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Developing competitive advantage as an investor (October 9, 2016)

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Investing literature is rife with guru’s urging investors to buy companies with competitive advantage.   Investors are also business people taking capital allocation decisions.  They face opportunities and threats and have to use their personal strengths while avoiding blind spots.  How can one develop competitive advantage as an investor to take better decisions?

 

We believe analytical ability is table stakes and not a differentiator. For sure, some investors are more skilled in being able to see around the corner; but by and far, we believe competitive advantage lies in consistent use of a good process and control of behaviour during market extremes.

 

A few suggestions I have found useful in my journey.

 

a) Find and stay true to a process that works for you

There are multiple paths to nirvana.  People have made money investing and trading.  However, there are very few people I know of who have created wealth doing the same simultaneously.   That is not surprising.  Trading and investing require different approaches and mind sets.  It is hard to simultaneously retain two opposing constructs in the mind and function well.  For example, many traders will cut losses at a stop loss, yet investors will buy more at lower prices.

 

Finding the approach that works for you is a journey of self- discovery.  This may take some time and experimentation. That’s fine.  Its important to have conviction in the process you eventually follow.  Not the one that has made your neighbour rich because their capacity for risk taking, or tolerance for mark downs may be far higher than yours.  The biggest risk is not having an opinion of your own, that is backed with conviction.

 

Staying true to a process is even more critical.  We have chosen to be ruthlessly focused on long term outcomes.  As a consequence, we have eliminated equity derivatives trading at our firm because we want everyone focused on long term outcomes.   Over time, we are also becoming more selective in only buying quality companies rather than make a quick profit on those available cheap.   One can’t foster a long term focus if rare exceptions are made for short term decisions as opportunistic profits lay the foundation for bigger losses down the line.

 

b) Long term Investors need to accept corrections as part of the journey

History teaches us that stock prices are slaves to earnings.  By extension, we believe that the key to long term investment success is the ability to buy and hold onto companies that can compound earnings over long periods of time.  However, that is easier said than done.  Programmed over millions of years, our brains our wired to send signals to flee when faced with threats.  Hence,  falling markets tend to trigger signals to sell.  Taking an action to sell gives one the emotional comfort of taking control to prevent losses.   Successful investing requires one to act contrary to natural instincts.

 

At a value investing conference last week I heard Mr Raamdeo Agarwal shared his personal journey of wealth creation from 0 Cr in 1987 to 1000 Cr in 23 years.

  • His journey had 3 incidences where the total Assets from peak to trough declined by over 50%.   Despite his discomfort with market valuations, he stayed invested.
  • He remarked that it is hard to judge when markets will correct.  Trying to exit positions to re time entry is a bigger risk
  • And,  as long as the underlying company earnings are growing, while prices may correct, the underlying value of your investment continues to expand.

 

I witnessed the same discipline in Rakesh Jhunjhunwala when I worked under him.

  • Gripped by fear during market declines, I must have sold TITAN at least 4 times between 2006 to 2012, only to buy it back higher at every instance; finally he sat me down for a chat and lightning struck.
  • While RJ made over 40X on the Investment over 8 years, my returns are too traumatic to share as they are a reminder of what could have been

 

Willingness to bear temporary markdowns is an inescapable part of the journey for long term investment success! This is a common trait amongst all great investors.  

 

How does one minimise the chances to self-destruct by selling early?

  • Don’t invest in what you don’t understand.  This will minimize fear of the unknown
  • Find someone you respect in the fraternity to speak with before you choose to sell.
  • Reduce the instances where investment decisions are required.  Stop looking at your portfolio often.  Frowning at the numbers won’t make them change; and exultation may cause you to take the profits.  Fidelity found that those investors who logged into their portfolios infrequently outperformed the more regular by a wide margin.
  • Invest per your risk bearing capacity.  Don’t invest funds you require for the next 3 years into equities.  If you don’t need the money, higher probability you can talk yourself into staying invested
  • Use investment managers if you don’t have the time to do it yourself.  Invest the time to understand their approach
  • Give only lock in money to your Investment Managers– we don’t accept money if clients won’t commit to a “gentleman’s agreement” of a 3 year lock in

 

c) Read financial history

Investing is a lonely business and investment decisions should not be made by consensus.  Successful investing requires managing personal emotions around Greed and fear.  Understanding past behaviour of markets will give you the courage to take a contrarian position during extremes.  One of the gems I have framed on my office wall as a frequent reminder of market excesses is “Nothing undermines a man’s judgement more than the sight of his neighbour making money” (JP Morgan).

 

Reading financial history will also help practice “balanced detachment”.  While one needs to be responsible with tracking their investments (after all it’s a legacy for your children and grandchildren), some detachment is essential.  Financial history will reveal the role of market cycles and that every one, bar none, has great years and bad years.  I have not yet met anyone who has had only good years.  Keeping a broader purpose and history of markets in context, one is more likely to enjoy the journey and take gains and losses magnanimously.

 

d) Elongate your investment time horizons

Many fund managers do not have the luxury of being long term oriented because they are measured in short time horizons, typically between a few months to a year.  Hence, they tend to chase momentum.   We don’t tend to make decisions about our kids futures, our careers or our spouses in the same manner.  Why should investing be any different?

 

A longer time horizon opens more opportunities.  Take the analogy of the Chinese bamboo tree that stays dormant for 4 years and then grows 80 ft in 6 weeks.  There are companies who are investing heavily in building competencies by reinvesting profits from the core business into new ideas (research and development, opening new markets, testing customer propositions etc).   Even as the business model is being strengthened, reported earnings are depressed.   Hence, valuation ratios based on traditional metrics render the companies expensive.

 

An Investment manager who is evaluated on short term returns is unlikely to buy these for you.  By elongating your time horizons, you increase the probability of buying tomorrow’s leaders.    A process we follow is to think of Investments under three categories and allocate Capital accordingly – today’s leaders, emerging leaders and Chinese Bamboo trees

 

e) Selling smartly

While the adage “time in the market is better than timing the market” is true, it should not be interpreted to mean one should never sell.  Successful investing is also about existing during excesses (as opposed to mild over valuation).  I have heard the smartest investors regret not selling Infosys at the time of the dot com mania.

 

Signals of greed are not difficult to identify.  However, one should differentiate excesses from mild intoxication, and look at individual company valuation rather than the market.

 

A process we follow to decide exit is one that “minimizes regret”.  We stay invested if valuations are ~20% above what we think is fair zone. We start trimming above 20% and sell above 50%.  Sure, one could make a mistake in exiting because a company grows faster than estimated, but we believe this discipline will serve us better in the long term as we are more likely to escape bubbles and we don’t have the constrain of size as yet.

 

f) Ask what you learnt from your mistakes

When you make money, its not entirely clear whether it was because of a good process or because of luck.  However, when you lose, in almost all cases there was a flaw in the decision.  Introspection on these mistakes is invaluable.

 

Our best clients (while reviewing performance) always ask me what I learnt during the last 6 months.   They understand that wrong calls are an inescapable part of the journey and by ensuring I am aware of them, the probability of repetition is reduced.

 

Enjoy the ride

 

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