the semi-final match of the Hero Cup, played between South Africa and India. India, batting first, posted a meek 195 on the board. South Africa initially succumbed to 145 for 7. But then, a 44-runs partnership between McMillan and Richardson left it needing just six runs off the last over. With just one over to go, India’s skipper Azharuddin could have chosen Kapil Dev, Srinath or Jadeja to bowl (established bowlers had 11 overs off the quota remaining). Instead, he asks Sachin Tendulkar, 20 years old at the time, to bowl his FIRST over of the match, and that too with South Africa requiring just six off six. Miraculously, Sachin manages to concede just three and India went on to win, not just the semi, but also the Hero Cup championship. Azharuddin was hailed as the captain with tremendous foresight.
Fast forward to 2015. The Seattle Seahawks are playing England Patriots for Super Bowl XLIX. The Seahawks, with just 26 seconds remaining (and trailing by 4 points) had the ball on second down at the opposition’s one-yard line. The easiest decision was to call for a hand-off to the running back Marshawn Lynch, one of the best running backs in NFL. Instead, coach Pete Carroll calls Russel Williams to the pass. And then the anti-climax! The Patriots intercept the ball, winning the Super Bowl moments later. Headlines next day termed Carroll’s decision the ‘worst play call’, the ‘dumbest call’ or a ‘terrible mistake.’
Fun as these stories are, the bigger question is, why were people unanimous in their hailing of Azharuddin (if you are a cricket fan, you certainly remember that Joginder Sharma over) and total condemnation of Carroll? Because, for them, the proof of the quality of their decision was solely, totally and absolutely dependent on the eventual outcome. If you have won, it MUST be because you made a good decision. And, as a corollary, if you lost, you must have made a bad one.
Taken to an extreme, no sober person thinks that getting home safely after driving drunk reflects a good decision or good driving ability. You have managed to reach safely DESPITE a bad decision to drive while drunk. And yet, companies often take business decisions solely on the basis of results. Annie Duke, author of Thinking in Bets, says that professional poker players have a word for it – Resulting. Just because they won the hand, they must have played well!
Now, as investors, we do need to ask ourselves, how many times have we resorted to Resulting? (thinking that we are smart investors, just because we made money. Or believing that an investment strategy is great, just because it led to a momentary outperformance).
The table above summarizes the 11 broad market cycles (or unequal time frame) over the past two decades. The table below is a more detailed (albeit difficult to read) data. BSE Sensex returns are compared with sectoral indices.
Take the example of the BSE Capital Goods Index. Over the past decade, this index has fallen more than the Sensex during downcycles and risen less in upcycles (barring one instance). Based on this, there is a common belief among investment managers that those are bad businesses and should not be held in the portfolio. Nevertheless, we often forget that in the previous seven years, the same index outperformed all other sectors as well as the Sensex. In fact, it clocked positive returns even during September 2000 to April 2003 during which period the Sensex had fallen 28%.
On the other end, over the past decade, the FMCG Index has been the best performing Index–rising higher than the Sensex during upcycles and falling lesser in downcycles. Consequently, there is a near consensus among fund managers that consumption is the best sector to own, because it generates high returns and it does not matter if valuations already build in assumptions that companies will find extremely difficult to meet.
As noted earlier, as prudent investors, we need to desist from resorting to Resulting. An investment strategy is not great just because it led to a momentary outperformance. To end it, this quote from Nassim Taleb rings true, “heroes are heroes because they are heroic in their behaviour, not because they won or lost.”
Blog: Samuelson’s bet, myopic risk aversion and the banking conundrum
“Would you like to take this bet?,” asked Paul Samuelson to one of his colleagues—a 50% chance of winning USD200 or losing USD100 (inflation adjusted bet of cUSD1,700 now). The colleague politely turned down the offer but indicated that he would be happy to play the game 100 times, if he did not have to watch each individual outcome.
If that sounds like an obvious answer, do consider this happened in 1963. Back then, the modern portfolio theory rested on the assumption of rationality. The utility theory, popularised by John von Neumann and Oskar Morgenstern, was the accepted dogma on how individuals made economic decisions (how alternatives are presented is not as pertinent as much as the conclusion of what is best for oneself).
That started changing in 1968, when Daniel Kahneman invited Amos Tversky to a lecture at one of his seminars. It was the beginning of a partnership that would last for almost three decades (until Tversky died in 1996) and one that would redefine economics altogether in its wake. In 2002, the Nobel Prize in Economics was shared by Vernon Smith and Daniel Kahneman—a remarkable achievement for both men, but especially for Kahneman. For, you see, Kahneman is not an economist, he is a psychologist.
Kahneman’s and Tversky’s work on ‘judgement under uncertainty’ and ‘decision-making under risk’ brought out what we now consider customary behavioural finance terms—anchoring, framing, mental accounting, overconfidence and overreaction bias. They were able to mathematically prove that individuals regret losses more than they welcome gains of the exact same quantum (by a factor of 2x—losses cause twice the pain compared to pleasures from gains); a stunning revelation.
This study was taken forward by Richard Thaler (now a professor at Chicago Booth School), along with his co-writer Shlomo Benartzi (now a professor at UCLA Anderson School of Management). Samuelson’s colleague was willing to accept the wager with two qualifiers: (a) lengthen the time horizon; and (b) reduce the frequency of watching outcomes. Using these, Thaler and Benartzi coined myopic risk aversion.
They examined the return, standard deviation and positive return probability for stock with time horizons of 1 hour, 1 day, 1 week, 1 month, 1 year, 10 years and 100 years, and applied a utility function of loss aversion factor of 2. The outcome: the utility function did not cross over to a positive number until 1-year holding period—i.e., frequency of evaluation of returns more often than once per year causes more pain than pleasure. Clearly, investors are less attracted to high-risk investments like stocks when they evaluate their portfolios over shorter time horizons. ‘Loss aversion is a fact of life. In contrast, the frequency of evaluation is a policy choice that presumably can be altered.’
Had one taken Thaler’s and Benartzi’s advice seriously, and not looked at one’s equity portfolio since the start of the year, the person would have not felt the pain of the 30% draw down in Nifty, which has nearly completely retraced. The banking sector is another story, however. Rebased as of 1st February 2020, the Nifty Bank Index had under performed the Nifty Index by 8.5% through 23rd March 2020 (when Nifty Index hit a bottom). As of 30th June 2020, the under performance had increased to 16.7%, and as of writing this (26th August 2020), it has increased further to 20.9%. How domestic equity mutual funds are positioned is even more interesting!
As of the quarter ending June 2020, the domestic equity mutual fund industry’s exposure to the banking sector (including diversified financials) stood at 29.6%—lowest in the past five years. Between December 2019 and June 2020, mutual funds reduced their exposure by c8.1%. Evidently, some of it will be driven by the relative under performance of the sector itself. Nevertheless, mutual funds went from an overweight stance of 0.7% in December 2018 to an underweight stance of 2% in June 2020.
A large part of the aversion to the banking sector comes from the fact that it is a leveraged business. A small reduction in value of assets can lead to a larger change in book values. And, at a time when a few customers are not paying their installments (due to loan moratorium), the aversion is understandable as well. Nevertheless, one wonders if this is another case of a ‘myopic loss aversion’ from seasoned investors (please see table below).
Source: ACE Equity, Buoyant Capital calculations
For one, the current dip in Bank Nifty is the steepest relative under performance witnessed on record (data since 2000; (absolute dip in Bank Nifty was steeper during the Global Financial Crisis). One could argue that the banking system in India is yet to encounter a steeper challenge than the one posed by the Covid-19 crisis. This despite it witnessing the massive Global Financial Crisis in 2008, rising NPA cycle in 2015, demonetisation in 2016 and the NBFC crisis in 2018.
What’s clear, however, is that, historically, it has always been the case of myopic loss aversion for markets whenever a crisis appears. For example, from March 2006, the Bank Nifty under performed for three months by 12.4%, but returned 165.9% over the next 19 months, outperforming the Nifty 69.7%. The rest of the data in the above table must be read accordingly.
Now that we are in the midst of the highest relative under performance ever seen in the banking sector, only time will tell whether it is the case of another ‘myopic loss aversion’ by investors or ‘this time, it’s really different!’
Blog: Demons, Butterflies and Margin of safety
How well can we predict the future, and how should our investment decisions reflect that?
If the answer to the first part of the question is obvious, we should revisit history. The notion that future is not predictable is a rather recent phenomenon. Newton theorized the laws of motion and universal gravitation in the late 17th century and post that, the motion of planets; eclipses and appearances of comets could be predicted years in advance with total precision. The French physicist PS Laplace manifested a super-intelligent being (now known as Laplace’s demon), who was aware of the motion of every particle in the universe. “If this intellect were vast enough to submit the data to analysis… for such an intellect, nothing would be uncertain, and the future, just like the past, would be present before its eyes,” he said. As if, the future was totally determinable, and we just needed enough information to decipher it.
However, Newton’s equations would explain things in a ‘fixed point attraction’ world (say, like planet earth revolving around the sun). But, introduce a third body (say, a moon – two forces of gravity now) and the equations didn’t work. It wasn’t clear for almost 200 years, until Henri Poincare suggested (in what later became the Chaos theory) that there is no fixed solution to the three-body problem.
Chaos came into the limelight in the 1960s when Ed Lorenz simulated the atmosphere on his computer using twelve variables and twelve equations. One day, he halted the simulation mid-way and manually entered the outcomes for the run to continue. That gave a totally different outcome compared to the previous runs. Ed later realized that he had entered the numbers rounded to three decimals, whereas the computer memory was working with six decimals. A change of ‘one part in a thousand’ led to totally different outcomes. This is better known as the ‘Butterfly effect’, i.e., a butterfly flutters its wings in a rainforest in Brazil, which can lead to a tornado in California. Essentially, the future was now not only unknown, but for some events, a very tiny change in initial conditions led to a dramatically different outcome.
To mitigate this conundrum, ‘margin of safety’ (MOS) investing was popularized by investors Benjamin Graham and Warren Buffet. In this principle, you purchased securities only when their market price is significantly below their intrinsic value. Intrinsic value can be arrived at by several methods, but all essentially involve forecasting the future. If you pay lower compared to a business’ intrinsic value, the downside to your investment will be limited even if the intrinsic value turns out to be lower.
The past few years, however, have not been kind to this theory (considered to be part of the ‘value investment’ framework). It has underperformed the ‘Growth at any price’ framework by a wide margin.
Consider this example. Over the past decade, while an Indian FMCG company’s share price is up 9X, its net income has grown only 4X. It now trades at a price-to-earnings ratio of c74x last year’s adjusted earnings. In order to justify its current price, a reverse discounted cash flow model has to assume that: (a) its free cash flows (FCF) will post 20% CAGR for the first decade; and (b) the terminal value is calculated using cost of equity of 10% & perpetual growth rate of 5%.
These are extraordinarily high estimates for any business to meet. It implies that the company’s FCF will jump 10x by 2040. Additionally, this is already built into the stock price now! For the stock to deliver returns higher than its assumed cost of equity, it will have to positively surprise the Street.
In addition, the outcome is sensitive to small changes in assumptions: For example, if we lower explicit forecast FCF growth to 10% (vs. 20%) and terminal growth to 3% (vs. 5%), the valuation of the business falls by 62%. The stock, nevertheless, continues to outperform even with little MOS in buying this business. This has happened largely because there is: (a) a scarcity of quality large investible businesses; and (b) inflow of money in the insurance & mutual fund industry continues to remain high. More money chases the same good quality asset.
While financialization of savings is on the rise, which continues to get channeled into mutual funds, and in turn, they keep buying businesses with little margin of safety, it is difficult to ‘predict’ if the value framework will ever make a comeback. Nevertheless, what is not sustainable, will find a way to not sustain; if it has not in the past, I believe it will not in the future as well. When, and not if, is the broader question.