Reblog: Some Mistakes…

So much has been written about vicarious learning i.e. learning from mistakes of others. It is humbling to admit that despite all the knowledge out there, I failed to learn vicariously. The purpose of writing this piece is to put down the learning’s (very expensive ones) over the last decade or so.  I hope to smarten up in the future though.

Before writing about what did not work, it is important to set the context. There is no best or the right way to invest – investors have successfully generated huge returns from different investing strategies – be it buying and holding quality companies, chasing growth even at high valuations, buying cheap companies betting on turnarounds etc. People have made large amount of wealth by having concentrated as well as diversified portfolio. So investors have to explore what works for them, given their financial requirements, temperament, skill and time horizon.

Two important factors to consider while looking at the mistakes (and lessons) are:

1. Allocation strategy: diversified or concentrated. I go with a concentrated strategy so these mistakes are more relevant in that context.
2. Portfolio approach: It is important to look at the portfolio return and how the portfolio is structured. This is different from trying to maximize returns from each individual stock.

The major mistakes (with very high opportunity cost) made over the past years:

1. Selling good businesses too early: I typically sold out too early without giving due importance to long term growth outlook and the potential of the business to scale vis a vis the short term expensive valuation. Sundaram Finance, CRISIL and Gruh Finance are among the mistakes in this bucket. They went on to become multibaggers in the years ahead after the sale. Also these stocks were never cheap enough to be bought again. When you are too early into a stock (which is a good thing), your mind gets anchored to historical valuation range, without adjusting for new potential of the stock – either with better performance or increased market interest.

Lesson: If you are invested in a growing business, do not sell it for temporary overvaluation – there may be some time correction which is fine, which should be managed at a portfolio level. At the same time, one needs to be careful of slowing growth or fundamental deterioration in the business e.g. Exide Industries/ Shriram Transport Finance.

2. Going down the Quality curve: This is a derivation of the above (first) mistake. Mostly when I have sold out of good companies, which were growing well, I ended up investing in cheaper but low quality/ growth companies. Over the cycle, this resulted in sub optimal returns. E.g. Sold out of Page Industries and Indusind Bank, and invested in IDFC Bank/ IDFC Ltd.

In theory, it is logical to say – ‘What’s the sense in holding an overvalued company, when you don’t see making any money in the next 12-18 months. One should just sell it and invest in something where you can make good returns over the next 1-2 years’. Now that’s all good to say but in practice the challenges are:

a. When you sell and raise cash, there is a mental pressure to invest. The pressure increases with time and level of cash allocation. The market may move against you for a long time, and even if you get a correction, it may still be at a higher level than what you sold out at.

b. Because of the pressure, you end up investing in low quality companies. (Value traps, no growth, hope value trades, relatively cheap trades etc.)

3. Waiting for a little lower price to buy: This has been a very expensive lesson – losing 10-20 baggers waiting for 20-25% lower price! I missed the boat on so many opportunities trying to just get them a bit cheaper, which never came. The buy price keeps moving up, just behind the actual market price! If you have your thesis right, you will make good money if the business does well, so it’s stupid to wait for just a little cheaper price. What I prefer to do now is:

a. Buy a base position even at 20-25% higher than the ideal price

b. Keep adding to make it a full allocation (either with time correction or price correction)

c. If the stock goes up without any correction, atleast you have a base position and have not missed out totally, though it’s not the ideal scenario

There may be times wherein you have a drawdown or a loss because of buying expensive than the ideal price, but the potential profits forgone due to waiting for a little cheaper price are far more than these losses. Some examples here are Bajaj Finance, Hatsun Agro, Avanti Feeds, Supreme Industries.

To think about it from another angle: over a 5 year period, the stocks you like on a fundamental basis can go up multiple times and the downside to them is say 20-30%. So on a portfolio of such stocks, it’s better to be long atleast with a smaller & growing allocation than not to buy them. On a portfolio level, the downside would be even much lesser and maybe it’s just the dead money or opportunity loss.

4. Failing to consider overall market change and its impact: This is one of the least talked about topics of investing. Different stocks work in different market environments. In a bear markets, companies which are consistently growing their earnings give surer returns, while in the bear to bull market transition, major money is made from valuation rerating relative to earnings growth. e.g. In the 2010-2013 bear market, growing companies like Cera, Kajaria, Astral, Indusind Bank etc gave good returns, while in the bear to bull market environment from 2014 till date, stocks like KRBL (where earnings went up 2-3x times and the stock got rerated from 4 P/E to 25-30 P/E in last 4 years), Escorts (earnings went up 3x and the P/E rerated from 11 to 40) gave far higher returns.

5. Not experimenting enough in the portfolio: In my concentrated portfolio, the minimum position used to be 10-15%, which meant that to add anything to the portfolio, it had to pass very exacting standards. Also when adding anything to the portfolio, I used to do it in one shot rather than building up a position gradually. Now this prevented me from adding stocks with smaller allocation, due to any of the following factors:

a. New company or sector which I haven’t looked at in the past so I was not comfortable investing big there, but the company looked good per. se e.g. Chemical companies.

b. It was difficult to get more information about the company and the sector e.g. Avanti Feeds, Garware Wall ropes

c. Stocks which were very expensive, even though they were a good growing company. e.g. Gruh Finance

d. No future visibility within a timeframe e.g. Hitachi Home, Cyclicals

e. Special situations – demergers etc. e.g. Gulf Oil

Buying GARP stocks in Indian stocks makes one disinterested to look for new opportunities, which might add value to the portfolio in terms of differential alpha. One needs to have many arrows in one’s quiver, which can be used depending on where one can find best and easiest opportunities. Focusing only on a single style – Moat stocks/ Special situations/ Cigarbutt stocks can make one a man with a hammer. What we learn most from Warren Buffett is sheer range of investing strategies – Cigarbutts, high quality in distress situations, pricing power high cash flow stocks, Cyclicals, Commodity, special deals, business buyouts, index derivatives, super cat insurance bets, and now technology moats! How do you become a learning machine if you don’t experiment in real time with real money?

Now, I think it makes more sense to allocate a part of portfolio (10-20% depending on each investor’s own comfort), as a hunting ground to scale up positions as one gets more comfort. Also, it allows to allocate some capital to companies which potentially can give very large returns but you cannot make them core holding at the outset due to any of the above reasons.

6. Having a very large cash allocation: In volatile or sideways markets, cash gives mental relief. While possibility of deploying cash in steep corrections is there, but it’s very difficult to get it consistently right. It is better to be more invested (based on overall allocation), even if there is short term over valuation and gradually take profits. I have been guilty of keeping large cash balance and often times one of the 2 has happened:

a. Either the stocks, which I wanted to buy, did not correct much

or

b. The price to which they came down after correction was still not much different from the original price I saw them initially at.

From a portfolio perspective, how much cash one is holding also has a major bearing on the decision to hold or sell high growth expensive stocks. With a relatively higher cash allocation (20-25%+), it is easier to hold these stocks since any market correction which will lead to drawdowns in these stocks, will also give you an opportunity to invest the cash. High market valuations should be used as an opportunity to move from low quality to high quality stocks and not vice versa. Most of the seemingly cheap or relatively cheap stuff in a rising market is junk so that has to be avoided totally.

Even in the 2008 crash, very very few people got both the legs right – they either went into cash and did not reinvest reasonably well or they went into cash the wrong time.

7. Holding on to the non-performers for too long: When these stocks don’t move for period of time, we start treating them as cash proxy, hoping for an earning rebound. Also, we start paring down good performing companies in the portfolio as their marked to market allocation keeps increasing with performance, further impacting portfolio performance and quality.

8. Thesis change, market view changes: Often the eventual reason of the success of a stock has little to do with the initial thesis. One needs to be open minded about new data points. The initial reason for bullishness on Eicher Motors was cash and CV business, with RE being a side business. Investors got into Hatsun Agro for valued added products, but it was the liquid milk business which got success. Hawkins, TTK Prestige and Gruh Finance were slow compounders, until they hit sweet spot and then the market fancy took over.

9. The need to be Contrarian: When we see markets or stocks moving up fast, the natural urge is to be contrarian and call it speculation. It sounds more intelligent to be bearish and contrarian. In our interaction with top investors, one thing came out clearly – the overall bet has to be on economy, capitalism and entrepreneurship. One can be selective as to the economic segments or timing where one wants to be bullish, but the underline trait has to be optimism and confidence. This need to be contrarian is especially true for fast growing, quality companies – earlier examples being HDFC Bank, Asian Paints. Even in down markets, they are relatively expensive. And when they get discovered, the rerating happens very fast. Though moat is a much abused word now, it is true for select companies! Being reasonably early with fast accumulation of stock and long term view is the better way.

10. Focusing on macro: Again talking about macro sounds intellectual, but for a bottoms-up individual investor, it has little relevance. Spending more than a couple of percentage of your time on macro tracking or discussion is normally waste of time. Economic macros can mostly be dealt at portfolio level decisions, which need not be done on a regular basis. Mostly, only sector and company-specific macros are worth tracking.

A lot of these mistakes can be avoided by focusing on the portfolio return rather than each individual stock return. This makes it much easier to hold part of the portfolio which may time correct in the near future with earnings catching up with valuations. Additionally, you can selectively invest in stocks which may not give linear returns over the next 1-2 years, but hold potential to give very high returns over a longer period of time. When a large part of the portfolio compounds at 25+%, the overall portfolio return can still respectable. Essentially it comes down to optimizing the portfolio return rather than trying to maximize it.

The original post appears on the Investment Blog of Altais Advisors and is available here.