Look for pockets of pessimism, where there is no earnings visibility in 3-4 quarters, but business is likely to show significant improvement in 12 quarters and beyond.
Let the general elections 2019 get out of the way, let there be some clarity and then we will deploy more money to work. The sentiment appears to be a popular consensus as we move into elections season.
Erstwhile political rivals have tied up to fight against Modi and BJP-led NDA alliance, equity investors, too, have started doing the math & are turning cautious. However, there is a big paradox – by the time there is clarity, valuations may not be in favour. This applies to macros & markets as well as individual stocks. Either you will get good news or good prices.
Most investors prefer clarity. It’s visible when we see stocks with high degree of certainty and non-cyclicality trading at above average multiples. Majority of analysts, too, are fixated on the next four quarters since they have to come up with EPS projections. They are more worried about getting it right for next few quarters than in the long run. It’s an occupational hazard since they have to answer the most important question on Dalal Street – “next quarter ka EPS kya lagta hai?”
The moment you start thinking beyond 12 quarters, competition starts reducing. It allows you to have an open mind & look at companies going through a phase of transition, temporary headwinds, etc. There is a fortune to be made in the markets when such companies start performing.
Need to differentiate between uncertain earnings & uncertain businesses
For this approach to work – the key lies in the ability to differentiate between uncertainty & risk. Earnings are volatile and they fluctuate wildly over a business cycle. But very often, underlying asset values do not change overnight. Idea is to look for businesses where there is earnings uncertainty in the short run but they have assets that are going to remain relevant over a period of time.
For example, there is no certainty over earnings of thermal power companies. Will the country still need thermal power assets after next 5 years, 10 years? Most probably yes. That becomes the starting point before digging deeper into the sector-related value chain.
In another example, there is a reasonably good amount of certainty that we will continue to watch TV & have set top boxes for the next 3 years. Given the changing technology, data speed & smart devices, will we still need them after 10 years? Most of us have no idea on that front. It’s a serious risk wherein the business model itself becomes irrelevant.
Apart from determining business model risks, basic hygiene factors like balance sheet risks, promoter/corporate governance risk, regulatory risks, entry valuations, etc. must be checked which goes without saying.
Stocks with uncertain earnings are usually out of favour. They may not add to portfolio performance immediately & hence drive away most of the institutional money. But individual investors can consider them. One can never time entry in such themes, hence, we must start small & learn to scale up as the symptoms of change are visible.
It is one of the most important lessons I’ve learnt over the years. Discovery of a stock idea is not everything. Slow down, spend time with the idea & gradually scale up. There are instances where I found something incredibly cheap, it was out of favour and the future looked great. But I ended up buying too early. The waiting period was just too long and frustrating.
By adopting to slow & gradual scale up approach in such stocks, investors have other advantages, too. Your understanding of the company becomes much better and chances of haphazard decision making goes down. You are well ahead of the market when small changes occur. Subtle shifts in business and earnings profile, management change, improving cash flows with change in product, changes in trade mix, etc. are often missed by the market in the initial stages.
-Look for pockets of pessimism, where there is no earnings visibility in 3-4 quarters, but business is likely to show significant improvement in 12 quarters and beyond.
-Try to determine if things can get worse before they get better, how bad it can get, whether the company has the balance sheet to survive a prolonged downturn.
-Whether the valuations are above or below historical averages. This is very important – ideally such stocks are to be bought at a significant discount to their intrinsic value.
-Start small. Get to know the business & scale up based on milestones, symptoms of change.
It helps if you have a longer time horizon & are willing to take probabilistic bets while embracing uncertainty in the short run. Chances of an information edge are less, so having a behavioral edge & ability to deal with unknown gives a solid advantage.
The article was part of the Personal Finance section of MoneyControl and it was published on 18th Feb 2019
Link: Stock picking for retail investors: embrace uncertainty, look beyond next 3 years
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