Chapter 12: Market is the Best Teacher
Fundamental analysis can help us understand whether a company is investment-grade by studying its publicly available information (annual report). These companies operate in an investing landscape with several market players, each with a different strategy. In this chapter, we will learn how to observe stock market investment behaviour and learn the golden rules of investing from famous investment moguls.
In this module, we saw how a company works and reports its financial data, the factors surrounding the company, and how they affect its performance. After all, fundamental analysis is about owning a business, not a stock. It can help you identify the intrinsic value of a stock based on its future growth potential or a company’s assets. It can also tell you whether or not the stock is an investment-grade stock.
How many stocks should you have in a portfolio?
You can generate stock ideas and research each stock. But how many stocks should you own to have a successful portfolio? Frankly, there is no magic number. Some famous investors who made their wealth from stocks had not more than 5-10 or at least 20 stocks in their portfolio!
For a strong portfolio, you should diversify your investments across different asset classes, sectors, and stock types.
Asset Class
An asset class is a type of investment instrument that has the same laws and regulations and often behaves similarly in a marketplace. For instance, equities are one asset class, and real estate, fixed-income bonds, and commodities are other types of asset classes.
It is not the quantity but the quality of stocks that counts.
Taking note of investor sentiments and biases
Finding stocks is just one part of the investing game. The next part is understanding the market sentiments and protecting your portfolio from several investing biases.
Herd mentality – Most beginners and retail investors fall for ‘herd mentality’. Some stocks might be popular and this popularity might be driving their stock price, making them overvalued. Since everyone is talking and investing in that one stock, we tend to follow the herd and buy the stock without reading their fundamentals. This could put you in danger of buying poor-quality stocks at inflated valuations.
Loving tendency and over-optimism – Sometimes, you may buy stocks of a company you love and ignore the red flags or weaknesses of the company. There is also over-optimism around the stock, even though the fundamentals say otherwise. There is a thin line between being confident and being overconfident. Remember, this overconfidence sank the unsinkable Titanic on its first voyage. Hence, fundamental analysis requires you to look at a company as it is.
While these are some common investing biases, you can learn from them on the go by understanding the kind of biases you are most inclined to make and taking proper steps to avoid them.
Lessons from Investing moguls
You can take lessons from several investing stories of success and failure and learn from their investing experience. You will see contrasting lessons from different investors; sometimes, the same investor might give contrasting lessons. There is no right and wrong in investing. It depends on which investing strategy you use in which scenario and on which type of stocks.
Some common lessons that apply in every scenario are:
Lesson 1: Don’t predict, prepare.
Many investors, including Warren Buffett, reiterate the same lesson: The future is uncertain, and so is the market. No one can predict it. However, fundamental analysis can help you prepare for various scenarios.
For instance, the pandemic and the Russia-Ukraine war were unpredictable events. Even the strongest of the fundamentals faltered when they hit the world unexpectedly. Airlines, hotels, and tourism were out of business for two years while tech stocks flourished. Times like these teach you to prepare a portfolio of asset classes and sectors that react differently.
This is where Warren Buffett’s investing lesson of “Understanding the business” comes in. When you know the business, you can analyze the best and worst-case scenario and state the reasons for buying a stock. If the reasons for buying are no longer valid, do not hesitate to sell the stock. This is where you need to overcome optimism bias.
Hence, Buffett, who popularised the “Buy and Hold Strategy,” said, “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes,” they also said, “The most important thing to do if you find yourself in a hole is to stop digging.”
Lesson 2: Historical performance does not guarantee future returns
Rakesh Jhunjhunwala and Ray Dalio taught us that historical data may not dictate future performance. There are times when a company’s stock price continues increasing while its underlying fundamentals do not. So, while historical fundamentals can give you a base to forecast future earnings, historical stock prices do not. Unlike fundamentals that are influenced by the company’s performance, its stock price might be influenced by factors like market optimism, investors’ emotions, easy availability of capital, etc.
Lesson 3: Spend time in the market
Here again Stanley Druckenmiller, former chairman of Duquesne Capital, Rakesh Jhunjhunwala and Warren Buffett hold the view that just picking a good stock is not enough. You have to stay invested in it and give the company time to grow and give returns.
6 types of stocks
All these lessons are best used in former manager of the Magellan Fund at Fidelity Investments Peter Lynch’s investment philosophy, which categorizes stocks into six types based on their unique characteristics and uses different investment strategies for each category.
- Slow growers: These companies have little scope for expansion but may give generous dividends and reduce downside during a market downturn—for instance, utility stocks. You can use such stocks to minimize the overall portfolio risk and secure a stable source of income.
- Stalwarts: Large companies are growing consistently, even during downturns. They may not show excessive growth, but consistent gradual growth because of the nature of their business offerings. For instance, FMCG and pharma. They protect you from a bear market and give you strong returns in a bull market.
- Fast growers: These are small or new-age companies growing rapidly. They could generate significant wealth but come with downside risks.
You can buy and hold the above 3 stocks for the long term. Now, let’s talk about some riskier ones.
- Cyclicals: Some stocks see periodic upside and downside, especially automobile, banking, and metals stocks. These stocks are significantly affected by interest rates and raw material prices. A buy-and-hold strategy may not work here. To invest in them, you first need to identify the cyclical upturn and then buy in the downturn to get double-digit solid returns.
- Turnaround: This distressed company is going through a significant revamp. While the past performance might show weak results, the future performance could generate positive returns. Such stocks might trade at a lower valuation based on their past earnings and investors’ failure to realize their future earnings potential. Such stocks could give you significant growth. The best example of a turnaround is Eicher Motors (the one we discussed in Chapter 1).
- Asset play: These are asset-rich companies with significant assets like land or cash. However, the stock price does not reflect the asset value because of a downturn. Their stock price could grow in a strong or recovering economy when the asset value rises.
These are just a few lessons seasoned investment moguls learned from the market. You can learn from their experience and build your own experience by practicing and perfecting an investment strategy that suits your requirements. It will take time and you might make a few wrong decisions or losses in the process, but eventually, with more practice, you will get a hang of it.
Summary
- Fundamental analysis helps you identify investment-grade stocks. However, navigating the investing landscape requires you to understand the market.
- There are some investing biases most investors fall prey to:
- Herd mentality – Follow the crowd and invest in stocks everybody invests in.
- Overoptimism is being optimistic about the stock because you love the company and ignoring the red flags highlighted by the fundamental analysis.
- The market has been the best teacher of seasoned investors, teaching some common lessons that apply to all scenarios.
- The future is unpredictable. Don’t predict; prepare for the worst-case scenario.
- Historical performance does not guarantee future performance, as the past may be influenced by some factors and the future by others.
- Spend time in the market and adopt a long-term approach with fundamentally strong stocks.
- Invest with the mindset of never losing money. Don’t shy away from accepting mistakes and cutting losses. You can invest the money in a more successful investment and earn back the lost amount.
- Depending on their characteristics, stocks can be categorized as slow growers, stalwarts, fast growers, cyclical, turnaround, or asset plays. You can use their nature to create a mix that can strengthen your investment portfolio.