17 Sep, 2019

Dalal Street Rules

Prologue – Circa 2008

I made a mistake in presuming that the self-interest of organisations, specifically banks and others, was such that they were best capable of protecting their own shareholders.

Alan Greenspan, Oct 2008, Congressional Hearing

Post the Great Financial Crisis (GFC) of 2008, many investors, economists and academics started questioning their intellectual and philosophical moorings. No body less than Alan Greenspan questioned his belief in the ability of markets to correct excesses.

Ajay Kaul was the the founder and portfolio manager at Aks Capital which he had founded in 2002. A CA+MBA from a top tier school from the batch of 1995, he had worked for 7 years with a $ 10 bn long only hedge fund in New York. He came to India in 2002 and starting with seed capital of $50 mn he raced his way to the $ 1bn mark by 2007. Helped by the “India Advantage” story, and benign global economic markets. India was snapping at China’s heels. Investors were lining up to invest in India. Nothing dampened their enthusiasm. No one wanted to miss out. Until 2008 happened.

I regret I didn’t retire in 2006. Then I would have had this extraordinary record nobody else ever had. They would have thought I was a genius. By 2009, I was like an idiot.

Bill Miller, Legg Mason

Chaos on Wall Street……

Firms that Ajay had looked up to on Wall Street, disappeared every other weekend. The bail out of Bear Stearns by JP Morgan in March 2008, was viewed by many as the end of the crisis. But as it turns out, it was only the beginning. Later in the year Lehman filed for bankruptcy, AIG, Fannie Mae and Freddie Mac had to be bailed out, Merrill married BoFA. Goldman Sachs and Morgan Stanley had a narrow escape. The Japanese firm, Mitsubishi UFJ rescued Morgan (after both MS and GS became bank holding companies with access to the Fed window) and Buffett stuck gold for a sweet deal with Goldman Sachs.

Bear Grins on Dalal Street

…..does not spare Dalal Street

Indian markets were not immune, however much economic commentators said that India had decoupled from the global economy as the Rupee did not have a fully convertible status. However, that premise was incorrect. FIIs fled to safer havens like USD and Treasuries. They sold a record Rs. 1,01,802 crs worth of cash equities in 2008. It took almost five years to see a similar net buying figure. And to add to that the rupee has depreciated by almost 70% to the dollar since. Dalal Street was reeling under selling pressure and the panic was spreading to Main Street or the real economy.

A regular day on Dalal Street in 2008

Aks Capital

Aks (pronounced as “axe”) Capital was hit hard by the downturn in 2008. Managing a long only hedge fund was not too tough in the Goldilocks environment of 2003-2008. Low interest rates, low inflation, high Return on Equity and multiple expansion (high valuation) made every fund manager look like a genius. They could do no wrong up until 2008. From an AUM of $1 bn it fell to $200 mn in a few months due to precipitous fall in the market as well as redemption by investors.

Berkshire Hathaway’s Structural Advantage

Ajay’s intellectual diet till date, had an overload of Graham and Buffett with a dash of Soros, but even they had endured enormous drawdowns. Buffett had just endured almost 50% drawdown in 2008. But the most important distinction here was that Buffett was not answer able to third party investors. Else even he would have been fired (if he had real third party investors and not friends and family monies in 1956-69 period). The last time he had that structure was in 1969, and he sensed a coming bear market, he took a cash call and liquidated his fund. He took on the title of Chairman of Berkshire Hathaway started consolidating his holdings on the company’s balance sheet. A structure where he could use cash generated by the business to invest in stocks. It gradually evolved in to a structure where if someone didn’t agree with him, they could sell their stake in the open market and exit. And if he didn’t agree with the market’s valuation of his shares, he would buy them back. And Soros was running a family office, Quantum Endowment Fund. So he too wasn’t answerable to clients. But then he also made 8% in 2008.

Hedge Funds didn’t have that luxury. Private equity funds had that to a large extent but not long only hedge funds. They were under immense scrutiny and pressure to perform and generate numbers on a yearly basis. Not as bad as mutual funds though where the pressure was daily. No wonder most of them were closet indexers.

Preparing for a Post GFC World

The market is a zero sum game. If someone lost, it meant that some had made money. Who were those people? And that was the question in Ajay’s mind. Was it time to move from being long only and move to a market neutral strategy ? Or be long only with rail guards in place ? The world was going to be a very different place post 2008. No one knew how though. Would we see runaway inflation or a global repeat of Japan – where Quantitative Easing had had failed to reflate the economy even after 3 decades. He knew the answer intuitively. It was time to add additional components to his strategy. It was uncharted territory 2009 onwards.

Is Quant the way to go ?

In 2009, Ajay decided to investigate this recurring thought – who was on the other side ? He reread Soros’, Alchemy of Finance and his Theory of Reflexivity. As he started reading the book, he could not put it down for the next 3 days. It accompanied him everywhere. That led him to the next series of books – Market Wizards, Trend Following, Turtle Traders, and finally The Quants. It was time to invite Cliff Assness, Jim Simons, David Harding, Larry Hite and John Henry to the mix.

But by this time he had realized what needed to be added to his investing process. An objective and not a subjective process on when to sell. How could he have forgotten the lessons of LTCM and Dot Com bubble? How did he forget Soros’ reflexvity loop. A bull market does that to you.

Team at Aks Capital putting the system together

After six months of introspection, backtesting and discussions with his team, they came upon agreement on a set of rules which captured their investing philosophy. It was time to take this strategy live and see how it performed when the rubber hit the road. Aks Capital was experimenting with going quant.

Disclaimer: Nothing in this blog should be construed as investment advice. This is purely for educational purposes only.  Please consult an investment advisor before investing