Keep off this market - article by Chandrakant Sampat

Not for nothing is Chandrakant Sampat reverentially called the Warren Buffett of India. He’s built a fortune virtually from scratch over four decades. He doesn’t buy stocks for short-term profits, but buys businesses and holds them for generations. He likes businesses that “even fools can understand”, that have sustainable cash flows, competitive advantages and require little capital investments. If US rates keep rising, imagine what can happen if money that has come in leaves Besides being a passionate investor, Sampat is also a keen observer of the world. What sets him apart is his ability to successfully marry these observations and ideas with numbers in his stock decisions. In a somewhat one-sided conversation with Clifford Alvares, Sampat constructed a multi-layered argument to show why this market is risky and fragile, and what stock strategies investors should follow. Here’s peeling the layers, in his own words… The time has come to see the markets differently. Markets essentially operate in the global economy, which is the real macro economy. Countries and whatever happens to them is microeconomics. Coming back to the macro picture, the dollar is the reserve currency of the world — it is accepted everywhere. In order to understand this dollar, we have to understand the US economy. Let’s redefine profits. What we call profits are really not profits; these are the cost of staying in business. Put another way, there are no profits, there are only deferred costs — something that has accrued, but not been incurred. These deferred costs can be postponed for sometime, but ultimately they catch up. The US, today, has a deferred cost of $90 trillion. Of this, $40 trillion is debt issued by the government, $40 trillion is on account of promised medicare, $10 trillion is social security. That’s $90 trillion in a $30 trillion world economy. But the US economy is only $12 trillion. The US government’s way of handling this $90 trillion gap is to keep postponing, postponing, postponing. As people in general and baby boomers in particular keep ageing, these costs keep coming closer and keep mounting. The US will have to do something to compress it, but can’t do much now. All this is being financed by the rest of the world, as the dollar is the global reserve currency. In other words, the dollar is the base macro. But this is unlikely to continue. All this has happened because Alan Greenspan decided in 2000, when the capital market bubble burst, to reduce the pain by lowering interest rates from 6 per cent to 1 per cent. When Greenspan started cutting rates, the financial community, which today is purely based on the greed of funds, decided returns were elsewhere. So, money flowed into Asian markets. Now what happens if the interest rate cycle is reversed? With this kind of investment and spending patterns, and no savings, if US interest rates keep rising, imagine what can happen if money that has come into India leaves. In order to prevent that from happening, India will also have to raise interest rates. Whether we can match the US hikes is another question, which no one can answer at this moment. That’s the macro. Emotions that can cost investors As much as it is grounded in numbers and about making judgements, investing is also deeply linked to emotions. It's been proven empirically that investors are not efficient decision-makers, as they tend to be swayed by these three emotions. 1 Fear. The predominant emotion of an investor is the fear of losing money. It is this fear that encourages some investors to invest mostly in low risk, but also low return, bank deposits. Flip side: it's difficult to create wealth through zero-risk investing. 2 Greed. But at times, greed overrides this fear. The greed for quick, no-effort money has pushed many people to take risks on the stock market that far exceed their risk appetite. Not equipped with adequate understanding and skill, they end up destroying their wealth. 3 Pride. Most equity investors believe what they are doing is the smartest thing and that they are a step ahead of others. Often, pride encourages stock pickers to hold on to losing investments. Pride gets people to say: I can beat the market. And we know how often that happens. So, what works? Hard work, level-headedness and commitment. …affect India Nothing can compound at 40 per cent forever. Ultimately, you go to a reversal, to an average Now, on to the micro: our economy. Our fiscal deficit, including that of the states, is 10 per cent of GDP. We have also started having a current account deficit of about 3 per cent, which keeps inflation down. A recent issue of The Economist has a story on India’s booming economy, where a surprising statement is made by extrapolating from last year’s statistics. It says the economy grew 7-8 per cent, but the liquidity growth is 30 per cent. The normal thing is that if the growth is 7-8 per cent, the liquidity growth to sustain it, if it’s really a growth, cannot exceed 15-16 per cent. Now the question is: how long can this liquidity drive GDP growth, which the markets are looking at? The answer appears to be, not for long. In the past four years, the Sensex has gone from 2,800 to 10,000 — a compounded annual return of 35-40 per cent. Nothing can compound at 40 per cent forever. As Peter Bernstein says in Against the Gods: The Remarkable Story of Risk, ultimately you go to a reversal, to an average. If that happens, what will happen to the index and what will be the events that will bring it about. Stock strategies Buy simple business with little debt and capital expenditure, and good free cash flows Now, what can an investor do? There are derivatives. There is hype, plenty of it. Warren Buffet rightly says that when the tide is on, nobody knows who is swimming naked. A few months back, I was looking at a table of 100 Indian companies ranked by return on capital employed (RoCE). At some point, these stocks were quoting at eight-year lows, which is strange. Look at Siemens. It did an eight-year low and now it’s quoting at Rs 5,000. Tata Steel was down at Rs 40-50 and now, after adjusting for bonus, it’s Rs 700-800. Of this set of companies, if investors pick up something quoting at a 10-year low, it appreciates 10 times. Pick up good companies with good managements when their share prices are at an eight-year or 10-year low. Alternatively, if you still want to do something, buy good companies that are 40 per cent lower than their 52-week high. I will buy only those companies that… • Are in a business that even fools can understand • Have very little debt • Have free cash flows • Don’t have much capital expenditure, which is nothing but deferred cost There’s another story that appeared in the book The Future for Investors by Jeremy J. Siegel. Between 1953 and 2000, $1,000 invested in companies that were in what he describes as a capital space, became $5,000. An identical amount invested in the S&P 500 index became $55,000. In companies that had minimal capital expenditure, it appreciated to $600,000. So, the companies you say are growing, are they really growing? The answer is ‘no’. They have to keep all deferred costs aside, they can’t declare hefty dividends, as the future costs. So, that’s another lesson — buy stocks that have minimal capital expenditure. These prices are unsustainable. Good times are always followed by bad — it’s a law of nature. IPOs always come in at the last stage of a bull run. Don’t fall for guidances, as they mislead you rather than lead you. Keep it simple. Keep away from this market — there’s nothing you can do about it. Heed the words of Charlie Munger, Buffett’s right-hand man: patience is waiting.

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