Don’t confuse brains with a bull market – 16 – MASTERING THE MARKET CYCLE

When there is unusual profitability, higher return ratios command by a business then such businesses attract the incremental capital from others. This incremental capital results into the stiff competition and particular business become crowded where such unusual profitability and higher return ratio gone for a toss.

Reversely, businesses which are not able to generate huge profitability, higher return ratios, huge capital requirements etc. then such businesses fail to attract the attention of the new capital so that fewer players remain in the industry and due to challenging business environment, those few also reduces. This consolidation results in moving a cycle of profitability and return ratios to the improvement level.

Examples – high profitability and return ratios become lower (Telecom) and

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Merely 2-3 telecom operators to ~14 telecom operators and then again reach to strong 2 telecom operators. This journey suggests the rise and fall of companies.

lower profitability and return ratios become higher (Paint)

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So that we need to understand that business does not grow to the sky. They all have a cycle. Also, we need to keep in mind that best investors do not get successful all the time. Our human nature makes our success and that also moves in a cycle.

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Success changes the people and they start thinking that they are smarter. Success has a negative consequence also where people become richer and motivation level of them started reducing. Unconventional thinking transforms into conventional thinking. Rather we should know our limitations and also, need to understand that we can fail though we become successful investors.

Successful investors believe that they are mastered in the investing and they have less self-doubt, the worry about being wrong and risk of losses. This invites the risky situations.

We have to keep in mind that – “Don’t confuse brains with a bull market.”

Success teaches us to make money and failure teaches us an important of the risk aversion. We always have to focus on risk while balancing between the aggressiveness and defensiveness. When there is a bull market, everyone gives us a piece of advice. But the quality of advice getting checked during the bear market only.

Making money in the market is always an easy task but keeping secured that earned money is a difficult task.

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We keep doing hard work and keep learning for achieving success in the investing journey. One success does not make us a successful investor.

If we have earned an Rs.100 cr but we do not have the skill to keep it secure then it will not take time to again reach at zero.

We have seen that when the asset is not accepted by the crowd and all are uncomfortable to hold then the particular asset will be available at a bargain. Similar to us, when we start getting popular, everyone wants to make contact with us, everyone accepts our thoughts then we will not be available at a bargain. We also become crowded. We have to keep ourselves grounded and keep reminding ourselves that no rule, no strategy will work forever.

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When risky assets are penalized by the market and due to that, it will be available at the valuation where it will be no riskier.

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When there is a monopoly of the business, business generating good return ratios, decent profitability etc. These invites a competition, these plants a seed of failure. Reversely, when everything seems to be worst, then seeds for success getting planted.

Examples – monopoly kind of business worsening due to competition (Auto OEM) and

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Competitive business turns out to be good (Footwear)

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We believe that a good time will follow more good times but actually, we forget the cyclical nature of everything especially success. So that good time itself having a seed for the bad time and bad time itself having a seed for the good time.

Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation. 

Read for more detail: Mastering The Market Cycle: Getting the odds on your side by Mr.Howard Marks

BIBLIOPHILE: THE MOST IMPORTANT THING BY HOWARD MARKS “INVESTING DEFENSIVELY”

ID 01

Whenever someone asks us for an investment advice, then our first step must be an understanding his attitude towards the risk and return. We need to ask a question to him that what his choice – making money or avoiding losses is.

We cannot able to do both the things simultaneously in each and every situation.

If we provide an advice or we make an own investment without knowing attitude towards risk and return then we will not able to provide a proper solution. This is as similar as an asking for a cure from a doctor without disclosing our diseases to him. Investing is a full of bad bounces, uncertainty and random events which challenge us every time. So that such uncertainty requires knowing our risk-reward attitude for long-term survival into the market.

While we hit fewer losers then our probability to win the game is much higher. We need to choose how to play the game of investment – Offensive or Defensive.

ID 02

We just need to do is to protect our wealth by not picking wrong opportunities. In investing, only avoiding losers is in our control, not everything else. We do not know what will happen in the future, our best investment can be turnout as the worst investment. But we have to be ready for it. We have to focus on missing wrong shots so that can protect game if our best turnouts as a worst.

ID 03

If we look at the sports, many a time we need to protect our wicket rather play aggressively to make scores. Staying on a pitch provide us an opportunity for making a score while we get a good hitting opportunity. Investing also having many points which are similar to the game either positive or negative. As in cricket, Dhoni, Sachin, Rahul Dravid, Virat all having a different style to play a game. Some play defensive, some play aggressive and some make the balance of it. We cannot able to judge any players by looking towards his one match. Successful players perform well over a longer period of time with consistency.

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Sometimes even a good players overestimate short-term success and forget to focus on the consistency of performance over a longer period of time.

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As all players cannot be a Sachin, Dhoni, Dravid. As similarly, all investors cannot be a Warren Buffett, Charlie Munger, Howard Marks, etc. We just need to focus on our game in our comfort zone.

We are not able to know what will the result of the game we played, any uncertainty can affect it. We cannot only focus on one single investment ideas, we need to work on a selective group of ideas.

Negative side – If we keep on playing an aggressive investment game then we might not able to stick for the longest period of time in the game. Many uncertain events work as bounces for us.

Many a time, short-term investment success can become a reason to ignore the durable and consistent track record of investors. And few get attracted towards shine without checking its durability.

When opponents try to keep on throwing bounces then referee blows the whistle to give warning sign to opponents but in investing, there is no one who blows the whistle, we cannot able to get protected. Also in sports, we get notifications for the change of turn from our to opponents. But in investing, there is no notifications are available to us. We have to decide ourselves for changing the game from offensive to defensive.

We need to focus on the outperform into the bad time rather focus on outperforming into the good & best time. In good time, everyone can able to generate a good return but skill comes when we can able to outperform into the bad time. Doubled your Money in Last 3 Years? Skill or Luck?

Every player can able to play well against a weak team but a good player who can able to play well against strong opponents.

ID 06

We should focus on either making more score or stay on the pitch for a longer period of time. We cannot say that only one way is the right way and we just need to select it. Selection of way can be based on our experience, learning, market environments in which we operate, etc.

ID 07

We require a different kind of mindset for doing a right thing and avoiding doing the wrong thing.

Defense is focused on avoiding bad outcomes. It can help us to generate a higher returns but more through avoiding bad outcomes, through missing bounces, through managing risk.

If we bought an asset at Rs.100 and it falls to Rs.50; it falls by 50% but for reaching to Rs.100, that asset has to rise by 100% to just reach break-even.

ID 08

When we play offensive and if it works then it will add additional returns to our investment. BUT if not works then it creates a damage to our investment and to our wealth.

Defensive game help us to stay in the game during a tough time also, it helps us to survive for a longer period of time.

Majority of a time, financial markets works in an average manner but it shows one abnormal day which has reason to destroy our financial health. We need to prepare for that worst day. We just can prepare for the worst day but cannot predict how worst it can be or when that worst day will come. But it’s sure that worst day will come.

ID 09

It is hard to say in investing that whether our investment becomes successful or not and it works in the future as we have expected, economy /industries / Companies moves in a certain way and we prove to be right every time. We need to take care of the unforeseen future events which can go against us and can meltdown us. Warren Buffett has given concept which can protect us from such unforeseen events that called “Margin of Safety”.

ID 10

When we buy Rs.100 worth of an investment for Rs.90 then we have a chance to gain. But when we buy that same thing at Rs.70 then we have very less chance of loss and if odds will be in our favor then we can able to make a good return. So that buying cheaper provide us a “Margin of Safety” when our assumptions go wrong.

In the over-optimistic scenario, people buy Rs.100 worth of investment avenue for more than its worth (I.e. Rs.150, Rs.160) and then find a greater fool who will buy at the higher price from him.

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When we need an above-fixed returns then we need to go for more uncertainty but how to balance the defensive game with the inclusion of offense is the key area to focus. We cannot get higher returns with the exclusion of offensive game. We cannot able to win the match by just keep on making a single run. We need to hit 4 & 6 but with also focus on not losing a wicket.

Our first focus is to play a defensive game for staying on the pitch and then the inclusion of offense to the game for generating higher returns. Such approach provides us a consistency for a longer period of time.

ID 13

If we take out a history of investment managers, investors then we will come to know that very few get survival for the longer period of time. Not due to their inability to make a 4 & 6 but to lose wickets in many matches. Many investors come and performed well in a good time but worst time make them disappears.

The managers who do not get survived for a longer period, the majority of them have built up their portfolio on based of favorable scenario and with the hope of likelihood of outcomes without keeping a room for the occurrence of an error.

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Aggressive investors require competitive technical skills with fortitude, patient mindset, and capital. The investment might have potential to work well in a long-term but above quality provides a support to stay in a game for a long term.

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We should focus on controlling risk, avoiding losses rather than try to focus on gaining again and again.

ID 16

Simply defensive investing means being scared while making an investment decision. Worrying about losses, bad luck, worrying about something we don’t know, bounces etc.

ID 17

Read for more detail: The Most Important Thing Illuminated by Howard Marks

BIBLIOPHILE: THE MOST IMPORTANT THING BY HOWARD MARKS “CONTROLLING RISK”

In the last article, we have talked about the identifying risk and recognizing risk. Now, in the current article, we discuss regarding controlling the risk. Generally, in the market, we put much emphasis on the higher absolute return instead of superior risk-adjusted return. But the great investors are those who focus on the risk and generate moderate returns with low risk or high return with moderate risk.

Generating higher returns with the higher risk for a long time is rare in the market. The risk of losing money arises when our investment meets adverse situations and Loss does not occur till the negative events occur. We should always focus on controlling the risk because we do not know that when the negative situation arises and we met losses.

When we bought the home, we check that the home is constructed in a way which can be protected by earthquake or not. The similarly, we should focus on our investment. We should focus on the situations where the occurrence of such negative situations can destroy our wealth. And work as an earthquake in our financial position.

It can be possible that an earthquake will never happen in life long, but we bought the home which can be protected with an earthquake. Similarly, it may be possible that adverse situations will not arise during our investment time, but we should focus on raising of adverse situations and how we can able to protect our wealth from such situations.

The risk is not always easily visible. If our surrounding environment is positive, then we start thinking that negative situation may not arise due to the influence of that positive environment. But in fact, the risk is always present in the good environment also. And anytime good environment can easily turn out to the bad environment. Such transformation does not come to us with the prior intimation. We must have to be ready properly with such considerations before making investment decisions. Even controlling risk is becoming essential into the good environment because nobody is talking about risk and in a bad environment, risk takes care of itself because everyone fearing of risk.

Generating superior return compared to benchmark with the similar risk nature is a good performance. But, a good value addition is while we generate a return which is like the benchmark return with the lowest risk and with proper controlling of the risk. Such scenario is even better.

 

When the environment is positive, everyone rides the wave and we cannot able to say which one is better. (Good article – Doubled your Money in Last 3 Years ? Skill or Luck ?)

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So that we should always focus on the controlling risk, whether it will rise or not. Because we cannot able to really predict the occurrence of the risk.

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Careful investors always know that they cannot able to know the future so that they try to focus on controlling risk and try to factor the risk of loss of capital while they make any investment decisions.

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We start avoiding focusing on risk as the environment is going positive. Initially, we might put weight on risk, but many times that risk might not get triggered. So that we start avoiding it and started believing that there is a no risk into the environment. Such risk will not occur and we saved from the negative situation.

As we have seen in Russian Roulette with 100 chances, we may save for 99 times, but the 1 time can kill us. Or if we are lucky we can be saved all the 100 times. It doesn’t mean that there is no risk or risk may not arise in the future.

Example – THE EVENTUAL CONSEQUENCES OF RISK SEEKING OR RISK BLIND BEHAVIOR

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We constructed belief in our mind from our past experiences. If we have seen the positive environment, then we have made belief that negative situations never come. We should always keep in mind that occasionally extreme situations can arise and that can be out of our all belief.

In the year 2007, also welcome structured products, huge capital inflows, etc.

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We should not run from the risk but should manage risk intelligently. We should take the risk, but at the appropriate time and most importantly at an appropriate price.

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When we walk on a road with keeping our eyes closed and we do not meet an accident, then it’s not our talent, it’s a pure luck which plays out. We are a real blind if we consider such situation as our own skill. And such risky situations do not stay rewarding for a long period and we must walk on the road with keeping our eyes open.

Read for more detail: The Most Important Thing Illuminated by Howard Marks

BIBLIOPHILE: THE MOST IMPORTANT THING BY HOWARD MARKS “UNDERSTANDING RISK”

For making any investment decisions, we have to be dealt with the future, which is uncertain in nature. So, that when there is an uncertainty, then there is an involvement of risk and we cannot escape from the risk. We must have to focus on asserting risk while making any investment decisions.

When we focus on the return of the particular instrument, then we have concentrated our focus on half of the movie and rest half will get completed with asserting risk in that particular investment.

Risk 01

Traditionally, we all have learned, that in making a higher return, we need to take an incremental risk.

But we think logically about the same that if we get a higher return for the taking of incremental risk than there should not be a risk. We get rewarded by the returns for taking a higher risk.

Risk 02

Traditional risk/return graph has communicated the positive relationship between risk and return but ignored uncertainty involved for making such returns. Additionally, traditional risk/return graph has shown a risk as similar to volatility, but not focused on the danger which is involved in the investment.

Many a times volatility cannot be an as riskier as compared to other dangerous events for our investment.

Risk 03

So, that risk is not a volatility in the price of stocks, but the real risk is the permanent loss of our capital. And we must have to be worried about the permanent loss of capital rather than volatility. We must have to focus on the understanding of the risk which could have the probability of erosion of our capital.

Many a times risk is not only limited to, permanent loss of capital or to volatility, some kind of risk are objective and personal in nature; such as-

1) Falling short of one’s goal

Many investors have a different need, goals and not meeting those by investment results can be the risk for the particular person.

If someone just requires meeting the routine expenses, then getting a fixed return from fixed return instrument might not be at risk for the person, but if someone who wanted to build capital for investment then such a lower return can be a risk for that particular person.

2) Underperformance

Such kind of risk is related to the investment manager. If the investment manager cannot able to generate higher returns compare to index than the investment manager might lose his clients.

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3) Career risk

This is an extreme form of underperformance risk. Continuous underperformance can have resulted in the risk to the career.

4) Unconventionality

This risk is connected with a being different while making an investment idea. If unconventional idea got wrong, then there might be a risk to the career.

We buy metals, sugar stocks, etc. (at the worst time of the cycle). Instead of buying pharma, IT, Banking which is a darling of the industry. And if our stock picks up doesn’t work, then we have to face trouble and extreme risk of loss of career.

5) Illiquidity

This risk arises when investors need a money for some urgency and unable to break his investment.

Let me take an example of the cricket match for understanding a risk.

The main risk in the cricket match is to losing the match, series, etc. as similar to losing our capital in investment. If all the players play a poor game, then definitely team will lose the match and similar to an investment; if all our investment resulted in poor returns or more risk oriented than we might lose our capital or lose real value of capital.

As we have seen in Indian cricket history that Mr. Sachin Tendulkar, Mr. Rahul Dravid has played very well and created the record, they don’t always come to the ground for making a century or creating a huge score but always played well for protecting their wickets. Their focus on protecting their wicket helps them to play well for the longer period of time. And on against to them, many other players came to Indian cricket history and gone also; cannot able to stay for a longer period of time. They just have focused on making a score and sometimes due to the luck they can able to make good score but not always.

If players do not able to play well on a continues basis, then they will have lost the opportunity of staying with the cricket team (Career Risk). Also, we have seen that Mr. Mahendra Singh Dhoni has taken a many unconventional decision for the team during the match. Many of his decisions got success and many not. When he filled with his unconventional decisions, he has to face the anger of the people. This is as similar to our unconventional investment decisions and has to face anger from our clients if we filed into the unconventional decisions.

It is not necessary that we only can be incurred a loss by buying weak fundamental stocks. If we bought the comparatively lower fundamental company at a very lower price than that investment turns out to be a successful investment.

Sugar IT

We can see that if we have bought the comparatively lower fundamentally good stock at a cheap price than this stock has generated a higher return compared to the good fundamental stocks in last 5 years.

Also, not good macro environmental promises of safety. Because too positive news brings up prices at too high and any small adverse development can be enough for damages to our wealth.

People generally tend to associate with the things that are doing well. And that investment might be able to fulfill expectations for a while and thereafter small negative event can damage much higher. Such scenario having an involvement of higher risk.

So, that value investors believe in achieving higher returns from lower risk. We have to be ready with underperformance risk while we are buying bargains and market is in a heated bull phase. We need to accept it rather than incurring losses.

Risk 05

Investment is dealing with the future and the future is highly uncertain. And it’s impossible to know anything about the future.

Risk means more things can happen compared to what happened in the past. Understanding of risk requires a second level thinking and it’s not an easy task. The risk of losing money is observed by one that’s similar is not observed by another one.

Read for more detail: The Most Important Thing Illuminated by Howard Marks

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