As temperatures drop in New Delhi and New York, things economic and political are only getting hotter. US markets closed the quarter with a 10% rally making 2013 a scorching 30% year. Ben Bernanke gave way to even more dovish Janet Yellen. The Fed taper started with $10 Billion being taken away from monthly purchases but the market took it in stride.
In India the election season is almost in full swing. With a surprise strong showing by the openly socialist AAP in Delhi the impending Lok Sabha elections have become even more interesting. The market longs for a government without coalition though recent history makes that a long shot. India’s NIFTY index rallied 9.92% for the quarter and hope is once again in the air. Hope for better governance, a stronger central bank and a robust economy. We hate to rain on this parade but India’s recent record of meeting expectations is rather sobering.
The news from the business community at large, whose opinion we value far more than the economists’, is not great. India’s share of corporate profits to GDP stands at a decade low of 4.5%. The mood is slightly more buoyant than last quarter. However, all it takes is an unfavorable election outcome, a regressive policy stance or a bad monsoon for things to take the wrong turn. We remain cautious buyers of cheap high quality companies with extra emphasis on quality.
India as an investment destination
We invest in India because we believe that we understand Indian businesses better than the investor base at large. This relative advantage is crucial in our business, which is largely a zero-sum game. But is India inherently a worthy investing destination? We certainly think so, especially for rational, business minded investors. There are two primary reasons and to sound like we know what we’re talking about we’ll call them drift and noise.
By drift we mean favorable long-term growth prospects and by long term we mean decades, not the next 2 or 3 years. The Indian consumer, as it currently stands, is grossly underserved. His consumption of almost everything material remains abysmally low; be it cars, toothpaste, bank loans or hours of TV watching. Even when compared to other emerging counties. On top of that he’s getting younger, richer and more literate by the day. He’s far more prone to borrowing and spending than his predecessors. This confluence of hunger, means and access will create enormous demand in the coming years. Companies that profitably fulfill this demand will make their owners immensely prosperous.
In the short term though the noise rules. Indian economic and socio-political landscape has always been volatile and will remain so for the foreseeable future. Most investors, especially the foreign kind, think of it as a problem of magnitude rather than frequency. In other words, there is widespread belief that India’s crises are somehow worse than other countries’. We disagree. Be it financial debacles, scams or plain old business cycles, the pain is as deep when it comes to places like US, Europe and Japan.
However, India takes the cake when it comes to the frequency of such scams and crises. Whether it’s the 2G scandal, NSEL fraud, implosion of a highly levered sector or our nagging current account deficit, its never a dull day in India. This economic uncertainty coupled with a nervous investor base makes Indian markets bounce around like a Japanese seismograph on steroids. But “that” as Martha Stewart would say “is a good thing”.
Rational investors are in the business of buying a stock when it trades at a discount to its intrinsic value and selling when it trades at a premium. Without the random market noise they would never get the opportunity to do so. In other words, the drift creates great businesses to choose from and the noise creates great prices to transact those. India with its ample supply of both should be near the top of every value investor’s list.
Lessons learnt from the year past
The biggest detractor to our 2013 performance was the Indian Rupee. In hindsight we should have hedged against this risk but there are two reasons why we thought it was a bad idea. Firstly, our record of macro predictions is rather unreliable, especially since we don’t make them. Frankly, we think the swarms of economists crawling this planet share a very similar record. Secondly, a hedge is an insurance policy. One buys an insurance policy only when it makes sense. While most of us carry health insurance we don’t buy trip insurance every time we buy air tickets. Insurance policies come with costs and the cost of insuring against a Rupee decline seemed far too high to us at the time. In fact had we hedged our entire portfolio on January 1st 2013 for a year using available options we wouldn’t have done materially better.
The second biggest performance drag was company size. Specifically, the annualized performance of each of our stocks was almost 100% correlated to its market capitalization. Our larger cap stocks did well and smaller cap stocks capsized. We prefer small cap stocks for a good reason, i.e., they are very sparsely followed by the investor community and hence sometimes trade at stupid prices. However, during times of market distress such stupid prices often get stupid-er. This is exactly what happened in 2013 and small and mid-cap indices dropped by significant amounts. We have done very well relative to these indices and expect to fully participate in their upside as prices recover over time. However, going forward we will demand a higher margin of safety from our smaller cap stocks. This will make our portfolio more resilient in distressed markets while making it lean towards slightly higher capitalizations.
The most important lesson learnt in 2013 was from mistakes that we did not commit. There were a few instances during the year when we loved a stock for its underlying business as well its price. However, we decided not to buy purely for corporate governance reasons. We are happy to report that it saved us considerable amount of money. If we have one wish for 2014 it is be to repeat this inactivity on our part.
Current Positions <private>
Apart from these stocks we have a few other positions that we are in the process of buying. As we complete our purchases we will update you further in our letters.
Please reach out to us with any questions or concerns.
Our brand of investing is simple. Find great companies. Buy them at the right price. Sell when they get properly valued. Rinse and Repeat.
If we're able to do this we make money. Its a simple formula that hinges on four things and four things only. Or as a sceptic would put it ...
How do you know that the company is great?
How do you know what the right price is?
Why would sellers sell their stock at the right price?
Why would a stocks ever converge to their proper value?
Volumes have been written on the first two questions. We ourselves write about these in our investor letters fairly regularly. So in this post lets focus on the last two. Besides, these are much easier to answer anyway. The answer to questions three and four simply is "We do not know but they do". To both the questions. Since we don't know the answer let's check what Ben Graham, the father of value investing, had to say about it.
Here's an excerpt from a Senate committee hearing on Factors affecting the buying and selling of equity securities. Specifically, this is the statement and the Q&A section for Graham. Towards the end of a rather candid and insightful interview the following exchange takes place ...
THE CHAIRMAN: When you find a special situation and you decide, just for illustration, that you can buy for 10 and it is worth 30, and you take a position, and then you cannot realize it until a lot of people decide it is worth 30, how is that process brought about-by advertising, or what happens?
Mr GRAHAM: This is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. We know from experience that eventually the market catches up with value. It realizes it one way or another.
Even Graham didn't know!
We can perhaps speculate why someone would be in a hurry to sell something at a ridiculous price. It could be any of the following ...
The point is that it's often impossible to put one's finger at THE reason. From the sellers perspective the reason could in fact be quite rational. The result is always the same; more volatility. And this volatility is EXACTLY what creates opportunities.
Strangely though most of the finance community does not agree with us. Volatility is a dirty word especially the academic part of the finance circles. Volatility to them is risk. To us the possibility of capital loss is risk. Risk a mistake made valuing a company or a drill rig that catches fire or an owner who decides to plunder the company. Volatility, to us, is what makes the investment world go round.
To be fair we can think of at least two ways that volatility can harm an investor. First has to do with a human being's emotional make up. Without volatility there will be no trading. After all, if the slot machine always comes up with 2 bananas and an apple then what's the point in playing? So more volatility (to an extent) equals more trading, which means more commissions out of an investors pocket. Ergo, lower returns.
Moreover, if greed and fear belong to the same zip code in your brain as investment analysis then volatility must be avoided at all costs. It will simply force you to buy euphoria and sell misery.
The second reason is leverage. A levered position does very poorly in the face of volatility. When a margin call comes you have to liquidate regardless of the long term prospects of your position.
However, the volatility-risk mix up in finance literature has nothing to do this these two reasons. Volatility in finance is simply a construct best avoided. Why? We have our suspicions but let's explore those in our future posts.
For a value investor of our ilk volatility is a blessing. Volatility happens. People sell things for personal, financial and sometimes totally dumb reasons. Sometimes at the right price (from our perspective).
Similarly, once we buy the stock at the right price should we pray for the stock to just sit there? The right price is one that's far below the intrinsic value of the business. In other words we just created a heads-we-win-tails-we-lose-little situation for ourselves. So what's the point of NOT flipping the coin?
So in summary while its impossible to know exactly why a stock diverges from and converges to its intrinsic value, it does. And praise the lord that it does. For without this random movement there would be no value investing.
Letters to Investors
A collection of our views, thoughts and ideas, as we communicated to our investors.