Practitioners’ Insights : Investing Under Uncertainties

By Kuntal Shah

13th May 2020

1
 Investing Under Uncertainties

“Man is a deterministic device thrown into a probabilistic

universe. In this match, surprises are expected”
― Michael Lewis

2
Index

Sr. No. Section Slide No.

1 Pre-COVID-19 Conditions 4

2 COVID Moving Parts 15

3 A Tale of Two Centuries : 1910-1930 vs. 2000-2020 27

4 Process : Portfolio Construction in a Post-COVID World 30

5 Annexure 38

Compiled by :

Kuntal Shah Neharika Bayas Raj Agrawal Upasna Lamba Utsav Adani
Member, Student, Student, Data Analyst, Data Analyst,
Board of Management, FLAME University FLAME University Oaklane Capital Oaklane Capital
FLAME University Management LLP Management LLP
3
 Pre-COVID-19 Conditions

"It is difficult to make predictions, especially about the future”

- Niels Bohr

4
 Elevated Debt Levels and Rock Bottom Interest Rates

U.S. Interest Rates

5
Source: Bloomberg, PIMCO, Hover Analytics
Negative Bond Yields and Currency Interplays : Supply or Price, but not Both?
T Yield, AAA, S&P 500 and NASDAQ Index
9% 300
10 year T Yield
8%
30 Year T yield 250
7% Moody AAA Corporate
NASDAQ Index
6% 200

Equity Indices
S&P 500 Index
Bond Yields

5%
150
4%
3% 100
2%
50
1%
0% 0

2010
2010
2011
2012
2013
2014

2018
2015
2015
2016
2017

2019
2000
2000
2001
2002
2003
2004
2005
2005
2006

2008
2007

2009

2020
The Negative Bond Yield Matrix
Country 6 Mo 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 yr 8 Yr 9 Yr 10 Yr 15 Yr 30 yr
Switzerland -0.75 -0.64 -0.89 -0.91 -0.89 -0.87 -0.79 -0.76 -0.69 -0.63 -0.52 -0.29 -0.01
Germany -0.58 -0.68 -0.74 -0.76 -0.74 -0.68 -0.64 -0.58 -0.46 -0.4 -0.31 -0.1 0.27
Netherlands -0.59 -0.72 -0.7 -0.64 -0.61 -0.5 -0.42 -0.32 -0.25 -0.15 -0.01 0.3
Japan -0.13 -0.17 -0.2 -0.22 -0.23 -0.22 -0.22 -0.22 -0.21 -0.16 -0.12 0.07 0.36
Denmark -0.66 -0.7 -0.7 -0.68 -0.45 -0.28
Austria -0.54 -0.65 -0.63 -0.57 -0.47 -0.39 -0.28 -0.22 -0.14 -0.03 0.31 0.7
Finland -0.66 -0.63 -0.61 -0.54 -0.45 -0.19 -0.01 0.56
Sweden -0.4 -0.62 -0.55 -0.26 -0.01 0.18
France -0.59 -0.6 -0.68 -0.66 -0.62 -0.53 -0.41 -0.31 -0.21 -0.1 0.02 0.38 1.15
Belgium -0.57 -0.58 -0.6 -0.66 -0.6 -0.54 -0.42 -0.25 -0.14 -0.06 0.09 0.4
Slovakia -0.33 -0.24 -0.5 0 0.18 0.26
Ireland -0.41 -0.55 -0.45 -0.46 -0.39 -0.24 -0.14 0.45 0.22 0.58 1.16
Slovenia -0.48 -0.3 -0.31 -0.14 0.25
Spain -0.41 -0.39 -0.4 -0.34 -0.27 -0.21 -0.06 0.08 0.2 0.29 0.43 0.8 1.47
Portugal -0.38 -0.34 -0.37 -0.25 -0.17 -0.14 0.05 0.16 0.28 0.44 0.55 0.95 1.5
Malta -0.23 -0.2 -0.1 0.02 0.74
Bulgaria -0.13 -0.01 0.05 0.37 0.58
Italy -0.16 -0.02 0.22 0.71 1.03 1.31 1.53 1.61 1.77 1.82 2.12 2.45 3.17
USA 2.19 2.03 1.81 1.75 1.78 1.89 2.03 2.52
Source: FRED, Federal Reserve Bank of St. Louis, Refinitiv, Bloomberg, Business Insider 6
 Scale of Historical Bull Runs
Difference between Annualized S&P 500 Index Return and Nominal GDP Growth 14%

1982-1987

8% 11%

7%
1990-2000 2009-2020
1949-1957
5%
3%
1957-1962
2% 2002-2008

0% 1962-1966 Increasing Duration of Bull Market

1970-1973
1974-1982 (2%)
-2%
1966-1970 7
Source: Bloomberg
Duration of Boom and Bust : Decreasing Duration and Increasing Frequency

Source : sharelynx.com 8
 Valuation at the Extremities

“The Fed, in effect, has become a serial bubble blower”

- Stephen Roach

9
 Sources of Stock Price Appreciation
“Give me a lever long enough and a fulcrum on which to place it, and I shall move the world” - Archimedes

November 1907 to November 1916 August 1921 to September 1929 June 1932 to May 1946

May 1947 to December 1961 June 1962 to December 1968 December 1974 to August 1987

December 1987 to August 2000 February 2003 to October 2007 March 2009 to December 2019

Inflation Dividend Yield Earnings Growth Valuation Changes 10

Source : Robert Shiller’s Data Library
Easy Money and Congenial Interest Rates are Necessary Conditions for Bubbles

Cyclically Adjusted P/E Ratio

Overvaluation Zone

Fair value zone

Undervaluation Zone

Source : Advisor Perspectives , Meritocracy , Robert Shiller and S&P, Forbes 11

Low Future Interest Rates Embedded in Current High Valuations
Average 10-year S&P 500 Annualized real total return
based on Price/Average 10-year Earnings
We’d be better
off here 12.00%
9.74%
8.96% 10.00%
8.12% We are here
8.00%
5.85%
6.00%
4.00%
1.44% 2.00%
0.00%
Cheapest 20% 2nd Cheapest 3rd Cheapest 4th Cheapest Most Expensive
Average PE = 20% Average PE 20% Average PE 20% Average PE 20% Average PE
9.00 = 12.95 = 16.14 = 19.48 = 26.84

50 Stock Market Bubbles Happen at 90th Percentile–Plus Valuations 120%

45 Price to 10 year median Percentile 100% 94%
96% 100%
97%
40 92% 91%

Price to 10 year Median

35
80%

Percentile rank
30
25 60%
20
40%
15
10
20%
5
0 0%

1905

1935
1941
1947

2001
2007
1881
1887

1911

1965
1971

1995
1917

1953

1977

2013
1893

1959

2019
1899

1923
1929

1983
1989
Source : Advisor Perspectives , Robert Shiller and S&P, Forbes 12
Significant Role of Buybacks in the Current Valuation

What’s thehave
Buybacks source of the rally
consumed in the
about one-quarter of Buybacks have provided significant support
stock market since 2009 ? Buybacks
developed market companies’ operating cash flows to global equity markets
Attribution of total cumulative returns for the MSCI World Index

Source : State Street Global Advisors 13

 Significant Role of Interest Rates in the Current Valuation

Inflation vs Interest Rates vs S&P 500 Earnings Yield

16%

14%

Inflation Interest Rates S&P 500 Earnings Yield

12%

10%

8%

6%

4%

2%

0%

-2%

2020
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
1990
1992
1994
1996
1998
1960
1962
1964
1966
1968

1980
1982
1984
1986
1988
1970
1972
1974
1976
1978

Source : FRED, Thomson Financial, Bloomberg 14

 COVID-19 Moving Parts

“People take the longest possible paths, digress to numerous dead ends, and make all kinds of
mistakes. Then historians come along and write summaries of this messy, nonlinear process and make
it appear like a simple, straight line”- Dean Kamen

15
 A Modern Pandemic in the Era of Airlines and Social Media
Twelve Large Pandemic Events with at least 100,000 deaths
Event Start End Deaths
Black Death 1331 1353 75,000,000
Great Plague of London 1665 1666 100,000
First Asia Europe Cholera Pandemic 1816 1826 100,000
Second Asia Europe Cholera Pandemic 1829 1851 100,000
Russia Cholera Pandemic 1852 1860 1,000,000
Global Flu Pandemic 1889 1890 1,000,000
Sixth Cholera Pandemic 1899 1923 800,000
Encephalitis Lethargica Pandemic 1915 1926 1,500,000
Spanish Flu 1918 1920 100,000,000
Asian Flu 1957 1958 2,000,000
Hong Kong Flu 1968 1969 1,000,000
H1N1 Pandemic 2009 2009 203,000

Sources : Wikipedia, Visual Capitalist 16

A Highly Contagious Global Pandemic Triggering Multiple Exogenous Shocks
 Demand & supply shock
 Subsequent waves
 Highly contagious
Global
 Asymptomatic transmission
Pandemic

 Wide range of Investor  Job losses

outcomes Psychology Economics  Sharp GDP contraction
 Policy errors Cycle Severe of Stoppage  Cost of stimulus
 Market dislocations Global  Low commodity prices
Recession

 Money supply  High Debt/GDP

Low Interest
 Velocity of money High debt  Low GDP growth
 Inflation/Deflation
Rate Cycle  High government spending
 Flight to safety arising from stimulus

Liquidity dependent, inherently interconnected and a complex adaptive system

Source : FLAME University 17
 Framework of Investing in the Post-Covid-19 Situation

Pandemic Citizen Business Macro View Asset

Markets

• Virus will set timelines • Access to healthcare • Demand destruction • Stimulus packages • Market dislocations
• Subsequent waves • Restricted living • Cashflow preservation • Restart policies • Flight to safety
• Containment vs • Lifestyle changes • Cash is king • Debt and deficits • Volatility
suppression strategies • Economic pain • Supply chain issues • Who pays for the bill? • Collateral and solvency
• Mutations • Psychological issues • Impact of helicopter • Liquidity terms
• Interim treatment • Cognitive overload money • Correlations
protocols • Uncertainty • Policy errors • Supply side issues
• Flattening the curve • Feeling of helplessness • Moral Hazard • Dealing with extremes
• Living with the virus • Blame game of bubbles & crashes

Source : FLAME University 18

Odds, Frequency & Impact – All Three Matter

Frequency vs. Magnitude : Expected Value

Probability and outcome, both matter Expected Value is the weighted average value
for a distribution of possible outcomes.
Good Probability, Bad Expected Value
Probability Outcome Weighted Value Take the probability of loss times the amount of possible
loss from the probability of gain times the amount of
70% +1% +0.7% possible gain. That is what we’re trying to do. Its
30% -10 -3.0 Imperfect, but that’s what it’s all about
- Warren Buffett
100% -2.3%

Bad Probability, Good Expected Value Risk vs. Uncertainty

Risk : We don’t know the outcome, but we know
Probability Outcome Weighted Value
what the underlying distribution looks like
70% -1% -0.7% (incorporates the element of loss / harm)
30% +10 +3.0
Uncertainty : We don’t know the outcome, and we
100% +2.3% don’t know what the underlying distribution looks like
(Need not incorporate loss / harm)
- Frank Knight

Source : Risk, Uncertainty and Profit

19
 Citizens’ Needs
Unknown Unknowns : Biological Perspective

Source : FLAME University 20

 Consumers’ Perspective

Source : FLAME University 21

 Corporate Business : Operating Managers’ Perspective

Source : FLAME University 22

Macro Perspective

Source : FLAME University 23

 Asset Market Perspective

Source : FLAME University 24

 Flight to Safety : Rising SpreadsCitizens’ Needs
7
10 Year Treasury vs. AAA vs. BAA Spread
6 10-Year Treasury Constant Maturity Minus 3-Month Treasury Constant Maturity
5 Moody's Seasoned Aaa Corporate Bond Yield Minus 10-Year Treasury Constant Maturity
4
Moody's Seasoned Baa Corporate Bond Yield Minus 10-Year Treasury Constant Maturity
3
2
1
0
-1
-2
1990
1990
1991
1991
1992
1993
1993
1994
1994

2000
2001
2001
2002
2003
2003
2004
2004
1982
1982

1995
1996
1996
1997
1997
1998
1998

2000
1999

2005
2005
2006
2007
2007
2008
2008
2009
2010
2010
2011
2011
2012
2012
2013
2014
2014
1983
1983
1984
1984

2015
2015
2016
2017
2017
2018
2018
2019
2019
1985
1986
1986
1987
1987
1988
1989
1989

Source : Refinitiv, FRED, Moodys Analytics, NBER, Factsheet 25

Ring of Moral Hazard

“He did it…..”

Source : Slickcharts.com 26
A Tale of Two Centuries : 1910-1930 vs. 2000-2020

“It's a recession when your neighbour loses his job; It’s a depression
when you lose yours”
- Harry S. Truman

27
The Great Depression vs. The Great Recession vs. The Great Lockdown
Great Depression 1930s
9,096 - 50% of banks
Bank Failures
(Jan. 1930- March 1933)
Global Financial Crisis 2008 Ongoing COVID-19 Recession
57 - 0.6% of banks Banks well capitalized,
(Dec. 2007 - May 2009) new NPA cycle likely

Unemployment Rate 25% 8.5% 14.7% (09-05-2020) and counting

-4.1% (last quarter 2007 - second

Economic Decline -26.5% (1929 1933) Severe and counting
quarter 2009)

Biggest Decline in Dow-

-89.2% (Sept. 3, 1929 - July 8, 1932) -53.8% (Oct. 9, 2007- March 9, 2009) Unfolding movie
Jones Industrial Average

Change in Prices -25% (1929 - 1933) +0.5% (Dec. 2007-March 2009) Unfolding movie

2.5% of GDP for 2 years

Emergency Spending 1.5% of GDP for 1 year Fiscal Stimulus > 11% of GDP
(2009 American Reinvestment and
Programs (increase in 1934 budget deficit) (08-05-2020) and counting
Recovery Act)

Federal stimulus plan gives fiscal Rate cuts, asset purchases, back
State’s Response Raise taxes, cut spending relief to states to lessen impact of tax stopping money/ bond markets, USD
increases swap lines and ongoing measures

Increase in Money Supply

17% (1933) 125% (Sept. 2008- May 2009) 13.7% (27-04-2020) and counting
by Federal Reserve
Source : www.gold-eagle.com, https://jhss11rajankalsi.wordpress.com 28
 1910-1930 Conditions in the Era of the Spanish Flu Pandemic and The Great Depression

Source : Federal Reserve, Bureau of Economic Analysis, Census Bureau, European Historical Statistics, Historical Statistics of the United States. 29
 Process

“The essence of investment management is the

management of risks, not the management of returns”
– Benjamin Graham

30
What are the Qualities that Bring Longevity, Resilience and Anti-Fragility?

Anti-Fragile
Resilient/Robust
Parameter Fragile Companies Companies : Resilience
Companies
with Optionality

Redundancy & buffers

System Efficiency optimized Degeneracy
driven

Hate errors :
Error Irreversible, large Fail fast, frequently,
Longevity of growth
Considerations errors leading to but cheaply
blowups

Incentives No skin in the game Skin in the game Soul in the game
What Investors
Focus on
What Investors
Ignore Reactive Proactive Positive serendipity

Management Delayed by small Survives change in Gets better when

Consideration changes in plans plans plans change
t
A = P ( 1+ r ) Siloed Partially connected Fully Integrated
100
Source : FLAME University
31
 Ideal Portfolio Construct : Barbell Approach of Resilience and Optionality
Anti-Fragile
Mediocre :
Resilient companies : Survival Issues /
Parameter Only Optionality Neither Resilient
Companies Resilience with Value Traps
nor Optionality
Optionality
Core of portfolio Rare but large Many positions but Avoidable commitment Avoidable
allocation small allocation.
Allocation Maximum of this
bucket is capped
Timeline of investment Longevity of growth Large total Cheap, getting cheaper Market performer
horizon arbitrage and level of out of the addressable market due to deteriorating
Valuation money optionality and network effects core business
Consideration implied in the current
prices
Sector leadership Take advantage of Venture capitalist Avoid commitment Filter out at screening
volatility to add and investing framework bias level
Markets share and trim positions
adjacencies Extension of tail leads Alternative Companies stuck in
Rare companies; to minimizing of error. opportunity cost the middle, though
Investor should be averaged Foot in the door and a they can give buy low,
Consideration up. Risk contribution possibility of sell high, or round
will be more equally averaging up or tripping opportunities
distributed i.e. large trimming down
position represents depending on
the same risk as a subsequent outcome
very small position
Source : FLAME University 32
Gold : Hedge Against Inflation and Negative Interest Rate

Source : FLAME University 33

 0
200
250
300
350
400
450

50
100
150

500
700

0
200
300
400

100
600
01-2000 09-2005

07-2000
03-2006
01-2001
09-2006
USD/INR

USD Gold
07-2001

Source : FRED, Refinitiv

T-Bill
01-2002 03-2007
USD/RENMINBI

07-2002
09-2007

NASDAQ Index
01-2003

Real Estate Index

07-2003 03-2008
Golden Performance

01-2004
09-2008
07-2004
USD/YEN

03-2009
USD/EURO

01-2005

Gold
07-2005 09-2009

01-2006
03-2010
07-2006 S&P 500 Index
01-2007 09-2010

07-2007 03-2011
01-2008
09-2011
07-2008

01-2009 03-2012

07-2009
09-2012
01-2010
03-2013
07-2010

01-2011 09-2013
Gold vs. Currencies

Gold vs. Asset Classes

07-2011
03-2014
01-2012

07-2012 09-2014

01-2013
03-2015
07-2013
09-2015
01-2014

07-2014 03-2016

01-2015
09-2016
07-2015

01-2016 03-2017

07-2016
09-2017
01-2017
03-2018
07-2017

01-2018 09-2018

07-2018
03-2019
01-2019

07-2019 09-2019

01-2020 03-2020
34
 High Yield Bonds
Issuer Rating YTD YTD
Amt. (mm) Coupon Price Yield G Spread Z Spread
(US$ Secondary Levels) (M / S / F) (ΔYield) (ΔSpread)

Large National Bank B1/BB-/-- 300 5.50% 97.125 7.71% 753 735 3.44% 481

Gold Finance Co. --/BB-/BB- 300 5.90% 76.45 17.13% 1689 1678 -- --

Housing Finance Co. B3/--/-- 350 6.38% 55.5 39.78% 3958 3942 21.46% 2282

Transport Finance Co. --/BB/BB 500 5.10% 71.5 16.96% 1669 1660 -- --

Gold Finance Co. --/BB/BB 550 4.40% 83 10.57% 1029 1021 -- --

Private Bank Caa1/--/-- 477 3.75% 84.25 10.45% 1020 1009 -0.07% 125

Finance Lending Co. Ba3/--/B+ 400 5.88% 63 23.98% 2372 2363 -- --

Source : Citi Bank, Credit Suisse, Bloomberg 35

 Polarisation ?
INDIA
S&P 500 49.95 50
MSFT, GOOG, AAPL, AMZN, FB
S&P 500 – (MSFT, GOOG, AAPL, AMZN, FB) 40
30
20
2.85 10
0
-10
-20
-30
-40
-46.1
-50

Ongoing Market Weight Market Cap Valuation Tech Bubble Market Weight Market Cap Valuation NIFTY 50 Market Weight Market Cap Valuation
(2020) (in %) (in $B) (P/E) (2000s) (in %) (in $B) (P/E) (1970s) (in %) (in $B) (P/E)
Apple 5.4% 1164 19.1 Microsoft 4.5% 581 55.1 IBM 7.1% 48 35.5

Amazon 4.1% 1021 60.6 Cisco System 4.2% 543 116.8 Eastman Kodak 3.6% 24 43.5

Microsoft 5.9% 1328 28.4 Intel 3.6% 465 39.3 Sears Roebuck 2.7% 18 29.2

Alphabet 3.4% 793 23 Oracle 1.9% 245 103.6 General Electric 2.0% 13 23.4

Facebook 2.1% 434 19.6 Lucent 1.6% 206 35.6 Xerox 1.8% 12 45.8
FAAMG Tech Bubble NIFTY 50
20.9% 4740 23 15.8% 2040 55.1 17.1% 115 35.5
Aggregate Aggregate Aggregate
Source: Citi Bank, Refinitiv 36
Talking Win–Win v/s Walking Win-Lose
Every day, managers must decide whether to enjoy a dollar of profit this year or two dollars a few years from now
GILLETTE
• 1996 : Promised investors that it would
grow its earnings at 15% to 20%.
• Began channel- stuffing products to its’
distributors to meet projections
• CEO Kilts stopped issuing earning guidance
• Overextended pricing power benefited in
short term but drove customers away and
invited hungry new customers
STARBUCKS
• 2010 : Howard Schultz said Starbucks
had paid around $300 MN in healthcare
costs in 2010
• Decision Unpopular with the investors
• Declined the offer to cut Healthcare
spending to retain the respect and
value of his employees
Source : The Investment Checklist
SOUTHWEST AIRLINES Boeing
• Kelleher : Sold a plane instead of laying off
• Boeing spent 74% of its Free Cash Flow
employees & formed a “No-Layoff Policy”
in Stock Repurchase in the last 10
• 2010 : Was the biggest domestic airline in
years. Cost cutting was one of the
USA, with a market cap. Greater than
reasons for failure of its aircraft (737-
all its domestic competitors combined
MAX) and then the company had to be
• Happy employees take care of the
bailed out
customers. Happy customers take care
of the shareholders by coming back
COSTCO
• 2008 : Galanti refused to make
employees pay more than 10% for
healthcare to save $10 – $20 Million
per year
• Wanted to give their employees as
much as they could in tough times
37
Additional Resources : History is not a Road-Map, but a Compass

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Additional Resources : History is not a Road-Map, but a Compass

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Additional Resources : History is not a Road-Map, but a Compass

40
Additional Resources : History is not a Road-Map, but a Compass

41
 Questions?

“We cannot control market’s outcome or returns , but we

can control our behavior , processes and cost structure.”
- Anonymous

42
 Disclaimer
This video/presentation is purely for educational and informational purposes. Information provided in this
video/presentation is based on information available in the public domain. Information provided in this video/
presentation has been compiled from sources believed to be reliable, but no warranty, express or implied, is made
with respect to its timeline or accuracy. This video/presentation may contain forward-looking statements about the
economy and/or markets, their performance or prospects. Forward-looking statements are not guarantees of future
performance and cannot be relied upon.

Views expressed regarding a particular sector or the company are not to be considered as investment advice nor
they shall be considered a recommendation for buy or sell. This video/presentation is purely for educational and
informational purposes only and is not intended to provide specific individual financial, investment, or tax advice.

“We cannot control market’s outcome or returns , but we

can control our behavior , processes and cost structure.”
- Anonymous

43