A Distressed Mr. Market and A Devastated Ms. Economy — A True Test Of Your Investment Strategy

Dear Investors:

When the economy is booming and the markets are riding on the economic boom, most investment strategies do well. In fact, some investment strategies which do well during boom times might not be worthy of being labelled “Strategies” at all. However, the investment community is designed to respect “data”, by which it means the last 1-month, 3-month, and 1-year performances. Whatever “strategies” are seen to be delivering the highest returns are considered the smartest and everyone wants to know what these are. If there is continued performance of these strategies for a reasonably long period, they build-up a huge following and most market-aware participants including fund managers and retail investors start adopting these. This means that these have become the “herd” strategies.

The test of these strategies is when Mr. Market goes into distress, i.e. the market crashes 20–25% or even more. Sometimes it comes back quickly and the strategies survive this event. In fact, some of these strategies might gain even more popularity on the back of these mini-events if the recovery is faster for these strategies.

However, when an event happens which disrupts the economy in a fundamental way and consequently the markets realize that their assessments of the companies might have been wrong, the true stress situation arises. These are the true stress situations which test whether the portfolio can survive — i.e. robustness — and thrive — i.e. anti-fragility.

With the coronavirus and Covid-19 situation, the economy is devastated, and the markets have crashed significantly. There are fundamental impacts on the cash flows and incomes of most companies as well as on their balance sheets.

This is the time to assess whether your portfolio is likely to survive. The way to assess a portfolio is NOT its NAV. Typically, the assessment would be that the market crashed by 30% but my portfolio crashed only by 25%, so I have a strong portfolio and hence I must have had a strong strategy. Maybe. Maybe Not.

While the NAV has a role to play in the long-run, the proper way is not to look at the NAV. But it is to look at whether the fundamentals of the portfolio companies are still intact. One could begin with assessing the following:

· How strong is the balance sheet?

· What kind of debt is there?

· Are there any debt servicing obligations within next several quarters?

· How are the cash flows going to be impacted?

· Is there enough cash or cash flows to pay the interest costs?

· What about other obligations?

Of course, there are numerous questions like that on which the portfolio has to be assessed. But these are some of the most important and urgent ones.

While in many cases the earnings and cash flow impacts might be temporary, there are companies in certain sectors which could be impacted permanently due to disruptions in how their customers behave in future. The good investment strategy is not expected to have visualized an unknowable like the covid-19 and its impact. It is not supposed to have anticipated fundamental changes in human behaviour which can happen as a result of covid-19 and designed a portfolio apriori based on that. That would require clairvoyance.

However, a good investment strategy would have focused on chasing safety fundamentally. This means focusing on companies with strong balance sheets, ideally, zero debt and cash-rich; companies with strong business operations; companies with persistent competitive advantages, resulting in low capex relative to profits (high roc) in the form of high margins or efficient asset utilization or both.

The investment strategy would have focused on the above type of companies and would utilize a sophisticated and conservative valuation toolkit which would define the maximum market price at which they would yield a satisfactory return given the risk of equity investing. Further, the investment framework would be able to analyse the whole market to value the other investment opportunities available and define an appropriate opportunity cost. Any company would need to provide a higher expected return than the opportunity cost to be eligible for the portfolio. Companies not meeting these criteria or meeting these criteria only under highly favourable conditions would not be eligible for the portfolio.

The above defines Scientific Investing. In evaluating our US Omni Supreme portfolio, we see that the above has held us in good stead. Majority of the companies in the portfolio are cash rich. The AIoT portfolio has even more cash rich companies. Most of the other companies in the portfolio have a net debt which is lower than or comparable to their operating cash flows. The total cash on the balance sheet of US Omni Supreme companies is $182 billion and on the AIoT portfolio is nearly $0.4 trillion. While covid-19 could impact their business operations and hence cash flows for a couple of quarters, these companies are best positioned to weather the storm compared to their peers in the industry with weaker balance sheets.

We believe that the Scientific Investing process with its focus on chasing safety, results in a highly robust portfolio — and in the case of AIoT, perhaps, an anti-fragile portfolio. As a reminder OmniScience Capital’s investment philosophy is based on the insight that “chasing returns results in risks and chasing safety results in alpha”.

Disclaimer:

Past performance is not necessarily indicative of future results. Omniscience Capital Advisors Private Limited (Omniscience Investment Advisers) is a Registered Investment Advisory firm with SEBI-registration no. INA000007623. Equity investments are subject to market risks. Please read all investment related documents carefully. An investor should consider the investment objectives, risks, and charges & expenses carefully before taking any investment decision. This is not an offer document. This material is intended for informational purposes only and is not an offer to sell any services or products or a solicitation to buy any securities. Any representation to the contrary is not permitted. Omniscience makes no warranties or representations, express or implied, on the products and services offered. It accepts no liability for any damages or losses, however caused, in connection with the use of, or on the reliance of its product or services. This document does not constitute an offer of services in jurisdictions where the company does not have the necessary licenses. This communication is confidential and is intended solely for the addressee. This document and any communication within it are void 30-days from the date of this presentation. It is not to be forwarded to any other person or copied without the permission of the sender. Please notify the sender in the event you have received this communication in error.

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