All of us agree that equity investing is complex.
It must be. Else why would there be only few success stories.
Theoretically though, “if you are buying a well managed, growing business, at a right price, stock will perform”
The above statement somehow doesn’t sound as complicated. We all do understand –
- traits of a well managed business;
- meaning of growth; and
- basics of valuation
We therefore, are capable of identifying good investment opportunities.
So why and how do we drift?
I looked for an answer based on my own experience. I came across many factors contributing towards the drift – greed, fear, over confidence, blind faith, envy, undue influence and the superiority complex.
- Bought something out of greed given the underlying momentum and ignored the exorbitant valuations.
- Sold something to book quick profits, though the Company continued building on strengths.
- Bought something because management with average track record was promising the moon.
- Sold something based on few qtrs of natural headwinds in the sector.
and so on and so forth.
Natural human tendencies in each of the above drifts were easy to note. The difficult part was how to overcome or mitigate those.
One needs something easier to try manage such vastly different divergencies; sort of an EASY HACK.
and to me that hack is COMMON SENSE.
Failure to apply it was a theme that was running across every drift.
Let me list below some situations, demonstrating how Common Sense may mitigate the lapses. Checkout if you can relate.
1. Management has announced a clear path towards profitability over the next two years. It’s a buy.
The immediate common sense question should be why you should be looking at a loss making entity at all. It is not making actual profits (certain) and only predicting profits (uncertain). Margins is a separate discussion.
The next common sense question should be – there are so many other businesses available to invest with a track record of delivering profits. Why not them?
You may argue, that the newly profit making company can generate higher stock returns. However, check whether you have any special insights here or only going by what the management is telling you. If the former, you are taking a calculated punt. If the latter, there is a greater risk of you getting punted.
Other common sense checks could be –
- Management spoke about turning profitable 5 years back also. Why did it not happen since then and why will it happen now?
- Management’s prediction is widely known. Won’t the prediction be already discounted in the current price?
- Which are the other comparable companies in the industry that are already making profits and why?
- Even if the Company turns profitable, would that be sustainable and if yes, would it be able to quickly achieve respectable margins?
2. A big corporate with deep pockets is entering into this sector. Competition will be tough going forward. Let me exit and book profits on one of my best performer before it’s late.
These kind of talks have increasingly become common in India after Jio disrupted the telecom sector. If they can do it in one sector, why not in others. They have deep pockets.
In my personal view, this is typical market noise and over generalisation.
Some Common Sense checks here could be –
- Is it really true that whenever anyone with deep pockets enters a business, others shut or become laggards for ever? How many cases do you actually remember?
- Your fear is based on some well thought through analysis for the concerned sector or only based on fear?
- Regulations, execution, brand loyalty, quality, R&D – lot of factors impact a business and not everything can be played through money.
- Does my business (the stock that you own) has any strong moat and piercing that would not be easy? E.g., customer habit of using my product or the undivided laser sharp focus of my promoters.
Many of you may argue that it’s better to be safe than sorry. Why should I take any chance? I will exit now and buy back later if my Company is able to weather the storm. The stock price has anyways corrected by 20% since the announcement came. The more I wait, the more I lose.
In my personal view, all the above statements are reflective of the market noise. Neither do they factor in the strength of the invested business nor the strategy of the new entrant.
A common sensical approach here may be needed more than ever.
3. My Company is being over conservative, sitting on cash and not buying anything new. The competitor on the other hand is aggressively buying across. Let me switch.
We all love action and want our companies to be in the news and buying/ launching new things.
We anyways have studied about the relevance of efficient capital allocation. Companies sitting on cash should either utilise that to expand or distribute it back to the shareholders – else they are pulling down the shareholder’s returns.
Result – boring conservative managements lose and aggressive risk taking managements win… in only perception though !
Before arriving to this ill informed conclusion, it may make sense to check –
- Is competition overpaying for acquisitions and your Company is actually safeguarding your interest by not doing so?
- Has the capital structure of competition become more risky because of too much expansion and your Company is better placed to generate a stress free sustained business growth?
- Is your Company being lazy or being conservative? Former is a red flag, whereas latter will mostly work out well.
- What exactly is the management’s reason for not returning cash to the shareholders? Siphoning (bad), manage working capital volatility (good), reserves for selective value acquisitions (very good).
You may argue that in today’s world one can not expect to buy cheap. Company by not utilising it’s available cash aggressively is weakening itself against the competition.
I personally don’t agree to this logic. Future group’s aggressive growth vs Dmart’s build up over the years is a relevant example to think and decide for yourself.
Above 3 are only example situations to demonstrate the importance of asking common sensical questions.
It helps cut the clutter, see through the noise and maintain the calm. It helps much more than any complex world changing analysis.
- For DCF, you have assumed a 25% annual growth rate for the next 5 years based on company’s annual growth rate of 35% in the last 5 years.
- Have you thought that as the base grows bigger, even 25% may be too high?
- On expected growth and last three year’s average trailing P/E multiple, the stock seems to be 50% undervalued.
- Is last 3 yrs trailing multiple double of last 20 year average multiple and is because of recent momentum in the overall sector? The sector was under owned and now institutions may have gone overboard.
- Everyone is recommending this stock, including veterans on news channels and social media. Business performance of the Company anyways is rocking.
- Can it be a pump and dump strategy?
- Does recent business performance include any one offs or is a result of any temporary trend (e.g., post Covid pent-up demand)?
- If everyone already knows about everything, won’t the stock price reflect that and hence is already trading at fair value?
- Have looked through everything, company is surely going to turnaround soon and this is the future.
- What has been your own experience of making money on the turnarounds?
By now you would have got the essence of the post.
To me, asking basic wins every single time. Sometimes it throws open the best of the opportunities and sometimes helps mitigating worst of the risks.
I am sure, you would have your own interesting experiences. Please feel free to share privately on my email or publicly in the comments section.
Do always remember, “Common Sense is Not So Common”
Happy Investing !
Other articles you may find interesting –
Discipline in investing – a known unknown concept
Every Stock has a Unique Character.. and it really matters !
What management wants me to know VS what I actually want to know !