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Do You Believe in This Investment Myth?

Jan 27, 2016

In this issue:
» Solid growth in the global car market in 2016
» Markets could see a crash similar to that in 1987
» ...and more!
0:00
Madhu Gupta, Research analyst

The current spell of volatility in the stock markets has left the lay investor confused. Almost every analyst worth his mettle is busy prophesying about the markets. And in this hullabaloo, the lay investor is at his wit's end trying to make sense.

The other day, my friend was reading a stock report by a brokerage firm. He seemed very impressed by the complex calculations the analyst used to support his view.

I asked my friend if he understood the company's business model. He nodded hesitatingly but asked me to explain it to him. Honestly, the workings were compelling. But vouching for its reliability was anything but simple for me.

My friend was unfazed. For him, the reliability of a report is directly proportional to its complexity.

So I told him a story on the Japanese philosophy of Kaizen that was shared by a speaker in a motivational workshop. Kaizen is the process of improvement through a series of continuous small changes.

A factory manufactures children's toys, which are packed in cardboard boxes for shipping. The mechanised assembly line sometimes accidentally packs and ships empty boxes.

To solve this problem, the manufacturer seeks expert consultation. A technical expert quotes a princely sum to make complex structural changes to the assembly line. But a Japanese consultant offers to solve the problem at a fraction of the cost.

As the business is going through a lean phase, investing in a significant technological overhaul is unaffordable. Left with little choice, the company reluctantly chooses to go with the Japanese consultant.

After studying the assembly line, the Japanese consultant places huge fans at strategic locations. These fans blow away any empty boxes exiting the assembly line. This simple solution completely eliminates the problem...and that too at a minimal cost.

The story drives home the point that complex and costly solutions need not always be the most effective.

In the world of finance, models, even elaborate ones, cannot accurately predict the future. In fact, often they are way off the mark.

But people are so impressed by complexity that they rarely question its efficacy. More often than not, though, complexity is a reflection of the analyst's limited capacity to understand business dynamics. And falling for this myth that complexity is always and everywhere good can be costly.

Albert Einstien said, 'If you can't explain it to a six-year old, you don't understand it yourself.'

Warren Buffett believes in investing in businesses that he understands completely. According to him, 'Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.'

The lay investor should not blindly rely on complex models that may well be value traps. Rather, his focus should be on understanding the business and its moat.

Have you ever been fooled by the complexity myth? Let us know your comments or share your views in the Equitymaster Club.


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3:03 Chart of the day

One of the factors that gives an indication of the health of any global economy is the sale of automobiles. So in this regard, how have the countries fared in 2015?

One way to analyse this is by looking at the new registrations for passenger cars. As reported in The Economist, and evident from the chart below, the results paint an interesting picture.

Take Europe for instance. The EU countries are battling high debt, prolonged recession and rising unemployment. And yet, growth in the car market was quite strong in countries such as Spain and Italy.

China is another interesting point. Growth in the car market in the dragon nation has considerably slowed. It must be noted that China is largely a luxury car market as compared to India, which is more of a small car market. And the growth of luxury cars in China has particularly been hit hard on account of the turmoil in the Chinese economy and its stock markets. This was evident in the results of Tata Motors' Jaguar Land Rover (JLR) operations as well. Indeed, for JLR, China was a very important market and had witnessed robust growth in prior years. Thus, the contribution from China to JLR's revenues rose steadily over the years. This changed last year when the crisis in the country hit the volumes very hard, thereby impacting JLR's overall performance in the market.

The Indian car market has also been slowly limping back to recovery although some segments of the industry remain weak. But volumes will likely jump up once the Indian economy starts growing at a faster pace.

By the way, our colleague, Vivek Kaul, who takes a close look at the economy in his Diary, shared some very compelling statistics on passenger car sales and its relevance to investors, in the latest Equitymaster Conference. In case you have missed listening to him in person, you can get online access to the video recordings of the Equitymaster Conference 2016.

Solid growth in the global car market in 2015

4:01

The start of 2016 has not been a particularly good one for the global stock markets. The country grabbing the headlines has been China. Slowdown in the Chinese economy coupled with the plunge in global oil prices have sent the markets the world over in a tailspin.

In fact, Marc Faber, publisher of the Gloom, Boom & Doom report, has gone one step further and stated that markets could see a sudden crash similar to the one in 1987. That was when the Dow Jones fell around 23% in a single day.

In his interview with CNBC, Faber opined that the markets will remain very volatile because interventions with fiscal and monetary policies, instead of lowering volatility will only postpone it.

Indeed, the US Fed may have raised rates by 0.25% for now. But is quite likely that should there be any hint of turmoil or weakness in the US, the Fed will go back to its near zero interest rate policy. This is something that Bill Bonner - Founder of Agora Inc, and Ajit Dayal - Founder of Equitymaster highlighted very distinctly in the recently concluded Equitymaster Conference 2016.

Given that most of the stock market gains have been a product of expansion in credit, and money printing policies of the central banks, bouts of volatility are here to stay for some time to come.

4:45

Indian equity markets had a volatile trading session today as they barely managed to stay afloat for the larger part of the day. Buying activity, however, intensified post noon. At the time of writing, BSE Sensex was trading higher by 121 points and NSE-Nifty was trading up by 36 points. Mid cap and small cap stocks found favour too and were trading higher by 1% each.

4:55 Today's investment mantra

"If the job has been correctly done when a common stock is purchased, the time to sell it is almost never."- Philip Fisher

This edition of The 5 Minute WrapUp is authored by Madhu Gupta (Research Analyst) and Radhika Pandit (Research Analyst).

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Equitymaster requests your view! Post a comment on "Do You Believe in This Investment Myth?". Click here!

2 Responses to "Do You Believe in This Investment Myth?"

jins

Jan 28, 2016

Your take on Kaizen is one of the best articles I have ever read.It has really enlightened me. I will make it sure to note it down in my checklist.

Like 

Sadasivan

Jan 27, 2016

As far as stocks are concerned look for the following:-
1.Debt-Free Cos
2.High Cash Flow Cos

Like 
  
Equitymaster requests your view! Post a comment on "Do You Believe in This Investment Myth?". Click here!
DISCLOSURES UNDER SEBI (RESEARCH ANALYSTS) REGULATIONS, 2014
INTRODUCTION:
Equitymaster Agora Research Private Limited (hereinafter referred to as "Equitymaster"/"Company") was incorporated on October 25, 2007. Equitymaster is a joint venture between Quantum Information Services Private Limited (QIS) and Agora group. Equitymaster is a SEBI registered Research Analyst under the SEBI (Research Analysts) Regulations, 2014 with registration number INH000000537.

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DISCLOSURE WITH REGARDS TO OWNERSHIP AND MATERIAL CONFLICTS OF INTEREST:
  1. 'subject company' is a company on which a buy/sell/hold view or target price is given/changed in this Research Report
  2. Neither Equitymaster, it's Associates, Research Analyst or his/her relative have any financial interest in the subject company.
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Definitions of Terms Used:
  1. Buy recommendation: This means that the investor could consider buying the concerned stock at current market price keeping in mind the tenure and objective of the recommendation service.
  2. Hold recommendation: This means that the investor could consider holding on to the shares of the company until further update and not buy more of the stock at current market price.
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