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Quality is forever

The more uncertain and risky the future looks, the more fundamental business quality comes to the fore

Quality is forever

Frightened by what the equity markets are doing to your investments? Don't be. As I wrote in these pages more than a month ago when the virus was just limited to the country of its birth, unanticipated negative shocks are part and parcel of equity investing. In fact, this risk is why there is a premium on equity investing, on why equities can earn more than deposits and such. Risk and returns are two sides of the same coin, the only problem being that we don't understand that risk is actually risk.

The investment industry, by talking about risk tolerance and risk modelling and such things, has created the impression that risk is something predictable. It's not. In fact, it's the very definition of risk that it's not predictable. We make the error of calling normal variance risk. In reality, it's only what we are facing now that is real risk.

Decision-making under risk and uncertainty lies at the heart of equity investing. We don't know what's going to happen, but that does not mean that we don't know what to do. That may sound strange at first but actually that's true of all equity investing, whether in good times or bad, in normal times or perilous ones.

Every time you take an investing decision, it's actually on the same principle. You don't know what will happen, you just have an expectation. Sometimes the expectation turns out to be justifiable, sometimes not. Moreover, there are always unexpected events. If you have been investing for a few years, you may have noticed that the most unexpected events tend to be negative, not positive.

Not only do wildly unpredictable events hit much more frequently than a naive extrapolation of trends indicates, such unpredictable events are overwhelmingly more likely to be negative rather than positive. Does that make sense? Let me explain what I mean. Can there be an event which causes the world's economic output to drop by some catastrophic amount, say 10%, in just a year? Yes, definitely. We could be in the first stages of such an event right now. However, can the opposite happen? Could something happen that could cause an equivalent boost in a year. No, the chances of such a miracle are as close to zero as possible.

So what should we do as investors? The answer is simple: a relentless focus on quality. Not just in the situation that we are in now, but all the time. Over the last few decades, there have been plenty of times when the markets have fallen 20-50% and have soon - within a couple of years - gained back the losses. However, in these episodes, quality really shines through. Here's a great example: back in 2008, HDFC Bank fell to half its value. If you had bought it before that crash, when it was at the peak of that time, your money would today be 5X after absorbing that huge loss. From the bottom, it's about 10x. There's no shortage of quality stocks that are going abegging right now at once-in-a-decade bargains. Conversely, there were many stocks - almost all infra ones - that fell 70-90% in that crash and never came up again.

There's no way of anticipating extreme events and then trying to clean up your act hurriedly. Instead, this has to be a continuous thing. The trick is very simple. Every time you buy a stock, you should be aware of what happens if a disaster strikes immediately. Of course, you buy for the upside, but as the proper investment method goes, have a clear idea of what would happen if real risk hits and the markets quickly tank for some unforeseen reason.

What would happen to your investment if that happens? The only way of having any degree of confidence is if you are reasonably certain of the fundamentals of the business and the stock. That's exactly what's happening today. The stock markets are crashing, but when it turns around, quality will matter.