This Article was Published in Market Express
Over 90% of active managers in the U.S underperformed the benchmark index over the past 10 years. While it may not be that bad for emerging markets, still fund managers on the whole underperform the broad market. If this is the result for trained, qualified fund managers, one can imagine the plight of retail investors. Clearly fund management is a tough act. But we also constantly hear about successful investors like Warren Buffet, Peter Lynch, George Soros, Seth Klarman, etc. So, where is the disconnect? I will make an attempt to penetrate the reasons.
When it comes to investing, especially equities, you need to get three things right:
What to Buy?
When to Buy? And
How much to buy?
You will have to get nearly right on all three in order to make it big in your investment adventure.
What to Buy?
This is probably the first and most important step of investing. The investing universe is so huge (more than 8,000 stocks in India), that you can easily get lost in the vast hyper market. You should be a trained analyst (either by qualification or by experience) and should have a robust process of identifying good stocks. It calls for intense research based on vast accumulated knowledge and this is where experience is a huge plus. There are hundreds of financial and non-financial issues that one needs to look into before making an informed opinion about the company. A good company is normally in a good industry, has shown good topline and bottom-line growth, enjoys high margin, pays out regular dividends, adopts best practices, is a preferred employer, adopts highest level of customer service, modestly leveraged, etc.
While historical information available in the public domain is a great start, it is just that, a start. Mostly it is backward looking and most of the time comes with a time lag. Any serious research process should focus on information lying in fine prints, unexpected places and regulatory filings. One should develop a filtering mechanism to weed out unnecessary stocks and generate a focus list for further research and analysis. Initial analysis should be followed by detailed fine print research followed by company visits and stakeholder interviews. Even then, the picture will be murkier as it will still not cover qualitative issues like management quality, ethics, transparency, fairness in operations, etc.
In short, it is a very intense activity and extremely time consuming.
Successful investors like Warren Buffet give it the time needed in order to make an opinion. Ordinary investors (including fund managers) mostly go by sell side research (research given out by broking firms) and top of the line research approach. Worse, retail investors mostly go by tips/recommendations from friends and associates or stock tips doled out in TV and online channels.
When to Buy?
The first question of what to buy can help to find good companies. But, good companies need not be good stocks as they may not be available at a good price. Normally companies are available at good price when there is a broad market sell off or when a particular company specific development cause its share price to fall significantly. As one can notice, such broad sell offs come rarely and unanticipated. The global financial crisis of 2008 is a great example. Here, patience is a virtue. I am always reminded on documentaries that I see in National Geographic channel. I believe, the people involved in shooting those documentaries spend days and months in the middle of forests waiting patiently to capture the best moments. Market timing is something similar to that.
Also, when market sell off occurs the mood is generally somber and pessimistic. To ride against the tide and buy require guts. Celebrated investors like WB precisely do this. Wait patiently for a market crash and enter. Retail investors normally do not have the patience. More importantly, individual investors tend to buy at the wrong time when market is in bull phase for the simple reason there is optimism all around and you can jump in confidently (requiring less guts!).
Academic research says that market timing is not recommended since it will be impossible to predict when the next crisis will occur. While it is true, however buying during market crashes will definitely produce out sized returns compared to either buying under all market conditions or worse buying when the markets are enjoying bull phase and there is optimism all around.
How much to Buy?
To me, this will rank as the most important question. There is obviously a difference between buying 50 shares and buying 500 or 5,000 shares! After investing considering time and effort in finding an opportunity and also patiently waiting for a favorable market or company event to occur, it is no use buying a small part. The reason being, even if the investment turns out to be a great winner, it will not move the needle unless the original investment is of significant value. Here is where even institutional investors get caught on the wrong side. Institutional investors are bound by an index and they are allowed to deviate only slightly from the index weights. If a particular company’s weight in the index is say 2%, they can at best go up to 3% otherwise they will risk high tracking error. Here is where individual investors have a great advantage as they don’t have any such constraints. Again you need guts in good measure to take a significant position after convincing yourself that it is a good company available at a good price.
In summary, fund management is a tough act where you need to be right on all three parameters of what to buy, when to buy and how much to buy. It won’t pay off even if you get two out of three right. That’s why it is best left to professional managers. If not, be prepared to give it the time, energy and focus throughout your life.