We are close to completing our first year of investing at 2Point2 and this is a good time to take stock of our performance so far. Since inception, we have generated 34.74% in returns compared to 11.64% of the Nifty 50 and 24.74% of Nifty Midcap 100 index. The overall performance has been quite good on both absolute and relative basis. This calls for a celebration. But, maybe not.
Consider the game of cricket. If you aren’t a good player, it is certain that you would struggle to even make it to the gully cricket team let alone dream of being part of the Ranji or national team. Thus, cricket is largely a game of skill. On the other hand, investing (over the short term) is an activity which has a high component of luck. Over the long term, the role of luck diminishes substantially in investing. However, sometimes luck can play a role even in a reasonably long investing period.
The Skill-Luck Continuum[1]
The last few years have been great for equity investors. While the BSE Sensex has increased by 60% over the last 4 years, the mid-cap index has more than doubled and the small-cap index has almost tripled in this period. Returns have been inversely proportional to the size[2]and quality of the company. The higher the risk investors have been willing to take (by investing in small/micro companies with limited operating history or suspect governance standards or high valuation), the higher the reward has been.
The skewed nature of the returns has led to a peculiar outcome – most investors and fund managers (including yours truly) have comfortably beaten the index returns over the last few years. This is because indices give higher weightage to larger companies and they have substantially underperformed smaller companies. As most fund managers also invest in companies that are smaller than the typical index stock, they have been beneficiaries of the outperformance of small/midcap companies. Only those who were highly concentrated in larger companies have struggled to outperform. Here is a random portfolio generator(built by Capitalmind) that shows how a set of 10 random stocks beats the Nifty over the last year (Keep hitting refresh to turn into a rockstar fund manager). If compared over the last 4 years, we would find that a random portfolio outperforms the large-cap, the mid-cap and probably even the small-cap index (simply because there are a larger number of smaller companies listed on the exchanges).
Michael Mauboussin presents a simple test of whether there is skill in an activity[3] – “ask whether you can lose on purpose. If you can’t lose on purpose, or if it’s really hard, luck likely dominates that activity. If it’s easy to lose on purpose, skill is more important.” Over the last few years, it has been quite difficult to lose (i.e. underperform the indices) by investing in the Indian equity markets. Even a random portfolio has done quite well. Therefore, luck seems to have been the primary driver of outperformance rather than skill.This leads to a much sober self-assessment of our performance over the past year as our portfolio too has few small companies which have significantly outperformed.
However, we believe that the large role of luck is unlikely to persist very long. The role of luck has been high due to the skewed nature of the returns favouring smaller companies. Once larger companies start outperforming or even matching returns of smaller companies, it is certain that the random portfolio will not be able to beat the indices. Fund managers (including us) will no longer have the tailwind of luck and will have to depend on their skill to outperform the indices. Large and stable companies most often outperform smaller companies in challenging market environments and that’s when we will probably see skilled fund managers outperforming the indices. As Buffett says – “Only when the tide goes out do you discover who’s been swimming naked.”
At 2Point2, we believe our conservative approach focused on protecting capital should help us better withstand any significant market decline (“when the tide goes out”). We deploy capital only in businesses that we really like (sustainable competitive advantage, high standards of corporate governance), understand and that are available at a reasonable price. When there are not too many businesses with such characteristics available, we prefer to stay in cash.
[1] Untangling Skill and Luck, Legg Mason Capital Management, Michael Mauboussin
[2] More information can be found in SageOne’s January 2017 investor memo – https://goo.gl/bH9wtw
[3] Untangling Skill and Luck, Legg Mason Capital Management, Michael Mauboussin
