(category)Deepak's Memos

You can't plan for everything. But you can plan to respond better.

This month, we speak of the complexities of predicting things, versus building the muscle that responds better. In markets, we are always worried about the next big bad thing around the corner. It was Ukraine, then US interest rates, the Silicon Valley Bank, then the situation in Gaza, then Indian elections and later this year, US elections. There will always be something to fear. Should we predict and act, or wait and react? We explore.

Deepak Shenoy


We've had a very warm welcome to the summer of 2024, and the markets have also been kind and probably just as blazing, looking at the performance.

Capitalmind PMS April 2024While we don't dwell on performance, it's now useful to see 5 year plus returns in our portfolios beating markets. In the longer term, though a small difference in return percentages can be very high in absolute terms. As an example, 18% returns over 5 years takes Rs. 50 lakh to Rs. 114 lakh. And 21% returns - a mere 3% higher - takes the same 50 lakh to Rs. 129 lakh. The difference of 15 lakh rupees accounts for nearly 1/3rd of the original capital - and it's achieved by "just a few percentage points". The math sometimes isn't as transparent about this fact until it's revealed in the absolute numbers.

This months, we speak of the complexities of predicting things, versus building the muscle that responds better.

Dubai had an unseasonal storm recently. With showers of a magnitude they'd not seen earlier. A single day of heavy showers ended up drowning the landscape - cars were underwater, streets were flooded, houses were full of it and so on. 250 mm of rain in less than 24 hours, when the average rainfall is around 100mm in a year. It's was what you would call a disaster, but if you look at if from the lens of a Mumbai, which routinely gets even more rain in a single day, it wasn't that much. And then, Dubai was seeding rain clouds, a concept which does lead to higher than expected rainfall sometimes. So should Dubai have planned better, for a storm that should have been expected?

This is myopic. Because you can't really prepare for the absolute worst case in every situation. There's a reason you don't walk on the pavements with helmets. Even if you know that India sees far more pedestrians die in road accidents than riders of vehicles. You make the (valid) assumption that wearing a helmet while walking, is a little too much. These are not calculated risks - it is almost clinically insane to take this level of precaution.

If you don't expect this, what do you do? You respond better. You look right, left and right again when you cross the street. You take evasive action if a vehicle seems to be driving terribly around you. You stay a little away from those electricity poles where there's a bit of sparking near a transformer. You do things that are more responsive to the traffic, to minimise the chances that you will be a victim. Not by wearing a helmet or telling every car or bike that their speedometer should stop at 20 kmph.

Preparing to respond is one thing when you know the complexities of the problem. If you have a flat in one tyre, you open the tyre nuts a wee bit, use the jack to lift the car, and then change to a spare tyre. If you have two flats at the same time, you can't do that; so you figure out someone to call that can help you or take the help of a passing stranger to help, or call for a tow truck. The latter is an emergency response - it will work for two flats, a broken down engine or even a car crash. Over time, as countries get developed, they develop better emergency response systems simply because you can't cover for all of the things that can happen.

Why am I speaking of this? Because as investors, we love to speculate on what happens to markets. A conversation I often have is:

Friend: I have to buy gold.

Me: Why?

Friend: Because there could be a third world war and only gold will work, not currencies.

Me: You mean people will trust gold, but not the rupees you own in your bank or as cash?

Friend: Yes, see what happened in Zimbabwe, or Argentina. Their currencies are worthless. People had to rely on physical gold.

Me: But if you're in Gaza or Ukraine, and you own a lot of physical gold, it's going to get taken from you by a person that has a gun.

Friend: You're crazy, no chance that we will have that kind of a situation. I can't buy a gun!

Me: So you think you're preparing for a third world war, but people will hopefully only swear at each other?

There's nothing wrong with preparing for a doomsday situation which is not precisely doomsday. It's intellectually stimulating, and provides partial insurance. "Take my gold and don't kill me", still leaves you alive, sometimes. But it isn't "being prepared" in any meaningful sense of the term. (For the record, there is no real preparation for a third world war. You just hope it doesn't happen.)

In markets, we are always worried about the next big bad thing around the corner. It was Ukraine, then US interest rates, the Silicon Valley Bank, then the situation in Gaza, then Indian elections and later this year, US elections. There will always be something to fear. And the question that overrides all of this is: "Should I just sell everything and go to cash waiting for this to pass us by?"

Because the markets are at close to all time highs, the answer, looking historically is a categorical no. But markets always seem to get back to all time highs, over time. And yes, markets have sometimes frustrated people for decades (Japan) or years (India in the 1990s). Yet, in both these times, absolute fortunes have been created in the markets, just by rotating capital into the right stocks. There will always be money making opportunities in markets, and we know that. Predicting an overall fall in the markets will turn out right eventually (you could say it every year and you will be right at some time). But if your response is to cower down in fear has two basic problems:

  • Markets keep going up and you stay in cash
  • or, Markets fall, and you feel so good with yourself that you think it'll fall even more and before you know it, all time high again.

These two situations are portfolio killers. You either feel miserable, or just feel good and then feel miserable. We love to predict. We've yet to build our own emergency response mechanisms to market volatility. (Note that the Federal Reserves answer to any problem is usually to just cut rates and print money, much like my college doctor whose response to anything, from a headache to a broken leg, was Calpol)

What we do at Capitalmind is: feel the same pressures and pain from market volatility. We have the same feeling of oh my goodness, the market is going to crash. But we can only be different in the way we choose to react - by saying that the actual event, whatever it does, will give us the understanding of what to do. It's better to drive looking at the road in front of you, not only through a rear view mirror or the crystal ball in the form of a Google Map. Experienced travellers know when to ignore that map voice saying "take a left" when the road it points you to is approximately 6 feet wide. You ignore it and trudge on, knowing that after its freak cries saying you are all going to die for not taking that left, it will "reroute" you through roads meant for human beings, eventually. You have learned to respond, despite all that AI and technology and what not. In some strange way, we've learnt to ignore a few things in the markets when there are voices telling us that is exactly what will happen.

Dubai had a relatively rough time recovering from the sudden rain. Dubai airport had to cancel hundreds of flights. Trains remained cancelled for weeks. Cars were submerged and apparently, insurance companies don't really want to pay. Mumbai, Bangalore and Chennai have been through this - they know there is some form of preparedness that is needed, but it's never going to be enough. While we are guilty of not building better infrastructure that won't crumble this much, the response seems to be getting better each time - and we seem to bounce back faster. Maybe, apart from building better drainage systems that we need anyhow, we might also install lifeboats in police and fire stations, have multiple response mechanisms for all forms of emergencies (floods, earthquakes, heat waves) and then, when things go haywire, use the smartest teams to develop a response for the issue at hand. In the markets, the appropriate way to respond is to tackle each problem as it happens, rather than attempting to take action in advance.

The BSE complexity

Here's a little segue into a stock we own, the Bombay Stock Exchange (BSE). Recently, it's been making a lot of revenue by having option trading in the "weekly" options migrate partially from the NSE to the BSE. Noticing this, the regulator (SEBI) decided that the BSE is paying a lot lesser fee than it should be. The NSE paid a SEBI fee based on the "notional" turnover; meaning, if you paid Rs. 50 premium for a call option at 23,000, NSE would pay a fee that was a percentage of the 23,000. BSE paid a percentage of the 50.

SEBI then told the BSE to recalculate and pay all the past fees with interest. And that added up, it seems, to around 169 crores. This sounds like a lot; but the important thing to note was how BSE responded.

  • They first revealed the amount of the fee as expected, in April itself, even though the results were coming up in May.
  • They provisioned an amount for this fee in the results in May
  • Despite that, the BSE showed a 17% increase in net earnings from 91 cr. last year to 107 cr. this year.
  • And then, they increased the fees they charge customers so that they can recover these fees.

The scale of the fee in comparison with their earnings, and the fact that despite that fee, they've grown earnings enough to warrant a big increase in profits shows, in some way, the power of their franchise. But the important thing to us is how they reacted to the problem, without making much ado of the issue and provisioning appropriately. This is not to say that they are the best thing since sliced bread - for the record, we don't know and we know that we don't know enough to praise the company to heaven and back. But we do know that their actions in this context are worthy of appreciation.

(On a different note, we don't even think sliced bread was a good thing)

On the question of elections: I'm scarred, perhaps, because I was there in the last big real surprise in election results in 2004. We saw a bit of a surprise result, and the communist left party came to power. You would think this was disastrous, and the markets thought so, for two days, and the Nifty fell about 24%. Yet, in four months the Nifty was back to it's pre-market level, and in the next three years, it went up 3x, from 1700 to beyond 6000. This has been so remarkable that I believe this: even if we predicted election results correctly, we would have no idea about how markets will react, in the short or long term.



(tag)Capitalmind PMS

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