Our investment process emphasizes focus on “Secular and Structural” growth opportunities vs “cyclical” ones. Secular and structural implies growth irrespective of economic conditions while cyclical implies opportunities that will be affected by trends. We believe cyclical opportunities should not be core long term holdings in a portfolio. However, they may provide opportunities for “trading gains” – if one has that bent of mind.
An example to illustrate the point is shown in the graphs below.
The charts below shows the performance of two financial firms in India, both run by exceptional management teams. We believe one of them is a structural and secular growth story, while the other is relatively cyclical.
- Chart 1 shows a basic measure of profitability, Return on Assets or ROA of both the Secular/Structural vs the Cyclical opportunity. Note the differences in consistency.
- Chart 2 explains why the ROA of the Cyclical firm is so volatile. Its Non-Performing Loans are linked to the vagaries of the monsoon. A key variable of its success is not within its control but dependent on the mercy of the Rain Gods.
- Chart 3 shows relative share price performance. Despite significantly lower ROA, the more consistent performer has outperformed the cyclical one over long periods of time. While the Red line is broadly smooth, the Blue line has periods of significant outperformance and underperformance.
- Chart 4 shows how the cyclical firm, in euphoric conditions (a good monsoon) has started outperforming the steady compounder.
Now for the moment of truth. How will you react? Will you stay invested with the steady compounder or will you try and jump in and out to make a spread on the cyclical? We cannot time entry in and out of markets; further, even if we could, we need to consider the impact of brokerage and short term capital gain taxes on net investment performance. Hence, if you decide to stay (keep a long term out-look) one needs to be willing to bear the pain of short term underperformance