Investment Philosophy
The key to long-term investing success is to find great companies and hold onto their shares as long as you can.
Before we start with Investment philosophy, let's look into the major investment mistake to avoid -
Investment mistake - Holding on to bad business for long period of time hoping to get money back and selling good businesses soon before losing paper profits.
Rather than above, investors should always - Water the flowers, not the weeds.
1. Market Capitalization (large/mid/small cap) doesn't matter as long as it is growth company
Investing in growth stocks can be a great way to earn life-changing wealth in the stock market. Growth stocks are companies that increase their revenue and earnings faster than the average business in their industry or the market as a whole. Unlike value stocks, growth stocks tend to be more expensive than the average stock in terms of metrics like price-to-earnings, price-to-sales, and price-to-free-cash-flow ratios. Yet despite their premium price tags, the best growth stocks can still deliver fortune-creating returns to investors as they fulfill their awesome growth potential.
Value investing looks more at whether a stock is attractively valued than at its future growth prospects, seeking to find out-of-favor companies that have had their share prices unfairly beaten down.
2. How to find growth companies
Identify powerful long-term market trends and the companies best positioned to profit from them - Companies that can capitalize on powerful long-term trends can grow their sales and profits for many years, generating wealth for their shareholders along the way.
Further narrow your list to companies with large addressable markets - The larger the opportunity, the larger a business can ultimately become. And the earlier in its growth cycle it is, the longer it can continue to grow at an impressive rate.
Narrow your list to businesses with strong competitive advantages - Invest in growth companies that possess strong competitive advantages. Some competitive advantages are - (1) Network effects, (2) Scale advantage, (3) High switching costs
3. Growth companies can be expensive
Stock prices are high relative to their sales or profits. This is due to expectations from investors of higher sales or profits in the future, so expect high price-to-sales and price-to-earnings ratios. They're expensive now because investors expect big things. However if growth plans don't materialize, the price could plummet.
Don't obsess over valuation - instead, focus on business quality. It's far more important to be right about the quality of a business that it is to anxious over its valuation. Overpaying for a stock doesn't make sense, but certain stocks can carry what seems like high valuations and still do very well over a long period of time.
4. However Market provides ample opportunity to buy Growth companies
This is the stock price chart of Asian Paints over the past 20 years - stock is up >110x during this time. It looks so simple to buy and hold quality companies, however it has not been easy journey.
During period 2000-03, too much volatility in the stock, even though business remains good. Also, almost no return in 3 years.
Again from 2003-2004, nothing happened for 2 years and then 3x from 2005 - 2007. Within this bull run, stock corrected 20% from Jan 2006 to Jun 2006.
By Jan 2008, it was too tempting to sell the stock after long bull run.
However, those who not sold the stock saw biggest decline of almost 40% within period of 10-11 months from Jun 2008 to Mar 2009.
The next 5 years saw the biggest run of stock up 9x in 5 years. Stock has become overpriced from value investing perspective (intrinsic value), however those who did not sold saw stock going further 2x during 2015 to 2020.
It clearly shows that those who held Asian Paints (or similar such businesses) for these 20 years saw huge wealth creation, however it was not a simple buy-and-forget decision. The act of ‘not acting’ on a longer time frame was made up of hundreds of small decisions that led to the ultimate decision to ‘not act.’
Sitting on stocks – the ones that remain high quality – is not as simple as it sounds. And that’s why patience is one of the most important yet difficult skills one must cultivate while investing in the stock market.
To make money in stocks you must have “the vision to see them, the courage to buy them and the patience to hold them.
Patience is the rarest of the three, and is not an easy skill to develop however easy experienced investors or advisors may make it sound. But if developed and practiced well, it pays off well in the long run.
5. Think and act long-term (invest for the long term)
Stock market has a fundamental identity: It is a place to buy and sell pieces of a business. This also means that a stock will do well over time if its business does well. So to excel in investing, one need to identify companies that can grow strongly over the long run. If everything you do needs to work on a smaller (let’s say 3 year) time horizon, then you're competing against a lot of people. But if you're willing to invest one a sever-to-ten year time horizon, you're now competing against a fraction of those people, because very few companies are willing to do that.
Long-term horizon also means that you don’t have to follow the stock price every single day and you can focus (spend time) on building your conviction on the quality of the business.
Also, I advocate that if you invest for the long haul, then prefer never to sell the stock (unless you realize big mistake from your side during research process or something changed drastically as described in section 9 below). This helps winner to get big positions and will dwarf the losers.
Best way, is to do your research, have conviction, then do proper allocation to the stock, followed by patience which will help to create wealth.
Learn to average up - if you have conviction on your research & identified strong/great business, then don’t hesitate to average up over time. This is no general rule, as it depends on the timing of your purchase. If you have just bought a stock and the whole market corrects by 10%, then you shouldn't hesitate to average down instead of averaging up.
6. Volatility is normal
Volatility in stock prices is a feature of the stock market and not a bug. Even the stock market's best winners exhibit incredible volatility. For example, Monster Beverage's share price was up by 105,000 percent from 1995 to 2015, making it the best performing stock in the US market in that timeframe. However the truth is that Monster has been a gut-wrenching nightmare to own over the last 20 years from 1995 to 2015. It traded below its previous all-time high on 94 percent of days during that period.
On average, its stock was 26 percent below its high of the period two years. It suffered four separate drops of 50 percent or more. It lost more than two-thirds of its value twice, and more than three-quarters once.
Volatility scares enough people out of the market to generate superior returns for those who stay in. There really is nothing to fear about volatility. It is normal.
7. Expect, but don't predict
The financial markets are incredibly hard to predict. So it's important to stay humble. What I do to handle the uncertain future is to expect. The difference between expecting and predicting lies in the behavior. A look at history will make it clear that bad things - bear markets, recessions, natural disasters, diseases, wars - happen frequently. But they're practically impossible to predict in advance.
If we merely expect bad things to happen from time to time while knowing we have no predictive power, our investment portfolios would be built to be able to handle a wide range of outcomes. On the other hand, if we're engaged in the dark arts of prediction, then we think arrogantly that we know when something will happen and we try to act on it.
8. What do I look in the company before buying (checklist) - 4 M's
You need two things — a moat around the castle and you need a knight in the castle who is trying to widen the moat around the castle. ~ Warren Buffett
Moat/High entry barrier - A moat is obviously the water around a castle but in investing terms, a moat is the durable competitive advantage that a company has that protects it from being attacked by competitors. It makes a company predictable and allows us to put a value on the business. Moats are important from an investment perspective because any time a company develops a useful product or service, it isn't long before other firms try to capitalize on that opportunity by producing a similar--if not better--product.
4 steps to identify whether or not a company has an economic moat -
Evaluate the firm's historical profitability - Operating Margin, Return on Equity (ROE) and ROCE
Assuming that the firm has solid returns on its capital and is consistently profitable, try to identify the source of those profits - Is the source an advantage that only this company has, or is it one that other companies can easily imitate? The harder it is for a rival to imitate an advantage, the more likely the company has a barrier in its industry and a source of economic profit.
Estimate how long the company will be able to keep competitors at bay - the longer the competitive advantage period, the wider the economic moat.
Think about the industry's competitive structure. Does it have many profitable firms or is it hyper-competitive with only a few companies scrounging for the last dollar? Highly competitive industries will likely offer less attractive profit growth over the long haul.
Types of Economic Moat - (1) Low-cost producer, (2) High Switching cost, (3) Network Effect, (4) Intangible Assets (such as intellectual property rights (patents, trademarks, and copyrights), government approvals, brand names, a unique company culture, or a geographic advantage).
Management - need to have confidence in the management. Management should put shareholder value above any superficial or selfish motives.
Focus on ROIC (Capital allocation skill)
Share repurchase during down market cycle
Compensation
Monitor management guidance & execution skill - read all annual reports and management interviews
The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share. In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if managements and financial analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes in that figure. - Warren Buffett's 1979 Letter to Berkshire (BRK.A) (BRK.B) Shareholders
Momentum / growth -
Sales and profit growth rate - level of growth at greater than 10% every year over last 10 years
EPS growth rate
FCF growth rate
Book value per share growth rate
Margin of Safety - Calculate value of stock through several methods and find out margin of safety
Relative valuation (P/E ratio, P/Book value)
Discounted cash flow
Expected value framework
9. So when to sell the stock
Generally prefer to have holding period as forever
Our favorite holding period is forever - Warren Buffett Buffett says if you don't feel comfortable owning a stock for 10 years, you shouldn't own it for 10 minutes.
As we have seen in the above example of Asian Paints, if the company is a good business, keep holding the stock forever even though short-term volatility in the market. Now this short-term can even by 2-4 year period which can unnerve any investor, however key is to focus on the big picture and hold on the stock.
However there are times when fundamentals of company deteriorates or Moat of the company gets invaded, in this case re-look into the investment.
When I realize that I made a mistake in buying a stock.
When the business model of a company deteriorates.
When the cash flows of a company deteriorate.
When the debt on a company’s balance sheet crosses my comfort level (usually 50% of equity) and is expected to remain there for some time.
When something happens to cast doubt on a company management’s integrity (like a bad diversification, or an overvalued acquisition).
When the return on equity falls below 15% with no sign of improvement.
Conclusion
Spend time finding good business (it may take few years to do so and that's okay). Once you find the good business, be patient enough to accumulate the shares. At times, you may find shares overvalued as compared to the valuation framework, however have patience to wait and buy during market corrections. Good businesses have long run way and stock market will keep giving opportunities to accumulate shares at a regular interval, as we have seen the case above for Asian Paints.
If you know how to analyze and value businesses, it's crazy to own 30-40 stocks because there aren't that many wonderful businesses that are understandable to a single human being in all likelihood. On a personal portfolio basis, I own one stock but it's a business I know which makes me very comfortable.
Three wonderful businesses it's more than you need in this life to do very well. If you had a really wonderful business, which is very well protected against the vicissitudes of the economy over time and competition (economic moat), then three of those will be better than the portfolio of 30-40 businesses. ~ Warren Buffett