It was the later part of March 2020 and I was really worried about the tail risks to our portfolio. I started getting worried about Covid in late feb/early march and wrote the following posts on it
And the key post in the series: Economic sudden stop in which I wrote the following
What is an economic sudden stop – It is when most economics activities for a location come to a sudden stop due to a financial or natural disaster. In most cases such sudden stops are local such as due to a flood or an earthquake.
Global sudden stops are extremely rare and have happened only during the great depression in 1930s and 2008. Even during wars, we do not have such a situation.
The current crises has the potential of an economic sudden stop (and may have started). I have been thinking of this risk (which I have been referred to as a Tail risk). Over the weekend, I drew the following crude picture to illustrate my hypothesis (please excuse my drawing)
In view of this risk, I decided to analyze all my positions for bankruptcy risk. I wanted to assess how long the companies in my portfolio would survive, if there was complete stoppage of business (revenue = 0)
I am attaching the analysis below. Please note all companies in the note are for educational purpose only. Also we don’t hold these stocks now.
“It’s not supposed to be easy. Anyone who finds it easy is stupid.” – Charlie munger
Investing is very easy when you are investing in a bull market. If you are ‘unlucky’ to begin investing in a bull market, you start dreaming of being the next Rakesh Jhunjhunwala or Warren Buffett
I used the word unlucky on purpose because every new investor who starts investing in such periods gets a rude awakening in the next bear market
Bull market stories
A common theme during such periods are stories we hear from people who are striking it rich at such times
US covid Tech boom
“Buy quality at any price”
“Chor bane mor”
Secular growth of financial services
Perpetual growth in Infrastructure
The last one was in fashion in 2006-07 when a lot of current investors were not around
What happens at such times is that investors fit a story to the price action and think of it as a law of physics. These stories gain prominence as more investors get sucked into it. Eventually the trend runs its course and a lot of investors are left holding the bag when it eventually turns
Beating the market appears deceptively easy
Can you think of any activity in life which pays well, is competitive in nature and easy all time ? Is it easy to be a doctor, architect, actor, chef ?
Investing seems to be the only field where a lot of people get fooled into thinking that its easy. The reasons are not complex to understand
For starters this is a probabilistic field with returns accruing in spurts. A 15% CAGR over 10 years is not spread evenly over this period. Its more like +25%, +10%, -15%, + 18% and so on. Anyone who invests during a bull market thinks of it as normal and tends to extrapolate it
During such bull run making money appears to be easy. Just buy whatever is in fashion and it works. No need for any kind of risk management
Its easy to trade and getting easier by the day. Open an account in a few days and start trading in F&O. A thousand rupees is enough to get started. There are no qualifications or gate keepers to stop you
Performance over the cycle
Anyone can be a bull market genius. The true measure of performance is over multiple cycles which include several bear markets
Most investors get washed out after a bear market, never to return back. The few who stick around, dig deeper and learn the craft of investing. Even so, this does not assure you of above average performance
The reason for it is that the basis of out-performance changes over time. What worked in early 2000 does not work now. As I look back on my old posts up until 2013/14, it was easy to buy good quality small and midcap companies at cheap prices to make multi-bagger returns. That game is over now
In the same manner, quality at any price worked in the 2015-18 period, or loss making tech companies were the go to place in 2020. A lot of investors tend to stick with the old theme even when the paradigm has shifted
Beware of the snake oil salesmen
If you want to do well over the long run, you have to overcome your natural biases which trip most investors. One has to un-learn and relearn every 3-5 years as the paradigm shifts. If you miss one, then be prepared to live through a period of under performance till you adapt to the new one
That’s the reason why a lot of successful long term investors have said: Trading or active investing is a tough way to make easy money
I can vouch for that. I have worked in the corporate world and invested actively at the same time. I can tell you that making a living from the stock market is much more difficult than a full time job.
So anytime someone tries to tell you that beating the market is easy over the long run, keep these points in mind
They are trying to sell you something which is not worth buying
I am most proud of an investing decision I made years back.
Let’s go the beginning.
I have been investing for last 20+ years. In the initial years, I was fumbling in the dark and trying figure it out. I had several failures and lost a decent portion of my tiny net worth. Over the years as I gained confidence, I started investing more of my net worth in stocks and moved out of mutual funds entirely by 2009. I launched the advisory in 2011 after investing my own money for 10 + years.
During the initial I did not invest a single penny of my mother’s money as I did not want to risk her hard-earned savings on my trial and error. However, by 2011, her savings were dwindling as inflation was eating into it. The interest on her savings were barely enough to cover her expenses and at that rate, she would have run out of money in the next 7-9 years.
Now you must be thinking – That’s what kids are for. I should be taking care of her to which I wholly agree. However, this line of thinking misses a key point – Independence and choice.
Fear of markets
Our parent’s generation is over cautious and conservative. They consider the stock market to be a risky place and media doesn’t help the cause. As a result, most of them invest mostly in fixed income. In doing so they take on a different risk – loss of purchasing power due to inflation.
This fear may not be rational, but you cannot blame them for it. In the 80s and 90s, the Indian stock market was poorly regulated with brokers often cheating their customers (it happened to me a few times). No wonder the earlier generation has been wary due to the speculative cycles and poor regulation of the past.
Instead of wishing the problem away, I tried my best to give psychological safety to my mother when I decided to invest for her
This is what I did in 2011.
Invested 50% of her net worth, same as my own/ advisory portfolio.
Reduced the withdrawal rate from her accounts to bare minimum and covered the balance.
Have not withdrawn anything from the portfolio and let compounding do its magic.
Promised to backstop her portfolio. I would cover any losses personally.
The last point was the key. It ensured that she would not lose money if I made poor decisions.
In the last 12 years, her equity portfolio is up 13X and is 80%+ of her net worth. The dividend income alone can cover her expenses.
There is a joy in having enough money of your own so that you don’t have to depend on your children. I continue to take care of her, but my mother knows that she doesn’t need it and she has a choice. She can ‘choose’ to spend her ‘own’ money as she sees fit. It’s a different point that she has limited needs and spends most of it on her kids and grandkids.
I cannot be prouder of this achievement. I can sense the satisfaction she has from knowing that she has enough to spend as she wishes and not depend on anyone.
If you have older parents, I suggest putting at least a small portfolio of their net worth in mutual funds (if you don’t invest directly). At a minimum, this money would act as an inflation hedge.
However, remember to manage their fears and caution about the stock market. Preferably, start small and earn their trust over time. Finally, be conservative and risk averse with their money.
Believe me, in 10 years you will be glad that you convinced them to do it.
In my 2022 year end note, I spoke about some changes in my approach and using stop loss to manage the risk.
These changes are by design and have not been done lightly. I have always resisted chasing performance based on the latest fad of the day. However, my failures with a few positions such as PEL, Edelweiss and Shemaroo made me question the process and look for my blind spots.
When these positions declined, I dug deep into the financials and thought a lot on it, but could not find a clear way to answer the question – do we sell or hold? The numbers looked good and so we held. It turned out that the market had already anticipated the collapse in the earnings.
That has led me to a 3+ year journey of understanding technical analysis, momentum, factors in investing and so on. As I have studied these other areas, I have adapted my value approach to fit the changing market structure.
10-15 years back, markets were slow in responding to earnings miss and business cycles. These things have changed considerably now. Markets react much faster now – mainly due to higher competition and automated algorithms. In effect the time horizon of markets is shifting.
I have now blended momentum and Technicals to my value style. The core focus on value and long-term value creation remains, however, momentum sometimes acts as a booster and Technicals are more like a trip wire to alert us
Purity of style
I have practiced value investing for 20+ years now. I used to wear it as a badge of honor and made it a part of my identity as an investor. Even my blog is titled valueinvestorindia.com
It is time to go beyond that.
I am not talking about switching from a long term buy and hold to swing trading. However, being religious about my approach is not the way forward. I have belatedly realized that other approaches to investing have their own strengths & weakness and adapting some of these strengths to our style strengthens it.
For example: Risk management is a strong point of successful traders and blind spot for buy & hold value investors like me, who believe in holding a stock forever irrespective of losses.
In a similar manner, momentum/quant investors have simplicity of approach in their favor. Their approach can be boiled down to a few bullet points and easily automated. Value investors like me have layers and layers of complexity. I have used this mindset to strip away the non-essentials.
For example: Over the short-term valuation and management quality are important but not critical. Overweighing this information, which does not add to returns, means we have missed out on good ideas with a 1–2-year time horizon
Stop loss and zone of action
I spoke about having stop loss for each position in my last update. I review the stop loss regularly but will not share it with anyone. The reason for it is simple – I want to retain the flexibility to change my mind.
There is nothing special about the stop loss. It is based on a blend of fundamentals and technical factors including max loss or downside. In case of long-term holding, the stop loss is wider than a trade as that is a position we wish to hold longer.
As long as the price is above the stop loss and I am comfortable with the long-term fundamentals of the company, I will not react.
We cannot react every time the stock drops or rises a few % points. On the other hand, we don’t want to ignore a 20%+ drop, which we have done in the past. A few % change matters for a swing trader but is noise for us. However, a 20%+ drop means that there is something occurring at the company or sector level and a lot of investors including traders are exiting the stock.
At such points, we need to react and make a decision. Are we ok with holding the stock for an extended period and bearing a much larger loss or should we exit and live to fight another day. On this count my thinking has changed. I would rather take a hit to my ego and come back to the position another time.
Evolution
I rarely talk about the macro conditions. It’s not that macro is not important, but there is already enough noise and drama around it
For example – The fed or RBI decision on interest rates is the same for all financial service companies. What’s the point of talking about it? A good financial institution will figure out a way to work around it. HDFC bank has performed well over 30 years even as PSU banks have faltered. Surely it is not because of the interest rates.
I want to focus on what matters for a company and how it can do well in the long run. In the same manner, I want to do the same for us when writing to all of you.
My investment approach and framework will have a lot more impact on our relative returns than the macro. If the world has a major event, such as COVID, all investors including us will be impacted. Our approach will however decide the level of impact.
I spoke extensively about the evolution of my investment approach in this podcast. You can review it if you are interested.
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. We feel the same pain as we invest our own money in the same stocks.
We will treat all of you in the same manner as we would want to be treated if our roles were reversed. This means that we will be transparent and honest about our actions even when we have made a mistake.
Disclaimer – Stocks mentioned in the above note are for information / illustration purposes only. This is not a Buy / Sell recommendation.
Let me share two personal stories, one recent and another from 25 years ago.
I have a relative who recently passed away at the age of 50 due to a heart attack. He had a very stressful job and was facing financial pressures as well. After losing his job, he found himself short of money, and it seems (though I don’t know for sure) that he thought an easy way out of his financial troubles would be to trade in the stock market.
He lost his savings and sunk deeper into debt. I am certain that all these stressors took a toll on him.
The second story is even closer. This is the story of my own father, who passed away around the same age as this relative. I have shared this story here. He lost money with a plantation company, and when I visited their office, I was told that the money was gone. I can never forget this episode in my life.
Have a Heart
I recently posted a tweet when a bank in the US collapsed
If one invests in a ‘teak’ company or in the stock market, the person may have some idea that they are taking a risk. However, when a depositor puts money in the bank, they are NOT putting that money in with an upside
I received a few replies back, saying that such people do not deserve to get their money back if they did not analyze the bank’s financials before putting their money in. I have analyzed banks for 25 years and am sure that I know more about banks than these folks. Barring a handful of analysts or insiders, no one, including the top management, can tell you with certainty that the bank will not fail.
You have to be a heartless !@@### (insert your choice of word here) to make this statement.
I have been very numbers-driven throughout my investing life. However, there are areas in life where I draw a line. The safety of a person’s life savings is one of them. You can never understand the despair of a person who has lost his life’s savings
Implicit trust
There are vehicles such as bank FD, government debt, Debt mutual funds etc which have an unwritten safety/guarantee implicit in them. If you make every depositor or investor read the 100 page prospectus or study 10 years of financial statements, the system will come to a grinding halt
Our world works on implicit trust and not everything can be driven by contracts or due-diligence. Do you check the safety certificate of a plane or its maintenance manual before boarding a flight. We implicitly trust the system to make flying safe for us
If a plane goes down, we don’t blame the passenger for it
Even if you don’t consider the humane aspect, you will realize that if you do not the guarantee deposits, the whole system will collapse
Don’t believe me? read about the banking failures of last 100 years and you will understand why regulators and government rush in to protect depositors. Hint: they did not in the 1930s and that led to the collapse of the US economy
Are more regulations the answer
There are a lot of regulations from SEBI, and these keep growing by the day. My partner, Kedar, carries all the burden, and it is tough to keep up. However, considering the number of bad actors and terrible advice on social media, I personally think that’s a small price to pay (for people like us)
Bad faith investment advice and get-rich-quick schemes are not harmless gimmicks. They cost lives and destroy families.
I was in college when my dad passed away unexpectedly.
It was a shattering experience and only those who are unfortunate to experience it early in life can relate to it. Your notions of stability, risk and how you see the future changes completely
As I came to terms with his death, I was forced to deal with my family’s finances. This was the start of my investing journey. Till that time, I was never bothered about money, much less about stocks and bonds
We were financially insecure and that feeling drove me to learn about money & financial independence which led me to stocks, Warren Buffett and so on
I cover my initial years of investing in this video
A lot of time has passed since then and I have done well beyond my expectations. However, I don’t think my world view has changed. Such events influence your thinking on risk & money for a lifetime
I often chuckle when I read about some formulae on risk and all kinds of mathematical approaches. These formulae are without context and designed for some hypothetical person with no emotions and life experiences.
We all go through different life experience and our notions of risk, money and future are different. My own life experiences means that I will always remain a financial chicken all my life
I wrote this note to our subscribers today. Hope you find it useful
At the height of the epidemic, I shared my thought process on the next steps
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.
We paid a price for being conservative. We lagged the indices in 2020 at a time when others rode the surge in small caps and achieved stellar returns
I wrote the following at the end of 2020
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 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 be 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 continue to stand by my conservative approach, though I should have reacted faster when all central banks pumped in a huge amount of liquidity into the system. By the time, I could appreciate the dynamics, it was too late
I have been following this drama closely and by mid of 2021, felt it was getting crazy. Valuations of profitless growth companies in the US went through the roof, Crypto was all rage and then we had the NFTs.
Some of these innovations could change the future, but why would I pay for a promise? If you are a buy & hold buyer (as many claim), then you should be paying a price which doesn’t discount the future. On the contrary at height of the mania, buyers were paying for the most optimistic future
The last one year has reminded me of the 2000-2001 dotcom mania. I had just started investing and resisted the mania for a long time, but finally succumbed to it in early 2000 when the bubble peaked. I promptly lost 80%+ of my meagre investments in the next few months
The advantage of experience is that if you can avoid repeating the same mistake. I have stayed away from all this madness and just watched it with amusement. You can see all the updates on my twitter feed @rohitchauhan
When the tide goes out
I created a presentation last year but did not upload it then for some reason. Interest rates have been on a 40 year downward trend and were close to 0% (and even negative). The investing world has gotten so used to this zero cost capital, that even a slight increase would be devastating to most assets
Although I could not forecast inflation and other macro issues, it was clear than any normalization or even reduction in the liquidity was going to be a problem for the market
We know what has happened since then – Inflation has surged due to war, supply shortage of commodities and all kind of supply chain issue
The net result is that interest rates are rising and have some distance to go. All central banks, including RBI have to raise interest rates and reduce liquidity to control inflation
Flip the script
So what’s my point in all this ? We all know what is happening.
If a cut in rates and increase in liquidity, resulted in a V shaped recovery, then the reverse should cause an extended downturn?
I think a lot of the correction has happened. However that does not mean markets cannot shoot on the downside. Long term investors often ignore the implications of liquidity
The net result is that the tailwinds of the last 2-3 years are now headwinds. If this turns out to be true, then there is no central bank to bail out investors this time around in the near term
Hunker down
My thinking is colored by my experience after the dotcom bust. As liquidity was pulled back, it took the markets years to normalize and start growing again. The current events are not the end of the world. At the same time, we should not expect that market will turn suddenly and resume their upwards trend
We are holding 20% cash as I write this note. My plan is keep looking for new opportunities (as always) and start with small positions. As these companies execute, we will scale into the position over time
Even as we invest and reshuffle our portfolio, we should expect losses in the near term. No amount of conservatism can save us from that. I have harping about diversification and asset allocation for last 2 years as I felt that a lot of the recent rise has been due to liquidity conditions around the globe
We can expect volatility and a tough slog for some time. The key is to manage the risk and focus on building a diversified portfolio
Let me share two graphs, which appear quite similar
Are they from the same data but drawn differently? Both graphs show periods of growth followed by consolidation or pullback
Let me zoom out and show the source of this data
The first graph is that of our model portfolio and second is of Vinati organics. One is a portfolio of stocks and another is a portfolio of products. Our portfolio has delivered 24% CAGR in the last 10 years and Vinati organics delivered 40% CAGR over the same period.
There is a deeper lesson in the above charts
Progress is never linear. It happens in fits and starts with periods of stagnation and backtracking.
Short-term thinking and extrapolation
It is easy to enter the portfolio (or a stock) at point A and just extrapolate that trend or at point B and do the same. The problem with this mindset is that the individuals expect progress to be linear and steady (purple line) whereas reality is the brown line of our portfolio
This is a problem no one can solve for us. I have seen this all my life, especially with investing. A lot of investors want immediate gratification and jump in at point A, only to be disappointed.
The right mindset is to zoom out and look at the long term trajectory. Does the mindset and approach of the advisor make sense and will it work over the long run. Is yes, then you must give it time to play out
What drives this behavior ?
I think the problem is our own expectations and lack of patience. We want immediate and consistent results. That’s the point of tweet below
The world is not kind to give something for free. If you want zero volatility – go for a fixed deposit. If you want high returns, the price you pay is the volatility of the returns.
Somehow everyone gets this in other facets of life – everything of value has a price. Patience and persistence is the key to success – in stock markets and a lot of other endeavors
2022 – Drop in US markets and now Russia Ukraine war
There is no regularity to these events and does not mean we will get these drops in even years. Such drops have occurred in the past and will occur in the future too.
You have to study the market history to know that there is always something to worry about and scare the markets
Bottoms instead of top down
I have never planned the portfolio based on some specific forecast or event. In the last 11 years of our advisory, we have seen all kinds of micro and macro events occur. At that time, the event appeared to be a big deal and then eventually everyone adapted to the new situation
What I have changed in the recent past (as I noted in the annual letter) is my response to company level events. If a company is not doing well or the management is lacking in execution, we would rather exit than hope things will work out
Doing so ensures that we clear the portfolio of its deadwood and have positions with higher level of conviction. That’s the reason we have 25% cash level in the portfolio, not because my crystal ball forecasted a downturn in 2022
What does the crystal ball say now?
My crystal ball is as murky as it always has been. The same is true for others, even if they claim otherwise
However, a few long term trends which impact investors the most, seem to standout. Inflation and by proxy interest rates appear to have bottomed and could rise in the future. This will exert a downward pressure on valuations.
Commodity prices and supply chains will continue to get disrupted due to this conflict and other geopolitical events
All of this means a lot more volatility in businesses and stock prices
How to invest with higher volatility
In my mind higher volatility means that managements of companies will have to be flexible and adapt faster to change. For us as investors, this means that the operating environment for our companies could change suddenly leading to a break in our thesis
When that happens, we may have to sell and move on. Holding onto an outdated thesis and hoping it works out is a recipe for disaster
We have been doing that for the last 6 months and will continue to do so. I am not counting on luck to bail me out.
The second change is portfolio diversification across companies and sectors. I have tried to spread out our investments across companies and sectors to ensure that a hit in one does not derail the portfolio. The same holds true for your overall portfolio outside of equities. I would recommend being diversified across asset classes with allocation adjusted to your personal situation
A plan of action
A lot of you have asked if you should add to positions which have dropped below the buy price. The simple answer is Yes. The only time when this happens is when there is chaos and crisis in the world. Such prices come only during times of trouble
It does not mean that if you start adding today, you will not see lower prices. No one can predict how low the markets can go and when they will turn around.
This is the price of investing in equities and no matter what system you follow, there will always be losses from time to time. you can use a stop loss but then on the flip side if the market suddenly turns, you will lose the upside.
The best option is to invest in a steady and measured way keeping in mind that your purchases could show a loss in the short to medium term. Invest only if you don’t need that money for the next 3-5 years and the amount is such that these losses will not cause you to lose sleep
We continue to look for new ideas and with the recent drop, a few are becoming attractive by the day.
As always, our money is invested the same as the model portfolio and we continue to eat our own cooking
I got introduced to poker in 2020 and have taken to this game. You can read the rules of the game here. The rules are quite simple. The richness comes from the lack of perfect information
As the community cards open on the board, one bets not only on one’s own cards but also based on the strength of the opponent’s hand. As the opponent’s hand is hidden from us, we are forced to make probabilistic decisions
As the card are dealt, one makes these decisions based on betting and other actions (called as tells) of the opponent. The beauty of the game is that one can see the result of the decisions quite quickly – in a matter of 5-10 min as the hand is played out. This allows for rapid learning
As you play the game, the parallels with investing/trading become clear. Investing has far more variables and is not the same as poker. That said, both involve decision making under uncertainty
I wanted to share some learnings from the game, as related to investing
Losing even when odds are in your favor: Decision making under uncertainty involves making probabilistic decision. Even when the odds are in your favor, the result can go against you. The probability of win could be 60% which is considered high in poker, yet 40% of the time the result will be against you (no surprise there). This happens often and inspite of all the rational thinking such events do upset me. Most other players in poker or investing are not even thinking of probabilities
The key is to focus on the process and not the outcome (easier said than done)
Keeping losses low: Odds will often not be in your favor and you will be tempted to make a bet. At such times, folding your hand against all your instincts is the right decision. Making such decisions is never easy as one is losing money – by folding in poker or selling a position in the portfolio. However, such decisions are the key to doing well in the long run.
What ‘feels’ good in the short term is not good for long term results and vice versa. That’s why investing is simple but not easy
Know yourself: Some players are aggressive risk taker. They will bluff often and make big bets when odds are slightly in their favor. Other players like me are more conservative. I am constantly calculating the odds and making bets accordingly. I am also focused on not going bust in a game (losing my entire stack). I invest in stocks in the same manner. The only difference in my poker game is that I will occasionally bet high when the odds are really good.
Successful players play to their natural bent of mind, but at the same time should try to do what is not comfortable for them. Combing the right amount of offense and defense is an art and a lifelong process in poker and investing
