Why the Investment Process is our Compass?

Investment Process — Stuyvesant Capital Mgt - Value Investing Since 1978

Change is the only constant – Heraclitus, Greek Philospher

Unfortunately, the last act of 2021 and the opening days of 2022 have brought confirmation of a 3rd wave of Covid-19 in India and across the world. This has been brought upon us by ‘Omicron’ a new variant of the Covid-19 virus. What provides comfort is the news and data on hospitalization and severe cases. However, we must cross our fingers and observe all protocols. The vaccination drive which has now been expanded in scope should further help mitigate risks.

The Nifty 50 Index closed the year higher by nearly 24% building on a near 15% gain in calendar 2020. Not quite the outcome one might have imagined in March 2020 when the whole world went into a pandemic induced lockdown and vaccination was a distant prospect. Incidentally 2021 marks a sequence of 6 years in which the Nifty 50 Index has finished higher. Of course, there have been swoons and sharp drawdown during this 6-year period as happened early in 2020 or the recent peak to trough drawdown of about 12% (Oct21- Dec21) in the Nifty 50 Index.

There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know – John K Galbraith, Economist & Diplomat

This is as good a time as any to remind our readers that what happens in the stock market in any given year has little relevance to what might happen in the next. We do not claim to have a crystal ball that tells us what the market may or may not do in 2022. It will likely fluctuate. Our investment process is not guided by a market forecast. We do not have a forecast for 2022 just like we did not have had one for 2021 or 2020.

Our process for research and portfolio construction relies on what believe are the tenets of a good business that help it grow and create wealth. Our preference is for the businesses generating consistent operating cash flow and a return on capital higher than the cost of capital. Of course, some businesses and industries are more cyclical than others and what matters in such situations is the return on capital over the cycle rather than the return on capital in a specific year.

Don’t miss the forest for the trees

Further when it comes to valuation, it is important to remember that the intrinsic value of a stock is that cash that will accrue to shareholders over many years adjusted for time value. All valuation metrics be it P/E, P/B, EV/EBITDA, Cash flow yield, PEG (Price earnings to growth) etc are merely ‘short hand’ substitutes of a more complex discounted cash flow to determine intrinsic value. These common valuation metrics are useful for making comparisons, particularly within the same industry, but could be misleading when the underlying fundamentals (Return on capital, Reinvestment opportunity, Free cash flow etc) of the companies are vastly different. So all valuation metrics must be used with care and with regard to the context.

While we do not have an opinion of what the market may do in 2022 that is not the same as saying that we can ignore the future. When we analyze a business, we are looking at its past – the reported financials, the ratios that underpin the business, the dynamics of the industry and the quality of the management. However, we recognize that it is what happens in the future; that determines our returns from owning the business. In our experience the likely (but not certain) path for the future metrics of a business is provided by how the metrics have behaved in the past. But it is only ‘likely’ and not ‘certain’ because things do change as Heraclitus succinctly opined at the beginning. This could be to innovation, changing consumer tastes, technology, regulation, and a host of factors some known and many unknown. We guard against this by diversifying the portfolio, position sizing and following a discipline. We must rely on the superior metrics of the business and the quality of management to navigate the companies through change and troubles.

The stock market sets a price for the businesses we own every second (or nano second) of every trading day. This price is subject to a valuation cycle which is influenced rather significantly by the degree of greed and fear experienced by market participants. When greedy they see far into the future and believe only good things will happen. When fearful they presume the worst and worry that things may get worse. This poses a further challenge – a change in the sentiment of the market could lead to a change in the price of the business though nothing may have materially changed for the business i.e., the intrinsic value may not have changed. But this can also be used to investor’s advantage – i.e., the mood swings of the market may allow you to get a margin of safety on your purchase.

You can’t predict. You can prepare – Howard Marks, Fund Manager

Thanks to the anchor provided by our Investment Framework – ScoreAlpha we stick to the tenets of our research process and manage a diverse set of funds, each with a distinct approach and appropriate guardrails. You can track this by referring to our Equity Ready Reckoner in which we publish the monthly statistics for our portfolios. In addition to this month end statistics, you can also track the ingredients in our portfolios and our portfolio construction outcomes in our product presentations in which the same statistics are presented on a quarterly basis over a 3-year time frame.

While we cannot tell you what will happen in any given year in the stock market we can articulate with data and guardrails how each of our funds is positioned. Our objective is to generate alpha for our funds compared to the benchmark. The market has moods and seasons; what works well in one season may not do as well in another; but over a cycle we aim to outperform. When you think of diversification – its not just about asset classes and but also about investing styles. The intelligent investor expects that drawdowns are inevitable when invested in the market; and recognizes that there will be tough times (when a style is out of favour) and good times – when the stars shine on the style.

What is crucial therefore is that your chosen fund or funds sticks to its strategy in a disciplined fashion, and you can monitor the data that tells you that the fund is being managed as was articulated. Our investment process drives that discipline.