Be Very Careful About the Stocks You Buy Now

A lot of easy money has been made in the stock market over the last eighteen months.

In retrospect, all you needed was access to capital and the guts to ride a wild recovery amid a raging pandemic.

Of course, those things were far from easy at the time. But even media hypes and speculative guesses would have worked to fetch quick, handsome returns.

IPOs of new, disruptive businesses made such speculative gains seem easier than ever.

The profits hereon won't be easy money. You will need to carefully select your stocks, assess the risks, insist on a margin of safety, and make timely exits.

The reason I say this is because, the trend of too much money chasing too few good stocks is reversing. The rising interest rate cycle could now reverse the direction of fund flows globally.

Also, the post pandemic recovery is well factored into earnings projections and market valuations.

So from now on, I believe the earnings recovery could be disproportionately high only in rare economic circumstances.

I will spare you the technicalities of such economy led earnings trends.

But let me tell you how the last century affected the economy and the world's most vibrant stock market.

Here is Robert Gordon in his book The Rise & Fall of American Growth (2016)...

• Though not a single household was wired for electricity in 1880, nearly 100 percent of US urban homes were wired by 1940, and in the same time interval the percentage of urban homes with clean running piped water and sewer pipes for waste disposal had reached 94 percent.
  
  More than 80 percent of urban homes in 1940 had interior flush toilets, 73 percent had gas for heating and cooking...In short, the 1870 houses were isolated from the rest of the world, but 1940 houses were 'networked', most having the five connections of electricity, gas, telephone, water and sewer...
  
  Networking inherently implies equality.
  
  Everyone, rich and poor, is plugged into the same electric, water, sewer, gas and telephone network.

With such rapid changes in infrastructure, consumption, and investment, most businesses had shorter lifetime of peak profits. Meaning stocks in the American benchmark index, the S&P 500, exited it more frequently.

For example, in 1935 the average lifetime of a largecap company in the S&P 500 was 90 years. But in by 1960s, that had declined to 61 years. It then declined to 25 years by 1980.

In 2020, the average lifetime of a company on the S&P 500 was only 18 years. So, the rate of 'churn in the S&P 500 index' has been about 50% over the past decade.

As per estimates, if the trend continues, approximately 75% of companies on the S&P 500 index will be replaced by 2027.

If we were to make a similar comparison for India, the past decade itself has been a game changer.

The highway road network has doubled.

Bank accounts per household has tripled.

Number of flyers has tripled.

Mobile subscriber base has gone up 5x.

Broadband subscriber base has gone up 120x.

So, don't be surprised if, despite a reversal in foreign fund flows, some stocks keep soaring over the next decade.

The last time Indian businesses witnessed a big shakeup was in 1991, with the end of the License Raj.

The 1991 reforms led to 60% of Sensex stocks exiting the index in the next decade. That is 18 of the 30 Sensex constituents in 1991 had been in the index a decade later.

The variety of listed stocks is quite diversified now. A quick study of the Nifty 50 will help us understand this churn better.

First, the index has increasingly done away with large conglomerates, leveraged businesses, and stubborn PSUs.

Second, firms that failed to take advantage of technology, keep up with innovation, deleverage, increase profits with better supply chains, have languished the most.

As a result, about 40% of the Nifty 50 stocks keep getting replaced on a regular basis. So, don't assume every longstanding index stock could be a long-term wealth creator.

On the other hand, holding on to the consistently compounding stocks could make a huge difference to your net worth.

A decade later, you may find just a few of the Nifty 2021 stocks have offered you double the returns of the Nifty.

So be very careful about the stocks to buy for the long term. Be even more watchful about the stocks you wish to hold.

You should also be clear, rigid, and disciplined about the stocks you need to sell.

Each of these carful decisions will determine how you profit from the Nifty's 40% churn in the coming decade.

Warm regards,


Tanushree Banerjee
Editor, StockSelect
Equitymaster Agora Research Private Limited (Research Analyst)