They say investing is easy, but it is hard to implement. You buy a great business at a reasonable price, hold it for a reasonable period of time and let it compound. It is very simple. We all know that, but it is very hard to implement. Why is that?
Sanjay Bakshi: That is a great question and I have a whole subject that I teach around it. It is obviously behavioural and you are absolutely right. The idea that you should buy things when they are cheap and let go of them when they are expensive is a very simple commonsensical idea. Why are a lot of people not able to implement that? It is just that when things are cheap, there is a lot of pessimism.
Pessimism produces fear and fear makes people worried about what is going to happen tomorrow. So, there is this recency effect that plays out. Recent terrible news is extrapolated into the future and people get scared about making a financial commitment at that point of time. And the same thing happens on the other extreme.
When things are going well and there is a lot of greed and there are people who are not in the market, they want to jump in because they are experiencing FOMO, they are experiencing envy, they are seeing their brother-in-law get rich by speculating in some IPOs which listed at a ridiculous valuation compared to the price that they paid for the stock. So, all of those factors and many more.
There are about 17-18 models out there which are part of behavioural finance. They all contribute to the difficulty of actually implementing the commonsensical point that it made.
If we talk about the current Indian market, on one side, the culture of large SIPs which are genuine long-term investing – has got created. On the other hand, there is a lot of speculation in the F&O market where trading volumes are at an all-time high. Why do long-term investing and short-term trading coexist? What does it mean for the investing culture in India?
Sanjay Bakshi: It is a complex question. If you want to simplify the problem, you have to decide whether you want to be a business analyst or a market analyst. You can be either or both. But, I long ago decided to be a business analyst which means that I do not really want to pay attention to what is happening in the markets. For example, money flows or SIPs or what the FIIs are doing or what the Indian mutual funds are doing and so on and so forth. Those are important factors for many people to be sure but not for me. Those are important factors for determining what will happen to the near-term stock prices, but they do not have any impact on the underlying fundamentals of the business. So, if your focus is on the business and not on the stock price because you are training yourself to be a business analyst and not a market analyst, you have to do fewer things. The number of moving parts that you have to focus on drops by 90%. So, to keep things simple, I decided long ago to be a business analyst and not to be a market analyst. So, how will money flows change and how will short-term behaviour change? We have always had speculation, it is not going to go away. I am not happy about the idea that India is now running the world’s largest casino in futures and options trading and I think regulators are right to control that because people have a propensity to gamble and desire to become rich quickly is very strong.
Even the founders of the platform Zerodha have disclosed that most day traders actually lose money and the ones who do not lose money in monetary terms, most of them actually do not even beat the fixed deposit rate of interest. It is an extremely competitive field with very high mortality rates but that has not stopped people from getting attracted to it because you do not get to hear about the losers, you only hear about the winners and people are attracted to that. The propensity to gamble has to be sort of reined in through regulation, through taxation.
So, I am all for that. But as an investor, I do not pay much attention to those things because if you focus only on the businesses that you want to invest in and to see if there is a mispriced opportunity out there, that is the only time when the markets become important to me.
Mathematically, we know that good businesses are hard to find and great businesses are even tougher and very few companies genuinely can really compound and create wealth. So, when you look at investing or when you look at identifying a company or a theme or an idea, what is the starting point? How do you start?
Sanjay Bakshi: It is a good question. Again, there could be many starting points but one very frequent starting point for me has been astonishing financial performance in the past, going back long into the past, which means that you automatically exclude businesses which do not have a long track record. I think that is important to recognise because then you can see what happened to that business during stressful periods. COVID was recently a stressful period but it was a great environment during which you could study businesses that have survived and thrived and those which got completely evaporated or eliminated from the so-called gene pool.
So, to study businesses and see how they have done during tough times gives you some idea about what is called the Lindy effect. The longer a business has been around, the more conviction one gets about its ability to survive and thrive in a tough environment. It could come from many factors. It could come from a variable cost structure. It could come from a strong balance sheet. It could come from diversification across various product categories. It could come from many sources. But if you really study, especially in some sectors, in cyclicals, in financials, there is a lot to be said about studying survivors.
So, when you see that astonishing financial performance, especially during tough periods, then you start looking at the inherent strength of a business and you start asking questions to why did this business thrive in an environment where others were sort of being eliminated and then you start focusing on the factors that have gone into creating that business and running that business. As you mentioned in your question earlier that it is becoming harder, I do not think so.
When a bear market comes or when there are some macro factors or when there is volatility caused with the help of spread of technology where manias can spread very rapidly happens, then the market has the propensity or tendency to sort of paint everything with the same brush or to throw the baby out of the bathwater.
So, when that happens, even great businesses which may be hard to find, but you know that they exist, but are just not attractively priced, tend to become very attractively priced during those periods of time. So, for an investor to find a good quality business is obviously a starting point and it can come from many sources, but it is not that you have to invest in it right away.
If you already know it is a great business and because of some external development, stock has become ridiculously cheap, then you have to act, then you have to overcome the loss aversion and the fear factors and get over all those psychological tendencies that I mentioned earlier and go and act and deploy capital. While it is difficult to identify great businesses, during severe bear markets, they become extremely cheap and that is the time to go and invest into them.
Munger would always say that you should be ready, you should be prepared. So, is that a good strategy for any long-term investor to just wait for that loose ball and hit it out? Identify a good business, but wait for that panic in the market so that you get your price?
Sanjay Bakshi: That is his strategy and it worked for him and that does not take away the elegance or the intelligence behind the strategy of being almost fully invested in India. India is a growing market. India’s market cap has grown from less than a trillion dollars 10 years ago to more than 5 trillion dollars now, primarily because of the growth in India’s GDP and also because new companies have come to market.
So, there is this very large pond in which we are fishing and that pond has grown to now more than a $5-trillion market cap pond and it is going to keep growing as India grows. I do not see that as a problem at all. The key is to find out just a handful of companies. As you are going to have thousands and thousands of companies which are available for investing, the job of the investor is not to select but to reject. Primarily, the problem from a mathematical point of view is to reduce from 5,000 odd plus companies to a portfolio of maybe a 10-stock portfolio or 20-stock portfolio or even a 100-stock portfolio.
So, even if you have a very widely diversified 100 stock portfolio, you still have to reject a few thousands of companies. You need to have rules to quickly say no to what just does not make sense and I think figuring out what those rules are is very important.
In one of your recent blogs you mentioned about the size of the pond, that one needs to fish in a large pond. What is the definition of a large pond and how can one identify it?
Sanjay Bakshi: We should be grateful that we are not living in Bangladesh or Sri Lanka or Pakistan. We live in what has become a large economy in terms of GDP and we are almost hitting $4 trillion in GDP and large GDPs produce large market caps. India’s market cap is now more than $5 trillion and by the way, this is after accounting for currency depreciation and that is just an outcome of being a large economy that keeps getting bigger but it is also an outcome of the fact that there are businesses that have been part of GDP but are now entering market cap.
These are privately held businesses which were not there in the markets but have gone public recently. LIC is the case in point. There are so many of them which are multi-billion dollar market valuations but they have gone public. They have been around for a long time and their economic activity contributes to GDP but has not yet entered market cap. So, it is a large pond and the pond is going to get larger and you are trying to fish in a large pond by constructing a 10, 20, 30, 40, 50-stock portfolio.
So, I go back to the point I was making. The idea is to construct filters to quickly reject what does not make sense. When you have that, you have to say no to basically almost everything and there are all sorts of things that will pop up which will excite you or entice you and you have to basically go to the discipline of what makes sense because at the end of the day you cannot own everything unless buy an index fund, and even then an index fund will replicate a 30 or 50 stock portfolio, even the indices are rejecting more stocks that are available for advancement.
