Expanding on The First Principles of Equity Investment – Part II

Posted on June 27, 2011

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This post continues where I left off in part I.

Past Indicates Future But Beware the Recency Effect

I have always relied at the past performance of a company to predict its future results. I firmly believe that history is a far better guide to future performance than any exercise, qualitative or quantitative, that aims to analyze competitive advantages of countries, industries or companies. A company that has delivered average returns over the past 5-10 years is unlikely to experience a magical turnaround and deliver significantly improved results simply because the management believes that their analysis says so. There is a world of difference between can and will.

However, there is a tendency amongst number of investors to give into the recency effect, i.e. they base their estimates on what the company reported last quarter or last year. They then use these performance numbers to predict what the future growth would be for the company and hence determine its value. While there is merit in looking at the recent past of the company’s performance, it is a folly to take a decision based on it. Businesses go through cycles and the recent past could be a trough (or a peak) and you may end up valuing the company much lower (or, horror of horrors, much higher) than what it is really worth. I recommend that to fully understand the quality of a company’s financial performance one must look at period of 10 years. If getting data that far back is not practical, then make sure that you have data for no less than 5 years. This period is enough to smoothen out the effect of cycles and give a reasonably accurate picture. Using this analysis as a basis for predicting future performance is likely to give a more accurate estimate of what a company is worth.

Very few companies are candidates for a detailed analysis of past performance over a significant period. A lot of companies in India are not that old or it is difficult to get detailed financial results going back a decade. In cases like these, I employ additional hurdles for the company to cross. These include ratios such as price to earnings, debt to net current assets, price to book value, etc. Such hurdles help wean out poor performing or poorly structured companies. I also tend to want to buy these companies at much lower price than what I would pay for similar performing companies with much longer histories. Most of the stocks in my portfolio are selected via this method.

Margin of Error

Another important concept in arriving at the price at which to buy a stock is a margin for error. While longer histories increase the comfort of the value prediction exercise, it still does not take away from the fact that value prediction is an exercise in future gazing and can never be error free. So I apply the principle of margin for error. After arriving at what I believe is the fair value for a stock, I reduce the same by a factor say 10-15% to arrive at a price that I consider as the right price to buy. The margin for error provides me exactly what it promises, a margin for error in predicting the value of the stock.

My approach to investing is to identify good businesses, arrive at a conservative estimate for the fair value of the stock and then buy at a price lower than the fair value.

Hold or Sell

This is supposedly a classic dilemma that an investor faces: to hold on to a stock that is performing well or to sell it and book profits. I see no such dilemma. As I mentioned right at start, investing is owning a business. If I have succeeded in establishing a position in a good business at a fair price, I see no reason for wanting to exit that position no matter what price the market values my position. I am happy to stay invested in such a stock till kingdom come or till such time that the performance of the business no longer meets the tests that I set for all stocks. A businessman does not enter or exit businesses at will, neither should the intelligent investor. Owning business is not playing a game of rum and gin, pick cards that currently look promising while discard that are least promising. I think this tendency of investors to shuffle the deck constantly is probably the most important reason why sub standard results are experienced. Then there is a practical difficultly of exiting a stock that has delivered good results. What so I do with the proceeds from such a sale? The most difficult part of intelligent investing is to find good business at a fair price. Exiting one such business is the easiest thing to do, finding another to enter may be the toughest.

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