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Ignore this 'Amitabh Bachchan' stock filter at your own risk

Apr 15, 2015

In this issue:
» Does it still make sense to invest in mid, smallcaps?
» BoFA: 6 in 10 chances that US markets won't fall in an declining earnings scenario
» Round up on markets


00:00
Recently, while doing some random search on a leisurely Sunday, a rather interesting looking list grabbed my attention. It was the list of some of the top Bollywood dialogues of all times. Guess which actor had the maximum entries in the list? Amitabh Bachchan of course. His is a visage and voice tailor made for delivering great dialogues don't you think. And over the years, producers and directors have milked these attributes of the Big B to the maximum in my view.

What is an article on dialogues and Bollywood doing in a space dedicated for sensible long term investing you would ask? Well, just as dialogues have come to be the heart and soul of a lot of Bollywood movies, a dialogue holds an important place in your investment process as well.

Don't trust us? Just ask Charlie Munger about this. Apparently, Buffett's right hand man is convinced that having a dialogue about investments with another like-minded investor brings in tremendous value. And mind you, his discussions around investments weren't always with Warren Buffett. It's just that he always had someone to talk to. As is usually the case with Munger, his reason behind doing so is as fully seeped in logic as ever.

You see, our brains are unique in the sense that each brain will tend to process the same information differently. Therefore, even though all of us may be exposed to the same data and information, it is absolutely normal to expect us to come to different conclusions in areas like investing. So why not exploit this quirk of nature in a constructive manner as per Munger. Therefore, to the extent that one can find someone who's thoughtful and not processing data similar to us, it can be tremendously useful to have dialogues or conversations around stocks.

I'm sure just as I do, you also know a lot of people who have certain deep rooted beliefs or habits that look weird to the rest. Like this one about a certain relative who always insists on sitting in the very same chair at the very same place every time India plays a cricket match. Why? Simply because the last five times he sat there, India won. No amount of explaining that India has also lost on other 10 occasions that he sat there has made him give up this routine.

What I just highlighted is another quirk of our brain. When forming certain beliefs, it only takes in that information that conforms the belief. Try presenting it with information of the opposite kind and it will promptly reject it.

Trust us, this can prove pretty dangerous while picking stocks. For once you start to form a positive view of a company; you'll reject or not give the necessary weightage required to any bad news or a genuine concern that could be damaging to the company's long term prospects.

This is another area where having a dialogue or a conversation with another investor who's perhaps not as enamored by the company as you can come in really handy. In fact, some successful investors we know of go to the extent of inviting for a presentation, an analyst or an expert whose views are in total contradiction to their own views. Indeed, doing this does not totally eliminate all errors associated with stock picking. But it does help arrive at as sound a judgement as can be possible.

So, in conclusion, having a dialogue around stocks helps immensely we believe. It not only aids in putting thoughts in an organised manner so that the other person can understand. But also helps in getting a perspective that could be a lot different from our own and therefore help identify holes in our theory.

Please note that we do not necessarily have to agree with the point of view of the person we are having our dialogue with. Also, we have to ensure that the other person has no vested interests and as Charlie Munger says, it's just two people having conversations about thoughts.

So, go ahead and engage in dialogues about stocks and make this filter, which we can in a lighter vein the 'Amitabh Bachchan' filter, an important part of your investment process if you haven't already.

Do you have dialogues with a like-minded investor every time you contemplate buying a stock? Let us know your comments or share your views in the Equitymaster Club.

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02:50
  Chart of the day
At the peak of the 2008 bullrun, the S&P BSE Midcap and S&P BSE Smallcap indices touched their highs of about 10,110 and 13,975 points (closing prices) respectively. It was only after in November 2014 - or almost seven years - when the midcap index crossed that figure. It is currently hovering around levels of 11,070 points. The smallcap index on the other hand, is yet to breach its all time high figure. Currently it trades at about 11,900 points.

Nevertheless, small and midcaps have been on a tear over the past year. As today's Chart of the day indicates, the smallcap index is up by 59%, while the midcap index is up by about 52% from a year ago. The BSE-Sensex on the other hand is up by only 28% YoY. Given the sharp run up in the former two indices, their valuations have surged substantially as well.

More steam left in mid, smallcaps?

As reported by the Business Standard, midcaps on an average are trading at 40% higher valuations as compared to the benchmark indices; smallcaps trade at a premium of about a fourth.

So does it make sense to invest in smallcaps in general in such markets? We asked Richa Agarwal, our Managing Editor of smallcap stock recommendation service - The Hidden Treasure - to give her views on how to approach investing in smallcaps in such markets. This is what she had to say:

"It is evident that there is a solid bull rally in the smallcap space. I have no doubt that many smallcap companies are geared to grow at a solid clip in the coming years. The optimism in the valuations is a reflection of the expected turnaround in the Indian economy. But investors should not go overboard as smallcaps tend to be highly risky. There are these four things you should never forget while investing in smallcaps. 1) Look for companies with sustainable business models; 2) For companies with strong fundamentals, it may sometimes make sense to pay a slight premium. But as a thumb rule, don't overpay. 3) Invest for the long term. Don't be swayed by short term price swings. Smallcaps are a pretty volatile lot. 4) Asset allocation is the key. Don't overexpose yourself to a single smallcap stock."

We would like to emphasize on the last point. Asset allocation is key in such markets and we believe rebalancing one's portfolio would be key to ensure one does not have too much exposure to a particular stock. A quick gauge at the risk reward ratios should help in identifying the stocks that need trimming in case they have shot up in this bullrun.

04:10
Continuing with our discussion on valuations and earnings growth, we came across an interesting write recently. It seems that analysts over at Bank of America Merrill Lynch are not very concerned about the earnings growth downgrades that are happening at the moment in the US. They do not expect stocks to follow suit as long as the economy maintains its non-recessionary phase. How did they come to this conclusion? Well... the analysts seem to have done some back testing and learnt that in similar times - that of non-recessionary quarters in which earnings per share growth was negative - the S&P 500 moved higher by an average or 2% about 6 out of 10 times.

Sure, back testing does make sense. However, we do believe that such claims at a time when valuations are at their highest levels in nearly a century, and a bull run that is obviously driven by loose monetary policies, should be taken with a pinch of salt.

04:40
Meanwhile, Indian stock markets had a negative outing today with the Sensex closing lower by around 245 points. The NSE-Nifty ended more than 80 points lower. Healthcare and auto stocks were amongst the biggest losers. Amongst global indices, while Asian indices closed mixed, European indices have opened on a positive note.

04:55
 Today's investing mantra
"In the short run, the market is a voting machine but in the long run it is a weighing machine" - Benjamin Graham

This edition of The 5 Minute WrapUp is authored by Devanshu Sampat and Rahul Shah.

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