Saurabh Mukherjea, Rakshit Ranjan & Salil Desai
The year 2019 ended on a pretty strong wicket for equity markets around the world. Most major indices were up 10-25% during the year. The Dow Jones increased investors’ wealth by ~22%, the FTSE, Hang Seng, and India’s Nifty by ~12% and the Nikkei by 18%.
However, 2020 brought with it the rumblings of what eventually became a global pandemic, bringing some of the largest economies of the world to a standstill. As Covid19 spread worldwide, stock markets crashed globally, with many indices recording their worst-ever quarter performance and many others seeing the fastest-ever correction in recent history.
In India, the broader markets were anyway appearing shaky due to the weak growth in corporate profits for the past 6-7 years. Then came Covid-19 to add to investors’ troubles. And in the middle of all this came the collapse of Yes Bank. In a matter of weeks, the stock markets and the larger economy were dealing with a full-fledged crisis.
In five parts, Saurabh Mukherjea, founder of Marcellus Investment Managers, and his team elaborate on their investment process and emphasise on the techniques that have helped their fund navigate through tough markets and a crisis.
The futility of timing the market
Summary: Investing in a portfolio of consistent compounders makes the timing of entry and exit redundant. We show that trying to finetune the purchase price of a stock is not worth the time and effort. The reason for the same is that stock price movements are largely driven by growth in earnings and hence for healthy long-term returns, what is most important is the assessment of the long-term earnings potential of a business.
Investing in Consistent Compounders makes timing redundant
“I can’t recall ever once having seen the name of a market timer on Forbes’ annual list of the richest people in the world. If it were truly possible to predict corrections, you’d think somebody would have made billions by doing it.” – Peter Lynch
In this five-part series on investing though a crisis, our discussion so far has largely revolved around assessing a company’s core fundamentals and the strength and long-term sustainability of these fundamentals which enables businesses to keep growing earnings while maintaining a return on capital in excess of its cost of capital. These companies not just survive a market crash or a crisis, but emerge stronger from them, in turn consistently compounding an investor’s wealth.
However, when markets crash, all stocks tend to first correct before investors start factoring in the differing fundamentals between the weaker companies and their consistent compounder counterparts. Should investors then try and take advantage of the market-wide correction by exiting their holdings of consistent compounders and buying them later at lower levels? We touched upon this question in Part 4 of this series and delve further into the question in this concluding section.
Assume we have two investors – both of whom invest Rs 1 crore annually in shares of Asian Paints. The first investor is Mr. Gifted. He is skilled at perfectly timing his stock purchases, and each year buys Rs 1 crore worth of Asian Paints shares at the stock’s lowest price point for that year. The second investor is Mr. Mortal, who believes he cannot time share price movements. As a result, he buys Rs 1 crore worth of Asian Paints shares on the 1st of April each year, regardless of the then prevailing share price.
Mr. Gifted and Mr. Mortal start investing in Asian Paints from April 2010.
In their first year of investing, Mr. Mortal invests Rs 1 crore in Asian Paints at Rs 203 per share on April 1, 2010. Mr. Gifted on the other hand, using his timing skills, invests his Rs 1 crore on May 21, 2010, when the Asian Paints’ stock price is at its lowest during the fiscal year (Apr-Mar) 2011. Both our investors repeat this exercise annually for a period of ten years, including years in which their purchase prices differ materially. For example, in FY2014, Mr. Mortal’s investment on 1st April 2013 is at a price of Rs 495 per share whereas Mr. Gifted waits to buy on August 28, 2013 at Rs 392 per share. Mr. Gifted’s purchase, at the lowest price point during FY4 is 21% lower than Mr. Mortal’s – inarguably a material difference.
At the end of their ten-year investing cycle, the two investors compare their portfolio values and the compounded return they have earned (XIRR).
Mr. Gifted’s portfolio is worth Rs 36.3 crore, an XIRR of 22.6%!
Mr. Mortal’s portfolio is worth Rs 34.5 crore, an XIRR of 21.7%!
Mr. Mortal’s portfolio value is only 5% lower than that of Mr. Gifted!! Mr. Gifted has surely done better than Mr. Mortal, but his relative outperformance is not material enough to see significant benefit from market timing. The chart below shows the progression of their portfolio values during the 10 years investment period. Note: These portfolio values DO NOT include dividends – they are based only on share price movements. Including Dividends will increase the XIRR numbers by 1-2% for both investors.
Moreover, FY11-20 was not the only 10-year period when Mr. Gifted failed to add much value via his skills of timing his annual investments into Asian Paints share price. The table below shows that no matter when the two investors started this exercise, the most Mr. Gifted ended being ‘more wealthy’ than Mr. Mortal was 15% at the end of their ten-year investment cycle.
Other variants of this analysis
• If we consider investing in the Sensex (instead of Asian Paints) over any 10-year time period after 1991, the outcome would not have been dissimilar. Mr. Mortal’s 10-year portfolio value would have been 80-95% (average of 83%) of Mr. Gifted’s portfolio value.
• If we increase the time frame of investment of each portfolio from 10 years to 20 years for any year after 1991, the outcome would still be the same! Mr. Mortal’s 20-year portfolio value would have been on average 82% of Mr. Gifted’s portfolio value if invested in Sensex, and an average of 85% if invested in Asian Paints.
Why does this happen?
The simple reason why Mr. Mortal isn’t too far behind Mr. Gifted in all these portfolio iterations discussed above is that – earnings drive 80-90% (if not higher) of the stock returns generated over the long run. As a result, provided the underlying asset (company or an index) delivers a modest or healthy earnings growth, it does not matter whether the entry point of one investor was 20% higher or lower than another investor.
Most investors have recurring cash flows to invest each year. Many of these spend a lot of effort trying to be Mr. Gifted and waiting for the ‘right’ opportunity to deploy their funds. And as we have seen above, not only is it difficult being Mr. Gifted in market timing, it is also not worth the effort.
The philosophy we follow for Consistent Compounders PMS aims at investing in companies whose earnings we believe will compound consistently at 20-25% over long periods of time. Instead of worrying about how best we can time the market volatility and entry valuations for these investments, we spend all our efforts trying to understand and build high conviction on their fundamental strengths which are likely to drive their earnings in the future.Conclusion
When markets crash in a crisis, panic is usually the more common response of investors and many end up exiting their investments at or near the bottom. Such market corrections should in fact be viewed by investors as an opportunity to build a sound portfolio for healthy and steady long-term returns. The Covid-19 related crisis in early 2020, although serious in nature as well as its far-reaching impact, wasn’t the first such major correction to hit the Indian stock market (major corrections took place in 1993, 2000, 2008, 2013 and 2016) and very unlikely it will be the last.
In order to navigate the vicissitudes of the market, investors need to build a portfolio of stocks that is not only resilient in times of crises but is also capable of seizing opportunities that arise when conditions normalise. The Consistent Compounders possess these highly desirable twin characteristics.
Fortunately for us, India is blessed with a number of firms that dominate their industries and earn returns on capital far higher than their cost of capital.
Identifying the Consistent Compounders among these requires a thorough exploration of the sustainable competitive advantages of these companies. An understanding of how these companies create barriers to entry around their businesses and acquire pricing power is crucial to understand their cycle of large free cash flow generation being deployed back into the business for higher growth and for the strengthening of competitive advantages, which in turn leads to even higher free cash flows.
As proponents and practitioners of long-term investing, we have seen that a portfolio of 12-15 Consistent Compounders delivers market-beating results on a consistent basis – both in bull and bear markets. Investors desirous of further exploring how to build such a portfolio will do well to read the book “Coffee Can Investing: The Low-Risk Route to Stupendous Wealth”.
(This is the fifth installment of a five-part series by Saurabh Mukherjea, founder of Marcellus Investment Managers. Rakshit Ranjan is Portfolio Manager, and Salil Desai, Portfolio Counsellor at Marcellus Investment Managers.)
Read the first installment here.
Read the second installment here.
Read the third installment here.
Read the fourth installment here