January 27, 2018

Annual letter to subscribers: On risk, Bitcoin and thinking long term

The following note was published recently to my subscribers. Any reference to performance or individual companies has been removed to ensure compliance with SEBI regulations.

I hope you find the note useful

What drove the performance
We exited 5 positions and replaced them with four new positions during the year.

It’s a unique year that none of our portfolio positions dropped in value. It is however not surprising considering that various indices were up 40-50% during the year, with almost 100+ stocks increasing by 100% or more. If we just compare the numbers, our performance is nothing to get excited about.

If you just threw darts at the small cap index, you could have done quite well. If, however, you were ready to throw caution to the winds and were open to go down the quality curve, then the gains were even higher. I am not crying sour grapes here. Let me explain why -

At any point of time, I am looking at several companies and track them over time. If I find an idea interesting, I usually create a small starter position to understand the sector and company better.

A lot of such starter positions are up anywhere between 60 to 400% during the year. So, when I say that, if you were adventurous and ready to take on risk, the returns were higher, it is not an academic point. I have seen the same happen in my personal portfolio.

You may ask – why did I not do it in the model portfolio? To that point, let me state something which I have repeated in the past.

The model portfolio mimics our (Kedar and mine) personal portfolios (except for a few small positions) and that of my family and friends. I will never ever take excessive risk just to look good and gain some boasting points.

A year of misses
This was a very frustrating year too. A few new ideas passed through the initial filter and ended up on the tracking list.

Several of the companies on this list seem to be decent bets for the long run, subject to execution by the management. I prefer to start with a small position and increase the size as the management executes as per the plan. If, however the management slips or the business conditions change for the worse, we will exit the position.

In several of these trail positions, the stock price rose rapidly, in anticipation of the improvement. It’s quite possible that the market is able to foresee the improvement much before I can. In that case, we may end up starting the position late with a lower upside, but with much lesser risk.

We need to be patient in all such cases as you never know when opportunity would knock again.

Change in approach: fail fast and small
There has been a subtle change in my approach in the last 1-2 years which I think should be shared with all of you. I have become more open to trials (starting with small positions) and then killing these ideas quickly if they don’t work out.

It is one thing to maintain a buy list, but emotionally very different to actually commit money (even a small amount) to an idea. Once you do that, you are financially and intellectually (and even emotionally) vested into the position. In such cases, it is important to constantly stress test the idea and exit if the thesis does not pan out.

A failure on a small 1-2% position will not hurt our portfolio over the long run. If, however some of these positions work, we can scale into them and make them much larger.  This is the mental model used by venture capital firms and it makes sense to adopt a similar framework (even if the type of companies we target is different) for our portfolio.

What truly drives the long-term returns
I have shared the changes in the intrinsic value of the portfolio with the price changes in the past and would like to reiterate the following points again

a. Businesses and their intrinsic value tends to be less volatile than stock prices
b. Over the long term, stocks prices tend to follow intrinsic value. However, in the short term (1 year or less), these two numbers don’t have to move in lock step.  
c. If the underlying business is increasing in value, it makes sense to have patience as the returns will eventually follow. As an example, if we had gotten frustrated after the measly returns of the last two years and exited in 2016, then we would have missed the gains of 2017

2017 has been a year when the portfolio price has again caught up and run ahead of the value. As a result, we can expect lower performance for the next few years till we can get the fair value up via a combination of new ideas and increase in value of the current holdings.

In the long run, this back and forth will continue, and I don’t plan to play the game of timing to squeeze a few extra points of performance. We will focus on increasing the intrinsic value of the portfolio as much as possible and let the market give us gains as per its own schedule.

Measuring the risk

I had written about risk management in the last letter, which is reproduced below again

I am not trying to make the highest possible returns in the shortest period of time, but above average returns over time with the lowest possible risk, with risk management taking a higher precedence. Risk Adjusted returns are more important than absolute returns.

This focus on “Risk” has led us to cap our top positions at 5-7% at the time of purchase, keep sectoral bets capped at 20% and maintain a cash level of 12-15% over the lifetime of the model portfolio. A more aggressive stance in the form of more concentrated positions or lower cash would have raised our returns (5% per annum by my rough guess), but increased the risk too. I have no regrets of foregoing these returns. I will always prioritize risk over returns and if it means slightly lower returns, so be it.

If we continue to earn above average returns in the future, the magic of compounding with risk management will allow us to reach our destination. I want the journey to be pleasant and would like to sleep well at night. There is no point in dying rich if you have a terrifying time reaching that point.

I have discussed about risk in a subjective manner in the past, without using any ratios or measures. One quantitative measure is drawdown of the portfolio over various time periods.
On an annual basis, we can see that we have lost less than the market during downturns.
However, we do not have enough data points to make this evaluation statistically significant.

In order to have more data points, I have computed the monthly returns of the portfolio and compared it with the large cap index. For the data purists, a monthly period may not be the right duration or they may quibble about using a different index for reference. My response to that – it is better to be roughly right and directionally correct, instead of trying to get it right to the third decimal point.

For the duration of the model portfolio, the average monthly loss for the index has been around -3% (when the index has dropped during the month). In those periods, our portfolio dropped less than the index 63% of the times and our average drop during these ‘bear’ market months has been around -1.1%

The above statistic is quite noisy as I think monthly returns are usually meaningless, but over a long period this statistic can give an indication of the level of risk in the portfolio. In other words, we have had lower drawdowns. We cannot avoid bear markets, but if we lose lesser than the market, we should do quite well in the long run

I am more focused on reducing the risk, than doing better than the market. I have always felt and continue to feel, that the long-term momentum of the Indian economy and the stock market is such that we will do well over time as long as we can reduce the downside risk and avoid doing something stupid.

In case you are curious on how we have done during bull periods (when monthly returns are positive), the model portfolio has returned 5.3% versus the 4% by the index during the same period.

As you can see, that although we have done better than the market on average during the bull markets, our outperformance against the index has been higher during bear markets.

If you are really hoping to do well with me, hope for a bear market now.

Cash is not a macro call
We currently hold around 28% of the portfolio in cash which may appear to be some sort of a macro call. However, let me assure you, it is nothing of that sort. I have never bothered with economics forecasts around GDP, interest rates or any global or geopolitical situations.

My analysis is always bottoms up with a focus on company level factors.

The reason for the high levels of cash is that the price of several of our ideas have far exceeded my estimate of fair value due to which I feel that the long-term returns are likely to be lower compared to the risk of holding those positions. As a result, I have reduced the position size.

At the same time, the speed with which I can find and understand new ideas has been far slower than the rate at which the market has recognized and re-priced them. This is something I cannot fix unless I can buy some extra IQ points to speed up the pace.

The question I am constantly asking
As the markets have risen, I am constantly asking the following question for each position : Will I continue to hold this position if the stock price drops by 50%? If not, why am I holding it now?

The time for risk management is now, when there is euphoria all around and not when everyone is heading for the exits.

If anyone of you, cannot bear a 20-30% drop in your portfolio, it would make sense to do a mental exercise now – how much should I invest in equities so that even if the equity portfolio dropped by 30%, I will not lose sleep.  No one can answer this question, but yourself and the time to do it would be now.

Why do I constantly harp on risk? Is it because I foresee some market crash?

The emphatic answer for that is no! We are not in the business of forecasting which can be left to media personalities. For me and Kedar, Risk is personal and we want to look at it as an integral part of investing. Our monies and that of our families are invested in the same fashion as the model portfolio. We are not managers who will only benefit from the upside, but have no risk on the downside.

We will have quotational losses from time to time, but do not want to be in a situation where our greed or envy of some else’s performance leads to a permanent loss of capital for us, our families and you.

Bitcoin and popcorn
I have been asked by a few subscribers on what I think about Bitcoin. I have a rough idea of the technology that under pins cryptocurrencies – ‘Blockchain’ and think the technology has a lot of potential in reducing transactional costs, improve asset tracking, develop decentralized networks and several other use cases which we cannot imagine as of today.

That said, I do not have a view of Bitcoin as I do not understand it well. There are several other things I don’t understand well enough to be able to make money such as Short-term trading, technical analysis, Bio tech, Mongolian companies and so on. However, that does not disturb me as there is enough for me to do within the scope of what I do understand.

If we can invest conservatively and earn an above average return in Indian equities, the end result is likely to be very good. Why should we then get all worked up if something is doing well for others and they are becoming rich as a result?

There will always be someone doing better than us in all sorts of stuff. Someone could be running a restaurant or a tech startup which is doing very well. Does that mean we should follow them as a short cut to riches?

I continue to study the technology out of curiosity and watch the drama on the sidelines. I also have some popcorn (unbuttered to avoid cholesterol issues) on the side to enjoy the show.

The Indian bitcoins
When I look at companies which are priced at lofty multiples, I try to break it down to the first principle of investing – The value of an asset is the sum of its discounted cash flow over its lifetime.

A company with a high multiple, is not necessarily expensive if the company can grow its free cash flow for a long period of time. This means the market ‘assumes’ that such a company has a sustainable competitive advantage and a large opportunity space. Please note use of the word ‘assume’. The market is not some “All knowing” entity which can see the future. It is just the aggregation of the combined wisdom (or madness) of its participants.

The market on average and over time gets the valuations right, but not always.

As I look at several companies in the small cap and midcap space now, I am left wondering if investors really understand the implications behind the valuations. A company selling at a PE of 50 will need to deliver a growth of 25% for 10 years to justify the price. In order to make any returns for an investor buying at this price, the actual growth will have to be much higher and longer.

How many companies are able to deliver such growth rates for so long? Let’s look at some numbers from the past

In the last 10 years, we had around 233 companies in the sub 3000 cr market cap space, deliver a growth of 25% or higher. That’s around 6.2 % of the small/ mid cap universe. As the market cap/ size increases, the percentage of companies which can deliver this kind of performance only shrinks.

How many companies in the above space currently sport a PE of 50 higher? around 22% or roughly 675. So, 3 out of 4 companies in this group of ‘favored’ high PE companies are going to disappoint investors in the coming years in terms of growth

In other words, if you could buy all these ‘favored’ companies (greater than a PE of 50), you have a more than a 50% chance that you will lose money. Why would you take such a bet?

All investors in aggregate are taking this bet assuming individually, that their ‘chosen’ companies will not be the ones to disappoint. Of course, every individual thinks he or she is smarter, more handsome or <insert your criteria here> than the crowd (also called illusory superiority).

The odds are against everyone being right. So, it makes sense to be cautious and do your homework well enough.  Some of these companies could turn out to be the bitcoins of our market: assets with promise but without cash flow. In such cases, the end result is likely to be unpleasant.

A long-term partnership
I repeat this every time in the portfolio review and will do so again

– I do not have timing skills and cannot prevent short term quotation losses in the market
– My approach is to analyze and hold a company for the long term (2-3 years). As a result, my goal is to earn above average returns in the long run and try to avoid losses during the same period
– In spite of my best efforts, I will make stupid decisions and lose money from time to time. The pain felt will be equal or more as I invest my own money in exactly the same fashion

    Me and kedar look at our association with you as a long-term partnership. As a result, whenever someone joins us, we are very explicit in letting the person know that they cannot expect quick wins or a stock tip a week or something on those lines.
    We want your association with us to span years, if not decades. In our view, financial management is something which lasts a lifetime and hence, as your advisor, we want you all to focus on the long term. We try to instill this focus via multiple actions from our side such as       
      -   Avoiding a short-term focus on performance such as daily, weekly or monthly scorecards
-    Buy companies and hold them for the long term as long their prospects remain above average
-        Focus on risk and reducing the downside

A lot of subscribers have stayed with us for the long term and hopefully benefited from that. We will continue to maintain this approach irrespective of the latest trends in the market. If that costs us business, so be it. I would rather have some of you disappointed with the short-term result (and consequently leave), than lose money due to chasing the latest trends in the market and then leave (while cursing us).

If you are interested in our advisory services, please email us on enquiry@rccapitalmanagement.com

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.

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