Wrote about my thoughts on frameworks and rigidity in following them. Putting a link to it here so that I can expound on them later, if I get around to it.
Just to add to my thoughts to the above:
What is a good business? What is a quality business?
Lawrence Cunningham in his book Quality investing defines quality businesses as those which can generate high levels of free cash flow, return higher than cost of capital, is sustainable and can grow its earnings consistently over long periods of time.
In another excellent book, competition demystified, Bruce Greenwald talks about entry barriers. This actually roughly ties in with the sustainability of earnings point.
Michael Mauboussin writes this about good quality businesses:
A high-quality business is one that is profitable, typically as a result of high margins, has relatively low debt, a very capable management team, and a business that is unlikely to change abruptly in the near term. So essentially it is a business with a high return on invested capital and stable prospects.
And this about good management:
All roads in managerial evaluation lead to capital allocation. A high-quality management team is one that knows how to take resources, including capital and people, and put them to their best and highest use. Quality executives are ethical, open-minded, thoughtful, judicious risk-takers, transparent, and long-term oriented.
The challenge is all this is very difficult to figure out in real-time. Most of the time, tailwind or headwind in the business makes a management look far better or worse than they actually are. We, most of the times, have to go with our gut-instinct about the management based on a few interactions or how they speak etc.
Example - When Pidilite management is able to brand a commodity business they are termed after many years of success as visonary. Asian Paints was able to do the same. When Astral was doing it the same thing was being said. Now I hear the same thing for APL Apollo. But no one talks about all those other players who also tried creating brands and failed miserably (not for the want of trying). Nerolac, ICI, Dendrite etc. They remained marginal players in the same industry. Even DHFL used Shah Rukh Khan as their brand ambassador. A world of good it did for them!!
Next question is then how to distinguish between a good and a great business? Or conversely, between a good and mediocre business.
One thing I have firmly seen is a consistently good return on capital (whichever way we measure it - RoE, ROCE or ROIC etc) for a good business. But a good ROCE does not automatically mean that the business or its earnings are sustainable for long periods of time. Or that the business cannot be disrupted materially by external or internal conditions over a short period of time.
Back to Mauboussin. On source of competitive advantage.
The closest thing I’ve seen to an empirical study of this question is the work by Michael Raynor and Mumtaz Ahmed, consultants at Deloitte, that was discussed in their book, The Three Rules . They analyzed thousands of companies going back to the 1960s and suggested that superior performance, results that are above and beyond what luck allows, is the result of companies following two rules. The first rule is “better before cheaper.” In other words, do not compete on price. The second rule is “revenue before cost.” Successful companies focus on increasing sales rather than cutting costs. The title suggests a third rule, which, irritatingly, is that there are no other rules.
Those rules seem closer to a differentiation strategy than a cost leadership strategy.
So, question to ponder is this – is there genuinely a way/model/framework possible that is going to help drill down business quality into its components? Or is it just a chimera we are running after?
I will end this with the following study done by McKinsey on the 50 companies appearing in the 3 seminal books - Good to great, Built to last and In pursuit of excellence.
Performance of the “excellent,” “lasting” and “great” companies vs. the S&P
|"In Search of Excellence"||"Built to Last"||"Good to Great"|
|Stars (more than||Wal-Mart||Philip Morris||Phillip Morris|
|5 percentage points||Intel||Marriott||Nucor|
|better than the market)||Merck|
|Johnson & Johnson|
|Outperformers (more than||Procter & Gamble||American Express||Kroger|
|2 percentage points||Avon Products||Johnson & Johnson||Wells Fargo|
|better than the market)||Walt Disney||IBM|
|Middle||Dow Chemical||Procter & Gamble||Gillette (a)|
|Amoco (a)||Merck||Abbott Labs|
|Emerson Electric||Hewlett Packard|
|Underperformers (more||Maytag (s)||Ford|
|than 2 percentage points||Hewlett-Packard|
|worse than the market||IBM|
|Delta Air Lines (s)|
|Failures (more than 5 pct.||Schlumberger||Citicorp||Pitney Bowes|
|pts. worse than the market)||Kodak (s)||Motorola||Fannie Mae|
|Raychem (a)||Sony||Circuit City (b)|
|(a) Acquired during||Dana (s)|
|evaluation period||National Semiconductor (a)|
|(b) went bust during||DEC (a)|
|evaluation period||Data General (a)|
|(s) subsequently acquired||Kmart (b)|
|or went bust||Wang Labs (b)|
We came to some interesting, even surprising, conclusions.
Great companies were more likely to do really badly than really well.
Their odds of outperforming the stock market were 52-48, hardly better than a coin toss. But there are more big losers than big winners on the lists. Just eight companies outperformed the index by more than 5 percentage points, while twice that number underperformed by the same percentage.
Seeing Ray, Reich and Midnight’s children in you list, I wish to suggest a work based in Bengal : The Wicked City by Sumanta Banerjee. The sub title of the book is misleading. It spans the vast cultural canvas over 300 years. In turn, Sumanta’s book reminds me of “London Triumphs”.
“The investor’s chief problem—and his worst enemy—is likely to be himself. In the end, how your investments behave is much less important than how you behave.” ~ Ben Graham
The most important aspect of investing is to reduce or eliminate behavioural biases.
December 2019: 7.90% ( Closed on 28-Feb-20)
January 2020: -0.82% (In Progress. Sell Date 2-Mar-20)
February 2020: 1.19% (In Progress. Sell Date 1-Apr-20)
XIRR (till date - for 6 months since inception): 54.5%
The last 1 week has eroded a significant part of the gains for all 3 blocks. That is as expected. The strategy is designed to outperform during bullish phases.
The January block has slipped into negative after being up nearly 20%. The February block is still in the positive. Next 1-6 weeks I think will be interesting to observe.
Notes to self: Need to start working on a market-neutral strategy for a part of the portfolio and test to see if it can be made to work systematically.
Just wanted to note down some thoughts on the possible impacts of the current Coronavirus pandemic and the resultant global market crash. I am not an economist, neither a political analyst but merely an observer of human and system behaviour.
Supply chain optimisation likely to incorporate redundancy and failover
The current global supply chain is optimised based on cost and time. That is manufacturers tend to get their components or parts built in places where it is cheapest t produce and ships it to the factories just-in-time. With a large-scale pandemic like situation, which comes right on the heels of US-China trade war, large (and small) corporates will rethink their supply chain and dependency on China. They will now need to build in inventory costs as the supply chain would need to factor in redundancy and supply disruption constraints. This will, in turn, increase the cost structures and reduce margins. Some industries, like electronics, which ran of wafer-thin margins, may find it very difficult to survive or will need to take price hikes.
Move from globalisation to localisation may get accelerated
The last few decades had seen an unprecedented wave of globalisation with free movement of people and products. This is increasingly facing headwinds as resistance builds up in local communities leading to economic and social strife. The rise of the right-wing globally and Brexit are manifestations of these social shifts. As more business shifts inwards, global companies will need to have a better local presence in countries they wish to do business in. Second-order impacts may include a decline of tax havens and higher taxes for global companies as they would need to pay taxes for profits in each individual country they operate out of.
New work culture building up
Working from home was prevalent in only a few industries like IT. With a lot more people getting used to working from home, it is likely that more companies will realise that they can actually run their businesses when employees do not come to one centralised office. This is a very profitable move for companies as they would be able to reduce expensive office space, maintenance, electricity and other such costs. Second-order consequences are too many to list here but a few prominent ones are negative sales impact on auto, petroleum, real estate prices. Shorter-term it would also have a negative impact on all crowded places like restaurants, shopping malls, movie theatres.
Ecommerce likely to get a boost
Online sales have already started getting bigger and is likely to expand much further once more and more people hesitate to go out in public places like crowded shops and malls.
Government & Central Banks have limited options
Respective governments and central banks essentially have two policy actions that they can use – fiscal and monetary. That is, they can tinker with taxes, government expenditure and interest rates. The issue is you cannot fix a supply-side issue with a demand-side solution. That is, if you are running say an automobile factory and don’t have the necessary supply of engines from China, then reducing interest rates will not solve your problem. This is the same reason why when food inflation shoots up, you can’t really do much by cutting rates, simply because the food is just not there. Similarly, neither does cutting taxes, both corporate and individual, help in any way. What these measures do is to price the risk in the market. With reduced interest rates, central banks (and governments) push the people to invest in riskier assets or fuel consumption or both. The last option that the government has is spending out of this problem. Government expenditure has the potential to create employment, provide a sense of security to corporates and basically spur the economic engine to start working once again, with the hope that it leads to a positive spiral of higher consumption and sustained growth coming back.
The Indian government gets a Godsend as crude prices collapse
India, as a major crude importer has just received a Godsend with crude oil prices collapsing due to the fight between Russia and OPEC (Saudi). The government finances are in a mess with no money to spend at all. With this fall in crude, the government can potentially use the money saved and channelize into infrastructure development. There are large areas where India can and should invest in for future global competitive advantage. Now is the time to get into those areas like green energy, increasing healthcare facilities, schools, colleges, railways, airports, inland waterways, ports, defence. The list can go on.
China is in a precarious situation
China is a very insulated country. But rumours are that the banking system in China is under stress and the coronavirus has only exacerbated the situation. Unless it can demonstrate that it has been able to successfully contain the outbreak and are getting back to normalcy, they will be the biggest sufferers as the global manufacturing supply chain will readjust and leave them behind. This will have a large long term impact on the social and political situation in China. But with an authoritarian government in place, it is likely that China will be able to show the resolve required to quickly get back to normal.
First global crisis in the age of social media and fake news
This is perhaps the first major global crisis in the age of social media. Social media amplifies and distorts messages, so the impact of people is very different from when all media was state-controlled or influenced.
Flight of capital to safety
There is a flight of capital towards safety and security. Unfortunately, in India, last 2 years has seen multiple critical situations in the banking and financial sector, one of which is currently underway. This has severely eroded the faith that investors have in banks. With a possibility of further rate cuts from RBI, bank deposits will become more unattractive. IN such a scenario, gold and US dollar tends to do well.
Investment horizon reduces during crashes
Market crashes have a way of reducing our time horizon from decades or years to weeks and days. If an investor just sticks to thinking about the underlying businesses and how they can get impacted by the change in the context, and maintain the long-term horizon, it will perhaps help in reducing the stress and anxiety.
Better to stick to your investment plan
All crises finally come to an end. This too shall pass. And when there is a global crisis, governments tend to take coordinated action. I would be very surprised if we do not see significant quantitative easing (reduced interest rates) and other policy measures announced by governments across the world.
So, fasten your seat belts and enjoy the ride. After a few years, you will probably tell the next generation of market participants, “Heck! I lived through that!”
The Index Fund Bubble
The global order for investment management firms have changed in the last 5 years. Index investing now more or less accounts for 20-40% of the global capital deployed whether through index funds, ETFs or index-hugging funds. Since, an index does not have a cash allocation, there is no buffer when it starts going down. While going up, it feeds into the frenzy and the index constituents get more than their fair share of capital flows. And no once complains. When the tide reverses, the exact opposite happens. Stocks fall because they have fallen a lot. A virtuous cycle turns into a vicious cycle.
This is what we are seeing now.
The way it possibly ends is when other investors (discretionary / quant / alpha-oriented funds) decide that some factor they are tracking (could be valuations, could be any other metric like volatility, global macro, relative strength, overbought/oversold indicators etc) is now in their comfort zone and start buying. The other possibility is that large investors will get scared of the fall in the indices and full out money thereby starving the passive funds of their fuel.
This is a reason why we are seeing such increased volatility in the global markets.
From a fundamental perspective, earnings are going to be severely hit, supply chains dented (maybe permanently for some, which I have discussed in my previous post). People still are trying to assess how bad things are going to be.
One thing I am sure. We will now be extrapolating our fears.
No one said investing was easy. Equity gets a risk premium. Yes. A risk premium. Because it is risky!!
To end let me quote, my friend and fellow VP member @zygo23554:
This virus is God’s wrath that brings to the fore fragilities and frailities in your health, relationships and portfolios.
Fear yourself, not the virus. All it does is show you the mirror so you realize who you truly are.
I shared the following with investors in my advisory.
The C3 Effect.pdf (644.4 KB)
Excellent post - Thanks for sharing.
Till date mostly rally lead by some financial banks/NBFC. Given the very high valuation and negative news from this sector (IL&FS, Yes, etc), will there be change in leaders who can lead next rally? what your thoughts on this?
Below is thought from someone who had experienced bull & bear cycle.
Who is the quote from?
How is the quant portfolio performing wrt the conservative portfolio?
If the quant is giving a sell signal and the stock is in lower circuit with no buyer then how will you rebalance?
Any learning so far.
Guess this is a quote from Basant Maheswari from the book “the thoughtful investor”
I received on whats-app. Don’t know who is the author of the quote. But similar philosophy mentioned in “Thoughtful Investor” book as told by @amrutayan
TCS has been one of the best wealth creators in the last decade, so I don’t agree that IT sector has not done well post Y2K. Obviously you will not find IT companies at the crazy valuations that they had during Y2K but there are enough counter examples
The quant portfolio gave a graded stop exit earlier in the month.
There will always be problems of slippage etc. But over a full cycle of implementation such problems even out.
There are hundreds of examples where individual stocks continue to do well irrespective of bull-bear cycles. What tends to happen is if there is a large bubble in any particular sector that sector takes a much longer period to cool off. So, there is no basis for thinking that individual stocks that had done well in the past can no longer do well.
In fact, I would still tend to think that once the near term problems of Coronavirus is over, stocks like Bajaj Finance will come back as one of the strongest businesses. Whether it gets the vaulted valuation any time soon, I don’t want to guess, but the business is more likely to do well.
Note down and remember all those who are asking for the markets to be shut. Then think about the kind of investor who would want a market shutdown. When the markets were going up none of these guys cam and said markets should be shut, we are making too much profits.
These are people whose investing temperament is suspect in my eyes. I would keep my distance from them in the future, specially if they are market gurus, advisers, fund managers etc.
For those who question why the markets should be open when everything else is closed, the simple reason is that i) markets are completely digitally operated these days and ii) you need to provide the comfort of getting out for people to get in. The reason we have issues related to labour employment in this country is primarily because you are not sure if you can fire an employee when the going gets tough. If you are assured of it, you would probably be much more comfortable hiring people. Same principle here. If you know that my exit may get constrained, then you will think 10 times before investing.
Equity investing carries RISK. That is why you get a RISK PREMIUM in the returns. You cannot wish away the risk and only ask for great returns.
Yes, our tendencies to be asymmetric about our profits and losses makes us this way. You have provided a great heuristic to measure temperament
Markets maybe halted or shutdown if the exchange fears counterparty risk. Not sure how many remember the 1982 BSE shutdown because Reliance shortsellers could not square up.
Markets also provide liquidity to the seller and value to the buyer. Someone sitting with cash would love to trade his cash to a desperate liquidity seeker and buy a stock at terrific bargains. That’s a very real and useful function of the markets. On the other hand folks who want it stopped are worried about unrealized losses or incentives linked with it, like fees linked to NAV, which reduces upon mtm losses.
My booklist for the lockdown:
Origin - Dan Brown
Come into my trading room - Alexander Elder
The Triumph of Contrarian Investing - Ned Davis
Broker, Trader, Lawyer, Spy - Eamon Javers
According to this article, there are around a 100 people from NSE and BSE who are traveling everyday just to keep the markets open and functioning.
Now if this is true, do you still maintain the position of judging those who are asking for markets to be shut? What if some of these come in contact with an infected person and lead to hundreds of cases and some deaths?