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Opinion | Portfolio Yoga - Part 4

Category: Opinion

An Update on the Markets and what to Expect

The following is part of a note written to subscribers. Sharing the same here

It would not be an understatement to say this week was a tumultuous one for mid and small cap portfolios. While a small correction is not really something one should be worried about, the fact that the correction is coming after months of rise should make us pause and take a deeper look.

As I wrote in the Monthly Newsletter last week, our performance has been inline with the performance of the small-cap universe since the start of this rally in April 2020. Since the low in March 2020, Nifty Small Cap 250 has delivered a return of around 200% vs returns of 110% for the large cap universe.

This outperformance came with barely there volatility. But if history is any guide, this is going to change. 

One of the philosophies followed by Technical Analysts is Elliott Wave Analysis. This theory posits that markets move about in waves. Bull markets are divided into 5 waves while bear markets are divided into 3.

The theory has its faults but in the broader sense it actually showcases how Fear and Greed combined with economic cycles are seen in markets. While pure ellioticians use the strategy to try and predict to a precise level where the index shall go, I use it to get an understanding of where we are in a cycle and how the future could unfold.

The Wave 1 of a new cycle is always sharp, mostly surprising and one that sees investors mostly itching to get out versus getting in. If we were to take the move from the lows of March 2020 to today, it fulfills the first couple of requirements. The strong move up was a surprise to the best of the analysts tracking the markets. 

Let’s look at what to me are a couple of Wave 1 in action in the past. Do note that these may not match the purists who are more detailed, but my objective here is not to try and find where the markets shall end at but provide a context to the move and what we can expect in the forthcoming weeks / months.

The bust of the Dot Com bubble brought Nifty down 55% from the peak. While the Vaypayee led NDA government was in power, for the markets, it may well have been the Deve Gowda period – a period of absolute lacklusterness and low activity.

Starting in May 2003, the markets took off in a way that was reminiscent of the dot com bubble but was more broader than the previous avatar. From the low of 920, Nifty went up to cross the 2000 mark before the correction started.

The correction in itself was deep owing to the surprise fall of the NDA government with Nifty at the worst point being down 36% from the highs. The move up in the Indian markets wasn’t really independent. The S&P 500 Index too started to move from Mid March 2003 before topping out in February 2004. 

While the Indian Markets saw a deep correction owing to local factors, S&P 500 went more or less sideways though the direction was on the upside. 

The more recent move that can be categorized as Wave 1 in my view would be the one which started in March 2009. Was this as unlikely as that of 2003? You bet it was. The world was supposedly coming to an end and there was little that anyone could do.

From the low’s of 2009, Nifty Small Cap 250 rose by 235% over a period of nearly 1.9 years. To give a context, Nifty Small Cap 250 has risen by 223%.

2011 was a year of correction with Nifty dipping 30% from the highs while the Nifty Small Cap 250 dipped 45%. 

Corrections are important for they ensure that valuations which tend to go way high during bull markets get smoothened out in either time or price based corrections and from every evidence we have, we could be at the start of one such correction.

The breadth of the markets continues to remain strong. That is not surprising since no broad indices have even breached the 10% draw-down from the high water point. While Nifty 50 has made a new all time high even today, since mid February 2021, Nifty has been flat – what we call as a time based correction and is up just around 7% while Nifty Small Cap 250 is up 30%. 

This divergence is not sustainable and shall generally get closed out. But these could stretch too. The chart below plots the route differential between the Nifty 50 and Nifty Small Cap 150. 

While the end result is the same, the path they took has been different.  

Now let’s look at a time frame when the Small Cap for a while did better than Nifty 50, the correction in the Small Cap indices brought the returns to the same levels as Nifty 50 by mid 2018.

Now let’s look at the same comparison but much more recent

Most Momentum Multicap Portfolio’s tend to underperform when the broader markets are underperforming. We saw this between 2018 to around mid 2020 before the strong move from mid 2020 has more or less made Momentum the most chased strategy by retail investors today. 

There is no easy way out. One way would be to shift from a multi-cap portfolio to a large cap portfolio. This will reduce the risk though if Nifty crashes, there is no avoiding the same. While even the Momentum strategy will move to more of a Large Cap over time, past experience has been that draw-downs should be expected. 

Another way to reduce risk would be to cut down on the exposure to the markets. Asset Allocation is a wonderful way to reduce risk. But there is a trade-off. If the market continues to rise further, the pain of not participating fully can come back to haunt one to the extent that one makes mistakes at the first sign of opportunity.

Nifty continues to hit all time highs and the breadth remains extremely good. While wobbles such as the one we saw this week may suggest that we are closer to a top, it could also be an intermediate stop.   

Overall Corporate Earnings have come at either expectations or have done better. This bodes well for the market in the short to medium term. The risk though as Barry Ritoltz emphasized in his blog could come from a resurgence of Corona in the US. He wrote,

If we do not radically improve our Vax rates ASAP, the entire economic recovery and precariously positioned, somewhat expensive market is put at risk of a 20-30% crash. This one will not have the trillion-dollar stimulus and rapid recovery of the 2020 edition, but rather, will be long, slow, and painful.

Ritholtz

This is not to say that the markets will react. The data for now suggests that it may continue to move higher. But the moves in the broader market is starting make one wary. Could be a false positive in which case, mea culpa in advance.

Nostalgia of the Past

Do it yourself by investing while not exactly the flavor of the day has been gaining momentum. While smallcase and websites today offer a variety of portfolio’s to choose from, back in the good old days, Do it yourself meant Do it yourself. Starting from researching ideas to buying the stock and getting them transferred to your name, the investor of today has very little idea of the hassles faced during those times.

A weekly momentum strategy would have been unfathomable during those times. The delivery itself took 2 weeks if not more. Then you had book closures and record dates that required you to send the stocks to the company for transfer. If it was a great company, you would hopefully have them back in a month or so, with many others it was an ordeal following it up and finally getting it transferred.

Sometimes one was unlucky that the seller’s signature did not match with the company’s record. They would send back the certificate which you gave back to the broker who gave them to the exchange and who themselves handed the same to the originating broker. By the time you received the replacement share, remember not yet transferred to your name, it would be a month. Time really flew those days.

Markets for most part were sedate. Brokerage was high which led to a lower number of transactions and turnover. Information was scarce. With no Television to blast out the results the second they are out, everything came with a lag. 

Times have changed though. The regional stock exchange where I wet my foot had at one time nearly 300 members. Today barely 50 are active and even among them very few actually having client business worth talking about. 

Today, trading in markets has exploded, education democratized and retail itching to invest in stocks and securities. Oh, Zero Brokerage for delivery. Who would have ever dreamt of that couple of decades ago.

But human behavior hasn’t changed much. In 1999, we had a client who was a Chartered Accountant. Had some fantastic companies as his holdings. The IT boom was just taking off but he was not deeply interested. While one had no relative performance to compare on Social Media, one was relatively isolated from the happenings on the exchange floor.

As the rally continued, for active investors it very soon became tough to see clueless investors make tons of money while those who actually worked to identify good companies lagged. Starting in early 2000, he shifted his portfolio wholesale from the old economy companies to the new age. KLG System, Satyam are those that I remember buying for him. 

What was interesting was not just the change in his portfolio but change in his viewpoint on why these companies were worth even after having rallied a lot in recent months. The narrative he spun was more or less the creation of the print media in which many investors took up lock, stock and barrel.

Once the dot com boom exploded, we lost touch. While I hope that he did well post that mishap, experiences of other folks who saw the boom and bust though doesn’t give me comfort. The 2000 bust followed a long and sedate period which lasted until April 2003. 

Markets have never been the same. While the 2008 boom and bust is still new in the minds of many investors, the euphoria one saw in the dot com was something else. At the peak of the bubble, Bangalore Stock Exchange had almost 50 companies which were being traded. Very few exist today. 

The dot com bubble in hindsight was brought about by the easy money policies of the fed. Has anything changed today one wonders.

Thanks to the actions of Central Banks, Fed Primarily, Investors have been protected from a deep and long draw-down recession for a decade now. Can they get it wrong – well, history shows the mistakes of Japan’s Central Bank created the bubble and later the mishandling of the bust. A more recent mistake would be the ECB with countries like Greece.

As this post was being written, the Fed policy came out with its views. The low interest rate seems to stay for a while. When we are in a bubble, it’s not easy to imagine that one is living in a bubble. Are we living in one? I guess only time will tell us to be sure.

Active Investing is Uncomforting

Investors for most part want returns that are higher than what the market offers. But Investors also hate doing things differently from the crowd. There is a certain comfort in being part of the crowd – when they are happy, the investor is happy, when they are sad, the investor is sad. 

Owning a Value stock such as ITC is seen as a sin while owing an out and out Momentum stock such as Adani is seen as a Sin too. Between these two extremes lies the portfolio of most investors. 

Market rewards investors for both doing things differently as well as doing things the same as the markets. To do something similar to the market is easy – buy an Index fund. To do things differently though is hard. 

In the last one year, companies have gained in terms of market cap astronomically. Yet no group has gained as much as Adani. Motilal Oswal talks about 10x in 10 years. Most Adani companies achieved this in the span of just one year. Adani Enterprises, the parent company had a market cap of around 17 thousand crores last year. This year it’s worth 1.7 lakh crores. 

A Momentum Investor is expected to hold such stocks. The risk though is when stocks fall off suddenly and ferociously as it happened with Adani on Monday. While how the investor reacts to such events may be different, the Momentum Investor should be mentally prepared for the same.

A Value Investor faces a different kind of pain – the pain of the market not recognizing the true value of the stock for a long period of time. Adani Enterprise adjusted for the spin-offs it has seen in the past has had its stock price go nowhere.

The stock was trading at 115 Rupees in 2010 and was available at 121 during the recent covid crash. The 10 year CAGR at the lows was below 5%. Today the 11 year CAGR is at 30%. One year has made all the difference to the investor who was able to stick with the company.

We can argue whether the stock is a value or not, but good stocks can go through a long period of doing nothing before doing something extraordinary in a short span of time. In the past we have seen Reliance, Hindustan Lever, Nestle among many companies with similar trends.

There is this famous Martin Zweig quote,

“It’s OK to be wrong; it’s unforgivable to stay wrong.”

When does one know it’s wrong? The views one forms is mostly a form of resulting. Writing in her book, Thinking in Bets she says, Resulting  is our tendency to equate the quality of a decision with the quality of its outcome.

Momentum Portfolios for most part spent 2018, 2019 and half of 2020 without hitting the highs they saw in early 2018. How long does one give before deciding the strategy is wrong? 

Relative Returns are how most fund managers get judged. This brings to mind the famous cartoon

Returns of every strategy gets benchmarked to the returns generated by a broad based Index. The Index represents the opportunity cost to the investor. An investor choosing a specific factor is not choosing the same to try and maximize returns. Instead he aims to maximize his ability to deploy as much capital as possible in the strategy.

Twitter for me is a window to the world. Yet Twitter can be many a time unnerving. Value Investors ridiculing investors who believe in Quality. Momentum folks ridiculing Value and so on and so forth. 

Conviction cannot be built in a noisy atmosphere and yet there is no escaping the noise. Bull markets make it easy to build conviction. It’s the bear market that tests one’s conviction. 

Lately I have been testing with a few microcap stocks. Truth be said, the exercise is uncomforting given the knowledge that once the music stops, there may be no easy exit. But it’s fascinating from the angle to crowd psychology and behavior to not just observe but to actually take part in the madness.

As Shane Parrish paraphrasing Charlie Munger wrote

If you want to improve your odds of success in life and business, then define the perimeter of your circle of competence, and operate inside. Over time, work to expand that circle but never fool yourself about where it stands today, and never be afraid to say “I don’t know.”

Portfolio Management Services – understanding it better

At a time when Mutual Funds are seeing withdrawals, assets for Portfolio Management Service (PMS henceforth) are blooming. This even though Mutual Funds are better off when it comes to how one gets taxed as well as the fees. Mutual funds, even the active funds charge these days much lower than what the investor ends up paying at most portfolio management companies.

For the outsider – a Portfolio Management Service is very opaque. Maybe this is what gives them the edge – the exclusivity that investors demand after having achieved a certain level of financial well being. With the minimum investment of 50 Lakhs, its a signature investment of having arrived.

When SEBI introduced the concept of PMS, the spirit behind it was that high networth individuals would want to have professionally managed but personalized investment services. Before the arrival of rules, we did have brokers who acted as fund managers but without much oversight or transparency. 

Today there is very little personalization in reality with most fund managers offering the same model portfolio for all clients regardless of his or her requirements or risk tolerance. The only difference lies in their ability to have a higher concentration versus Mutual Funds.

The biggest bane for the HNI investor is that mutual fund managers are never available to speak to unless one is big enough to move the needle for the firm. On the other hand, many Portfolio Managers will be happy to meet investors and if the investor is big enough, willing to drive down to his place if required. Whoever said Money can’t buy everything evidently hasn’t worked in the financial services industry.

Analyzing a mutual fund is very easy. It’s easy to get access to the funds historical day to day returns, their monthly portfolio’s, the fund managers letters and ability to compare the fund with others in the same category using freely available screeners.

Analyzing a Portfolio Management Service on the other hand is so much harder. Almost all PMS companies are wary of any disclosure of the portfolio – not even the top holdings get disclosed. Returns on the website of the firms are generally (with exceptions) dated. 

Over a three year period, an investor could end up (markets being good and performance inline) paying the fund manager a few lakhs in fees. It hence makes sense to  invest some money and time to decide on whom to bet with and there is nothing like a good old one to one personal dialogue with the fund manager to convince you of the merits of your decision.

Websites like PMS Bazaar offer a way to compare multiple PMS providers but only if they have tied up with the company. As per a Business Line article, they have tied up with just around 100 firms which means that 250+ firms are outside their database. 

One can get the monthly returns from SEBI website where the same gets posted by the respective fund houses but until recently it was a single number regardless of the number of styles / strategies they were running. Also, did I mention the pain of trying to download data month on month for each fund house?

Returns of the past also need to be looked at with context of what is happening in the markets. In 2017, investors rushed to invest with small cap PMS funds only to get severely burnt as the markets rolled over.

Filtering down the list of suitable candidates with whom one wishes to invest is hard but essential for the next steps are time consuming. The key is to try and reduce the list of probable candidates to say 10 fund houses and then dig further.

So, how does one go about eliminating the funds one does not wish to invest into. For most investors, this process is by selecting only funds that are well known or have a large asset base or managed by a fund manager who they trust. 

This eliminates the majority but also eliminates good fund managers for the single reason that they haven’t grown big for their brand to be noticed. In the Mutual Fund space this doesn’t happen because of availability of data. 

Unlike Mutual Funds, we don’t have comprehensive data on how much of inflow is due to push sales and how much due to pull. While PMS is supposed to be for the discerning investor, there are still a lot of push based sales where the client takes the advice of the seller in deciding which fund he shall invest into. 

In its early days, PMS was sold only by Wealth Management Firms for their clients. Today selling PMS is something that is undertaken by a whole gamut of individuals. Then again, while one shall get  around 0.75% for selling a Mutual Fund, the fee a distributor gets for selling a PMS is much more liberal (some PMS share even the performance fee with the distributor who brought the client).

With minimum investing being 50 Lakhs (some PMS have a higher minimum), this for most would be a substantial investment. An investor faces two risks with any investment – the risk of an actual capital loss and the risk of an opportunity cost.

The risk of actual realized losses is easily spotted, tougher is to spot the opportunity cost. Benchmarking is one way to spot the opportunity cost. Beware though of using the wrong benchmarks for they can make an old person look young.

The best benchmark is not the Index but Mutual Funds. This is because other than for Large Caps, the other Indices suffer from a bias where their best stocks get removed frequently and thus limits their upside. The only stocks that are removed from Nifty 50 or Nifty 100 on the other hand are those that aren’t performing.

With very little if any disclosure of portfolio holdings, the next best step when it comes to analyzing a fund manager are his public writings – do note that not every fund manager writes a monthly or even a quarterly letter to clients and one that is provided to the public. 

To understand a company, the key is to go through a few years of Annual Reports. Similarly, one would need to go through a few years of the letters. The idea is to get an understanding of the philosophy of the fund manager  

The reason to read is that the investor would want to have a long association with the fund manager and that can only happen if the philosophy he talks about appeals to him. While returns are important, given the lumpiness of returns, the ability to stick with the fund manager during the bad times helps take advantage when the tide turns in favor of the strategy of the fund manager.

To better understand how lumpy returns can be, here is an example. A large PMS fund at the end of May 2020 had a 4 year CAGR of -1.60%. The CAGR at the end of May 2021 comes to 15%. 4 frustrating years were offset by one good year.

The only way to stay with the fund manager after seeing multiple years of gains being wiped out is only by having conviction both in the fund manager and the strategy he is implementing. 

Not all PMS’s can be compared for their universe could be different. While the majority of PMS go for the Multicap universe, some PMS restrict themselves to Large Cap or Small Cap. This is an important distinction.

Size Factor is a phenomenon where it is observed that mid and small cap firms in the long haul have a tendency to outperform large cap. This outperformance comes from the portfolio’s being more risky in nature and the rewards if captured are a prize for taking those risks.

While Mutual Funds are forced by law to be more diversified – Concentrated Portfolios is the biggest differentiation for PMS. Concentration in itself doesn’t mean a higher risk though the volatility would be higher. 

Finally, the elephant in the room is fees. Today, an investor can get an Index fund that costs as low as 0.20% of  investment. Active funds but Directly invested by the investor would end up being charged 1% approximately.

PMS follow 3 different styles of charging to clients. 

  1. Fixed Fee Only: The fund manager here charges a fixed fee on the total assets managed and the calculation is similar to how it is calculated and charged at Mutual Funds. This ranges from anywhere between 1% to 2.5% of your assets. 

The biggest advantage of a flat fee – it’s clean and easy know what one shall pay 

  1. Performance Fee Only: Rather than charging a fixed fee, some PMS firms offer to charge the investor a fee if they deliver above a certain hurdle rate. From the limited data I have, I have seen this hurdle rate being 6%. Given that until recently you could get 6% from a Risk Free Investment, this hurdle was in effect saying that if I don’t outperform the risk free, I don’t get paid. The way it’s calculated is that if a fund generates say 12% returns for the year, for an investment of 1 Crore and a performance fee of say 20% above 6%, you will pay 1.2 Lakhs (which is equivalent to a fixed fee of 1.2%).

The reasoning behind charging only a performance fee is to suggest that the fund manager will get paid only if he delivers for the client. While on the surface it seems logical, do note that in the long term, an Index fund has on an average delivered 12% returns. 

Lower the hurdle rate, higher the fee the investor will end up paying. In good years like FY 2020 – 21 when Nifty went up 66%, the fee would come to 12 Lakhs( or 7.2% of the total current value of the fund – post 66% appreciation on an investment of 1 Crore). This of course assumes you invested on April 1, 2020. 

While the investor will not pay any performance pay till the high water mark, if he were to exit during a drawdown, the investor would have ended up paying more than what he may have paid using the simple fixed fee route.

  1. Fixed Fee plus Performance Fee: Finally, there are funds that charge you both a fixed fee and a performance fee. The hurdle rates here are a bit higher but not that high that makes it tough to generate any performance fee in the long run. 

While this is how most Hedge Funds charge their clients, this is also in a way trying to maximize revenue for the fund manager at the expense of the client. In a good year like the one just gone by, the fee would easily be multi year fees for any active mutual fund. 

Performance fee in my opinion should be calculated on the Alpha generated over and above the opportunity cost. The opportunity cost would be what one would have chosen as an alternative investment. But there is no such model available as far as my knowledge.

In addition to the fees, PMS also passes on all incidental expenses that are directly relatable to your account such as Broking, Demat, custody etc. This can easily come to 0.4% and something to keep note of.

For the investor, the biggest difference is how one gets taxed with respect to gains. If one is investing for the really long term, say Retirement Goal, with a Mutual Fund one pays Zero taxes as long as one remains invested. In a PMS, it’s normal for the investor in a PMS to regularly pay capital gains taxes on profits books by the fund manager.

Depending on the holding period of the fund manager, this can dampen the returns substantially if there is a high degree of churn. It goes unnoticed for most until the time to pay the tax arises. But in a good year, one is already happy and he or she is unlikely to complain with respect to paying taxes for the investment has grown substantially too.

The biggest advantage of PMS is the transparency (once you are a client) with respect to transactions. You get to know each and every transaction which while may not be really useful in the larger framework , it can provide you inputs on the thought process of the fund manager.

Once upon a time, Stock Brokerage was a personalized business which allowed the broker to charge you 2.5% and then some more and yet have the client not complain. Technology rudely awakened that Brokerage is finally no different from any other commodity business and the friction costs have reduced to Zero.

With the advent of more low cost ETFs that cover a gamut of strategies and tech enabled platforms, my view is that managing one’s one money based on one’s own convictions will become easier. While managing money may never become a commodity business, over time fees should go down from what is seen as acceptable today.

A new concept that is picking up in the US is “Custom Indexing”.An interesting concept where the advisor or his client has the ability to modify the portfolio to suit their custom requirements. Patrick O’Shaughnessy has a podcast which is worth a listen (Link). 

FAQ on PMS by SEBI 

Building Wealth by Moderating Expectations

I recently stumbled upon a PMS that takes in their clients based on reference from people they already know. In a world where PMS managers are happy to give up as much as 100% of their first year fees in an attempt to get a client, this to me was astonishing. 

As I read more about them and also interacted with someone who knows them better, I understood that the reason lay in wanting to be sure the client understood and was aligned with their thought process.

When Warren Buffett started out forming his Partnership’s, he partnered with folks who I assume he knew enough. Even his reluctance to split his stock which recently exceeded the maximum digits Nasdaq system allowed comes from wanting to have shareholders who are  interested in long-term plays, who have extended investment horizons

Advisory is a tough field. Most advisors end up losing 50% or more of their clients every year and to just stay where you are one needs to keep adding more clients. Of course, like equity one has lumpy years like the one we are seeing today where the growth becomes lumpy and huge but they in my opinion are more one off. 

The reason is simple – most clients start out with the wrong expectations and when the expectations aren’t met, the thought is that it’s the failing of the advisor. In a way, the advisor has failed too because he / she was unable to provide a perspective on what to expect. 

Once in a while I get a call from a prospective client who wishes to sign up but isn’t really sure. The noise around Momentum in the last few months has meant that there is this assumption or unstated fact that you are missing out on something if you aren’t invested in a Momentum portfolio.

Nothing could be further from the truth and yet this silliness keeps going on everytime we have a good time with a strategy. ContrarianEPS had written this tweet a few years back 

Between 2018 to Mid 2020 (for almost everyone), there wasn’t much interest in Momentum even though the number of advisors continued to climb higher. The key reason for the lack of interest was the continued underperformance of the strategy vs the broader index – Nifty 50 / Sensex.

This changed in 2020 not because the strategy was bound to do well after such a long period of underperformance but basically because the market as a whole took off. Between April 1 2020 to March 31 2021, we had 460 stocks that doubled, 157 stocks that tripled, 72 stocks that quadrupled and the list goes on. This list of course is constrained to only NSE listed stock. BSE has a much bigger number. A 100% or more on a portfolio based on such data doesn’t really appear out of the world.

In his book, A Random Walk Down Wall Street, Burton Malkiel wrote “A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts. Well, last year, you could have just used a dart and come out as well as most of us Momentum Investors.

Since the Federal Reserve started its quantitative easing in 2008, life has never been better. Yes, there was 2011 and then again there was 2020 but every fall has made it seem like all it requires to be successful is stay invested and voila you get paid for the risk you haven’t taken.

While I am not a fan of looking at backtests in isolation, backtests provide a perspective that is not available elsewhere. From the kind of draw-down you should expect to how the strategy behaves in different environments, everything is out there for analysis. Yet, the focus generally comes down to Returns.

Momentum being a factor of the market cannot outperform the market itself. What happens post years like 2008 for example is hardly discussed or debated. The assumption for most part is that Momentum will escape some amount of damage by going into cash early.

While limiting drawdowns is nice, the question is how long it would take for real gains to accrue. My own back-test shows a CAGR return of 7% for the period from 1st January 2008 to 3st December 2013. That is 5 years during which the 30 stock portfolio bought and sold approximately 210 stocks. 

Most Indices did not even generate positive returns for the same period and in that sense Momentum definitely outperformed. If I fine tune the strategy, I may even get a higher number but I would be cheating no one but myself.

Value, Quality or Momentum are all good factors to be invested into. But real wealth is mostly accumulated through either Inheritance or Income from Salary / Business. Returns start making sense only after a long period of time. 

There was this quote that went around some time back 

Buffett made 95% of his wealth after the age of 65.

The statement is true though it ignores that by age of 65, he was really really Wealthy. That base and the continued high returns allowed him to grow his wealth even further. Without that base, he would have been one of the many fund managers who came and went.

Direct Investing can lead to better returns than what the market delivers but there is a trade off. First, there is a risk that you shall have a worse return too and second it requires a commitment in terms of time for both understanding as well as learning. 

Being prepared for the second is the key to success in markets for time is the greatest inhibitor to investment success. As I was writing this, a substack that came into my inbox had this data

“over $8 billion of leveraged collateral was liquidated from more than 775,000 traders by decentralized and centralized lenders”

This from the crypto markets which saw huge swings in the last few days. Basically nearly 8 Lakh trader accounts got liquidated because the accounts weren’t prepared to handle the volatility (and one which was not really out of the world for this has happened way too often in the world of Crypto). For many of these traders, it doesn’t matter if Bitcoin goes back to 100K, they don’t stand to gain anything.

From Mutual Funds to Advisory, the behavioral gap is well known and yet is the biggest stumbling block for most investors. The key reason to me is not because investors wish to chase returns (some do) but more so because the reality is different from the expectation they were sold into.

As Rudyard Kipling wrote, If you can keep your head when all about you are losing theirs, success in markets is guaranteed. Else we become the collateral damage that is counted in number and not names.

April 2021 Newsletter: The Urge to Predict

We say we don’t like to predict but every day prediction is what most of us end up doing. Is the market too high, Is the market going to crash, Is the RBI or the Fed going to raise Interest Rates, Is the price of Crude going to pull Inflation higher, Is … the questions never end.

When things start to do way too well, there is this lingering fear that the judgement day is not too far away. Markets for most part have been incredibly well and even that would be an understatement of sorts. 

S&P 500 for instance had a one year return of 61.50% (as of April 2021). This is the second highest one year return from any starting point it had seen since its inception. The largest one year return came post the 2008 crash (66.60% As of March 2010).

Market falls of the past were seen as shaking off the weak long position holders as well as clearing dead wood. Investors used to panic and sell out at lows only to see the markets climb back again. But for a moment there, investors were happy to have bailed out of their positions even with incredibly large losses. 

Today, Investors are so well educated that rather than jump out during market crashes, they jump in even more. Berkshire Hathaway meeting these days witness Millions log in live to hear two grandpas speak about Investing. The cult of long term investing that has been endearing to say the least. 

Stocks have been going up for so long that an idea has taken shape that if you are willing to hold on for long enough, you shall be profitable. But stocks don’t go up one way all the time. We climb up mountains, we climb down mountains and in between spend time in the valley’s.

While the number of Covid Cases and deaths continue to climb up, the markets too continue to move higher. This discrepancy is explained off by saying that markets are looking at the future and not the present or the past and in a way this is indeed true.

But the question is how far into the future is the market discounting.  Start discounting too far and you have too many edge cases that can derail the excel formulas that run many of these models. 

From the US to India, we are seemingly headed higher in terms of inflation. How high is too high before the Fed or the RBI starts stepping to stem the wave before it becomes a tsunami that is impossible to control?

From the low’s of 2016, the Nifty Small Cap 100 Index went up 130% over the next 2 years. From the low’s of March of last year, the same Index has gone up 170% in a span of just around 14 months. 

Some of this can be explained that unlike in 2016 where the Index had come out of a long time based correction but one that did not really hit big on the prices, this time around, we had seen both time and price correction (2018 to 2020) and hence even though the rise seems too much, it’s still well within reason.

Narratives generally color our ability to form a conclusive opinion. Snowflake, a US listed stock for instance, got played up on its IPO debut since it had an investment from the Legendary investor Warren Buffett. Today when it’s down  50% from the peak and back to where it opened at, none seem to harbor any remembrance. 

We have seen that in India too when prominent Investors are seen as applying or holding stocks that are coming up with an IPO. Personally I would say give an IPO stock a year before taking a call on whether it’s worth investing for many a time the strong balance sheets become weak very soon after its IPO. 

But back to the question – why are the markets heading higher even as uncertainty pervades. I found this quote from the book (More Than You Know: Finding Financial Wisdom In Unconventional Places  by  Michael J. Mauboussin) 

The practical difference between . . . risk and uncertainty . . . is that in the former the distribution of the outcome in a group of instances is known . . . while in the case of uncertainty, this is not true . . . because the situation dealt with is in high degree unique.

 —Frank H. Knight, Risk, Uncertainty, and Profit

I think this explains why the market behaved in the way it did in March 2020 when we had barely any cases of Covid versus how it’s behaving today. March 2020 was a time of uncertainty that was unique and never experienced before, today it’s a risk we know that at best will be offset over time.

Momentum has been extremely strong. My own returns for the month of April were the second best since I started out in May 2017. Stocks that were Value a few months back are today part of Momentum Portfolios This is dangerous territory for like a rubber band, if it’s stretched too far on one side, the only outcome is that it will lash back angrily. Yet, are we really too one sided?

Every bull market is different and Every crash is different. When we were trading in the dot com bubble, it’s not that most of us were immune to the valuation or the risks but a narrative of “this time is different ” was enough to make most investors want to get onto the infotech bandwagon.

In 2007, while it was housing in the US, in India it was Infrastructure and Real Estate that were the primary drivers of the narrative of a new India. 12 years later the Nifty Real Estate Index is still 43% below its peak of 2008. 

Having said that, I am yet to see any reason to be fearful of the markets. While the large cap Index itself has gone nowhere since the beginning of this year, we are seeing some really good results when it comes to individual stocks in sectors that are hot at the moment. Breadth of the markets is as good as you can get indicating that the bull market is broad and not limited to a few individual stocks.

I surmise that the first leg of a bull market is always difficult to digest for there are multiple reasons that seem to suggest that there is something wrong with the markets. All indications are we are currently seeing one such run. A fall I would seek as more of an opportunity than an indication of a total reversal of gains we have lodged until date. 

Regardless of where the market is going to go, the Virus seems to have decided to stay for now. Be Safe and Get Vaccinated at the earliest.  

Book Reco: One of the better AutoBiographies I read this month was that of Robert Souk. Starting his life as a Rice Merchant who later in life was a well known Sugar Trader (trading in future while at the same time diversifying to both growing Sugarcane as well as having his own Sugar factories), his biggest achievement would probably be the establishment of Shangri-La Hotels & Resorts. Starting from nowhere, it’s impressive that today they  own and/or manage over 100 hotels and resorts throughout Asia Pacific, North America, the Middle East and Europe. 

Amazon Link: Robert Kuok: A Memoir

Can Momentum Strategy Avoid Manipulated Stocks

The big fear for most investors is about getting caught on the wrong side of a stock that went up only due to manipulation and once the deed has been done, has lost all of its gains without providing investors an opportunity to exit.

I recently did a Twitter Spaces talk and this was one of the questions raised. While getting caught in manipulated stocks is possible regardless of the strategy one follows, the lack of narrative and fundamental reasoning for Momentum leaves us particularly exposed.

Pump and Dump is something that is not new but one that has been evident from the time we had stock markets. The oldest example of that would be in the South Sea Bubble. 

There are basically two kinds of Pump and Dump that happens. One involves manipulating the accounts so as to suggest the company is doing way better than it is really doing while the other involves just squeezing the price higher without fundamental triggers.

Cases like Satyam Computers, Vakrangee among others belonged to the first group. The accounts were not a true reflection of what the reality was and this enabled the price to shoot higher. 

Cases of pure Pump and Dump of stock prices are dime a dozen. Stocks seem to go higher and higher for no reason and with very little volumes before a reversal happens and all the gains are lost.

The pure price based pump and dump is actually easy to evade for Momentum Investors. Have a high enough bar of how much value a stock should trade on a normal day (for a long enough period) and voila, 99% of such stocks will get automatically rejected. Pump and Dumps that don’t have a fundamental backing generally are operated by a small coterie and are not really well traded.

The fundamental driven frauds are much tougher in that sense. When Vakrangee for instance was going up, it was accompanied by positive spin. Some positive tweets / articles of those times

Heck, the stock even made it to MSCI Largecap Index. Not that everyone was gung ho on it, Nooresh Merani and Amit Mantri were among the few to question it 

But there was not a single tweet I could find that had the words Vakrangee and Fraud. Of course calling out Fraud on even Fraud companies in India is Risky and one would rather not be invested than question companies that have connections which can result in midnight calls or even sent to jail.

I got caught in my personal account in Vakrangee. While I did interact with very many intelligent folks, I decided to hold onto the stock since selling would be essentially breaking the cardinal rule of Systematic Investing – adding the discretionary element that one hopes to eliminate.

I was lucky in the sense that when the stock made its top, my return from the stock was at 100% and when I got the ability to exit, it was back at my entry price. So, even after a 50% fall, I got out at cost with the only loss being opportunity cost.

I was not having a Momentum Investing strategy when Satyam Crashed but the crash unlike that of Vakrangee took place at the high point. Rather, the stock was down 78% from it’s all time high and down 67% from its 52 week high. Momentum strategies would have long ignored this stock and would have had no impact whatsoever.

Yet, there is no saying the next stock that may be part of a Momentum Strategy and turn out to be a fraud. Or for that matter, stocks can fall big time within the timeframe of a rebalance without there being any fraud.

In March 2020 for instance, one of my PF constituents was AU Bank. The stock was bought on the 1st trading day of the month at around 1150 and by the end of the month was at 500. A 57% fall in one of the stocks can be fatal to any Portfolio and my was not immune especially since I was having a significant weight to financials which bore the brunt of the damage.

What saved me though was that I have always felt that since we are dealing with a lot of unknowns, a good amount of diversification while reducing the returns slightly can enhance from the risk management angle. In a 30 stock portfolio, each stock has a weight of just 3.33% (approximately) and even if a stock was to go down 50% before you can exit, the damage (assuming the rest of the stock overall did not fall like a pack of cards), the damage to the portfolio is just 1.67% – something that is honestly very much bearable.

Other risk management techniques that can be used are trailing stops, stops based on either the equity curve or based on moving average on a benchmark index among others. The risk of trying to manage risk though in a way can actually enhance the volatility since there would be more stocks in motion (going in and out).

While four years is too short a time frame to judge a strategy – Meb Faber recently tweeted that he believed that to clearly judge a strategy as being good or bad required 20 years of data – my experience tells me that with a good set of filters and maybe once in a way allowing the luxury of not entering a stock even if it tops the momentum list (I did it with Adani Green, Tanla among others), risk of getting into stocks that you don’t have a easy exit can be vastly avoided. 

At Portfolio Yoga, our aim is not to maximize reward but to maximize the ability to deploy a larger capital. A 20% gain that comes via a risky portfolio is worse than a 15% gain that can come through a lower risk (there is nothing like no risk) portfolio but one where you can confidently deploy a much larger percentage of your money.  

On that note, let me leave you with this post from Seth Godin – Optimized or maximized?