Investing Through Cycles

Understanding how various types of stocks, bonds, and other assets have historically performed at various points in the business cycle may help investors identify opportunities as well as risks. This business-cycle investing approach differs from both short- and long-term approaches because shifts from one phase of the business cycle to the next have historically taken place every few months or years on average. This blog will discuss how knowing the cycle may help investors evaluate and adjust their exposure to different types of investments, as the likelihood of a shift from one phase of the cycle to the next increases. Historically, different investments have taken turns delivering the highest returns as the economy has moved from one stage of the cycle to the next. Due to structural shifts in the economy, technological innovation, regulatory changes, and other factors, no investment has behaved uniformly during every cycle. However, some types of stocks or bonds have consistently outperformed others and knowing which is which can help investors set realistic expectations for returns.

10 Oct 2022
Investing Through Cycles
Based on the backdrop, PMS Bazaar conducted a webinar themed “Investing through Cycles”. The keynote speaker was Mr. Jigar Mistry, Co-founder of Buoyant Capital. Mr. Mistry first introduced the 6Ts of Buoyant Capital and explained the Core and satellite structure of their Opportunities fund and its performance. Later, he spoke on topics such as fed rate hikes, investment through cycles, sectoral outlook, and more.

Below, we bring to you excerpts from the question-answer session with Mr. Jigar Mistry.

Host: With inflation rates rising throughout the world, central banks are being hawkish about fighting inflation with traders. The recent Fed rate hike was about 75bps, which also pushed RBI to raise our interest rate by 50 bps. How do you see the Indian economy moving forward and what is your opinion on it?

Mr. Jigar Mistry:  Before Jackson Hole Symposium there were two alternative points of view. One point of view is - since inflation is high in the U.S and historically it has not been as high as we see it right now, there is a chance that "when push comes to shove", the FED will back off. Therefore, the rate rises they are taking now are only the dry powder to decrease rates when the economy enters a recession. They might continue to learn and live with a four percent inflation vs the two percent target. The other point of view is that FED is very serious about what it's trying to communicate, and it will go down to a two percent inflation target, and beyond that, it doesn't matter that economy can go into a recession and can get crushed. But FED will continue to push inflation down.

When the market recovered before Jackson Hole, the first alternative was very eloquent as being presented, but with the Jackson Hole speech, the FED Chairman essentially killed option number one, which was reiterated in the latest meeting where he said that we have to crush the economy and learn to live in short-term pain so that the inflation rate comes down to two percent.

Furthermore, I don't notice many investors enquiring about the likelihood of quantitative tightening at the moment and its causes. If you look at the balance sheets of either the Federal Reserve or the Central Bank, you will see that they have both continued to expand since 1994. Yes, they have increased rates in the interim, but the balance sheet value has not decreased. That has begun to diminish today. So, over the past 27–28 years, while each of us gradually honed our investing acumen, we have continued to live in a world where an expanding gush of liquidity is driving asset prices higher. As a result, all you had to do was find a great firm, and with the valuations continuing to expand, even if you made a mistake it would only be a time mistake. So we invented terms like time correction etc.

But now, if your balance sheet is going to contract, which Powell, in my opinion, very explicitly stated they want to do, then, according to my prediction, your cycles will start to become shorter, leading to those immediate consequences that would cause commodities to perform well one day and fail or perform poorly the next. Therefore, the cycles that we have observed over the past two decades may get shorter, and one must sort of continually assess where to get invested within the equities asset class.

Coming down to it, there was a respite earlier this week when the Bank of England (BoE) decided to buy a significant amount of bonds. I believe the market perceived this to suggest that the BoE has pivoted when in reality the BOE was merely attempting to calm the market. Therefore, that was only a very short-term respite; it does not imply that the FED or even the Bank of England will pivot. It's only a short-term solution to the issue. India practically increased its repo today by 50 basis points as well, but unlike the rest of the world, India does not have a problem. Our economy is not overheated in any way, but over the past few months, we have lost about 90 billion dollars in reserves. The RBI is aware of this and is eager to protect the currency, which is likely to hit 82 (depreciation of the rupee against the dollar). In that case, India will need to continue raising interest rates in the hopes that FDI flows, at least on the debt side, will not be negative. As one might expect, the central banks have not yet completely decoupled. India will need to increase interest rates even if the economy is not heating up.

Host: Smaller mid-caps by nature tend to stay volatile and fall more during volatile times like this. How do you manage this volatility in your portfolio? How do you protect it? How do you move your small- and mid-cap holdings during this volatile period?

Mr. Jigar Mistry: Small- and mid-cap companies, in general, go through their own cycles, so the first thing to remember is to not get carried away. All of us in 2017 was looking for the next multi-bagger when ideally we should be looking at the best dividend you will name. And at the height of COVID, we were focusing on the best dividend name when we really should have been looking for the next multi-bagger. The way we address this is by looking at what we pay for the businesses we buy. Therefore, unlike earnings and price-to-earnings ratio, which finally becomes challenging, PE is a state of mind. That's when you know you should start thinking about whether you should be buying those businesses or not.

The second point I would highlight is that volatility is a fact of equity markets, although we equate volatility with risks. theoretically, volatility may not be a risk because nothing goes up in one straight shot. The best-performing stocks have had a 40-50 drawdown. so instead of getting perturbed by volatility if you understand the value of the business you are buying, volatility actually can be very good. You can take advantage when the market is very exuberant and then also take advantage when the market is very depressed in terms of how it views this business, and then get your positions curated accordingly.

Host: While one agrees that investing through the cycle is a great idea, every fund manager keeps insisting that the timing is not worth it as you lose out in a long run, how do you react to this philosophy?

Mr. Jigar Mistry: I think there is a subtle distinction between timing the market versus investing through cycles. “Timing the market is whether you go in and out of businesses, whether you go in and out of markets and I am with you in terms of that you lose the 10 best days of the market, and your returns will be substantially lower.” Our essential fight is against the belief system that once you have identified a great company you start believing that that is a great investment at all points in time. People often give the example of Warren Buffer and we have a lot of followers who just blindly follow Warren Buffett. But if you look at his investment style, then that is not what the followers do.

For instance, Warren Buffett first bought it in 1988, and then he increased his position in 1989 and then again increased a slight quantity in 1992, which was the last quantity ever bought. Coca-Cola, I think is in his top three holdings, it could be the second-highest holding, but I could be mistaken, but certainly the top three. But after 1992 even when Coca-Cola corrected he never put in the money He chose not to invest in Coca-Cola after 1992 despite the stock correcting 50% from the top. So my argument very simply is that when we identify a company as great company what do we do? We take that logic to the extreme and make it as if that great company is a great investment at all points in time, which is not right. As investors, we start believing that a good company is always a great investment because some sections of people believe in that thesis. That is when cycles get generated which we can take benefit of. However, I am not for once suggesting that when the market is up you come in, and then when it's down you go out.

Host: You stated that you wouldn't test the market, but given the supply chain issues and unpredictability in China, Indian chemical manufacturers should be taken into consideration as an emerging incredible alternative. How optimistic are you about the chemicals sector?

Mr. Jigar Mistry: I think China plus one is an interesting theme and for that, you need to look at where China comes from. For example, not just in China, but in the late 90s your Asian tigers - Indonesia, Thailand, etc., went through the same route. Their labor cost was low, so they became the manufacturing hub of the world, which gave them control over their current account because they are largely exporting and not importing as much. And therefore the standard of living across the economy increases.

China eventually comes out of becoming the manufacturing Hub of the world because labor now started getting a lot more expensive. You also start seeing possible scenarios where pollution and ESG concerns take over, and now China wants to focus on other things. They want to make the next Hypersonic missile, build planes, high-tech bullet trains, etc. India is on the contrary a two and a half thousand per dollar per capita GDP. Services form a majority part with very little manufacturing. So we have the opportunity, and the government is focusing on PLI (an initiative that provides incentives to domestic industries to boost local production), and so there would be a lot of sectors in the China plus one zone or maybe EU plus one zone. India will be able to take benefit of not only bulk chemicals but also textiles and other sectors.

Host: Moving on to your strategy, you mentioned using a satellite portfolio called Cyclical One. Tell us how you choose your stocks there and how you see it in the next three-five years.

Mr. Jigar Mistry:  Satellite selection as I said we've broken down into three parts – cyclical, turnaround, and value and there are times when we typically go defensive as we did in August 2021. At the peak of Covid, we were something like 70% small- and mid-caps because people wanted to just buy FMCG, and Pharma since these sectors are Covid mainstays. In the rest of the market, we could buy businesses at one time one and a half time normalized earnings. And when the cycle recovered we sort of generated a lot of money into them. When we started turning defensive on August 21, we focused a lot more on large caps, which was70 a percent of our portfolio. As we see the market today, it essentially boils down to the fact the inflation in the US has still not come down and one might wonder why crude is down, and commodity prices have crashed. This is because inflation now is being driven by the services side.

The previous administration created strictures on visas and immigration in general and a lot of people post-Covid are not that keen on working that hard. So prices have gone up for people and employment is refusing to come down and that might force FED to continue to be a little restrictive. We believe India may not be that decoupled. If I took you back in August 2021 and made this prediction that over the next year NASDAQ will be down 20%, Dow Jones will be down 10, crude will be higher by 35 dollars, FIIs will withdraw 40 billion dollars at the end of one year, what is the chance that Indian market will be positive. I'm sure you would have said zero percent. But that's what has transpired. The decoupling has happened to some extent because post-Covid Indian investors have realized that Equity is a serious asset class and not a gambling casino where you come in and get out.

SIP is generating very serious amounts of money and so domestic investors pulled the first leg of the rally, and then post Russia Ukraine conflict, FII investors realize that there aren't a lot of places where they can invest. Russia, China, and Hong Kong are roughly 50 percent of the flows. So in that scenario, you are likely to see a place where India gets a lot of flows. So yes, India will be relatively better given the flow situation. But I would caution investors from using flow as an investment strategy because you cannot predict flows and in the short term certainly you can't predict flows.

So if your fundamentals are weak, you should use this opportunity to hold large caps, and you should use this opportunity to own more core stocks, and eventually, we'll be presented with the time when there is exasperation in the market.

Host: You know the IT sector is underperforming since the global recession is happening. It has fallen around 20-25 percent. Do you think people should get out from the stock selection or feel this is something that is basic and people should enter now? How do you feel about it?

Mr. Jigar Mistry: You see India does not have technology companies. What we have is IT services. Post-Covid, Nasdaq started rocking because Nasdaq has tech businesses. The difference is a company like Zoom can increase its Revenue 5x times in any given year The smallest of IT services companies in India may have to move Heaven and Earth to report a 20% growth. This is because you have to hire those many numbers of people, you have to let those many numbers of people deliver, which means you have to train 1.2 times the people, which means you have to hire 1.5 times the people, and this is not an easy task. So in theory, we always believed that IT companies should not have re-rated with the increase in NASDAQ companies. But you know the market being as it is, they did get related, and now when the NASDAQ is falling these companies are falling in line with that. If you talk to most of these IT companies, they are still not happy with regard to the business they are getting or margins that are contracting, valuations have come down to average levels, etc. So with the sector having corrected as much as it has, we don't really have a large exposure beyond one or two names. But again in percentage terms, it's relatively fair. I think it would be the largest underweight sector that we have, but we'll still have to wait for a few months to get better valuations.

Mr. Jigar Mistry discussed all the above topics in detail at our exclusive webinar. Relive the entire session with the appended link below.

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