Temperament cannot be bought or taught

I wrote this note to all of my subscribers. Hope you will find it useful too

A lot of new subscribers have joined us and so I am writing a short note to talk on several topics such as how to build your portfolio, our investment philosophy, ongoing crises etc. For those of you, who have been with me for a long time, this may seem like an un-necessary repetition. However I think it is important for new subscribers to know what they are getting into with me and for the old subscribers to be reminded of it.

Let me state this again – My approach is to buy good quality companies at a reasonable price. There is nothing magical or new about this. Every other value investor professes to do this and I am no different. There is no secret sauce and I make it a point to share my thought process and analysis as much as feasible.

I am not looking for quick flips based on interest rate changes, slightly better monsoon, modi’s reaction to Pakistan or some astrology sign. There could be others who practice this type of investing and it may work for them. I have no interest in doing the same.

I have practiced a value based philosophy for the last 15+ years and it has served me well. I have no plans of changing a sound and logical approach for something else in the future. As long as I continue to do follow it rationally and with discipline, I think the long term results will be good even with occasional spells of under-performance.

Building your portfolio
One the first comments I get from a new subscriber after joining is this – I had a look at the model portfolio and I cannot buy more than 2-3 positions for now. I have a stock response for that – please be patient and give it some time. I have usually seen that most new subscribers are able match the model portfolio over a span of 2-3 years as some stocks drop below the buy level and new positions are added.

How true has this statement been?

If you look at the price action of our 17 odd positions for the last two years – you will find that at least 14 hit the buy point and even went lower for a few days or more. So in effect, it’s quite possible to be 80% matched to the model portfolio for those who joined the subscription in the middle of 2014. I do not have the statistics of how many have done that, but my point is that over a 1-2 year time frame, one will get enough opportunities to buy and build your portfolio. One needs to have the patience to do that and not get swayed by short term events.

Recurring crises
We started the model portfolio in Jan 2011. We have had several actual and imagined events such as Grexit (did not happen), Chinese hard landing (cannot say if that has occurred), Brexit (did happen), oil crash (occurred in 2014) and mismanagement of the Indian economy by the previous government.

These are the big events which come to mind. If you pick up a newspaper, there is a lot more to worry about from day to day. Now imagine if we had remained in cash or got frightened out of our positions due to some real or imaginary risk and compare that to what we have achieved in those years. Does it make sense to take actions based on unknown guesses about the future or concentrate on individual companies and make informed decisions?

Now someone could counter this logic by pointing the risk of 2008/09 collapse when mid and small caps crashed by 60%. What if one of these events had snowballed into a similar crisis?
Let me answer that concern via two arguments

–           For starters, one cannot invest based on the low probability, high impact macro events. One can diversify against black swan risks at an individual company level, but not at the country level. To give an extreme and silly example – how will you protect yourself from the risk of an asteroid crashing into a major city in India and causing a major economic crisis? Can one really diversify against such an extreme risk?
–           My second argument is that one needs to invest based on the higher probability risks (such as inflation) and insure against the low probability, but extreme ones. In other words, invest to beat inflation or secure your retirement and buy life/ health insurance to hedge the other extreme kind of risks. Finally there are some kind of risks, where one can only hope and pray that they don’t occur and we can do nothing about it.

Having the right temperament
If a 10-15% drop in the portfolio is going to scare you (as it may have in Feb of this year) and cause you to lose sleep, then equities are not for you. I can share my analysis and thought process, but cannot fix your temperament. You will have to bring a steady and calm mind of your own to the table.

If you think you cannot bear to see your portfolio drop by 15% or more from time to time, now is a good time to exit. I don’t think there is anything to be ashamed of in recognizing your risk tolerance and acting according to it. My own family was never into equities as they were never comfortable with the volatility of the stock market. I started investing for them a few years back after they felt confident that I will not blow up their savings (or maybe it was just their love for me …I don’t know)

Looking for trends
Some of you may have noticed that the model portfolio generally does not have a specific theme or view. One will often hear from investors that they have positioned their portfolio to benefit from better monsoon or revival in capex or some such factor.
The benefit of identifying a broad trend and then investing to it has a lot of upside. However I have generally not followed this form of top down, trend based investing as I have found it difficult to identify a truly long term trend and then find a reasonably priced idea to leverage this trend.

One needs to keep in mind that a good monsoon or lower inflation is not a long term trend, but only specific events which play out for a small period of time. A long term trend would be something like demand for housing/ housing loans which leads to a growth of 2-3X of the average GDP growth rate.

We have three positions which seem to play to this theme. However if you read the original thesis of these ideas, I was looking far more closely at the company specific factors and only vaguely realized that there were some tailwinds for the sector. It is after holding these stocks for 2+ years that we can now make a story of a theme or trend for these ideas, but this was never the case when we started these positions.

Why am I discussing this point now? I think there is a lot of value in identifying such trends early and investing based on it, provided one does not overpay for it. As a result, I have now started looking at some of the current ideas from a trend point of view. We will however not know if the trend was real or a mirage, till a few years pass.

It is never easy

The following note was sent out to our advisory clients in February. This was in response to the jitters, some of them were experiencing after a 15% drop in the market.

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I am not feeling any better knowing that the model portfolio is down less than the overall indices. I increased the cash holding a bit in the last few months and avoided the momentum stocks in the later part of 2015. Inspite of these defensive measures, the portfolio is getting hit and it is not pleasant to see losses every day.

At the end of 2014, after a 100%+ rise, I had written the following

It is easy to feel smug and complacent after a 100%+ rise in the portfolio. However it is precisely at this stage that the risks are the highest. The various companies in our portfolio are performing quite well in terms of business performance (topline and profit growth). In addition, we exited a few companies where I felt that the performance depended more on the macro than the company specific condition such as the management or the target market

In effect my effort has been to reduce the business risk of our portfolio. This however does not mean we do not face a price or a quotation risk. If the stock market drops by 20% (just an example, I don’t know what will happen), then our portfolio will get impacted too.

If your time horizon is less than 3 years and you cannot bear a 15%+ drop in the portfolio, then you need to take action when the times are good (such as now) and not after the market drops due to some macro factor.

In my case, I consider my equity investments with 3-5 year perspective (or more) and will continue to hold the positions through any future volatility.

I did not know when a drop in the markets will happen, but was sure that it would occur as that is the nature of markets – greed and fear. We had a period of greed in 2014 and 2015, which has now turned to fear.

A repeat of history
The recent events and volatility we are seeing, is not new and has occurred from time to time. The reasons have been different, but the end result is the same – fear and rush to the exits.

At times like these, no one is looking at the company and its fundamentals. The selling is often driven by panic and a desire to reduce the pain.

My own portfolio is invested exactly the same as the model portfolio and hence it is not a theoretical loss for me. I have seen this happen several times, and still feel the same level of pain. Experience does not change the reaction to such losses.

The only difference is that I try to ignore the pain and focus on the individual companies, their business and the intrinsic value. That helps me in maintaining some level of rationality.

I have been asked by some on how bad this can get? I don’t know and anyone who claims otherwise is lying. It could get worse and it will not be easy to hold on to our positions when everyone around us is panicking and selling.

How to handle the volatility

Let me share how I am looking at the current situation (as I have done in the past)

Do not shorten your time horizon
Let’s say (and I hope that is the case), that you have invested your capital with a 2-3 year time horizon. As long as the market is rising, everyone is a long term investor. It is times like now that this belief is tested. There is no dial which increases or reduces the time horizon at an aggregate level. One needs to look at each holding and decide if you will be comfortable holding that position for the next couple of years.

I have been doing that for all the positions in the model portfolio and have exited some, where my level of confidence was not high . As the market crashes and causes some level of business risks, it is important to have a decent understanding of the companies in the portfolio.

We have held most of the companies in the model portfolio for atleast one or more years and have seen them go through their ups and down. I think most of these companies would be able to survive and manage the risks

Position size and diversification
I have often been asked about position size and the level of diversification one should have in the portfolio. I have a much simpler approach – size it to a point where you can sleep well. If the size of a position or the level of diversification causes you lose sleep, then it is too high.

The above is a very subjective point and varies from person to person. One way to think about it is to look at how much of your net worth is in equities and are you comfortable with it? Can you bear a 20%+ drop in your portfolio without losing your cool?

Look at the intrinsic value
I have always emphasized the important of intrinsic value and its growth for a company. One should always focus on that number. As a long as that number is stable or increasing, then one should stop worrying about the stock price.

Do not fixate on the turn
Another common feature at a time like this is the tendency of investors to call the bottom of the market. This is a toxic way of managing the portfolio. It leads to a focus on the short term and disappointment if the turn does not happen.

My approach during such times in the past has been to add to my positions slowly over time as they became cheaper (subject to size limits) and not expect to make a killing in the short term.

There is no pill for courage
The final point I have to make is that there is no magic pill for courage. There is a reason why equities have high returns – Volatility and risk.

My effort is to reduce the level of risk (of permanent loss of capital) in the portfolio. I have not tried to reduce volatility actively. Courage and ability to ignore the volatility comes down to temperament and that cannot be supplied by anyone.

To summarize
– Think long term and focus on the portfolio with a 2-3 year time horizon. This means you should not be investing any money which is needed in less than 3-5 years.
– Ensure that the position size for each stock and the overall diversification lets you sleep soundly at night
– Focus on intrinsic value and performance of each company
– Do not try to time the market (now or any other time)
– Avoid listening to forecaster, pundits and other doom and gloom guys. It will weaken your resolve
– If you manage to hold your nerves and plan to invest, stagger it over time. I am planning to do the same.