10 lessons of 2016

Swanand Kelkar, ED, and Amay Hattangadi, MD, at Morgan Stanley Investment Management share their learnings.
By Guest |  29-12-16 | 
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Morningstar invites thought leaders from the investment community to share their insights. Views expressed are personal and should not be construed as investment advice.

The second half of December lends itself well to introspection. In that spirit of look-back, here are 10 things that we learnt (sometimes the hard way). To be fair, some of them are eternal truths but forgetful pupils that we are, we often need to be reminded.

1) The nadir for pollsters

The most conspicuous casualties of this year were pollsters who failed to predict the two big binary events - Brexit and outcome of the U.S. Presidential election. As Jason Blakely observed in his Atlantic piece “The forecaster on the New York Times home page showed 85% chance of a Hillary Clinton win at the beginning of the election night only to swing to a 95% Trump win in a few hours”. The core of the issue is that human behaviour does not lend itself well to pure science-like modelling. Attempts to quantify human behaviour with mathematical precision is at the heart of social science’s ‘physics envy’ but one can predict the trajectory of a projectile with reasonable accuracy but not the vagaries of human behaviour.

2) Betting on events

While pollsters not getting it right was obviously a problem for a trader looking to bet on the event outcomes, what compounded the problem was that market reaction to the “surprises” was totally surprising too. In the week of U.S. election results, the Dow Jones index was up every single day - the first two days because it looked like a shoo-in for Hillary Clinton and next three because the markets viewed a Trump presidency positively. As Howard Marks put it in his memo “Whatever was good for the market yesterday, its polar opposite was good for it today”. That’s why, tempting as it may be, it’s better not to trade binary events.

3) Beware of the consensus trade

At the peak of a consensus trade, nobody has the breadth of imagination to envisage what can possibly go wrong with it. Everybody agrees on how strong the rationale is and there isn’t a speck of risk on the horizon. Through the year, everybody (including us) was gushing about how compelling it is to buy shares of non-banking financial companies (NBFCs). That’s when this curve ball called demonetisation hit us and what were made out to be structural benefits like ability to have deep reach and effectively collect loan repayment instalments in cash, suddenly became the nemesis for the sector. To be sure, the last innings in this game hasn’t been played yet but this is no longer a consensus trade. The lesson here is to be disciplined about valuations when things clearly get over-extended. Towards the middle of the year, valuations for NBFCs had gone into uncharted territory. All the reasons for reversing the winning trade may not be evident then, but bear in mind that as things get heated, the odds are increasingly stacked against you.

4) Templates of the past may not hold

Periodic bouts of volatility are part and parcel of investing. But as far as India is concerned, the playbook for volatility in the past has been large capital outflows, significant currency weakness and investors piling into export driven Technology and Healthcare sectors. This may not be the right template this time around. For one, despite capital outflows the rupee has held up reasonably well against its peers, and both Technology as well as Healthcare sectors are facing challenges of their own. Conditioned responses to volatility may not work every time.

5) Be prepared to change your opinion

For most of their history, Oil marketing companies (OMCs) were shunned as mere trading stocks due to lack of independence. One punted on inventory and currency fluctuations or subsidy-sharing shenanigans and consequently, made or lost a quick buck on them. That template of analysis changed a couple of years ago when these companies were freed from the shackles of subsidy-sharing and the Government to its credit, dutifully allowed free pricing for their products. The return on equity (ROE) ratios that were languishing in single digits suddenly got into the twenties and from being punts, the stocks morphed into core holdings in portfolios. In 2016, these stocks have stood out as islands of absolute return in an otherwise listless market. But even today, we find a healthy degree of scepticism in this metamorphosis especially from investors of a slightly older vintage. It’s natural that past experiences and prejudices weigh on decision-making but being flexible about your convictions when presented with new facts was Keynes’ sage advice. It still holds true.

6) Staying close to the metrics

One of the most abused terms in investing is possibly - “a long runway for growth”. India is a very promising market for almost everything if the measure of future potential hinges on a per capita metric given its sheer size of the population and relatively low levels of income. Yet the markets are littered with carcasses of companies that were operating in these hugely promising areas. Long runway of growth can’t be the sole investing rationale and one has to be prepared to roll up the sleeves and focus on company and sector specific metrics. Every year we scratch our heads about at least one company or sector that had everything going for it from an opportunity standpoint but just failed to deliver. One such example this year is stocks in the alcoholic beverages sector. Favourable demographics, changing attitudes to alcohol consumption, rising urbanisation etc. made the top down story very alluring yet the stocks simply failed to deliver as other idiosyncratic issues held sway.

7) There are themes that work even in challenging markets

In times like these one feels a palpable sense of despondency even with hard core stock pickers. As the slightly older generation of cricket lovers will remember, at 100 for 5 in an overseas test match it seems all is lost and then the crisis man VVS Laxman appears at the crease. We feel themes like beneficiaries of pollution reduction and control or the data consumption boom will admirably endure this period of gloom. The fact that even in a year with near zero market returns, city gas distribution stocks have done remarkably well is testimony to that.

8) Escape from the echo chamber

The most telling reaction post Brexit was from a London based friend who apart from lamenting the outcome went on to say that he didn’t know of a single person who was likely to have voted “Leave” and hence felt that the outcome was rigged. This is what we called the “echo chamber” in one of our earlier essays. We tend to be surrounded by people who are like us and share our world view. Social media accentuates this by tailoring our news and opinion feeds to match our pre-set views. To avoid falling into this homogeneity trap, one needs to seek out and dispassionately engage with people whose views differ from your own and that’s true not just for current affairs but your favourite stocks as well.

9) Forecasting after unprecedented events

Demonetisation has been the most talked about event in the last couple of months. Forecasting the effects of such unprecedented events is understandably challenging and predictably, analysts have opted for status quo. Thus FY18 earnings growth for Sensex that was forecast at 18% predemonetisation is now forecast at 18.6% while that for FY17 has been marginally cut from 13% to 11%. If this indeed comes true, all the brouhaha would have to be filed under much ado for nothing. What the eventual impact of this move on earnings growth is difficult to predict, but one thing we are sure of is that it is not going to be the non-event that the current forecasts seem to indicate.

10) A sense of detachment

We close with a slightly philosophical lesson. People with a passion for the markets tend to get totally consumed by this animal. All of us have frantically hit the ‘Refresh’ button on our little screens at 9.15 am but as we grow a bit older, we realise that there is a lot more to life than the daily gyration of the indices. Psychologist Amos Tversky puts it nicely “The secret to doing good research is always to be a little underemployed. You waste years by not being able to waste hours”. So take a step back, cultivate a sense of detachment, tick off some items from the bucket list and be prepared to have a good laugh even if it is at your own expense. Find some time to enjoy a sunset and smell the flowers. Odds are it will make you a better investor.

Best wishes for a great 2017!

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