Home >Opinion >Investing lessons from 2015

In his book Black Box Thinking, author Matthew Syed highlights the divergent approach to failures in the two most safety-critical industries in the world, namely aviation and healthcare. In the airline industry, the process of evaluating failure is institutionalized. Every aircraft is equipped with two almost-indestructible black boxes—one records instructions sent to the onboard electronic system and the other records the conversations and sounds in the cockpit. By systematically learning from failures and working to make improvements, the aviation industry has attained an impressive safety record. In 2013, the accident rate in the aviation industry was one per 2.4 million flights. In contrast, Lucian Leape, a Harvard University professor, estimated that a million patients are injured by errors in hospital treatment and that 120,000 die each year in the US alone. It is believed that preventable medical error in hospitals is the third biggest killer in the US, behind only heart disease and cancer.

While having such institutionalized processes is a big advantage, the gains need not be restricted to just failure mitigation. Having a log of what goes on in the cockpit also enables operational improvements and better productivity, all leading to superior outcomes. How we wish that as institutional investors we had a black box that recorded our thoughts and actions while running our portfolios, but short of that, we have to make do with a periodic, reflective look back at the time that went by.

In that spirit of spotting mistakes, improving processes and hoping to become better portfolio helmsmen, we conduct our annual exercise of looking back at what Mr Market dealt us in the year gone by and as always, stay away from the tribe of crystal-ball gazers attempting to make predictions for 2016.

1) A bad year for investing

The year 2015 was unequivocally a bad year for almost all asset classes. To borrow a phrase from Bill Gross, investors have been crying in their beers in 2015. Barring a long US dollar trade in the currency markets, most other assets from oil, gold and commodities to bonds and equities performed poorly, even more so when measured in US dollars. That the best-performing large equity market for the year was Japan, with a paltry dollar return of 3.4%, tells the story. Once in a while, Mr Market will hand a D grade to every pupil in the class.

2) The party was behind closed doors

Though there was no samba on the streets for the public market investor, behind closed doors of the private equity club, the party was roaring. As per a Goldman Sachs report, in the US as of September 2015, more than 120 companies were valued at more than $1 billion in the private market (popularly called “unicorns"), up from just 43 at the beginning of 2014.

These trends were mimicked in India as well. The best performing company in 2015 in India might well have been Flipkart with its valuation going up in every successive round of funding, from $1.6 billion in early 2014 to currently about $15 billion. Liquidity can find its way into unexpected places.

3) Fixed deposit is also an asset class

For only the third time in the past 15 years, the bank fixed deposit was the best performing asset in India, out-performing equities, gold and property. After returning 32% in 2014, equities (BSE 100) were down to -6.4% in 2015. At the same time last year, expectations were running high for a strong performance for equities in 2015 on hopes of a reform-oriented government and a V-shaped cyclical recovery in the economy. At the beginning of the year, very few would have given fixed deposits even an outside chance of being the best performing asset for the year. The importance of disciplined asset allocation for retail investors to maintain a balance between equities and fixed return instruments was reinforced.

4) Think stocks, not sectors

In 2015, sector selection did not matter much. Compared to the past few years, inter-sectoral performance deviation was much lower. Investor commentaries often focus on how sector allocation hurt or help in overall performance. But for an investor, the basic unit of thinking should be an individual stock.

5) Look out for change in the ‘beholders’

Of the three calendar years with negative returns in the past decade, 2015 has been the only one where in a falling market, mid-cap stocks have outperformed the large caps (Nifty Mid Cap +2.8% vs Nifty 50 -7%). Conventional wisdom suggests that in years of negative returns, mid-caps underperform large-cap stocks owing to higher pressure on earnings and lower liquidity in the markets.

In our June 2013 essay titled “Beauty and the equities market", we had highlighted how a few stocks had disproportionately contributed to market performance since the year 2008, driven both by superior earnings growth and a significant re-rating. These market darlings had seen continued buying from foreign investors. In 2015, we saw some reversal in the fortunes of these companies led by fundamental reasons combined with the fact that the “beholders" in the markets were changing. Net foreign buying in equities at $2.7 billion was far lower than net domestic institution buying at $9.7 billion. When the beholders change, the idea of beauty changes as well.

6) Good macro does not equal good markets

The year 2015 stands in sharp contrast to 2012. The former was a good year for macro, as measured by the four key parameters of GDP growth, inflation, current account deficit and fiscal deficit. But this did not translate into spectacular returns for the stock markets. In comparison, almost nothing went right on the macro front in 2012, but it marked a great year with the markets returning 30%. The Reserve Bank of India cut rates by 125 basis points during the year, yet the yield on benchmark 10-year government securities, which was at 7.86% as at end 2014, was hardly changed at 7.79% as we write this. In the short term, macroeconomic fundamentals may not have a positive correlation with market returns.

7) The effects of being in a bad neighbourhood

Emerging markets (EMs) had another bad year, which compounded the fact that trailing returns for the EM index on a three- and five-year basis are now negative. While all commentators expected India to stand out, it hasn’t been easy at all. Despite the fact that India is a good house, there was no denying that it was in a bad neighbourhood and, in the short term, it is the perception of the neighbourhood that dominated in determining returns.

8) Evidence triumphs hope

Equity investors take pride in buying ahead of a turn in the indicators that are relevant for a particular stock. Making bets ahead of a budget while attempting to forecast tax rate changes, or buying stocks in the hope of a rural India pickup, or in the hope of a capital spending turnaround, or an asset quality improvement for banks has simply not worked in 2015. In contrast, if one had picked up stocks based on ground realities, or what we call evidence, the returns would have been much better. Beware of storytelling; keep your nose buried in evidence.

9) Patience is a virtue

In April 2013 (“Oil prices as India’s stealth saviour") we had highlighted that oil prices could fall owing to technological advances and new sources of oil. We had called cheaper fuel as India’s stealth game-changer. It took almost 15 months for our thesis to play out when oil decisively cracked in June 2014. Today, oil prices are at one-third of the peak in 2014. The lesson learnt here is that when it comes to macro trades, patience is a virtue.

If you believe in the fundamentals behind a macro call, it is very likely that prices do not follow the expected pattern for a long period of time, but when it does play out, it could be swift and steep. Such was the case with oil that it diverged from other commodities like coal, iron ore and steel as it stayed higher for longer, but eventually caught up.

10) Post-facto narrative fallacy

Every year, the markets are caught up in the narrative fallacy surrounding hyped-up events. The lift-off by the US Federal Reserve was one such event. Closer home, the actions of the Narendra Modi government have been seen by supporters and critics very differently, a point we highlighted in our essay (“Reverberations in an echo chamber") on the dangers of the echo chamber. The story on oil is playing out quite similarly. Most analysts are highlighting why oil prices should head even lower, the typical reasons being glut of supply and weak economic growth. We wouldn’t be surprised—if oil prices had remained at elevated levels, the same analysts would have been talking about the tensions in Syria and other parts of West Asia, and pressures on the fiscal balances in Russia, or the Organization of the Petroleum Exporting Countries (Opec)’s cartelization to justify higher oil prices. Finding a story to fit the facts is an engaging but useless pastime.

At the risk of sounding like a broken record, we think India is on a path for gradual and uneven recovery and just because a calendar year has changed does not mean that reality will change. One’s investing style should remain the same in that one should look for growth inflections that seem durable and look for high-quality stocks within those spaces. This isn’t about finding the next big macro trade, but as Peter Lynch neatly summarized, “The person that turns over the most rocks is going to win the game."

Amay Hattangadi and Swanand Kelkar work with Morgan Stanley Investment Management. These are their personal views.

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