Quarter 1, 2018

A broad market sell-off in India was partly responsible for our Q1 drawdown. Additionally, since most of our holdings are of the small cap kind, a category that sold off violently, we underperformed the benchmark indices. It’s disappointing when your better-than-average stocks do worse-than- average. But history tells us that Indian market can pretty much make anything happen in the short term. Letting that dictate our investment process would be a sure-shot road to ruin. We buy good businesses at good prices. After that, we have no choice but to wait for the market to agree with us. So far it has. ​

As to why the sell-off happened? We offer our standard answer – we have no idea. We can probably conjure something up – trade war, high valuations, global uncertainty (whatever that means), or, if all else fails, Donald Trump. But we are not very good at that, and it’ll be a waste of your time. Instead, we want think aloud about how, if at all, could such random market drawdowns affect our long term performance.

Funds like ours, that manage concentrated portfolios of cheap, small-sized, and sometimes troubled value stocks, often make their lives unnecessarily difficult in a few predictable ways.
For starters, they at times onboard investors whose philosophy is at odds with the long-term nature of the business. Folks worried about every short-term fluctuation will inevitably quit when the occasional drawdowns happen. In the process, they make the situation worse by forcing the fund to sell positions at exactly the wrong time. Fortunately, thanks to you, we have never had to worry about that.

Second, some managers, while picking relatively safe stocks, make their portfolio vulnerable by using excessive leverage. Drawdowns in such cases lead to margin calls, and margin calls lead to forced sales at low prices, often starting with the best stocks. A portfolio that would have otherwise led to a great long-term outcome ceases to exist, with large and unrecoverable losses! Again, we don’t have to worry about this because we use zero leverage.
Finally, sometimes managers load up their portfolios with companies that are exposed to nasty feedback loops. For such companies, not only does the business affect the stock price, which is normal, but the stock price also affects the business. During a downturn, the stock sells off, which dampens the earnings, which makes the stock sell off more, etc. The culprit here, again, is leverage. Companies that repeatedly access the capital markets for their survival, find their financing costs shoot up when their stocks misbehave, which directly affects earnings. We currently hold two such companies, which together make up about 5% of our portfolio. They both sold off more than 30% during the last quarter. The underlying businesses have certainly not gotten worse in the last three months, so the stocks look even cheaper. If these were normal companies, we would have added to our positions. In this case we have no choice but to pass. There’s some room for such companies in our portfolio – when the likelihood of risk is small and commensurate reward is huge, but that room is very small.

​Overall, our portfolio is performing well. Our companies keep getting stronger and more profitable, and that’s all that matters in the long run. As a positive side-effect, the random market sell-off is giving us cheapskates a chance to go back shopping. We welcome that. We will likely add to our favorite positions and buy some new ones.