What to expect from Scientific Investing in a time of Crisis?
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The Scientific Investing Approach To A Crisis
What is the job of an investor?
There are several types of market participants, generically termed as traders or investors. Many people use these two terms interchangeably. Further, many people think that they themselves can do it or their fund manager’s job is to do this for them. Which begs the question what is “this” which needs to be done?
If I ask a typical “investor” they are most likely to say that they want to make money and they expect their fund manager to do it. It does not matter to them how the fund manager does it as long as they make money for them. According to them, the winning approach is to just buy “good stocks” and sell any “bad stocks”. They believe that in their personal accounts they do this all the time and they expect their fund manager to do this on their behalf.
If you ask them what is a “good stock”, there could be several different answers, but at the core they all turn out be defined by the fact that the stock price has gone up significantly during some recent past period; the period could be 1-month, 3-month, 1-year, 3-year, or 10 years or more. Since the stock price has gone up in the past it is expected to go up in the future as well.
Similarly, a “bad stock” is one which has fallen in stock price. If the stock price has fallen, especially recently, by more than 10% or 30% then it is viewed with suspicion and god forbid if has fallen by 50% to 70%, it surely is a “bad stock”. We do not agree with this definition at all.
A brief review of Scientific Investing
The Scientific Investing approach classifies the full investment universe, i.e. all the stocks with intrinsic value of more than INR 1000 crores for the Indian multicap strategy, or all the stocks in S&P 1500 fo the US multicap strategy, into 4 groups. We remove the Capital Destroyers,i.e. companies with weak business operations and weak balance sheets resulting in them being permanently vulnerable to internal or external shocks, the Capital Eroders, i.e. companies with no competitive advantages resulting in inefficient use of shareholder capital and hence slowly bleeding the shareholders over the long-term, the Capital Imploders,i.e. companies which are significantly overvalued making them vulnerable to either company or sector specific shocks or general economic or market shocks when they miss investor expectations.
What remains in the universe after the above removals are Capital Multipliers, which are companies with strong, cash-rich balance sheets powering business operations with persistent competitive advantages, resulting in them being “robust”, i.e. well-placed to “survive”any internal and external shocks and, frequently, “anti-fragile”, i.e. well-placed to “thrive”in an environment of known and even unknown growth opportunities that might arise. The most important characteristics of these companies are that they are available at a significant discount to their intrinsic value.
A portfolio of 20–30 SuperNormal Companies @ SuperNormal Prices is created from the Capital Multipliers. This is followed by continuous portfolio governance which includes a review of the long-term fundamentals of the portfolio companies every quarter and an annual review and rebalancing of the portfolio.
During the Crisis
With the above review of the Scientific Investing approach it should be clear thatit is unlikely that weak companies can enter our portfolio. This doesn’t mean that the stock price of our portfolio companies cannot fall. If the market falls, most likely, they will fall as well; in fact, it is possible that they might fall more than the market. But the fact remains that their strong balance sheets allow them to operate and survive even in situations where revenues are going to be hit, such as the Covid Crisis.
Scientific Investing Stress Test: A Zero Revenue Survival Analysis
In fact, we carried out a “survival analysis” for all our portfolio companies with the specific constraints that they have “zero revenues” while maintaining their full cash expenses. We found that portfolio would survive for several months to several years without any revenues, using their cash and equivalents to take care of their expenses. Further, these companies could reduce their monthly expenses if they expected this zero revenue situation to last for longer than a few months. Under such cost-cutting initiatives, the survival would be much longer. In many cases, the revenues are actually non-zero even during the lockdown. Our stress test showed that the portfolio can survive a “zero revenue” situation for several months, at least.
Portfolio Governance During Coronavirus Crisis-Existing Portfolio
Sometimes an external or internal shock, such as the Covid Crisis, could permanently change the future earning power of a company. For example, travel, tourism, entertainment and hospitality are permanently, negatively impacted by the Covid Crisis. We would have to be continuously vigilant for any companies in our portfolio which could have a permanent change in their fundamentals because of this crisis.
We believe that a SuperNormal Portfolio is robust to fundamental deterioration at the portfolio level. As mentioned, under certain shocks, some specific companies might have their future fundamentals permanently weakened. In this case, the company has lost its original status at the time of selection as a SuperNormal company. Naturally, the Scientific Investing approach would do the intrinsic value analysis afresh and compare the current market valuation with it. If the current market price is significantly higher than the new intrinsic value, the stock can be considered for a replacement with another SuperNormal Company. If the current market price is significantly lower than the new intrinsic value we will carry it for some more time unless and until we find another SuperNormal company which is at a similar or higher discount to intrinsic value. Needless to say that in the annual rebalancing the company is very likely to be replaced irrespective of the valuation discrepancy since it is no longer a SuperNormal company.
Portfolio Governance During Coronavirus Crisis — Search For New Opportunities
Given the OmniScience Capability to select from the full universe, during the recent 30%+ fall, we again classified the full market into the 4 groups. It should be clear that Capital Destroyers and Capital Eroders would not change because of a fall in market prices. The possibility which we were looking for is that some Capital Imploders might have become Capital Multipliers, since now they might be available at a discount to their intrinsic value. However, despite a diligent search we were unable to find new stocks to add to our existing portfolio.
However, the crisis is still on and there is a possibility that new SuperNormal companies might be available for buying and we continue looking for those.
Portfolio Governance During Coronavirus Crisis — Fresh Allocation Strategy
All the great investors, such as Buffett, Templeton etc., would support the assertion that the time to buy is during a crisis when Mr. Market is extremely pessimistic. We are currently in that situation. However, the allocation strategy for the fresh capital being allocated by clients is to spread it over the next 3 months which gives us additional flexibility to monitor the situation in case of further economic information and market volatility and extend it to a longer period for the remaining capital. On a broad basis, in our opinion, investors who can bear the risk and have unallocated risk capital, or their risk capital is allocated to other asset classes should redeploy to equities for a holding period of 3–5 years or more.
Past performance is not necessarily indicative of future results.
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