Traversing from Observation to Analysis to Judgment Optimally
It is unfeasible for an individual investor to study each of the roughly four thousand actively traded stocks on the Indian stock market. Practical considerations require that we narrow our focus to a manageable selection of stocks where investment opportunities are more likely to be favourable. This would make the task manageable, but it doesn’t guarantee investment success. There are additional considerations that our investment process should address. These include establishing robust guidelines to help us avoid many common investment mistakes, ensuring only thoroughly investigated and well-understood ideas are selected to build the portfolio, and preventing our mood swings, caused by market volatility, from instigating unnecessary portfolio shuffling.
My investment process, whose precise nature I am unaware of, wasn’t intentionally crafted. Instead, it evolved naturally and gradually over the years. Something catches my attention; that’s how the process begins. It could be a stock price spurt, a consolidating stock price, an earnings revival, or even just the name of the stock or its industry. Typically, I follow up the hook with a glance at the stock’s price chart and financials in a stock database (for me, it’s screener.in) to decide whether to pursue the idea further. If my intuition finds sufficient merit to proceed, I gather and organise the relevant stock’s ten years of financial statements into a spreadsheet, observe for relevant patterns, and make judgments about its prospects in conjunction with information from its recent annual reports, earnings call transcripts, and investor presentations. The stock’s gross profit margins, revenue growth, cash flow, capital allocation, and valuation are key factors that primarily influence the final judgment.
My judgment about any stock’s prospects develops through a writing process that aims to enhance clarity by distilling observations and interpretations made during the analysis, and understanding their importance to the stock’s investment potential. I write from my initial observations through to my final decision. To me, the word count of the final draft indicates the depth and effort involved in reaching that judgment. Writing slows down our thinking, inadvertently uncovering valuable thoughts that might otherwise remain hidden. A written report makes it easier to generate more honest and thorough feedback later, whether the final decision results in poor or excellent outcomes. Writing also ensures that the final decision results from original, independent thinking.
A moderating business cycle causes a company’s revenue growth to slow and, probably, its operating profitability to decline. It is challenging to maintain a positive long-term outlook on the stock under such situations. How do we know these setbacks are transient and the stock’s long-term prospects remain positive? There must be a cliffhanger that allows us to maintain our optimism amid a short-term challenging period. The source of a stock’s earnings power is the optimal cliffhanger, and identifying it requires going behind the numbers. It could not be understood from what the numbers reveal, but only from what they hide. A high return on capital reveals a stock’s superior operating profitability, but at the same time, it might be hiding lower business investment, likely diminishing the stock’s earnings power.
To identify opportunities that could deliver superior investment return, we must look at where no one is looking. Or else, we must look at what everyone is looking at but see it differently. That’s the essence of being contrarian. However, a contrarian has a trade-off to make. He challenges popular and dominant beliefs at the cost of social recognition and reputation. The trade-off is between maintaining their contrarian mindset and protecting their social reputation. He cannot have both. A temperament to appear wrong before others, even if only temporarily, is essential for a contrarian. The period could last from weeks to months, or even years. As preserving a contrarian style within the mainstream investment community is going to be hard, a contrarian may have to stay on the outside or at the periphery.
A contrarian investor seeks investment opportunities in assets or stocks that are undervalued, overlooked, ignored, or underinvested by the mainstream investment community. These stocks tend to show poor recent returns and low valuations, reflecting the standard view of limited prospects. However, some of these stocks’ actual prospects may differ from the general perception. Only a contrarian investor who challenges the prevailing view could find opportunities among these stocks. By focusing on stocks with poor recent performance and low valuations, we can increase our chances of discovering valuable investment opportunities. A popular stock, even if it has high growth potential, trades at a very high valuation by virtue of being found by most, and thus has poor return prospects despite strong earnings power.
Being unconventional and contrarian is the only reliable route to sustained investment success. It requires courage and perseverance to be contrarian. Being contrarian and unconventional doesn’t just mean going against the consensus. Every move or strategy should have strong underpinnings in fundamental investment principles.
“If you haven’t made any mistakes in your life, then it means you have done nothing in your life”, a quote often attributed to Albert Einstein, gains importance here. A collegial relationship with mistakes can significantly improve your investment process and make you a better investor. A prudent investment process shouldn’t prevent all mistakes; instead, it should encourage risk-taking and new mistakes while avoiding repeated mistakes. At the start, I said my investment process evolved gradually and naturally. Evolve means progressing to a higher, better state. It was my mistakes that fuelled the evolution of my investment process. My current process and strategy may seem archaic compared to those of most contemporary professional investors. Yet it is far improved from what it was three, five, or ten years ago. I, too, have changed along the way, arguably for the better.
In investing, if someone is so sure about something, there is probably a problem. The outcome of every investment decision hinges on future events, which are inherently uncertain. Investing is a game of probability, and if prominent mainstream guys start treating it as a game of certainty, it’s time to increase caution. We should always remain open to the possibility that our assumptions, beliefs, and interpretations could be wrong. The act of just thinking about the many possible ways we could be wrong – that itself can significantly improve the quality of our decisions.
Growth becomes difficult for a company if the industry it operates in lacks opportunities, even if the company itself is capable and prepared. Studying only what happens within a company won’t give a proper understanding of its growth potential; this is only possible when the company’s developments are assessed within a global context. Extensive reading, observing, and listening on the economy, business, and financial markets—through national and international newspapers, magazines, books, expert interviews, blogs, and podcasts—can enrich your understanding with valuable information on related, closely related, broad, and diverse subject matters.
A historical context can complement this global context. Here, we aim to understand the importance of recent company developments by comparing them to similar past situations. Suppose that a company announces a significant capital expenditure. Analysing its previous capital expenditure cycle shows that its operating profitability, and consequently its stock price, declined during past periods of capital expansion, suggesting a challenging period ahead. An investor lacking this historical insight would have interpreted the significance of the latest capital expenditure initiative quite differently.
The essentiality of an effective investment process for investment success is not confined to professional investors who must choose between stocks and build portfolios. A process can be helpful for less sophisticated investors as well, who prefer to delegate their portfolio management decisions to outside managers. Instead of asset allocation and policy decisions, their process is more concerned with evaluating managers to choose the best suited to achieve their return expectations, understand their risk profile, and fulfil their spending objectives.
Most investors make the mistake of evaluating managers based on recent performance, which is unfortunately the worst way to assess an investment manager. Suitably, the manager’s investment approach and character traits should prevail over his performance. Most managers choose to stay safe by closely mimicking benchmark indices, which, sadly, guarantees mediocre returns. Society plays a significant role in encouraging managers to choose conventional routes that effectively eliminate the possibility of superior returns. Society is less harsh to those who fail conventionally, while it effectively ostracises those who fail unconventionally. You can keep your job if you fail conventionally, while you lose your job if you fail unconventionally; which will you choose?
Investors wishing to delegate their portfolio management decisions to outside managers would do well to evaluate possible manager candidates based on their investment approach rather than solely on their investment performance. The approach should be return-oriented rather than fee-oriented; unconventional and contrarian; long-term-oriented rather than short-term-oriented; and, at the same time, thoroughly rooted in fundamental investment principles.
The main issue with selecting managers based on performance is that consistent, exceptional results are nearly nonexistent; good performance often follows poor performance, and vice versa. Investment success depends on how much you gain when you are correct and how much you lose when you are wrong. Choosing and replacing managers based on recent results leads to buying high and selling low, which would have disastrous consequences. Our performance tends to lag behind benchmarks and the manager’s overall track record because we buy and sell at the worst possible moments.
Let an investment approach based on fundamental principles such as long-term focus, diversification, and contrarianism guide your investment decisions. Then, there is no need to switch managers due to short-term performance issues. A meaningful relationship, developed over time through several face-to-face interactions and founded on mutual trust and understanding, makes this possible.
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