September 12, 2010

Ignore the index – clearing some confusion

As expected, my previous post got a lot of good comments and emails questioning my logic (and sanity :) ) . Most of the comments highlighted a lot of valid points against my assertion, that one should ignore the index when investing directly in stocks. I can bet a lot of you must have rolled your eyes when you saw the title and read the post :)

The main reason why my previous post may have appeared rash is that I did not explore all the nuances of investing, while ignoring the index. Let me start by highlighting some assumptions behind the previous post

- My key assumption behind the previous post was that the investor is investing for the long term and would not be bothered by short term fluctuations of the market or the stock price.
- The investor is a reasonably informed and diligent investor (a do it yourself kind of person)
- The investor has done his or her homework or analysis and has sound reason for believing that the stock is undervalued. In other words, the investor has evaluated the business well and believes that the company will do well in the long run (increase its intrinsic value).
- The investor is looking at building wealth in the long run and would be satisfied with above average returns (couple of percentage points above the index in the long run) and not looking at beating the index every quarter or year.

Let’s explore further by what is meant by investing while ignoring the index –

Sound fundamental analysis
The first requirement for this type of approach is that the individual has analyzed the company in detail and has good reason, backed by experience, to believe that the company will do well and the stock is also undervalued.

It is common to find undervalued and cheap stock during bear markets and market panics. It is however not a fact written in stone that one cannot find cheap stocks during bull markets and overpriced one’s during bear markets (hint – look at bharti airtel’s performance since Jan 2009 during which period the index has almost doubled).

When I suggested that one should ignore the index when investing in individual stocks, I did not mean that one should stop thinking and buy a stock which does not offer a good margin of safety. My assertion is that the process of evaluating a company and deciding if it is undervalued or not is not linked to the index levels.

A stock is undervalued if the current price is well below the conservatively calculated fair value of the company (which depends on the future performance of the company). This undervaluation or overvaluation does not depend on whether the index is overpriced or if it is raining in Timbuktu.

What if the market drops?
If you believe that company is selling below the fair value and you have confidence in the long term performance of the company, why does it matter if the market and the stock price drops after you have bought? Is it a tragedy that you bought a stock at a 50% discount to fair value and the stock went to 60% discount before eventually reaching fair value and giving you a 100% return in the process?

Is your approach to buy at the very bottom and sell at the absolute top ?

The problem with most of the investors is that they look at the short term price performance to validate their analysis. If you have that mindset, then it is very difficult to hold a stock for the long term as almost every other company which has given good long term returns has had short term spells of absolutely disastrous price performance.

The sole validation of your analysis should be the fundamental performance of the underlying business. If the company does well, the stock price will follow in due course of time. In the short run, the stock price will be influenced by market sentiments, news, liquidity and god knows what other factors. In the long run (usually 2-3 yrs), the price does catch up with value.

If on the other hand, the underlying business performance starts going south, then the best course of action is to sell and cut your losses (easier said than done). You will lose money in such a company even if the index goes up.

Buying the stock cheaper
The other argument I read repeatedly is that the stock price will come down when the market drops and an investor should be patient to wait for such opportunities.

I am all for being opportunistic and keeping some cash on hand to take advantage of such opportunities. I did not recommend that one should be fully invested during bull runs and not have some cash around if an opportunity presents itself. Asset allocation depends on several factors (age, target allocation % etc) and should be made based on your personal preferences.

Let’s say you do have ample cash and have to make a decision on a specific stock. If however you think that the market is too high and would like to wait for the market to drop to pick the stock cheap, then how do you know if the market will drop in 1, 3 or 8 months. In addition, can you be assured that the company will not keep doing well during this period and even if the market drops, the price may never drop to the current levels?

Finally, if you are confident that the market is going to drop soon (based on some logic or intuition), then are you buying index puts to benefit from it? If the market drops as you thought, then you will make money on your puts and also be able to buy the stock cheap !!!

Should you invest blindly during bull runs
I actually got accused of saying this in the previous post ! I personally don’t recall making this statement. Ignoring the index does not mean that you become blind to the valuation of individual stocks and start investing like a monkey.

It is true that stocks are usually overvalued when the market is in a bull run. Usually does not mean always and all the time.

My suggestion is this – disconnect the process of analyzing the stock and deciding whether it is undervalued or overvalued from the level of the market, GDP growth projection and other macro factors. One should focus on the specific factors which will drive the performance of the company and based on this assessment, decide if the stock is undervalued or overvalued.

If it is undervalued start buying! If you think the market will drop, then buy slowly and add to your position when the price drops. If you are wrong, then you would have missed a good opportunity. ofcourse all of this is easy to say and tough to execute.

The most cherished assumption
The market level seems to be one of the most fundamental drivers of buy/ sell decisions for most investors. I personally think it is worth evaluating this assumption and not dismissing it without thinking about it. You can always test it with a single stock or a very small amount of your capital and see if the assumption holds up.

The downside of this test is that you could lose a small amount of your money, but the upside is that it could open up a completely new way of thinking about the market and investing.


sachin8778 said...

Hi Rohit,
Thanks for this followup post.

This all makes sense to direct stocks investing by do it yourself investors. I think mutual fund investment, buy/sell decisions remain out of this thought process. I had bad experience by not booking profits in highs of 2008.

In your response to my comment on earlier you sounded like you have a different opinion on MFs and index level. I am looking forward to your thoughts and experience on this. Please do share at your convenience.


Sarang said...

Absolutely agree with your post. I will give a very recent personal experience to strongly support this.
Two stocks I analyzed thoroughly few months back and was convinced highly about their potential and that they were trading well below their intrinsic value, giving me margin-of-safety of at least 50-60%!
But I had a fear [as many of us have been having ever since the 'great-fall' :)] that market will correct soon so I didn't buy those well enough.
The stocks were Airtel and Bilcare and the price at what I analyzed those were Rs 260 (for airtel) and Rs 479 (for Bilcare).
I invested only Rs 13k in Airtel (@260) and 1.5k (yes... only 3 shares!) in Bilcare (@479) with target to invest at least 50k in each of the two once market corrects.

Now.... you see the price of these stocks today - Airtel Rs 350 and Bilcare Rs 630!!!

Assume a correction of 20-30% in the index now... you think I will get both these stocks below my 'first-buy-price'? - I hope I do, but I know I won't!

Lucky said...

Even better put. It is amazing how much you care. Thanks a lot.

Navjot Kashyap said...

Hey man,
Here we all keep talking about making money.But what about SPENDING it.Now its all well and fine that we invest and grow it,but without any plans for spending it,its just like putting it in a black hole.
So please write a post on it too.
To all the readers of this comment-I am very curious to know your views too.Please share them if you can.

Rohit Chauhan said...

Hi sachin
yes the post was more for direct stock picks. let me put my thoughts on mutual funds at a later date in a different post.

hi sarang
if you like these stocks and the worst case scenario happens ...then you will get an opportunity to add to these stocks. ofcourse that means that you are confident of your analysis and will the nerve to buy them. unfortunately that is something one cannot avoid if investing directly in the stock market


Rohit Chauhan said...

Hi navjot
thats an interesting question reason for not disucssing it is because it is a very personal decision and any dicussion about may sound like a sermon from me ..i dont want to be preachy ...

anyway will try to write something about it in the future


Rohit Chauhan said...

Hi lucky
thanks for the comment


Sarang said...

Thanks Rohit,
I am confident of my evaluation especially as I am investing for 5+ years. And one important thing the fall has taught is not to regret missed opportunities... not to chase a missed bus... gotta find out another stock or wait for these stocks to come down to right levels.
Market is to big to not provide value-buys to small investors! :) I am pretty much buying some bottomed out stocks (as per my analysis) and have a list ready for shopping when market crashes.

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