“In life, the challenge is not so much to figure out how best to play the game; the challenge is to figure out what game you’re playing.” (Kwame Anthony Appiah http://appiah.net/)
CLSA is a reputed broking house. It published a report 2 days ago recommending investors book profit in India.
We agree with CLSAs that valuations in India, on aggregate, are stretched. In our last letter we mentioned, we were “cautious, but not bearish” and that because we have borrowed returns from the future, we could be in for a period of muted returns.
However, we are not aligned with CLSAs message of “booking profit” because we are playing a different game. Playing the long and short game simultaneously confuses the mind. One should make choices. We choose to exclusively play the long game and don’t optimize for short-term outcomes. That means accepting periodic draw-downs with equanimity.
Summarizing our approach briefly.
- We want to own 15-20 well-run companies where a high probability road map exists to 15-20%+ stock price compounding over the next 5 years, even if they are richly valued at present or their short-term earnings prospects are uncertain.
- Market valuations are only a reference point as we don’t buy the “Indian market” but individual positions. Valuations of individual positions can stray far from the market, or even from the sectoral average. Spec Chemical valuation are rich at present but Banking is reasonable. Navin Fluorine is richly valued at present, but Solara is very attractively priced.
- Price corrections can occur from any starting point. They are not correlated with high valuations. They are often the result of a variable which markets had not considered (demonetisation, ILFS bankruptcy, Covid …) and its impact needs to be factored in.
- Hence, the fear of a price correction due to valuations alone will not cause us to cash out if we continue to see good 5-year outcomes ahead in individual names.
- However, we will practice “good churn”. We will sell individual positions when we believe incremental IRRs on positions are lower than what the market can deliver, and we can re-allocate to better opportunities at over a 10% IRR spread.
What is historical wisdom on booking profits? Here is Morgan Housel. “The history of the stock market is that it goes up a lot in the long run but falls often in the short run. The falls are painful, but the gains are amazing. Put up with one and you get the other. Yet a large portion of the investing industry is devoted to avoiding the falls. They forecast when the next 10% or 20% decline will come and sell in anticipation. They’re wrong virtually every time. But they appeal to investors because asking people to just accept the temporary pain of losing 10% or 20% – maybe more once a decade – is unbearable. The majority of investors I know will tell you that you will perform better over time if you simply endure the pain of declines rather than try to avoid them. Still, they try to avoid them. The upside when you simply accept and endure the pain from market declines is that future declines don’t hurt as bad. You realize it’s just part of the game” https://www.collaborativefund.com/blog/same-as-it-ever-was/
Mathematically too, taking cash calls is futile . Even if one were to sell down 30% of the portfolio, and the markets correct 30% and the seller gets both the sale and the re-entry decision perfectly right, over 5 years, it impacts portfolio IRR by ~ 2.2%. If it is a 20% cash call and 20% market decline, the IRR differential is 1%. And we have not met anyone so far with the ability to time the market. Taking cash calls offers short term emotive relief but will adversely affect outcomes over longer time horizons due to the impact of taxes and inability to time re-entry
CLSA message is more relevant for someone playing a different game, perhaps with very short time horizons or a strategy aiming for complete downside protection.
- Someone managing money with shorter time horizons (eg a hedge fund that has to beat an Index over short time frames)
- Someone with a Long/Short mandate à never lose capital at any point
- A global allocator of capital investing from a low tax jurisdiction who takes macro valuation calls on countries
If a steep market dislocation happens, it will be a source of opportunity for us.