Letter # 42

Of the two bad outcomes, which one do you reckon is worse: (a) a virus that kills more people, but spreads slowly; or (b) the one that spreads faster and kills fewer people.

If that sounded like the “blinding glimpse of the obvious” and you answered it right away with option b, I’d say Kudos! The onset of covid wave two (a more virulent and less pathogenic strain) has proven in practice, what we can only theoretically calculate in an excel.

But, the mathematic around it can be a bit of a stretch to wrap our brains around. After 20 rounds of infections, (a) above with case fatality (CFR) of 2% and reproductive rate (R0) of 1.4 results in 800k deaths, whereas (b) with CFR of 1% and R0 of 1.5 results in 900k deaths. As I said, both are bad outcomes, but one that spreads mildly faster (1.5 vs 1.4), but has only half the CFR (1% vs. 2%) still produces 13% higher deaths at end of 20 rounds (and 70% higher deaths after 30 rounds).

Math aside, Michael Lews in his book Premonition writes George W. Bush, the 43^rd President of the US, was aware that freakishly terrible events can and do happen. After all, he had presided over the deadliest attack on American soil and the most destructive American natural disaster in a century (Hurricane Katrina). Which is why he moved to action when he read John Barry’s book The Great Influenza in the summer of 2005. He put in place a three-part pandemic strategy, made sure US Congress allocated USD7bn to it and set up a team of experts to get cracking on it.

That team included a doctor named Carter Mecher. Carter had a unique way of looking at problems and finding a ‘logical’ solution to them. Whereas the accepted opinion was to lower the R0 below 1, Carter ran various scenarios—what happens when you isolate the ill or quarantine entire households, follow social distancing among adults or use antiviral drugs. Nothing seemed to work. And remember, this was 2006; they hadn’t heard of covid yet.

Then, Carter noted that a communicable disease fell off the cliff when you… ‘shut the schools!’ How can such a small change drive such a large fall, he wondered. But then he noticed that on an average day, school busses carried twice as many people as the entire US public transport system. And once in school, the kids don’t practice social distancing—they aren’t aware and the schools aren’t built in a way that social distance can be maintained.

Coming to this conclusion was one part, but convincing relevant authorities was another matter. They argued back, “it is not going to work; kids will start hanging out at malls, crime rate will skyrocket, poor kids will starve” etc. Carter argued back: (1) crime rates fell on weekends when kids were out of school and juvenile crime peaks at 3:30 pm on weekdays (when schools end); and
(2) kids won’t starve. 30mn kids attended school, but his survey showed that only one in seven parents would have a problem feeding their child without the school programme. That is not 30mn kids, that’s just 3mn—a problem that can be managed with food stamps. But the ‘logical argument’ wasn’t getting him anywhere.

At some point, Carter decided to stop appealing to reason and began appealing to emotions instead—he stopped making the argument and began to tell a story. He created a picture, a 2,600 square-foot home, but with same population density as an American school. A single-family home suddenly started looking like a refugee prison in the next slide. He had started getting their attention now.

He would put a heart-tugging photo of a nine-year old girl in 1918, smiling and dressed for church; and in the next slide describe how she and other children would end up as bodies, stacked like cordwood. As the last straw, he made the problem personal: If there is a pandemic anything like the one in 1918, how many of you would send your kids/grandkids to school? Now, they were invested in the outcome. Finally, he didn’t care who got the credit, and voila, the report finally saw the light of the day!

For Carter, his story got the work done when his arguments failed. Let me try and do the same with markets. The argument first—of the 3,000 odd stocks that got traded yesterday, nearly half quoted within 15% of their 52-week highs, and over 500 stocks were within 15% from their all-time high. Does that sound like the market is heating up too fast? How about I sweeten it up for you with this chart?

It contrasts rolling one-year returns of three indices – BSE Sensex, Mid cap and Small cap (when mid and small-cap indices outperform Sensex, it shows up on the positive axis, and vice-versa). On a one-year performance basis, as of yesterday, the small caps have outperformed Sensex by a whopping c60%—the highest in the past 10 years. Now that the argument is made, let me tell you a story.

Pabrai Funds invested in Rain Industries in mid-2015 when its market cap was USD175mn with revenue of USD1.9bn in 2014. Mohnish, who runs Pabrai Funds, thought that Rain could generate a post-tax profit of USD175mn in not too distant a future. He bought 10% of the company, but was happy to buy even 30% if regulations permitted it ⁽¹⁾. Rain indeed earned USD165mn in FY18 and its market cap zoomed to over USD2.35bn—12x return in just three years. Did he sell there? No. What stopped him from selling was that he got to know the business and its amazing leader Jagan Reddy. “It would be very dumb to say good-bye to such a gifted leader and capital allocator,” wrote Pabrai.

Rain made a high of INR461 in Jan-2018 and by Jan 2019, it was down 75%. The stock kept falling further till it bottomed in Mar 2020 at INR54—down a whopping 88% from highs just two years back. Mohnish writes that in hindsight, it was likely a mistake not to lighten up when the stock went over INR400/share.

The idea of the story is not to deride Mohnish; if anything, I am a great fan of his books, his investment style and his way of life. The idea is to learn from mistakes—ours and those of others.

When I had argued in Sept2020 ⁽²⁾ that the market is too focused on ‘growth at any price’ companies and small caps have underperformed Sensex by 30%, there were hardly any small-cap stories that were getting pitched to us. The scenario is largely reversed now. Increasingly, all we get recommended these days are great small-cap stories that have tripled over the past year, but can double from here as well.

I wouldn’t say that just because small caps’ outperformance has historically reversed from current levels, the small-cap index has topped. I am also not arguing that just because Rain did not work out for Mohnish, any other story will not work for us. But, the battle is half won in knowing that it is in times like these (when just a week’s research is generating superlative stock returns, the entire market is focussed on the next multi-bagger opportunity, that buying the dip almost always makes sense) that we are at our most vulnerable to commit our largest mistakes. Markets may not be at their top, but it might behove us to be at the top of our vigil.

Notes:
(1) Mohnish Pabrai on Rain Industries – Alpha Ideas
(2) Ant colonies, self-organized criticality and small-caps – Buoyant Capital
The letter was originally published here: SmallCap Index hits all time high; how should investors approach it – cnbctv18.com

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