The business of forecasting is a giant distraction to the process of investing
“There are two kinds of forecasters: those who don't know, and those who don't know they don't know.” — John K Galbraith, Economist & Diplomat
This is as good a time as any to remind everyone that what happens in the stock market in a given year has little relevance to what might happen in the next. We do not claim to have a crystal ball that tells us what the market may or may not do this year. It will likely fluctuate. Our investment process is not guided by a market forecast. We do not have a forecast for 2023 just like we did not have one for 2022 or 2021 or for any year before that.
“You can’t predict. You can prepare.” — Howard Marks, Fund Manager
Our investment process ScoreAlpha is the compass that guides us and keeps us focused. It guides us in the research process and in the construction of portfolio. The positioning of the fund is managed and monitored based on data and guardrails.* ScoreAlpha is also a behavior management tool, which keeps us disciplined in the face of uncertainty and fluctuating emotions that the market throws in our path. Under certain conditions wherein decision making can suffer, this investment process acts as a compass and guides us and enhances our quality of decisions.
*You can track this by referring to our Equity Ready Reckoner in which we publish the monthly statistics for our portfolios. In addition to this month-end statistics, you can also track the ingredients in our portfolios and our portfolio construction outcomes in our product presentations in which the same statistics are presented on a quarterly basis over a three-year time frame.
A significant change in seasons in 2022
Below we use the two pillars of our investing process: Return on Capital Employed (RoCE) for other than financial companies / Return on Assets (RoAs) for financial companies and Operating Cash Flow (OCF) to explain the change in the seasons that we experienced.
First, we look at the performance of the Nifty 500 index when broken up into its different tiers based on RoCE/ RoA (refer to Annexure 1 for a description of the tiers):
|CY 2022 Performance of R1, R2 and R3 Tiers|
|RoCE Tiers||Weight in Nifty 500 Index||Weighted Average Return|
Data as of December 31, 2022.
As the table indicates, businesses with a higher RoCE under-performed lower RoCE businesses in CY 2022. The best stock price performance as a group was registered by businesses with the lowest RoCE businesses (below cost of capital). In terms of strategies, this would typically underpin stronger performance by value-oriented strategies versus quality/ growth strategies.
The table below highlights performance of the Nifty 500 index when divided into groups based on their Cash Flow Statistic. This is not as acute a picture as it was for RoCE except that slightly less consistent businesses in terms of generation of cash flow outperformed the most consistent cash flow generators. The most inconsistent cash flow generators were the worst performing group of stocks within the index. Financials for which there is no cash flow rating outperformed strongly.
|CY 2022 Performance of C1, C2 and C3 Tiers|
|CFO Tiers||Weight in Nifty 500 Index||Weighted Average Return|
Data as of December 31, 2022
This sharp tilt towards value and away from quality/ growth was the change of season that marked the year 2022.
This can be seen in the performance of the Nifty factor indices during the year. For this purpose, we compare the performance of broad market Nifty 500 index with the Nifty 500 Value 50 index and Nifty 200 Quality 30 index. While the Nifty 200 Quality 30 index does not have a growth factor, it has a resemblance and significant correlation with a basket of stocks selected on quality and growth.
This is reflected in the breakup of the indices across different RoCE tiers:
|Nifty 500 Value 50||Nifty 200 Quality 30||Nifty 500|
Data as of December 31, 2022
The below table compares the Nifty 500 Value index vs the Nifty 200 Quality 30 index and the Nifty 500 index. This performance table tells roughly the same story; the one-year period that corresponds to CY22.
|Period||Nifty 500 Value 50 TRI||Nifty 200 Quality 30 TRI||Nifty 500 TRI|
Source: MFI Explorer; Data as of December 31, 2022
The above table indicates the shifting cycles of performance over shorter periods, but as the time horizon is extended the divergence in outcome gets smaller. Our objective is to generate alpha for our funds as compared to their respective benchmark index. The market has moods and seasons; what works well in one season may not do as well in another; but over a cycle we aim to outperform.
UTI’s approach to portfolio management
At UTI MF, our investment process emphasises on disciplined portfolio management within guard rails and supports diversity of styles and factors. For investors, diversification across styles is as important as diversification across companies and sectors by fund managers. Investors can use our products and capabilities that span the entire range of styles to achieve their financial goals.
The intelligent investor accepts that drawdowns are inevitable when invested in the market and recognises that there will be tough times — when a style is out of favour — and good times — when the stars shine on the style.
That brings us to a likely follow-up question: Can we identify turning points in the cycle? To that our answer is: Forecasting is difficult, but you can be prepared by using diversification.
Or if I may paraphrase the words of John Bogle, founder of The Vanguard Group: ‘The business of forecasting is a giant distraction to the process of investing’.
Here’s the original comment by John Bogle: “The stock market is a giant distraction to the business of investing.”