In the ancient Indian epic story, the Mahabharata, once Drona poses a challenge to his royal students. He hangs a wooden fish on a tree above a water body and asks his students to look at the reflection in the water and shoot the arrow at the fish’s eye.
Now this is an incredibly difficult task. One is working in a direction opposite to what one normally is accustomed to and then there are ripples in the water and the wooden fish could be swaying with the breeze and then to shoot at the eye of the fish. See one version of the story here. There are probably several other versions of the same story and in some it is a wooden bird and not a wooden fish, but you, too, are friends with Mr. Google yourselves.
I recommend that you read the fantastic story. However, the crux of the story is Drona asks each student to take aim and then asks them, “What do you see?” As soon as they say that they see a tree and branches and the sky etc. he asks them to put the bow and arrow down. However, Arjun says that he can only see the wooden fish’s eye and nothing else.
It is this focus on the task and the removal of all that is irrelevant to the task being removed from the view which Drona thinks is the essence of the great archer and warrior.
The task of equity investing is equally tricky. And it requires a similar level of focus to succeed. There is all kinds of distracting information which is available. There are the macroeconomic data, the GDP growth rates, the unemployment numbers, the PMI, the forex rates, the crude oil price, the inflation numbers, the RBI and the Fed rate and so on. There is the country growth rates, the sector data, the industry and sub-industry, the competition, the market shares, the input costs, the margins trend, and so on. Out of the thousands of stocks which stocks to buy? When to buy? How long to hold? When to sell? Why to sell? Then do what with the money? There is more than enough to get distracted.
We believe in a Scientific approach to investing. Just like the above principle of focus of Arjun, there is a broadly analogous principle of parsimony in the Sciences. For any observed phenomenon the principle of parsimony states that one should build a theory which is the simplest theory which can explain the phenomenon. The minimum amount of variables which explain the phenomenon are kept and the rest are removed using the Occam’s Razor.
Warren Buffett’s guru, Benjamin Graham, has reduced the thousands of pages of the 2 books (Security Analysis and The Intelligent Investor) to 3 words, “Margin of Safety”. Building from those 3 innocuous sounding words, we have constructed a minimalist theory based on the “Margins” of Safety which we call the Scientific Alpha Investment Engine.
Starting from the whole investment universe —in this case, all Indian listed stocks with market capitalization more than INR 1000 crores (around 700-800 stocks)—we have used Scientific Alpha to classify the whole market into four folios. This study was carried out last year (2017); see here. It was covered in this article by Business Today.
This year we have carried out the whole exercise again in our Fable of Four Folios 2018 edition. More important, we also have the results of how the four folios performed over the last one year.
Before getting into the details, let me summarize the four folios. The four folios are the following:
- The Junk Folio: These are companies with unstable business models and weak balance sheets.
- The Half-Buffettologist Folio: These are frequently companies which have stable businesses with strong balance sheets but with overvalued Often times, there are companies which are Quality-traps, as well, AND which are overvalued, in this folio.
- The SuperNormal Folio: These are companies with stable business models, strong balance sheets, persistent competitive advantage and are available at a discount to intrinsic value. In short, this folio has SuperNormal Companies @ SuperNormal Prices.
- The RoM Folio: These are companies which are left over after the other 3 folios are constructed. Typically, these companies have nothing special about them. They are mediocre or slightly above average companies which are probably fairly-priced or pretty close to it.
The interesting part is that the results are in for how the four folios fared over the last year. Last year this exercise was done for all companies with market cap of INR 10,000 crores, roughly 200 companies.
This is how they fared:
|Folios||Returns (%) (Last 1 year) *(See Disclaimer)|
|Nifty 500 (Market)||-3.2%|
It is clear that removing the Junk folio from the market would have resulted in a better result for the remaining portfolio of stocks. How much better? There were roughly 1/3rd companies which were in the Junk classification. These companies would have been removed. The resulting positive impact would have been nearly +6% on the remaining stocks. The Nifty 500 would probably be up +3% instead of -3%.
It is clear that the Junk folio was a risky folio and it has manifested strongly in the returns. So removing it is providing two margins of safety, viz., mitigation from business risk and financial risk.
The Half-Buffettologist folio was true to its nomenclature. It delivered zero returns! These were like the old Ajit (Bollywood film villain) joke, “Isey liquid oxygen mein daal do; oxygen isey marne nahi dega aur liquid isey jeene nahi dega”. (Translation: Put him in liquid oxygen, oxygen won’t let him die and the liquid won’t let him live”.)
The stable business and the strong balance sheet of the Half-Buffet to logist folio didn’t allow it to have negative returns. However, the high price paid didn’t allow it to have positive returns. In a more normal year, they would, most likely, have provided close-to-market returns or a slight out performance or under performance around it. Exceptions would have been the years of a quality-bubble. In those years, this folio would have been in momentum and might have looked outperforming. However, eventually, the market prices it sensibly and the discount rate, i.e. market return is delivered.
The RoM of mediocre companies provided a negative return. In a more normal market, they would have provided a return which is slightly better than the market because the junk has been removed already. However, it will fluctuate wildly in a fairly tight range around the market returns in most years.
Finally, the SuperNormal folio delivered extraordinary returns, outperforming the market by nearly 16%! It is clear that the four margins of safety, i.e. stable business model, strong balance sheet, persistent competitive advantage and buying only at a significant discount to intrinsic value result in significant risk reduction and the lowered risk leads to high returns!
Absolutely, contrary to the accepted wisdom of “low risk, low returns”! It is actually, “low risks, high returns”.
We will be releasing the report shortly and you can get a copy by contacting us.
The above discussion is purely for research and illustration purposes. The above returns are hypothetical returns. Please do not invest in any company or folio or strategy based on the above discussions. Please do your own thorough investment and suitability analysis or ask a professional financial advisor to do the same for you, before investing in anything. This point cannot be overemphasized. Please read the detailed disclaimer below as well