7 equity investing principles

By Larissa Fernand |  28-08-19 | 
 
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About the Author
Larissa Fernand is Website Editor for Morningstar.in. She would like to hear from you and welcomes your feedback.

If you are investor starting out, or even a fairly seasoned one, I recommend that you follow D. Muthukrishnan on Twitter. Not because he dishes out advice on what to buy or sell (he certainly does not), but the wisdom he imparts is extremely valuable.

My colleague Ravi Samalad wrote about him a while back.

MUTHUKRISHNAN has always emphasized that aggressive savings, prudent investing, and avoidance of debt are the keys to get you on the wealth creation path.

Over here, he articulates his thoughts on investing.

1. Three keys to ensure financial stability: Diversification, zero leverage, and asset allocation.

As Ben Carlson says, diversification is an admission of a lack of foresight about an uncertain future. Anything can happen. To protect against the unexpected, diversify.

Avoid leverage. As much as leverage can magnify gains, it can completely wipe you out as well. Saying no to leverage is the price you pay to stay in the game. In markets you need staying power, so leverage is dangerous. The unexpected can happen. Have at least few years of expenses in bank and liquid funds. Hope for the best while prepared to face the worst.

Focus on asset accumulation before asset allocation. To allocate, you first need to accumulate. Dividing a small sum of money among various asset classes will never make you rich. When in the accumulation phase, being overweight in equity helps, provide you, as the investor, can stomach sharp downturns.

For most people, most of the time, a 60:40 (Equity: Debt) allocation should do. But this is not written in stone. If you have adequate risk covers and a contingency fund in place, there’s no harm in deploying 100% of the long-term money to equity.

2. Making money is not easy, preserving it is even more difficult.

Concentration builds wealth. Diversification protects wealth.

Preservation of capital should never be ignored. So, while focus is needed, simultaneous diversification is also mandatory. In my experience, a minimum of 10 stocks and a maximum of 20 should give you the benefits of both.

Take the same principle deeper, across sectors. Since the number of stocks is not large, diversification across sectors is key. Too much concentration on one sector can magnify both gains and losses.

Avoid both extremes. Extreme concentration and over diversification.

As far as mutual funds go, 4 to 5 diversified equity funds should provide the diversification you need. Avoid thematic and sector funds. Neither would I recommend small- or micro-cap funds.

3. Don’t enter the stock market without a strategy.

My stock investment strategy is extremely simple: Buy quality companies; expect to hold for at least 10 years.

I would not look for the next HDFC Bank or Nestle when the original itself doing and growing well.

My personal portfolio comprises of 12 stocks across sectors.

The stocks I own are very well-known companies and leaders in their respective industry. There is nothing to brag about owning Pidilite, whereas a discussion on a granite stock can be captivating. When it comes to my portfolio, I focus on sensibilities, not sensationalism.

I also look for a reasonable upside in a bull market and less of a downside in a bear market.

My portfolio will never match the crazy returns that can be made by small-cap investors, but I am comfortable with positioning and expectations.

4. Try not to overpay.

When it comes to expensive valuations, investors often hark back to the Nifty Fifty. Let me explain.

Late 1960s in the U.S., 50 stocks were identified by Morgan Guaranty Trust as some of the fastest-growing companies on the planet. Their popularity sparked a radical shift from "value" investing to a "growth at any price" mentality. They peaked in 1972 with Xerox trading for 49x earnings, Avon for 65x earnings, Polaroid for 91x earnings.

Of these 50, some never survived and some never lived up to their promised growth (Emery Air Freight Corp., Simplicity Patterns, Eastman Kodak, Polaroid). Others like Philip Morris, Anheuser-Busch and Wal-Mart delivered exceptionally, far higher future returns than S&P 500. But we fail to take into account how stocks like Walt Disney, Procter & Gamble, and PepsiCo delivered in subsequent decades despite being bought at high valuations.

Assume you invested $50 equally into U.S. Nifty Fifty in 1972. The $3 representing Wal-Mart, Philip Morris and Anheuser-Busch alone gave higher returns than $50 invested in S&P 500. Remember, we're completely ignoring the other 47, out of which sizeable stocks became great wealth creators.

Am I suggesting that it is alright to buy at expensive valuations? No. I would encourage you not to. But even if you do overpay for a diversified basket of good quality companies, they should be able to do better over one to two decades. Let's say someone bought Infosys at 300 PE. No doubt, it was a foolish decision. But if the same investor has bought 10 or 20 quality companies (diversified basket including Infosys) in 2000 at prevailing prices, I’m confident he would have beaten the index.

Many value investors look only at price and not the value that can be created in the long run. For good quality companies, what we consider as expensive today would look cheap in hindsight 10 years down the road. It took 10 years for me to come out of low PE mindset causing me to miss good quality companies and steady compounders.

Today, I would rather overpay and buy a good company foregoing first few years of return than buy a lousy company even if it is cheap.

Frankly, I do overpay sometimes. But I reiterate, what we optically consider as overpaying is not really so in the long run. But, this logic is applicable ONLY for good quality companies.

5. Draw a balance between buy-and-hold and buy-and-ignore.

I very rarely sell. But that does not mean I do not keep track of my investments.

I keep a tab on whether or not my investment thesis still holds or a buying opportunity has presented itself. For example, post the Maggi fiasco, I began to accumulate Nestle. I was of the opinion that a great company was going through a temporary problem and was available at good price.

Take HDFC Bank. I am aware of the rapid progress and disruption caused by fintech in financial services. I also believe that HDFC Bank is doing an amazing job at reinventing and disrupting itself continuously. So I do believe it has a good chance of surviving and thriving the disruption.

Or United Spirits. I am reasonably sure people will continue to consume alcohol in the future. It's not subject to disruption as financial services.

I am a firm believer in the buy-and-hold principle. But I also realize that nothing can be held forever. I buy with the intention of holding for at least a decade. Buying and holding good companies for the long term reduces one important risk; reinvestment risk.

Having said that, I will sell if the fundamentals permanently deteriorate.

6. Tune out the noise.

I don’t pay much attention to macros.

I have no idea if the world is heading for a global recession. Neither am I aware of the ramifications of an inverted yield curve.

I try to buy companies that are capable of surviving the downturn better. And downturns will occur in an economy.

7. Beat your emotions to beat the market.

Do not let emotions come in the way of staying the course. If you cannot manage your emotions, you will never be able to manage your money. I am not saying that my investing strategy is the best. Different investors have different strategies, and it works for them. But the common trait behind every single investor is keeping their emotions and behavior under control. Most fail simply because of their inability to handle their emotions and get carried away in extreme markets.

This is not easy, but it has been my strongest edge. You cannot ignore fear and greed, but you can manage it. As Warren Buffett says, if you cannot control your emotions, you cannot control your money.

Please note:

D Muthukrishnan of Wise Wealth Advisors, is a Certified Financial Planner (CFPCM) and Personal Financial Advisor. He is NOT a Registered Investment Adviser (RIA).

The mentioned stocks are NOT recommendations. He has provided a few examples ONLY to provide clarity with regards to his investing process and thoughts.

He suggests that it is best that you cultivate your own investing strategy and take the help of a professional should you be unable to do so.

Investment involves risk of loss.

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