Given the current backdrop of global economic scenario, Prashant K Trivedi, Chairman of Multi-Act Trade & Investments Ltd, talks to us about his views on the “Cockroach” Portfolio approach, the effects of quantitative easing, his process of estimating valuations based on current conditions and outlook for Indian equities.
“Whatever is going on currently in the global market – the sharp decline in crude oil and commodity prices, ultra low interest rates and concerns on Chinese growth – was completely expected if you follow the Austrian School of Economics (ABCT),” says Prashant K Trivedi, Chairman of Multi-Act Trade & Investments Ltd, a financial services firm based in Mumbai, which engages in independent investment research and management. The principles of the Austrian School of Economics plays an integral role in his investment process and he is very bullish about gold, gold mining companies, commodity mining shares and equities from emerging markets such as China, Russia and Brazil.
This apart, when we spoke to him last year, he spoke to us about his portfolio construction approach called the “Cockroach Portfolio” where one essentially invests one fourth of a portfolio equally across Gold, fixed income, real estate and equities. In this interview, he talks to us about his reallocation strategy based on this approach, apart from sharing his views on the current global market scenario, the effects of quantitative easing, his process of evaluating valuations in the current conditions and the outlook for Indian equities.
On Austrian School of Economics
Current reading of the global economic scenario given the backdrop of a sharp decline in crude and commodity prices, ultra low interest rates and concerns on Chinese growth
Austrian School of Economics’ theory (ABCT) talks about mal-investments and one of its key tenets is the business cycle theory. This theory states that when Central banks guide or administer interest rates below a “natural” rate of interest, there is a credit boom which inevitably leads to a credit bust. And, this is exactly what’s happening now and that too at a global level.
From the Austrian economist’s point of view, whatever is going on currently was predictable and completely expected. The only thing I would say about the ultra low interest rates is that these are not naturally driven but the result of continual intervention by central banks in order to drive down interest rates as much as they can in the bond market. Let’s take the example of the Italian Government. They have a debt of almost 133 per cent of their GDP and yet the Italian two-year rate is floating fairly close to zero or negative. This is not the result of any market driven ultra low interest rates, but of manipulation by the central bank.
Any second order effects in the current global scenario which the market participants may be ignoring.
The big second order effect that has materialised is what happened in commodities and crude. For example, we got huge mal-investments (which led to a “boom”) in China, which drove up commodity prices across the board. A lot of market participants assumed that this boom was going to continue for the foreseeable future. In fact, companies made some serious errors in assuming that this kind of investment boom was going to continue for at least another 10 years or so. In a way, we are dealing with second order effect of the unintended consequences of that boom, which subsequently went bust and had an impact on countries like Brazil and Russia.
But the main second order effect which is being ignored by global market participants is the result of the ongoing quantitative easing (QE) and low interest rates. The Central bankers are allowing a massive mispricing in credit and this mispricing runs through the entire global economic structure. At some point in time, when we reach limits of continued QE or where negative interest rates result in unintended consequences such as cash and deposit withdrawal from banks, you will find that that suddenly the issue of pricing credit in the right manner is going to come to the fore. When that happens, we will see gold, for example, as the only monetary asset without any counterparty liability find its way into all portfolios. So, the main second order effect being ignored almost throughout is the mispricing of credit and when that mispricing becomes apparent, gold as an asset class will shine in the market place.
Your process of evaluating valuations adapt to the current world with continuous QE programs and ultra low interest rates
We use several different methodologies to try and assess valuation. One, we look at averages relative to metrics like earnings, book value and free cash flow over a long period of time. The idea behind that is that the market is like a voting machine in the short term, but in the long term, it’s like a weighing machine. We are using the market’s weighing machine characteristics over a long period of time to get some measure of valuation and identify what market participants have in the past thought when individual securities were cheaper. But one evaluates the long term historical process and that doesn’t change much even with the kind of short return behaviour as a result of QE.
The second part of our exercise is to get valuations on the basis of normative valuations – that is, on return on equity, underlying return of a business and cost of equity. Given these characteristics, we decide the valuation assuming a margin of safety.
To a certain extent, what QE does is that it can distort prices but it doesn’t distort valuations on a normalised basis. In other words, there are extended periods of time when prices have diverged quite extensively from valuations, but QE doesn’t change the correct valuation so that an investor can earn the appropriate return on a prospective basis. When we had the bust phase, as we are having right now in commodities, prices drop but our evaluation of the appropriate valuation to be given does not undergo a material change. QE can distort asset prices for a sustained period of time, but it doesn’t affect long term valuations other than temporarily distorting earnings. But we are not just using earnings on a short term basis for our measure of valuation.
Any investment opportunities that you have missed as a result of your style of investing
We always invest in companies with a fairly long history and have gone through several phases where we understand how different cycles affect the company’s business. We try to understand how the management uses the cash flow in a strategic sense. And hence, the opportunities that we missed would have been in companies which turn out to be high quality businesses but where we waited for a period of time while they are getting seasoned. In other words, we wait for such a time when they have enough history, and then we can begin to evaluate these metrics. We didn’t invest in Google or Facebook early even when they seemed cheap at a cursory glance because we didn’t have history or knowledge on what these businesses would evolve into.
In our earlier interview, you had advocated an interesting portfolio construction approach called the “Cockroach Portfolio” where you essentially invest 1/4th of a portfolio equally across Gold, Fixed Income, Real Estate and Equities. In the current investment environment, what changes to the allocation does your investment framework suggest?
The whole idea behind this cockroach portfolio is that cockroaches have survived five mass extinctions. So what we want to do is to design a portfolio which can handle any kind of turmoil in the markets by giving you assets that act, to a certain extent, contrary to each other. But more importantly, you build an asymmetric optionality to the portfolio. This means there is more upside than downside in those asset classes resulting in a permanent portfolio.
I am not saying that one should change the allocation. But, it is evident that, now, global fixed income investments are a very low return asset class. Hence, one has to be more inventive and creative in bringing in the right fixed income into the portfolio. Right now, although we will keep those allocations as it is, there are more opportunities in currency diversification or some local currency fixed income than would originally have been the case three to four years ago. You’d want to keep the allocations broadly the same, but as far as individual securities in those allocations are concerned, there is an opportunity to find individual securities that are mispriced at a particular point in time. Now, we are finding a lot of mispricing amongst local currencies, especially those in the emerging markets.
You had also mentioned that you were evaluating opportunities in gold, gold mining and commodity mining shares and China, Russia and Brazilian equities. What is your current evaluation of the above mentioned opportunities?
We continue to remain very positive on gold and gold mining shares. We think that as market participants begin to understand that QE cannot possibly work and they understand that QE has allowed for mispricing of credit throughout the global financial system, the refuge is going to be gold and gold mining shares as a proxy for gold bullion. Additionally, they are going to want to be in equities or any instruments that are the most proximate to real assets that they can find. So they will shun remote financial assets and invest in assets that are as close to a proxy of a real asset as they possibly can. And hence, these three areas should be favoured in some intermediate time frame, say three to five years.
In terms of China, Russia and Brazil, again, Chinese indices boomed and then burst since the last interview. As far as Russia and Brazil are concerned, they still continue to trade at low levels. Not just these three counties, but almost all emerging markets are fairly attractive as compared to developed equity markets now. We would say that trying to find high quality emerging market equities is one of the most interesting asset classes in the current global financial markets.
At this juncture, where else are you finding attractive investment opportunities both globally and from an Indian perspective?
We still feel that high quality companies in India, even though they might have nominally high PE ratios, continue to be the most attractive asset class. We do think that in addition to that, there are attractive opportunities also in one particular public sector bank, where all the worst news has been factored into the pricing . Again, we think that some of the commodity companies in India and in some cases globally, which are low cost producers, continue to be attractive on an intermediate term basis and even some of the regulated utilities are offering at least cost of equity returns going forward from here. From an India perspective, it is important to invest in strong business models and strong balance sheets and restrict investment into businesses that will emerge stronger despite the market turmoil.
Outlook for Indian equities and do you see any signs of earnings recovery?
We are more constructive on Indian equities than the general market seems to be, as there is more reward than risk at this point. We think that there could be an earnings recovery as the Indian Government’s initiatives work in its favour. Firstly, to cut down on consumption subsidies and reinvest these subsidies in infrastructure (in particular road, rail and defence). The amount of investment that the government is going to make in those areas is quite considerable and we suspect that almost all those investments are going to be a societal positive. In the sense that returns on the investments will be positive for the economy as a whole. Those public sector infrastructure investments would jump start private capital expenditure, especially to the above mentioned sectors and with that you should get private capital expenditure coming back into the economy over the next three to five years.
Second is relating to FDI. There has been considerable effort to increase and attract FDI that has yielded in results. FDI in India is at a record high in the most recent fiscal period. Quite clearly, there have been a lot more positive signs that overseas companies are making a concerted effort to establish a foothold in India not just for servicing the local domestic market, but even for their overseas market.
Third part is the fact that the Indian government is making a concerted effort to clean up the bank balance sheets. They have given a rough deadline of March 2017 for banks to clean their books. Even if that deadline is missed by six months or so, it will be an achievement for the Indian financial sector to have clean set of books. With such things coming together, there should be some sort of a capex in investment revival in the three year time frame. Once that comes together, we think that prospects for earning revival are much brighter than they appear to be right now.