STOCK MARKET INVESTING: WHAT MATTERS MOST?

This article is written by Mr. Modan Saha, Managing Director, AxisDirect.

Individual investors often get attracted to the stock market when the markets have shown very high returns in the recent past. Recent returns give confidence to a number of new investors that the market is at a stage when they can make money in the short run. They search for tips by talking to friends, reading recommendations in business newspapers or by surfing various business new channels. Unfortunately, in most cases, this is the time the markets are most vulnerable to correction, as returns in the stock market are mean reverting in nature. The stock market as a whole cannot grow at a pace delinked from the ups and down of the economy and its growth would always depend on the growth of the underlying economy. Growth of share prices of individual companies would depend on the return on equity provided by the underlying business, which is linked to the performance of various sectors of the economy. Therefore, in the long run, the performance of a stock cannot be delinked from the performance of underlying sectors of the economy and the return on equity the companies are able to generate from the opportunities the economy provides. Any divergence in value in the short run is expected to self-correct in the medium to long run. Therefore any abnormal growth in share price of a company or stock market as a whole cannot be sustained unless it is accompanied by structural shift in the growth of earnings potential of the underlying companies. When the share price of a company is in an abnormal high growth stage without any specific reason which is expected to significantly increase the return on equity in the medium to long term, it is most vulnerable to correction. Often, individual investors end up entering the market when it has significantly run up, and exiting the market after a severe correction and after booking their losses. The story of a large number of such individual investors coming in and getting out of the stock market is abounding. So what does one need to do while investing in the stock market? First of all, if one does not have the inclination and the time to research and track individual companies, one should not directly invest in the stock market, investing through index ETFs or diversified mutual funds would be a much better option. For High net-worth investors, discretionary PMS, with personalized attention of a fund manager, is one more option. However for direct investing, one has to be in a position to take ownership of his / her decisions. This can only be done if one understands what investment one is getting into. An investor can take inputs from various researchers and advisors before investing, however the final decision needs to be his or hers. This requires investment in time by the investor along with interest and skill. Herding in and out of the stock market based on market momentum can cause significant losses to a retail investor. So after the investor has decided to give the time for investing in equities, what should he do? How does he go about choosing the right stocks to invest in? Without an appropriate model to evaluate stocks, an individual investor can easily fall prey to various behavioral biases including buying on tips and rumors, anchoring ones investment decisions on recent purchases / sale or recent highs and lows, etc. As Benjamin Franklin has said, To the man with a hammer, every problem looks like a nail.

Just like any other purchase for the long term, the basic principle behind share purchase is to buy high quality companies at below their intrinsic value. One needs to identify shares of high quality companies selling below their intrinsic value. A simple investment checklist would include the following: 1. 2. 3. 4. Look for businesses that are expected to deliver high return on equity over a long period of time. Make sure the company has sustainable competitive advantages which shall help it maintain high return on equity over a period of time Look for a trustworthy, shareholder-oriented, high-quality management team Look for companies selling below intrinsic value

Which of these are more important? To me it has to be identification of businesses, which have the potential to deliver high return on equity over a long period of time. Over the long term, it's difficult for a stock to earn a much better return than the earnings of the underlying business. For example, if a business earns 7% p.a. return on capital over 20 years and one holds it for that 20 years, ones not going to make much different than a 7% p.a. return even if one originally buys it at a significant discount. Conversely, if a business earns 15% on capital over 20 years, even if one pays a relatively higher price, one is expected to end up with good returns. To illustrate the above, lets take example of two stocks A and B, whose intrinsic value is Rs.100. Lets take a scenario where A is available for purchase at Rs.130 and B is available at Rs.70 in the stock market. A is expected to provide 15% p.a. growth on the intrinsic value of equity for foreseeable future, while B is expected to grow at 7% p.a. Let us look at the expected fair value of stocks A and B after 5, 10, and 20 years as a multiplier of initial purchase price (IPP) as illustrated below:
5 years Stock A (IPP Rs.130) Stock B (IPP Rs.70) 1.55 2 .00 1 0 years 3.11 2.81 20 years 12.59 5.53

As illustrated above, if your holding period is long (which should be in case of equities), what is more important is your ability to identify businesses, which have high earnings growth potential over a long period of time and the management has found an approach towards building sustainable competitive advantage. As the legendary investor Charlie Munger has said, So the trick is getting into better businesses. Obviously if you get them at a bargain it helps. However, if it is a tradeoff between cheap stocks vis--vis quality businesses, it must be quality. Value without growth cannot deliver sustainable long-term return. As legendary investor Warren Buffett says, Value and Growth are joined at the hip. This example also showcases the power of one of the simplest but often forgotten mathematical concepts that retail investors should make a part of their habit The power of compounding. As Einstein has said, Compound interest is the eighth wonder of the world. If you can identify high earnings growth companies relatively early in their life cycle, and stay invested in them over a long period of time, you are unlikely to get disappointed, even if you have paid a slightly higher price compared to you assessed fair price at the time of purchase.

Are there any dangers in the above approach? Does it mean equity at any price? No. Lets take the above example further. Lets assume you pay Rs.300 for Stock A, based on quality of the companys earnings growth.
5 years Stock A (IPP Rs.130) Stock B (IPP Rs.70) 0.67 2.00 1 0 years 1.35 2.81 20 years 5.46 5.53

As illustrated above, even after 20 years, Stock A would underperform stock B. Thus investment hara-kiri can result from paying too high prices. All of us need to be aware of such danger. How does one get into great companies? The challenge is to find them and invest in them when they are relatively small. For example, buy an Infosys or Wipro during their early stages. Not easy, but good research and insight, with the ability to take a long-term view would definitely help. With large well-established companies, it would be difficult to beat the broader market index. After identifying the right business, the quality of management is the next important thing. By their business decisions, they can change the earnings growth trajectory of their company. They would implement strategies that help build sustainable competitive advantage for the company. Some of the above can be attained through some basic due diligence. It might not take a genius to understand that Narayan Murthy or Azim Premji were more insightful and better managers than their peers in other companies. The table below shows stock performance (excluding dividends) of Infosys from the date of listing till Feb2012, compared to that of Sensex.
Date of Listing Infosys Sensex*
* Calcutated from March 1994

Return si nce inception (p .a.) 62% 9%

Return since Jan'02 (p.a.) 19% 18%

Return sin ce Jan'07 (p.a.) 4% 5%

31 M arch 1994

As clearly visible above, as a company grows significantly large, largely mimics the return of the index, while investing early in good companies can result in significant outperformance over the long run. As Warren Buffett puts it, when one does get an occasional early opportunity to get into a wonderful business that's being run by a competent manager, its time to invest in them significantly. To summarize, identifying companies which have more than a fair chance of delivering high return on equity, relatively early in their growth lifecycle is a key tool for generating significant returns from investing in equities for the long term.

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