Over time I have asked myself a lot of questions about stock market investing and here I am trying to pen my thoughts down in Q&A format.
Q. Why invest in stock markets?
A. Investing in businesses is a proven wealth creating mantra. The stock markets provide a convenient and easy way to hitch your fortunes to a company or entrepreneur your choice. Investing is also one of the rare economic activities which reward you well for doing nothing, i.e., patiently holding investments made wisely. My inherent laziness has found this attribute of investing particulary attractive.
Q. Why not invest in mutual funds instead of picking stocks directly?
A. Personally, I have chosen to go with direct stock picking over mutual funds for the following reasons in no particular order:
- I enjoy the learning. Trying to identify opportunities and putting your money where your mouth is, is enjoyable. One pays tuition fees by the losses one makes
- I enjoy the idea of being pitted against the best and have chance at beating them at their own game
- In funds, others actions (namely subscription and redemptions) affect my returns. Something I really don’t like. How this happens is a topic for another post and is fairly nuanced.
- Very few fund managers have a view of risk as I view it hence I feel safer managing my own money
- Fund managers’ incentives are too aligned to short term objectives which is very detrimental to long term investment returns.
Q. What is your basic return expectations from the stock market.
A. I am looking at a 2x to 2.5x return over the government 10 year yield over a 10 year period which translates to about 16% -20% CAGR over the next decade. I am quite happy with this return and hopefully will not increase risk profile in search of greater returns. (Everyone advised to read the chapter on “Reasonable Expectations” in Howard Marks’ “The most important thing illuminated” for a brilliant explanation)
Q. How do you view riskiness of investment?
A. I fall back on the oft quoted “permanent loss of capital” as the definition of riskiness of investments. Having said that there are certain other risks I am unwilling to take. I am not willing to take a chance with known issues of management integrity/corporate governance no matter how attractive the price. In this regard I clearly do not belong to the “everything is a good investment at a price” camp. I am more of the “Somethings are not worth the risk no matter how attractive the price”. This thinking is based on the “there is never a single cockroach in the cupboard”. Also it is discipline I try to maintain to avoid getting into bad habits. My investment process has management integrity, corporate governance and Outside Passive Minority Interest (OPMI) friendliness as a GO-NO GO criterion
Q. What are your criteria for investing in a company?
A. The following are my criteria for looking at an investment opportunity
- Management/Promoter Integrity, Corporate Governance an OPMI FriendlinessI am convinced that managements and promoters who dont genuinely beleive in sharing the the fruits with minority shareholders are not worth the risk. Hence I use this as first strike. Any past actions or red flags make it a NO-GO. Once this scan gives a GO, i move to my other evaluations. A sample list of red flags:-Warrants to promoters
-Excessive insider buying and selling
-Pledging of promoter shares in excess of 10% of promoter holding
-Excessive related party transaction (e.g. royalty to promoters to use of brand)
-Auditor not auditing any other listed company
-Excessive remuneration to promoters/managements
-Litigation to detriment of minority shareholders
-Strong political connections
-Any feedback from scuttlebutt
Here I try to satisfy myself to the answer of one question “Am I comfortable holding this investment if it stopped trading for 10 years or possibly delisted? Will promoters treat me fairly even then?”
- Runway of opportunity: Here the most important question is “Is the market opportunity large enough to allow company for many years of growth going forward?” This is a personal preference and I try to avoid too small opportunities even if priced cheap. Here I am reminded of a quote by Bharat Shah “Without growth a stock is a bond”
- Business quality : Business quality includes worthwhile margins and decent ROE, ROCE preferably in excess of return expectations. I am far less less tolerant to sales growth faltering than I am to profit growth faltering. Sales growth faltering is usually indicates problems of product-market fit, supply constraints and demand slow down, all of which are inherently more difficult to fix and take more time to get resolved
- Industry structure : I try to see if industry structure is healthy ( few companies at least doing well), there is no dumb competition/hyper competition and not excessive regulation.
- Capital allocation skills : This involves checking dividend policy, past acquisitions and diversifications to get an idea
- Leverage : Very moderate leverage at best is what i look for. The quote “Leverage is like driving a car with a dagger tied to the steering wheel; one bad bump can get you killed” by Warren Buffet summarises by thoughts on leverage beautifully
- X factor : This is a very difficult to quantify factor. It is a combination of hunger to make it big and the ability to go where the puck is going to go in ice hockey parlance. Lots of companies simply seem to have lost hunger for growth and usually end up as value traps. Piramal and Marico stand out as examples of companies with uncanity to go where the puck is going to go instead of where it is today
- Price : Finally if an investment seems worth investment I try to estimate at what price I will make my expected returns. If in range, I start buying it.
While all criteria are important, the first is GO-NO GO while all others are kind of scaled responses
Q. How do you value companies?
A. First I decide the parameter I am choosing to value a particular company, PE ratio, Price to Book, Price to free cash flows. Having done that I choose an expected return I expect from this investment and a period of time. the i reverse calculate what growth in business (increase in book value, earnings, free cash flow) will give me that at the current multiple. At the other extreme I see what re rating in market multiple gives me my expected returns. If combination of business growth and re rating looks likely to give me the return, then price seems right for investment or I calculate at what price it becomes attractive. To give you an example if stock trades at Rs. 100 with a PE of 10 and I want 18% return over 4 years. This implies a four year forward price of Rs. 200. Now this can be achieved by either earnings growing at 18% with PE remaining at 10 or earnings remaining same and PE becoming 20. This framework forces me to know before hand if I am expecting business growth to give me returns or the multiple of the same. Needless to say I prefer opportunities where bulk of returns are based on business growth rather than re rating of market multiple.
Q. How do you find stock ideas?
A. Over time I have developed a list of companies i find good and clean. I try to understand businesses on that list and try to put levels where they would become aa buy. I also have a few fellow investors I knock heads with and exchange ideas. But currently discovering ideas relies more on serendipity than any process. I need to improve majorly in this area by following sites and fund managers like more closely
Q. When do you sell a stock?
A. Selling is where most of errors have happened. Selling too early and selling too late are two mistakes that are hard to avoid. The most important reason to sell has to be when initial assumptions while making investment violated. I have learnt the hard way to exit such positions ASAP rather than trying to find new reasons to hold on to positions. I have also learnt at great cost to avoid letting “capital gains tax” affect my selling decision. One of the most frequent reasons I have sold stock is when I find myself thinking too much about a stock or just feel uncomfortable. I quickly intend to sell down such positions to a comfortable sleeping position. I really like Prof. Sanjay Bakshi’s of returns per unit of stress. Some returns are just not worth the stress. I also intend to sell when I find myself fully invested and find opportunities better than those invested in but I have yet reach that position as I’ve never been fully invested yet since April 2012 when I started my investment journey in right earnest. Having said that selling is undoubtedly is the harder part of investing as even most super investors admit. Selling remains an under studied and researched part of investing. I have found only one book dedicated to selling stocks “It’s when you sell that counts” by Donald Cassidy. Monish Pabrai in “Dhandho Investor” also has a great chapter on selling likening it to Abhimanyu and the Chakrayuh. He says you should have exit strategy clear before you enter.
Q. What are your views on position sizing and concentration?
A. this is very much work in progress but I am veering towards a concentrated portfolio. I would like a stock to be at a minimum 5% position in my portfolio. Having said that I also try to by a minimum 2% straight away. This helps me avid being too trigger happy and building too many small positions which require regular pruning. Generally I find investment worthy ideas very had to find so I do not intend to hold more than 10-12 stocks at any time. In a fully invested portfolio I would like to have at least 7-8 stocks. On maximum single stock exposure I am okay with it running up to 35% of my portfolio at which point i intend to sell it down. This limit is my only protection against overconfidence and error in judgement. I do not expect to have such a large position usually, only in the rarest of cases when all the ducks line up.
Q. Where do you stand with respect to holding cash?
A. While a lot has been said on concentrating entirely on individual stocks and ignoring the general market sentiment and macros, I am not entirely comfortable with this approach. Neither am I comfortable with a quant based approach to asset allocation. I believe asset allocation contributes as much if not more to returns as does stock selection. I am still trying to find a method to do asset allocation. I am trying to see if I can develop something on Howard Mark’s checking the “temperature”of the market checklist. For the most part I intend to let stock picking dictate asset allocation except in times of times of euphoria or excessive over valuation. As of now I plan to be at least 25% in stocks at all times though I’m not sure how I will take exposure if I find everything overvalued. Maybe then i will be 100% cash. As you can see I am yet to make up my mind on this.
Please send in your comments and questions to help me refine my thoughts