The narrative that a few fixed sure shot formulae help a portfolio outperform the market on all occasions have neither worked in the past and are unlikely to work in the future.
The year is 1988 and tennis fans are keenly watching two players—Andre Agassi, ranked No. 3, and Boris Becker, ranked No. 4. By 1989, they would face each other on three separate occasions and Becker would win all the three matches (Agassi did not win even one set in two matches). By the end of 1989, Becker went on to occupy the No. 2 spot on ATP rankings and Agassi was pushed to No. 7.
Then… something snapped. They played three matches in 1990, and as if by a stroke of luck, Agassi won all three (won 2 matches in straight sets). In 1991, they played two more games, and again, Agassi won both. Over the course of their careers, they faced each other on 14 occasions, and Becker managed to win only 4 matches or just one more after three wins by 1989, and Agassi won 10! What happened there? A brief detour before we go there.
In the fall of 1948, most of the newly arrived post-grad math students at Princeton University were cocky, but one was even cockier, writes Jonathan Aldred in License to be Bad. Still in his twenties, he made an appointment to see Einstein to discuss a few things. The meeting lasted an hour, at the end of which, Einstein grunted, “you’d better study some more physics, young man.” That young man was John Nash, who later went on to win the Nobel prize for his contribution to ‘game theory’. Initially, Nash had to face a lot of criticism and was about to give up, until his PhD supervisor decided to present Nash’s thesis in the form of a story.
Two members of a criminal gang are imprisoned separately and cannot communicate with each other. The police have enough evidence to convict both of a minor crime, but not the major one that they suspect them of having committed. They offer both the following deal: “confess and implicate your partner; you receive immunity from prosecution, while your partner gets 10 years.” If both stay silent, both get two years for the minor crime. The dilemma for both prisoners is, if the other speaks out, I get 10 years, and he gets a free pass and vice versa. The best course of action, obviously, is to stay silent. But the question is, should I take the deal first, under the assumption that the other will take it first?
In 1950, no one had an inkling that the Prisoner’s Dilemma would later become the most influential game in game theory and was widely practiced in the nuclear arms race between the US and USSR. In 1955, however, the philosopher Bertrand Russell took the game theory forward (in the context of nuclear disarmament) by publicising a game called Chicken. Imagine the US and USSR are rival hot-blooded drivers, speeding towards each other down the middle of a long, straight road. If neither moves out of the way (‘chickens out’), both will die. If one chickens, both survive; but the one who moves out earns the everlasting contempt of his rival.
Coming back to Agassi vs. Becker. Agassi later revealed in an interview that he kept watching the tape of Becker’s service and noticed a tell. Just as Becker was about to serve, he would stick his tongue out—in the middle if he was serving up the middle and to the left if he was serving wide. Having discovered his tell was only half the victory; resisting the temptation of reading his serve for the majority of the match and rather choosing the moment when he could use that information to break the game open was harder.
Now, what do tennis and game theory have to do with investments? Over the course of the past few months, I have vehemently argued (with data) that in markets there are no formulae (buy high growth companies that generate strong return ratios or avoid commodities of PSU stocks etc.) that allow the portfolio to outperform across market cycles. I have also written that historical data does not support several myths—a portfolio always outperforms if you buy leaders, buy companies with the highest ROCEs, buy only large-cap businesses or small-cap businesses etc.
The reason that a fixed formula cannot work is because the very knowledge of its existence will make the formula worthless. Let’s assume that everyone starts believing that say… buying “high growth strong return ratio companies” will result in outperformance at all times, and they start buying. While demand for shares of such companies rises, supply remains limited; as a result, their stock prices catapult swiftly over a short period of time.
At a certain point, new investors realise that these businesses are quoting at stratospheric valuations (earnings can rise only so much) and decide to wait. Now, if earnings growth is cyclical and starts shrinking, stock prices will collapse (Nifty 50 in the 1970s, tech bubble in the early 2000s). If earnings rise at a steady pace, the stock price stops rising for multiple years till the valuations start looking decent again (Coca-Cola, Walmart, Hindustan Uniliver and Colgate between 1998 and 2010). Investors are in a constant state of Prisoner’s Dilemma–do I keep buying under the assumption that everyone still believes that this formula works? And, if I ‘chicken out’ while everyone else continues to believe the theory, I stand to miss out.
Agassi knew that if Becker found out the ‘tell’ was made, the advantage would be lost. He could have decimated Becker by exploiting the tell on every serve; but, apparently, that was still too large a risk to take. He chose to use it just for those crucial moments.
Now take RenTec for example. The firm founded by Jim Simons, which has generated 66 percent returns (pre-fees)—exceptional returns—between 1988 and 2018. They did manage to build something akin to a formula (albeit not a fixed one, but one that was ever-evolving based on new information) to beat the market across cycles. RenTec used to charge a 5 percent fixed fee and 44 percent performance fees (highest fees ever in the asset management business) and yet when they found that the strategy is not scalable enough, they stopped running clients’ money altogether (they just ran their own money).
Now, compare that to the “free advice” you get from self-proclaimed market experts on how doing a, b or c will get the job done. While the narrative is important on how decisions are made, the narrative that a few fixed sure shot formulae help a portfolio outperform the market on all occasions have neither worked in the past and are unlikely to work in the future.
—Jigar Mistry is the co-founder of Buoyant Capital. The views expressed in the article are his own
Disclaimer: Information in this letter is not intended to be, nor should it be construed as investment, tax or legal advice, or an offer to sell, or a solicitation of any offer to make investments with Buoyant Capital. Prospective investors should rely solely on the Disclosure Document filed with SEBI.
(Edited by : Ajay Vaishnav)