The 'Broken Leg' Fix for Your Broken Portfolio

In this issue:

» Marc Faber's insane prediction for US Dow

» Global markets round up

» ...and more!

When he is not inspecting people's endocrine glands, Dr Atul Gawande is penning some of the finest articles you'll ever read on medicine and public health. One such article impressed Charlie Munger so much that he immediately wrote Gawande a cheque of US$20,000 as a mark of appreciation. Now that's some serious endorsement.

However, had we been in Munger's place, we would have probably written Gawande a cheque just for the following quote:

• In psychology, there's something called the broken-leg problem. A statistical formula may be highly successful in predicting whether or not a person will go to a movie in the next week. But someone who knows that this person is laid up with a broken leg will beat the formula. No formula can take into account the infinite range of such exceptional events.

It is not that we are in agreement with Dr Gawande here. But the quote has some serious investment implications.

The broken leg problem is a classic case of relying on human judgements vis-a-vis rule-based models. It argues that an actuarial formula can accurately predict whether an individual can go for a movie or not. However, if the individual has a broken leg, it would make a lot of sense to ignore the formula and rely on human decision making. Why would one want to turn to a formula when it is obvious that a guy just cannot go for a movie.

Rule-based models will almost always get some extreme cases wrong. However, what about the average case? For a large sample size of people, which would have the higher accuracy rate - the model or the humans?

Type in something to the effect of statistical prediction rules in google and we think you'll get your answer. Almost sixty years of research has shown that in hundreds of cases, even a simple formula (i.e. a rule-based model), makes better predictions than leading experts do.

Sample this. One rule-based model developed in 1995 shocked the entire wine tasting industry when it predicted the price of mature Bordeaux red wines at auction better than expert wine tasters. If formulas can break into a domain as sensory and personal as this one, imagine the effectiveness they can have elsewhere.

Sadly, though, their use isn't as widespread as one would like. Our deep-seated biases, such as overconfidence in our own judgements and abilities, have prevented us from adopting models on a much greater scale. We still think we're much better decision makers than we actually are.

What about investing? Can rule-based models help generate superior long-term returns?

Our Microcap Millionaires service deliberately looks for stocks that have been declared broken legs by other investors. In other words, priced as if they are going out of business. But do all of these stocks actually go out of business? Certainly not. The inherent biases in human decision making creep in here as well.

A lot of the businesses aren't broken legs at all and eventually go on to recover. And because they are priced so low, the ones that recover end up giving disproportionately good returns to investors.

A returns of more than 100% for Microcap Millionaires since its inception in February 2014 as opposed to 39% for the benchmark index is proof of the effectiveness of this approach.

Seeking broken legs and investing in a handful of them does look like a winning formula in the stock market. Come to think of it, that's precisely what value investing is all about.

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Public sector Banks continue to be saddled with large amounts of stressed loans. After the mandatory asset quality review by the Reserve Bank of India in the latter half of FY16, PSBs were compelled to recognise risky restructured assets as bad loans and provide for them. This led to a significant amount of restructured advances getting converted into gross non-performing assets (NPAs) or bad loans. As at the end of June 2016, gross NPAs stood at a whopping 11.3% of the overall advances. The restructured standard advances had a share of 4.1% in the overall advances.

But dealing with restructured assets has not been a simple exercise for banks. As per the Finance Minister, PSBs are finding it difficult to find alternative promoters and buyers for companies whose debts have been put under strategic debt restructuring (SDR). The SDR scheme allows a consortium of lenders to convert loans of distressed companies into equity and acquire management control to turn around its operations and recover dues. The Finance minister also hinted that there are fiscal limits on the quantum of funds that can be infused into PSBs. The government has earmarked a capital of Rs 700 billion to be invested in PSBs over the next four years till 2018-19.

No Improvement in Sight in Asset Quality of PSBs

Marc Faber is someone who we like listening to. Dr Doom as he's called, is famous for making gloomy predictions for the global economy. So it was with some surprise that we read a news headline which stated that Faber was predicting a level of 1,00,000 for the Dow Jones Average!

But he hasn't turned bullish. This forecast applies to only an extreme case. Faber believes central banks could resort to massive money printing in the event of a global recession. They could monetise every asset imaginable. Stocks would be among the first things they would buy in this scenario. Many central banks are doing so already.

The story of such a manipulated market will have a bad ending in his opinion. We agree with him on this point. We are certainly nowhere as bearish as Dr Faber. However, we are aware of all possibilities. In a recent premium edition of The 5 Minute WrapUp (subscription required) we presented our views on this disturbing trend of central bank purchases in the stock markets.

We believe, as does Faber, that this trend implies that the private sector in the developed world is slowly dying. And it is being replaced by the public sector. This will result in stagnant economic growth and an ever greater risk of a massive market crash.

Global indices ended the week on a lower note. France (down 3.5%) and Hong Kong (down 3.2%) were among the leading losers. The French index witnessed heavy selling pressure in its Oil & Gas, Utilities and Financials sectors. Global markets remained under pressure over the week amid concerns regarding central banks, particularly the Fed, becoming less accommodative in the future and the prospect of Fed increasing the interest rates sooner than expected.

While there has been a lot of talk around the slow recovery of the world economy, the world still continues to look up to major central banks with heightened expectations that they will continue with their helicopter money policy, the central banks themselves seem to have plenty of fire power left to continue their policy of asset repurchase programs. This means that the liquidity driven rally in the financial markets might continue for a long time.

The European central bank has been fighting ultra-low inflation, it has introduced a huge stimulus in recent years. Primary among them is their program of buying 80 billion euros of bonds a month, to pump money into the economy. Last week, the ECB said it was examining options to keep its asset purchases going, which markets took as a signal that even more easing may be coming. Inflation however, continues to remain just under 2%, with this level of money in the system without any desired impact, there is an increasing risk that businesses and households will lose confidence in the ECB's policies. With two major central bank, the Bank of Japan and the US Fed scheduled for their monetary policy review next week, their comments will be closely watched by all the market participants alike.

Back home, the Indian indices closed lower over the week. The BSE Sensex was down by 0.7% for the week. The finance minister, Arun Jaitely expects the Reserve Bank of India to cut repo rates in the monetary policy review scheduled next month. The finance minister was also hopeful that banks will transmit these rate cuts to its customers.

Performance During the Week Ended 17th September, 2016

04:55 Weekend investment mantra

"I make plenty of mistakes and I'll make plenty more mistakes, too. That's part of the game. You've just got to make sure that the right things overcome the wrong ones." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst).