Investing – Insights from an equity investor

To be an equity investor is difficult. For some, it can be downright scary. The fact remains that more people lose money in equity investing than make in it. Why is that so?

You see equity investing is a science. There is a whole lot of financial analysis and valuation methodologies that enable an investor to make decisions. Interestingly, it is an art too as it is subject to ‘views’ of individuals. The simplest example of it being an art is that one company can be valued very differently by two individuals.

The real magic of investing happens at the ‘horizon’ where the ‘art’ and ‘science’ meet.

I have been on the search to find real world investors who practice this amalgamation of ‘art’ and ‘science’.

By pure chance, I came across Balaji Sridharan, an equity investor who also has a full time job as a CXO of an organisation. Balaji has generously shared his approach and thought process on equity investing.

You might be investing in direct equity or via equity mutual funds or just be getting prepared to start your journey as an equity investor, I am sure you will benefit from his ideas. I have benefited for sure.

This is Part 1 of the note. You can read Part 2 here.

So, let’s read what Balaji has to share.

When I was asked to write an article on equity investing, I almost scoffed at the idea.

What expertise did I have over tons of other better equity investors out in the world? Why should anyone read this? Would they gain something different than reading the literature that is already out there?

Despite being skeptical about the above questions, I decided to write a report for the new investor in the hope there might one or two things that a new investor might add to the repertoire.

I like to think of myself as a value investor who considers growth as a key component of value. My portfolios are usually concentrated and I consider myself lucky if I get a few ideas in a year that make a difference. Using this simple approach, I have had a decent delta over the markets in India over the last five years.

However, in the article below, I have included examples from the U.S. market because I continue to hold a lot of the stocks in the Indian market that I would not want to publicly comment on.

Similar to all my stock ideas, I have decided to start out by listing down the risks and the possible downsides in what is discussed below. Value investing is simple but not easy. It takes time, discipline and patience. These ideas are not new. Furthermore, the performance over the last five years could be largely through luck or skill or a combination of both.

It pays for the readers to take the article with a pinch of salt and come to their own conclusions. Relying on someone else’s expertise or borrowed conviction in the investment game has proven to be injurious to health over a period of time. I would like to emphasis the reader to treat this as nothing more than an account of one amateur investor who could have been totally lucky over the last five years.

A few important questions for starters:

• Am I an above average investor objectively?
• Is investing worth my time?

These are questions every equity investor must ask himself and must do so at regular intervals.

The first hurdle is the illusion of superiority bias.

87% of MBA students in Stanford considered themselves to be above average and 91% of drivers in the USA considered themselves to be above average in two different studies. While it is mathematically impossible for more than 50% of the two groups to be above average, as the average will adjust to the new higher bar if a majority performs better than the prior average.

So, using a similar analogy, I know that I have beaten the market indices over the last five years handily but it begs to be questioned.

A.) It says nothing about the construction of the indices. If one goes by the number of mutual funds and investors who I know have beaten the market, there might be some truth to the fact that the indices are probably not as optimised as one thinks.

B.) Given A, it also is not clear whether there are enough investors who are not invested in the index, which may or may not be more than 50% of the investors out there.

While the thoughts have crossed my mind, I have not delved into the matter deep for one simple reason. I am not trying to be an above average investor, I am just an investor who has surplus capital. I know the after-tax returns that I will get from deposits and I can easily gauge the performance of an index that with no effort will give a certain return. If my returns are meaningfully over the index over a period of time, it is worth my time. Else, it is not. Easy. Your goal will determine the path you will take.

Does that mean I should not take the index seriously? You should absolutely treat the index with all seriousness. However, the index should merely act as a benchmark beyond which any effort into investing will prove to be useful as you can get the index return without any effort and invest time into something else more productive that  increases your capital.

What about equity mutual funds and fund managers? We will not go in a lot of depth here.

I have next to zero investments in mutual funds for the simple reason that with the expenses of the mutual funds it will be tougher to beat the markets. If a fund were to charge 2% annual expense ratio and if one were to consider long-term index returns to be say 12% (you can think 15%, 17% etc) then the fund manager needs to be 2% of AUM better annually just to break even with the market. Unless you are convinced that the manager brings in significant alpha to the game, one might be better off with the indices.

Furthermore, it rankles me that the mutual fund manager is just much incentivised to increase AUM as for performance. I use the words ‘just as incentivised’ and not ‘more incentivised’ as over the long term the AUM will also depend on the performance of the manager.

In addition, investing in a fund with a great history of returns might be akin to driving while looking in the rear view mirror. Not a good idea unless we are convinced that the manager brings special alpha to the table. It must however be noted that there are a quite a few mutual funds that have beaten the market in India over long periods of time. It raises more questions on the construction of the indices than the alpha of the managers in my opinion.

Are you ready to be an equity investor?

With little or no effort, one can invest in the indices or one can outsource the effort to equity mutual funds. If one were to look even beyond that and decide to invest in equity on one’s own, then it begs a few questions.

1. What is your edge over the market?
2. Are you open to the risk that you might discover that you are not better than the market over a period of years and the efforts might have gone down the drain?
3. Are you willing to pay the required tuition through the mistakes that are inevitable to happen and still perform above the market? Not expecting mistakes while investing on one’s own is similar to try and learn swimming through a postal course.

Let us address each one of these in that order.

Firstly, one needs to understand what is one’s edge over the market. The sources of advantages could be several. Focusing on the long term could be a potential source of advantage. There are too many people in the market focused on the next quarter’s earnings or the next year’s earnings. If one were to see the market from the long term perspective, there could be bargains that could open up. However, this needs another characteristic, which could be a second advantage.

–>Temperament and patience. The ability to focus on the long term while ignoring short-term performance will depend a great deal on the temperament and patience of the individual. The ability to wait and do nothing is a great source of advantage. Two out of the four biggest positions have been in my portfolios for close to five years now and the other two close to a couple of years and I am nowhere done with those. Lower the portfolio turnover, lower the fees and trading costs. It goes without saying that you also know your stocks much better.

Yet another source of advantage could be identifying exceptional capital allocators. Lots of investors are focused on identifying quality businesses but exceptional capital allocators can create exceptional value and potentially future quality businesses.

Being small is another source of advantage, as you don’t move the market prices when you buy stocks. If you don’t manage money for others and are not answerable for short-term results and your ego is not on the line, there is so much less pressure.

Yet another one would be to completely ignore macros. I personally don’t care about GDP, GNP, rate cuts. The only relevant macro metric I look at is after tax return of a 3 year FD as it is the base benchmark that I need to beat. When you combine some of these advantages, you get great results.

A specific example warrants attention here from the U.S. markets – Markel corp. is an exceptional insurance company with a very strong capital allocator in Tom Gayner. The market recognizes this and the stock always trades at a premium to book value. However, in Dec 2012, just for a couple of days, Markel Corp. traded at book value. We put close to 10% of all capital available to work then.  Here was an exceptional business, available at a great valuation, with a good capital allocator.

Note that the final action was preceded with a thorough study spanning several quarters prior where the research was done but the trigger not pulled on the stock. Our capital was small so we could buy without moving the price, our horizon was very long term (we still hold the shares), we were not worried about short term earnings. Markel bought Alterra and the market spooked for 2-3 days before realising what a great buy it was and we were okay with short term under performance of our portfolio because we have no outside investors.

The stock has since more than doubled. We have had tailwind from the INR depreciation against the USD. We have invested several times in both the Indian and the US markets to our advantage using similar principles.

Understanding one’s edge and using it appropriately is key.

The second question is about the risk that one might not be better than the market. Remember how we discovered that only 50% of the investors are better than the market.

After a reasonable period of time, three or five years or through the cycle, if the investor does not create value over the market, the time might be better spent outsourcing of investing in a market index. These objectives if decided upfront, written down and tracked will help the investor from the risk of discovering chronic under performance very late in the investing career. Personally, I track this on and off. With the XIRR method, now it is pretty simple for an investor to track his performance over a period of time.

The third question is whether one is willing to pay the tuition and learn from mistakes. This is a key source of learning. I keep an investment journal that keeps track of why I am buying and selling specific stocks. Writing down helps me crystallise my thoughts better. I realised early on that two-thirds of my decisions were wrong. Through deliberate practice, I have been able to reduce my errors to one-half.

It is key to not confuse the right or wrong with making money. A lot of the decisions that were wrong also made money. It is to fine tune the thinking process and see how it plays out over a period of time. It is amazing that with one half to two thirds decision being wrong, we have been able to beat the market handily. However, the decisions are related to only acts of commission (buying and selling).

There is another way to look at it. There were hundreds and thousands of decisions taken on act of omission. Not buying stocks (good and bad), not selling too early (good and bad). I do not have a good handle on the hit rate of that. However, the residual acts of omission on the holdings I have, turned in a good performance over the long term.

The other interesting observation is that with time, investing is a game that you get better in. It is amazing that Warren Buffett made over 90% of his wealth after he attained the age of 65. Make no mistake, none of us are Buffett but it raises interesting possibilities on what happens with deliberate practice and learning from one’s mistakes.

I have made mistakes with investing in companies that were outright frauds, my thesis was completely opposite of what happened later in the markets, I just got lucky with the timing of my buys in several cases. There are others that in my portfolio that have made a lot of money but I am still uneasy about the stocks.

Once you are past all these hurdles, then begins the question of how does one think about companies? Which ones do you invest in?

 

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Click here to read Part 2 of this article which will address this question.

Was this helpful? If you have any comments, please send to beowulfcapital@gmail.com. Balaji will try and answer your questions except stock specific questions.