Bedrocks to Fall Upon in all times
Investors may differ in their approaches to the market, but all share the same objective: consistently achieve superior risk-adjusted returns. Anytime we embark on a worthwhile journey, it is beneficial to have a set of time-tested beliefs and principles to guide us. An investment philosophy, the synthesis of our investment beliefs and principles, could do the same for investing by helping us make informed investment decisions. Having an investment philosophy makes the journey less confusing, less toiling, and more rewarding.
I too have an investment philosophy, shaped by my learnings and experience in analysing and investing in the Indian equity market for close to two decades. It is guided by three key tenets: a long-term perspective, a narrowly diversified portfolio, and a contrarian approach.
Long-term Perspective
Most investment principles require us to go against our human instincts. Humans generally tend to prefer instant gratification over future well-being. This inclination leads investors to pursue smaller, short-term gains rather than larger, long-term gains. However, lasting investment success never accrues through short-term gains. It requires a long-term commitment. Market history has demonstrated that building durable wealth in the highly competitive investment market requires a long-term investment perspective.
‘Invest with a long-term perspective’ is our most entrenched investment principle. Once we invest in a stock, if there is no significant change in its fundamentals, we give it at least three years to realise its potential. Until then, we sit out any adverse impact market vagaries might exert on the stock’s price.
However, the decision to stay put shouldn’t be made lightly. Instead, it should be a carefully thought-out decision. Staying invested in a stock is only warranted when its underlying fundamentals remain promising. Just as large gains are made in the long-term, significant losses are also made in the long-term. Holding on to a stock even after its fundamentals have significantly worsened is not in our portfolio’s best interest.
However, in the short term, a stock is typically influenced by several ephemeral factors that are irrelevant to its long-term prospects. These factors, when present, are very persuasive. They compel us to tamper with our investment positions, which is never in our best interest. We must resist those tendencies.
Some form of uncomfortable feelings always precedes our tendency to tamper with our investment position. It could be a fear of loss or a fear of missing out. Nevertheless, our feelings want us to do something that is not in our best interest, which we are unaware of at the time. Once we have done what our feelings wanted us to do, only then do we realise that our feelings have deceived us. But by then, the damage has already been done.
Investors need to learn to sit with their uncomfortable feelings. How powerful they may appear at any moment, feelings are transient. We don’t need to fight it, or satiate it, or hide it. By doing nothing about it, by letting it play out, we cause the feeling to dissipate slowly. It is then gone and no longer a concern.
An investor should possess patience, self-control, and perseverance to adhere to a long-term investment strategy. Patience is likely the most important. Strong arguments should support a prudent investor’s decision. However, a stock does not start moving according to our thesis from the moment we purchase it. It may linger for months or even years. The lingering affects us psychologically. Uncomfortable feelings such as annoyance, anxiety, and frustration will gradually surface within a few months of lingering. They may prompt a desire to act, such as exiting the position. Meanwhile, the original thesis behind our decision to purchase the stock may still be valid. The proper course of action under such conditions is to stay invested. That’s where patience comes in handy. It safeguards us from the undesirable tendencies ignited by any uncomfortable feelings.
Patience comes from self-control – the ability to restrain our emotions and desires. Patience is a form of self-control that empowers us to overcome impulsive tendencies triggered by uncomfortable feelings. Self-control doesn’t come naturally to us. We are naturally impulsive and are inclined to seek instant gratification. Self-control requires deliberate effort. Successful individuals employ various strategies to exercise self-control while pursuing their long-term objectives. Distraction is the simplest one: take a break, go for a walk, watch comedy TV shows, or read a book. Time will fizzle out the impulsive tendencies. Mentally simulating various courses of action and their consequences is another way to exercise self-control. Mental simulation helps us make better choices by showing beforehand the damaging effects of impulsive actions. The better option always is to delay gratification now, so that we can enjoy greater benefits in the future.
Patience helps us overcome the influence of short-term market vagaries on our investment decisions. Self-control helps us stay on the right course, which is to focus on the long term. But they aren’t enough for successful investing. In investing, the outcome we aim for depends on future events. The future is uncertain. Most of the time, things won’t work out as expected. There will be setbacks. We will make mistakes. Many lack the motivation to continue striving for their goals amidst obstacles and setbacks. However, that is precisely what we need to succeed at investing. There is nothing more challenging than consistently making money from the stock market. We will have to persevere greatly to succeed in investing.
Personally, I would have to examine at least ten ideas before arriving at an idea that is investment-worthy. That means I would have to explore a hundred ideas to identify ten investment-worthy ones. However, even if I invest in all ten investment-worthy ideas, only two of them are likely to deliver superior returns. Return-wise, that might be enough: the superior gains from the two successful ideas would more than make up for the underperformance of the other eight ideas. However, the odds don’t look good in terms of effort. I had to examine a hundred ideas to discover the two successful ones – a success rate of only 2%.
Mastery through experience and practice may increase the success rate to maybe 10%. Still, 90% of our efforts yield no significant results. Living through such unfavourable odds is excruciating. Without a necessary degree of perseverance, most would abandon the endeavour very early in the process. However, it is intriguing that, despite the extremely unfavourable odds in terms of effort, a very few persevere and succeed. What differentiates the very few from the larger others?
You are more likely to persevere if you love the process more than the results. If you love analysing companies more than the investment gains that effort would eventually bring, then you are more likely to stay on the course than those who care only about the investment gains. Passion aids in perseverance. If you are not passionate about investing, then find someone who is.
Investing is a money game. We keep score in investing by the amount of money we make. But the money factor is a cause of predicament as well. We are likely to make erroneous judgments about our passion for investing by misinterpreting our desire for financial gain as a genuine passion for investing.
An objective examination of our actions in the market could help us out of the predicament. Where do you spend more time: Checking the market prices of various indices and stocks several times a day? Or evaluating the investment prospects of a few stocks by analysing their business, financial performance, and valuation? The more time you spend on the latter, the more likely you are to be serious and passionate about investing.
Empirical evidence strongly supports the imperative of a long-term investment perspective for achieving durable investment success. However, adhering to such a perspective is not as easy as it may seem. The biggest hindrance is our proclivity towards instant gratification. A long-term perspective could be maintained only through deliberate effort. The qualities of patience, self-control, and perseverance should complement the effort. Science has proven that our brain is malleable, which means these qualities need not be inborn; they can be nurtured.
Narrowly Diversified Portfolio
Stocks have delivered the best returns among major asset classes for over two centuries. They have outperformed other asset classes, such as bonds, gold, commodities, and real estate, by a wide margin. However, during good times, not all stocks performed alike. Most of the leading stocks of today never existed three decades ago, and most of the leading stocks from three decades ago don’t exist today. Moreover, there were also times when stocks overall performed poorly relative to other asset classes. Stocks have experienced significant drawdowns on multiple occasions, resulting in substantial losses for investors, including the periods from 1929 to 1932, 1973 to 1974, 1987, 2001 to 2003, 2008, and the early 2020s.
We don’t know which stocks will perform best (or poorly) in the coming decade. We also don’t know when (or whether) stock markets will experience significant drawdowns in the coming decade. However, the risk is real, and for investment success, we must put guardrails in place to mitigate it.
A diversified investment portfolio can significantly reduce this risk. By limiting an asset’s share in the portfolio, diversification limits the adverse impact on portfolio returns if the asset performs poorly. The very small-sized stocks that we typically consider for our portfolio are often regarded as high-risk stocks. If things go well, these stocks could deliver a 5- or 10-fold return on investment. However, if things go badly, these stocks may face massive drawdowns, say 60 per cent or 75 per cent.
An effective investment policy should achieve two contrasting goals. The primary goal is to capitalise on the high return potential of equities. The second goal is to provide resilience to the portfolio against significant price declines during challenging market conditions. Both these goals could be achieved through a diversified, equity-oriented investment portfolio.
However, simply spreading out your investments among several stocks or assets won’t suffice. Diversification is much more than that. The spreading out should be done wisely so that the correlation between the portfolio’s individual constituents remains minimal.
Firstly, we must clarify what diversification can deliver. Diversification cannot obliterate investment risk; it can only reduce risk to a certain extent. Basically, there are two kinds of risk: market risk and individual asset risk. Diversification, when done correctly, is effective in reducing only the risk associated with individual assets. In other words, don’t count on diversification to minimise market risk.
An investment has two sides: return and risk. In our quest to deal with risk, we may lose sight of the return side. As we increase the number of stocks in our portfolio as part of diversification, adding more stocks beyond a certain threshold won’t help reduce risk. Research indicates that this number is around 40 to 50 stocks. However, the problem is that building a 50-stock portfolio involves considerable effort; it would require a team of analysts to develop and maintain such a portfolio. Despite that, even if we create such a portfolio, its return is unlikely to deviate much from the average market return. Buying passive index funds would suffice for market returns. Active investing should provide alpha (superior or above-average market returns). But too much diversification, in a sense, hampers the likelihood of alpha.
Risk is the possibility of incurring a loss. Market participants generally use market volatility as a measure of risk. The more volatile a stock’s price is, the higher the stock’s risk. Likewise, the lower the price volatility, the lower the stock’s risk. However, market volatility reflects the market participants’ perception of risk. The actual risk may differ from the generally perceived risk. Anyway, to achieve alpha, we must learn to endure a certain level of short-term volatility.
The traditional 60:40 portfolio – 60% in stocks and 40% in bonds – was designed to safeguard the portfolio against market volatility as bonds are less volatile than stocks. However, during periods of rising interest rates, both stocks and bonds underperform. Bond prices might fall less than stocks then, but that doesn’t provide much protection to the portfolio. Instead, cash or short-term deposits could have provided much more resilience to the portfolio. It is better to purchase bonds for their investment merits, rather than as a shield against market volatility.
Diversification is a risk mitigation strategy. However, most of the spreading out of investments fails to deliver on the intended purpose. Those portfolios that succeed in lowering risk meaningfully through diversification, on the other hand, may fail to deliver on their promised returns.
I have shaped my own version of a diversified portfolio, which may not be considered diversified by some. It involves spreading out investments, but very narrowly. It consists of only two asset classes: stocks and cash equivalents. The strategy involves identifying four to five high-conviction stocks and allocating 10% of the portfolio to each of them; the remaining portion of the portfolio is invested in cash equivalents, such as short-term bank deposits, savings deposits, or liquid funds.
Limiting the number of stocks in the portfolio to five or fewer at a time is vital to the strategy. It is easy to keep five stocks in our mind without overburdening the mind. The high share of cash equivalents in the portfolio provides the essential stability, saving you from sleepless nights.
The high conviction strategy requires an in-depth and time-consuming analysis of each stock’s prospects. High conviction in a stock’s return prospects does not mean we are certain in that prospect. That would be arrogance. Investing will always be a game of probability. Certainty is the enemy of an investor. Conviction means ‘’Highly Likely” on a probability scale. As we observe several favourable factors during the analysis, we attain a high degree of confidence in the stock’s potential to deliver superior returns in the future. That’s how conviction is achieved.
For me, conviction in a stock’s prospects comes from a superior gross profit margin, strong cash flow, enterprising capital allocation, and high revenue growth. Some may be bewildered by the absence of the ‘profitability’ factor in the conviction list (Profitability measures the return a company generates on a unit of capital or revenue. Accordingly, we have two principal measures of profitability: return on capital and profit margin).
Profitability is indeed the principal driver of a stock’s price. However, firstly, superior stock returns are less likely to come from stocks with high profitability. Instead, they are more likely to ensue from stocks with expanding profitability. The scope for improvement (or expansion) in profitability is limited when profitability is high, whereas the scope is higher when profitability is at a lower base. Secondly, profitability is an effect, the cause of which lies in the conviction list: superior gross profit margin, strong cash flow, enterprising capital allocation, and high revenue growth.
The policy of holding a large part of the portfolio in cash equivalents may appear counterproductive at first-level thinking. However, the policy has subtler benefits, in addition to its primary purpose of risk management. The notion that staying fully invested in stocks increases our chances for higher returns stems from a lack of understanding regarding the complexity of real-time investing.
Our choice of stocks for a fully invested portfolio differs significantly from that for a partially invested portfolio. The difference lies in the level of risk we are willing to endure. The type of small stocks we typically invest in carries high risk. The substantial buffer provided to our investment portfolio by holding a significant portion in cash equivalents fuels our readiness to invest in such risky small stocks. Without the buffer, we would have preferred safer stocks with more curtailed return prospects.
An analogy with our daily life could better illustrate it. Suppose someone whose personal financial situation is so tight that it is challenging to meet even the most essential expenses, such as food, shelter, clothing, children’s school fees, travel, and other necessities. His mind will be highly stressed, worried, and fully occupied with these things. However, if he had enough savings to meet his most necessary expenses for at least two to three years, his mind would be free of worry regarding the above physiological and safety needs. It frees his mind, allowing him to focus more clearly on higher-level needs, such as personal growth, career planning, health and fitness, relationships, family life, social respect, belongings, learning, or social connection.
Likewise, we derive a similar benefit by holding a significant portion of our investment portfolio in cash equivalents and limiting a stock’s exposure to 10% of the portfolio. It enables us to effectively capitalise on a stock’s high return potential without worrying about the risk it poses to the portfolio.
Contrarian Approach
Equity investors don’t benefit much by betting on the general market opinion. Even if they turn out to be right, they could deliver only mediocre to poor returns. For stock prices to rise in the future, we need more prospective buyers than prospective sellers in the market. However, if the general opinion is that stock prices are to increase in the future, then investors would have already loaded up on stocks to profit from the expected rise. This leaves a dearth of prospective buyers who could drive stock prices higher in the future. Therefore, when the event that is expected to drive stock prices higher materialises, prices won’t rise much due to a lack of buying power; those who wanted to buy it have already bought it.
However, as many have loaded up on stocks, we now have an excess of prospective sellers. They might try to book profits (if any) once the event has materialised. When many investors attempt to book profits simultaneously, stock prices tend to fall. Initially, the general opinion was that stocks would rise in value. Instead, they have fallen. All this drama suggests that following the general opinion in the hope of better returns often leads to disappointment.
It was a herd mentality that led us to adopt the general market opinion credulously. Herd mentality is a leading impediment to investment success. It persuades us to do what everyone else is doing. The fact that it is a natural human instinct makes it even more challenging to overcome.
We must be contrarians to achieve enduring investment success. Contrarian investors behave and hold opinions that widely diverge from the consensus. If not an outright rejection of public opinion, at least maintaining a sceptical attitude towards prevailing public opinion is needed. Opinions and beliefs once formed take time to change, even after the facts and reasons that led to those opinions and beliefs have ceased to exist. Once we have formed an opinion or belief, we tend to reject any new information that contradicts it. In psychology, this is known as confirmation bias. Being a contrarian helps identify the changed reality.
The current market price discounts the prevailing opinion about market prospects. Even if the prevailing opinion may have become irrelevant due to changed market realities, investors take time and only gradually embrace the new market reality. Therefore, it takes time for market prices to reflect the changed market realities fully. The investment advantage lies in recognising the changed reality early on, before it is reflected in market prices. This ‘recognising early on’ is not an easy task. Only a contrarian stands to have a chance of doing that.
Being contrarian doesn’t mean holding an opinion that is just the opposite of the consensus and then betting on it. That would be foolhardy. The contrarian perspective should have strong factual underpinnings.
Stocks that trade at high valuations do so due to investors’ high expectations about the stock’s future earnings. Those expectations may or may not be met. The stock outperforms if earnings exceed expectations; the stock underperforms if earnings fall short of expectations. Therefore, the ability to form real expectancies is essential for investment success.
Stocks are part ownership in a business, and businesses are going concerns, which means their fundamentals and prospects are constantly in flux. Therefore, it is a costly mistake to form rigid expectancies about any stock’s prospects. An astute investor must continuously recalibrate their expectations about a stock’s prospects in response to changes in the stock’s fundamentals or general economic conditions.
A contrarian investor first deciphers the general opinion about a stock’s prospects from its valuation and price performance over the past few years. Low valuation and low returns in recent years suggest a general opinion of poor prospects; investors usually disregard these stocks. High valuation and high returns in recent years indicate a general opinion of high prospects; these stocks are investors’ favourite stocks. The contrarian investor then analyses the stock extensively for facts that could feed a different opinion.
Most of the time, the general opinion about a stock or the market is correct. If so, the contrarian investor does nothing, since no significant gains can be achieved by going with the general opinion. Successful contrarian investing involves identifying higher prospects when the general opinion is low or identifying lower prospects when the general opinion is high. Profits are made when these discrepancies are eventually corrected.
Inaccurate expectations are formed when judgments are based on emotions and biases rather than objective evaluation of facts, evidence, and reasons. Being aware of the presence of emotions and biases is the first step in countering their harmful impact on our judgments. There is no awareness when consumed by emotions. Emotional awareness ensues from a detached observation of our mental state, from the understanding that we are not our emotions. With awareness comes control, and with control comes the power to choose our intellect to guide our behaviour.
However, employing intellect in the situation also presents challenges. Biases, in various forms, could distort our thinking and reasoning. Although we invest to make money, the desire for money itself can be a cause for biased thinking, causing us to overlook otherwise obvious risks. Jumping to conclusions, confirmation bias, and wishful thinking are a few ways biased thinking happens.
Mitigating biased thinking begins with awareness. Making the information more diverse and slowing down the analysis and decision-making process can help reduce bias. There are certain things we can see only when we slow down.
Investors make investment decisions based on a stock’s future earnings power. They pay higher prices for stocks that are forecasted to generate higher earnings in the future. The more visible these future earnings are, the higher the price they are willing to pay. Likewise, stocks forecasted to generate lower earnings in the future are accorded lower prices in the market. Moreover, the less visible these future earnings are, the lower the price accorded. However, historical analysis of stock price performance over the past hundred years in different countries has shown that lower-priced stocks consistently outperform the general market, while high-priced stocks consistently underperform the general market. Such obvious empirical evidence reinforces the imperative of maintaining a contrarian outlook for durable investment success.
Markets almost always invalidate investors’ expectations about future market performance with their actual performance. The cause of this failure lies with investors’ psychology. Most investors are overconfident in their ability to forecast future earnings growth and profitability. However, extensive and long-ranging statistical analyses have shown the pathetic record of most market forecasts in predicting the future. But those results haven’t in any way sullied investors’ overconfidence in their ability to forecast future earnings and profitability. They continue to forecast earnings very far into the future, have high confidence in their forecasts, and place their investment bets accordingly.
A contrarian doesn’t try to make accurate market forecasts. Instead, he is aware of investors’ proclivity to overreact to market events and their overconfidence in forecasting future earnings. A contrarian attempts to achieve superior returns by taking advantage of the market price discrepancies caused by investors’ psychological shortcomings.
Rephrasing David Dreman, the leading apostle of contrarian investing: “It is almost impossible to forecast future market events accurately. As a contrarian, don’t you ever try it. However, there is a predictable pattern in how investors react to those market events. Emotions and biases drive those reactions. Restrain yourself from reacting in those predictive ways. Instead, understand those patterns and take advantage of them, because there lies the edge towards a durable investment success.”
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