It seems ages since I wrote the following comment three months back

How does one invest under such extreme uncertainty? One option is to assume that there will be a quick recovery and go all in. The other extreme is to wait till it is all clear and then deploy the capital. In the first approach one is making a bet on a specific scenario which may not occur, leading to sub-par results. In the second case, we may end up with sub-par returns too but only because prices will adjust once all the uncertainty goes away.

At that point of time the future was uncertain and anyone making a specific bet was ‘assuming’ a specific scenario. If we assume that 50% of the investors bet on rapid recovery and the other 50% bet on the whole thing dragging on, the first group turned out to be right.

You are now hearing from such investors who went all-in, in the month of March/April.

It could have easily gone the other way and in that scenario, the second group would be highlighting the merits of being cautious, whereas the first group would have been silent.

I personally avoid taking a specific view of how the future will unfold. The risk of doing so is high, if you get it wrong. If you are managing money for others (like me), then the risk is asymmetrical. If you get it right, you can tout your performance. If not, then your investors bear the brunt.

I will not tar all managers with the same brush. A lot of them, including us, are invested the same as their investors. In such cases, the behavior of the manager changes quite a bit. In such cases, your focus shifts to survival, than shooting the lights out. It does not mean that you will not make mistakes, but are very focused on managing the risk.

If the goal of investing for an individual is to achieve his/her financial goals, then the first priority is to ensure that you don’t incur a massive loss from which you cannot recover. The older you are, the higher the risk. I would recommend an individual investor to NOT look at the performance (especially near term) of professional investors. You should never do what this class of investors is doing, not because they are smarter (they are not), but because of the asymmetry of risk faced by them.

I took the following approach in the middle of the crisis

Under the circumstances, my approach is that of ‘regret minimization’. That’s a fancy way of saying that I will do something in middle, so that I can avoid FOMO (fear of missing out) if the first scenario occurs, but at the same time have enough dry powder available incase the economic recovery takes longer.

Instead of going all in, we have slowly added (and even sold) positions as shape of the crisis has become clear at the company level (and not at a macro level). It has allowed me to sleep well and live to fight for another day.

In investing, there is no finish line and gold medal at the end of it. The end goal is survival and meeting your financial goals.

-2%

-28%

-48%

This is what you have lost in the last three years if you invested in nifty 50 (large cap), Nifty Midcap 100 and Nifty Small cap 100. Even these numbers understate the actual losses. Large caps appear to be a safe haven, but even that is driven by a handful of companies.

One can find comments on media, comparing equities with other asset classes such as fixed deposit, gold etc. and implying that equities are doomed to perform poorly in the future.

I think such people are too lazy to look at the data. Equities over a 3, 5 and 10 year periods outperform all other asset classes. What is not stated that equities DO NOT outperform in ALL 3,5 and 10 year periods. This difference may appear to be subtle, but the effect of it is not.

The probability of equity underperforming other asset classes is as follows

3 Year rolling buckets     :             25%

5 Year rolling buckets     :             18%

10 Year rolling buckets   :             10%

What the above stats mean is that for every 3-year rolling period, equities can underperform other asset classes such as fixed income, one out of three times. The recent 3- and 5-year period has been one of those times. This is another representation of risk, namely that a particular asset class will underperform from time to time.

If you are losing patience with equities as an asset class, there are two questions you need to answer for yourself

Do I believe equities as an asset class will deliver high returns in the future?

The way to look at this question is to look at the last 100+ year of data across countries. This data supports the view that equities do outperform all other asset classes over the long run. However, there are periods of underperformance which test the patience of almost all investors.

Do I believe the fund manager can deliver above returns?

The way to look at this question is to look at the performance of this individual/fund house over the long run (across market cycles). Different styles are in favor at different points of time. 2014-2017 saw small and midcaps do well. Large caps, especially quality has done well in the last two years. In order to eliminate the chance of luck, look at the performance of the manager over a 5 to 10-year period and check if the investment approach makes sense to you (and suits your temperament).

There is no magic pill which will convince you to invest in equities. Data can help you make a rational decision, but at different points of time in your investment journey, you will need some blind faith to keep going.

I have been through such periods in the past (in different aspects of life including investing) and often faith supported by data has worked for me.

I shared a framework in the previous post on how I am analyzing  my current positions to evaluate the risk. Some of the companies in the portfolio have applied for a debt moratorium which if accepted, reduces risk for the company. At the same time other companies plan to raise debt to fund working capital due to the drop-in revenue.

We are likely to see similar actions by other companies across the spectrum (debt moratorium, debt or equity raise)

I have been running a similar filter on the new ideas too, which need to have the capacity to sustain operations for a year without running out of cash (either from operations, balance sheet or through borrowings)

Regret minimization

This is a lot of discussion in the media and investor community on the shape of the recovery – will it be a V, U, W or some other form. In my mind, this is an important but unknowable factor. It depends on the following factors which cannot be forecasted with any certainty.

• How long will the lock down last?
• Will the lock down be lifted in phases (both in terms of time and geography)?
• How will this event impact consumer behavior (short and long term)?

How does one invest under such extreme uncertainty? One option is to assume that there will be a quick recovery and go all in. The other extreme is to wait till it is all clear and then deploy the capital. In the first approach one is making a bet on a specific scenario which may not occur, leading to sub-par results. In the second case, we may end up with sub-par returns too but only because prices will adjust once all the uncertainty goes away.

Under the circumstances, my approach is that of ‘regret minimization’. That’s a fancy way of saying that I will do something in middle, so that I can avoid FOMO (fear of missing out) if the first scenario occurs, but at the same time have enough dry powder available incase the economic recovery takes longer.

I continue to look for companies which can survive the crisis and will add them to the portfolio in a staggered fashion. We will not be able to pick the absolute bottom or make the highest possible return, but at the same time will be able to avoid any extreme outcome.

Obsession with market bottom

There is a lot of chatter on social media and I have received some emails on this point too. The question usually is – Has the market bottomed or is it some way to go? The true question which people are asking is this – Is it safe now to buy stocks considering that the market has already passed its bottom?

Although there are some technical approaches which are used for finding market bottoms, I am in the camp that no one knows for sure and it is not even worth knowing. I personally think an obsession with market bottom is worse than a waste of time. It will impact your thinking and corrode your decision making.

If you agree with the analysis in my previous note, our focus should be on solvency and survivability of the companies we hold or plan to add. If a company can survive the next 1-2 years and its business model is not impacted, then it makes sense to start buying the stock if the valuation is attractive. This assumes that the company has good prospects in the long run.

We started adding to our positions recently and it is quite possible that the market and our portfolio could drop from the current levels. I am however not concerned with such losses. I am more focused on the short-term health and long-term prospects of the companies we hold.

Impact of one year

Let’s review the first principle of investing – The value of a company is the sum of discounted cash flow from now to the time when the company closes/goes out of business or is bought out.

If we analyze a company and conclude that it can survive the next 1-2 years of stress without an impact to the long-term business model, then it comes down to evaluating the impact of the epidemic to the fair value of the company.

Let’s assume that the company will not have any profits for 1-2 years. If you run a DCF with this assumption, the intrinsic value reduces by 8-12% depending on the assumptions around growth, return on capital etc. If that is the case, then most companies have corrected much more, and the market is assuming a worse outcome for them.

To be fair, a DCF is just one input and the market does not work on pure math and logic. The point I am trying to make here is that if we can buy or hold companies (based on our framework) which survive the next 1-2 years, without an impact to their long-term prospects, then the long-term returns would be good.

If you agree with the above approach, does it really matter if we are able to catch the bottom of the market or a particular stock? As I have said repeatedly in the past – If I get the analysis of a company wrong, a 10-20% difference in buy price will not make a difference. The key is to get the analysis right.

Changing my mind frequently

A lot of assumptions and expectations have changed in the last few months. What was considered impossible (locking down an entire country) has happened now. In such an environment, where facts keep changing, it is important to keep an open mind.

I am following the news as everyone else and do not have any special crystal ball to see the future. As a result, it is important to change your mind and not hold onto old assumptions. I did that in the early part of the year when I suddenly became bearish and raised the amount of cash in the portfolio.

We are adding to the portfolio (in a staggered fashion) but this is not based on some specific forecast. If the situation changes, I will change my stance again. Please be ready and prepared for any decisions I take.