Market Sense — 050 — Aug 2020
The Month Gone by!
The GDP Growth rate for the first quarter of FY21 showed contraction of 23.9% over the corresponding period of the previous year. This contraction was the first time in over 4 decades, making the critiques of the government happy. The major reason for the contraction was the decline already, priced-in by economists in sectors such as Manufacturing, Hospitality, Travel & Tourism etc., However, the stock market and the general business community have given this data the go by, for a valid reason.
The market was more worried about the tussle with China rather than the economic contraction. The reason for this behavior of the market is pretty simple. The market have a tendency to look forward to the future. The stock prices are a reflection of the future earning of the company.
The fall in cashflow and difficult business scenario has helped to clean up many businesses. Heavily debt funded Promoters such as GMR Infra, GVK Infra, Future Group etc., sold their businesses to stronger promoters helping to prevent another banking crisis and protecting the employees and other stakeholders of their livelihood. This trend may continue in the days to come with businesses changing hands from weak promoters to stronger ones. These changes in the business landscape can help seed the next Bull Market.
The markets are currently pricing-in the earning of the year FY22. The caveat being, any nasty surprise in the banking and lending business can disturb the apple cart.
High Returns from Low Risk: A Stock Market Paradox
According to financial theory risk and return are positively related (The risk-return tradeoff). In simple terms this means, potential return rises with an increase in risk. Consequently, we generally associate low levels of uncertainty with low returns and vice-versa. Hence we associate the returns from Bank Deposits, Government Paper etc., lower compared to the returns from Corporate Bonds, Equity etc., which are supposed to come with a higher risk of default and possible loss of principal or capital.
Howard Marks of Oaktree Capital, wrote in his seminal book The Most Important Thing –
In bull markets — usually when things have been going well for a while — people tend to say ‘Risk is my friend. The more risk I take, the greater my return will be. I’d like more risk, please.’
The truth is, risk tolerance is antithetical to successful investing. When worry is in short supply, risky borrowers and questionable schemes will have easy access to capital. Too much money will chase the risky and the new, driving up asset prices and driving down prospective returns and safety.
The Stock markets are currently awash with liquidity unleashed by the massive stimulus packages. We are facing a strange phenomenon when in-spite of the poor economic fundamentals in the near term, the markets seem to be on high spirits.
Risk, which Marks and Warren Buffett have often defined as losing significant amounts of money and permanently. Risk (of losing money) often moves in the same direction as valuations. In other words, risk increases/decreases as valuations rise/fall. Marks and Buffett suggest that risk is lowest precisely when prospective returns are the highest, and risk is highest precisely when prospective returns are the lowest.
Low volatility anomaly
While highly volatile stocks may indeed deliver bursts of impressive performance, it is found that lower-volatility stocks have historically generated better risk-adjusted returns over time. This is known as the low volatility anomaly. The low-volatility anomaly was already known in the early 1970s. In their book, “High Returns From Low Risk: A Remarkable Stock Market Paradox,” Pim Van Vliet and Jan de Koning have made a case for the investing paradox.
According to the authors, companies with higher debt are inherently riskier because of the possibility they may default — that’s not a risk among companies with no debt. Studies showed that stocks with higher leverage generated below-average returns.
Pim Van Vliet and Jan de Koning credit a study by Robert Haugen for discovering the Stock Market Paradox. Robert A Haugen was a financial economist and a pioneer in the field of quantitative investing. Together with his former professor A James Heins, he discovered in the last 60s and 70s that, contrary to the prevailing theory, low risk stocks actually produce higher returns.
Van Vilet proved that low-risk stocks have outperformed high risk stocks on the longer term across market cycles. The paradox was found to be applicable to Mutual Funds, bonds and other assets classes also. The authors also found evidence of a negative relationship between risk and return. The paradox was found in several speculative markets viz., lottery tickets, gambling and horse races apart from stock and commodity markets.
Conclusion & Way Forward
Van Vliet and de Koning demonstrated that the paradox is all around us, and that low-risk securities of many kinds outperform high-risk securities.
Mohnish Pabrai, Value Investor and Author of ‘The Dhandho Investor: The Low-Risk Value Method to High Returns’ have suggested a few ways to identify low risk high return investments in his book.
- Investing in existing businesses; of which the stock market is the best option.
- Investing in simple businesses; where intrinsic value can be calculated “back-of-the-envelope” using conservative assumptions about future cash flows.
- Investing in distressed businesses; where a few fundamentally great stocks might become great deals on bad news.
- Investing in businesses with durable moats; earning high returns on invested capital keeping in mind that the majority of moats are hidden or in partial view and that there’s is no such thing as a permanent moat.
- Invest in copycats rather than innovators
Mohnish Pabrai suggests that each Investor should invest in businesses where Heads I Win, Tails I don’t lose much. This principle should help investors to succeed in these uncertain times.
Happy Investing……………