“Vishal, since the market is up so much over the past 3-4 years, and especially after the surge over the last few months, I’m looking for cheap stocks and sectors that have been left behind, even if they are average businesses,” a value investor friend Ravi told me this as we met for lunch last weekend.
“Why?” I asked.
“Because it’s almost impossible to find value among good quality companies…your so-called moat businesses. And I am a true blue ‘value’ investor you see.”
“Oh no,” I told Ravi. “That is a dangerous thing to do.”
I understood what Ravi was hoping to do. It also sounded logical i.e., to identify and buy stocks that remain cheap in a market where most businesses are quoting at high valuations.
But sensible investing doesn’t work that way.
“There is a big difference between ‘cheapness’ and ‘value’, Ravi.”
“Why do you say that, Vishal?”
“Think about stocks from the real estate and infrastructure sector as an example,” I said. “Since March of 2009, which was the bottom of last major stock market crash, shares of companies like DLF, Suzlon, GMR Infra, and JP Associates are down between 15% and 60%. Note that I am talking about these returns from the bottom of 2009, when almost everything was cheap .
And we all know what has happened to these stocks from the peak of January 2008. These are down anywhere between 90% and 96%.
“Now compare these with a few high quality businesses (as in 2008) like Asian Paints, Pidilite, and Titan. If you had owned them at the peak of January 2008 (note again, at the peak), and you held on to them till today, you would have earned CAGR of between 20% and 30%.
“And we all know what has happened to these stocks from the bottom of March 2009. These are up anywhere between CAGR of 40% and 50%.
“In short, if you had bought bad businesses in March 2009 when they were cheap , you would have been sitting on losses even six years later. On the other hand, if you had bought or held high quality businesses when then were seemingly expensive in January 2008, you would have still made big gains over the years.”
“So are you advising me to buy high quality businesses, even if they are expensively valued?” Ravi broke his silence.
“No, not at all Ravi. Far from that! Consider what Warren Buffett has said so often –
It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
“And why? Well, here is Buffett again –
Time is the friend of the wonderful company, the enemy of the mediocre.
“The message is simple, Ravi. Avoid the mistake of buying ordinary companies just because they are trading cheap and you have nothing to buy among high-quality businesses.
“Patience, as I understand, is required not just after you buy a stock, but also before you buy it.
“Look Ravi, what we have seen over the past few years has been an amazing bull run in stocks. If a stock did not rise in this run up, you must investigate why it has been so. Maybe something is wrong with the business. Maybe it is cheap now for a reason.”
Ravi was listening carefully, and so I continued.
“Most people, like I used to do earlier, think that it’s safer to buy a cheap stock – one that didn’t participate in the big run. They think that there’s some safety there. They think that it can’t fall as much as the ones that ran up, simply because it doesn’t have as far to fall.
But having been an investor in the markets for almost 14 years now, and seeing others investors who have done really well over the years, I know this isn’t how it works. Buying the previous underperformers that are trading cheap doesn’t provide you any protection against market crash, or a potential for reasonable return in the future.
“Some stocks that did not participate in the past run up may do well in the future, but it’s because their underlying businesses do well and not because these stocks were cheap at the start of their turnaround.
“Once the market has run up like it has, the temptation is to look for deals among ordinary companies. Resist that temptation, Ravi. Trust me, it doesn’t work.
“Learning this lesson was hard for me. I hurt myself a few times looking for cheap stocks after bull runs before I got it. But it doesn’t have to be a hard lesson for you. Now you know it. Don’t let yourself get burned by cheap stocks, too. Focus on business quality and then wait for the right valuations for them, even if you have to wait for some time.
“But how long should I wait Vishal?” Ravi asked.
Well, wait till you find high-quality stocks worthy of buying, Ravi. As Charlie Munger says –
It’s waiting that helps you as an investor, and a lot of people just can’t stand to wait. If you didn’t get the deferred-gratification gene, you’ve got to work very hard to overcome that.
“It’s the curse of the bull market that leads people to give up on their sound investment philosophy and become impatient (especially because ‘others’ are making money fast). But take my word – this stuff doesn’t work in investing. It has never worked.
“Beware this curse of a bull market that makes you forget the risk of ‘losing’ money, and leads you to assume that making money in stocks is easy.
“And with that, let’s begin our lunch,” I told Ravi, “I am very hungry, so let’s talk of good food now and not investing.”
Note: This post was originally written in November 2015, but because the curse (of the bull market) is once again upon us, and because I could not write it better, I am sharing this again.