An important distinction here is about the fundamental fabric of the economy in which we are making these decisions. An economy does well over a long time when (a) more people work, and (b) people work more efficiently (labour force participation and productivity gains). With people, ideally, we should measure effectiveness, and not efficiency, but I digress. In India, more than 90 million people will join the labour force over the next decade, and we are continuously finding more ways to be efficient. Accordingly, the conclusions for India’s investments will be different from what has transpired in Japan over the past three decades.
Despite that, retail investors in India own just 8% of the market (16% including mutual funds), but that constitutes an even smaller percentage of their overall savings. For a vast majority of retail investors, stock markets are no longer considered akin to gambling casinos, but we are still far away from where equities are a must-have allocation in one’s savings.
Nevertheless, to this reading cohort, I don’t have to enlist the benefits of equity as in an investible asset class, I will take it as a given. In that case, the only decision that we must make is regarding the approach. To me, using leverage is not sustainable as a universal strategy. Leverage makes us terribly path-dependent. If we buy a certain stock at 100 on leverage (the fair price of which we believe is 150), and the stock dips to 70 before it reaches 150, we might be forced to liquidate. We build an acceptable path (for leverage to sustain) based on what has happened in the past. But increasingly, things that have not happened in the past are happening all the time now (markets had never corrected 30% in a month before COVID, and no market recovery had happened in a straight line before 2021). And any strategy where ruin is a possible scenario, however low, the a priori probability is unlikely to yield long-term success across all practitioners (ergo, not a universal strategy. Works with a few, and we celebrate the winners. But those who leveraged and got wiped off, we don’t know them!).
If India’s economy is on a strong fundamental foundation and equity as an asset class deserves allocation within our savings and leverage is not an alternative, the only question that remains to be answered is – should we always stay invested in the market, or keep getting in and out (either fully or partially – aka, take large cash calls)?
The chart below compares the long-term returns of an investor who managed to invest all their surplus at the absolute market bottom (dark red bar) versus an investor who kept investing regularly (grey bar). Despite the huge market correction in the Global Financial Crises (light red bar), the difference in long-term returns of both investors is not material.
The higher value of the red bar over the grey bar is assuming that the investor can accurately time the market. The difference between the two bars then, is the benefit of cash calls, if you will. Now let us look at the costs. Over the last three decades (13,500 days), if an investor missed just the best 10 days of the market, the investor returns would have been 65% lower. Miss 30 days and returns fall by a whopping 92%.
Put another way, if an investor absolutely nails the market bottom, the advantage he gains is minuscule compared to the costs (65% and 92% lower returns). The risks are not commensurate for marginally higher returns, in my opinion. Why then, one would wonder, would investors focus so hard on taking these cash calls?
I would submit that, for many, it is an emotional issue. Investors don’t consciously calculate the difference in returns that their strategy (higher cash calls) generates but derive huge comfort and satisfaction when they are able to invest in market corrections. It ‘feels’ like that strategy would generate superior returns given that we are buying during a market correction, but an accurate assessment of opportunity cost is not done.
I would propose a different approach to cash calls. Rather than letting it be an input parameter (‘markets are expensive, so let’s create cash’), let cash be an output of articulated actions. For us, a good business is a great investment only when we pay the right price for it. Admittedly, there are different ways to arrive at the “right price” (we use reverse discounted cash flows), but when the price of the businesses we own gets too high, and we do not get decent businesses to buy, that’s when the cash percentage should increase. If that coincides with markets topping out, so be it. This approach will ensure an investor’s mental bandwidth is utilized in arriving at the right business to own, and the right price to pay versus incessantly worrying about market movement and behaviour.
(The author is Co-Founder & Director, Buoyant Capital.)