Financial markets are like the ocean, and the investor the captain of the ship that must sail across the wide expanse. The wise captain knows that he will encounter both fair weather and storms during his voyage, but he cannot be sure when and for how long each will last. He thus must sail a ship that is fast enough to arrive at his destination within the allotted time frame, but speed will mean little if the ship is shipwrecked during one of the many storms he comes across
The ship in this metaphor represents the investor’s process, which must strike the appropriate balance between controlling for risk and seeking return. It is easy to extrapolate good times as lasting forever, or believing that it is possible to run with the crowd right up to the edge of the precipice, stopping millimeters from the drop. It is hard to develop and then stick by a process in a disciplined fashion, especially when the markets are rewarding risky behaviour. As Howard Marks points out in his memo “There they go again, again”
- awareness of history,
- belief in cycles rather than unabated, unidirectional trends,
- skepticism regarding the free lunch, and
- insistence on low purchase prices that provide lots of room for error.
Adherence to these things – all parts of the canon of defensive investing – invariably will cause you to miss the most exciting part of bull markets, when trends reach irrational extremes and prices go from fair to excessive. But they’ll also make you a long-term survivor. I can’t help thinking that’s a prerequisite for investment success.
The last few years have been particularly good for midcaps and smallcaps in India, so much so that a lot of people have adopted the lottery ticket approach to buying stocks: if they can only find that elusive multibagger or two that will oblige them by multiplying multiple times within the same year so they can quit their jobs to start an equity advisory service.
The trouble is that when everyone starts to chase the same set of stocks, suddenly the inflated valuations mean that forward returns often aren’t so compelling, a result of a rather pesky phenomenon known as mean reversion. Furthermore, a lot of junk tends to rise as the notion of fundamentals soundness gets tossed in the quest for a quick return, and the trend can continue for some time as more and more investors, attracted by recent returns pile into these stocks. Eventually though, the tide goes out.
The last week seems to have put a bit of a dampener on the party. Is this the start of a prolonged correction? I’ll leave that to the pundits on TV to answer, I have no idea and will continue to have no idea as to which direction the market as a whole goes. I think this obsession with absolute index levels is rather unhealthy anyway, and constitutes what Buffett calls “watching the scoreboard” rather than focusing on the game. There is already no doubt a plethora of articles saying “markets have done x last week, what should the investor do”, along with another set being furiously typed out for the next week as I write this. Suffice to say, there is little to be gained from reading them. I can’t tell you what to do, but I can tell you what my process tells me to do and avoid.
My process tells me to:
- Read annual reports, credit reports & con-call transcripts of businesses to better understand their economics and try to find mis-priced bets that are either
- Decent businesses selling at a deep discount based on their asset values and normalized earnings power
- Exceptional businesses with a long runway for growth and high return on incremental invested capital that are at the very least, fairly priced.
- Read books, magazines and blogs to improve my understanding of the world and develop useful mental models.
- Focus on asset allocation, position sizing and risk control
- Asset allocation: Balance the % of total assets in equity and fixed income, and hold cash in reserve for when market prices are elevated
- Position sizing: Limit the total invested in any one position or sector to avoid overconfidence and unforeseen events causing excessive damage to the portfolio.
- Risk control: Avoiding areas of overvaluation, companies with weak fundamentals, industries with poor economics, high cyclical nature and irrational competition,and limiting exposure to any one sector or geography are some ways to achieve this.
- Be disciplined about expenses and maintain a high savings rate in order to maximize the amount of money I have to invest in the first place. What ultimately matters is that you have high portfolio returns as a whole, and the constant infusion of new capital from savings matters, especially in the early years.
- Focus on maintaining the twin edges of a longer than average time horizon and behavioural discipline
- Write everyday in order to work out ideas and help clarify concepts. Morgan Housel recently wrote a great article urging everyone to write.
My process tells me to avoid
- Recent news on market movements. (I think it is far better to study financial history over very long periods of time)
- Staring at stock prices daily (I have already long uninstalled moneycontrol and other such apps)
- Worrying about things that have no bearing on my process such as Trump’s war of words with North Korea or China’s saber rattling over the border with India.
- Price anchoring: just because something has fallen a certain % or risen a certain % doesn’t make it cheap or expensive, only relatively cheaper or more expensive than what it was. This is an important distinction, and a good way to think about the problem of valuation is the reverse DCF approach where you try and work out what implicit growth rate is built into the current market price and then accept or reject the market’s assumption based on what is likely from the evidence. For example, if the implicit assumption is that profits will grow 50% a year for the next 10 years, there’s reason to believe that a degree of skepticism is necessary. While not impossible, such a scenario offers little margin of safety.
- Stock tips and recommendations (useless without sound reasoning) and market forecasts (they tell you more about the forecaster than anything else)
- The temptation to make big all-in highly concentrated bets which do not fit with my system of capital protection, downside mitigation and overall portfolio returns.
Develop a process grounded in rational decision making and stick to it. When you are investing for the long haul, discipline and the temperament to stick to a plan matter more than trying to make brilliant decisions all the time. As Charlie so aptly put it at Berkshire 2017: “A lot of other people are trying to be brilliant. We’re just trying to be rational.”