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Why 'change' in investing may not be good for you...

Apr 29, 2015

In this issue:
» China's stock market pays no heed to earnings
» Top performing sectoral indices in FY15
» Will the rally in crude oil last?
» ...and more!

The other day, I met up with a good friend of mine at an upscale restaurant for a long chat. She seemed a bit distraught. And a nice ambience, good food and some company was what she needed to soothe some of her fears. Once we soaked in the atmosphere and placed our orders, we settled down to discuss what was troubling her.

It was essentially this. My friend works in a well known cosmetics company in the field of market research. The division that she was part of focused on a very niche segment. For the last four years, she had developed a good rapport with her colleagues, sales people, clientele etc etc. She had also become quite good in her job and consistently received good grades. Salary was also not a problem. Working hours were decent and gave her ample scope to pursue some of her other interests such as painting. So far so good.

One day her boss had a frank talk with her and suggested that a vacancy had come up in another department and that my friend should consider applying for it. The boss' reasoning was simple. My friend could not continue doing what she was doing forever. Not if she wanted to grow in the organization. And so this opportunity was something that she should grab with both hands.

But there was a catch. It was a completely new position. So she would have to work right from scratch. Not only in terms of understanding the demands of her new assignment but also in terms of building new relationships. And developing a connect with a different boss. To put in a nutshell, this was a big change for her.

For most of us, change can be quite unsettling. It certainly was for my friend. She does not like change. But after a lot of thinking, she acknowledged that it was very crucial if she wanted to grow and did not want to stagnate.

Change ultimately is an integral part of our life. And while the example that I have given is related to work, our personal lives require change as well. This is if we want to become wholly rounded individuals.

But is change a good thing when it comes to investing in equities? Probably not. Now the decision to invest in stocks, among many other things, depends a lot on the 'business model' of the company. This means as an investor, you would need to understand the business first, get a grasp of the competitive advantage that a particular company enjoys before you choose to invest in it.

Understanding a business can become quite challenging if it is part of an industry whose dynamics keep changing. Warren Buffett certainly did not like change. In his 1987 letter to shareholders, he wrote, "Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or 10 years ago."

The tech industry is a classic example of this. Today, Apple is the world's most valued company and the recent result season saw Apple post a healthy growth in earnings. This is commendable given the general air of uncertainty in the US economy. Apple's growth was largely driven by the iPhone, which accounts for a significant chunk of the company's sales. This in itself could be a problem. It is questionable whether the company can continue to rely on one dominant product to drive growth for a long time. And it is highly possible that another company, probably, could come out with a product that could once again change the entire landscape of the industry, the way Apple had done some years back.

And that is probably why Buffett is reluctant to invest in the company even though he acknowledges Apple's firm position in the smart phone market and superior financials. He does not understand the business too well and is not sure whether Apple has that competitive edge or moat that can be durable for the next 10 years.

Only time will tell whether Buffett is right or wrong. And I am certainly not suggesting that Apple is not a good investment. That will be a different discussion altogether.

The point is that as an investor, it makes sense for you to invest in businesses that you understand. And this becomes possible, when the business models are simple with not too many changes and disruptions.

Do you think it is alright to invest in companies that constantly need to innovate to retain their edge? Let us know your comments or share your views in the Equitymaster Club.

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If you thought that the US was the only country where the stock markets and corporate earnings moved in opposite directions, think again. China has joined the bandwagon as well. As reported on Bloomberg, the Shanghai composite index has soared 90% since mid-October even as 2014 profits missed estimates by the most in 6 years. Indeed, so wide is the disconnect that it is now bigger than in any of the world's top 40 markets.

The reason why the markets have rallied despite disappointing earnings is because of expectations of further government stimulus. It is an all too familiar story where markets are driven more by likely policies than any fundamentals. This cannot continue for long though. If company earnings fail to grow, the pace at which stock prices have surged, will be mirrored in the quantum of downfall as well.

  Chart of the day
As the first month of FY16 draws to a close, let's take a look back at some of the top performing sectors of FY15. It's well known that most traders in the markets have a short memory. Thus, when stocks from a particular sector start to run up, a herd mentality quickly takes over. Stocks with poor fundamentals also run up along with the strong ones just because they are part of the hot sector at that time. Unfortunately, the same is true when the situation reverses as well. In FY15, pharma, consumer durables, auto, capital goods and banks had a dream run.

However, if you hold stocks with questionable fundamentals in these sectors, we believe the time is ripe to do a cleanup of your portfolio. It is important to understand that a lot of the profits made last year were due to the run up in the markets in general and these sectors in particular. Thus, when the tide turns, it would be those same stocks that would feel the brunt of the selling pressure.

Will these sectors remain outperformers?

Perhaps the biggest talking point last year, apart from the general elections, was the steep fall in international crude prices. Saudi Arabia's historic decision to hold on to their energy market share instead of their profit margins led to a free fall in crude prices. This was a big positive for India as it helped to contain the current account deficit (CAD) as well as cap the government's subsidy burden. However, it must be pointed out that that crude prices have firmed up since the start of the year. Some 'experts' are even talking of the possibility of Brent crude prices hitting US$ 100 per barrel once again.

We take such predictions with a heavy pinch of salt. None of these so called experts predicted the crash last year. It would be wise to go strictly by the facts. And the facts are quite clear. There is a record glut of crude oil in the US (the world's biggest consumer) from shale oil fields, amounting to nearly half a billion barrels! What's more, there are about 4,000 under-construction shale wells in the US as per Bloomberg. Thus, it clear that supply is abundant. What about demand? Growth in US demand for crude has been as slow as the economic recovery. The world's second largest consumer, China, too is in the middle of an economic slowdown. In such a situation, it is next to impossible to make a bullish case for crude prices we believe.

Markets had a rather volatile trading session today as attempts to stay above the dotted line were quickly followed by profit booking pushing the indices into the red. At the time of writing, the BSE-Sensex was trading lower by 74 points. Weakness was seen in FMCG and auto stocks. While most Asian markets were trading in the red, markets in Europe were trading mixed.

 Today's investing mantra
We are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Radhika Pandit.

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