Adani-Hindenburg case: Structures should not become shackles

Short-term traders believe in listening to what the market is telling them. Long-term fundamental investors believe over a period of time, stocks will ultimately reflect their fair value. Thus, both believe in a just market; ie ‘market is supreme’, although their time frames are different.

However, the Supreme Court’s recent pronouncements following a PIL filed in relation to the Adani-Hindenburg saga may pose some questions on this style of market functioning. Last week, the Supreme Court wanted to know if current regulatory framework and mechanisms can protect Indian investors from sudden market volatility in the future. Further it has also noted that investors (in Adani Group stocks) have lost in lakhs of crores of rupees. It wants a committee to examine the ability of current regulatory framework to protect investors from sudden market crashes.

What these recent pronouncements indicate is that, the Supreme Court may also have to consider a few other factors relating to market mechanisms and functioning. For example, is the volatility that hit the Adani Group stocks bad for investors? Many market participants believe ‘volatility is your best friend.’ One of the greatest investors of all times, Warren Buffett, has this to say on volatility — ‘you have to be prepared, when you buy a stock, having them down 50 per cent or more and be comfortable with it.’ He has highlighted how quite a few times in its history, the stock of Berkshire Hathaway went down by 50 per cent.

Thus during such interim phases, investors of such global giants would have faced losses that may make some of the Adani companies’ market cap losses look more like rounding errors. Take this, for example — from peak levels in 2021, Amazon investors have lost almost a trillion dollars — that’s over 80 lakhs of crores in Rupees.

In Buffett’s view if business does well, the stock eventually follows. Thus if Adani Group fundamentals are strong and their stocks’ stratospheric valuations were justified, then it really should not matter if one is a long-term investor, as stocks will eventually retrace to fundamental value. For example, Infosys investors experienced heightened volatility at the time of Vishal Sikka’s sudden untimely exit and also when there was a whistleblower complaint against it in the US in 2019. In both instances, within months the stock retraced back the losses. Thus for those investors who don’t panic, volatility is actually a friend. The market crash of March 2020 and the opportunity it provided is a testament to this. Those who have tendency to panic must rethink their extent of involvement in the stock markets.

So,a market framework that looks to subdue volatility may become a case of ‘structures becoming shackles’. That broader markets have continued to withstand the attack on Adani Group may actually be a good indication that current regulatory framework and mechanisms may be good, in fact. Probably the focus should be on even better execution.

Return-free risk

To the Supreme Court’s point on lakhs of crores of rupees lost by investors, while an important point nevertheless, there is something more significant to take note of here. More than 10 lakhs of crores of rupees was made by investors between March 2020 and till the time the Adani group stocks were trading at peak levels. This increase in market value was excessively disproportionate to the improvement in fundamentals of Adani Group companies.

Mean reversion is a fundamental concept in markets. In fact, Michael Burry, who was amongst the few individuals (amongst billions) to spot and short the housing bubble that morphed into the Great Financial Crisis, once explained how he identified the bubble that highly qualified professionals sitting in regulatory and statuary bodies missed. In his observation, home prices had grown disproportionately versus the growth in median income levels, indicating a strong disconnect.

Markets are a place where millions of brains exchange views on what is the value of an asset. Most of these brains are influenced by greed, fear, panic, and — in few rare cases – sound reasoning and rationality. As these views are exchanged, volatility, losses and profits are unavoidable.

Thus risk-free return is non-existent in markets. If one buys at a time when greed is high, lakhs of crores of rupees of losses may follow. This is what hedge manager John Hussman terms as ‘return free risk’ – ie investors taking on risks (by buying stocks) at price levels from where long-term returns are likely to be zero or negative.

Can asset bubbles that result in return free risk be prevented? The history of markets from the tulip mania centuries back, through the dotcom bubble to the subprime crisis, clearly indicates that is not possible. Over the centuries, regulatory frameworks have substantially improved, but bubbles have continued to come and go. Human emotions can outdo any regulation.            

So what can be done?

In the pursuit of profits, avoidance of losses is not a zero probability event. And neither can there be limits set to the losses. However, the probability and quantum of losses can be reduced with rational decisions, sound investment process and risk management. Just as seat belts and airbags reduce the risks on road, so too can good asset allocation policy, and sufficient diversification within stock investments reduce the risks and provide optimal returns in the long term.

So, more than a new or modified regulatory mechanism, what investors need is more lessons on investing responsibly and having emotions under control while making investing decisions. Those who are not sure about their skills on this must take the public transport – i.e. mutual funds route.    

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