Bulls Interrupted: Avoiding Small Caps Is Shorthand For Not Doing Homework, Says Ramesh Damani

This episode was particularly painful compared to the others either because: a) I was ready for the previous ones or, b) We were in somewhat cash.

So, I went into this bearish phase, if you might call it, fully invested in the markets and I did not know what hit me. It was not a bear market because we look for signs of a bear market all the time. There is no extreme in market in terms of say, high interest rates, overdose of optimism and excess risk-taking. The market was fine in all those parameters. And as you will correctly note that bear market definition is 20 percent fall from the top, which never happened in the Nifty or the Sensex.

So, all the signs you look for in a bear market were not there, but the way the mid and the small caps fell, they fell almost worse than a bear market. While technically it was not a bear market situation, we had to deal with it like we were in a bear market.

As it is said “we live life forward, but we understand it backwards”. I think some of the changes that happened almost precipitated the crisis. One was that you shrunk the economy by doing demonetisation. Then, of course, the Insolvency and Bankruptcy code — for the first time in India, managements that were negligent, would go to zero or would get wiped out of equity.

That started a Domino series of falls. If you recall the 80s or 90s, no company went to zero. If you went to BIFR, the equity held, it came back and because you bought inflationary assets, they came back up in time.

Now for the first time, very well-known promoters and well-known assets were priced close to zero which is a new experience that the market has not dealt with. Plus, you have the ongoing rigmarole of the market getting knocked out because of poor quality earnings. So, what happened is that the investors did — to use an old English saying — ‘threw the baby out with the bathwater’. They wanted to focus on the highest quality earnings and highest quality businesses, and they d only those businesses, maybe about 50 in this country and threw the baby out with the bathwater.

So, even good mid cap companies, good track records, good promoter franchises were knocked down to single-digit multiples and treated with a lot of disdain. So, I think, we were not ready for that. There’s no way you can be ready for that. It’s just what the market teaches you. It taught us this time that the market will do the reverse for the poor quality—it will throw the baby out with the bathwater. And that’s a painful lesson learnt.

A lot of these stocks we have watched very carefully since years. Suddenly, despite paying dividends, despite the taxes, despite having good corporate governance, these were knocked down 50-60 percent. So, it’s a very painful lesson that the market teaches us every time.

After 30 years in the market, you expect to be prepared for something like this—but I wasn’t. One of the few times you get caught with your pants down; it was disturbing—am I getting old? Am I losing my reflexes? You go through these things out there. The good news is: at the end of the day great businesses will find a way to come back. The cream will rise to the top, so I am not concerned about that. But in between, we had to go through a huge amount of pain in the stocks we selected. I will give you examples of the companies in the last 18 months have paid dividends Rs 50-25-12.50 on a Rs 500 stock. So, they paid Rs 80 dividend and the stock is at Rs 400 right now. So, the market is not respecting anything other than the highest corporate governance. The truth though, as you say, about capitalism is that there is always summer coming, no matter how deep the winter is. The system won’t work, capitalism won’t work [otherwise].

At some point, the price will get discounted and the smart money scoops in and finds the bargains and that the low base effect kicks in and again you start getting rewarded for the things you make. As you often read in newspaper headlines, the time to buy is when there is maximum pessimism on the street. I’ll give you a case study for that. There couldn’t be any worse headlines in the news press than what happened to telecom companies. They were all destroyed over the last few weeks because of the headlines of adjusted gross revenues, the enormous amount of tax liabilities. Yet, these stocks are up 20-30 percent in the next few weeks following that. So maybe, we have reached the point of maximum pessimism and maybe the investors who had made an error of optimism earlier, are now making an error of pessimism and maybe the optimism maybe in the high quadrant and high stocks and the error of pessimism would be in the small and mid-cap stocks.

If there’s one iron rule of finance that I’ve have learnt is, you always regress to the mean. So, I think both won’t hold. I think the high-quality stocks will suffer periods of slowdown and the low-quality stocks which will survive, will prosper over the next few years.

No company is an island to itself. The broad economy has to do well. I think because of a lot of companies going to zero, investors panicked and said, “I want my money back. I want to go to companies who make money” and then they ignored the P/E ratio.

At the end of the day, history teaches us there are very, very few businesses—one in a generation or one in five generation have come along that can afford a multiple of 100 or 80. Businesses that grow at 20 percent should not be d at 80 times earnings, but in a bubble, anything can happen.

There is an old lesion I learnt about bubbles. Every bubble is accompanied by a pin and when the two meet, the new investors are going to learn a lot of old lessons. But leave that side, I think given the fact that the bull market is intact—we never corrected 20 percent, so theoretically we are intact though it didn’t feel like it. But theoretically, we are intact. I think there are some bargains to be had in the sections that the market is ignoring—the small and the mid caps. If you believe—as some of my wiser friends tell me—that these companies will survive for five-10 years, that’s where you want to put the money because these companies have survived, and they have had a good track record but the investors are throwing them away. There is an air of pessimism in the market. Typically, to get superior returns, you need to buy it at a good price and at an attractive valuation.

I would proposition to you that the high quadrant companies are great companies but the valuations reflect that whereas the mid-cap and the small-cap companies, some are good companies at absolutely pathetic valuations. So, the next opportunity or the next swing will have to be in those kinds of stocks. And for all those people who come out routinely and say, “you should never invest in small-cap, you should never invest in mid-cap stocks”—it’s just a shorthand for not doing your own homework. There are great companies, which are available and should be looked at, and if you are right, you will be handsomely rewarded by them.

There are two things. First is the acknowledgment that even veterans like me have made mistakes in the portfolio and those are like cans in your portfolio, it’s best to get rid of them. We should not try to average them. Then it’s a losing game in those stocks. So, if I am not comfortable buying those stocks at 50 percent, it’s clearly an error in my judgment to have bought the stock in the first place. It’s hard to explain this but one of the criteria used in my 30 years of picking stocks is to believe the fraudulent companies and ignore them.

So firstly, I won’t look at dividends, earnings, ratios, P/E ratio, etc. because I know so many businesses in India are short-changing their investors. So, 90 percent of the stocks; I will not look at because I believe the management is the suspect. So, I look at the universe of 10 percent, cull from 100 percent of the database and then the 10 percent out of those stocks have gone to zero, right? So, that’s a pretty pathetic performance, you know? But that’s the truth of the matter.

So, if I believe that those companies don’t deserve my investment of time and money, let’s get rid of them, alright? The other stocks- if you are not willing to buy them at 40-50 percent then I would bet that you have not done your homework. So, that’s why, you should go out and buy them but you should also look at newer opportunities because the market will latch on to newer themes. I have been saying this publicly for a while that I like the public sector stocks for example because I believe that while they offer , we now have a trigger for change. A trigger for change happily as you know, is the disinvestment and privatization process that even as you speak, is undergoing with the government. The government actually manages to go ahead and do a couple of these privatisations by March 31st, I think there will be a whole re-rating waiting to happen in these stocks.

In 2003-04, when Arun Shouri did the disinvestment programme for the IPCL and other companies, there was an absolute party in the public sector stocks. The index itself was up 5X in a period of two years or so.

I think we could perhaps return to those kinds of heady days in the stock market because the stocks are so cheap. I will tell you why we like these stocks. A, they have order book visibility, while the private sector has no visibility right now in terms of growth. These companies typically have a bill-to-book ratio of almost 5 to 10X, right? It means they have a 5 to 10-year visibility.

They are trading at single-digit yields and because the government has single-digit Ps, because the government has requested these companies 30 to 60 percent as pay-outs, you are getting almost 7 to 8 percent dividend yields in this stock. For stock pickers, this is heaven. It is unpopular, it is cheap, it has visibility and it will be privatised. A lot of them will be privatised over the next 2 or 3 years. So, that is usually, inherently very unlocking. So, I think, while we certainly address some of the stocks that have been beaten down, you also try to look for new themes in the market which could lead this market higher and which are the sectors which could lead higher. I would suggest that maybe the market is missing an opportunity by not looking at these public sector stocks.

CMC was merged ultimately with Tata Sons, but it did well ultimately. But the private sector will bring in efficiency of capital, efficiency of corporate governance when these things get privatised. First leg up would be when someone comes and buys the asset. These assets are trading so cheap that if someone pays a premium for that, that itself will re-rate and then there will be sweating of these assets which will take place which is so obvious that it will happen. The third point of the PSU which I said also to make my claim for that is that a lot of my fraternity is very bullish on the Modi government.

They are very ultra-bullish on the prospects under the BJP government-under the romance and honeymoon of the BJP government. How can you be bullish on the BJP government and not bullish on the companies that they run? That is clearly the same type of sweating of the assets and the anti-corruption drive, better corporate governance will come to these companies. So, it seems to me as almost like a perfect storm for these companies; we have waited out and seen this hypothesis play out, but I am optimistic.

You want to buy companies that you understand. I belong to the Peterling school where you have to explain investments with a crayon to a child. If you can do that, then you are onto something. It can’t be too complex, maybe one or two variables affecting rate investments. You need to be able to do that to articulate your position. (You) might’ve been trading positions in a number of stocks but to articulate your position, you have to be able to synthesize all that and explain to a child why you are buying this position and I think that works the best.

If I have to synthesize my position, say explain to the public sector stocks or the other sectors what I meant, I think I am generally far ahead of the game.

I think I hold that with conviction. Investors should make distinctions between price and . They can’t base their investment decision with price. If the price goes up, it’s good. If the price goes down, it’s a bad decision. It has to be based on the which is independent of the price. As long as they know the of the business I am buying, I can deal with the price up to and down. So, I would suggest, focus more on the you’re buying, the of the business than the price because the price will fluctuate. The market has good days and bad days so it will keep doing that.

A lot depends on the price at which you bought that particular asset. If you buy it right, you can sit tight with it. There is no issue about that, you can sit through a lot of periods of pain because you bought it right. A great asset should be kept almost bought permanently if you can. You should have that discipline as long as you have that business that even if it’s a compounding machine, I will keep it and invariably, there will be drawbacks.

Markets will be between greed and fear. That’s the nature of markets and you need to figure it out. There are very few businesses that actually right that out, but the most important thing investors can do is, buy it right. There is no substitute of buying it right. The greatest company in the world bought at a bad price is a lousy investment. I would rather buy a company (in terms of the small-cap, large-cap debate) a 10-million-dollar company earning at a 15 percent return or a 100-million-dollar company earning a 5 percent return because I am going to compound the money most significantly. That’s the nature of the business but beyond that, you want to look at buying it right, just buying it at the right valuation and I think, there is no substitute for that.

That’s just coming from experience and a lot of people to come back on the previous answer, base it on price and use that as a moniker for what is right or wrong. That’s sometimes a mistake because it’s good for speculation. You need to speculate on price, but you need to invest. As Warren Buffet has taught us, you should be head over heels buying it at 20 because it’s so much cheaper right now and typically, investors will do the opposite. They will love it at 40 and hate it at 20.

That reflects the lack of understanding of the business. So, I keep repeating- don’t evaluate the price, evaluate the business you’re buying and what is the of the business. Once you do that, a lot of cobwebs in your head will be cleared. ‘I am happy to hold this company, it’s trading at net current assets, it is trading at 8 percent dividend yield, it’s trading at a market cap which got selected for 5X the amount in 3 days. So, I think those kinds of matrices are more helpful to individual investors than basing it just on prices. Price has been very ruthless this time but even then, I am arguing that you need to look beyond that and the business that you are owning.

Absolutely, I very strongly believe that. The little amount of cash that I have raised in the last few years, I have deployed that back in the market because the first time when you are buying stocks and making money, when was the last time we made money in telecom stocks? And yet, there were up 20 percent in the last four weeks or so. So many other stocks; a lot of the public sector stocks have gone up handsomely, some have listed handsomely- IRCTC or whatever.

So, you are making money. One of the good criteria that keeps the bull markets intact is that your purchase shows that are making money. If you are losing money, you have to be quiet and you have to be reticent. But if you are making money- if you buy something and it goes up in the next week or next month, I think you are on the right track.

To me it seems that once the corporate tax rate is cut, the market’s going to look ahead to the budget and a lot of Draconian measures that the market was expecting from the budget; for example, the wealth tax, I think have now been shelved. On the other hand, we could see a cut in the personal income tax rate, we could see a great movement of privatization. So, a virtuous circle of events would take place for the next three months rather than a vicious circle that took place.

There is a deemed slowdown in the market, there is no question about that in the economy. I mean, some stats (statistics) that really frightened me. They said in rural India, consumption of salt and sugar was down. Now, that means they are eating less because they have no money. Those are really bad statistics. Now, my counterpoint to that is and I hope I am right about this, I don’t know; is that markets are typically six months ahead of the real economy. So, while the economy is still feeling the pain, the headline news is still bad, the numbers of industrial production are still bad, the numbers of exports are still bad. The economy, the market is looking 6 months ahead and perhaps seeing a revival.

I hope that this is true. The market’s signal to us if they feel that the Bull market is over and from where I sit, I don’t see those signals coming. I haven’t seen a signal two years back though the market went through a very painful period. But the good news is, the market is recovering, its index is all-time high. Individual stocks- I see a recovering. There are a lot of stocks which will not recover, don’t get me wrong but there will be a lot of stocks which are headed to zero because of the movement from the unorganised to organised sector, the movement to GST, the movement to insolvency and bankruptcy code and there probably deserve to be zero. My concluding point is what I said in the opening also was that: investors are making a mistake of throwing the baby out with the bathwater. They need to be more discerning in what they are doing.

The favourite one was: I was ready, I was invested and we made lots of money. The bull markets are to make money. The right time to make money was clearly in the 2000s when I was a software programmer in my earlier life and we had a tech bull market in the early 2,000s so I was invested in tech. Technology comprised 95 percent of my portfolio and it went up 5X, 10X, 50X. Who knows how much it went up! Those were heady days. I was just starting my family and we made a lot of money and suddenly we had the financial security that I yearned for and I realised that in this bull market and in the subsequent bull markets that bull markets are magical in nature, it’s like an eclipse, and it’s the time to really make a lot of money. In Egyptian times, they said: “Seven years of feast and seven years of famine.” Bull markets are years of a feast, that’s when you make money and then, you protect yourself during a bear market and then, you wait for the next bull market. That’s the nature of the beast. The whole capital system will not work if you have a permanent bull market or a permanent bear market. So, don’t get too pessimistic, don’t get too optimistic. I think the future is still bright and to come back to your original point, the 2000 bull market was the first time we made some serious money. We got a lot of stocks right and we could encash a large part of those gains so that made me tremendously happy.

You’ll see in 2003, 2008 and the current bull market so each bull market should make you richer, stronger and wiser than the previous one. That’s my big takeaway which I tell all the young kids that each bull market you see, and you will see maybe five or seven bull markets in your career. But each bull market, at the end of the year, you should be richer, wiser and smarter. I think most people who lived in India have seen the indices to have made 800 to forty thousand, have lived their dream. But people who chase price or chase speculation, perhaps have suffered more than most people but otherwise, most people that I know have prospered, as their index has gone from 800 to forty thousand. So, I think that is great learning from bull markets.

With bear markets, the converse is don’t get too pessimistic, it happens. It is the nature of capitalism that there will be good years and there will be bad years. The feast and famine are out there, and they will always be on the next door. There will always be the next dawn, there will always be the next rain, there will always be the next summer. If you are young, say a 30-year-old in India, you want to look forward to the bear market because you will get stocks for cheap. That’s when you invest and compound your money for the next 20 years or so. So, there is no need to be too pessimistic. This is a growing country with a billion-plus population out there, in a sweet spot with demographics, democracy. All pointing to the consumption boom ahead. So, don’t get too pessimistic in the bear market, that’s the time to buckle down, do your homework and find the great companies you believe will be there for the next 5 years, 10 years. Like I suggested, perhaps the mid-cap, small-cap companies in India are offering that opportunity because investors are just throwing away the towel. So I am saying that every bear market should be instructive for you to go and find those great companies and every bull market should make you richer, powerful and stronger than the previous one.