If someone were to ask you, What was the right time to buy Nifty in the last five years?
What would you say? Easy, buying at the lowest point on March 23, 2020. Buying at this point and holding till January 1 2024, would give you a return of 290%. For an index, that's wild. That's a CAGR of 30%.
Tell me one more thing: how many would dare to buy the index when the future was so uncertain and the news headlines read the following:
"Chaos and hunger amid India coronavirus lockdown" and
“Coronavirus: India's pandemic lockdown turns into a human tragedy”
We could find many more news articles, but you get the picture. It's easy to say in hindsight but hard to follow when our portfolio suffers the brunt of it. So how do we determine a fall is an opportunity for any share price to buy? I found this answer in a book called "What I Learned about Investing from Darwin", and the answer is the
concept of proximate and ultimate causes. They are biological terms, but I will define them with context to the stock markets.
Proximate causes are events which are immediately responsible for causing some observed result. Ultimate causes are the actual reasons that can cause changes in the intrinsic value of a business in the long run. Basically, an event that can cause significant fluctuations in stock price and earnings but is only temporary is a proximate cause. If the situation is structural and likely to persist, it's an ultimate cause.
Let me provide an example. A structural shift is already taking place to benefit India: a shift in the chemical industry's supply chain. MNCs wish to de-risk their supply chain and reduce their dependence on China; hence, they are looking for partners in India. This has been visible since COVID-19, and stock prices reacted accordingly. Although nothing can be certain in the world, we will assume that a structural shift is taking place for this mental model's sake. With this, we have established an ultimate cause.
We are not geniuses who are the first to figure out such trends and hence will not get very attractive valuations, but there is one way—a proximate problem during an ultimate structural event.
Let's look at the last few quarters. The results of chemical companies have been lacklustre for several reasons: China dumping, inventory destocking, problems in the Western economies, etc. Are these problems likely to persist for 5-10 years? I argue not. These issues are temporary in nature; Chinese companies can't keep dumping inventories, nor can interest rates keep rising in the West. Since they are not structural changes, we can conclude that it is a proximate cause. Yet, many stocks have corrected by 30-50%. This is what I consider an excellent opportunity to enter. We can enter businesses at very attractive valuations by identifying a structural trend and waiting for short-term troubles. There will be multiple ideas occurring simultaneously where we can use this mental model. For example, betting on consumption as GDP per capita increases, increasing domestic production, formalisation of the economy, etc. Having a long-term vision is an edge in itself.
Using this mental model is not only helpful in finding themes but also in determining whether to stay invested in them or not. The investors who are already in the chemical trend can understand the issues and decide if they are likely to stay or not. Investors, 20-30 years ago, could have identified the internet as a disruption and gotten out of newspaper businesses. I personally believe that I would not have been smart enough to recognise the internet as a disruption rightly, but I hope some of us are.
Of course, there are drawbacks to this idea. The biggest is that we can never really know if anything is ultimate or proximate. Only in hindsight, perhaps. Hence, we need to think probabilistically and determine the likely outcome. The only way we can increase our chances of being right in classifying a trend as ultimate or proximate is by delving as deeply as possible by learning and understanding the whole industry. It is a great tool to have; it simplifies the process and keeps our mind clear; now that we have gone through the entire mental model, reach out to me and let me know which structural trends are going through temporary corrections!
Key Takeaways:
It is scary to buy during a fall, but we can eliminate this fear by following the idea of Ultimate and proximate causes.
An event that can cause significant fluctuations in stock price and earnings but is only temporary is a proximate cause.
Ultimate causes are the reasons that can cause changes in the intrinsic value of a business in the long run.
Supply chain shift from China is the ultimate cause. Dumping and inventory destocking are proximate causes.
We can identify the nature of events, segregate them into two of these causes, and act accordingly.
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