Notes on long term thoughtful investing

Month: May 2017

Markets are at a High

“The stock market is a giant distraction to the business of investing” – John Bogle

Stock market is a place with an ongoing tussle being the proverbial ‘bulls’ and the ‘bears’. Or as a philosopher might put it, between greed and fear. May be a neurologist might call it a fight between the two chemicals which our brain secretes – testosterone and cortisol.

Whichever way one thinks about it, markets reflect the underlying psyche of its constituents. And these are people with their own fantasies and fears.

Sometime either of these bull & bear periods could be prolonged enough to engulf even the toughest of the minds.

When it so does, the results are pretty silly. An adult with all this accumulated wisdom and with access to all unbiased facts ends up acting foolish. He does what his mind is ‘hardwired’ to do right since the days in savanna – following the crowd. “After all”, he thinks, “how can all of these intelligent fellows be wrong?”

And they are – if all are justifying their actions based on that of others. How is much is worth all your wisdom if you wish not to use it?

To me, it is crystal clear that we are living in one such irrational period of time. Broader market multiples are way far from where they generally are. In fact, they are literally going through the roof!

Image Source: Multi-Act newsletter (March 2017)

Current valuations are atleast 50% higher than their long term averages based on price to earnings ratio. And the results of such divergences have seldom been a ‘happy ending’.

So for current valuations to revert back to their long term average, there has to be at least one third of price correction or earnings should rise by 50% in the near term. Safe to say, chances of former is higher than the latter.

What should one do?

Armed with this knowledge, how should one respond? Is there a way to protect ourselves from someone else’s folly or even better, can we take advantage of Mr. Market’s folly?

This is how I happen to think about the subject:

  1. Predicting a fall is a futile exercise:

    Facts show that valuations are stretched and at some point, it has to revert back to its mean. But they don’t tell when. And they never do. There are hundreds of important variables interacting to determine our future. And to predict the it, one first have to predict those hundreds of variables, accurately.

    Any one wishes to give it a try?

  2. Ignoring valuations is dumb:

    People say that Indians are very price conscious. One generally does research, read reviews and ask friends before buying a 10K smartphone. They hardly do the same thing when investing 10L.

    Valuation is like gravity. Ignoring it is like intentionally hurting yourself. Higher the sums, more would be the damage.

  3. Be comfortable living with volatility:

    Just as gracefully one accepts ‘multi-baggers’, one need to take in those horrifying 50% falls. As Charlie Munger says, if you cannot stomach 50% declines in your investment you will get the mediocre returns you deserve.

    Well, I would add to it two things here (a) do not invest sums you would be needed within the next 5 years (b) if you indeed cannot stomach that kind of volatility, choose someone to work with who has a demonstrated track record of doing do.

I continue to do things I generally do. That is trying to turn around stones in search for bargains. Needless to say, this search has become painstakingly more difficult since, during such times, what we get is more dirt beneath those stones rather than what one would expect.

Which is fine. I don’t expect Kohli to turn centuries in every match then why should I expect too much from myself every now and then? I plan to continue with the routine and occasionally doing away with the overvalued securities and waiting on the crease for the ball that I can play well. Its test cricket which people are mistakenly considering as T20s. Difference between how one plays in each of these is huge!

How (not) to read quarterly results

So the quarterly results season has begun and the street has come out of its 2-3 months long hibernation. And the juggernaut called ‘market’ is all set to pounce upon the under & over achievers.

As a long term investor of value investing pedigree, I sometimes ponder how much relevance should one attach what a bunch of guys achieve over a 3 month period? Should one swear by it – as market usually does – or just be indifferent to it? Three months just looks to be too short (after all, it’s only 66 weekdays right?). And we know the problem with shorter sample size or in this case, shorter periods of evaluation. Basing long term judgements on shorter history is, basically, devastating for your financial health.

So the problem we face is somewhat more than required information flow. But all information is good – provided we know which bits to attach importance and which to ignore. That is, one needs to separate information from the noise. Ignoring vital information just because there is too much noise around may not serve us well as business owners.

We need a framework which can take in all those quarterly figures, digest them and interpret those results in the overall business context. Check how things are progressing vis-à-vis our initial thesis. And if required, make amendments to the thesis. Finally, check out how the margin of safety now differs versus what was it earlier.

Simple right?

Indeed. But the key lies in figuring out the interpretation part well. After all, what differentiates a truly good investor from the rest is how well can he interpret things and accordingly make a decision.

Following are some pointers to this end:

  1. Ignore the coveted EPS: Majority of the investors today, including ‘professional’ investors, are short term focused i.e. having less than one or, in few cases, two years of horizon in mind. Also, almost all swear by the P/E ratio. The result – near term EPS is what their mind is anchored to. Basing decision on quarterly EPS is far from making a worthwhile decision. EPS, in fact, is relatively easy to ‘make up’.
  2. Dig Deeper: Ignore those headline numbers. Focus on what leads to that reported sales growth or margin expansion. Look at how every cost & income item disclosed in the P&L is moving. If available, make sense of those segmental numbers. Look out for any accounting gimmicks. Managements, in general, never fall short of the same.
  3. Footnotes: Many times, those exceptionally good, EPS boosting results are explained better by notes to accounts than operating numbers. Such moves tell us more about the management rather than the business performance.
  4. Apply the sustainability filter: Margins may be higher due to some temporary favourable development. These breather periods are not known to be prolonged. As investors, we would be wise to ignore those temporary gains from our evaluation. Vice-versa for unfavourable profit tolling developments.
  5. Sit back & think again: This is the most important of all and I will explain more on this below. But it is important to wait & reassess things before coming to a conclusion. Our minds are not wired to be ‘independent observers’ when there are already lot of things going behind the veil of our mind. We, by default, end up wearing coloured glasses. And it takes time & deliberate effort every time to wither these biases down.

Currently, I’m reading this gem of a book – The Hour Between Dog & The Wolf written by a trader who then went on to become a neuro scientist. It is a gem of a work for every serious investor to understand. Essentially, what it says is our minds are predominantly driven by varied chemicals at different points in time.

Testosterone when aided with dopamine leads to ‘on top of the world’ kind of reckless optimism.

Say, you expect a company you hold to do 15% sales growth, 10% margins over the medium term. In the just announced quarterly results company reported 20% sales growth, 13% margins and unexpectedly high EPS. At this point, our mind enters a different zone. It losses its ability to carefully think through things. You no longer wish to read the results further. You know you are right. You have done it.

God forbid, consequences could be far reaching if one were to act during such times.

And it is when information becomes a bane. For our thesis what is more important is what company achieves over his medium term horizon of say 5-7 years but our mind ends up substituting short term improvement for a medium term outlook improvement. And this could be far from truth. One can see this effect live when a company reports better than expected result.

This is what happened to share price of an apparel retailer, V-Mart, when it reported a robust December quarter sales growth – which looks difficult to sustain in all seriousness.

Just one good three-month period was enough for company to quote at 2x its price!

The effect of this chemical is more pronounced during bull markets when there is enough optimism and capital around. And given that we are currently going through one such time, we need to be cautious.

The other exact opposite of this chemical combination is another chemical called cortisol. It basically breeds depression & pessimism in our minds. So even if things are good enough, one would fail to appreciate it. 2001-2003 bear period in the Indian market would vouch for it. Company quarter after quarter, year after year kept on reporting good numbers, but market would not budge!

So earnings went up, stock price remained flat leading to significant decline in trading multiples in general, overtime. We are yet to see something as depressing as that particular and widespread period. Be it large cap or small cap, all were equals.

Today’s markets are exact opposite where smaller the company, higher is the growth opportunity – or so does the buyer says – and higher are their valuations versus larger peers.

Ben Graham would have had a hearty laugh looking at current market euphoria. He has lived through many of these. Just as we eventually would.

Overall, before arriving at a conclusion sit back and allow for some cooling period to pass. Never jump out of the chair and run to be the first person to announce to the world the numbers which just got reported. Quarterly numbers are an important & authentic source of information. But half-baked assessment is no better than noise.

And while reading quarterly numbers appropriately requires no special skills, training our minds and getting over our hard wired mental blocks does take time & effort. Especially for those companies which we hold or closely track – i.e. where we need our interpreting abilities the most!