May 27, 2018

An underappreciated edge

I wrote the following note recently to our subscribers. Hope you find it useful too.
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I wrote extensively on risk in the last year’s annual update (read here) and highlighted the fact that cash levels in the model portfolio were at an all-time high. (around 30%).

The reason for pulling back in, the latter part of 2017, was due to the frenzy and crazy valuations in the market. I was no longer comfortable with the risk reward situation and decided to stick to our process even if it meant that we had to forego easy returns.
I think we delivered fairly good results for CY 2017, even though we lagged the market in the second half of the year. More importantly, we dialed down the risk as much as we could.

Not easy to be disciplined
It was not an easy decision. It is painful to watch companies you are researching go up by 50% in a span of few weeks, even before you get a chance to finish your analysis. However, I have felt that a key edge for individual investors is their ability to be patient.

I can assure that it is not easy to sit and do nothing. I am an Engineer and MBA by education and have worked in a corporate job for a long time. As you all know, being patient and doing nothing is not acceptable in these roles. The more you do, the more you are rewarded.

Investing is not the same. More action in terms of buying or selling, especially for our style of investing does not improve returns. On the contrary, as I have often found out, may even result in worse outcomes. The work on research and analysis of current and new position continues behind the scene, but the act of pulling the trigger must be done thoughtfully.

Ignoring noise
We don’t have to react to every bit of news which gets published – oil prices up, interest rates up, some news about the manager’s nephew’s aunt etc. The point extends to the quarterly results too. I have been analyzing the results which have been good for a few of our positions. Overall, if the long-term trajectory of a company is intact, I do not want to read too much into it and take a short-sighted decision.

Most of you are aware of the above attitude and it is not new to you. However, it makes sense for me to emphasize this repeatedly to all of you. In this age of instantaneous news and social media, everyone thinks that reacting to news all the time is the key to making above average returns.

I am increasingly of the view, that in the current environment of hyper speed and automated systems, investors like us will do better by taking an opposite view – slow down, think deeply about a few companies and focus on the long-term trends. We will win as we simply have much lesser competition in this space.

Several of our current positions exemplify this mindset. We have held them for years and will continue to do so as long as they continue to perform and are not overly expensive.

Not blind to risk
The above does not mean that I am blind to risk and will be patient for the sake of it. If something goes wrong at a company level, I want to take time and think deeply about it and then take a decisive action.

However, my bias is usually do nothing as I have learnt from experience that most activity in the portfolio does not add much to the returns, only makes us feel that we are doing ‘something’. Although some of you may not share this sentiment and have numbers to back up a more active form of investing, I can only say that one has to invest based on their own temperament.

You will have to be comfortable with our slow and plodding style of investing.

A structural advantage
Mutual fund managers and other professional investors cannot  afford to lag the market for long due to career risk. If you think otherwise, then you under-appreciate the pressure on someone who may not be able to provide for his or her family if they lose their job due to under-performance. A rare few can manage that pressure, but don’t count it.

There is a structural advantage if the Investment advisor (we should mention Investment Adviser) does not have a career risk when he or she makes good long-term decisions, even if that causes the portfolio to lag in the short term. This advantage (for the clients) is further enhanced when the manager invests a majority of his net worth in the same manner as the client.

Me and Kedar have setup the partnership in such a way that we do not face any such career risk. This edge has allowed us to be patient and not worry about the optics of our actions. I have often ignored emails from some of you, wanting to do ‘something’, if I don’t think it makes sense in the long run.

In addition to that a large part of our networth is invested in the same fashion as the model portfolio. This does not guarantee that each of our decision will be right, but our incentives are aligned with yours. We eat our own cooking.

We have also made it a point to ensure that subscribers who join us, are aware of our approach and buy into it. We will not deviate from it even if some of you write to me and start getting impatient (wanting to pull the trigger).

In the pipeline
Our cash levels are around 30% of the portfolio and I continue to look at new ideas. I don’t want to rush into it. We will add to the existing positions or to new ones if the price is right and I feel comfortable with the company’s prospects.

If all of us plan to invest for next 10-20 years, a few months will not make all that difference. We are in this for the long haul.
 

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

April 1, 2018

Get Ready

I wrote the following to my subscribers recently. Hope you find it useful too.
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I am sure some of you got sick of my repeated discussion of risk management last year. In a bull market, the last thing you want to discuss about is risk. If a small cap stock, especially an IPO goes up by 3X in 3 months inspite of having an operating history of just a few years, forgoing such an opportunity to reduce portfolio risk appeared foolish.

This is always the case in bull markets. However, the same people who ignore risk in the stock market, do not behave in a similar fashion in other parts of their life. Have you ever heard someone with auto insurance, regret collecting the assured amount, inspite of paying the premium?

The price of focusing on risk and managing the downside during bull market is paid in the form of forgone returns. One should think of these ‘lost’ returns as an insurance premium you pay for the bear markets.
 
Let me explain how

Volatility at play
Let’s look at two managers who end up generating the same returns over a 5-year period.

Manager A (cautious and nervous)
Year 1 :           +20%
Year 2 :           +20%
Year 3 :           -5%
Year 4 :           +23%
Year 5 :           +20%

This manager has delivered a CAGR of 15% with low returns in up markets and a lower drop during the bear market.

Manager B (bold and confident)
Year 1 :           +50%
Year 2 :           +50%
Year 3 :           -50%
Year 4 :           +40%
Year 5 :           +30%

This manager has also delivered a CAGR of around 15% and beats the market by a big margin during up markets, but also get wacked during the downturn.

The reason manager B does well during bull markets, but get hurt during the downturns is often due to a high level of concentration in the portfolio. It is close to impossible to have a highly diversified portfolio of 30+ stocks and deliver a big outperformance.

The price of a concentrated portfolio (and high returns), is the much higher volatility of returns.

The guts to hold
Now, some of you may argue that as the eventual returns are the same, the path to it does not matter. To answer that question, you have to ask yourself – will you hold on if your entire portfolio dropped by 50% (and not one stock) and what if it’s the first year of your investment? More importantly, will you stay with a manager who performed this way?

I can state with a high level of certainty, that almost 99% of investors will dump the manager B and exit if the entire portfolio dropped by 50% or more. It is tough enough to hold based on your own conviction. To trust a person, you do not know personally, with this kind of volatility is close to impossible.

The net result of the above two styles is that manager A will end up delivering a CAGR of 15% for investors whereas those with manager B would end up with a CAGR of around 6% (assume they exit in year 3 and put all that money in FDs).

The above discussion is a mathematical and behavioral reason for my following comment – ‘No point getting rich, if you had a terrifying experience reaching that point’. The reality is that most folks will throw in the towel in middle of the journey and never get rich by the magic of compounding.

Time to get ready
We started raising the cash levels in the middle of last year as valuations went crazy. Our model portfolio trailed the midcap and small cap indices in the second half of the year

That was the insurance premium we paid to sleep better this year.

Since the start of the year, the two indices are down by 10-15% whereas we are down by much lower. I hope you are holding on and not planning to throw in the towel. I am amused to see a lot of commentators and investors talk of this drop as some major event. It clearly shows they have not followed the market history.

The Indian stock markets, especially the small and mid-cap indices have dropped by this level every few years. The real bear market in this segment is when the index drops by 25%+ and the scary one is if it drops 40%+. Will that happen in 2018? – I don’t know and have never tried to predict.

What I do know is that on average the companies we hold are doing well and as prices have dropped, the market is presenting an opportunity. By my last count, atleast 6 companies in the model portfolio are below the buy price and can be bought upto the allocations in the model portfolio.

Will the market continue to drop and more stocks drop below our buy price? Will the stocks already on the buy list continue to drop due to which you could have quotational losses (and not real losses) in your portfolio?

To both the questions – my answer is – I don’t know and it’s quite possible. I personally, don’t worry too much about these drops if the company is expected to do well in the long term.

I have said it in the past and will repeat here again – I can supply the analysis, but you need to come with the courage, cash and patience. If you have all the three in place, time to get ready and start purchasing slowly for your portfolio.

End note: By the way, Manager A has more career risk and will end up with lesser assets than manager B who can tout his returns during bull markets. However, investors in manager A come out ahead than those with manager B, as some of the investors in the latter case just drop out and never make the stated returns.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

February 28, 2018

The staircase chart



There is a chart pattern which can either cause dread or euphoria in the hearts of investors.


There may be no formal name for it from technical analysts, so let me call it the stair case chart.This is either a stock hitting the upper or lower circuit continuously for days at end. The pattern looks like a staircase in a particular direction. More than the pattern, the investor psychology during this period is instructive

We had several stocks on the ascending staircase last year. Whenever such an event occurred, it was fascinating to read the comments of investors on social media. Everyone was patting each other on the back, congratulating the management and generally puffed up about their brilliance. The more intellectual types threw terms like moat, great management and large opportunity size to sound rational.

Of course, a rising price tends to obscure all risks and this occurred often in 2017.

The current year has been the reverse. We are now seeing the dreaded descending staircase chart pattern for a lot of companies. In these cases, the stock price is locked in the lower circuit and a lot of investors who want to get out of the stock, are not able to do so.

It is again fascinating to watch a different set of investors (it’s never the same) now talking of the dishonest management, bear conspiracy and the lack of liquidity.
It is tempting to make fun of others in either of the two scenarios, but I would caution you from doing so. It is not difficult to find yourself in one of these camps in the future. On the contrary, if you invest long enough, one of these patterns will hit you.

I track and study such events to understand the psychology and see what I can learn from it. This is my short summary
-        Do not mistake correlation for causation. People invent reasons for quality or lack of it based on the price action. The time to evaluate quality is before the price action starts and not after it. Once the trend begins, it is not easy to avoid the emotional contagion
-        You will never know everything there is to know about a company and its management. There are always unknowns and it’s important to stay humble – that is acknowledge your ignorance. Once you do that, you will respect risk and size your positions accordingly.
-        Always have an estimate of fair value in mind. When the market goes crazy on the upside, reduce the position size to manage the risk of over concentration.
          Have a downside plan in place. If you invest long enough, one of your position will eventually hit a wall. Know what you will do in advance as it is not possible to react rationally at that time.
-        If you have bought into a speculative position, acknowledge that you are riding a tiger. As long you are in control, you are fine. If the table turns, be ready to be eaten (figuratively speaking). Position size and risk management is critical in such cases, so that you live to see another day (in terms of investing)
-        Finally keep an open mind. This is of course easier said than done. The most common reaction for almost everyone is to attack someone who is arguing against your view point. In my case, whenever I read an opposing view, I take a deep breath and do nothing at that time, other than make a note of it. This allows me to calm down.
 
I usually come back to the argument after a few days and try to dig into the points being made against the thesis. In my case, I will note down these points and try to separate facts from opinion. Facts can be easily validated and disposed off. If there are opinions, then the best option is to analyze the reasoning and look for evidence to support it. Even if you don’t find the evidence right away, be on a look out. If you do see the evidence supporting the counter argument, then you know the other person is right.

Investing is all about betting on the future of a company and the best of us will be wrong from time to time. The key is to be on the lookout, acknowledge your mistake as soon as possible and fix it. The ones who make lesser mistakes on average do better than others over time.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.