Swanand Kelkar is Managing Director at Morgan Stanley Investment Management.

Markets In 2018: Not A Year For Doubling Down

Simhavalokana is a Sanskrit term to denote the retrospective gaze of a lion. It is said that as the lion traverses some distance in the jungle, he looks back to examine the path he chose and how he covered that distance.

It is that time of the year again when things thankfully begin to slow down. Many times this tumultuous year, I have daydreamed of the serenity that the second half of December brings and wished it would come sooner. From trade wars to crude price volatility to liquidity squeezes, this year was a handful, making investors feel like Kareena Kapoor in Jab We Met* when during a very eventful night she says “Please Babaji ab to hadd paar ho chuki hai, ab iss raat mein koi excitement mat dena, boring bana do ji ab iss raat ko please”. Naturally, a year like 2018 packs in a lot of learning, some timely reminders of old truths and some new perspectives. Here are a few things that I learned.

1. Correlation Between Hard Work And Results
Relentless hard work gets results is something that has been drilled into most of us. Not getting good marks? Study harder. Not losing weight? Sweat it out more in the gym. Sometimes this is where we make the Venn diagram mistake – yes, good results require hard work but there are times when hard work by itself does not guarantee success. During the volatile middle part of the year, I reacted to portfolio under-performance by giving it all that I had, so much so that eating right, working out, time with friends and family fell by the wayside. I need not have.

It was a time when the macro narrative was so dominant that individual stock picking—where most of the hard work gets done—was of little consequence.

As the chart below suggests, the market performance was quite narrow in 2018. Only 18 out of the 51 Nifty stocks outperformed the index. We had a similar scenario in 2013 when macro worries dominated the market and individual stock picking took a backseat.

Within these narrow outperformers, the index heavyweights punched above their weights and the only question that mattered for a relative investor was how much of these names did you own?

More humility and acceptance would have helped but the older brother of ‘Want more marks? Study harder’ is ‘Getting bad marks? How can you be doing nothing about it?’ and that is a very difficult question to stifle.

2. Investing For Yourself And Investing For Others
There is a difference when you are investing for yourself and investing for others. When you are investing for others you can be forced into doing things which you don’t agree with as an investor because that’s how typically fund inflows and outflows happen. In mid-2017, we were writing about the fact that the macro improvement that India saw from 2014 was reversing and market valuations were not factoring it in. However, money kept flowing in all through 2017. Foreign institutional investors net bought $8 billion of Indian equities in 2017. On the other side, during the panic months of September and October 2018 money was leaving the country. With net outflow of $4.6 billion as of Dec. 17, the year is on track to be the worst year for FII flows, barring 2008.

So as an investor managing money for someone else, you were buying through 2017 and selling in later months of 2018.

Managing money for others in that sense is about the ability to hold two sets of nerves – your own and your investors’. 

 3. Does Macro Matter? Yes And No.

In one of our earlier Simhavalokana pieces, we had written that macro does not matter for stock picking. We forgot to put a ‘terms and conditions apply’ asterisk there. The longer your investment horizon, lesser is the relevance of macros.

If you are like Warren Buffett—who is happy to hold on to stocks even if the market shuts down for ten years—then you need not pay any attention to the macro. If you stand in front of an investment committee every quarter, you better be paying heed to it.

This holds true for politics too. If your investment horizon is, say, the month of May 2019, a single event is going to matter for your performance. If your horizon is January 2019 to January 2029, you can afford to totally ignore what happens in May 2019. The chart below shows the Nifty performance from Jan 2004 to December 2013. The period has two general election result days and on both those days, the market was locked on a double-circuit breaker.

However, those violent reactions are but a small wiggle on the ten-year chart. 

4. The Impossible Trinity Of Money Management
While the impossible trinity of macroeconomics is quoted often, I discovered—the hard way—the impossible trinity of money management this year.

Concentrated portfolios, low turnover, and short-term performance measurement are an impossible trinity.

If you run low-churn concentrated portfolios, you have little control on short-term performance. If you want to have control on short-term performance with low churn, you should run a quasi-index diversified portfolio, which is passive investing. It’s an untested hypothesis, but running concentrated yet high-churn portfolios may give you some control over short-term performance. Choose two, let go of the third

5. How Portfolio Quality Dilution Happens
Most fellow investors I talk to utter the word ‘quality’ in the first two sentences when we chat about investments styles.

So if everybody is so quality-focused, how do low-quality stocks creep into institutional portfolios?

They enter mostly at the tail-end of red-hot rallies like 2017 when yes, you are quality-focused but you are also valuation-focused. The best-in-class stock in the theme that you like is trading at astronomical valuations. You go down the quality curve because you want palatable valuations. The added difficulty is at that time, there is a huge squad of motivated investment bankers and sell-siders cheer-leading the next XYZ (fill in XYZ with your favourite unaffordable stock)

Towards the end of 2007 mania, there was an unending quest for the 'next Larsen & Toubro' and in 2017 I was pitched at least three 'next Bajaj Finances'. The lesson here is simple: always gravitate towards best in class. If it’s unaffordable, wait. Don’t settle for a look-alike.

Genuine quality stocks are like tennis balls, they bounce back. Lookalikes are like eggs, they break.

6. Lessons From Tom and Jerry
Growing up, one of my favorite cartoons was Tom & Jerry and I used to love the hilarious chases that Tom used to routinely undertake. One that drew the most guffaws was when Tom used to keep running in the air after the end of a cliff, and then fall down in a straight line. That happens to markets too.

They can over-extend after the underlying fundamentals have turned, as if running in air. That happened when markets kept rallying hard till January 2018 despite the fact that the macro story had clearly turned downward. This happens on the other side as well when markets and stocks just ignore fundamental improvements and it can be quite frustrating for an investor. But the lesson here: stay with your fundamental convictions. Even Tom could not defy gravity.

7. Volatility And Productivity
Recently I activated the Screen Time feature on my iPhone. It measures the amount of time you spend on your phone and sends you a summary at the end of the day. Without giving you details, let me just say I have been disgusted at the amount of time I have been spending on the phone. I think the Bloomberg Terminal too should have this feature, especially on volatile days.

Things are moving all over the place, the screen is hypnotic and you sit in front of it immobilised or worse, succumbing to negative thought spirals that through one route or the other take you to the impending end of the world. And just like that, it is 3:30 p.m.

Avoid getting sucked in by the spiral by planning your circuit breaker in advance; anything that forces you away from the screen. Personally, I lock away the phone, gather a bunch of piled up reading and relocate to the coffee shop below our office. In a place full of financial services firms, the coffee shop is generally deserted on such volatile days.

8. The Greatest Enemy Of Growth Investing
The greatest enemy of growth investors is de-rating i.e. when markets opt to pay a lower multiple than before for same earnings stream because it views current growth to be unsustainable. If predicting earnings and cash flows is the science of investing, then predicting the multiple that the market will ascribe to it, is the art. It involves understanding the narrative around a stock or sector and what the market collectively feels about its future. At times like these, when disruption is a buzzword, stress-testing the high growth companies in your portfolio for vulnerability from disruption, either real or perceived is important.

A simple question that I ask myself in these situations is, whether the next three years are likely to be higher-growth years or lower-growth years than the last three?

If you get this right, you will most likely get the multiple right.

9. How To Survive Underperformance
In an earlier essay, I wrote about how a fund manager can cope with portfolio underperformance. The key here is to be clear about one’s investment style and state in advance what kind of market environment the portfolio will do well and badly in. We typically express this with the following bell curve chart and there was a lesson here as well. Most of us learn to see the world map in two dimensions. As a kid, it took me a while to understand that you can reach Hawaii quite quickly from New Zealand and you don’t actually have to fly westwards all the way back.

As an investor, it took me a while to understand that you can get to ‘batten down the hatches’ quite quickly from ‘off to the races’

10. ‘Comfort Zone’ Is Not Always A Bad Thing
In an all-pervasive performance culture that extends from sports to the corporate world, ‘comfort zone’ has become a bad word. It has become something that has to be avoided at all costs if you don’t want to fall behind in life.

But in a trying year like 2018, it’s extremely important to have cultivated a comfort zone.

A place or a routine that gives you a sense of calmness, helps you put things in perspective and rise above the pushes and pulls of daily life to see the bigger picture. It’s a place you come to recharge your batteries and be a bit easy on yourself. There is a small temple close to where I grew up, that thankfully hasn’t made it to ‘Top 10 places in Mumbai if you are seeking divine intervention’. On days, which aren’t the favourite of the presiding deity, it is quite empty. It’s on such days, sitting cross-legged in the cool inner sanctum, that I have been able to quieten the mind. Once in a while, I have also remembered to fold my hands and pay obeisance.