Preparing for a downturn

We published this note to all our subscribers today

I have been doing a detailed analysis of the past bear markets of 2008, 2016, 2018, 2020 and 2022. I looked at the indices, individual stocks and our past holdings during this period. It has allowed to me understand context of the market and mistakes I made during these periods.

I am listing a few learnings from this study. This should give you a context of our actions in the recent months during which our cash levels rose from 6% to 33% now

The current market reminds me most of the 2007/early 2008 and 2017/early 2018 period. It does not mean that we will have a financial crisis later this year. Please keep in mind that it is about similarities with these periods, but you cannot use it to forecast the market

A few learnings

No one can predict the market but often there are signs of froth, and it makes sense to become cautious. One can guess ‘what’ may happen, even if you cannot figure out when it will happen

• Valuation extremes: In the past, when valuations hit the extremes, it took months for the excesses to be wrung out of the system. Valuations are now at their 10+ year high in the small cap/mid cap space. Promoters have been launching IPO/QIP etc to raise capital when it is cheap
• Deep corrections: Theme stocks of the current cycle, no matter how good the prospects, get hit the most and can easily drop 50% or more. Other stocks will not be spared as indices drop 10-30% from peak to trough
• Nowhere to hide: During deep corrections, there is no place to hide, and all stocks will be impacted. The key is to remain invested in those companies with a robust business model and good growth prospects for the next 2-3 years

Mistakes from the past

We made the following mistakes which I am trying to avoid now

• We were concentrated in a few sectors/ stocks in the previous downcycle. When these stocks were hit, our portfolio had a big impact
• We kept buying or held on to stocks which were in continuous down trend. A lot of these companies did not recover for another 2-3 years
• Heavy losses made us risk averse and we were not prepared enough when the market turned

Some recent actions

1. Reduce valuation risk – We have reduced or eliminated positions where the valuation was much higher than the median. This was to reduce the valuation risk in the portfolio
2. Reduce concentration risk – We have reduced the size of some positions which are fairly valued. This was done to reduce the concentration risk
3. Exit weak sectors – We have exited some stocks where the stock and the sector seem to be topping off and growth is slowing such as the FMCG space

Go forward plan

We have not started a new position for some time.  As we have shared in the past, we will not invest to show activity from our side and justify our fees. We will act only when the risk reward is favorable

Just because the market is down 10% does not mean that it’s a good time to buy. If you expect steady stream of ideas, you will be disappointed as markets don’t work that way. There are times to be active and then times to just wait and prepare

We continue to monitor all our positions and will not hesitate to exit or reduce some of them if the risk reward is not great. Just because a stock is already down, or a turnaround is around the corner is not the right way to make decision.

Experience in prior bear market has taught us that hope is a bad strategy. Take your hits, clean the slate and conserve your financial and mental capital. We will be ready whenever the market turns