Since that fascinating November day when India switched its banknotes and America its president, both the markets have done rather OK. Expectations for them had been anything but OK. So quite naturally the bears are getting progressively shriller. Apparently the valuations are so high - both NIFTY and S&P 500 are now trading at 24x P/E (some coincidence!), that markets will soon spontaneously combust. We have our doubts but will happily side with the bears. It’s been a long time since we have seen a market-wide garage sale so a part of us yearns for a sell-off.
The other part worries what will happen to our portfolio in case of a sell-off. To be clear, it’s not the drawdown that worries us. We will certainly suffer drawdowns during downturns. In fact, some of our smaller market-caps holdings will likely get disproportionately punished. We can’t avoid that and we absolutely cannot time that. We can only avoid buying sub-par companies at high prices.
What really worries us is whether a sell-off will affect the underlying operations of our portfolio companies? In other words, can the effect become the cause? The phenomenon has many names: Feedback, Reflexivity, or just tail-wagging-the-dog (or is it dog chasing its tail?).
Consider the following scenarios:
The list goes on …
Clearly, this ugliness happens often enough that we have to worry about it. Mitigating this risk involves putting some rules in place. First and foremost, we want to make sure that drawdowns for us don’t result in forced fire-sales by us. So we choose the right level of portfolio leverage – ZERO, and we choose the right kind of long-term investor – YOU. We are extremely fortunate that you share our views on investment horizons.
We also mitigate market risks by avoiding companies that require large amounts of debt or equity-raises in order to grow. Some of our portfolio companies are in fact woefully under-levered. Although they have plenty of assets and earnings to support leverage they’re run by conservative owners who don’t like debt. We are okay with that. Many of these companies will gain marketshare during down cycles due to their cost leadership and ready access to cash.
Finally, we stay mindful of our total commodity and FX exposure when making new investments. All else equal, we like inward looking companies that are hitched to the long-term India growth story.
We believe that if we do all this well then we’ll do fine in the long run. We are convinced, and we hope through our communications we have convinced you too, that market volatility is a good thing. In fact, it is a pre-requisite for an operation like ours. Without it value investing dies. Fortunately, we haven’t found any scarcity of volatility in India just yet. Lucky us!
At the end of this letter, we describe two recent purchases, both of which highlight the aforementioned issues. The price is low, the quality high and the business resilient to market shocks.
New Positions <private>
Notes & Letters
A collection of our thoughts, views, and excerpts from our investor letters.