Base Rate Investing: The Smart Investor’s Secret

Base rate investing offers a distinct advantage to investors encouraging them to look beyond the noise and focus on underlying fundamentals and longterm trends. The article explains how by understanding and applying this strategy effectively, you can make informed investment decisions and potentially outperform the market over time
 

You are feeling exasperated, not due to age, but because you have been pulling your hair out in frustration. A few months back, you subscribed to investor services from a renowned publication house based on a promise they made – a monthly recommendation tailored to your chosen investment themes, focusing on fundamentally strong companies. The salesperson painted an enticing picture, touting the research company’s stellar background and emphasising their purported long-term approach. Like clockwork, they pledged a dedication to avoiding losses (as though anyone aims for the opposite!). [EasyDNNnews:PaidContentStart]

They even boasted of a strategy mirroring that of ace investor Warren Buffet – buying when others sell. It sounded familiar, a spiel you had probably heard countless times before. There was sincerity in their delivery, or perhaps it was just a convincing act. Now, a quarter has passed, and you have invested in three recommendations given by them. At the end of the quarter, the value of your investment to the tune of ₹ 300,000 stands at ₹ 280,000. You know that the market has been a bit weak lately due to the ongoing war between Russia and Ukraine, and so you ignore the minor loss. You are a patient sort and don’t fret over the value of your investments daily like many of your friends. 

But when you check your investments the next quarter after you have acted on three more recommendations, you see that the value of your portfolio is now only ₹ 510,000. You have taken a hit of 15 per cent in a couple of quarters. To rub salt on your wounds, they have given other recommendations you are entitled to and you have to act on it. One more month goes by, and you are aghast to discover that the value of your investment is now down 30 per cent within seven months. Ridden with anxiety, you write to the company about the sorry state of your investment’s performance. You get a very mundane response from them. 

The research head repeats the same mantra: remain patient and see the longer term picture. He convincingly asks you to keep investing in recommendations and not skip the process. You feel nervous and talk to some of your friends who appear to be stock market experts. All of them advise you to stop investing any more as per their recommendations. With great reluctance, however, you invest in their recommendations once again. You have read Buffett’s great annual letters and listened to his interviews on TV. You remember that he advises investors not to check their stock holdings obsessively. 

Hence, this time, you decide to wait two more months before reviewing how your portfolio has performed. Your worst fears are realised. Your investment value has almost halved. Apart from continuing to tear at your remaining hair, what should you do? Should you cancel your subscription or renew your subscription? This is the kind of situation many investors find themselves in for the simple reason that out there in the investing world are many such ‘experts’ who will feed you recommendations that are without any merit. Nor are they based on any actual research. It’s just smooth talk that takes your goat!
 

Base Rate Investing 

In the fast-paced world of finance, where emotions often trump logic, base rate investing offers a refreshing perspective. This strategy, based on the concept of the ‘base rate fallacy’, empowers investors to make decisions grounded in general information, avoiding the pitfalls of overreacting to specific short-term impacting news. Imagine flipping a coin. You see three heads in a row. What’s the probability of the next flip being heads again? Many would intuitively say that it would be high, influenced by the recent streak. But logic dictates that each flip is independent, and the base rate of heads remains 50 per cent. This is the base rate fallacy, where we overweigh recent, specific information and disregard the general underlying probability. 

In the stock market, the base rate fallacy manifests in various forms. Investors might: 1. Overreact to news. A positive earnings report sends a stock soaring, but is it a one-off event or indicative of a sustainable trend? Base rate investing considers the company’s historical performance, industry trends, and overall economic conditions to provide a more balanced view. 2. Chase hot stocks. The fear of missing out (FOMO) can lead to buying into overvalued stocks based on recent hype. Base rate investing emphasises long-term fundamentals and valuation metrics to identify stocks with a higher base rate of success. 3. Neglect undervalued gems. Companies facing temporary setbacks might be unfairly shunned. Base rate investing encourages looking beyond short-term noise to assess the company’s long-term potential based on its fundamentals and industry position. 

A committed long-term investor directs attention toward businesses primed for sustained growth over expansive timeframes, often spanning decades. Illustrating this approach are prominent examples such as Warren Buffett’s strategic investments in Walt Disney and American Express. Similarly, in India, the late Rakesh Jhunjhunwala stands as a beacon of this philosophy, exemplified by his decision to invest in Titan Company during 2002-2003. During this period, Titan Company encountered a barrage of internal and external challenges. 

Internally, management disputes led to a critical factory lockout at Hosur, severely impacting the company’s revenue streams and profitability. Externally, adverse factors like escalating raw material costs, particularly for gold, intensified competition, and subdued demand further eroded the company’s financial performance. This decline in profitability is starkly evident when examining the profit after tax and dividend data from Titan Company’s profit and loss statements for fiscal years 2000-2001, 2001-2002, and 2002-2003 as outlined below.

The table clearly shows how dividend payouts by the company had also been reduced along with profit after tax. There were other important ratios too that deteriorated sharply for Titan Company during that period, as evident from a market decline in other key metrics like return on capital employed as shown below: 

Amidst a litany of challenges and dismal performance metrics, the share price of Titan Company plummeted to an eight-year nadir of ₹ 29. Adding to the bleak outlook was the absence of palpable signs indicating an imminent recovery. Nevertheless, Rakesh Jhunjhunwala seized the opportunity, initiating stock purchases of Titan Company during this downturn at bargain prices ranging from ₹ 30 to ₹ 35 per share. This prompts the inevitable question: What prompted his confidence in a stock seemingly forsaken by others? A deeper examination of the company’s sales figures across various product categories sheds some light on this inquiry, elucidating factors that contributed to his discernment. 

As can be seen from the data above, even during the difficult years of 2001-2003, the company’s jewellery business had grown 30 per cent. The jewellery brand, Tanishq, had opened 52 stores across the country and had introduced a number of innovative schemes to boost customer interest and retention. In fact, the management was actively pursuing a strategy that could make the jewellery segment its main business in the coming years. We see that Titan Company’s profits had dropped significantly within a few years. However, judging the long-term potential of a company based on only its recent performance might be the wrong approach. To better understand why that might be the case, let’s take a closer look at its profit and loss statement for FY 2001 to FY 2003. 

The notable decline in the company’s profitability can be attributed partly to a provision of ₹10 crore set aside in FY 2003 to address losses, earmarked specifically for restructuring operations in Europe. Despite this, Titan Company’s operating profit remained relatively stable, hovering between approximately ₹16-18 crore throughout the FY 2001 to FY 2003 period. This consistency suggests that while net profit figures may indicate otherwise, the company’s operations and revenues maintained a robust stability. For Jhunjhunwala, every ₹1 lakh invested in Titan Company now boasts a staggering value of approximately ₹22.16 crore, reflecting an impressive annualised growth rate of 41.52 per cent. His investment in this company now stands at a remarkable ₹18,000 crore. 

Success in such investments hinges entirely on the enduring prosperity of the underlying companies. Unlike day traders or short-term speculators, whose fortunes may fluctuate independently of business performance, a long-term investment strategy is anchored in the enduring success of enterprises. In theory, this approach seems straightforward:focus exclusively on evaluating and nurturing the long-term quality and performance of invested businesses. 

However, in today’s hyper-connected world dominated by social media platforms like FB, Instagram, Reddit, Twitter and WA, it is challenging to filter out the noise that threatens to divert attention from the pursuit of genuine and enduring success. Whether it’s the looming default of a real estate giant in China, fluctuations in the U.S.’ job growth, breakdowns in OPEC negotiations, hints of future Federal Reserve policies, or fluctuations in company revenues, stock prices react swiftly to short-term stimuli. Conversely, bullish projections from the International Monetary Fund (IMF), policy rate adjustments in China, successful product launches, or lucrative business deals can propel stock prices upward. 

Yet, these short-term fluctuations often deviate from the factors that truly drive long-term business success or failure— and consequently, the intrinsic value of a company in the market. The question that investors often overlook but should prioritise is straightforward: Does this immediate event have any bearing on the long-term success of the business? Interestingly, while immediate causes dominate headlines and news cycles, the enduring, fundamental factors driving business success often remain overlooked by the mainstream media.
 

Factors Causing Short-Term Distortion
 

Macroeconomic Factors — Despite the recent surge in talk about de-globalisation, the reality remains that we inhabit an exceedingly uncertain and hyper-connected world. On February 14, major equity indices opened with a more than 1 per cent decline from their previous close. Some of the IT companies saw their biggest decline. This downturn was attributed to the release of the January 2024 Consumer Price Index (CPI) report on February 13, which indicated that the substantial economic adjustments in the U.S. following the pandemic are far from reaching a conclusion. 

Following a peak inflation rate of 9.1 per cent in the latter half of 2022, there had been a hopeful decline in both headline and core inflation. This downtrend in prices, extending from essentials like gas and food to core items such as used cars and trucks, buoyed the optimism of economists and market participants alike. After experiencing the most aggressive rate-hiking regime in modern history in 2022, which precipitated declines in both stocks and bonds, the hopeful narrative was that the Federal Reserve had concluded its rate hikes and might even be poised to implement multiple rate cuts in 2024. 

However, the latest CPI figures did not support this narrative of impending inflation moderation, causing the global equity markets to plummet. With the month of March now in motion, we are witnessing new all-time highs in the equity market. So, there are two problems with treating macroeconomic factors when it comes to taking long-term investment decisions. First, that these macro events are uncorrelated with longer-term stock price performance. Second, quantifying this and using conclusively how it is going to impact company performance is very hard, if not impossible. 

Thematic Factors — Ever since the U.S.’ equity index S&P 500 reached its most recent low point in October 2022, seven prominent stocks — Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla — have collectively surged by nearly 117 percent. This impressive rally far surpasses the performance of the remaining 493 companies in the S & P 500 index. Together, these stocks have earned the moniker of the ‘Magnificent Seven’. However, it’s not solely the remarkable price appreciation of these stocks that has propelled the S & P 500 to a record high closing. 

In the past 12 months alone, their gains have contributed to more than 60 per cent of the overall return in the S&P 500. The Indian market is no different. At various times since 1998, several themes have created and then destroyed value to the tune of billions of rupees in the capital markets – real estate, infrastructure, education, microfinance, consumer lending, and technology services to name a few. Therefore, these themes can play out for a while but if you are a long-term investor, they should be treated with caution. 

Company Factors — We have studied this in our discussion about late Rakesh Jhunjhunwala’s investment in Titan Company. As usual, at the extremes, the decision is straightforward. If the share price declines owing to a downturn in one or two quarters, it is better to ignore the decline, considering it a temporary event. But if the decline results from a loss of market share for more than couple of years in a row, you should ask if there is something fundamentally wrong with the business. If the answer is no, remaining invested makes sense. 

Subscriptions and Recommendations — Let’s go back to the issue raised at the start of the article. Your investment is down by more than 30 per cent. Every stock recommended seems to be heading down. Apart from continuing to tear your hair out, what should you do? Absolutely nothing! One year down the line, the markets would have recovered amazingly and most of your investments barring a couple of them, would have hit their target price before their due date. And if you would have remained invested in some of them, they would have been multibaggers. 

Base rate investing offers a distinct advantage to investors encouraging them to look beyond the noise and focus on underlying fundamentals and long-term trends. By understanding and applying this strategy effectively, you can make informed investment decisions and potentially outperform the market over time. Remember, the key is to do your research (or believe in the research carried out by the publication), stay disciplined, and avoid the pitfalls of the base rate fallacy. 

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