When it rains, it pours
The southwest monsoon descended on the city of Mumbai with all its fury this July. Thankfully though, there were only a few tales of traffic jams, flooding or disruptions to life. And that it rained very hard where we need it the most — near lakes that supply year-long water to the city — was even more fortunate.
As per the municipal corporation, the collective water stock in the seven reservoirs that supply drinking water to Mumbai climbed to 88.73% of capacity on July 31. The stock was just over 10% of capacity even till the end of June. During the same time last year, water level in the lakes was 74.98%, while in 2020 the lakes were at 34.49% of capacity. On July 11, when the city received one of the heaviest rainfalls this year, the lakes’ capacity climbed by 5%.
The distribution of rains in Mumbai during Monsoon can be quite uneven. As mentioned above, while July 2020 saw low water level, the deficit was balanced in August when the city received significant rains. And, by early September 2020, the lakes were at 98.18% of capacity. The megacity has not experienced any significant water deficit over the past decade, even though the distribution of rain during Monsoon has been erratic. And, we have to thank the rain gods for that.
Just like the distribution of rains, stock market returns can be random too! They are not only random in their distribution but also stochastic, a pattern that may be analysed statistically but not predicted precisely.
In the month of July this year, the Nifty-50 index climbed 8.91% and the Nifty 500 index climbed 9.73%. Could this have been predicted by the sequence of returns in the preceding months of this year? We could argue that intelligent investors took advantage of the swing of the pendulum in favor of equities that we highlighted here and here. However, in statistical terms, the outcome experienced in July by such wise investors counts as a lucky outcome.
The wise investor does not invest because the distribution of returns in equities are even or predictable. In fact, equity returns are mostly never evenly distributed over time nor are they predictable. Over the past 42 years, ending July 2022, the average 10 years rolling returns was 15.07% and the median return was 15.03%. But the averages hide variations, which can be significant, as indicated by the standard deviation of 7.38%!
Out of the 8025 rolling 10-year periods (daily frequency) during this 42-year period, returns were negative less than 1% of the time. Returns were above 8% CAGR over 10-year rolling periods 81% of the time. In other words, distribution of returns can be erratic and prediction is not of much value because it is stochastic. Yet, the odds tilt meaningfully in favor of the wise, long-term investor. Thinking long term raises the odds in your favour.
Looking back at the data we have for the Sensex’s over 42 years or 172 quarters, we find that the market delivered negative returns 40% of the time i.e., in 69 quarters, and positive returns in 103 quarters i.e., 60% of the time. From the start of this period to the end, however, the S&P BSE Sensex delivered 15.21% returns Compound Annual Growth Rate (CAGR). In other words, drawdowns have always been a part of the market cycle. They cannot be predicted in advance and hence, they contribute to the erratic distribution of returns.
The discipline that the investment process drills in us is that we do not focus on the distribution of returns. Our focus is on businesses, portfolio construction and risk management. One of the variables we deal with is change.Change is the only constant
I was reminded of this by the recent new of BSNL, the government owned telecom company receiving a bailout package Rs 1.64 lakh crores from the Centre. For the companies in which we invest, change is both good and bad. The value of a company arises from its operations well into the future — at the minimum 10-20 years explicitly — followed by terminal value. Terminal value is the value that we expect a business to create during the rest of its life, after the explicit 10-20 years.
But do all businesses actually have a life of more than 20 or 30 years? Think MTNL, once India’s premier fixed line telephone company, a member of the Sensex, which fell victim to the transition from fixed line telephones to mobile telephones. The company is now a loss- making business and is likely to be merged with the government’s larger telecom company BSNL, which itself is the recipient of the aforementioned rescue.
The world of business is like being on a treadmill; once you stop moving, you start heading backwards.
The example of telecoms is instructive: as the demands of customers change, businesses have to pivot to meet these needs. And, that calls for investment in capacities, brands, technology and people. Often this investment may be necessary just to retain customers and the market share.
Let’s think of a commodity company that mines ores or drills for oil; with both the mine or oil well having a limited production life. During the initial 10–20-year period the company should use its profits to invest in finding new mines or wells. Otherwise, it would reach a point where there would be no revenues but only costs.
Every profit-making company needs to reinvest in its business or in an adjacency that could use its existing infrastructure, brands, network etc. This could be something as simple as a personal product company (manufacturing soap and shampoo) adding a deodorant to its range. In order to grow, a business must re-invest for the future and if the investment delivers rising returns on capital, even better. The business is now moving even faster on the same treadmill.
That in turn brings us back to the two pillars that underpin the equity investment process at UTI – ScoreAlpha. The process emphasises Operating Cash Flow and Return on Capital Employed. The key to wealth creation in all businesses is the ability to generate cash (as different from accounting profit) from operations. Then, the business must reinvest for growth either in its core business or in adjacencies; from the cash available after meeting its operational needs. Alternatively it would need to borrow money or raise equity from shareholders to invest. When the return on such capital invested is higher than cost of capital, the business grows and creates wealth.
We deal with the stochastic nature of the market by keeping our focus on the investment process and by not getting distracted by volatility, news flows and feedback loops. The distribution of returns in the market may be erratic, but we should not be erratic in our investing discipline.Above commentary is published in UTI Fund Watch (monthly factsheet) in the section of Update from CIO’s Desk, click here to refer to the factsheet.