Hope you had a lovely Holi celebration and may this festival fill your life with the colors of joy, friendship, and happiness always.
“The desire to perform all the time is usually a barrier to perform over time” – Robert Olstein
Through the journey of life, one faces numerous dilemmas in the multiple roles that one plays and so do we while wearing a fund manager’s hat. Over the past 36 months, we have been vocal in sharing our views on the markets - be it bullish/bearish, investment themes, risk & investment frameworks. This time around, we thought of sharing the dilemmas we face as fund managers.
When we started our journey three years ago, the first thing we deliberated upon was what is our fiduciary responsibility towards investors who have partnered with/trusted us in helping create generational wealth.
We realised, as a fund manager, our foremost job is focusing on efficient capital allocation which pivots around two pillars:
Capital Protection (Risk)
Generating returns keeping in mind time value (Growth)
While both the above complement each other in the long term, in the short term there could be a disconnect between input (process) and output (returns).
Our investment framework revolves around the above two pillars which stand as our guiding principles amidst day-to-day dilemmas and provides a backdrop to all the choices we make. We have shared our perspective on each of them in past letters. Here are links to our investment framework Jun-20 , Oct-21.
Happy to share our views on some of the dilemmas faced:
aligning investor interest with fund manager process
timing of flow of funds
cash calls
concentration vs diversification
Alignment of investor’s objective with process - While the investment process is of prime importance to a fund manager as it eventually defines the outcome (returns), outcome(returns) is the single most important factor for an investor; and there is zero doubt that both are right! Aligning both across all time frames is almost impossible, as markets have cycles, and no process works all the time. While investors/partners/advisors want to see performance all the time (more so in today’s hyper informative & competitive world, which creates noise) which we all well understand is not possible and rough times are bound to come, understanding the process only helps one stay firm. We try to keep the impact of short-term performance minimal through constant communication and managing expectations at our partner’s end.
We have always tried to focus on two things in our communication –
Our investment approach using the two pillars of Growth and Risk Management: Our prime focus remains on the risk side in avoiding Type A and Type C risk. If we get this right, we will always come out fine in the long run. Charlie Munger says – “Invert, always invert, tell me where I am going to die, I won’t go there.” It will be our failure if we have total loss of capital in our portfolio (Type A risk). Focus on Type C risk will keep our eyes open to potential opportunities.
Performance measurement: Likewise, performance measurement should be done keeping both risk & reward in mind. We see so much data getting published where returns are compared at AIF/PMS level (which is just a structure) in the same breadth irrespective of style/cap. We have always attempted to keep the beta of our portfolio low across all cycles which is adjusting risk all the time. Outperforming the index with high beta is not alpha. For example, in the table below, at the first look all portfolios have outperformed. But a detailed look at the adjusted beta (a measure of risk), reveals only the Alpha number changing substantially. There is a big difference between the performance of Portfolio A and B despite having similar return. On the first look, A & D has only 2% difference in returns but huge difference in alpha. One can look at many scenarios, we think looking at risk adjusted returns is best way.
It has been our endeavor to keep our beta lower than 1 and return higher than benchmark. It is also reflected in the chart below depicting the beta and adjusted alpha of our two portfolios since inception.
We will continue our focus on staying true to the process and withstand any market induced pressure in the short term. We are confident of outperforming in the long term.
Flow of Funds
Another enigma faced by portfolio managers is that money received in good times (after periods of good performance) is far higher than money received in rough times. Though a lot has been written around the impossibility of timing the market, it is equally true that investments made in bad/rough/volatile times generate best returns. Ultimately, returns are determined by the price you pay for the asset. For the same asset, if you manage to pay a lower price on account of a gloom/doom scenario, it is no big deal to understand that returns generated will be higher.
However, the most common investor psychology is to allocate money based on the recency bias - invest more in good times and lower in bad times, whereas the reward per unit of risk one takes is higher in bad times than good times. In fact, this psychology also explains why in most cases, NAV returns and investors returns are vastly different for investors. Investors who put money in good times are bound to have lesser returns than overall fund or rest of the investors. There are studies which have suggested that more than half of the investors suffer from this situation. And the only answer to this is to allocate in bad times, provided one is convinced of the long-term outcome (which has been the case for India for last many years and likely to remain so for next many years).
We have shared this philosophy constantly through our Carnelian Quarterly Calls and Letters to Investors when we have thought that it is best time to allocate capital (Feb 2023, Jan 2023, July 2022, May 2022, Jan 2021, Aug 2020)
We were the ones who aggressively told investors to invest in Manufacturing and IT in August 2020 when most were disbelievers!
How long is long term – While investing, investors come on board with a clear mindset of investing from a 3-to-5-year view; however, system’s focus on monthly performance, quarterly performance is relatively higher. With information overload these days, most of the clients are used to comparing month by month/quarter by quarter returns of funds vs benchmark/peers to judge for the superior returns.
On the other hand, for a fund manager in today’s world, given the technology and the number/types of participants involved, information asymmetry is rare. Further, when we discover transformation in businesses (what we call as Magic) for it to eventually reflect in numbers takes time. Thus, to achieve superior returns – the fund manager must identify and take calls which may take time (3 to 5 years) to fructify.
In our case there have been umpteen instances where we have been early identifiers of companies/trends which took time to get reflected in numbers and eventually in share prices.
To name a few, we early on identified a trend with the change in ethanol blending policy from an increase in the blending target from 10% to 20% coupled with change in CEO which led us to investing in Praj Industries which is the biggest beneficiary of this change. While the impact of this change in policy translating into order book took a while, we patiently waited for our investment thesis to play out. The two magic moments played out over time - Mr. Shishir Joshipura was appointed in April 2018 accompanied with change in industry structure (National Bio-fuel policy 2018) lead the road to handsome returns in 2021(Stock is ~5x in 2.5 years). On several other similar occasions when capex is completed, there is a change in CEO, etc. it takes time for the catalyst actions to get reflected in business performance.
Concentration Vs Diversification – A Fund manager has investment opportunities knocking at his door daily, and there is a constant challenge to manage the tradeoff between existing portfolio companies and new ideas generated which must be evaluated keeping Type C Risk (Opportunity Loss Risk) in mind. Further, extremes of both concentration and diversification can have their own consequences - playing to one’s conviction basis detailed work would help generate alpha while too much diversification basis little detailing will only dilute returns.
Keeping the above in mind, we have tried to create a portfolio with 20-25 names which gives good enough diversification yet keeps it focused. If we get new ideas, we try to compare with existing stocks and act only if the new one either increases the return potential or reduces the risk. Else we are better off continuing with the existing portfolio.
We hope sharing some of these thoughts have given you a little bit more insight into our mind and approach. We believe in being transparent in our approach. We will keep sharing more of these in the future as well. We are open to any questions/criticism/suggestion if you have any. We are not perfect, and the market teaches us lessons all the time. We hope to keep getting better at it over time and add value to our esteemed investors.