Buying the Pessimism by Niteen S Dharmawat

“The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The Intelligent Investor is a realist who sells to optimists and buys from pessimists.”: Jason Zweig, The Intelligent Investor.

Introduction: Mr. Niteen S Dharmawat is the founder of Aurum Capital  (a SEBI registered Research Analyst and Investment Advisory services company). He has more than 25 years of experience investing in equities and guiding and mentoring fellow investors.

Agenda: The session started with a definition of pessimism, followed by types of market corrections, importance of analyzing human behavior and margin of error. Mr. Niteen also shared a framework for picking up the stocks amidst pessimism along with some case studies from various sectors i.e., Infrastructure, Capital Goods, Paper, Hospitality, Pharma etc. as well as some practical learnings. The session concluded with an engaging round of Q&As from the participants.

So, what is pessimism?

Pessimism is a tendency to see the worst aspect of things or believe that the worst will happen. It is nothing but a notion that markets may permanently collapse post a prolonged correction or end of a sector/ company post the collapse of investor’s favorite sectors/ specific company events. For example, IT sector in 2001, Realty/ power/ infra sectors in 2008, leisure/ hospitality sectors in 2020 etc. But on the other hand, it is proven time and again that such extreme corrections provide the best investing opportunities only if we can rationally distinguish between transitionary vs permanent events. Usually, we fail to see the risk when the market trend is in green (going up) and the opportunity when the market trend is in red (going down). Optimism vs pessimism is characterized by fear of missing out in bull phase vs fear of crashing out in bear phase.

Buying the pessimism is thinking rationally vs emotionally and buying when the “carnage” is happening. In such times, if one is committed towards a particular opportunity then it helps to keep the initial expectations to minimum and not selling out during the underperformance phase. One can find a specific way to divert their attention during such times through an unrelated hobby i.e., meditation, reading, music etc.

The discussion then turned to the two main types of corrections i.e., Time correction where a stock faces prolonged stagnation/ decline as it has gained too much value due to optimism but without real growth and Price correction where the stock’s price corrects due to a macroeconomic/ sectoral/ company specific event. Some relevant examples of time correction (Meme Stock, Infra/ realty sectors etc. during 2008-09) vs the price correction (leisure/ hospitality sectors during Covid-19 pandemic) were also discussed. These events have also thrown the “multibaggers” in the subsequent periods. The most important aspect during such phases is controlling the human behavior where the investors continue to make rational decision without getting impacted by the short-term noise.

Mr. Niteen shared the following framework for identifying the right stocks during the times of pessimism:

• The sector/ company is currently out of favor, no one wants to talk about it! Such stocks generally trade at a historically low valuation
• Survivability test – can the company survive the current downturn?
  • is the disruption faced by the company temporary or permanent in nature? Temporary disruption can be related to raw material/ consumption/ any other issue vs permanent disruption is caused by a shift in the technology/ consumption habit (computers vs typewriters).
  • How much debt does the company hold? As companies with high debt levels may face additional challenges due to high interest cost vs companies with low/ no debt
  • How has been the cash flow generation during the most recent good 5 years? As the company might have the potential to achieve good cash flow generation post the permanent disruption
  • Have there been few survivors from the sectors in past?
  • Is the company’s buyer/ seller base is diversified? Large buyers/ sellers can pose significant risk
• Company’s promoters/ management buying its shares during the pessimism is a good sign, it shows their belief in the company
• The cost-saving initiatives have the potential to permanently improve a company’s profitability
• Low-capacity utilization is a healthy sign if the demand disruption is temporary as the company may not require additional capital expenditure to cater to increased demand.
• Improvement in the demand for the company’s products/ services is a healthy sign – indicating the worst is probably over
• However, companies with corporate governance issues should be avoided despite passing all the above parameters

Some examples where the framework held true:

• Paper sector during 2018-19 is a good example of price correction where the stocks were facing a downturn before Covid-19 pandemic due to external headwinds/ low demand/ lack of pricing power. Whereas these disruptions have been proven largely temporary in nature with a sharp improvement reflected in the stock price of the key players
• Capital goods sector during 2020-21 can be a good example of Time correction where the stock price of key players has been stagnant due to stagnant manufacturing sector/ capex/ exports. However, it is back in investor’s favor driven by improved demand sentiment, cost savings etc.
• Too much optimism for Technology sector during Covid-19 pandemic leading to a sharp rise in overseas investment from India however, only one fund investing in NASDAC could beat the benchmark.
• Indian IT sector during 2017 can also be a good example of price correction with experts sighting lack of innovation and product focus resulting in a price correction in Indian IT stocks. However, contrary to the popular belief of Covid-19 helping IT companies, some of the IT stocks had doubled investor’s money before 2020 largely due to new contract as well as cost-saving initiatives.
• Case study of a leading pharmaceutical manufacturer which was able to keep its revenue, profit, and cash flows largely resilient despite multiple external issues. In such cases, patience is the key which ultimately proves rewarding in the long run.
• Hospitality sector price correction during Covid-19 pandemic with entire hospitality sector basket available at ~19,000cr Mcap (1/3 of the pharma company discussed in previous point). Post the resumption of domestic/ international travel, the basket is up ~4x. This event highlights the importance of ignoring the short-term noise in favor of sustainable business model.
• Lastly, case study of video communications company which witnessed exponential growth due to Covid-19 restriction but despite the optimism, the stock is down by ~83% from its peak.

Last but most important segment was some of the real-life mistakes and learnings. Mistakes can occur because of omission (failing to analyze something) as well as commission (booking the loss too early). Generally, errors of commission prove more damaging to one’s portfolio. One should avoid mistakes which can take them permanently away from the market. Also, one should not overlook the headwinds, not underestimate complexities, and should aim to accept and correct the mistakes early.

Conclusion: It is rewarding to be optimistic during pessimism however, one should be extremely disciplined and patient in order to reap the results. Also, sticking with the framework, setting up milestones and avoiding companies with governance issues proves very helpful.

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