Great firm doesn’t necessarily mean great investment

Every bull cycle produces its own set of experts, and they find ways to justify the dramatic re-rating in the recently roaring sectors – be it the cement stocks in 1992, information technology pack in 2000 or power utilities in 2007. The intellectual firepower that the financial markets attract is unmatched, and yet – identifying a bubble when it is not yet busted could be rather tricky.

Consider this - between 2004 and 2007, the top-five contributors to Nifty Index, on an average constituted 50% of index returns, implying that businesses 6-50 (the remaining companies on Nifty50) combined contributed the balance 50%.

In the fiscal year ended March 2018, the top-five contributors accounted for 96% of index returns. If you think this was huge, consider the eighteen months ended September 2019—the top-five companies contributed a whopping 230% to index returns, with businesses 6-50 cumulatively making the negative contribution. To put it in perspective, over 18 months ending September 2019, the frontline Nifty 50 index increased 350 points – and 810 of those points were contributed by the top five companies. The best performing stock alone was responsible for the gain of 270 points (of 350). And it is not limited to just the index composition. Despite the frontline index rising about 1,300 points over the last year, 40% of all listed stocks have fallen 30% or more and 15% stocks fell 50% or more. That is how stark the returns have been.

There is another saying in the financial markets – that ‘nothing succeeds like success’. What it means is that when a select few stocks start driving the market’s performance, those stocks start attracting a lot more fresh investments. It quickly becomes a case of too much money chasing limited supply, which then becomes a virtuous cycle. As the author of the great book ‘Alchemy’ Rory Sutherland said: ‘Well generally, more data leads to better decisions. Except when it doesn’t’.

What causes the virtuous cycle to break is not known in advance, but something that has become unsustainable definitely breaks, and in hindsight, it appears ‘obvious’. Consider this: between June 2013 to June 2014, domestic institutional investors (mutual funds and insurance) invested 16% of incremental flows into the top 50 companies (BSE500 analysis) and the rest of the investment was broadly spread among the rest of the companies. This percentage increased to 77% between the months of June 2018 to June 2019. Investors keep investing in the same business over and over, and valuations keep rising.

However, buying a great business run by competent management is only one part of the equation. The other part is assessing what is the fair price one pays for it. If you knowingly end up paying a huge price, you are essentially hoping that someone will buy it off you at an even higher price.

And ‘hope’ is not an investment strategy. Hindustan Unilever was always a great business, and run by very competent management – and yet it underperformed the broader markets for ten years ending 2010. Similarly, Coco-Cola’s was very popular in the late 1990s, almost a decade after Warren Buffett bought it. It had reached a price-earnings ratio (PE) of 40 times. The returns for Coca-Cola between 1998 to 2016 was nearly ZERO – for almost eighteen years.

In the end, I believe that there isn’t a singular investment strategy that has managed to outperform markets at the expense of all other strategies over long periods of time. Yet, I do know that the herd mentality more often than not, yields results that would leave a lot of investors wanting. Equity markets are a fascinating place but choose your investment manager wisely.