Stock markets are a temple of learning for a capitalist. A person can spend a lifetime in markets and keep learning something new every time. I have tried to summarise some of my learnings in the stock markets over the past two decades in the following paragraphs.
Equities are growing annuities to perpetuity
While theory is clear about this, most market participants tend to confuse this simple fact. In my opinion, stock prices constantly discount cash flows to perpetuity and hence if any event occurs which impacts the business even in distant future, it shall be discounted immediately.
Quality (of business and management) matters
I have learnt it by paying some 'tuition fees' that quality of business is of significant importance in terms of long-term investment performance. Good-quality companies have delivered strong performance compared with weak-quality ones over a fairly long period of time. Quality means the ability of a business to earn substantially higher returns on capital over its cost of capital, throughout its lifetime. This can be achieved if a business enjoys some material competitive advantages over its peers.
Low P/E means cheap and vice-versa
Stock P/E multiple depends on four factors, viz., (1) sustainable earnings growth, (2) sustainable return on equity (RoE), (3) riskiness of business, and (4) risk-free rate of return in the country. Thus, some companies may be trading at a low P/E because either their potential future growth is low or their return on equity is poor or both. The reverse may be true for companies trading at higher P/Es. Hence, investors should not make investment decisions purely based on headline valuations.
Growth without adequate RoE is bad
Not all growth is good. Some companies are growing fast by consuming higher proportion of capital, which is bad growth. Market only rewards companies which are growing at a fast pace while maintaining returns on incremental capital employed higher than their cost of capital.
A high RoE without growth is not good either
Just like growth without an adequate RoE is bad, similarly companies enjoying high RoEs but having limited opportunities for growth would be rated low by the markets. Many companies which used to enjoy good RoEs in the past but are facing disruption in their businesses fall in this category.
Crowd behaviour is the same everywhere and every time
Behaviour of investing crowd has remained the same for centuries and across continents. Crowd is always subject to vicissitudes of greed and fear produced by markets from time to time. This is the reason behavioural investing is gaining popularity amongst investors.
Investing is boring - any attempt to make it otherwise impacts performance
Investing is not a part-time hobby or a get-rich-quick scheme. Investing is an act of allocating capital today in expectation of getting a return or profit on the same, along with getting back the original capital, over a longer period of time. Any attempt to make it exciting by trading in and out of securities or speculating can impact an investor's eventual performance adversely.
Cutting flowers to plant weeds
This is the most popular mistake made by investors. It's a general investor tendency to sell companies which have delivered good returns in the name of 'booking profit' and use the proceeds to buy companies which have delivered poor returns. As someone has said, you can never go broke taking a profit. On the flip side, you can never become rich by taking small profits when multi-bagger returns are possible. Good-quality companies with superior growth prospects are hard to find and hence, investors should look at a business's long-term potential before making changes to the portfolio.
This interview was conducted in June 2021