Simple questions, no easy answers?

BizNotes_Sep19

Downturns are no less exciting when it comes to anxious questions from investors. As a money manager, one gets pushed around by questions which may not have a clear short-term answer and yet have a broadly right long-term answer. Thought we should address couple of such questions through our monthly newsletter.

The most common ones that we face in a challenging environment like the one we are currently in,

  • Even if the Govt. takes measures to reverse some of the mis-steps, with no one willing to lend or take risk (liquidity/risk cycle broken), what will trigger the liquidity up-cycle for the real economy?
  • If nothing much is going to happen in the short-term, why not wait till things stabilize?

As any fund manager would concur, the first one is a more interesting one because it involves understanding of how the critical parts of engine works in the economy. With Govt. rolling back some of the mis-steps, it has also become a more relevant one.

Before proceeding to answer how liquidity cycle will turn, let us first understand what caused the severe choke in the liquidity cycle. What started as a usual risk-aversion on NPA crisis got aggravated by Govt’s overdrive on corp. cleanup, which further got accentuated by the cyclical slowdown in manufacturing esp. in autos. It is the confluence of these factors coming together than any one factor that pushed the economy into deeper slowdown. When all of them are playing out together, it appears as if it is apocalypse for India which is not surprising. But the impact on economy is huge because there is risk-aversion in each and every stage of the liquidity chain. Take autos for example. How fear of deeper slowdown results in serious risk-aversion in each link of the liquidity chain like bankers cutting down exposure to dealers/auto consumers, auto dealers cutting down on stocks that they carry (destocking), consumers in-turn postponing buying on unknown fear and so on. If one looks at the auto retail numbers and whole-sale numbers, one can see how dealer destocking has amplified this slowdown seriously. For e.g. in Aug, while the retail sales at the consumer level came down by 11%, the whole sale numbers at the OE level came down by over 25%+. The difference is on account of dealer destocking. Not to forget, when some bit of confidence comes back, the dealer re-stocking itself will optically boost the numbers at the OE level leading to dramatic change in the narrative in the media (flashing headlines like auto industry bounces back with a vengeance etc. will resurface mysteriously). Time for such change in news-flow is not far away.

Since people attribute, mistakenly though, to a single factor like Govt’s clean-up drive for the choke in the economy, naturally, they also think that this will never reverse as Govt. is unlikely to lose its grip on the clean-up. But in reality, over time, in the next few months, two of the three factors that caused the slowdown will reverse to give the required bump-up for the liquidity. This coupled with falling lending rates and rising liquidity in the system, will eventually de-clog the flow in the liquidity chain. Basically, the point is that the liquidity cycle will come back in full force once a bit of positive news-flow starts coming in. It looks like the “turn” in the auto demand in the festive season (even if the growth is just optical on low base effect, though better than expected monsoon is likely to revive rural consumption in the second half) could bring the initial trigger for the “turn” in the liquidity cycle.

Agreed, why not wait till we see some visibility of that turn? That brings us to our second question. Yes, one can wait for sure. But the challenge is, market doesn’t wait. It discounts far ahead. How do investors deal with this? Only way to deal with this, is to buy on pessimism without worrying about quotational losses in the short-term. How does one logically convince oneself to do that? Here is where our usual question we put to our investors who are in such a dilemma. If you have an opportunity now in which there is risk of 20% quotational loss in the short-term, but 2X gains in the medium to long-term (1 to 2 year), when would you buy? Of course, the answer is easy if one can time the bottom. Since it is not possible to time the bottom, one has to choose to buy now in spite of the risk of 20% notional loss. In theory, even this option sounds easy. But, when there is pessimism and uncertainty all around, it is difficult to execute this on the ground. The reason is, in such times, it is easy to get carried away by the fear that the risk of loss may be much higher, though it is still notional.

In conclusion, it all comes back to the same old understanding that, to execute value investing on the ground, one may not have any option but to buy when there is maximum pessimism without worrying about any trigger. Of course, it holds good in the top of the market as well (selling when there is all around exuberance). Both are difficult to execute (emotionally), but that is the only way to create long-term wealth. In that sense, in hindsight, this downturn will, most likely, go down in history as a one that threw a great life-time opportunity for long-term patient investors. Don’t miss it!!

Happy Value Investing!!

 

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