Prashanth Krish | Portfolio Yoga

Pilgrimage to Omaha – The Annual Confab

Going on a pilgrimage is as old as Religion. Men and Women have been for thousands of years going to the holy places of their religion in the search for peace, knowledge and enlightenment.

In the good old days before you could magically move from one corner of the earth to another in a matter of hours thanks to advances in transportation technology, this was a gruelling, time consuming and risky venture.

People didn’t go to pilgrimage of the holiest places as part of a tour package when young but as a search for something higher after having accomplished everything they desired to accomplish for there was no knowing if they would come back to the life they had.

For many years now, going to Omaha, the place of the Annual General Meeting of Berkshire Hathway has become a pilgrimage for those investors who emphasise on following the path laid down by the sage of Omaha as Warren Buffett is called.

From High Networth Individuals to Fund Managers to even Fund Distributors are now transported half way across the earth to be part of this big bash. While the meeting in itself is now web broadcasted, there is no dearth of those who wish to be part of the event physically.

While it’s one thing to believe in his principles, it’s quite another to follow and hence it’s not really surprising to see very few if any actually follow the path he walked upon.

Buffett Rule: “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”

The thought process here is that you are not buying a ticker symbol but a business that you understand and once you buy, there should be no regrets, at least in the immediate months and years due to market / earnings volatility.

I was looking at a fund from the same fund house that took their top selling distributors to Omaha and stumbled upon something interesting. Of the top 10 stocks they were invested into 3 years back, 6 (60% of the top 10) aren’t even in the complete portfolio of today.

While 10 years maybe too long a period to hold stocks given the changing ecosystem, I was surprised to see such wide changes by a fund management house that swears by Buffett.

On the other hand, I think they were right – all six stocks are either in Industries that are for a long period of weak earnings or worse. Finally, investors reward fund houses with more assets only when performance is great, talk itself is cheap.

In his 2016 Annual Report, he wrote and I quote,

“When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients,”

Yet, Fund Managers regardless of size of their Assets under Management try to charge the maximum that can be charged to their investors. Warren himself has gone on record to recommend investing in low cost options such as Vanguard ETF. In India though, such views are anathema.

Warren Buffett himself gets just $100,000 as Salary for being the CEO and CIO of a company that on market is worth 488 Billion Dollars. Don’t even bother to calculate the decimal point that is the fund manager fees.

One of the reasons for higher charges being accepted has been the fact that unlike the United States where the large majority of mutual funds never beat the market consistently, here fund managers have accomplished the impossible.

The new SEBI regulations on Categorization and Rationalization of Mutual Fund Schemes shall have a large impact on fund returns and the alpha they can generate going into the future.

Fund Managers can deliver Alpha in two ways. One is to differentiate in weights compared to the Index they follow. For example, assume a Stock ABC which has a weight of 10% in the Index while having a weight of just 1% in the fund. If the stock drops 10%, the impact on the fund is much lower than it’s on the index thus providing Investors with an Alpha.

The risk though is that if the stock moves up 10%, the fund under-performs the Index in a big way. This is a risk that most fund managers take by lightening their holdings in stocks they feel will no deliver while being overweight on stocks that they believe has a better future.

A second way to generate Alpha is by investing in stocks outside the Index. Since the stock is not part of the Index, if the stock delivers returns above that of the Index, the fund manager feels rewarded for taking the risk of being underweight Index stocks while being overweight other stocks.

SEBI’s recent circular now limits the ability of the fund manager to pick up stocks from outside the Market Cap the fund is categorized currently. While the Alpha picking ability of fund managers were already on the way down, this should accelerate since there is little you can do to differentiate yourself from your peers or the Index.

Yet, fund managers expect that paying 2.5% for that is “sahi hai”.

When Warren Buffett started to manage other people’s money, he had an interesting way of how he will be compensated for his efforts.

Firstly, he collected no Management Fee. While we are seeing a few funds today that are following the same strategy, remember he did this in 1956.

Second, every partner would be paid 4% interest on his capital (remember, capital which could be growing or falling). Returns post that 4% were then split 50:50 between Buffett and the Partnership Investors.

In 1958, he modified it to make himself liable to pay 25% of the losses and the 4% interest if he generated a negative return on the investment during the year.

While I am no fan of Warren Buffett, its things like this that make you wonder how far ahead he was in being fair and equal when it came to outside funds. They don’t seem to make men like him anymore.

Don’t walk behind me; I may not lead.

Don’t walk in front of me; I may not follow.

Just walk beside me and be my friend.

– Albert Camus

Source on his Fees: What was the fee structure of Warren Buffett’s first investment partnership started in 1956?

Momentum Investing – An Experiment with Real Money

“We’re too soon old and too late smart.”

For nearly a month now, I have been wondering if it made sense to make a post of the trails and tribulations of my one year journey with momentum investing. The idea here is not to sell you a product or a service but to provide you with an insight that is missing out there when it comes to Momentum.

I have been part of markets for more than two decades now and there isn’t a stone or a strategy I haven’t tried and mostly failed in an endeavor to find “The One” J. From Value Investing to Intra Day, from Forex to Coat Tailing, from futures and options to exotic options, there are very few things that I haven’t tried out.

The key to success as I understand comes down to your belief and knowledge of the strategy you implement. Borrowed conviction or strategies may give you a high once in a while but more often than not, will eventually knock you down.

Thanks to Mohnish Parabai, Coat Tailing has emerged has a very interesting strategy that can be applied in the markets. But unless you actually buy in the same proportion as the person you are coat tailing, your returns will be very diverse from the one whom you are attempting to replicate.

I believe in experimenting in markets – yes, it can turn out to be expensive but it also provides you with immense know-how and understanding of what works and what doesn’t.

The foundation of progress has come through Risk bearing Experiments. Not all experiments end up successfully with many would be inventor getting killed in the process but for those who did survive, rewards were many fold the effort.

Risks in finance on the other hand are much more subtle and unless one takes risk that is multitudes of what he can afford, very rarely does one end up being killed. Yet, investors love being part of the herd than try to plot their own path.

The greatest appeal with following the herd is that if it fails, one knows that one is not to blame for everyone fell in the same ditch. In the mutual fund space, it’s not very different with most fund managers sticking to the known devil than the unknown angel.

Blind bets aren’t experiments, they are death wishes and most likely destroys not just investors’ money but also confidence. Confidence once destroyed is tough to regain. The worst thing though is that we take all the wrong lessons from a debacle that was at best just an error in strategy.

In 2017, I started my Journey on yet another strategy – a strategy I was intimately familiar with and yet one that I had ignored for too long – Momentum Investing.

I have been a fan of Trend Following / Momentum for a very long time. I have talked on the subject to anyone who gave a willing ear, have written a lot about it and delivered a few talks as well. Yet, it took a catalyst in the form of joining Capitalmind to finally be able to put it into action.

Unlike other forms of Investing, Momentum Investing can be tested rigorously using historical data. There is no narrative fallacy out here though it’s easy to get trapped into one of the many other fallacies that trap quantitative based investors.

Momentum also better known as Trend following is generally seen as Speculative in nature for stock is picked with no reference or understanding of fundamentals. But fundamentals of a company are just one part of the equation – the bigger part is played by human behavior which gets exhibited day in and day out and one responsible for the wild swings in stock prices.

Efficient Market Hypothesis was for long the most important pillar of how markets valued stocks and why it was tough to generate, adjusted for Risks, out-sized returns. While the booms and busts have meant that markets may not be really efficient, to me, they just showcase that markets are efficient in the long term but swing around in the short to medium term.

It’s these swings, Momentum Investors wish to capture. While it’s nice to think ourselves as owners of businesses just because we hold 1 share out of a Million issued by the company, the fact remains that you are just a passenger in the bus with the direction and decisions taken by a few men, the bus owners, with little regard to what you may think about those decisions. The only action you can possibly do is get off the bus – but like the proverbial picture that has been seen by millions, what if you are giving it up just before you would have hit pay dirt?

As a momentum investor, our focus is more on the behavior aspect of the markets. We would rather be part of businesses where there is action, in terms of price, than one where we need to wait a long time before the action starts – or in many a case, wherein action never starts and we quit in disgust.

On any day, on an average, around 2000 companies trade on the twin exchanges in India. As an investor, you need to build a portfolio that consists of less than 1% of the said companies.

Of course, not all are great companies run by great managements that can generate strong risk adjusted returns for the Investor. Even if we were to assume that just 20% of the companies are companies that will generate returns for the Investor, using the Pareto Principle, we are still left with 400 companies to choose 20 to 30 stocks that shall form the core of our portfolio.

Take any factor and the thesis they offer is simple – How to come up with a small list of companies to invest into. You can base it on the philosophy you follow – call yourself a Value Investor, a Growth Investor, a Quality Investor or a Momentum Investor, your aim is to prune down the list to the best 20 – 30 companies.

It’s tough to do that would be a massive understatement. Assuming a portfolio of 30 stocks, for every company you choose, you are in affect ignoring the potential in 29 companies and some of those you ignore will generally come to bite you back by showcasing returns way better than the one you have chosen.

In other words, you need to reject 98 to 99% of companies whose shares are available for trading and invest in the 1% you feel are the best ones around.

But the Nightmare doesn’t end with the Selection of Stocks. In fact, it has only just begun for what would be a real roller coaster of a ride if only you are able to sit through the same.

Once you have selected a stock, the next big question comes in terms of “How much to Invest”. Invest too much and you could be burned brutally for the trouble, Invest too little and even the best of picks will not move the needle by much.

Investing is nothing like, Fill it, Shut it, Forget it. To maintain a balance, you need to keep filling it up as you move along your life trajectory while at the same time being able to shut yourself to the volatility that shall always be part and parcel of your investment.

Strategy and Tactics:

The thought process behind the selection of stocks was simple. Identity stocks which gained in price without volatility or rather, had very low volatility in relative comparison. In other words, the stocks picked-up had the highest Sharpe Ratio.

Strategies in Momentum needn’t be complex requiring use of Calculus or any other the other mundane mathematics most of us felt relieved when it ended post School. While this strategy does require some calculation, it’s not really complex given the resources that are available on the Internet.

The strategy was initially tested by my good friend and colleague Venkatesh and was further refined over time with the help of my Mentor Sameer. While markets are yet to encounter the kind of volatility we saw in 2008, I believe that the knowledge of how the strategy works and where it can fail alone can help an investor (in this case me) be better prepared and act on the plan without having to deviate.

The strategy was run on NSE Stocks (most good liquid stocks are on NSE and the few that are part of BSE alone, I am happy to miss out) with every month seeing a few stocks getting replaced. Other than once or twice, more due to accident than a plan, the strategy was always fully invested into the market at all times.

I started this strategy in May of 2017 and since then regularly added more money every month at the time of rebalance. For someone who isn’t a great believer in blind systematic investing, this was indeed a interesting excercise.

The strategy is Equity only – there is no cash component embedded. The Equity Debt Allocation mix was dictated by the Portfolio Yoga Asset Allocator (though I am guilty of not entirely sticking with the recommended dosage).

The churn has been incredible – over the last 12 months, I have had positions in 105 stocks though at no point was the portfolio greater than 30 stocks. This excludes the fact that some stocks made an entry and exit more than once.

To provide a granular view of the returns, here is the data plotted as in Mutual Fund. NAV started at 10 and is currently at 16.92. Nifty Small Cap 100 Index was taken as benchmark given the high correlation this portfolio saw with the Index.

While the strategy has done wonders, one needs to be aware of the fact that “One swallow doesn’t make a summer” and it would need much more data and time to make a comprehensive case that investing in Momentum with all its pains – paying short term taxes / excessive transaction costs can still provide for returns better than what you can by buying and sitting on an Index.

Momentum Investing returns aren’t out of the world. Academic evidence shows that its returns are comparable to one you can get by following the Value Investing methodology.

Returns though come with a big “IF”. If only you actually understand can you really devote the kind of money and time to make that difference can you reap the rewards as well.

This brings an interesting question: If the strategy was sold as a Service, would investors have reaped similar returns?

Momentum or Value or Growth or any of the major styles of investing is all about being different. This doesn’t come easy for it runs contrary to our beliefs and knowledge. This kind of thinking is not tough to develop but takes time and effort.

Mutual Funds are a Fund it and Forget it type of investment and yet even there, Investors generate much lower returns as a whole that what the fund itself has generated. In Do-It-Yourself kind of investing, the resulting returns can be even worse since with execution resting on your emotions, there is no giving as to whether you would stick in the good times, forget the bad.

Risks:

While there is no fundamental filter that is applied, I have using other measures in an attempt to limit entry of stocks that are of suspicious nature. But that doesn’t meant that we can get rid of all the bad stocks as experience told me.

One of the stocks the strategy invested was Vakrangee and when the sword fell, the portfolio was a sitting duck and lost 50% on the stock before it could get an exit. The only saving grace, the Investment had doubled by the time of the peak and hence even at time of exit, the damage itself was minimal.

Since the portfolio consists of a diversified set of 30 stocks, a couple of Vakrangee while causing heart burn cannot seriously damage the returns for their total allocation would be on the lower side.

Drawdown:

Any and every strategy will have its draw-down and my belief is that this will be close to the Index it benchmarks against or a bit more.

Why others don’t do it

The fact that a factor such as Momentum Exists and can be profitable over the long run isn’t new. The first comprehensive research was put out by Jegadeesh and Titman in the year 1993 (Returns to Buying Winners and Selling Losers:Implications for Stock Market Efficiency). Unfortunately for strategies to get a following you need more than academic evidence – you need practical evidence.

Value Investing may not have got the kind of following it has if not for the performance of many a manager who follows the methodology and has cleaned out his competitors. And then there is Graham and Warren Buffett. One does wonders what would have happened if Warren was swayed by something else than Value Investing?

Momentum on the other hand has barely much of a following. One of the oldest funds out there following a systematic momentum strategy would be Dunn Capital. But despite being around for 44 years, its total Asset under Management is just around a Billion Dollars.

Momentum faces the same issue like Small Cap Investing – more the capital, tougher it is to generate returns similar to what historical testing would showcase. Add to it the fact that most countries tax based on duration of holding and until recently, India had zero tax if you held a stock for more than a year versus paying 15% for short term gains.

Thankfully this spread has now been reduced to just 5% with Long Term Capital Gains too being taxed from this year onwards. Tax Arbitrage is now no reason for holding a stock even when the trend has turned bearish. But without a systematic strategy, not knowing when to get back in can have an negative impact too.

While there are a lot of closet momentum investors among fund managers, but I cannot spot a single manager who will talk about Momentum being a factor in his investing arsenal. There is just a lot of negativity by those who do not really understand and lump momentum trading with everything from manipulation to intra-day trading.

A bigger fear among investors is that somehow larger churn means that there is a bigger risk. In my testing and experience, Momentum Investing carries the same risk as any other strategy – maybe even a bit more but not suicidal risks. But risk is never known beforehand – its only ex-post.

In 2008, many Balanced Mutual Funds fell very close to what the Nifty had fallen despite the whole strategy being one of risk reduction at the expense of returns. Investing is always risky – what one needs to analyse is the magnitude of risk and the probability of recovery if one stayed the course.

Momentum has one big negative though – the inability of us to provide a Narrative as to why a certain stock was picked up. No Cinderella or Alice in the Wonderland stories about how great this stock is, how big the potential is, how cool the management are, how niche the industry is and hence how big their moat is.

When the system picked up Carbon / Electrode stocks across the board, it was not because the system was able to understand the international ramifications of the war on pollution in China. Or in case of Venky’s , it was not because the system felt there would be a positive impact of the Beef ban (or was that just a story without real substance I wonder) on the price of Chicken Feed / Chickens and Eggs.

These stocks were bought because the frickking momentum formula used to identify asked us to buy – nothing more, nothing less. Similar is the story when a stock moved out – it may and very well be a good stock to hold, but with hundreds of other opportunities out there, why stick with something that isn’t working for now.

In my own trading, I had a couple of interesting such times.

The system first picked up Venky’s in the very first month – May 2017. In June, with a month gone and nothing to show, the stock was thrown under the bus.

By August, the stock had shot up, nearly doubling from where the Initial entry was made and once again came into the radar and got picked up. Buying the stock that was sold nearly 50% lower is tougher, but systems have no emotions and stocks are picked up purely based on the logic that has been coded.

Since its entry, it once again doubled showing that missing out is not the biggest of crimes, it’s not getting back in even if it’s at a higher price that can turn out to be costly.

Can the Returns be sustained?

Its feel great to beat the markets and generate strong returns, but the reality is that this is not possible to do over the long term.

As Wes Gray of Alpha Architect fame wrote

“An investor might have an epic run of 20% returns for 5, 10, maybe even 15, or 20 years, but as an investor’s capital base grows exponentially, the capital base slowly becomes ALL capital, and all capital cannot outperform itself!”

Styles and Allocation

Momentum is a great strategy and one that can absorb quite a sum of money, but great rewards come with risks that one may or may not be able to digest.

For a while I have been having discussions and thoughts about how much of one’s equity exposure should go to Momentum. Is 100% too large or is 10% too small is a question to which I have absolutely no real answer, I think the real answer like a lot of stuff in life lies in the middle.

As much as each one of us would like to maximize our returns, the fact is that when it comes to crunch situations, we do not really know how we shall behave.

Momentum is one of the many Styles of Investing that has shown to generate Alpha. More styles would mean more work, but since most styles differ and offer very little correlation to each other, in the end, they offer you the ability to invest more in the markets than what an asset allocation matrix would dictate and yet sleep peacefully at night.

As the above data table from factor research shows, each factor has very little correlation with the others and if you can build three to four different portfolio’s, each confirming to one style, you should be able to get a good night sleep and a pretty decent return despite your portfolio consisting of a 100 different stocks.

In their book, Your Complete Guide to Factor-Based Investing: The Way Smart Money Invests Today by Andrew L. Berkin & Larry E. Swedroe, they recommend an Equal Weighted portfolio of 4 factors – total stock market (for beta), size, value, and momentum.

While this can reduce returns, it reduces risk while diversifying portfolio across multiple stocks which ensures that a fraud or a scam in one stock has barely any impact on total returns. Diversification is not a free lunch for concentrated positions can clearly provide higher returns – but the risk as Bill Ackman found in Valeant Pharmaceuticals can be very high too.

At the moment Momentum Investing is a Do it Yourself program. But in the future, there will be funds which will deploy based on philosophies other than just Value which is the dominant style of investing today. Its just a matter of time as more Academic evidence piles up showing the benefits of having Momentum as part of your portfolio.

A deeper look at Liquid Funds

Equity Analysis they say is complicated and yet I find Debt to be more complicated than Equity. Maybe this has more to do with the fact that much of my experience in finance markets has been with Equity compared to Debt.

In Equity Markets, I believe in applying my skillsets using Quantitative methods than Qualitative which can lead to Bias. In Debt, doing the same led me to errors that were realized when people who eat, breathe, and sleep debt pointed out that analysing Debt the way I was doing was error prone.

For much of the older generation, Debt meant one thing – Fixed Deposits at Bank and Post Office. Over time though, Debt Mutual Funds have come with options to invest in a wider variety of instruments – from short term Commercial paper to Long Term Government Treasury Bonds.

Trying to understand Debt from the same lens as Equity is futile. Equity, especially once you eliminate low liquid stocks, can be compared against one another using methods such as Sharpe. Sharpe ratio penalizes for Volatility and this is a good framework when tackling stocks where all other things being equal, you would want to buy a low volatile stock versus a high volatile stock.

The same in Debt would lead to wrong results. An illiquid low quality bond may not trade as much as a liquid high quality bond resulting in Sharpe being higher for the fund that holds the low quality versus the other fund.

With nearly 42% of total assets under management in Debt funds being in the Liquid category, this static alone makes it very important to understand it’s working. Add Ultra Short Term and Short Term to this, and we have 80% of the total market out there.

Fixed Deposits are the deposits of choice for vast majority of investors. But over time, the way Interest on Fixed Deposits is taxed compared to Debt funds have made them unattractive other than for Senior Citizens whose Income may not come into the tax bracket.

A secondary risk is in terms of locking of Interest Rates. Currently SBI pays an Interest of 6.50% on Fixed Deposits with term of 2 years or greater.

While this may be good in times of falling interest rates, this lock in can yield sub-optimal returns. For Corporates who have large cash flows, the differential is even bigger since Current Accounts pay nothing. Just investing for the weekend can for many of them provide enough returns to make the task worthwhile.

So, how does one go about Analysing funds?

Investor’s key reason for being fixed on Fixed Deposits is the Risk of default. Most are happy with lower returns than take the risk of default that can wipe out a permanent capital.

On 22^nd February 2017, Taurus Mutual fund’s Taurus Liquid Fund dropped a massive 7.2%. The reason for such a large drop was the Default in Bonds of Ballarpur Industries.

To understand how large that drop was, it was enough to wipe out One year of Gains. Anyone who invested in the fund just before the incident would have seen his fund value come back to square one nearly one year after the said incident.

In September 2015, JP Morgan, a biggie in the world of Fund Management had its own fiasco as exposure to Amtek Auto led to two of its funds taking a hit on the NAV.

Liquid Funds which invest in securities with maturity less than 91 days are seen as equivalent to cash – ultra safe. While Taurus fund showcased the risks of even Liquid funds, such instances have been rare and far in between.

For fund houses that manage large corpus of funds, any such default is a death knell since it tarnishes the trust that is required. JP Morgan for instance bowed out of the Mutual Fund business shortly thereafter selling it to Edelweiss.

As Warren Buffett once said,

“It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.”

So, how does one go about Analysing funds in the Short Term to Liquid Fund stable?

Looking under the Hood – The Portfolio:

The key to understanding the Risk taken by a fund is by diving deep into the portfolio it owns. It’s not an easy exercise either as lot of firms borrow using the subsidiary route.

The above chart is the Sector Holding Chart of Aditya Birla Sun Life Cash Plus, the largest fund liquid fund in India. The fund holds 171 different securities and while a cursory look seems to indicate no surprising entries, it’s really requires time and effort for a retail investor to really understand whether there are any unkind surprises lying out there.

Now, let’s look at a fund I like (Disclaimer: I have no financial interest in Quantum) Quantum.

While it’s true that this fund size is a miniscule of the bigger one, this is much easier to understand. The only risk out here is Sovereign.

When it comes to Risk, Generally smaller firms are willing to take a larger risk versus large firms which wish to stay away from unnecessary risks. In the field of finance, one’s ability to draw assets lie from performance and how can one perform without taking a bit more risks that can pump up the overall returns.

A 2012 study by Marcin Kacperczyk & Philipp Schnabl of Leonard N. Stern School of Business, New York University came out with some interesting findings on

Funds had strong incentives to take on risk because fund inflows were highly responsive to fund returns.
Funds and other financial services took on less risk, consistent with their sponsors internalizing concerns over negative spillovers to the rest of their business in case of a run – Remember the JP Morgan Episode. One bad call and the fund essentially shut shop.
Funds sponsored by financial intermediaries with limited financial resources took on less risk, consistent with their sponsors having limited ability to stop potential runs – Quantum being too small a fund for example may be a reason for them not to take risks verus bigger funds which having the backing of their parents can take a bit higher risks.

If Portfolio Analysis and probable implications is not our cup of tea, what other data can help us chose the better fund?

Size of the Fund House:

Rare are the times when a big fund house decides to let a bad investment call impact investor returns in funds such as Liquid. JP Morgan proved an exception to that rule and paid the price. A Birla or DSP or Franklin on the other hand wouldn’t like to damage their credibility by allowing pass through of bad calls.

But that would also mean as Buffett wrote in his recent annual report,

“Charlie and I never will operate Berkshire in a manner that depends on the kindness of strangers—or even—that of friends”.

JP Morgan is one of the largest financial firms in the world and yet they decided to let the investors suck it up. In case there is a default by a large firm, how ready or willing would be the fund houses to take the losses on their books?

Return & Expense Ratios:

Should an investor aim for the highest return or the lowest cost?

As the President of a Large Fund House said

“Ideally, seeking alpha in liquid fund is a fools game as this category can’t generate alpha by design and mandate”

While Expense ratio is definitely something to be looked at, it cannot be looked at in a isolation. Bigger funds for instance can easily cross subsidize their products making some cheaper than the rest – all in an attempt to be the largest asset managers in town.

Amfi data reveals that Individual Investors comprise a very small part of the Assets under Management when it comes to Liquid Funds. It would been interesting if we knew the percentage of funds invested by Individuals in Liquid + Ultra Short Term + Short term funds since these not only makeup 80% of the Assets under Management but also aren’t as easily impacted by Interest Rate changes as longer duration funds (Medium Term / Income Funds, Gilt Funds, etc) are.

Large companies are able to ascertain risk and rewards on a granular level and constantly be in search for the better option, for the smaller investor, its better in my opinion to be safe than sorry. Unless you think you can decode compex portfolios, the simplest ones generally end up offering the highest peace of mind.

Do note, that you can always bump up returns by proper allocation between Debt and Equity than trying to squeeze the last rupee out of any fund.

Thanks to Yamini Sood and Kalpen Parekh who provided me with perspectives and context on how to analyse debt funds. Being an Equity person, understanding and learning about Debt from people who are in the business for decades is immensely helpful.

Running out of Options and Money

Aircel was recently in the news for being the latest telecom operator to go under as it filed for Bankruptcy with 15,500 Crores of Debt on its books. In its statement, the company said it was forced to file for Bankruptcy owing to intense competition following the disruptive entry of a new player, legal and regulatory challenges, high level of unsustainable debt and increased losses.

“Unsustainable Debt” is another word for Leverage. While the business model may have changed over time, what ultimately caused its demise was that its Leverage ratio was just too high. In stock market parlance, that would be – the broker made the margin call and I had no more money to invest.

Aircel was a Private company and hence we may not know the exact leverage ratio, but we know of Leverage ratios of a host of companies that are either close to or already bankrupt.

As of 31^st March 2017, Bhushan Steel where NCLT is preparing to auction the company to the highest bidder had a Negative Equity + Reserves and a Large Debt. Interest pay out was 35% of Sales – Sales. Not of Profits.

JP Associates situation wasn’t so bad, but with Leverage of 10x, there is no way the company could have continued to operate without huge infusion into capital.

There are literally hundreds and thousands of companies that are doomed to survive thanks to their overwhelming debt – most of them being small private companies fly under the public radar and are noticed only as a line item when the Bank decides to write off the debt.

RBI said that total Non Performing Assets hit 7.34 Lakh Crore at the end of September 2017. Lest you get confused with the repetition of Lakh and Crore, the NPA figure RBI put out is Rs.73,39,74,00,00,000

To put that number into context, that number is bigger than the Annual Budget Deficit of the Union government. Yes, Banks have lost more money (or are close to losing since not everything is a 100% loss or has been totally written off) than the additional expenditure government thinks it will spend over its Income.

Traders in many ways are like the companies that raised debt hoping for a glorious future where one can drink a Beer and trade for a living, living off the beaches of Goa.

Trading, like every other business is capital intensive. You need a certain amount of capital to be able to try and live off the earnings. Unfortunately, unlike any other business, a trader doesn’t get bank loans.

This means that a trader has to come up with enough money on his own to be able to trade the position size he wants which in-turn hopefully will like a ATM machine can be used to withdraw money anytime there is a need.

Traders and our Dreams.

Dreaming is one, but how do you find enough capital to make it a worthwhile strategy to execute. I have in the past written about how much a trader should have as his capital before he even places a single trade and that number isn’t small.

Thanks to the Brokerage, Taxes and what not, Trading is a Negative Sum Game. What his means is that not all the losses of the losers go to the Winners. Brokerage and Government fees mean that winners do not get all that is lost by the losing party.

Yet, the appeal of trading using Leverage just doesn’t go away. While in the earlier era, we had Badla system where a financier would finance your positions for a price, now we have Derivatives where with a small margin you can get a large exposure – large enough to either make you or break up depending upon which side you end up when the move happens.

Leverage kills – be you an Industrialist or a small time Trader – longer you are holding the ball, higher the risk that someday will be your last day.

Selling options (with the hope that they will expire worthless) is a strategy followed by many. After all, if a large (60% to 90 %, depending on source of data) of all options expire, the seller is always having a better hand compared to the buyer is a argument I have heard often.

In his latest Annual Report, Warren Buffett makes an interesting point about avoiding leverage or rather over-leverage.

Charlie and I never will operate Berkshire in a manner that depends on the kindness of strangers – or even that of friends – Warren Buffett

I was reminded of the above quote when someone posted a tweet which read

There are two enemies for Option seller:

Huge Gap up or Gap down.
Huge two way move.

Both happened today and lost 6 months profit.

End of day to End of day, the day when the above tweet was made, markets didn’t crash by any significant measure. Yes, it was a volatile day, but by the end of the day, markets were slightly lower but not one that was of any unusual concern.

And yet, the person above had lost 6 months of his profits. 6 months for one day’s move. This guy is not an average investor or trader. His Bio reads and I quote “stock market expert with more 25 years’ experience in the industry.”

Long Term Capital Management was a firm founded by those day’s who and who in the finance industry and the results of the first four years showed the level of calibre as they delivered outstanding returns with very little volatility.

And yet, one bad stroke of luck and voila – the Federal Reserve had to step in to bail them out with every investor invested in the fund losing out on 100% of capital.

The attraction of trading options / futures is tough to deny. Where else do you hear about doubling capital in a month, generating good cash flow month after month among other stories.

But not everyone is suited to it and even those who think they are suited, there comes a time when they realize that they weren’t really ready. But then, that realization more often than not is realized after the Horse has bolted the Stable.

It’s one thing to be a rookie and get killed and quite another to think of one as a Ring Master and yet get killed by the very Lion one assumed had been tamed. Markets are wild; there is no taming it one way or the other. If you are exposed to risks that you aren’t prepared for, getting killed is a very real possibility.

Shortcuts, Experience and Expertise

I am not an expert in programming or technology. But technology in itself has evolved to such an extent that anyone can put up a website on his own without the attendant needs of learning to code programs with such exotic names such as Python (Snake), Ruby (of course, what can it be but a stone), C (character in English) among many others.

But as a very good friend of mine who also happens to be an expert in programming and infrastructure at systems says, the tougher part is not the programming but the maintenance of that website.

I personally am learning that first hand as this site repeatedly encounters issues that happen right at the time I am thinking of writing something or have posted something I loved writing on. It’s disappointing to get into a situation where you are ready for the visitors but the visitors are stuck because the elevator has a load issue.

So, what does that have to do with finance you may be beginning to wonder.

Well, in many ways, Finance, especially investing in the stock markets – directly or in-directly has become a whole lot easier than it was say a couple of decades back. When I got interested in technical analysis for example, getting data and the software that could plot the charts was the biggest challenge.

Today, a whole lot of sites provide for free what couldn’t be got for a price then. Exposure has also brought about a better understanding of markets and finance for the current generation compared to say the generation just above us.

Yet, as this cartoon clearly tries to convey, it’s one thing to know history and yet another to see while others fall into similar traps that one has experienced earlier.

An Engineer is certified after four years of rigorous training, a Doctor after 6 years, Lawyers after 5 years, Stock Markets Experts on the other hand – we don’t need that rigorous training for we are all self-certified.

This is not due to lack of Certifications – CFA – CMT – CFP are the top recognized in the Industry but given that these again are self-study courses and there isn’t a legal requirement to have such a certification, why even bother.

SEBI does require passing of exams if you want to be a distributor to Mutual Funds or become a Registered Investment Advisor but are in no way comparable.

Then again, Education in no way is really the determiner of success. As Warren Buffett put it wonderfully

“Investing is not a game where the guy with the 160 IQ beats the guy with a 130 IQ. Rationality is essential,”

Bull markets like the one we are currently in makes investors think that miracles do happen every day. Access to advisors who promise the moon only means that most become blind to the reality of what markets are all about.

Among factor investing, two key factors that stand out are Momentum and Value. Both require different style of thought process to be able to stay the course. Value requires a great amount of patience as you need to wait first for the opportunity to crop up and once you find a opportunity, for the market to recognize.

Momentum on the other hand requires you really ride the tiger, keep getting chunks of you eaten up and yet wake up every morning ready to try and ride another tiger. In short, if gut crunching volatility will not scare you, you should do well.

But these cannot be learnt by reading a couple of books or hearing to a few podcasts. Yes, they help provide you with the right context, but when you are down 30% or 40%, it’s not the bookish knowledge that drives you as much as the fear of losing everything you own.

FOMO – the Fear Of Missing Out.

If you were a Value Investor, your biggest trouble is to maintain sanity even as you see every tom, dick and harry minting money out of thin air. It’s hard to maintain that conviction in the face of the constant pressure of missing out

History teaches us what many of us learn – mostly the hard way. The ability to understand our skills and match it with what works for us the best. You cannot be a great Lawyer if you cannot argue much.

When markets were climbing new peaks, along with the rush into Mutual Funds there was also a pretty strong rush into subscribing to advisories who claimed to have finally found the holy grail – lose less when markets fall while making a lot more when markets rise.

Even though the markets haven’t exactly started a bear run, there are already grumbling voices about how they were misled, taken for a ride among many other excuses that are bound to be seen when one is caught on the wrong foot.

Reminds me of this dialogue from V for Vendetta

“Well certainly there are those more responsible than others, and they will be held accountable, but again truth be told, if you’re looking for the guilty, you need only look into a mirror”

The reason Real Estate or Gold was and in many ways still is the preferred way to invest large sums of money was that it required no real knowledge other than some simple guidelines. But those easy options are gone.

Markets are unforgiving and yet if one doesn’t invest much, he cannot escape the daily routine that he wants to get out of. But invest much and voila, suddenly you may find yourself in a deeper darker hole than you ever imagined.

Advisors in my opinion are like Psychiatrist’s. You need to go to them to find yourself. They can provide a good base for learning and understanding concepts and while they do advise to use them as they recommend, it finally your money on the line and who is a better judge of that than you.

Errors, Omissions & Commissions

The downside of strategies comes to the fore both at the best of time and the worst of times. At the best of times, the risk that suddenly pops open is disregarded as a one off incident that doesn’t entail much significance. But when similar kind of risk opens up during the worst of times, it generally is the last nail on the coffin of the strategy.

One of the stocks of my portfolio until recently was Vakrangee. Like any other stock in the portfolio, this was chosen based on just one Criteria – Momentum. And for a time, it did wonderfully indeed. While buying using a systematic plan took the average buying price higher than where I had started accumulating it, at its peak the stock had doubled in value.

All good things tend to end and this wasn’t any different though the violent ending it faced meant a bit of heartache as one saw the profits dwindle even as Exit was impossible, thanks to the stock circuiting at the lower end every day. Finally, I was able to come out at the same price I entered – tough in terms of the opportunity cost, but no damage to the portfolio.

But its instances like these that make investors worry about whether Momentum is really a good strategy for the long term and for larger capitals.

On the other hand, if I were to be trading the same system in 2008 / 2009, one stock that wouldn’t have been a part of my portfolio would be Satyam. Or for that matter, Punjab National Bank which has cratered 33% in this month alone hasn’t been in sniffing distance of getting a entry into Momentum portfolio.

Beating the benchmark Indices isn’t a piece of cake – big time professional fund managers are having a tough time beating the Index they benchmark against year after year. Active Investing requires one to beat the benchmark if only for the reason that there is no point in wasting time and energy if your returns could be generated by less action – by buying an Index fund for instance.

Concentrated or Diversified Portfolio is a question that has bothered many a brilliant mind. While Concentration can help if you get things right, Diversification ensures survival when things as usually they tend to do – go wrong.

In the latest Berkshire Hathway Annual Report, Warren Buffett writes and I quote

“Charlie and I view the marketable common stocks that Berkshire owns as interests in businesses, not as ticker symbols to be bought or sold based on their “chart” patterns, the “target” prices of analysts or the opinions of media pundits. Instead, we simply believe that if the businesses of the investees are successful (as we believe most will be) our investments will be successful as well. Sometimes the payoffs to us will be modest; occasionally the cash register will ring loudly. And sometimes I will make expensive mistakes. Overall – and over time – we should get decent results.”

As much as we would love to think ourselves as part owners, the truth is that you are not. Anyone and everyone who has held any share for any part of the company is part of a business. But it’s the Management who are the real owners – be they holding 100% or 10% for finally it’s the way they run the company that determines how (in the long term) good or bad your investment can turn out to be.

When you as an investor think of a company as “your company” and as many an analyst talk to the management of companies by using the word “our company”, you are setting up for disappointment.

When it’s time to exit an investment, the illusion of control and knowledge can make it more difficult to make the choices you would have made in the normal circumstances.

Momentum Investing comes with the same risk as Value Investing – nothing more, nothing less. But once that risk opens, how you deal with the risk is what it all matters.

Momentum Investing – Sin or Strategy

Ambhimanyu, the son of Arjuna had knowledge of entering the Chakravyuha but not the knowledge of coming out. This ended up with him getting killed and while the story being one of good and bad tries to magnify how the bad came together to kill him, the point that is missed is that he knew when we went in that he did not know the way out.

Investors in markets are in many a way Ambhimanyu’s . They know how to enter and hope that somehow they can exit before getting killed. But then again, the bad guys (Brokers, Operators, FII’s) all gang up and kill the poor little investor and snatch his monies.

Momentum Investing has its non-believers but I was kind of astonished to see that in a Document brought out by the Library of Congress whose ideas seem to be subscribed by the SEC (US Equivalent of India’s SEBI), one of the 9 sins they lay out which derail investors is “Momentum Investing”

The biggest misconception in my opinion about investing is that the style is seen to be dictated by the price move rather than knowledge of the style. Just like buying a stock that is falling doesn’t make one a Value Investor and Buying a stock that is going up doesn’t make one a Momentum Investor though it may seem to be very close to the idea.

The key to success in Momentum Investing is not about Entry but about Exits. A Momentum Investor exits a stock that stops seeing positive momentum – whether this is temporary or permanent is time will tell.

A common misconception is that Momentum Investing is about buying stocks regardless of whether they are fundamentally strong or not. But the irony is that rather than we being the deciders on whether a company is good or not, we allow the other participants through their actions dictate whether a stock A is good or not. What could be more democratic an idea than that?

I am a momentum investor and yet there are quite a few stocks that are having the strongest momentum yet not part of my portfolio. Momentum Investing doesn’t need to be about just blindly buying stocks that have gone up the most.

Look at the table below – these are stocks that have the best “Momentum Score” if you used a long term look back. If your portfolio has such stocks, are you a Value / Growth Investor or a Momentum Investor?

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Strategy and Tactics:

Risks:

Drawdown:

Why others don’t do it

Styles and Allocation

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Looking under the Hood – The Portfolio:

Size of the Fund House:

Return & Expense Ratios:

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