The power of mindset

I came across this article on the blog galatime. It’s titled ‘The effort effect’. The article resonated strongly with me. I think the power of mindset mentioned in the article is extremely crucial if one is to become a good investor.

The growth mindset (see diagram here) mentioned in this article is crucial to become a good if not a great investor. In comparison a fixed mindset (which a lot of us see around us) leads to poor performance in the long run. The key points of the growth mindset in terms of challenges, obstacles, effort, criticism and success of others are extremely relevant for an investor. As an investor one has to learn how to deal with new challenges and obstacles (the market and businesses around us are constantly changing). Effort is crucial in terms of a desire to constantly learn and improve oneself. Self criticism and an honest one is crucial too. One should be able to accept mistakes and learn from them and then move on. Finally I look at the other successful investors and try to learn from them.

The attitude referred to in the article is relevant to us not only as investors, but is important in other walks of life too.

In addition I found another link on the same blog on the mark of greatness. I found a similar article on greatness in fortune some time back (see link). The article in fortune mentions the following
Reinforcing that no-free-lunch finding is vast evidence that even the most accomplished people need around ten years of hard work before becoming world-class, a pattern so well established researchers call it the ten-year rule.

I have read in some other articles that 10 year or 10,000 hours of work is essential to achieve proficiency in a field. All the above research encourages me to keep working hard on becoming a better investor. Even if I don’t become a great or super investor, if I keep working at it, I will defintely be a better investor. My definition of a good investor is one who can beat the market by 5-10% points over a ten year period. I have done that for the last 6 years. I definitely plan to continue working on extending this performance.

update : 03/23

see here for an earlier post on the same topic

Wisdom of the crowds

There is a new article by michael mauboussin on wisdom of the crowds (see here). There is also a book on the same topic which I read earlier (see here). Website of the book’s author here.
The key take-away for me from the article and book has been as follows

1. The crowd is usually smarter than an individual. This means that one should discount what the experts are saying (most of the times). One should not waste time in heeding to their forecasts. It makes sense to read the insights of investment masters or good investors. One can learn from that, but stay away from forecast (especially short term) by the so called experts. Most of the personal finance websites is full of this junk. I consider it mostly as noise

2. The crowd (market) is right most of the time. What that means is that the valuation of most of the companies is right. It is not always right, but most of the time it is right. As a result if I think that the stock is undervalued and a good buy, I try to analyse my assumptions in depth and check my variant perception in more detail to be sure that I have got it right and market is wrong on it. Almost 90-95 % of times I have found that the market is right and my edge is limted to 5-10 % of the cases.

3. Be humble – One should always have a growth mindset and learn from the market and others.

4. Even if individual investors are not extremely smart, the market as a whole is smarter than the smartest individuals ( see the article and book on how this is true)

5. There are a few situations (bubbles and crashes) when the diversity and collective wisdom breaks down. In such situations, it makes sense to diverge in your thinking from the market and not be swept by the euophoria or pessimism. For ex : the dotcom boom of 2000

I would recommend reading the article and the book as it would be a great addition to one’s mental models.

Disclosure : I have no financial interest in anyone buying ,borrrowing or stealing the book. Unlike stocks, I am always happy to recommend books as there is a limited downside to these recommendations

Analysis - Facor alloys

About
Facor alloys is in the business of chrome alloys, which is used in the production of steel. The company has a capacity of 70,000 MT (industry capacity - 7 lac MT) and is located in Andhra Pradesh. The company emerged from a demerger of the FACOR group in 2004

Financials
The company was created by the demerger of the FACOR group into three companies, one of which was Facor alloys. The company had accumulated losses and underwent a restructuring exercise during the initial years. The current promoters for the company injected funds into the company and the debt was also restructured in the initial years
The company has since then turned around its performance. The debt has been wiped off and the preference capital has also been paid off. In addition the company, now has cash balance in excess of 30 crs which is around 25% of its market cap. The company has more than doubled its topline in the last 6 years and net profits have gone up considerably too. In addition the asset turns have reduced and Working capital turns have remained steady. All in all the asset efficiency has improved in the last 6 years.

Positives
There are several positives for the company. The company has a strong balance sheet. In addition the steel market which is the consumer industry for the company’s product is growing in excess of 7-8% and hence the company should see adequate demand for its product.
Chrome ore and power are the key raw material for the company. The company has ample cash on the books which it is planning to utilize to invest in a group company to access captive power. In addition the company is also in the process of acquiring chrome mines to gain access to reasonable priced ore. These two developments should provide some hedge to fluctuations in the price of the end product.
The management has also been sensible in allocating capital and has turned around the financials of the company. The company also has accumulated losses which should help in reducing the tax outflow and improve the cash flow for the company.

Risks
The company faces a lot of risk. The industry in which the company operates is a price competitive commodity industry. This industry has low to non-existent pricing power and minor competitive advantage from scale of operations. Due to the nature of the industry, most companies in this industry are unlikely to make high returns over a business cycle.
The company is a much smaller player with exports to various markets across the world. However the Chinese market has considerable impact on the steel demand and hence any slowdown in china could hurt the company, both directly and in-directly.
The company was re-structured in the past and has worked to turn the business around. Although small, there is always a chance that the performance could turn south again

Competitive analysis
The industry is a competitive, commodity type cyclical industry. There are a lot of small companies in this industry in india. Finally the Indian companies are at a cost disadvantage with respect to their south African competitors who have access to low cost power and better ore quality.
The pricing in the industry is determined by the demand supply situation and is also based on the mid to long term contracts with the steel manufacturers.

Management quality checklist

- Management compensation : fairly reasonable at less than 1% of sales
- Capital allocation record : fairly good for the last 6 years
- Shareholder communication – average
- Accounting practice : appears conservative
- Conflict of interest: none that I could see. The company has access to low cost ore from sister company
- Performance track record : appears good for the last 6 years. However industry economics are bad

Valuation
The net margins and the topline growth of the company maybe at a cyclical high. The fair value of the company is between 7-10 if one assumes that the normalized margins are in the region of 6-8% and the growth will average 8-10%. The reason for having a range is that it is difficult to pinpoint a single number as ‘the’ margin or topline growth and peg a fair value to it.
In terms of comparison to other companies in the sector, the company is selling at a 30-40% discount to other companies in the sector.

conclusion
If you search the internet on this company, you are likely to find this stock being touted the next microcap to make you rich. I have seen price targets ranging from 12-15 rs in the next 6 month. The geniuses giving these price target don’t know what they are going to eat tomorrow, but know what the stock price would be. It is still debatable who is the bigger idiot – the one giving the price target or the one acting on it.
I have personally created a small starter position in the company as I am now focused on learning and analyzing small cap and commodity type companies. These companies involve a different approach and mindset. The stock price is very volatile due to the nature of the industry and the size of the company involved. As a result, my estimate of fair value is not more than 9-10 in the best of the circumstances.
The stock can provide decent returns if the demand supply situation remains stable in the next 1-2 years and the company executes well. However, as I said before, if you want to build castles in the air and daydream then there are a lot of geniuses in the market ready to sell you a nice price target.

The anatomy of value traps

The number one problem faced by value investors is not a big permanent loss of capital, due to overpayment for growth, but the weak and anemic return from an average business bought at a cheap price.

Let me explain further –

A typical value investor (who are far and few anyway) generally tend to be conservative in paying up for a business. The deep value types go for the really cheap stocks (as measured by low PE or P/B ratios), whereas the others would pay up a bit for the quality of the stock and growth, but not too much.

A deep value investor typically looks for a company which is selling in low single digit PE ratios and in some cases if you back out the cash or other assets on the balance sheet, the core business could be available for almost nothing.

What is a value trap?
The problem with most of these investments is that the underlying business is stagnant with a comatose management who is not interested in either growing the business or ready to return the excess cash to the shareholder. In such cases, the market discounts this cash heavily and refuses to bid up the stock price.

Let me a give a personal example – Kothari products. You can read my earlier posts on this company here and here

Let’s look at the price history for the company below

As you can see, that the stock has gone nowhere in the last 5 years. If one includes dividends then, the return comes to around 15% for the entire 5 year duration. The index during this period has more than doubled.

Even a savings account would have done better!!

What are the key causes?
There are several causes for such value traps. The primary cause is a stagnant or declining business with a management which keeps pouring capital into the sinkhole. If on the other hand, the business is generating excess cash, the management keeps hoarding it and refuses to return it to the shareholder.

The second reason is that the underlying economics of the business has deteriorated and the market realizes it with a lag. Case in point – the telecom industry. The economics of this industry has gone into a tailspin for the last few years, with almost everyone bleeding money (except probably bharti airtel). In such cases, if you keep looking at the past data and do not understand how the economics of the industry has changed, you can get stuck in a no-win situation

The last category of value traps are the low return, second and third tier commodity players. These companies have a low return on capital over the entire business cycle, and unless you can dance in and out of the stock in time, you can get stuck with very low returns.

How to indentify value traps before hand ?
That’s the tough bit.

For starters, investors like me need to get out of the low PE, cheap stock mindset. A really cheap stock is often cheap for a reason. It makes sense to dig deep and understand the business in detail to figure out why the market is valuing the company at such low valuations ?

If a company has been cheap for the last 5 years, why should it suddenly get re-rated just because smart lil me bought the stock?

One needs to understand the economics of the business in depth and also confirm that the management is creating value for the shareholder and not just twiddling their thumbs. Only if you have a strong belief that that business is doing well and will continue to do so and the management is also good, then should you think of making a commitment to the stock

What if you are caught in value trap?
There are no easy answers. For starters, swallow your pride and sell the stock. That’s easier said than done – ask me!. The unfortunate bit is that people like me take 10 years to realize it :). Luckily for me these mistakes have not been big enough to damage my long term returns.

The risk of holding onto such investments is that although you do not lose money on paper, in reality you are losing the benefits of compounding by not investing the same money in other opportunities. It would be silly to compound your money at 10% in a value trap, when the index itself can give you 15% without any effort.

If you have invested in one of those low return commodity stocks, hope that the commodity cycle turns and market in its temporary fits of insanity, re-prices the stocks. As soon as this happens, sell the stock and never look back !

It is always a constant struggle to avoid value traps, as they come in various shapes and forms. One has to be vigilant and learn to exit them, once you have realized that you are stuck in one

Two differing ideas – Akzo nobel and Techno fab engineering

I have a constant struggle in my mind – Do I pay for quality (overpay?) or do I buy cheap stuff, which may turn out to be a value trap.

The ideal situation would be to get a high quality stock at a cheap price. But then if wishes were horses!, I would be a good looking billionaire with my own private island J.

So let’s look at my current dilemma

Akzo nobel

Akzo nobel is a global company in the business of decorative and auto paints and other industrial chemicals. The company acquired ICI plc a few years back and thus got the Indian business of ICI with the acquisition.

 ICI paints (atleast in the late 90s) was a company with good brands and was fairly aggressive in the paints business. At one point, they even tried to acquire asian paints by buying out the stake of one of the promoters.

ICI paints is one of the oldest paint companies in India and is fairly strong in geographical pockets (West Bengal) and in specific products (premium paints). The company has however not been able to capitalize on its strength in the past and did not seem to have a focused strategy. The new management however seems to be developing a focused strategy of introducing new products, expanding distribution and spending on brand building.

The paints business is a very profitable business with very high entry barrier (I saw this first hand when I was working in the industry). As a result, most of the companies in this business have enjoyed above average growth and high returns on capital

Akzo nobel india has a Return on capital of 100%+ (excluding excess cash on the books) and has been able to grow the topline  and profit by 30% in the last 5 years . In addition the company has been shedding the non-core businesses and freeing up capital. The company is also investing in manpower, its brands and expanding its distribution.

My hesitation in investing is the valuation. If one excludes cash, the company is selling at around 18-19 times earnings. On a comparative basis, the company is cheaper than other paint companies such as asian paints (around 30 times earnings). However I don’t believe much in comparative valuations and find the current valuation a bit high compared to the prospects.

Techno fab engineering

Technofab engineering is in the EPC space and is involved in various turnkey engineering projects in  industries such as power, industrial and oil & gas.

The company came out with an IPO in 2010 at a price of around 235 per share. The stock currently sells at around 142 / share (selling below the IPO price does not mean it is a bargain!)

The company has been in this business from 1970s. The company has grown its topline and profit by more than 30% per annum in the last five years (which means that in the past the business barely grew). The company clocked a turnover of around 290 Cr in 2011 and has around 900 Crs open order book (almost 3 yr visibility)

In addition to the above, the company has around 100 Crs of cash on the books (some of it due to the IPO) which will be invested in expanding capacity to manage the higher order volumes. The company is thus selling at around 2 times earnings, has shown 30% growth in the recent past and delivered a 30%+ return on capital during this period.

The company looks like a complete bargain?

I am not so sure. The EPC industry is characterized by moderate to low entry barriers, high levels of competition (from the likes of L&T and others) and high working capital needs. In addition it is also a very cyclical industry with drop in margins and cash flows during the down cycle.

The dilemma

So the dilemma is whether to invest in an above average business which may be fully priced or in an average business which is very attractively priced.

There is no obvious answer in the above case and it depends on each individual’s mindset. I have invested in technofab types of businesses  in the past with decent, though unspectacular results. In contrast if I am able to invest in a good business at decent prices , then the returns are fantastic

I have not made up my mind yet and have no position in either stock. I plan to dig deeper into Technofab engineering to get a better picture of the industry.

It is quite likely that I will just file away these companies and watch them till either the price is better (in case of akzo noble) or the business quality improves (in case of technofab engineering).

My personal investment journey - II

In the previous post, I described my investment journey till 2003. By mid of 2003, I had spent close to 6-7 years on reading and studying about the topic. I had read dozens of books on warren buffett and other value investors. In addition I had been analying companies for the past 5 years. So I understood the basics of investing, valuation and other aspects of investing.

What was missing was the experience and the softer aspects of investing. I had allowed myself to be swayed by the surrounding euphoria (partly though) in 2000. In addition by 2002-2003 when there were values all around (companies like L&T, blue star etc were available at a bargain), I was still not confident enough to go the whole hog.

If you have gone through this phase or are going through it, you will understand. If you have not seen a lot of success (mine was relative, I had done well compared to the market) and even if you feel that your are doing the right thing, it is not easy to jump in again completely. So during this phase, I increased my holdings, but I was very cautious (maybe overcautious) about it.

The market had gone nowhere for the last 10 years and so unlike today, no one was interested in stocks.

So what were the key learnings for me till 2003 ?

1. Do not over pay for a stock. I learnt this from SSI. Yes, sky is the limit for these hot companies. However for every Infosys or PRIL or L&T, there are 10 pretenders. In addition this kind of early stage investing requires a different mindset. I do not have that kind of mindset.

2. focus on companies with sustainable competitive advantage which have a profitable growing business and are available at a reasonable price. I have made the best returns from this group. Ignore the long shots ..companies which will be the next HDFC, next infosys, next L&T etc. Buy HDFC if it is available at a reasonable price otherwise find something else.
Valuation and price matters. Promise is all great, but if a company does not meet the promise then the stock price gets killed. I learnt it from SSI and a lot of other investors are learning that lesson now via other companies.

3. Be honest and brutual about your mistakes. Do blame others like analysts, media, friends etc. If you have made a mistake, accept it and move on. In short – don’t whine !!


2003 – 2006 (Beating the market and making some money)

By the end of 2003, the market was up 73% and I beat the market by a few points. As I had beaten the market during the bear phase too, I had gained in absolute terms by the end of the year.

The portfolio mix was roughly the same, with a new addition by end of the year of kothari products which was a small position (I started experimenting with a few graham type stocks)

By 2004 year end, my portfolio was doing fairly well. I had done better than the market with good gains in asian paints, concor, blue star etc. In addition I created a new position in BayerABS and Balmer lawrie by the end of the year.

I did no major additions or sale during 2005. Most of the stocks did well and the valuation gaps closed for several of my earlier picks as the market started recognizing these companies. I was able to do better than the market and was now fairly confident of my approach, which was now working well.

2006 was also a year with almost no activity in terms of buying or selling. To certain extent, I was still riding my earlier picks and to a certain extent I was finding it diffcult to find ideas which were as attractive as my exisiting one. I had done most of my picks during the bear market of 2001-2003 when good companies were available at throwaway prices. I was still searching for similar opportunities in 2006. That ofcourse was a foolish thing to do then. I was not going to get those kind of opportunities in a bull market.

By end of 2006, most of the companies I held, seemed to be fully valued. I liquidated almost 60-70% of my portfolio and ended the year with small holdings in asian paints, reliance (which I got through my RPL holdings), Bayer ABS and balmer lawrie. In addition I started building a small position in Merck and KOEL.

As an aside, in 2004, I discovered blogging and created my blog. This was my first post.

2007 (rethinking the approach)

I began 2007, with a fairly liquidated portfolio and few holdings.The really good companies seemed to be fairly valued and so I was not interested in them. As this time I started exploring graham kind of opportunities.

Till 2007, my approach was always to buy good companies and hold them for a long time. However I was always split between the idea of buying and holding even after the company was selling at or above my estimate of intrinsic value.

In 2007, I read a book by Mohnish pabrai (Dhando investor) and also a few other books and comments by warren buffett. I kind of realised that if one is interested in making higher returns then you have to look at buying undervalued companies and selling at intrsinsic value. The portfolio churn is more and you have work harder at finding new ideas, but the returns are higher. So I had a slight change in approach in 2007.

I built a position in KOEL (kirloskar oil) and sold when it hit intrinsic value. I created new positions in cheviot, India nippon, novartis, VST, manugraph, HPCL, grindwell norton etc. In addition I bought and sold IGL (after I felt I was wrong in my analysis), and did the same with MRO tek when it reached intrinsic value.

2007 was a crazy year. Anyone could have made money. I did well too (maybe too well). However I did not go whole hog as I was not comfortable with the valuation for most companies. I had not forgotten my earlier lessons. Frankly I don’t care how well others are doing or what they are recommending. Maybe some people can trade profitably by looking at the tides, but that’s not for me. Real estate companies, Capital goods companies looked like IT companies of 2000 and so I stayed away from them.

2008 (Doing more of the same)
Jan started with a major high in terms of the market and low activity from my end. I have been analysing companies since then and looking for new ideas constantly.

2008 has seen the market tumble from the all time highs. As I was not comfortable with the valuations by the end of 2007, I did not add much to my holdings. I try not time the market, but time the price (this is a quote by warren buffett). What that means is that my buy and sell decisions are based on the discount at which good companies are selling to their intrinsic value. If there is a big discount I will buy irrespective of the market level. Ofcourse, most of the times this approach takes you out of the market at highs and makes you more active when the market is tanking.

My activity levels in terms of buying or selling are higher this year. My portfolio was in a semi-coma state for a long period as there was not much to do. However with a slight change in approach and better values, there is more activity now.

Future ?

I don’t know how things will work out. What I know for sure is that I plan to keep reading and learning. I plan to add arbitrage to my portfolio and make it a higher percentage. However overall, I plan to develop my approach further and deepen my understanding of various areas such as accounting, options pricing, and economics etc . The focus is to learn topics which would improve me as an investor.

If you have been with me for these two posts, you can see why I have a strong preference for value investing. This approach has worked for me and allows me get a good night sleep. It fits my temprament of slow and delibrate thinking. I do not like fast paced action and thrills (in my portfolio, movies are a different matter).

Even among valueinvestors, there are varying styles and each one selects a different set of companies for his or her portfolio. I think it is driven a lot by one’s experiences. In my case, I have stayed away from high growth, hot sexy companies due to my bad experience with SSI and other IT companies. On the other hand the boring, dull but solidly profitable companies have given me great returns. Hence my preference for those kind of companies.

Taking advantage of quarterly results

We are deep into the quarterly result season and most of the channels and papers are talking about the X% growth or drop in the profits of companies. It almost feels like a fashion parade J
A few years back, the stock market reaction to quarterly numbers was not too high and stocks would rarely move by a few percentage points. Now a days, it is quite common to see a 5-10% swing in the stock price, based on whether the company has beaten or fallen short of expectations. Most of the times, the expectation is around the net profit with minimal analysis beyond the reported numbers.
If you can keep your emotions in check and look beyond the headlines, you can make some sensible investments during such emotional reactions

Homework

For starters, one needs to have done his or her homework before hand. You have to constantly look for new ideas and analyze them in detail on a regular basis. A lot of times, the company could be performing well, but priced for perfection (high valuations).
In other cases, the company could be going through a cyclical downturn and the stock price would be reflecting the near term bleak prospects (though the long term could still be good)
In all such cases, one should do a detailed analysis before hand and have a trigger price in mind. If you are lucky, a excessive reaction to the result could give you an opportunity to act.

Digging through the results

Once the annual / quarterly results are announced, it is important to analyze the results in detail and look beyond the obvious numbers.
For starters, look at the lead indicators. For example, in case of banks and financial institutions, disbursements / approvals start rising before the topline and profits pick up. If you keep a track of this indicator and see it rising, it is a good indicator that the performance of the company is likely to turn around soon.
If the price is right and the lead indicators point in the right direction, it may make sense to start a new position in the stock.

Have a sense of the business cycle

In addition to the obvious indicators, one needs to have sense of the business cycle too. You don’t have to predict the exact timing of the turn, but a general sense will help. This is relevant for the cyclical industries such as capital goods or materials (cement, steel etc) and banking too.
The quarterly results could give you a sense of the drop from peak to trough (drop from the peak profit levels) and can be used as a rough guide to plan your purchase.

Read /listen to the conference call
The conference call is unique source of information which is not available through any other channel. One should read the transcript or better yet, listen to the conference to gauge the thought process of the management and the direction of the business.
All the above suggestions may sound fuzzy to you and do not provide a clear buy signal at any point of time. The problem is that by the time the signals are clear and loud, it obvious to everyone that the company is doing well and the price starts reflecting the same.

If one wants to generate above average returns, then it is crucial to keep your emotions in check and look for the faint signal in all the noise. One needs to look at the results holistically and digest both the quantitative and qualitative information to arrive at a conclusion (which often means doing nothing). It is not as difficult as it sounds, but requires a different mindset and practice to have some success at it.

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

Cash and portfolio rotation

This short note went out to subscribers recently

You may have noticed that we have been churning the portfolio – selling down old positions and replacing them with new ones, but have not utilized the cash. This has been on purpose as I want to dispassionately look at all our positions and exit those where I feel that the overall risk reward equation could improve by replacing it with something else.

In some cases, the expected returns of the new position may still be the same, but the company has more avenues of growth and has shown consistent performance in the past. In effect the risk profile is lower for the new company. So, the rotation is not always to improve the returns, but often to reduce the risk of the overall portfolio too.

I have harped on the aspect of risk since last year and we were early on it. This will always be the case. No one can predict when the market will turn. Those who claim to do so, are lying and delusional. The best mindset to adopt is to focus on the performance of your companies and ignore all the chatter in the market.

We now have over 30% cash in the portfolio which is slightly higher than the start of the year. I continue to look for new ideas and that is my focus for now. As a result, I have even delayed the half yearly note, which can wait for now.

As the market continues to fall, several good quality companies have started to become attractive and we will deploy our cash when I am comfortable with these companies. I have no idea when the current downturn will end – though I am sure it will eventually.

In the meantime, we could suffer quotational losses on our portfolio (based on the market price), which should not disturb us if the companies we hold continue to perform well. The stock price will eventually follow the earnings.

As I have said in the past, one needs patience to invest sensibly in the stock market. Add a lot courage and a sense of long term optimism to it now.
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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

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.