Notes on long term thoughtful investing

Category: General Thoughts (Page 2 of 2)

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!

Why does an individual, in general, faces dismal odds of investing success?

It is remarkable what have our species, homo sapiens, have managed to achieve in the span of mere 70,000 years. Starting from a hunter-gatherer role, having no permanent establishment, ranking somewhere in the middle of food pyramid we not only moved to the top most position of it but rather have shaped the planet and its inhabitants.

Call it good or bad but our actions today will decide which species will survive next hundred years and which would go extinct, which direction will the temperature go over next several decades, how greener will landmasses be or not be. This is a phenomenon, for lack for any other word, achievement given the fact that we are just other any other animal in this vast kingdom (we share most part of our DNA with chimpanzees / apes)

In fact, what sapiens have achieved in last seventy thousand years is multiple times more of what Homo Erectus had achieved in over two million years of their existence on earth before they went on becoming extinct. Yes, we were never alone. In fact, there were three other species of humans (Homo Rudolfensis, Homo Erectus & Homo Neanderthalensis) but today there is only one – Homo Sapiens.

Yuval Harari has covered this evolutionary journey in his book Sapiens. The main reason for this achievement, he says, is attributable to the ‘cognitive revolution’ which happened during the period of those seventy thousand years. This revolution had two legs which set it going. One was ability to imagine things which may not otherwise exists and second was our ability to communicate.

Together these two meant that sapiens had the ability to mobilise a large group of individuals (100 or 500 people and as time progressed, even millions) and act systematically in order to achieve a common objective. This was unique to us. Chimpanzees, lions cannot do so at this scale though they can be doing it at a much smaller scale and for limited objectives coded in their genomes. Sapiens, thanks to their ability to imagine, were never restricted to what was built into their genes – we didn’t wait for thousands of years in order to develop fins to cross oceans – as other species did. Instead, we thought of building boats. We could imagine something sailing on water and which is big enough to carry us before we built it.

A short talk by Harari nicely put forth the basic tenets mentioned in his book. You can find it here.

It may come across as shocking but our ability to come up with stories (i.e. imagine things) and communicate it across masses, and hence act for a commonly established goal, explains why we are today what we are. Remember the age old saying United we stand, divided we fall. Our chief strength has been to act systematically (as imagined) in unity.

We can take this discussion fast forward to today with an exert from Mr Mauboussin’s beautiful work in his book More than You Know –

If you want to understand how broadscale sentiment shifts occur, you can start by thinking about the flu—well, actually, how the flu spreads. There are two key dimensions, both intuitive. The first is the degree of contagiousness—how easily an idea spreads. The second is the degree of interaction—how much people bump into one another. If the flu is very contagious but carriers don’t interact with others, it will not take off. If there’s a lot of interaction but the flu strand is not contagious, it will not take off. But combine interaction with contagiousness and you’ve got an epidemic.

Strong, convincing stories are contagious and this coupled with our innate need to interact (and hence spread it) results into a shift in sentiments. And this when something which otherwise has helped us as species over thousands of years of our evolution comes at odds when it comes to investing.

While biologically we may be right to act upon such stories or fictions in order to better ourselves & our community, as our evolutionary history would vouch for, it happens to be disaster when it comes to investing.

Why so? Successful investing is all about come up reasonable assessment of odds and acting if potential rewards more than compensate for the risk we are taking up. When it comes to acting based on convincingly laid out stories, amplified by the momentum which unfailingly kicks in, hardly any importance is given to looking up at those odds.

Individuals come to act when it could actually be the worst possible time to act paying little regards to think about what they are doing. Acting as their minds are wired to do over centuries.

In fact, after a point it becomes like greater fool theory – you are buying just to pass it on, at potentially lucrative gain, to even more resolute believer of the story. Dot com boom and bust in late 90s is the modern example in front of us.

Similar such episodes are well documented in a book by Charles Mackay called Extraordinary Popular Delusions and the Madness of the Crowds first published in 1841.

An outcome of this haphazard approach to investing has actually resulted the average mutual fund investor to earn only 4.4% p.a. much lower than 11.1% p.a. which mutual fund industry overall returned and even lower than 8.6% p.a. earned by an unmanaged collection of 50 largest companies called Nifty over last ten-year period. You can read more about this here.

How can an investor earn lower than the fund? It is precisely because he comes in at the wrong time and leave when he should actually stay put and commit more funds. He is influenced more by their rear view mirror than the windshield – hence resulting into an accident 🙂

Of course, incentives work in such a way that mutual fund operators have little reason to say no when they see funds coming to them without much of an effort, precisely at the time when they find it difficult to deploy funds on attractive terms for their investors.

Index investing helps to mitigate this randomness in inflows and outflows but even they are not fool-proof. In a growing economy like India investing in 50 large companies suffers on three counts, I believe (i) by investing in 50 companies, you are stretching ourselves too thin (ii) you are missing out on other phenomenally good businesses which may not make it to top 50 today (iii) there is no weighing of the attractiveness of the stocks and the odds it offers.

Still, since an index is least impacted by excessive speculation which may be gripping market participants in some specific sector (like during dot com boom) and general steadfastness associated with it, it actually promises investors to avoid costly mistakes rather than making excess returns.

When it comes to investing, the key lies in sticking with your commitments for decades navigating over the inevitable tsunamis and the opportunities it offers when it passes.

This simple yet effective hack enables us to overcome our otherwise fallible tendencies.

 

Niraj Bardia

 

Predicting stock prices Vs Owning businesses for the longer term

There are multiple ways of creating wealth in stock markets. On one side there are intra day traders and traders doing BTST operations (buy today sell tomorrow) fully resourced by their brokers giving them trading tips – just like the talking hosts on tv – and at the other extreme there are investors which don’t mind buying and literally forgetting holding their stocks for years if not decades.

And given that many variations of these – depending upon where do they fall in between the above two extremes –  are being followed in the market generally by the masses one can say that people find some utility in these (or at least they so perceive:) )

 

Which approach should one follow?

Just like in other aspects of our lives, the chosen path should be the one which is walk able (or practical to follow) given that one needs to continue his stride for fairly long time in order to reach his end goal and also the one which promises the fulfilment of the goals which the traveller initially looked up upon before starting to march. In other words, it should something which doesn’t burnout its followers – or else they wouldn’t live to travel the course – and should also be rewarding in the end.

Let’s explore both of these extremes (trading and long term investing) further and try to make sense of each of these:

Trading

Trading is simulating. It requires information to act upon, involves frequent decision making, has high transaction cost, is tax inefficient, has excess diversification involved and is mentally stressful

(i) Information: Generally, a trader is constantly looking for information upon which he can immediately act and profit. As such, it wouldn’t be wrong to say that after a while he becomes addicted to information streams. And combine this addiction with today’s 24×7 connected world which means that somewhere there is an information overload. Research tells us that as information increases, decision making ability deteriorates. Beyond a point, soaking information only makes things worse. Today, information is commodity and ability to filter it through and separating knowledge from noise is the chief task which a decision maker faces. It wouldn’t be wrong to say that today, given the information overload in some form or other, odds are stacked against the trader as increasing information only impedes decision making.

(ii) Frequent decision making: Traders need to make decisions several times a day, every day and we know that when the frequency of making decisions goes up, so does the error of commission. Taking a hypothetical example assuming that if both a long term investor and a trader were to earn 15% in a year, the number of decisions taken by the trader to earn that return would be way higher versus that of an investor.

(iii) Transaction costs: As the frequency of buying & selling stocks is high, transactions cost are also high. It ends up taking a toll on the returns one earns during the year. When it comes to compounding money over long periods of time – which is what our discussion is all about – such differences end up being significant in absolute terms. 100,000 compounded at 18% for 20 years is 35,60,000  and that at 16.5% for 20 years is 26,50,000. Every percentage point counts when it comes to investing.

(iv) Taxes: With frequent buying selling comes the need to pay taxes regularly. And generally short term tax rates are much higher than long term tax rates and in India currently, returns from long term investments in equities (>1 yr) are exempt . Also, we know that even if tax rates were to similar the fact that tax deferrals add value to an investor’s portfolio should not be forgotten.

(v) Excess Diversification: As a capital market participant some diversification is valuable but beyond a point (say >20 or 30 stocks) it starts adding negative value to the portfolio. Difference in weights between the hits & misses narrows. Remember, what matters over time is how much money you make when you are right and how much you lose if your wrong. When it comes to traders, things are even worse since generally they prefer to trade simultaneously in many ideas due to which they are unable to build worthwhile position (say >5-7%) in any investments.

(vi) Addiction to stock quotes: If you want to make a trader’s day worse, just cut him off from checking stock prices during market hours 🙂 . He would crave for have just one look.

(vii) Mental Fatigue:  Given the need to take frequent decisions, gulping in information in huge doses everyday, constant hunt for news flow, etc takes toll on physical and mental health of a trader. It is not unheard of young guys below the age of 40 dying in this industry due to heart attack. For compounding to work its magic, you need to be here not for a couple of years but decades all together.

It is clear that odds are stacked against a day trader when it comes to compounding money & wealth creation over a longer period of time. As the saying goes, activity is the enemy of an investor.

 

Long Term Investors / Business Owners

As against traders, long term investors enjoy several advantages. They can concentrate their holdings, take advantage of – as Benjamin Graham said – other person’s follies given their longer term horizon, save on transactions costs & taxes, retain their ability to separate knowledge from noise by avoiding information over dose and do all this while living a fulfilling life!

(i) Concentrated Portfolios: In markets, one is paid for his conviction. By investing in businesses which one understands and not over paying for the same, one can turn odds in his favour. When one starts to see a business from the eyes of the business owners while taking a longer term outlook, ability to take concentrated bets increases (say <15 or 20 stocks in a portfolio). This bodes well for a truly long term, value oriented investor

(ii) Taking advantage of market follies: As Graham once said ‘Market is like a voting machine is short term and weighing machine in longer term’. Market is known to be inefficient over long term (3 to 5 yrs) and this is precisely where the advantage of a long term investor lies

(iii) Save on costs & taxes: Since buying selling decisions undertaken by an investor is less versus a trader, he saves on transaction costs. Also, tax benefits derived by it over long periods could add up to be significant. Consider this, if an investor is holding just 10-12 stocks in his portfolio and has a holding period, on average, of 3 years. It means that he needs to find just 3 or 4 stocks every year to buy & replace the existing ones!

(iv) Avoid information overload: Unlike a trader, an investor who thinks & acts like a business owner is under no obligation to read every new bit of information which comes across relating to the companies he owns. He enjoys this luxury due to his understanding of the business, longer term outlook and owner like attitude.  In the end, odds are better placed for him to enable him to make better decisions since he never bombards himself with excess information dosage.

To sum-up, when it comes to compounding duration matters. One needs to find an approach which is something that can be almost religiously followed not just for years but for decades. While trading is tiring and in itself a ‘negative feedback loop’, long term investing is exact opposite of this. This is not to say investing is easy. Far from that. But it is simple and one just need not complicate it.

Cheers and happy diwali. Have a safe one 🙂

Is it really worth it?

This is my first post on the website. There were some thoughts going on in my mind as to whether I should go ahead with this idea of starting a blog or not.

After all, blogging requires a commitment of time & effort. And as Mr Munger says, if something is not worth doing at all, it is surely not worth doing well.

So question was – is it really worth the effort?

Investing frequently involves weighing value you get versus the cost you need to pay. While the cost involved was clear here (couple of hours every week), what was the value which I was looking to derive?

To start with, writing something makes us stop and think deeper. Habits like writing a diary or a blog regularly not only improves one’s thought process, it also helps in improving upon one’s communication skills.

Diary becomes a ‘log’ which can be looked back over time and thoughts could be revisited. In essence, this means that thoughts can remain ‘intact’ just as they were while writing.  Also, these could be improved upon learning from newer experiences, overtime.

In case of a blog, there is also a timely ‘feedback’ from the reader which sometimes gives the topic a different perspective which we would have otherwise missed.

To sum up, when it comes to investing, the importance of clear thinking cannot be understated. Writing about it will only make one better at it overtime while helping several others to get better at their own game – a cause which makes the effort worth taking!


 

Niraj Bardia

 

 

 

 

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