July 13, 2017

The logic of patience

Investors hear a constant refrain – be patient, think long term, blah blah blah. Is it similar to the sermons we hear about eating well and exercising more?

Let me share some thoughts on why patience is a critical to earning above average returns. I will try to approach it based on logic and not because the gurus of investing have been preaching it
Let’s walk through a series of logical arguments

1.     The stock market is usually efficient and generally prices most companies correctly based on their near term prospects. So if a company is growing at 30% per annum, earning 25% return on capital and has great long term growth prospects, then the market will value it accordingly.

2.     One can do better than the market only if you have a view about the performance of a company, which differs materially on the upside. If the company performs as the market expects, there will be no impact to the stock price. Only if the company performs better than market expectations, will the stock price will adjust upwards in response to the positive surprise. This is something most investor miss. They are looking for high quality companies with good management. The trick is find those where the market has yet to recognize the quality or improvement in performance (and price it into the stock)

3.     If you combine point 1 and point 2, it follows that some of the ways to do better than the market is if
  • You are able to identify the turning point in a cyclical industry, before the market. As it not usually not possible to time this perfectly, the best option is to be a bit early when there are some green shoots visible and then increase the position as the recovery gathers strength
  • The profits of the company are suppressed due to some short term issues in the industry (weather, demonetization etc.) which will be resolved soon. In such cases, one has to create a position when the outlook is still horrible and hold on to it till the external factors change for the better
  • Some One-off event such as a demerger causes one of the constituents to be mispriced
  • The profit of the company is suppressed as management is investing in the business which is hurting the reported numbers. As the market is still fixated on the reported numbers, one can create a position at an attractive price. However one has to wait for the investment phase to complete and the true profitability surface
If you look at all the above cases, one needs to ignore the near term prospects which are being overly discounted by the market, and focus on the long term. As a result, in such cases you will not see a validation of your thesis as soon as you create a position.

In my experience, one needs to look out at least 2-3 years and make a purchase accordingly. One then has to wait patiently and keep checking if the company continues to deliver as per your expectations

The impact of competition
For those of us who started investing in the late 90s and even around mid-2000, the level of competition in the market was much lower. One could find companies earning 30% return on capital, growing at 15%+ CAGR and selling at 5 times earnings (Marico was one such company). All one had to do was to dig around a bit and put in the money.

The mutual fund industry was nascent at that time and there were very few individual investors. I still recall getting blank stares when I spoke about value investing.
This has changed completely in the last 10 years. We now have an army of smart investors (professional and part-time) who scour the market looking for opportunities. In such as climate, I can bet that you will not find any obvious mispricing which can filtered on a screen.

In such a case, one has to dig deeper and put in more time and effort in understanding the business and its management. Once you get a better understanding than most other investors , you have to buy the stock and wait till the market, hopefully comes around to your point of view.
It would be foolish to assume that the change of opinion will happen as soon as you are done with your purchase. Some of the near term factors which drive the pricing, need to change before the market accepts your view point.

When is patience a liability?
Patience is of course tied with your style of investing and time horizon. If you are a day trader or momentum investor, then time is not on your side. If you time horizon is days, weeks or month then thinking of a multi-year period makes no sense.

The trouble starts when one does not know what kind of an investor you are? A lot of people think they are long term value investors (as somehow that is fashionable these days), but act like day traders – selling and buying over weeks. If you do not get your time horizon and investment approach consistent with each other, then you are in trouble as your will quickly tire of holding the stock and sell just before the inflection

Getting an edge
I had earlier written above three kinds of edge in stock market investing. The information edge is now more or less gone with tools for quantitative analysis and wide dissemination of information by management (look at the number of conference calls hosted by companies!). One has to rely on analytical and behavioral edge to make above average returns.

I personally think that analytical edge too is over rated as it is not possible to consistently have a superior insight with all your positions. Assuming that you are smarter than the rest of the market at all times, is pure hubris. The only sustainable edge left for an investor is the behavioral one and being patient in an age of distraction and immediate gratification is at the core of this edge.
Being patient is therefore not a moral imperative or something you need to do for the good of humanity, but is a logical necessity to do well in the market in the long run as a value investor.
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.


Unknown said...

Very true. Patience to hold a conviction stock while all moves and this one stands still ( as mkt takes it own course of time to price facts or company starts to deliver as per expected lines), is the key differentiator.

Unknown said...

Brilliant. thanks for sharing