CategoryAdvisory letter

Decisive action

Our approach in the past has been to hold and ride through the drop. This works if the long term prospects of the company remain unchanged and the company is going through a temporary drop in growth or has high valuations

In the past, we would hope and wait for the performance to turn which led to opportunity loss. More important, each position takes a certain amount of mental energy and the ones performing the worst, tend to take the most

We saw that happen with some of our failures in 2018 and 2020 which took away a lot of my mental energy. Swift and decisive action on exiting a weak position frees up my mind to  concentrate on better ideas

Stop loss

A Stop loss is commonly used by traders and some investors. We have resisted the idea as my approach has been to buy a company with poor outlook in the near term but good prospects in the future. In such cases, using a stop loss means we get stopped out before the company’s performance turns around

I have reflected on the past losses and have noticed my tendency to get carried away by the narrative of a company, especially after it has done well for us. The risk is highest when we have a high allocation in a company with high valuation. In such cases, disappointment in the performance hurts our portfolio more.

It is easy to set a quantitative stop loss and exit as soon as that is hit. However, that would have stopped us out of companies which went on to become multi-baggers

As a result, we are using a mix of subjective and quantitative criteria to set a stop loss for each idea

• Position size
• Long term compounding v/s a short term cyclical play
• Technicals such as 200 DMA
• Company level issues

I recently read a book called ‘Quit’ by Annie Duke and highly recommend it. There are two points from the book which I have taken to heart as it applies to investing

• Quitting on time, always feels early: remember when we quit IEX close to the top. It felt early to me
• Make the exit decision beforehand. At the time of executing the decision, the mind tends to come up with excuses. I experience it all the time

We have a stop loss for most positions and will cut the position in a graded fashion even if it feels early or we are proven wrong. If the position turns and the company starts doing well, we can always re-enter

Evolution

As the saying goes – Never waste a failure. I have always taken this maxim to heart. It’s not that I like to lose money. The problem with not being comfortable with failure in investing is that it happens quite often and not managing it well leads to further underperformance

For example – My tendency to hold on to losing positions in the past is a proof of this tendency

The performance of the last few years has made me reflect on some of the core aspects of our approach. One of them is – Buy and Hold

I continue to subscribe to the notion that wealth is built by investing in good companies and holding them for the long run. However, I have added caveats to it. There are very few companies which can perform consistently for a long period time (over decades) and the bar should be set high

For example, we started a position in PEL in 2012 as a cash bargain. The company evolved into a compounder as it built its pharma and then the financial services business. At the peak this was a 4X for us and a 10%+ position. However, we ignored a flaw in its business model – borrowing short term and lending to risky segment (real estate builders)

As I shared earlier in the note, I bought into the narrative and thought that the management knew what it was doing. To a certain extent, we must trust the management and their strategy or else we can never invest in a company for the long run

We failed in being critical enough, even though the market was telling us otherwise

We have become less complacent of the companies we hold and will not hesitate to exit our large and long term positions if we feel the risk  is high

Holding cash

We have held cash to the tune of 10-20% over the years. This has penalized our performance at around 2% CAGR. We never report our performance without cash as no one forced us to hold cash.

However, this cash holding is like tying extra weights on our feet while running a marathon. Cash has acted as a safety blanket for us and allowed us to sleep better. However, I am now rethinking the level of cash. We may hold lower amounts of cash in the future, but manage risk more actively based on stop losses

That said, we are not going to be reckless. If we don’t find any ideas, then we will hold cash. It’s better to underperform than lose money

Changing process – sudden or gradual

I have been thinking about our process for some time but only recently acted on it. The model portfolio and you the subscribers are not my guinea pigs.

We have a small tracking portfolio to add new ideas and track the companies for some time. I have been actively using stop loss in that portfolio. Some of the recent ideas were in the tracking portfolio for 6+ months before I added them to the model portfolio

This will continue in the future. At the same time, these tracking positions are small positions. Our buying happens at the same time as all of you.

Another change which is an outcome of this process, is higher volume of transactions. We sold 7 positions and added 11 new positions to the portfolio.  In hindsight, I was slow on the exit. We should have exited a few more positions earlier.

What has worked in the past, has become less effective in the recent years. This is expected due to the nature of the markets. As markets evolve and adapt, the bar is being raised and old timers like us must learn and adapt. We will continue to do so in the future

A long-term partnership

We repeat this every time in the portfolio review and will do so again (more for the benefit of the new subscribers)

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

We will treat all of you in the same manner as we would want to be treated if our roles very reversed. This means that we will be transparent and honest about our actions even when have made a mistake

I wrote the following as part of my half yearly letter to subscribers. Hope you find it useful (Names of specific companies have been edited out )

Some of our positions are a bet on Long term trends. Let me describe a few

• Migration of manufacturing to India (CDMO, CRAMS, Higher exports etc.) – The underlying trend is migration of manufacturing, especially high value added to India. There are multiple drivers behind it such as the China + 1 approach by the importing countries, Comparative advantage of India in certain sectors and so on
• Change in Real estate cycle – Real estate has been in a downtrend for the last decade. This is a cyclical industry with long duration cycles. Once the upcycle begins, it tends to last for 5-7 years
• Re-start of the capex cycle/ Infra cycle – The Capex cycle peaked in 2008-09 and has been down since then. With rising demand and utilization, we should see capacity addition in the private sector.
• Financialization of savings – Indians are increasingly investing in financial products and moving away from hard assets such as gold and real estate.
• Formalization of the sector – We are seeing the formalization and consolidation of several sectors in the economy

There are some names which are repeated, and it is normal for an Industry to benefit from multiple trends at the same time.  When this happens, it increases the tailwinds for the sector

There are a few factors to consider when investing in companies benefiting from long term trends

• Betting on the right management: Companies riding a trend have a long runway ahead of themselves. If the trend holds and management is capable, the company can compound value for a long time. Identifying the trend is easy, betting on the right management is much more difficult
• Optically expensive: Such companies appear expensive based on near term earnings. The reason is that the market is discounting a long period of above average compounding.

Case in point – HDFC bank and our own holding, Vinati organics. Vinati organics is up 50X since we first bought it in 2011. Our mistake was to look at the valuation in isolation and not in the context of the broader trend. As long as the trend holds and management is executing, one should hold the stock and be tolerant of higher valuations

• Boredom is the enemy: Unlike cyclical stocks, timing the purchase is not critical. Most of these trends last for a long time. Betting on the right management and holding through periods where the business keeps moving forward, but the stock price remains stagnant is the key

It is easy to overdo this trend-based investing and get carried away. However, the most common problem I have seen is investors, including me, lose patience during periods of slower growth even when the primary trend is active.

This has been the case with Vinati Organics where the stock has compounded at 40% CAGR but in spurts. The picture below shows the periods of stagnation

 As the above example shows, a great long-term result does not mean absence of short-term pain

In an earlier note, I wrote about the three factors which contribute to outperformance (doing better than an index). I expanded on the third factor in the most recent update.

Sources of outperformance
Superior performance versus the indices can usually be broken down into three buckets

Informational edge – An investor can outperform the market by having access to superior information such ground level data, ongoing inputs from management etc.

Analytical edge – This edge comes from having the same information, but analyzing it in a superior fashion via multiple mental models

Behavioral edge – This edge comes from being rational and long term oriented.

I personally think our edge can come mainly from the behavioral and analytical factors. The Indian markets had some level of informational edge, but this edge is eroding with wider availability of information and increasing levels of transparency.

We aim to have an analytical edge by digging deeper and thinking more thoroughly about each idea. Ultimately it, depends on my own IQ levels and mental wiring, which is unlikely to change despite my efforts.

The final edge – behavioral is the most sustainable and at the same the toughest one to maintain. This involves being rational about our decisions and maintaining a long term orientation. If you look at the annual turnover of mutual funds and other investors, most of them are short term oriented with a time horizon of less than one year. In a world of short term incentives, an ability to be patient and have a long term view can be a source of advantage.

An enormous advantage
We started the advisory in 2011. At the outset, we made a few decisions which has made our life simpler and saved us a lot of pain.

• We will not tout the wins on social media, which are often due to luck and can easily get hit by a random event causing a loss for anyone trying to follow them. If it works well, the person taking the tip attributes it to their genius. If it fails, we are responsible. Considering that the best of investors don’t get it right more than 60-70% of the time, what is the upside other than an occasional ego trip?
• We will focus on the investment process as that is the only repeatable aspect of investing over which we have some control. We cannot control the outcome.
• We will focus on the long term as short-term results are prone to random events, but the noise cancels out over time
• We will not indulge in making fun of other investors when we are doing well. It is stupid behavior and extremely petty. There are times when every investor goes through a bad patch – so what goes around comes around

Some of the behavior we see in the media, although loud, petty and promotional is not irrational. It allows the advisor/ fund manager to get visibility and increase their AUM. In the end, managing a fund is a business and one cannot live on high ideals alone.

The problem with this behavior is the type of investors you attract. If you talk about short term performance and multi-baggers, then you will attract people looking for quick gains and easy profits. The downside of having such investors, is that  they get quickly disappointed when the inevitable downturn hits the market.

Looking for quick gains, such investors join at the top and manage to get quick losses.

For the fund manager, there is no downside. If the market keeps going up, they get to make their fees. If the market drops and they lose a few investors, which is part of the normal business cycle. They just need to wait for the next bull market for a new crop of performance chasers.

Both me and Kedar don’t want to play this game. We are not running this advisory for the good of mankind, but do not like this behavior. In addition, we are in a financial position, where we do not depend on the fees we earn to put food on the table.

Why am I sharing this now after so many years?

The reason for sharing is that a person cannot be rational and make decisions for the long term if that results in career risk. Try telling your family that you took a 5-year view which cost you your job. It is never going to happen.

We have taken this element of risk out of the equation for us. As I mentioned earlier – we do not depend on the advisory to put food on our table. In addition, our own money is invested in the same way as the model portfolio. Put the two together and you will realize that we are willing and able to think long term with a focus on risk reduction.

I think this is a very important edge for us compared to most fund managers. We can safely ignore short term fads (such as the bull market in small and mid-caps last year) and panics and rationally manage the portfolio. This allows us to take bets which are unpopular and hold on to them.

In an age of huge computing power and easily available information, one is unlikely to get a durable analytical or information edge over other investors. However, the third edge – behavioral which is durable and cannot be competed away, is available to us due to the reasons I have shared.