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Four Magic Words for Successful Investing in 2017 and Beyond

Dec 19, 2016

In this issue:
» This is how to earn low or negative returns on investments
» Beware of these 'sunrise' sectors
» Market roundup
» And More...
00:00
Rahul Shah, Co-Head of Research

An army training base is not the kind of place you look for deep mathematical insights. But if you have a master chronicler like Michael Lewis and an astute psychologist like Daniel Kahneman, the magic can happen almost anywhere.

I came across a sweet little interview of Michael Lewis where he talks about how Kahneman took a simple observation by Air Force instructors and literally turned it over its head.

'Praise don't work for our pilots,' the instructors reported. 'When they do something great and we praise them, they're always kind of worse the next time. And when they do something bad and we criticise them, they get better.'

'That's an illusion,' Kahneman shot back. 'What you are observing is called reversion to the mean.' Pilots have a mean level performance as per Kahneman. If they deviate from this mean, they are more likely to go back to the mean next time.

Wow.

Now, if you've been value investing for some time, chances are reversion to the mean has been your best weapon and you didn't even know it. But pick up a copy of Benjamin Graham's Security Analysis and you will find the following inscription on the very first page...

  • Many shall be restored that are now fallen and many shall fall that now are in honor.

That's the philosophical version of Daniel Kahneman's reversion to the mean. For value investors, it means buy fallen stocks. Most likely they have diverted from the mean. When they are restored, you walk away with handsome gains.

Equities aren't the only asset class that mean reverts. Jeremy Grantham would know. The noted financial investor published an epic mea culpa earlier this year on how he got it horribly wrong in some other asset classes. His mistake? He looked for the paradigm shift that never existed...

  • I, more than most investors, should have known. Even some of the rare, extraordinary outliers can prove to be mean-reverting bubbles eventually.

In plain speak, he's saying that betting against mean reversion rarely works. An asset that has gone too high will eventually crumble under its own weight and revert to the mean. And asset that has gone too low will sooner or later ascend to the mean.

What about economic growth? Does it also revert to the mean? Well, here again, you'd better not bet against it. Do you know how long it took West Germany to recover its pride of place in the economic hierarchy after WWII? All of fifteen years. So here's a country that was reduced to rubble and still mean reverts to its prewar level of economic activity in all but fifteen years. (Source:GMO)

I suggest remembering these four magic words in 2017. 'Reversion to the mean' has certainly helped us cut through a lot of noise and maintain perspective across a range of issues and 'crises'.

Will Demonetisation hurt the economy? Will Trump be bad for stocks? Will the Fed disrupt the financial markets? Yes, these events could have a near-term impact on asset prices. But over the long term, they are more likely to revert to the mean than mark a paradigm shift.

In fact, let others think that this time it's different. Just remember the four magic words and take advantage of this thinking of theirs.

That's what we've been doing with the Microcap Millionaires service for three years now. Its returns of 117% vis-a-vis 28% and 83% earned by Sensex and BSE Small Cap index respectively does seem to suggest that the approach works.

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02:40 Chart of The Day

The really dreadful losses ...were realized in those common-stock issues where the buyer forgot to ask, "How much?". - Benjamin Graham

Today's chart of the day is a great proof of why reversion to the mean works in the long run. It plots Sensex valuations (trailing twelve months' price to earnings multiple) to the gains in Sensex over next 5 years. Unsurprisingly and invariably, the returns have been low, even negative, for the investments made when Sensex was trading expensive (high P/E). A classic case of investors ignoring reversion to the mean principle.

The Key to Earning Low Returns on Investments


What is true for Sensex is true for individual stocks as well.

Unfortunately, what sounds and seems simple is difficult to follow. Blame human biases and conditioning.... A common investor tends to be most optimistic and active in markets at its peak. When the correction comes, he is too scared of his previous losses to make the most of the opportunity.

At Equitymaster, "how much" is a key question we ask before recommending stocks. Margin of safety is a key pillar of our process. The stocks that don't qualify, don't get recommended with a Buy view. This is also one of the reasons why in certain months our readers get recommendations with Buy at lower price view.

Brokerages, however, may make you believe otherwise. As my colleague Ankit shared in one of the editions of Research Digest:

This morning, we interviewed a candidate for our research team. His curriculum vitae boasted experience at renowned institutional brokerages. And in the course of our meeting, he revealed some not-so-surprising insights into the financial industry...

    In a brokerage, analysts are not allowed to give outright 'Sell' recommendations. At most, we are allowed to give a 'Hold' view. At any point in time, we must have at least 70% 'Buy' calls.

As unethical as that is, we weren't surprised. That's their business model. Brokerages would not get enough trading volumes if they did not give mostly 'Buy' calls.

So the markets could be at their peaks...on the verge of crashing...and your broker would still push you to buy stocks.

This happened in 2007-08. And this happens all the time.

It's time you stop bipolar Mr Market and its participants influence your investing decisions. Instead, use its mood swings to serve you - Be fearful when others are greedy, and vice versa.

3:40

Are you looking for next sunrise industry or growth stock?

Well, before you go hunting, we have something to share.

We came across an interesting article in Livemint today. It had interesting excerpts from Mr Gautam Adani of the famous Adani Enterprises.

"Infra is a capital intensive business. At group level, our long-term debt to Ebitda (earnings before interest, taxes, depreciation and amortization) is at a comfortable level of 3.25:1. Overall, for infra business, we are robustly placed,".

One must note that at the end of FY 16, Adani Group companies had a minimum debt to equity ratio of 1.5 (for Adani Enterprises). The maximum debt to equity ratio stood at 7.4 times (for Adani Power).

Now that's something which is way beyond our comfort levels, even for growing companies. We are extremely cautious of the companies with high debt on the balance sheet... And of the managements that are comfortable with such levels.

Mr Adani further said that in a growth economy, even the group's existing businesses of ports, power and mining remain sunrise sectors. "... we are certainly evaluating other sectors that include coal conversions, defence and water. However, it's too early to say which of these would be the next sunrise sector for us."

The list of companies claiming to be beneficiaries of the India's growth story is long.

Like an investor forgets to ask "how much" while pursuing stocks, there are managements that forget to ask" At what cost" while pursuing growth opportunities in so called 'sunrise' sectors. The unsuspecting common investor, hoping to make money from investing in next sunrise sector is the worst victim of such claims.

This is what Tanushree, the editor of The India Letter has to say about such companies:

One needs to do a very thorough check of not just the past financial track record but also the management quality before investing in them. More importantly, investing based on the broad economic growth could prove to be false alarms of the Megatrend. So, investors hoping to strike gold by investing in such high growth sectors may be thoroughly disappointed if profits fail to show up even after a prolonged period.

The team itself continues to meet companies across the board, so that we can select only the best of the lot with equally good growth and shareholder wealth creation potential.

04:30

In the meanwhile, the Indian share markets continued to trade in the red after opening the day on a weak note. Sectoral indices were trading on a mixed note with stocks in the Consumer Durables sector and Realty sector witnessing maximum selling pressure. Oil & Gas stocks are trading in the green.

The BSE Sensex was trading down 63 points (down 0.2%) and the NSE Nifty was trading down 21 points (down 0.3%). The BSE Mid Cap index was trading down by 0.2%, while the BSE Small Cap index was trading down 0.1%. The rupee is trading at 67.74 to the US$.

04:55 Today's Investing Mantra

"The critical investment factor is determining the intrinsic value of a business and paying a fair or bargain price." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst).

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2 Responses to "Four Magic Words for Successful Investing in 2017 and Beyond"

Monita Mehra

Dec 22, 2016

I have read multiple times but the true meaning of "How Much?" I have understood only when markets correct and correct deep. Market correction and Equity Master has helped me understand margin of safety concept really well and today once again be reiterated helps.

Like (1)

Ravi

Dec 21, 2016

Stock picking

Like (1)
  
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