Avoid taking these baby steps towards investing disaster

May 14, 2015

In this issue:
» Chinese companies make cosmetic changes to ride on the tech boom!
» Which companies are most favoured by the FIIs?
» A round up on markets
»  ...and more!

For someone who researches stocks for a living, I often get asked by friends and relatives where the stock markets are headed next. And mind you, I cannot be off by too much. It is as if there's some unwritten rule that the more time someone spends at the feet of Mr Market, the better his clairvoyance.

Little do they know that this belief works completely the opposite way. In other words, the more I've tried to learn about stocks the more I am convinced that predicting stock market movements, more so in the short term, is an utter waste of time.

However, try telling this to the people quizzing me and all I get in return are cold stares. I could almost hear them mutter under their breath 'What a loser'. No amount of convincing that all that matters in investing is buying fundamentally strong stocks at attractive valuations seems to change their opinion of me.

Well, to be honest, I don't really blame them. They are displaying the same ignorance I would in front of say a heart surgeon. Now, a surgeon knows fully well that a heart surgery is a complex procedure. And therefore irrespective of how much experience and expertise one has, there's no guarantee a surgery of the heart will be successful. Yet when asked 'Woh theek to ho jayenge na', a surgeon has to reply in the affirmative. Imagine a surgeon saying 'Thoda risk hai'. Chances are we will immediately shift the patient out and opt for someone who can fake confidence better.

It is apparent in both these and a lot many other instances that one never knows what risks the future will bring. And therefore being honest and rational about it and making people aware of the risks involved is the most sensible thing to do. Yet, the person airing this view is seen as a weakling. Someone who's lacking in control and confidence.

Therefore, put differently, you can't win the trust and confidence of your customers and clients by pretending you don't know the future. On the contrary, try putting on a little display of confidence. Act as if you can predict the future with pin point accuracy and you'll be well on your way to becoming a star.

However, falling into this trap is the worst mistake one can ever make. In fact, it is like taking baby steps towards a disaster of a huge magnitude. As noted psychologist Daniel Kahneman observes, it is important that an environment is created where uncertainty is treated with respect. Not doing this would mean that the system rewards the most over confident and not the most rational decision makers. In other words, let it be known within an organisation that one does not have to be right. Instead, one just has to know that one is not likely to be very right.

What this self-awareness will do is ensure that there are enough checks and balances in place. So that even if one is wrong, which one will be every now and then, the organisation is not wiped out.

Now compare this with a brash, overconfident CEO who assumes that he is right all the time and therefore takes big bets. Well, it doesn't take a genius to figure out which organisation has a better chance of surviving in the long term, isn't it?

In fact, value investing is one form of investing we know that gives uncertainty the respect it deserves. And little wonder, it has turned out to be one of the safest and most successful forms of investing over the long term.

It is not for nothing that Warren Buffett acknowledges the importance of the concept of 'Margin of safety' in trying to make him the success that he is today. As per him, his style of investing has certainly evolved over the years. But what hasn't changed one bit is his habit of never ever underestimating the ability of the future to throw up nasty surprises. And therefore, practicing buying stocks with a margin of safety in valuations and also ensuring sufficient diversification are the single most important investing habits an investor should develop.

And this is irrespective of how much confidence he has in his abilities to spot winners. This will ensure that he does not get wiped out when he is wrong. And besides, also have much better odds of winning the investment game.

What do you think? Tell us your ways of dealing with an uncertain future when investing in stocks? Let us know your comments or share your views in the Equitymaster Club.

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We just spoke about the steps one should take to avoid investing disasters. However, when it comes to making investing disasters, the Chinese give most investors a run for their money. This may appear a bold statement. But you would agree us if we told you what's happening with Chinese companies and how investors are reacting to it.

China is undergoing a corporate reincarnation of sorts. With slowdown in growth, manufacturing and real estate sectors have taken a big hit. As a result, many Chinese companies are diversifying their business into the tech space. There are expectations that government policies will benefit this sector in the long run. To ride on this fad almost any and every company in China is trying to venture into this hot sector. The euphoria is so huge that one pure manufacturing concern bought a gaming company just to mark its entry into the tech space. And this is not a one of case. In another example of complete hysteria, one loss making Firework Company changed its name just to reflect its entry into the tech sector.

Basically, companies are interested in conveying their tech presence to investors. For that, some are making unrelated acquisitions while some are just making cosmetic changes to their names. And the irony is that irrational markets are rewarding these companies with a rise in share price as a mark of their entry into the tech space. However, once the market gains sanity prices may nosedive as changing name doesn't change the fundamentals which are far from great. Let's see when this name recreation bubble bursts!

 Chart of the day
You would remember that just last week we shared an interesting anecdote about conversation between an Indian fund manager and Jim Rogers. The Indian fund manager presented constructive arguments to what Jim Rogers had to say about India. And one of the contentions that Jim Rogers made then was that exchange control rules were a big hurdle to foreigners investing in India.

Today's chart of the day shares an interesting perspective on this viewpoint of his. It shows list of companies that are most favoured by FIIs.

Are FIIs in love with these companies?

As seen, FIIs are literally in love with HDFC with a collective holding of about 80%. Next comes Tata Motors with a FII holding of 56% followed by the rest. The fact that these companies have huge FII holding indicates that exchange control rules are not as big a hindrance as they are made out to be.

However, the bigger question here is should retail investors also follow suit and imitate FIIs and buy these companies? After all, FIIs are informed investors and they have better tools at hand than an average retail investor to arrive at any investment decision. Thus, mirroring their bets appears safe on face value. However, it can turn out to be a risky endeavour for many reasons. For one, borrowed conviction is dangerous. Also, the risk profile, return expectations, time horizon and liquidity needs of an institutional and retail investor are completely different. Hence, simply aping what an informed investor does may not be the right thing.

The Indian stock markets were trading in the red at the time of writing. While the BSE Sensex was down by 235 points, NSE Nifty was down by 70 points. The Asian stock markets were trading mixed at the time of writing. European stock markets also opened mixed today.

 Today's investing mantra
"Confronted with a challenge to distil the secret of sound investment into three words, we venture the motto, Margin of Safety" - Ben Graham

This edition of The 5 Minute WrapUp is authored by Rahul Shah and Jinesh Joshi.

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May 15, 2015

A holistic approach of combing value investing and technical analysis has been followed by me.

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