Marcellus: Crushing Risk is More Rewarding than Chasing Returns

OVERVIEW

Published on:14 June, 2019

High flown theories of Finance & Investing don’t work in India. What works in the Indian stockmarket is risk minimisation. We minimise risks associated with accounting fraud, with topline & bottomline volatility and with liquidity. In other words, we invest in clean monopolies selling essential products.

Sophisticated investment literature can be damaging for your wealth

There are many delusional theories in Finance. One of these is the Efficient Markets Hypothesis (EMH) which contends that since stock prices efficiently discount all the available information in the market, it is impossible to beat the market. Another is the Capital Asset Pricing Model (CAPM) which claims that the returns from a stock will be directly proportional to the systematic risk (or beta) represented by the stock.

Whilst Warren Buffett’s rubbishing of the EMH is well-known (see https://www8.gsb.columbia.edu/sites/valueinvesting/files/files/Buffett1984.pdf), thanks to the pseudo-science peddled by business schools, CAPM is still taught in classrooms across the world including in India, a country where CAPM is even less applicable than it is in America.

CAPM says that returns are proportional to risk, it follows therefore that the only way you can generate higher returns in the market is by taking more risk. Basis this elegant theory, wealth managers lead their clients down the garden path towards high risk products whilst selling the delusion that higher risk will lead to higher returns.

Crushing risk is the key to generating higher returns
Our decade of working and investing in India has led us to conclude that you need to minimise four types of risks if you want to generate steady & healthy investment returns in the Indian stockmarket:

1. Accounting risk: Whilst we all now know how prominent public and private sector banks in India fudged their NPA figures for years on end until the RBI’s Asset Quality Review forced them to come clean, the same problem exists with several housing finance companies (who don’t come under the RBI’s purview). The accounts of a leading cement manufacturer don’t stack up. Neither does the annual report of high flying retailer make sense. Ditto with a prominent petchem company and a prominent pharma company. In fact, the majority of the companies in the BSE500 have annual reports which don’t pass scrutiny. Using ten forensic accounting ratios and a financial model which contains time series data on 1300 of India’s largest listed companies, we seek to identify that 20% of the Indian stockmarket whose books are actually believable.

2. Topline risk: At US$2000, India’s per capita income is still very low (less than half the level of Sri Lanka and a quarter of the level of South East Asian countries like Thailand and Malaysia). As a result, beyond the basic essentials of life – FMCG products, pharma products, basic apparel – most other products in India are luxury items for most Indians. As a result, even for small cars or entry-level two-wheelers, demand in India fluctuates wildly. Eg. Maruti Suzuki typically experiences 5-6 years of strong demand growth (growth well above 15% per annum) followed by 3-4 years of famine (growth well below 5% per annum). Whilst its cross-cycle average growth tends to be around 12%, the stock price volatility reflects the volatility of Maruti’s topline growth. In contrast, a company selling essential products like Asian Paints or Marico, tends to see steady revenue growth – between 10-20% per annum – pretty much every year. Investing in companies selling essential products in India therefore reduces risk.

3. Bottomline risk: As the cost of capital is still pretty high for India, it is rare to find Indian companies who spend heavily on genuine R&D. Understandably therefore, the Indian economy is characterized by rapid imitation – one company spots a niche (say, gold loan finance) and within a decade it has a 100 imitators. This rapid new entry squeezes the profitability of the first mover and thus creates risk for its shareholders. In order to reduce such risk we look for sectors where over extended periods of time, 1 or 2 companies cumulatively account for 80% of the sector’s profit pie. Such monopolies have lower volatility in their profit margin.

4. Liquidity risk: India is the least liquid of the world’s top ten stockmarkets largely because promoters own more than half of the shares outstanding in the Indian market. As a result of this, beyond the top 30 or so stocks in India, liquidity – measured by average daily traded volume (ADV) – drops rapidly. By the time you are in the lower reaches of the BSE100, ADV is well below $5m per day. Such low liquidity creates stock price gyrations as investors go through their cycles of election induced euphoria followed by accounting fraud induced panic. Tilting the portfolio towards liquid stocks reduces this risk.

Investment implications

Over the past decade another corollary of CAPM – smart beta – has become fashionable. Smart beta practitioners (no pun intended) believe that there are various types of systematic risk embedded in stock prices eg. size (i.e. small caps should outperform large caps), value (i.e. cheaper stocks should outperform more expensive stocks), momentum (i.e. stocks which are doing well should continue doing well), etc. Basically, what smart beta practitioners are saying is that investors who take any of the four risks outlined in the preceding section should be rewarded by the market for taking that extra risk. That line of thinking does not work in India.

In my book “Coffee Can Investing: the Low Risk Route to Stupendous Wealth” (2018), I have shown that identifying stocks with low accounting risk, low topline risk and low bottomline risk using a simple quantitative filter (revenue growth should be in double digits and ROCE should be above 15% every year for ten consecutive years) consistently generates returns in the vicinity of 20% per annum with share price volatility half that of the Nifty. Even without adjusting for risk (volatility), you are far better off investing in this portfolio rather than in the Nifty. In fact, you are far better off investing in this portfolio – akin to our Consistent Compounder Portfolio (CCP) – relative to almost every other asset class in India (including real estate, private equity and government bonds) – see chart above. You do NOT have to take extra risk in India (or load up on beta) to get healthy returns.

Why does this simple filter-based approach to creating a CCP work so consistently? Because the CCP basically seeks to minimise the four risks outlined in the preceding section. If a company is able to grow revenues at double digits every year for ten consecutive years, it is almost certainly selling an essential product which will be in demand in both economic booms and busts. Secondly, if a company is able to generate ROCE above 15% every year for ten consecutive years, it is highly likely to be a dominant/moated franchise. (The vast majority of the Nifty companies have not generated an ROCE of 15% even once in the past ten years.)

Less than 15 companies make it through the two filters described above. And because we are seeking to minimise risk rather than chase returns, the occasional period of underperformance (see our recent newsletter:https://marcellus.in/wp-content/uploads/2019/06/Marcellus_CCP_Newsletter_June_2019-2.pdf) does not cause us to lose sleep. We are happy crushing risk rather than chasing the ephemeral fantasies of high returns.

To read our other published material, please visit https://marcellus.in/blog/
Saurabh Mukherjea is the author of “The Unusual Billionaires” and “Coffee Can Investing: the Low Risk Route to Stupendous Wealth”.

Note: the above material is neither investment research, nor investment advice. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India as a provider of Portfolio Management Services and as an Investment Advisor.