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The three words that help distinguish the best from the worst stocks

Jun 18, 2015

In this issue:
» Buffett is in love with newspapers
» How does the wealth distribution pie of Indian households look?
» US Fed maintains status quo yet again
» ...and more!


00:00
If you are amongst those who treat stock investing like paying equated monthly instalments, this is particularly for you. Being disciplined about investing is an excellent trait. So is the habit of keeping aside some funds for investing in stocks on a regular basis. But if your objective is to buy some stocks every month, chances are that you will end up with quite a few rotten apples in your portfolio.

Now unless markets are at 2008-09 kind of valuations, it is rather unlikely that you will find stocks worth buying with the routine analysis. For it is only at such times when investors have the privilege of finding the best companies at the best valuations. At most other times you will find the extremes. There will be stocks that you will find very attractive purely because of their valuations. And then there will be super performers that will lure you with their safety and unbeatable fundamentals. Which ones should you go with and how do you distinguish between the best and the worst stocks?

We get the answer to this from none other than the legendary Charlie Munger. He is known to draw parallels from fields as diverse as physics and psychology to his investment process. In a 1986 speech Munger talked about 3 words that he learnt from 19th-century German mathematician Carl Jacobi. The three words were "Invert, always invert" . Munger elaborated, "It is in the nature of things, as Jacobi knew, that many hard problems are best solved only when they are addressed backwards."

So what does "Invert, always invert" mean for our thinking as investors? And how can this help in assessing the true value of stocks? Well all it takes you to do is go back to questioning the assumptions that can help justify the stock price.

For instance, if a stock is trading well below book value and below the value of its net current assets, check if there is a possibility of the company actually going bankrupt. If the business model and balance sheet quality does not suggest so, probably such an undervalued business is worth looking at. Similarly, if a stock is trading at 20-25 times book value, ask whether the company's stock price has the upside to create more value than the potential increase in book value. If not you will be better off staying away from such a firm despite the soundness of fundamentals.

Stocks that are poles apart?
Below 0.6x book value Above 20x book value
MTNL HUL
GNFC Castrol
State Bank of Mysore Eicher Motors
GSFC Colgate
Union Bank Page Industries
Syndicate Bank Nestle
Reliance Infra Sun Pharma Adv Research
Bank of India Hawkins
UCO Bank Just Dial
Data source: Equitymaster, Ace Equity

Thus the technique of inverting the scenario can help you address the confusion over valuations. Also with the backward approach you can confront Mr. Market's price quotes with confidence. The knowledge that the price being quoted by Mr Market is based on unrealistic assumptions will automatically help you avoid mistakes in stock picking.

At Equitymaster, we are firm believers of the fact that investing requires patience and diligence over everything else. And hence recommending stocks to buy week after week, irrespective of valuations, is not us. Nevertheless, the 'Invert, always invert' formula has often helped us find lucrative opportunities. Ones that not just safeguarded capital but also offered immense long term upside.

Have you followed the practice of 'inverting' as propagated by Charlie Munger while making investment decisions? Let us know your comments or share your views in the Equitymaster Club.

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------------------------------


02:00
Since we spoke about Munger, his alter ego Buffett cannot be far behind when it comes to discussion on valuations. Can he? Well, Buffett has once again given us reason to believe in his contrarian approach to investing.

As all of us know, the days of reading news in the print version of papers seem long gone. With ready access to digital news across electronic medium, the days of reading newspapers seem history. And hence the days of newspaper companies seem numbered. The advertising revenues of the newspaper companies also have come down dramatically. Since advertising accounts for a larger share of revenues for most of them, the shift of preference to digital advertising has hit the companies hard. However, in Buffett's own words, he will be the last guy in the US reading a newspaper. The legendary investor had previously explained that despite the gloom scenario about newspaper industry there will always be a demand for regional newspapers. And hence he will be willing to buy such stocks whenever they are available at the right price. Well we quite agree with his view, that there are players in every industry that enjoy a unique moat. And these will be the ones that will continue to thrive despite the problems in the industry.

When it comes to print and newspaper stocks in India, it is the quality of their balance sheet and capital allocation skills that has been a worry, more than anything else.

02:45
 Chart of the day
Wealth inequality is quite stark worldwide. Even in India, wealth distribution is quite skewed. As seen in today's chart, Indian households having wealth of less than US$ 1 mn in 2014 owned 64% of the total private financial wealth of the country. Now being at the low end of the pyramid their proportion was always going to be higher. However, what is a bit discomforting is the fact that the wealth concentration of low income households is on a declining trend.

A closer look at the chart reveals that wealth distribution is not ideal. As seen in 2019, households that have wealth in excess of US$ 100 mn are expected to own 24% of the total private wealth of the country. If this indeed happens to be true then one fourth of the country's wealth will be concentrated in the hands of few millionaires!

Wealth distribution graph of Indian households

Equitable wealth distribution has always been a matter of debate. There is one section of the society that believes philanthropy or higher taxes for the rich are amongst few alternatives to wipe off this skewness in wealth. However, there is another section that believes mandating philanthropy or taxing the rich at a higher rate may be discriminatory. The rich are rich because of their talent and hard work. And they are not undeserving. Thus, just because they are rich, it may not be just to ask them to contribute more towards societal welfare. Essentially that is the job of the government.

We do not know which school of thought you belong to but the fact of the matter is inequitable wealth concentration is a societal evil. And the focus should be on eliminating it. The super rich and the elite contributing to this noble cause without any compulsion would be a welcome move.

03:55
They came. They debated (possibly). They left it untouched again leaving the street to do guess work as has happened in the past. Yes, we are talking about Federal Reserve's status quo stance of keeping the rates near zero in its latest monetary policy.

With the US growth gaining traction there have been speculations going around for quite some time that the Fed is going to bring an end to its loose monetary policy very soon. In fact, many are expecting a rate hike by as early as year end. But that would depend upon the improvement in labour market and inflation data to a large extent.

If rates are indeed increased it would be signal that the US economy is back on track. This may result in outflow of funds from Indian markets. Although many investors may have already exited in anticipation of rate rise, the US Fed is yet to walk the talk. Thus, investors who are waiting for the first action from Fed may still be invested in India & other emerging markets. They may see some erosion in their capital.

Though US equities would be in demand post rate hike, considering the growth prospects of India completely exiting the country may not be the right choice. Hence, their decision to remain invested may bear fruits in the long term.

04:30
The Indian stock markets were trading in the green at the time of writing. While the BSE Sensex was up by 295 points, NSE-Nifty was up by 79 points. However, the Asian equity markets were trading in the red at the time of writing. European stock markets too opened in red today.

04:50
 Today's investing mantra
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks" - Benjamin Graham

This edition of The 5 Minute WrapUp is authored by Tanushree Banerjee (Research Analyst) and Jinesh Joshi (Research Analyst).

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3 Responses to "The three words that help distinguish the best from the worst stocks"

Sanjeev

Jun 19, 2015

When I studied Jacobian transformations in the college 30 years before, I didn't know the great mathematician will chase me to stock market like Fourier & Fibonacci! Anyway, interesting & informative article. Thank you very much.

Like 

Dr Rajeev Kapur

Jun 19, 2015

The table compares entirely dissimilar stocks which does not seem rational. Is a complete collapse of company like Page, Colgate or Nestle more likely? Such companies may face temporary headwinds but can recover soon and in the worst economic conditions hold their place. Companies listed on the left side of table are not only poorly managed but some of them have management with doubtful credentials. What are the chances that they will invert and become like those on the right side of the table? It is unlikely that Munger would have ever preferred left side companies over right side. Tanushree is known for much better and rational articles than this one.

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MAUSUMI SEN

Jun 19, 2015

The idea 'invert always invert' is a very good and innovative to choose and pick good stock.

Like 
  
Equitymaster requests your view! Post a comment on "The three words that help distinguish the best from the worst stocks". Click here!
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