We told ourselves this many months ago – no chest thumping about returns when every TDH has delivered 40%+ absolute returns in FY24. We instead want to focus on something that is more relevant to investors after a good year
How can one continue to stay ahead of the market; as the nature of the market gradually changes?
Can one preserve the gains and not give back too much to the market, when the eventual market pivot occurs?
Some numbers from the 2023 year end India SPIVA report
“51% of active MF managers underperformed the benchmark over 1Y within the large cap category. Over the 3Y and 5Y timeframes, the underperformance rate goes up to 87% and 86% resp. Over a 10Y timeframe, the underperformance rate is 62%. The 10Y underperformance rate within the small & midcap categories rises to 75%”
Some more factors to consider based on our experience of tracking returns over almost 15 years are listed below. These are observations from managing real customer portfolios where we would calculate the scheme wise and portfolio wide XIRR every 2-3 months –
- The performance declared by funds is on time weighted basis (as directed by the regulator), actual customer return (XIRR basis) is usually lower than this declared return. It is not abnormal to see investor XIRR return of 6% p.a. when the TWIRR of the scheme indicates double digit returns
- Untimely corpus additions and redemptions further increase this disparity. Distributors and MF advisors tend to keep allocating more corpus to the funds that showcase healthy outperformance over the short term, hence a good chunk of the allocation to a scheme happens close to the peak of the cycle for that particular fund. Once the underperformance cycle of the fund starts, investors tend to pull out capital in the 2nd half of this cycle close to the bottom
- The range of outcomes is much wider for portfolios that hold lower number of stocks compared to an equity MF. If one were to do this exercise for a product like PMS, AIF or Smallcase where the number of stocks is ~20, one will most probably observe that the range of outperformance and underperformance over the benchmark/category mean is much wider in these non MF products
Depressing numbers for sure, but there is hope for investors.
Coming back to the questions, we believe that a simple set of principles need to be followed to maximize the probability of relative success over longer timeframes in the market
Investors have a say in the return we generate. When we allocate money to the equity market has a bigger say than what we allocate to, barring situations of multibagger returns. There are enough formal studies in classical finance that have come to this conclusion – asset allocation matters more than stock selection for most portfolios, timing matters too
Every market, sector and stock has a cycle, recognizing where we are on this cycle is a qualitative exercise. One needs to have a structured system to always keep thinking about this – fundamentals driven near term earnings assessment, tracking changes in shareholding pattern, technical analysis & anything else you can think of. The risk of not having this in place is that we tend to get carried away at exactly the worst possible time, for everything looks bright and sunny at the peak of a stock cycle and capital inevitably tends to go there
The long term is a series of medium terms, it is very difficult to turn around medium term underperformance into long term outperformance. Our own experience was that it took us uncomfortable decisions over ~12 months of back breaking, focused work to turn around the FY22 underperformance by delivering a 5% alpha in FY23 when the market was flat; so that we began FY24 on the right note. Such a turnaround becomes next to impossible within 2-3 years at large AUM purely because of the impact costs associated. Selling a 30 Cr position in a small cap is no joke even today, this alone can bring the price down by 10-15% in an average market
The very fact that you are outperforming big time in a market indicates that you can underperform big time if the market pivots to a different texture. After you’ve had a good run where you did much better than anticipated (or deserved), stay close to the exit door. The market has taught many great investors simple lessons once a bull run ends. No one is immune to a few blows every now and then.
As Vidya Balan said in The Dirty Picture – Entertainment, entertainment, entertainment; we investors need to keep telling ourselves – calibrate, calibrate, calibrate after a good year. The idea is not to have our finger on the trigger all the time but to have a clear cut plan on when and how to pull the trigger. Once a good run ends and every investor is loaded up on the same themes, buying force tends to disappear quickly. As technicals start flashing warning signs when most investors are sitting on large profits, triggers will be pulled. Most investors who have made 3x in a stock would rather take the safe bet of selling out and converting paper money into real money rather than making a risky bet on staying with the stock for the long term.
Managing this pivot at a portfolio level (~20 stocks across 7-8 sectors) is what makes continued outperformance challenging for investors in our assessment, more so for institutional investors with bigger impact costs. Doing well over 1Y calls for just a few things to fall into place, doing well over 5Y needs many more factors to fall into place. And it is not just the decisions that matter but also the sequence and timeliness of the decisions.
Investors tend to make mistakes because we get obsessed about individual decisions rather than care about the overall trend and impact on the portfolio. Our obsession with getting the micro decisions right tends to impede our ability to get the broad picture right at a portfolio level. Consciously leaving some money on the table is never easy to execute.
In our opinion, the ability to manage a market pivot from a roaring, broad based bull market to a narrow bull market; and then from a narrow bull market to a below average market sentiment is the most important skill that determines medium term outperformance. At the same time, it is not as straightforward as it sounds; sometimes this might be a suboptimal approach. Post the 2003-08 bull market, a secular multi-year run has not materialized in India. We have only had a start-stop market with one good year followed by an average year and then a bad year. Constant calibration and tactical bets can go against you if you are operating with the assumption of a start-stop market, while a secular bull run materializes instead. Figuring out whether we are in a start-stop market or a secular market needs one to reevaluate the calibration process too!
The next few months should be interesting and decisive as we seek answers to this question – is the start stop nature of the Indian market intact or have things changed this time around? The interesting part is that all corrections post 2008 have been shallow barring the madness of March 2020. Intuitively, the more skeptical investors are about a secular multi year run, higher the possibility that corrections will be shallow rather than deep.
As investors we also need to have a view on the depth vs breadth conundrum. For the longest time active investors have been told to focus on depth of understanding of a business, but the strong correlation across asset classes once modern monetary theory became the mainstay is worth thinking about.
We at Congruence Advisers have been in the breadth camp over the past 18 months. We were more worried about missing the forest for the trees rather than missing out on the next big investment idea. It was not an either-or debate but more of what could add the most value to us given where we were in our investment journey. If we hadn’t done so, we would have missed out on the capex rally that started in 2022 and would have most probably underperformed the BSE 500.
We will be launching a new series covering stocks trading below 3,000 Cr market cap. Starting from May, this should hit your inbox every month if you’ve signed up for our free updates. If India’s GDP growth continues as per the RBI’s anticipated trajectory, many small businesses can have multi year tailwinds to ride. Time to get some focus back on what made us successful at investing in the first place – regular, dedicated effort on micro cap research.