Eminent fund manager S Naren realised the folly of a "sound strategy", which was "grounded in decades of financial theory", when basking in the warmth of a bull rally.
He told Safir Anand how his attempt to maximise returns while minimising risk in the late 1990s turned into a "disaster". This was one of the many interviews Anand has done for his soon-to-be-released book Confessions of Stock Market Wizards.
In 1994-95, when Naren was rewarded handsomely by a bull rally, he says that he was "fixated on maintaining his portfolio's price-to-earnings (PE) ratio at a consistent level".
Naren was convinced that by selling high PE stocks and buying low PE ones, he could maximise his returns while minimising risks, Anand writes.
"On paper, it appeared to be a sound strategy, grounded in decades of financial theory. In practice, however he (Naren) says it turned out to be a disaster".
Why?
In a few years, by 1997-98, Naren realised that he had created a "junk portfolio" through this seemingly sound process and insistence on maintaining a consistent PE.
(This happens because in a bull market the stocks that are available at a low PE are more likely to be of poorly run businesses and the ones that command high PE are more likely to be of good businesses. Therefore, if a fund manager insists on buying low PE stocks and selling high PE ones, eventually the portfolio is likely to be biased towards poor businesses. When the bull run finally breaks, there more pain in store for such portfolios because the stocks of good businesses are able to defend their value better than the ones of poor businesses.)
The learning from this period for Naren was that "as the bull market expands, you need to improve the portfolio quality and increase the PE or price-to-book (PB) value of the portfolio, rather than reduce the PE or PB value of the portfolio".
Naren learnt that "when the market is in a bull run, you can't afford to sit on your laurels". He said, "You need to to upgrade your portfolio quality, not cling to rigid strategies".
Bigger storm coming
Even as this learning was settling in, there was an even bigger storm that was coming Naren's way, in the form of the 2008 financial crisis. He learnt that the strategies that worked during calm period suddenly become obsolete and that, to survive, one needed to adapt quickly.
In the 2008 crisis, his carefully balanced portfolio, which was designed to weather normal market fluctuations, was suddenly exposed to extreme volatility, writes Anand.
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Safe stocks plummeted and global economy looked close to collapsing. Investors panicked and were selling furiously, but Naren--now battle-hardened--decided to take a different tack.
Instead of selling, he began to buy carefully, selectively, knowing that the market would eventually recover and that the good picks would shine. When the market finally did in 2009, his portfolio delivered substantial gains.
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