Good stocks, bad prices | Value Research Buying good companies at low prices is sensible. But not all companies at low prices are good.
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Good stocks, bad prices

Buying good companies at low prices is sensible. But not all companies at low prices are good.

Good stocks, bad prices

Temporarily, bad things can happen to the stock price of good companies. That is at the heart of our cover story of 'Wealth Insight' February 2023 issue. Of course, there's a lot more to understand about this phenomenon, including, most importantly, that when these bad things happen, it's a good time to invest in these stocks. In fact, for high-quality businesses, it may be advisable to invest at a good valuation only when bad things are happening to their stock prices.

However, I will tackle a different but allied problem on this page. Once people believe the above aphorism, some start believing that if bad things happen to a stock, that must be a good company. That sounds almost laughable when I put it like that but believe me, it's an easy fallacy to believe in, even by experienced investors. For example, if you read our cover story of 'Wealth Insight' February 2023 issue cursorily without thinking about our selection methodology, you might believe - even if subconsciously - that companies that have had their stock prices drop many times in the past eventually do well. However, our analysis shows that (some) companies that do well have had their stock prices drop many times in the past.

The sentence is flipped around but the meaning and implications differ. In our methodology, we start with companies which we have identified as a good investment by other parameters and then see which of them have a depressed stock price currently. However, if we start with the ones with depressed stock prices, many (perhaps most) will be duds. Markets are generally right, and anomalies are few and far between. It's the job of the smart investor and analyst to spot and exploit those anomalies.

The investing fallacy I pointed out above is a case of survivorship bias. We look at some type of company that has done well, look at its past, spot some patterns and conclude that that pattern is associated with success. What we don't notice is the reverse: many more companies associated with that pattern did badly.

Sometime last year, there was a trend of people juxtaposing the following two 'facts' on investing-related social media: one, in 1990, someone offered to buy Infosys for Rs 2 crore. The company is worth Rs 6.5 lakh crore today. Two: in 2021, Info Edge's Rs 4.6 crore Zomato investment became Rs 15,000 crore in 2021. Many people concluded that these two facts tell them the same about equity: over a long period, equity investments can give gigantic gains. Not just that, they feel they can draw some lessons for their investments.

Nothing could be further from the truth. You are operating under a gigantic survivorship bias when you look back and see how amazing the Infosys journey has been. Hundreds or thousands of businesses would have been founded at the same time, and many failed and disappeared. You don't know about those failures. Of the new-generation businesses that you see today, too, many will fail. However, you don't yet know which ones. So, to conclude that Infosys succeeded, the new generation of businesses will also succeed is survivorship bias of the most misleading kind.

"The first principle is that you must not fool yourself - and you are the easiest person to fool," said the great physicist Richard Feynman. He meant it in the context of science and scientists but this is just as true of any field, even remotely resembling research and analysis of any kind. Indeed, it's true in investment research, whether done professionally or for oneself.

Systematic analysis and an awareness of the likely mistakes help one avoid such pitfalls.

This editorial appeared in Wealth Insight February 2023 issue. To read the cover story and other insightful analyses, columns and articles

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