Of Loss Harvesting, New Stock Ideas and a Good July

The month of July has been energising. Equity portfolios have been up between 4% and 8% and overall portfolios too have seen a small uptick (1% to 4%, depending on your debt-equity ratio).

Many of you would have seen a sudden bout of selling in your portfolios. This is the loss harvesting we spoke of. When we sell debt funds to generate cash to buy stocks, we also generate a profit. This is profit you have to pay tax on. So we sell some of your loss making stocks to generate enough losses to offset the profits we foresee you will make this year in the debt funds. That ensures you don’t have a tax surprise. Over the next few weeks we will redeploy that back into the stocks we’ve sold, and our estimate was that this was close to a “top” so we should be able to buy back even cheaper.

Is it a Top?

There’s no point calling tops. The market is irrational longer than you can be solvent, or breach your waiting periods. But there are pointers. Interest rates are rising - and indeed, RBI raised rates again on August 1. At 28 times profits, we have seen these earnings multiples only twice earlier - once in Feb 2000 and once in Jan 2008. Both times the market’s return has been less than stellar in the next few months. Will this be third time lucky?

We can’t say, and we won’t even try. We’ll just try and avoid extreme valuations on companies.

The Mega Underperformance of everything else, in context

The stark dichotomy between large cap stock returns (the “Nifty”) and pretty much anything else (midcaps, small caps, multicaps) has been very heavy in this year. In 2018, while large caps are up over 7% for the year, even large cap mutual funds have struggled with substantially lower returns. The midcap index - even with a stellar July - is down over 10% for 2018. Even the Nifty Next 50, the index of stocks ranked 51 to 100 in market cap, is down 3% for the year. That dichotomy has been huge.

But to be fair, the mid- and small-cap markets have majorly outperformed the large caps since 2013. Even today, after this “carnage”, the midcap 100 index has returned 24% annualized in the last five years. So has the Nifty Next 50. Versus a timid 16% for the Nifty.

This is also why we use the Nifty and the Nifty Next 50 for our benchmarks. The Nifty isn’t good enough. And we use the “total returns” index, which is basically dividends reinvested.

Indian markets are getting more domestic investors. Foreign institutions have taken out Rs. 3,000 cr. in equities, and 40,000 cr. in debt in 2018. Just the mutual fund industry has added some nearly 60,000 cr. in fresh investments in the same year.

There are many interesting factors at play. One is inflation, or indeed, the lack of it. I pay lesser for a mobile phone bill (Rs. 450 for three months of unlimited data and calls) than what I did in 2005 (average of Rs. 2000 per month). I pay the same for an entry level car - Rs. 250,000 - as I did in 1996. I know only because I bought my first car with a loan at that price. The amount I pay for rice, sugar, tomatoes or foodgrains is not dramatically different from what it used to be 10 years ago - and today, for the urban consumer, it’s a much lower percentage of the household budget compared to, say, rent and transport.

Even fuel prices, which get us all riled up on the rise, isn’t that dramatically different in rupee terms. In 10 years, the price of petrol has gone from Rs. 45 to Rs. 78. 10 year inflation, in the last five years, has been around 6% or less, in petrol prices.

Air ticket price inflation? No way. Hotel budgets? I’ve paid more in 2005 than I did in 2017. Cost of taking the family to a movie? Okay, that has skyrocketed, but we have governments and courts trying to restrict what they can charge us there too.

If you consider what this has done, it’s created a lot more room for urban savings. And this doesn’t go into gold, like savings traditionally did. It might not go into real estate because let’s face it, we have over built. It is likely to go into fixed deposits, to some extent, because India loves fixed income. But a reasonable portion, even if it’s tiny, is starting to go into financial markets. But should other asset classes become better, or inflation rise, or something else that changes this “higher investible savings” phenomenon, we will see the impact reverse.

But Aren’t These Just Excuses?

Every bull market has excuses. New story. Better country. Good governance. No other option. But these are traps, because in most cases the narrative follows the price. Even the famous economist, Irving Fisher, got it wrong in October 1929, when, after a 30% fall in stocks, he pronounced that stocks “are on a permanently high plateau”. The market proceeded to fall more than 50% after that. We have to be aware that all explanations are man made and therefore subject to exaggeration.

While the exuberance is on, we’ll participate but in a phased entry manner, and in the next month we’ll be buying more.

The Stock Strategy

We’ve maintained a diversified position on our stocks. It’s important to reduce the stock level risk for us. Our back tests show no significant change if we diversified in 30-40 stocks versus remained concentrated in 20. Concentration is more “panicky” in nature because each stock’s fall contributes to a larger fall in your overall portfolio and increases a fund manager’s need to question the decision. The impact is behavioural, rather than logical. And because most investing is behavioral, we recognize the damage it can do, and there is really no major disadvantage to diversification (at least with 30-40 stocks).

Secondly, what’s diversified today will become concentrated in a few years. We took a look at the Nifty as well. 10 years ago, if you had bought all the stocks in the Nifty in equal weights and slept since then (no changes), around 50% of your money today would be in only 10 stocks. The rest have hurt, or withered away or simply not done anything. Concentration over time by just sticking with the winners - that is what index investing is all about.

We’ve added a bunch of new stocks. Quess and Naukri (Info Edge) are our investments in the “inorganic” growth led market. Quess is on a major acquisition spree and will take some time to integrate, from the traditional personnel business to a more integrated player. For example, they’ve taken over a company that does landscaping. In the Bangalore airport, where they provide temp staff, they will now also take over the landscaping of the lawns. This brings in revenue without needing it to be linked to headcount -so operational optimizations, along with their ability to increase or decrease staff will play a role in the longer term nature of the business. They’re going up the value chain by owning balance sheets rather than offering pure services, and while there is execution risk, there’s also a big reward if they get it right.

Naukri is our gateway to performing startups. We can’t get direct exposure. So we get a billion dollar plus exposure to Zomato, Policy Bazaar and a bunch of smaller startups like Printo, through Naukri which invests in them. There’s no doubt this is a tough business, but even here, one big hit changes the game. And we get this alongside India’s top hiring platform that brings in 250 cr. of cash every year. A small allocation to this business for today will morph into a larger one if they continue to perform.

There’s more to come and please feel free to contact us if you’re worried about anything. We look ahead many years, so what happens today may not really be relevant. I would still welcome a crash, because we have so much more remaining to deploy.

Many of you have asked us - is it time to top up? I would suggest sticking to the discipline of regular top ups based on your plans. But if you really want to time it, I think the opportunities get better from September, so the next month or two should be good for any one time additions.

We now have a special customer support email - support@capitalmindwealth.com . Please feel free to contact us there. Also your login at https://progress.capitalmindwealth.com will continue to show you the data we have. We will be upgrading this portal soon and lot more additions will come your way. We are very excited about the future this market has, and how much potential it has to create wealth for every portfolio with us. As skeptical as we are about valuations of the market as a whole, we’re just as positive of the companies we own. For now, our focus is on navigation of these markets, rebalancing, removing of deadwood and getting new and better ideas in!

Cheeringly,

Deepak Shenoy