Back to writing after a short hiatus. We launched a dedicated small cap service (Emerging Business Portfolio) towards the end of February this year. This called for building the constituents and research notes from the scratch, since we wanted to ensure that every constituent business is in line with the current market texture. We knew what we had signed up for but the effort involved in executing this ended up higher than we had initially envisaged. Detailed research notes for every constituent ended up being a huge writing task in itself, hence other writing had to take the backseat for a while.
A lot has happened in the market recently. It is easy to fill paragraphs on the market action since April but it won’t get us anywhere. Market commentary with the benefit of hindsight is easy, forward looking commentary and decision making will always look challenging. In this newsletter we will instead pen down our thoughts on a couple of factors that every investor will need to think deeply about.
What is more important – clarity on the time horizon or clarity on the exit event?
Sounds simple but the implications are deep. If I look back at every single BUY of mine since 2016 (well before I branched out into managing money for others), every single one has made money; and every single stock would have beaten the FD return handsomely had I held through. But the strike rate of execution dips to below 75% when I look at the data. Why?
When you hop onto a story that is not yet priced for the positive developments you think will play out, you need tremendous clarity on the time horizon. A good quality business that is going through a phase of muted demand can stay deflated for many quarters before your thesis plays out. There is no point in getting frustrated that the price isn’t moving when your approach was to take the position before the rest of the market figures it out. In such cases, you need tremendous clarity on what your time horizon is so that short term paper losses will not shake you out. Clearly you have your eye on the medium term here, hence the short term shouldn’t matter too much.
When you hop onto a story where the positives are already priced in and with the expectation of > 25% CAGR, you need tremendous clarity on when you want to take your profits home. For most stocks and sectors are cyclical, just that the timeframe of the cycle varies. If you have hopped onto a stock that is already in Stage 2 and has printed good numbers for some quarters, you need well defined exit rules so that you can take your money home in a proactive way. Else you run the risk of being a medium term investor in a stock that can peak out in the near future. In such cases, you need to be clear about the EXIT event/valuation rather than the time horizon of the investment. This is one of those situations where you might be dealing with risk in the medium term while the short term looks much smoother.
Ideally, one should have clarity on both – time horizon and the exit criteria but real life rarely works that way. Else every good investor would operate at > 90% strike rate. I got the thesis right on TCPL Packaging in 2016 but did not have the exit criteria clear when the business started printing lower EBITDA margin once the paper cycle started gyrating. I had loaded up on the stock after the business printed good numbers and the valuation had inched up. I kept focusing on the time horizon while I should have been obsessed over the exit criteria. The final outcome was that the stock went up 6x after I had booked out at a hygienic profit and after having stayed invested for ~5 years. Opportunity cost gets to you psychologically, especially when you are having a below average performance phase.
We recently added two stocks to the Emerging Business portfolio where the FY25 numbers were muted but we believe that numbers can pick up significantly some time in FY26/FY27. In such cases, we won’t get worked up over short term gyrations or fundamentals since we know that the thesis can play out only beyond 18 months. On the other hand some of the stocks have started printing much better numbers than we anticipated and the valuation multiple is on a tear away rally right now. In these stocks, we are working towards clarity on the exit event/multiple rather than caring too much about the initial time horizon. Horses for courses – we’ll see if we can execute well this time and not make the mistakes we made in the past.
Stocks that show a lot of momentum in the short term can have looming risks over the medium term (due to valuation and mean reversion) while some other stocks can be inverted in their risk-return profile. When you allow an expensive stock to get more expensive, you are prioritizing the short term over the medium term. When you prune an expensive stock and allocate that capital to a beaten down name, you are optimizing for the medium term while leaving money on the table in the short term. Managing this paradox at the portfolio level without having clarity on the investment horizon can lead to mistakes.
With valuation multiples creeping up steadily, do you want to merge into the market view or diverge?
This will turn out to be one hell of an important decision for anyone managing money today. Especially if they have been investors in the pre 2017 era where good businesses could be bought for < 20 TTM PE most of the time.
To reiterate what we have said in many of our notes in the past, India has been a start stop market. The trend since 2010 is that we have one good year of > 30% return at the index level followed by a couple of below average/bad years. This trend is undergoing a steady change though, as the baton of ownership is being passed from the FPI’s to domestic funds and investors. SIP flows have increased from 8,400 Cr a month in 2018 to 25,000 Cr+ today and retail market participation continues to strengthen every year. India is already having its 401K moment, we’ve been speaking about this from 2019 and believe that it is already here in a big way. If this trend gets further cemented, the Indian market may finally break out of its start stop nature and actually give us a secular bull run, though at much lower index return compared to the 2003-08 run.
Even at a headline index return of 11-12% p.a. from here, if the common knowledge gets cemented with the thought that the Indian equity market reliably goes up every year, an extended good run can materialize. Our current thinking is that there is a good possibility that the Indian market can build up into an eventual bubble over the next 5-10 years. It also doesn’t help that the overwhelming majority of Indian public market investors live in an echo chamber, India is all we know and track; hence we cannot benchmark the Indian equity market to the equity market in other geos.
If you believe that equity market valuation multiples are much higher than warranted, where will you deploy your money? The repo rate is already at 5.5%, fixed income returns just don’t attract most people. And real estate prices are already going crazy in pockets. A semi premium 1900 sq ft apartment at Bangalore goes for ~3 Cr today before registration & stamp duty kick in. It is not that only equity prices are high, looks like other asset classes too don’t offer good bargains in India as of date.
If so, do you continue to participate in the market as valuation multiple keeps creeping higher? We’ve seen some of our holdings go from 20x forward PE to 35x Forward PE over the past 7 years. Do you now rotate into the more reasonably valued (but unproven) businesses or do you continue to pay a steep premium for the proven ones? Or do you sit by the sidelines and just watch for years?
Whatever be your view, if you are beyond the age of 35 years right now you might want to make the most of this phase before the tide turns. For when it turns, we can get stuck with a market that goes nowhere for a long time. See the chart of the DJIA in the US between 1973 and 1982, no reason why this can’t happen in India too. One needs to think deeply about asset allocation if equity market valuation multiples keep steadily creeping up this way. The recent market correction has pruned the market froth to a respectable extent. The longer the market continues to trade below its previous ATH, more the comfort you can draw that the market is subject to gravity and hence isn’t irrational yet.
What looked like a lost year for the broader markets has turned around within a very short span of time since April. It doesn’t help to be deterministic when the structure of the market (and the world in general) is changing to a new order. It is time to keep an open mind and stay away from perennial bulls and bears.
As the primary ownership of the Indian equity market pivots from hot money (FPI) to more reliable money (domestic funds), one should not be surprised if the start stop nature of the Indian market changes into a more steady one. Corrections will obviously happen along the way but if both growth and domestic liquidity continue to be in favor, there is no point being too pessimistic or deterministic.
One of the more interesting themes that can play out over the next few years is the resurgence of spending & self reliance in the stronger European economies. Some of the moves of the current US regime are drilling home concepts that were forgotten for more than 25 years. If one is looking to diversify outside of the Indian equity market, this could be one of the interesting places to explore.