We are living in entertaining times.
A time when a 25-year-old well-read bloke can quote Buffett, Lynch and other gurus on social media and rake up a 50K follower count despite having limited real time investing experience. In the social media driven world perception can trump ground reality for a long time, it has never been easier to fake social proof and success.
The downside of this is an abundance of investing gyan that sounds logical but is rarely personalized or contextual. Many investors fail to consider the various nuances that real world investing decisions demand. What appears simple to read is often tough to implement once you get down to the real world. Some of these concepts that are treated as gospel tend to misguide investors because they haven’t yet had enough real world experience to think through all the perspectives. Many of them end up becoming ready rationalizations to cover up for sub optimal thought processes and behaviors.
The gospel of earnings visibility
Every investor wants to see this in the businesses they own; higher and longer the visibility, higher the price that one is willing to pay for the stock; at least in theory. To the extent that some investors get obsessed about the predictability of the earnings so they can get their 20-year cash flow modelling skills to work and price the business to perfection.
I ask myself just one simple question – “Does the operating manager have the sort of clarity that investors are looking for?” Mind you, the operating manager has spent more than 2 decades running the business that you have spent 3 months analysing and tracking. If the operating manager does not need that much clarity before plunking in 300 Cr into capex, do you as an investor hope to have so much clarity before putting in 5 lakhs of your capital at work?
Then what does it eventually come down to? The historical rate at which earnings have grown over the long term or the “base rate” for the business. All analysis comes down to this tangible component for a mature business, barring a few exceptions where an investor really has an edge. And retail investors usually do not have that kind of edge.
A better approach is to accept the limitations of your own analysis and make an objective decision based on base rates. This may not give you an intellectual high but this works very well in practice. This is how you make 100% in 18 months by buying into an ITC or 50% in 12 months buying an L&T.
Circle of competence or sheer laziness?
I have been guilty of this one for many years. I stayed away from banking and pharma telling myself “This is outside of my circle of competence”. The truth was that I was just being a lazy bum who was not willing to do the grunt work in these sectors.
Circle of Competence applies to investors who have spent at least a decade investing, have seen a few cycles, and have tracked the business for more than 2-3 years. If an investor who has tracked, invested and failed at pharma sector over the medium says “outside of my circle of competence”, one can take this at face value. If a 25-year-old retail investor who cannot tell the difference between an DMF and an ANDA says the same, he is just being a lazy bum who is using Sir Buffett’s quote to rationalize away his own chosen area of incompetence.
My strike rate and overall understanding of the market has gone up significantly after I broadened my coverage across sectors and forced myself to do the grunt work across sectors. CY2022 would have been a washout in terms of returns had I not pivoted into capital goods, infra and financials in the nick of time. All of them were in theory “outside of my circle of competence” even in 2021. All it took was an objective look at where relative strength was in the market and 6 months of dedicated effort.
Do the work, broaden your coverage before you bullshit yourself on “circle of competence”
Pricing power – Does it mean what you think it means?
This is the ground reality right now – Relaxo is having a tough time selling a pair of chappals at a retail price point of below 200 while Metro shoes can sell shoes at an average price point of INR 1,500+
Pricing power is not perennial, it is a function of how that customer segment is placed at that point of time and also a function of how inferior the other alternatives are perceived to be. Marico rarely has a tough time trading up rural customers to branded coconut oil from unbranded but in 2022 they faced a tough time too. Imagine a brand that has ~60% market share saying this. Other FMCG players have struggled to pass on rise in input costs too, see the margin decline for most of them in FY23.
Pricing power needs to be seen as “how much premium can a business charge over the next best option without losing the customer” rather than YoY increase in realization. I have seen so many seasoned investors miss this because of their inability to put on the operating manager’s hat. They understand the same concept very well in their jobs and businesses but cannot apply the same logic in investing.
Are valuation multiples driven solely off business quality?
This has been the real killer in CY22. For the life of me I still cannot fathom how someone can utter “10-year horizon” and “valuation and interest rates do not matter” in the same sentence. It is mathematical nonsense once you get down the act of building a DCF.
The decade of 2010-20 was an era of low interest rates driven by a deflationary environment that led to a few stocks getting priced at below 10% discount rates. Else you cannot justify a PE of 70+ for a business that grows free cash flows at 18% p.a. Once the prospect of inflation came to the fore in 2021 (due to a multitude of factors) see what has happened to the quality brigade though the businesses have been growing at a decent rate since 2020. A valuation smash of many of these businesses is underway right now and may continue for more time. Before you judge saying this is a post facto take, do read this post where had we highlighted the possibility of these narratives unravelling well before the event happened.
You cannot price equities without having a view on fixed income and interest rates. Unless you know the basics of fixed income, you may well suck at being an equity investor from where we are. The best-known academic practitioner of equity valuation does the regular exercise of assessing where the current equity risk premium with respect to historical numbers. Equity risk premium as a concept existing because of the additional return investors demand over holding the risk free (at least in theory) yield for their investment horizon.
It is another matter than one cannot predict long term interest rates, which is why Buffett uncle harps on “margin of safety”. Assume that rates will be higher than you can imagine, then ask yourself what would you be willing to pay for this business.
Many of the current desi investing gurus started their investing careers when interest rates in India were in the higher double digits and equity market participation was abysmal. We do not have the luxury today. Listen to their views on “ignore the dollar index and crude price” and “interest rates do not matter in the long run” at your own peril from here.
Does a moat make the business immune to short & medium-term gyrations?
Moats do exist but they too are not perpetual. They get challenged from time to time; some businesses emerge victorious but many fall by the wayside.
The market became nervous the moment JSW paints scaled to 1000+ Cr revenue in a short period of time from the scratch. Now when Grasim announces a larger foray into paints the market turns even more nervous, even if it turns out to be unjustified eventually. The moat that got the market excited about Dr Lal Pathlabs is right now giving a few jitters to long term investors who bought into the long term durability of that moat. The fastest growing PVC brand is from the house of HSIL and not from Astral, Finolex or Supreme Industries. Astral has poached the ED of Cera Sanitaryware to run their building materials division that is set to hitting the market in FY23. All PVC players are competing aggressively for the 7,000 Cr water tanks segment that was dominated by Sintex for decades.
Only time will tell if the deluge of new players will make a dent but that is exactly the point – even the presence of a long-term moat does not make the stock price immune to underperformance over the medium term. If you fell for that narrative that a moat can give you peace of mind as an investor, that narrative has been questioned to some extent already. There are an equal number of examples of moats being taken to the cleaners as there are for moats that have endured.
Do not let a “feel good” factor dominate your investing style. Hedge your bets and work with a combination of factors.
The best stock to buy might be the one you already own
Lynch baba said this in a context that was well suited for him. He was a professional fund manager who would research businesses by the buckets, he did this over decades before he came up with this famous quote.
The average retail investor who started investing 5 years ago and still has the bulk of his money in index funds is unlikely to research more than 20 new stocks each year. Hell, a full-time money manager like me has a coverage universe of 300+ stocks and our team researches 30+ new stocks each year at the current pace. You must get the drift by now, don’t you?
Do not use this line unless you have already researched 500 stocks. You may have a greater level of comfort and understanding of the businesses you already own but that does not mean that your stock is the best one to buy out there. Every 6 months I find myself getting pissed off at myself for not having researched a particular stock before, that is how investing should feel like in the first 10-15 years or so. I hope to get to a stage where I understand 500 businesses reasonably well in the next 2-3 years. By then, I hope to have earned the right to quote this line. I have some white spaces in my coverage right now that I am working hard to plug.
Imagine a situation where a part time retail investor hops onto a story 5 years before I even get around to researching the same. And in the meanwhile, the damn thing turns out to be a 10 bagger.
The alpha generation game is unforgiving and brutal even on those who are full time, professional investors.