As an institutional investor and fund manager, I have studied and invested in a number of companies across sectors, witnessed multiple cycles and made my fair share of mistakes, only to realise that they made me a better investor. Here is what I have learnt about equity investing during the past 15 years.
Investors place too much emphasis on price to earnings ratio (PE). But I have learnt that “topline is vanity, bottom-line is sanity and cash in the bank is reality”. For building a strong business, cash flow is far more important than earnings. There are innumerable ways of managing earnings but it’s very hard to manipulate cash flows. Companies that have created long-term value clearly show that it is cash flows, and profits, that are most important.

Companies with good profits but weak cash flows get a lower multiple from the markets and vice-versa. I avoided some big mistakes by looking at not just the earnings statement but also the cash flow statement. Be careful of companies that are obsessed with driving quarterly earnings and meeting street expectations without caring for cash flows.

  • Growth is good, but not at any cost

No business can create long-term value if there is no growth. However, not all growth is good growth. If a company’s return on equity (ROE) remains below the cost of equity for long periods, high growth is toxic and destroys the value of the firm as the company needs to constantly raise capital to meet its growth needs.

Growth only adds value if the ROE is higher than the cost of equity. Also, in companies with high ROEs (30-50%) where growth is the most important lever for value enhancement, a further improvement in ROEs doesn’t add much value. Many growth stocks can remain expensive for long periods and valuations shouldn’t be the sole reason to sell the winners.

  • Meditate to maintain balance

Spiritual anchoring is essential for successful investing. Meditation helps align the mind, body and soul so one can remain grounded and focused. Investors are either too obsessed about the future or worry about the past while forgetting the present. Meditation lends mental clarity, enhances the emotional quotient and reduces stress. The market intoxicates us with success but also drains us with failures. Meditating for 15-30 minutes a day can help maintain a balance in both times.

  • Invest in quality businesses

Warren Buffett says “a truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital”. Invest in businesses that can generate superior returns on capital employed over sustainable periods of time, and growth which enables it to reinvest the cash flows back in the business. This leads to compounding of value of the business and the stock price. Focus on earnings capacity of the company rather than earnings itself.

A company may report a fall in earnings but its long-term earnings power may not be affected. Similarly, a company may report an increase in earnings but its competitive advantage to earn higher returns on capital in future may be weakening. Consider the theory of inversion. Knowing what not to do is more important than knowing what to do.

  • Don’t just pick stocks, build a portfolio

Build a portfolio that can endure sharp drawdowns and avoid permanent loss of capital. It is important how well you did in an upcycle but what’s more important is how you fared during corrections. There are two schools of thought regarding portfolio construction. My preferred approach is a diversified portfolio, what I call the “Gorilla to King Kong” strategy. You invest in a diversified basket of 50-60 sector-leading franchises (Gorillas). Some of them would turn into large mega caps (King Kong).

Even if certain calls don’t work, the portfolio doesn’t go through severe underperformance for long periods of time. The other approach is to have a concentrated portfolio where you invest in a dozen stocks and hold them for long periods of time. Which strategy you will go with is a personal choice. Choose the approach that suits your temperament, and then religiously adhere to it.

  • Read voraciously and meet new people

“I have known no wise people who did not read all the time” —Charlie Munger. There is no substitute for reading. Read books from varied disciplines as everything has something new to teach us.

For instance, reading books on psychology can give you a perspective on human behaviour. In the context of equity markets, reading annual reports of companies we are invested in or are doing research on gives good insights. Another important learning has been to meet and network with smart people across disciplines. Very often, I have got great ideas by speaking to people across the business and investing ecosystems.

  • Cutting the noise out and being patient

To generate long-term outperformance, filter the noise and remain focused. Some investors get carried away by stock price movement in the short term, and that provides a long-term advantage to serious investors. If any quality business is going through a temporary setback, that’s the best time to invest, especially if the setback has no real bearing on the intrinsic value of the company.

Major part of our success does not depend on choosing the best stocks, but our behaviour in the worst and the best of times. To experience true wealth creation, one needs to be patient. As per Chris Mayer (author of 100 Baggers), the average time it took to achieve 100 bagger returns was 26 years, with the fastest company taking 16 years.

  • Work on process and inputs

We should accept the hard reality that outcomes are not in our control. What is under our control is our process, inputs, stock selection filters and our temperament, which go a long way to achieve the desired outcome. Build a solid investment framework and philosophy that suits your investment style and temperament and keep improvising on it as you move ahead.

(The author is Senior EVP and Fund Manager at Kotak Mutual Fund. The views are personal.)

Read more: EconomicTimes

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