Jailing short sellers, capital returns and long-run cycles
Letter # 22, 11 December 2020
Do you remember the time when the stock market was looked upon as a barometer of the overall economy? In meteorology, a barometer measures the change in atmospheric pressure to predict a coming storm. By analogy, the market, through its participants’ collective wisdom, is supposed to predict the coming changes in the economic activity of a nation. There are some obvious limitations to both, ones that come with making predictions. But whereas the immutable laws of physics (and those alone) guide a meteorological barometer, a stock market is not guided by just laws of economics (demand and supply of capital); there are multiple variables at play as it is and regulators are now often choosing to add further randomness to the pile, like the short-selling ban.
South Korea’s market regulator, yesterday, declared that it will jail and levy hefty fines on traders who illegally bet against stocks of companies, reports the Financial Times (1). The short-selling ban rule was initially imposed after the KOSPI plunged 8% on March 13th (as covid hit markets globally) and was set to be in place till September 2020. It was later extended in August 2020 for another six months till March 2021 citing fresh wave of covid-19 (2).
South Korea’s benchmark KOSPI now trades more than 20% higher than the pre-covid highs and has risen close to 90% from March 2020 lows. When the ban was extended in August, the benchmark, having risen 60% from lows, was already trading above pre-covid level. Amidst this, total deposits at brokerage accounts of Korean retail investors have catapulted from USD25bn in February 2020 to over USD57bn in November 2020. Trying to protect retail shareholders from unmanageable price fall is one thing, extending it when markets have fully recovered is quite another. In our view, this creates a disequilibrium in the demand-supply dynamic. History stands testimony that such experiments do not end well (bread lines before the breakdown of the Soviet Union).
There are institutions that create this disequilibrium and then there are others that formulate a strategy to benefit from it. One example of the latter is Marathon Asset Management–opportunistic investor in global credit and fixed income markets. Instead of looking at simple ‘growth’ and ‘value’ distinction, Marathon focuses on capital cycles to identify businesses that can deliver superior returns.
The book, Capital Returns – investing through the capital cycle, is a collection of reports written by investment professionals at Marathon. They essentially view everything in terms of cycles and whenever a target company stands to benefit or get impacted by changes in cycles within that industry, they move in. The book itself contains several real-life examples of multiple industries and jots down the thought process of the investment professionals. It’s a fascinating read.
Analysing Marathon’s thought process got us reflecting on how, off late, the Indian economy and markets seem to be having their fair share of cycles. Prior to the GFC in 2008, economic cycles used to be fairly long (around five years). Since then, however, we have already witnessed seven mini-cycles, with several disruptions along the way, especially in India, and particularly over the past five years (Banking AQR in 2015, Demonetisation in 2016, GST implementation in 2017, NBFC crisis in 2018 and covid pandemic in 2020).
During that time, a predominant share of banking loans was extended to the retail sector and private consumption contributed bulk of the incremental GDP. Consumption-driven themes, therefore, have had the largest investor mindshare as they, during the downturn, fell the least and bounced back the fastest during recovery.
While the consumption theme has the largest recall, it’s not the only theme that has outperformed. A look at the table below might surprise a few readers. Each new cycle has produced a different set of sectors that outperform and those that don’t.
While stock market cycles are shorter, the broader economic cycles take much longer to change. The RBI survey on aggregate capacity utilisation has stayed below the 75% mark for majority part of the past five years (it had steadily started increasing before the pandemic hit). With: (a) material rise in government’s capital spending; and (b) newly announced production-linked incentives for various industries starting to take effect, that could change over the course of the next few years.
Since building high-intensity infrastructure and capacities take years, it would start reflecting in fiscal statistics (IIP, GDP) as well as surveys (RBI publications) only at a much later stage. In the meantime, investment frameworks that suffer from recency bias and work on formulated straitjacket approach will have a much difficult time picking up the change in the larger narrative. Consider the table below, which looks at two broad cycles over the past 17 years. Several sectors witnessed a complete reversal of performance versus the broader market. IT, FMCG, Healthcare and Auto, which had underperformed during 2003-07, completely reversed their performance during 2007-20, whereas Capital Goods, Metals and Oil & Gas, which had outperformed during the first cycle, underperformed heavily in the second one.
As with our previous letters (link, link, link, link, link), we reiterate our view that one cannot expect a unitary investment framework to deliver superior investment returns across all market cycles. While the recency bias (expecting what has happened over the past five years will continue to happen over the next five) is a serious one to overcome, generating superior returns over the long term calls for one to look beyond recent trends.
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.