by Chetan Parikh
Investing within a defined circle of competence (that is, investing in what one understands) is key to good returns. Focussing on a few good investment ideas and having the discipline and patience to wait for the right opportunity is also vital to being a successful investor.
Investing has always been made to look more arcane, esoteric and difficult than it actually is. The investment management business works on perverse incentives, encouraging intermediaries to think short term when investment goals are usually much longer. This leads to investor confusion that stock market volatility translates into risk rather than opportunity.
Romance adds colour and richness to life, but never fall in love with your investments. Business situations change or the market on occasion gives such fancy valuations that it could well be discounting eternity. Selling is usually the prudent strategy on such occasions. And the art of selling is much trickier to master than the art of buying. The best-loved ideas need to be constantly challenged and, if need be, changed. Being humble helps to avoid costly mistakes.
Mr Market reflects the collective emotions of the herd, which on many occasions tends to be fickle and irrational. As long as human nature remains the same, driven by fear and greed, stock markets will ebb and flow, putting at times capricious valuations on stocks. To be rational, objective and independent depends on the investor’s ability to correctly value businesses and thus stocks. This requires analysis, application and effort but is otherwise not difficult.
What has changed for long-term investing is that the process of creative destruction, an essential fact of capitalism, has increased, and the competitive advantage periods over which companies can earn superior returns on capital employed have shrunk dramatically. Joseph Schumpeter wrote a long time ago about innovative technologies that trigger the rise of new firms and organisational structures whose fortunes increase as the established order diminishes in importance.
Technology, while good for society, is usually not the way to increasing profits. Firms that need to make large capital expenditure, whether old economy or new economy, do not consistently generate free cash flows, so vital to good returns. The gains of any productivity improvement usually go to the consumer rather than the producer.
The deployment of new technology is usually the precursor to market bubbles. There is so much speculation and hype about future growth rates that overvaluation is almost inevitable. Innovation enriches the lives of the members of society who use the results of the innovation, but impoverishes investors who buy shares of the innovator without regard to the price paid.
While there is no gainsaying the fact that the centre of gravity of the world economy will shift eastwards, it is a moot point whether India will fully capture the opportunity. As usual, investors should not pay too high a price to participate in a potential Indian resurgence.