As someone wise said, markets are at the riskiest when there is widespread belief that there is no risk, since this makes investors feel it is safe to do risky things. With stock prices surging day-after-day (esp. in the broader markets), Indian markets may be racing recklessly in such a risky zone at the moment. The hardest thing for investors today is to spot where the risk could come from for our markets. When one has to struggle strenuously to spot the risks, investors increasingly feel safe to take higher and higher risks, which eventually makes the market riskiest. We may not be far from that stage.
This does not mean that the markets can’t rally further from here. In all likely-hood, the rally could relentlessly continue and test one’s patience on the upside. But with the rising risks, it is important to understand that valuation will regress to the mean sooner or later. This may be an apt time to remember the golden words of Buffett, “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.”
This is time for doing nothing, except few selective stock-specific actions with regard to pruning and profit booking. Raising cash levels in the portfolio using such selective actions is critical to capitalize on the correction that would eventually come.
Returns from investments are typically determined more by the price paid than the growth rate – Seth Klarman
Is investing all about identifying great companies or spotting the most mispriced ones? There are no easy answers to this. Growth investing gets glued on to the earnings so much that it exclusively focuses on its attempt to predict earnings growth to the decimal point. Invariably, it ends up spotting opportunities that are priced to perfection. With no safety cushion, any upset, which inevitably happens given the unpredictable business cycles, can dent the projections that have been made with so much precision by spreadsheet specialists. As a result, it becomes one of the most risky investing style in the long-term, though entices the investors with its short-term performance. It is a model designed to deliver short-term out-performance at the cost of long-term under-performance. Value Investing is diametrically opposite. It doesn’t excel in the enticing earnings model, but gets excited with the most mispriced moments. Value investing focuses on opportunities that are most mispriced to long-term intrinsic worth. Since growth is an embedded part of the intrinsic equation, it is a perfect blend of both.
Now, let us look at the more interesting part of investing. What is the inter-play of growth and value in terms of their contribution to the overall long-term returns? This is an interesting question to ponder. Intuitively, one might tend to believe that large part of long-term returns comes from growth. Surprisingly, the empirical evidence suggests otherwise. As the most renowned value investor Seth Klarman says, much of long-term returns come from the buying price ( Value) than the earnings (Growth). Our own experience in this market cycle (from FY13 to FY17) proves this beyond doubt. Below chart from our house research captures this data for stock ideas that we had invested in this cycle. Even to us, it was a big revelation that such a big part of returns (over 75%+ in most cases) had come from mispricing. Change in earnings had contributed far less in the overall returns.
Now comes the difficult part. To act decisively in the most mispriced moments require contrarian streak. For an investor, this is the most coveted asset. The big part of value, an investor or the fund manager brings, stems from this contrarian skill. It is as simple as that. As in life, simple things are the hardest to nurture and develop. More so with contrarian skill, as it encompasses enviable traits such as deep rooted conviction, rationality and agonizing patience. To paraphrase Warren Buffet, investing is less of an IQ game than an EQ (Emotional Quotient) one. Contrarian skill is one big part of this EQuation. Another chart that captures this value brilliantly is the one pictured below on the behavioral gap. Nothing much to be said further I guess, to emphasize more on the role of temperamental skills (soft traits) on successful investing. “Less is more” is apt here too.
Happy Value Investing!!