Insights

Table of Contents

Why Do We Invest in Stocks?

Passive – the Incorrect Solution

What Does the Solution Look Like?

• Moats: The Kind of Businesses to Own
• Owner’s Mindset: Improving the Probability of Earning the Underlying Returns of the Business
• Global: Reducing Country-specific Risks
• Valuation-driven: Reducing the Risk of Over-payment

Why Do We “Invest” in Stocks?

“.. latching onto things and piercing through them, to see what they really are…” – Marcus Aurelius

In a financialized economy with ever-shrinking average holding periods[1], it is easy to think of stocks as nothing more than instruments of speculation or worse still, gambling. What they truly are is a part ownership of the company issuing those shares, allowing the investor to share in the fortunes of the business they represent.

Role of the Business / Entrepreneur in the Economy. Entrepreneurs and businesses are the crucial cogs in a market economy. For a business to be successful, it needs to offer a product and/or service that is desired by the customer and be able to produce it at a cost that is less than the value that the customer ascribes to it. In this sense, the customer is of ultimate importance and the business has to find a way of serving the customer satisfactorily.

Returns Earned by the Business and Consequently, by the Investor. The profits that a business is able to earn is then a factor of:

• the amount of production that the customers want,
• the cost at which the business is able to produce, and
• the price the customer is willing to pay.

Businesses that serve their customers well, will be able to show high and increasing profits as there will be greater demand for their services and vice versa.

And therein lies the crux of investing in stocks. A successful investor will, on balance, own a better mix of businesses that are successful at serving their customers. It follows then that investors should take time to understand whether the companies they have invested in are serving the needs of their customers in the best possible way.

Passive – The Incorrect Solution

“What the wise do in the beginning, fools do in the end.” – Warren Buffett

The last decade has seen a big shift from active investing to passive. The idea of passive was rooted in minimizing the costs exacted by intermediaries. Much ink has been spilled by academics on equity market returns and the inability of active investors to outperform. And so, passive investing was proposed as the solution. However, this is an incorrect solution as it completely ignores the fundamental nature of stocks and the true purpose of investing in them as outlined above.

When a sufficiently large enough mix of market participants invest passively, the capital allocation function of the stock market breaks down. Capital isn’t allocated based on the ability of the businesses to perform their function properly. Instead, what we end up with is a flow-driven market. As Michael Green says, the investment function of a passive product is >> Give me money and I will buy, Ask for money and I will sell. In this investment function, neither the price nor the quality of the business are a factor in the capital allocation decision. And so, we end up transforming stocks from being an instrument of ownership, to being objects of speculation and gambling.

What Does the Solution Look Like?

The solution that we propose is rooted in the core nature of stocks and the true purpose of investing: as instruments of ownership and sharing in the outcomes of businesses. The portfolio we propose is designed to be the core equity exposure of the investor’s portfolio. It is structured to be extremely different from the benchmark equity indices. To effectively implement it, the investor needs to disengage from benchmark-driven evaluation of their outcomes, atleast over shorter horizons.

Moats: The Kind of Businesses to Own. Businesses that serve their customers’ needs most efficiently and ensure that the customer receives more value than the price they pay, end up earning a higher return for their actions. This is then reflected in the superior returns on capital, profit margins, and cash flows of the business. However, if the business doesn’t have a Moat, the kind of competitive advantage that will protect it against competition, the high returns on capital earned by the business will attract other entrepreneurs to allocate capital to that same activity. The eventual result will be that everyone’s return on capital is driven down.

To be able to generate superior investment returns that aren’t going to be arbitraged away, one has to identify a source of mispricing that market participants cannot compete away. This thinking is at the heart of why we invest in Moats, as opposed to the quality factor. True Moats, the kind of businesses that we look to invest in, have wide and durable competitive advantages that can extend to periods much longer than ten years. Such a long duration of excess underlying return isn’t amenable to the valuation models of most market participants. As a result, we end up with a higher probability that the underlying returns on our businesses and investee’s are higher than what is priced in.

Owner’s Mindset: Improving the Probability of Earning the Underlying Returns of the Business. As discussed earlier, the investment horizon of market participants has become progressively shorter. In a world too focused on short-term outcomes, an investor who is willing to have a long-term investment horizon (“time arbitrage”), has a competitive advantage.

Indeed, to earn these underlying returns one has to hold these businesses for the long term. This is what Warren Buffett means when he says that you have to think like a business owner. To have a higher probability of earning those high underlying returns, we need to own these businesses for the long term.

Global: Reducing Country-specific Risks. We do not believe that one can successfully predict what happens to specific countries. Accordingly, we suggest constructing a globally diversified portfolio of truly great businesses. An added benefit of doing so is that the investor can construct a portfolio that is also well-diversified across sectors and industries. At the same time, when the investor builds a global portfolio, as against mixing country-specific portfolios, the investor can significantly improve the overall quality of the portfolio. This is because when constructing a global portfolio, the investor can compare each one of his companies against all other companies globally, buying only the best,most competitively positioned of all of them.

Valuation-driven: Reducing the Risk of Over-payment. As investors in publicly listed entities as against being the entrepreneur, the investor has to contend with one additional element; the price that is being paid in relation to the value being received. No matter how great a business is, you will end up with a mediocre outcome if you pay too high a price. If the price being paid is high enough, it can have a meaningful negative impact on the investor’s returns over periods as long as twenty years or more.

We think that the right course of action is to be a valuation-sensitive investor. Market participants, every once in a while, become either too pessimistic or too optimistic about stocks. When such extremes in pricing materialize, the investor should look to use those opportunities to improve the underlying returns of their portfolios by buying what market participants want to exit and selling what they cannot get enough of.

This, in a nutshell, is what we believe to be the best way to construct the core equity portfolio. We have a simple and common-sense definition of what is a core equity allocation. It is that portion of your total portfolio that you will keep invested in stocks even if you believe a deep bear market is about to unfold. To our thinking, it is usually atleast a 10% to 25% allocation of the total portfolio of the investor.

As per data from WFE and IMF, the average holding period for stocks listed on the NYSE and NASDAQ declined from about 5 years in 1975 to less than 1 year over the past twenty years. https://www.etoro.com/news-and-analysis/in-depth-analysis/the-costs-of-rising-short-termism/