Bay’s Founder views on the market: Embedded Optionalities in Businesses

February 8th, 2020

There are instances in investing when certain events tend to get a disproportionately larger share of investor focus and attention. Many investors fail to see the longer term big picture , as it were. Since the beginning of the year, two such notable events have transpired in the span of a few days of each other– Brexit and the Indian budget. There is of course no relation between the two but the reason we mention these is to emphasise the possible disproportionate amount of importance placed on these specific events and the resultant behaviour of investors.

In the case of Brexit, the public discourse in the UK for close to 3 years had been around Brexit and observers might be a little surprised about how the event has passed without any immediate disastrous consequence. The simple message from Boris Johnson in the recent elections: “Get Brexit done” has meant that Britons are simply “getting on with it”.

A similar thing played out in India with the presentation of the Indian budget. As with most years in the recent past, the budget has ceased to be of as much importance as perhaps in the past. A lot of policy measures have and will continue to be presented outside of the budget. However , a week or two before the event, there is a disproportionate amount of mind space given to this singular event and the near term market reactions following this year’s presentation have been fascinating to us , to say the least. The stock market fall on the day of the budget and the equally steep rally to recover the losses has led to people really just “getting on with it”. While there are both near term and longer term ramifications , it is a little absurd that this one singular event gets such a disproportionate sense of importance.

There is a great tendency to focus on the near term and its possible implications on stock prices. The corollary to this is that high quality businesses continue to put in place value drivers, the benefits of which may not be very visible in near term earnings and in near term overt action. The embedded optionality that exists in well-run businesses is a characteristic often under-appreciated by investors. We refer to this as the “free lunch” wherein a long term potentially profitable segment or business unit gets overlooked by the larger market, more focussed on nearer term imperatives of quarterly earnings.

Microsoft’s business today is very different from what it was in 2014. The cloud computing business now accounts for a staggering $12 bn of revenues every quarter (annual revenue of $ 4 bn in 2014!). Apple’s services business has now become the new engine for growth. India’s largest conglomerate today is a different business to what it was in 2016 and its safe to say that 5 years out, it will shape up to be a dramatically different one. A lot of the consumer facing businesses in India also exhibit this property and this explains their longevity, their continuous success and their ability to continue to generate high returns on capital and eventually, their compounding returns to shareholders.

That said, while over-diversification to incubate potentially newer businesses is certainly a risk that investors must think about and balance out, all in all businesses which tend to think in decades are those that are able to innovate, to adapt, to evolve and to re-invest themselves to become sharper and more agile and more responsive to the changing impulses from the environment.

Investors will do well to insulate themselves from the “noise” around specific events and continue to be focussed on an individual business’s ability to evolve and to continue to incubate future growth drivers. At the end of the day, embedded optionalities highlight that perhaps there is such a thing as a free lunch.

Posted by Siddharth Mehta, Founder & CIO