Letter # 62

Earlier this week, a plan by US Senate Democrats to impose a tax that would likely affect 700 billionaires collapsed after a backlash. Negotiators have been trying to find new sources of revenue to pay for Biden’s ‘Build Back Better’ legislation, under which a USD2 trillion spending package had already been announced. Democrats had hoped to simply raise corporate taxes and individual income, and capital gains tax on the wealthy, but Kyrsten Sinema, a moderate Democrat from Arizona opposed it, reports FT ⁽¹⁾.

You might say: “Right, so one senator opposed it, big deal! This plan promises huge investment in infrastructure, housing, education, and healthcare; and is projected to create 10 million clean energy jobs. Part of this package (American Rescue Plan) has already been passed, the rest surely will, right? These things always work out, no?”

No. The US Senate is split 50-50 on party representation (Democrats and Republicans). Any one senator can single-handedly sink the chances of the bill getting passed. For US billionaires “spending more is not a problem, so long as everyone pays (through inflation) and not just us (higher tax on the wealthy).”

One wonders why the Democrats would stake so much on a plan that could be derided so easily. Alfred Korzybski, the Polish-American academic, answered it centuries ago with: ‘The map is not the territory’. He offered his audience biscuits wrapped in white paper. ‘Nice biscuits, don’t you think?’, he said, and got positive responses – until he tore the paper to reveal they were dog biscuits. Two students began to retch, a few ran to the washroom. The biscuits had tasted good, but only until the wrapper stayed concealed.

And it does not happen just in a controlled environment. Announcing the tiniest tweaks to popular products has been a disaster for Vegemite, Milo and the Cadbury Crème Egg. People so often notice a change in taste just because a change in formulation has been announced. So, when Kraft wanted to introduce a healthier formulation for their Mac & Cheese, they did not announce it for a long time. Practically no one noticed it until Kraft retrospectively put out an advertisement saying, “It’s changed. But it hasn’t.”

After his famous experiment Korzybski proudly announced: ‘You see, I have just demonstrated that people don’t just eat food, but also words. And… the taste of the former is outdone by the taste of the latter.”

Political parties are aware of the importance of optics, so being seen as trying to effect a change can often be as powerful as the change itself. This analogy is often extended to investments, but it has a critical flaw. Vegemite sales and how voters vote can be based on perception, but when it comes to investments, it is not a straight line. While the size of assets under management depends on how potential investors view one’s investment framework (i.e., the map), the investment returns themselves (i.e., the territory) are not based on perception. They represent a fact.

The last two weeks have been a rude reminder of that. Over the last eighteen years, different market cap-based indices have broadly given similar returns (Sensex 19%, Midcap Index 21%, SmallCap Index 22%; all numbers in CAGR). But it has not been a linear journey. In a market upcycle, the small and mid-cap indices outperform the Sensex and vice versa in a downcycle.

As we see from the chart above, the difference in returns has been rather stark in different market cycles. The problem arises when we start believing that the current cycle will last an eternity.

Take the example of the period between December 2017 and March 2020. During that time, while the Sensex fell 13%, the SmallCap index fell a whopping 50%. A large section of investors developed the belief that ‘there are only 20-25 companies that form an investible universe in India, and the rest is not worth looking into’. The cycle then turned in April 2020, and since then, the SmallCap index had outperformed the Sensex by over 100 percentage points (Sensex 110%, SmallCap Index 213%) in the run-up to October 18, 2020.

Of late, we seemed to have developed the conviction that SmallCap companies will keep outperforming the Sensex no matter how crazy the valuations. Over the last two weeks, however, while the Sensex has corrected 4%, the SmallCap index has corrected 7%, and more than 100 companies (over INR3b market cap) have corrected more than 15%.

While we are amid the cycle, ‘packaging’ an investment product that seeks to benefit from the cycle prevailing might appeal to a large investor base, but for returns to be truly superior across market cycles, two things are called for: (a) an awareness that indices operate in cycles, which invariably reverse, and (b) a dynamic mix of businesses across the market cap spectrum in the portfolio.

Notes:
(1) Democrats’ proposed billionaires tax collapses after resistance from moderates | Financial Times

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.