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.

Are we in a bull market already?

How can we tell if we are already in a bull market?

Yes, the frontline Nifty Index is up over 11% from its lows in September 2019, but that isn’t a great indicator. The Nifty was up close to 350 points between 1st Jan 2018 and 30th Sep 2019, but the top-2 performing stocks accounted for 450 of those points (yes, you read it right. Stock number 3 to 50 cumulatively contributed more than a negative 100 points).

Off late, the stock returns have been more broad-based. Within the BSE-500 Index, more than a third of the companies have managed to outperform the index since its lows in Sept 2019; close to 15% of those companies have even returned twice the index returns. Yes – that is an important feature, but even that is not it.

The tell-tale sign of a bull market is the heightened willingness of the promoters to raise capital, and the willingness of the markets to fund it. For the rally in the equity markets to sustain, one needs the supply of capital (from domestic and foreign institutions) to be much higher than demand for capital (from corporates looking to raise money, government looking to divest stakes or a group of shareholders looking to cash-in on an investment).

From that standpoint, in CY2019, companies have raised only INR118b in initial public offerings compared to INR312b in CY2018. When we combine the Qualified Institutional Placements (or QIP), the picture for the year does not look as bleak. Nevertheless, we are still way short of CY2017.

Demand of capital

Now that the market seems to have shown a willingness to fund capital, let’s look at the willingness of participants to demand it. As per our calculations, we expect over INR2 trillion of paper to come to the markets over the next few months. Let’s look at the individual components separately.

a) Supply of paper by the government of India

The biggest supplier of the paper is likely to be the government of India. The recent tax collection data shows that the fiscal deficit for 6 months has reached c93% of targeted deficit for the year. That itself would not have been alarming, had the corporate tax cuts not been announced.

But since the tax cuts have been announced, we estimate that the centre maybe staring at a shortfall of INR500b, even after accounting for the excess RBI dividend.

Compared to the originally targeted divestment of INR1 tr, we note that the government has so far raised only INR174b. To make good on the originally targeted divestment, we are looking at a capital raise of INR876b, which may likely increase to INR1.4 tr if the government decides to make good on the tax collection shortfall.

b) Follow on offer to reduce stake to 75%

We estimate that FPO of over INR215b will have to happen over the course of the next few months. The initial public offerings that happened by March 2018, in theory, can be delayed for a few more months as shown in exhibit below, but in practice, it is unlikely that the promoter group will likely wait for the last possible month to bring the public shareholding up to required levels.

c) Risk capital raising

In addition, according to media reports that there are several companies in the fray to raise risk capital from the markets, totalling to over INR227b. They are listed below.

Supply of capital

Right, so we are looking to raise over INR2 trillion over, say, the next few months; but is that really that large? It would seem so, considering that over the last decade, the highest annual flow from domestic and foreign providers combined has been just over INR1.4 tr.

Conclusion

While the demand for capital is likely to cross INR2 trillion over the next few months, the supply of capital needs to be reassessed. Although the financialization of savings (assets moving away from physical assets and into financial markets) is ongoing, historically, it has not yet resulted in a number large enough to fund the demand of capital that we seek.

Take into consideration that (a) overall savings rate in India (both corporation and households) has slowed down over the past few years, and (b) the individual flow of capital into equity mutual funds/life insurance does track the recent returns. Given that the equity returns (from the broader markets) over the last two years have remained subdued, the incremental flows might not be as easy to come by.

The thesis of bull markets will likely get severely tested in its ability to help supply over INR2 tr to the seekers of the capital. It will be interesting to see if the recent broad basing that we have witnessed in the markets will likely continue if these companies indeed manage to raise the equity capital that they seek.

Disclaimers

Information in this blogpost 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. Buoyant Capital may have/have had holdings in the stocks at mentioned in this blogpost at different points in time.

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.

BSE-Small Cap Index study

Historically, many investors increase investments in rising markets, and withdraw them when markets are falling. Returns for such investors are often lower than investment returns.

The front line index (Nifty 50) fails to capture the extent of draw-down in broader markets. Nifty is down just c9% from its all-time-high, but more than two-thirds of all stocks that are currently trading have more than halved, and more than a third have fallen in excess of 70%.

Instead, we choose to focus on the BSE-Small Cap index. It is 854-stock index with INR2 trillion (20 lac crores) in market-capitalization and no sector represents more than 11% weight. Contrast this to other front line indices, where financials dominate; and when combined with consumers and technology sector, they account for more than two-third of the index—very lop-sided for the purpose of a broader analysis.

As of yesterday’s close, the BSE-Small Cap index was down close to 35% from its all-time-high (reached in January 2018); the fourth time it has happened since the start of this century. They say that history seldom repeats itself, but it certainly rhymes. A look at previous instances throws-up interesting results.

The BSE-Small Cap index had fallen more than 35% in 2004, 2008 and in 2010 before the rout that extends today. Now, it is certainly possible that a business that one thinks is mispriced today, would not immediately revert to fair valuation tomorrow itself. If could continue to trend down despite being undervalued based on several extraneous factors.

Nevertheless, that does not mean we cannot formulate an investment strategy around it. In each of the three instances that we mentioned above, if one had started systematically investing a constant sum each month from the first time the index hit a 35% draw-down, one would have ended up generating between 18% to 39% CAGR over the next three years; truly superlative returns. This is despite the fact that in the 2008-09 global financial crises, the index, having fallen 35%, fell another 68% over the next fourteen months; and yet, if one had continued the SIP through the fall, one would have generated 18% CAGR over a three year horizon.

The same study, when extrapolated over a seven-year SIP time-frame yields between 13% to 17.5% CAGR, again a stellar performance over a longer-time frame.

Today, a large majority of the interesting businesses are available at below what we believe is their fair value and we think the time is right to systematically increase allocation to such businesses. Buoyant’s portfolio is now firmly tilted (70% of investments) towards what SEBI classifies as small and mid-cap companies.

Howard Marks puts it succinctly, “the refusal to catch a falling knife is a rationalization for inaction. It’s our job to catch falling knives. That’s how you get bargains!”.

Disclaimer

Information in this blogpost 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. Buoyant Capital may have/have had holdings in the stocks at mentioned in this blogpost at different points in time.

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

Pledged shares and stock performance – correlation versus causation

The year 2019 witnessed a spectacular collapse of business conglomerate that was once considered very savvy. The share prices of its flagship companies have fallen as much 99% from their all-time highs, even culminating in a bankruptcy in just the last year. A common string across these companies was that the promoters had pledged a large percentage of their shareholding.

A common fallacy in investing is that ‘Great companies almost always make for great investments.’ We easily forget that Hindustan Uniliver, a great company, was not a great investment for the entire decade ending 2010. Recency bias is the phenomenon that people easily remember something that happened recently, compared to something that occurred a while back.

That seems to be at play when one looks at the stock performance of a few companies where promoter shares are heavily pledged. Despite the analysts’ increasing their expectation of forward earnings over the last one year, the stocks in the table below have fallen between 16% and 55%. These are very steep corrections, considering that the underlying businesses are not nearly as challenged as those stock prices suggest.

That brings us to an interesting concept of correlation versus causation. They don’t mean the same thing, even if they co-exist. Correlation indicates that two variables are moving in the same direction, whereas causation indicates that one event is causing the other.

For example, stock prices and promoter pledges are two different variables. In some cases, there has been a causal relationship (pledged shares have been sold in secondary markets which has led to lower share price), but there is no reason why they should be correlated (that is, share prices should not continue to fall just because promoter pledges stay high).
 

 
Disclosures

Information in this blogpost 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. Buoyant Capital may have/have had holdings in the stocks at mentioned in this blogpost at different points in time.

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.

Indian IT services companies – multiples should de-rate materially

If you are an analyst covering the Information Technology (IT) sector in India, chances are that you might not have remembered that India’s Union Budget was on 5th of July. Companies in your sector derive over 90 percent revenues from across borders; what could the finance minister have done to impact IT! And yet, I think they are among the worst hit in this budget; read on…

First, buy back of equities will now attract 20 percent tax, the same as dividends. Mature IT businesses throw large free cash flows (in the range of 75% to 100% of cash profits), and large companies distribute majority of it. Think of an IT company that generates free cash equivalent to 90% of cash profits, distributes a third of it as dividends, and two-thirds through buy backs. For that company, this budget has permanently eroded 12% of its value (20% tax on two-third profits).

Second impact is from the Ministry of Finance asking SEBI to evaluate whether a higher public shareholding (at 35% versus 25% currently) made sense in arriving at a superior price discovery. Two of the top three companies (in terms of incremental supply of equity) are in the IT sector. Cumulatively, we reckon that it would lead to incremental supply of INR800b; or an annual supply of INR400b if SEBI gave a two-year glide path.

Points one and two when read together should imply that IT companies go from INR450 annual reduction in float (buy back) to INR400b fresh supply. The combined shift is very large for the markets to absorb, in my opinion.

This comes at a time when IT companies are struggling to maintain margins. Two factors are at play here. One, INR has appreciated versus the USD on an average by 2-3% compared to 4QFY19. In absence of mitigating factors, margins should trend down. Two, US financial institutions are evaluating their overall IT spends (including those on services); BFSI accounts for 30-40% of topline for Indian companies. Lack of profitable growth would put further pressure margins that are already battling adverse currency movement.

Over last 18 months, multiples for IT companies moved higher following INR depreciation, accelerating growth and reducing float. All three are now reversing; and valuation multiples should follow.

Cheers,
Viral

Disclosures

Information in this blogpost 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.