Letter # 54

It’s the crucial day five and India is in their fourth over of the day (86^th of the inning). Ollie Robinson has the new Dukes in his hand and is charging towards Pant who is batting on 22 off 45. Pant edges one to the keeper and India are 194 for seven. By the 90^th over, Robinson traps Sharma on the crease with a slower ball and India are down to 209 for eight. In walks Bumrah. A shaky lead of 182 and with two wickets to take, England is now favourite to win. By the time India declares their innings, they are at 298 for eight with a mammoth lead of 271 runs (Shami and Bumrah scored an unbeaten 56 and 34, respectively).

What happened there? How could the entire Indian top order collapse for a little over 200 runs and the ninth wicket partnership goes on to score an unbeaten 89! Former English bowler Steve Harmison had an interesting take on that.

He says ⁽¹⁾, “they didn’t have any slips, no catchers in any position while bowling at numbers 9 and 10. A good ball to Virat Kohli is a good ball to Shami and Bumrah. England just seemed to get one eye off trying to get Bumrah out by bowling bouncers at him.” Why, might you ask? “The inexperienced characters were trying to sort of stand up for Jimmy Anderson (Bumrah kept bowling bouncers at Anderson in the first innings and they were returning the favour). Sometimes, you just have to step back and take a couple of deep breaths.”

Essentially, to avenge the bouncers bowled to Anderson, the English team ended up giving 89 runs to the ninth wicket, gave away the highest runs ever and second 50 to Shami and lost all 10 wickets and the match with just 60 overs to play on the last day.

How rookie of them, one might wonder. Such a blinding glimpse of the obvious, right? But it happens often than we think, and it happens closer to home all the time.

Long Term Capital Management (LTCM) was started in 1993 by the renowned Solomon Brothers bond trader, John Meriwether with two Nobel Prize winning economists on the board of directors. The strategy was simple: (a) Identify a minuscule opportunity of arbitrage in bond markets’ and (b) Leverage to the hilt, which generates a significant return on equity even with a minuscule return on investments. At its peak, LTCM had USD5bn in equity and USD124bn in debt. When the going was good, returns were great–21% in year one, 43% in year two and 41% in year three prior to 1998. Then, they lost USD4.6bn in less than four months due to: (a) Asian and Russian financial crisis creating unprecedented situations in the bond market; but also (b) having a false assumption that arbs work equally well with equities (short volume, risk arb and equity relative value) as they do with debt.

Well, that was decades ago; let’s talk about the more recent implosion of Bill Hwang’s Archegos Capital late March this year. Archegos was structured as a family office, investing just Bill’s money. While US rules prevent individual investors from buying securities with more than 50% of money borrowed on margin, no such rules apply to hedge funds or family offices. By late March, Archegos’s leverage had increased 5 to 1. Also, Archegos used swaps where it got the upside and downside in stock performance without owning the equity directly (the name of the bank would show up in shareholder register). While even the banks that funded him were not aware of the complete picture, on March 26^th, with a staggering USD100bn portfolio defaulting, Bill Hwang became synonymous with LTCM. Such high leverage, what were you thinking, right?

Even if we directly don’t identify with these stories, there are lessons to be learnt from them. Equity markets have steadily risen since March 2020 and buying the dip along the way has always appeared to be a great decision in hindsight. It is during times like these, and unknowingly, the anchoring bias sets in. When markets correct, we anchor our decisions to latest prices. When a stock falls from INR800 to INR600 during a correction, we are tempted to average, without consciously thinking if INR600 is a good price in and of itself. That leads to sub-optimal decisions. What then should we be ideally doing?

At Buoyant, we always return to these two actions when we make decisions like these. One, we do a sort of ‘zero-based budgeting’. Let’s forget at what price the stock has recently quoted at, and rather assume that we had the opportunity to buy out the business entirely. If one were to run a discounted cash flow model on it, what assumptions would I have to make to justify the price today? If those assumptions look broadly achievable, we go ahead and buy more.

Second, and more importantly, to retest our thesis, we actively reach out (with utmost respect) to people who have a negative view on the stock than we own, even if they have gone wrong for the entire bull run. Shutting oneself to alternative view points and drinking our own cool aid is among the worst things investors can possibly do.

When the going has been good (in cricket, asset management or individual stock decisions), it is easy to lose the plot when the situation reverses. We risk losing the entire test match, returns of an entire lifetime or might find ourselves buying sub-standard businesses at slightly lower price just because it recently quoted at a price which now looks high. Being aware is a battle half won.

Notes:
(1) England lost the plot by trying to get back at Bumrah over bouncer barrage to Anderson: Steve Harmison (sportskeeda.com)
This letter was originally published here: What Not To Do During A Market Correction (cnbctv18.com)

Disclaimers:
Information in this letter is not intended to be, nor should it be construed as investment, tax or legal advice, or an offer to sell, or a solicitation of any offer to make investments with Buoyant Capital. Prospective investors should rely solely on Disclosure Document filed with SEBI. Any description involving investment examples, statistical analysis or investment strategies are provided for illustration purposes only – and will not apply in all situations and may be changed at the discretion of principal officer. Certain information has been provided and/or based on third-party sources and although believed to be reliable, has not been independently verified; the investment managers make no express warranty as to its completeness or accuracy, nor can it accept responsibility for errors appearing herein.