There are multiple benefits of maintaining an investment journal. Firstly, I use it to learn a lot about myself and to correct my biases. Maintaining a journal has helped me improve greatly both as an individual and as an investor. I have also maintained a personal archive of the media commentary and subsequent investor behaviour during various episodes of market panic since 2014.
I find it highly beneficial to refer to this information whenever the markets undergo their periodic severe corrections because human nature in the markets has not really changed much in many centuries. So maintaining a journal helps you maintain your humanity and calm during periods of market turbulence. Most importantly, it also helps you avoid hindsight bias because many times we confuse outcome with the process. Many times we may be right for all the wrong reasons. Investment journal helps prevent this bias and helps you get honest feedback on the outcome of your investing decisions. This is how you keep getting better over time.Well, that is correct. Even Buffett, one of the market gurus which you follow and who have made a note on your earlier book also is a big advocate of maintaining a journal. On June 5th, I see an entry from you in this book about smallcaps. Even now, smallcaps and midcaps are very frothy. A lot of young investors don’t know how smallcap, midcaps are treated in a bear market. How should the rules of smallcaps be in a bear market?
Well, that is a very good question and the number of demat accounts in India have actually tripled from three and a half crores to more than 10.5 crores since April, 2020 when the last bear market actually ended. And very few people actually know what a true bear market actually looks and feels like. And a real bear market will gradually wear you out mentally and emotionally. It is only when the last bull surrenders and gives up, then the bear market comes to an end.
Some of the biggest learnings always take place in a bear market and those lessons bear fruit for an entire lifetime. And I have shared many of them in this book and I will share a few of them with your audience today. Number one, if you want to make it big as an investor in the stock market, you need to be mentally and emotionally detached from stock price fluctuations because during periods of severe market stress, it becomes extremely difficult to endure such sharp drawdowns. That is the first point.
The second point is India will grow at a healthy rate. Nifty earnings will compound at low double digits, but at any point of time, there will be a few midcap and smallcap names which will grow their earnings per share at a rate of 25 to 30% over the next three to five years. They are bound to create wealth in the longer run. You just need to have the confidence and the conviction to back them. In the long run, what ultimately counts is earnings, earnings, and earnings.
Number three, sanity will eventually prevail after every bear market like it always does. So, it is always the darkest before dawn. You need to keep the faith that this too shall pass, and you need to just hang in there and not sell your high-quality stocks in panic. You need to have extreme levels of patience. The fourth and biggest learning, and this is very important is believe in India and the power of its entrepreneurs and business system. If you look at all the legendary investors of Dalal Street, all of them have one common attribute. They all had a relentless belief in the power of this country and its long-term future. These are some of the very big learnings which will help you stay the course during difficult times.
Sure. The other very specific example I want to understand from you is within the smallcaps and midcaps, the investing world is always very excited about special situation investing, be it a buyout, be it some kind of merger, demerger, unlocking of value. This usually is something the retail HNI is very excited about. What are the things one should be very careful about as far as special situation investing is concerned? If you could share examples.
Well, I have been practicing various forms of special situation investing over the last 15 years in the market, but in my view the base rates of success are the highest in three specific categories. Number one, demerger for microcap plus midcap from a largecap parent has got residual institutional shareholding because this often leads to force selling in the smallcap demerged stock after listing, after demerger and that is when one get a deep value buying opportunity; so that is the first instance.
The second one is merger arbitrage. I will give you a live example from the current market. Ujjivan Financial is basically merging with Ujjivan Small Finance Bank and for every one share of Ujjivan Financial, you will get 11.6 shares of Ujjivan Small Finance Bank. So if you just look at the merger ratio right now, there is more than a 15% merger arbitrage discount on the table. And we have a very high probability of this merger getting through and getting NCLT approval because we had a similar reverse merger which recently concluded between Equitas Holding and Equitas Small Finance Bank.
So you basically want to maximize your base rates of success by looking at similar situations which have taken place in the most recent past. It is not a stock recommendation we hold Ujjivan Financial in our PMS and in our India fund.
The third category of special situations just got a very high success rate, which I have talked about in my book; it is promoter or management change. And here the really big money in promoter and management change situations takes place not when the business being sold was previously being run efficiently. The really big money is made when the previous management which was running the business, was running the business either badly or far below potential. In investing, it is all about delta that wherever you find the maximum scope of change on the positive side, that is where the really big money is made because valuation re-rating is a key ingredient for multibagger stocks.
There is a saying on the Street that you should always keep a stock on your radar where either the story is changing or the storyteller is changing as far as special situations are concerned. Let us move on and talk about another style of investing which is timing the entry and exit in commodity stocks. A lot of time they turn out to be commodity traps.
Well, commodity investing in general is very counterintuitive because here, the lower the PE multiple, the more expensive the stock is in reality because the earnings per share, the denominator for these stocks is the maximum at the peak of the commodity cycle.
You ideally want to buy into such stocks when a couple of leading players in the industry are going bust, supply is coming out of the system, supply is reducing in the system and you want to basically capitalise on the capital cycle theory here.
So basically, capital cycle theory simply means that as the competitive intensity in an industry reduces, the return on capital of the remaining players in the industry start to improve, they exercise better discipline and during the up cycle, that is when you make the maximum amount of money. So you want to ideally enter into such commodity and deep cyclical plays when the industry is under severe stress and again, you just need to check for two things primarily, check the debt on the balance sheet to make sure that the company can survive another one or two years of an industry downturn and check whether the company has got sufficient positive operating cash flow to service the debt.
Once those elements are in place and the industry supply situation is improving, you should enter and that is how you get those big multibagger returns from commodity stocks.