If You Want High Returns from Stocks... Look for the Dog that Doesn't Bark

Are you a fan of Sherlock Holmes?

I am. It's a fascinating series.

Sir Arthur Conan Doyle created the most popular fictional detective of all time.

My colleague Kunal, wrote to you about his admiration for Sherlock. It has helped him follow and learn from India's super investors like Professor Sanjay Bakshi.

One of Doyle's short stories I like is The Adventure of Silver Blaze. The story deals with the disappearance of a popular racehorse the night before the race.

A conversation between Sherlock and Inspector Gregory, who is investigating the case, gives us a sneak peek into his mind.

Inspector Gregory: Is there any point to which you would wish to draw my attention?

Sherlock Holmes: To the curious incident of the dog in the night-time.

Inspector Gregory: The dog did nothing in the night-time.

Sherlock Holmes: That was the curious incident.

Sherlock observed an event that had not happened and deduced a conclusion based on it.

Since the dog didn't bark, it meant the suspect was someone the dog was familiar with. It implied the criminal was an insider...and not a stranger.

How can you use Sherlock's insight in the world of investing?

Sometimes, what doesn't happen is as important as what does.

2017 was such a year. You could close your eyes and pick any stock. Most would've performed well.

We had a lot of queries from our subscribers as to why we were avoiding certain stocks which were potential multibaggers.

But we had seen what hadn't happened yet...

We had met the management of many of these so called 'potential multibaggers'.

The meetings helped us see what was invisible to the outside world.

Thus, we avoided stocks like Vakrangee which is down 81% as I write this. We might have looked foolish in the short-term but the tanking of the stock validated our judgment.

You can do this too.

How?

Look for something that's obvious but which is ignored by almost everyone.

Here's a nice example...the banking sector in 2008-09.

The best banks at that time were the ones that did not grow.

Why?

Because these banks refused to lend to crony corporates when other banks were doing so.

As a result, they managed to survive the onslaught of bad loans that hit the sector a few years later.

The cautious banks reaped rich rewards and are now growing impressively.

How to Apply Sherlock's Idea in Your Personal Investing

Is a friend or family member shouting about how they made exceptional returns last year?

Do you get the feeling that you have missed the bus?

Be careful!

This is precisely the time when you could lose money. The fear of missing out (FOMO) can be strong.

When people see everyone, apart from themselves, making a lot of easy money, they tend follow the herd and disregard the obvious.

But this is usually the exact time that smart investors are making an exit.

Hoping to make a quick buck, the aam investor buys when the smart investor sells.

Then the inevitable happens. The smart guys win.

The stocks crash and the aam investor is left holding junk.

If you have experienced this, I understand. It can be painful.

But you can bounce back strongly. Relax.

Ignore the noise of the market and reject the stocks that are trading at expensive valuations. You will be back on the right track. More about this in today's chart below.

Just focus on buying quality businesses. Ask these questions...

• How does it make money?
• Is the market size or future potential huge?
• Who are its competitors?
• What is the management's past track record?
• Has the management rewarded shareholders in the past with dividends?
• Do the valuations of the stock justify the future potential of the business?

These basic questions will help you avoid junk stocks.

Once you've done that, you'll be focusing your time and energy on high quality stocks with good future potential, and able management.

Last week, I wrote to you about how a few big winners is enough to generate exceptional returns for your portfolio.

You don't have to chase every stock. Just focus on the best ones.

In Sherlock's immortal words: 'Once you eliminate the impossible, whatever remains, no matter how improbable, must be the truth.'

Chart of the Day

Do valuations play an important role in the returns that you get from stocks?

Yes.

We did a decade long comparison of the Sensex versus the its price to earnings ratio...and it certainly seems to suggest so.

Yesterday, Sarvajeet looked at the impact of US fed's rate hikes on the Sensex. Today we'll have a look closer home. We wanted to know how earnings drove the returns of the Sensex.

Sensex Falls When PE Rises Above 20

Price to Earnings (PE) is basically the price that you pay for earnings. A higher PE implies expensive valuations.

We found that the Sensex has fallen sharply whenever its PE moved above 20.

Conversely, PE levels below 15 have led to a sharp subsequent rally.

Such strong co-relation also proves that ultimately, it's valuations that drive future returns in the stock market.

You would thus be well served by focusing on fundamentals and valuations while ignoring the noise of the market. Tanushree Banerjee, editor of The 5 Minute WrapUp, can guide you in this endeavor.

Regards,

Girish Shetty
(Research Analyst)

PS: Have you heard about the Bombay Investing Society? It's a 16-year old society that has given more than 7,100 members stock recommendations with a success rate of more than 74%. And now this exclusive society is accepting new members. You too can join by clicking here...