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A constructive criticism of what we have been doing is important

LiveMint logoLiveMint 04-08-2017 Lisa Pallavi Barbora

In what came across as an unusual step, Ambit Capital Ltd, bared its market mistakes in a boldly titled report: ‘Ambit—Our Biggest Mistakes in the past 12 months’. While the report was not meant to be distributed to anyone other than clients, it was highly written about in media a day after its release. First, it is not common for companies in the securities business to speak so clearly and openly about missed opportunities and market calls that went wrong. Second, some of the calls made went starkly against reality and that casts a shadow on their assumptions. 

We spoke to Ambit Capital’s head of equity, Pramod Gubbi, about the report and some of the specific expectations that went wrong in the last 12 months. He pointed out that publishing ‘hits’ and ‘misses’ is regularly done at Ambit. Gubbi talks of the need to be upfront about such events as it underlines the intent and credibility of an equity manager rather than take away from it. Edited excerpts: 

Why was there a need to come out with a note on the mistakes that have been made? How did the clients react to something like this? 

This is not the first time we have done it. It has happened every year for the last 6 years, where around this time in the calendar year we consider what went right and what did not, and what can be improved from our end. This time we decided to publish it differently. Earlier it was called Ambit’s hits and misses, where both were talked about. This year we decided to put the misses upfront. 

Why did we start this practice of having a summary? The ethos of the firm is to continuously improve. To that context, constructive criticism of what we have been doing is important.

We are inspired in this by some of the greatest investment professionals. In Warren Buffet’s annual letter every year, the start is about the mistakes made in the past. It also brings in humility to the profession, which perhaps is the number one trait that you need to have as markets can bring you down after a period of success. Which is why acknowledging mistakes is important. 

Clients respect this. There are periods when the hits and misses ratio changes but there is no single investor who doesn’t make mistakes. The seasoned investors have been through multiple cycles and respect the ability to look back with humility about their own track record. If the intent is to improve upon the past, the feedback has to be positive. It brings in more credibility, given the balanced approach. We also put out a separate note on the calls that went right, that is, the hits. 

 The most glaring gap highlighted in the report was Ambit Capital’s expectation of a sharp fall in H2 FY17 GDP growth to 0.5% post demonetization. Ultimately, the number came at 6.5%. What were the assumptions that were made there? Was it too much of a risk to put out early estimates on the impact of such an extraordinary event? 

India was the highest among most economies in terms of the percentage of cash transactions, especially in terms of volume. Economic theory suggests that in some ways, the pace at which this cash changes hands is directly proportional to the growth of the economy. If you pull out 86% of the oil that greases that economic machine, the assumption is that the machine will creak. Hence, the assumption of a significant slowdown. A large part of our economy also is in the informal space. We assumed that the reserve bank would take longer to get the cash back into the system, which could have resulted in a prolonged slow down. 

The pace at which the cash came back in to the system was surprising. Also, the way Indian entrepreneurs figured out getting around the system surprised us.

Lastly, we think that the official GDP estimate does not capture the informal economy and the entire effect of demonisation. Although, our estimate was harsh, the truth probably lies somewhere in the middle. 

Another assumption was that the cash that was unaccounted for would not come back into the system. But there again we were surprised that so much cash came back into the system. 

Everything we do is about assessing and estimating the best we can. There is a risk to everything. A simple buy or a sell call on a stock has many variables around it. At the same time, if we are to help our clients, we must give an estimate which we think is accurate at the time. On 18 November 2016, when the note went out, the economy (because of demonetisation) was really bad. We had analysts on ground reporting back. We could have waited for a few weeks more, but we needed to get a view out on what we saw on ground. 

 Three of your sell calls, Maruti, Bajaj Finance and L&T belong to industries or sectors where there is structural demand growth. Do you think this is enough to drive earnings upwards and change your fundamental call, without the valuations overhang? 

I don’t think the market opportunity alone drives the stocks’ investment attractiveness. If the market is large and growing, it often tends to attract competition. What would have otherwise been an easy and smooth ride, now becomes a fight with many other companies trying to eat into the same pie. 

Smaller market opportunities, which are not always fast growing, have yielded a lot of opportunity for the market leader because it is not too attractive for others. There is no doubt that the passenger car market is huge and there is a huge growth potential. In case of Maruti, the concern was on competition, particularly in a specific segment of the market and its ability to hold market share against global peers. In case of L&T, while India does need infrastructure and L&T has the potential to dominate this space; but here it was not about competitive pressure, rather the capital allocation decisions. It was not only about the opportunity. Just using the size of the market is not enough. 

The sell on banking and financials segment was a broader call linked to the bearish macro view of the economy. While each bank does a similar business, should one use a broad brush or consider each individually? 

It is an interesting space. The sector is levered to the economy and vice versa. The dichotomy has emerged because 70% of the system got taken care of by public sector banks and the rest by private sector banks. Given the state of the balance sheets of the public-sector banks and lack of willingness from the government to recapitalize these banks, it impacted credit growth more in some sectors than others. This meant 70% of the supply decided to stay away from the credit growth in the system. The rest of the sector benefitted despite unsupportive macros. 

Within that, yes, there are a few which did better. Private sector banks which focused more to the retail assets have managed to hold on to their growth with less problems on asset quality. While it remains a macro-driven sector, at various levels, factors like target market, and strategies can make a difference for specific banks. 

You had a very aggressive 15% cash allocation in the portfolio. There is a debate on whether asset allocation is the adviser’s call or the equity fund manager’s call. Should equity portfolio managers take cash calls? 

It all really depends on the type of investor whose money is being managed. Let us say it is a pension fund that wants to invest in an India-dedicated fund. You can assume that the due diligence is done about where the money should get invested.

In such a situation, the money should be fully invested, rather than sitting on cash. On the other extreme, you take an average retail investor looking at investing every month. Awareness about timing market is limited; here one can assume that investors don’t understand when to be in cash or not. Here, some asset allocation calls can be taken but again it depends on the mandate one has signed up for. You must know your client and provide the right kind of advice and strategy accordingly. 

What are the themes you are positive about now? 

There is a consistent theme in terms of the government’s action so far. There is focus on corruption and black money as a result more money is getting channelled into financial savings rather than physical assets. Intermediaries who channel such savings into the financial sector are going to benefit. We have seen more bank deposits come in, which has helped in reducing the cost of funds for banks, wealth management companies and asset management companies too can benefit. We are likely to see more primary market offerings in this space. There is a possibility that this can lead to a structural reduction in cost of capital for the country and this can play into other segments of the economy, which are capital intensive. These segments can benefit from lower cost and higher return on capital. 

Sectors dependent on real estate as an input are seeing costs reduce. Segments like retail, hospitals and so on can benefit from this. 

The biggest theme we have seen is the shift in demand from unorganized to the organized sector. Every single move from the government has meant that increasingly it is difficult to operate in the unorganized space. To that extent, we will see the organized segment of certain sectors like apparel, textiles, building materials, electricals and so on grow better. These are all structural themes and companies will continue to grow irrespective of the market levels. 

For the savvy investor, is it time to make the cash call? Does one have to be nimble in this market or wait for a deep correction? 

This market is being driven by liquidity and flow and it is hard to predict when the flows will stop. Some of the flows are coming from mutual fund systematic investment plans, what will make the average investor discontinue that. There are very few other avenues for the average retail investor to make anything other than sub-optimal returns. Investments into the market are best made more systematically. For us as advisers, it is also difficult to use these flows or liquidity as a reason to invest in the market. 

For those with a shorter-term horizon, the 5-7% correction can work. For long-term investors a deeper correction is what will add value and margin of safety is better.

Disclaimer: Ambit and/or its associates do not have any interest in the above mentioned scrips.

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