Thanks Sushmita for taking my Stock Market obsession with light hearted note! :D

Emotionally disciplined way to buy/sell in Stock Market

Published in

Finance in 21st Century

12 min readNov 16, 2019

Collection of quotes and thoughts to build Emotional Framework for Master Investors.

After reading tens of book on Investing, here is a compiled list of pointers that I want to remind myself repeatedly till they become part of default behaviour.

Success in investing or as a matter of fact any other department of life is all about emotional discipline.

Price of a Stock ∝ Intrinsic Value * Speculative Premium

In other words,

Price of a Stock ∝ Maths * Emotions

Intrinsic Value of a stock is calculated based on its past earnings, Revenue, Sales, ROCE etc. Speculative Premium is the price an investor is willing to pay over and above the intrinsic value of a share. It can be positive if buyer sentiments are positive. It can be negative if buyers do not like a particular stock.

As a matter of principle, we want to invest in a company whose intrinsic value i.e. earnings are compounding consistently and preferably at a time when its speculative interest is low because of some temporary problem.

Price of a Stock = PE * Earnings

PE: PE Multiple fluctuates with people’s speculation and emotions.
Earnings: Grows exponentially for fundamentally strong companies.

“I am particularly interested in buying companies when their long term prospects are intact but they are cheap because they face short term issues.” — Robert Vinall

Future Value = Purchase Price * ( 1 + Annual Return) ^ Time

Above equation suggests that we should buy when Purchase Price is low, Annual Returns are high for many years to come and we should remain invested for a long Time.

Question is — when is Purchase Price Low ?
Answer — Bear Markets i.e. when the stock market is crashing!

Bear Markets

Bear markets are the times when the market is falling and panic selling is happening.

Feeling prevalent in a Bear Market:

Most common public emotion is Fear.
Everyone is fearful that they will lose all the money. They want to sell before others do. There is a panic selling!
People become Risk Averse.
They doubt everything, even their good quality investments.

Truth of Bear Markets

Values are found in Bear markets. Bear Markets puts stock back on Sale.
Quality companies are available at cheap prices.
It is only when the tide goes out that we know who has been swimming naked.
- Bad companies are beaten down real hard.
- Quality companies either don’t go down that much or bounce back fast
PE Ratios contract which are sign of a decrease in speculative interest.

What you should really do in Bear Markets

You should go shopping! You should go Bullish!
Strategy 1: Stick to buying good quality companies at discount > 20%
Strategy 2: Buy not so great company but at an astronomical discount like 60–80%.
Buy without fear because — Risk of going wrong is extremely low. Downside is less, and the upside is huge.
You should be happy if the prices go down. So, invest in steps and not all at once.
Only short sellers become happy when the price goes up.
Remember — Tails I win, heads I don’t lose that much

Bull markets

Bull Markets are where the stocks price increase is on a rampage!

What it feels like in Bull Market

It feels like if a stock has been going up, it will keep going up.
There is a lot of optimism and Happiness.
It is emotionally easy to invest in these times because it provides you with instant gratification.
You see some initial success and then you start feeling overly positive about your skills. You might beat Index in performance.

Underlying Truth of Bull Markets

Public Emotion — Greed. Be fearful
Since you are happy and optimistic, you become risk-tolerant. Even overpriced stocks feel like a good buy in these times.
IPOs and Growth Stocks are launched to exploit your risk tolerance.
Operators manipulate the stock prices to make you feel like a stock is worthy of buying. It is Harshad Mehta’s playground.
Herd mentality at play and leads to Bubbles.
Success in Bull Markets leads to ego, false confidence in your own skills.
Bull Markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria— John Templeton

What you should really do in Bull Markets

Keep building your cash reserves. Don’t take fresh positions in the stock market.
Don’t stop SIPs by going overboard. SIPs should continue irrespective of Bull or Bear.
You might want to sell some stocks though if you need money.
It’s time to get rid of your bad quality stocks.
Relax! One hurriedly made investment can kill your 10 good investments.
Invest only when one or the other company is going through temporary stress. You have to be an Eagle.

In Bear Markets, be a Bull. In Bull Markets be an Eagle

Bull Market Success, Ego & Self Declared Genius

In a bull market, you might have beaten the index and Mutual Funds for a brief period of time. This can lead you to believe that you are smarter than Fund Managers. Don’t be disillusioned.
Don’t confuse Bull Market with Brilliance.
“The riskiest thing is getting lucky — a false positive. You have a positive result, but your process was poor. That’s the most dangerous because, after a few false positives, you typically go bigger, and that leads to the old saying of “succeed small, fail big”.
The market is pretty efficient at grinding down the egos of those who succumb to the temptation of seeing profits as certification of their own genius. Leon Levy
Short Term performance means nothing. If you can achieve great results for a long time consistently, then that could indicate some skill.

Bull and Bear Cycles

Bull and Bear cycles will keep coming one after another.
A bull comes up the stairs and a bear goes out of the window.
Bull market builds up slowly whereas bear market crashes fast!
Every now and then all the stocks go on Sale! Just out-wait them

Profit is in the Buying

“Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results. The better sale will be frosting on the cake” Warren Buffett
“everything is AAA at the right price”. Howard Marks
If you focus on the entry price, exit generally works out well.
Compounded returns are inversely proportional to purchase price.
Returns ≈ (1 / Per share Purchase Price) * (1 + r)^n
Again, Heads I win, tails I don’t loose that much.

To fight all the above emotions, you need to learn how to be contrary!

Contrary Investing

You have to bet against the consensus and be right! — Ray Dalio
Sell when everyone is buying and buy when everyone is selling.
Be fearful when others are greedy.
Requires second-level thinking
First Level Thinker: All Banking stocks will go down during Corona because lots of people will default.
Second Level Thinker: HDFC Bank is a very conservative lender and the probability of default is lower. In fact when other banks will be struggling taking care of their NPAs, HDFC Bank will consolidate even bigger market share. — Saurabh Mukherjea.

Emotionless Investing

People who are unemotional have a greater chance of success at Investing
Hence, don’t buy based on feelings, instead, buy when the price is less than Intrinsic Value.

When to buy: Price < Intrinsic Value

======================================

Finding Quality Companies

We have talked about when to buy shares. Let’s explore how to find the companies which are worth buying.

The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine — Warren Buffett

These are the probably the companies you know very well but never bought due to high valuations.

Finding Good Companies Technique 1 — Coffee Can Investing

These are also called — Consistent Compounders
These are the companies that have delivered irrespective of Market’s up and downs.
ROCE > 15% consistently for the last 10 years every year
Revenue Growth> 10% consistently for the last 10 years every year
CCP asks you to ignore PE and PB Ratios.
https://docs.google.com/spreadsheets/d/10pFnreqA8fudXtH9S8oIIGUMh0Q1s4_vGbPWrn592Vw/edit#gid=0

Finding Good Companies Technique 2— Magic Formula

Finding Good Companies Technique 3— Economic Moats

https://www.morningstar.in/tools/wide-moat-stocks.aspx

Why Quality?

In the short run, markets are a voting machine but in the long run its a weighing machine. Hence, be Long Term Greedy
Time is a friend of wonderful businesses and the enemy of the mediocre.
In the long-run stocks go up only for three reasons: 1. Earnings 2. Earnings 3. Earnings — Peter Lynch

If you are not willing to hold a stock for 10 years, don’t bother owning it even for 10 minutes.

Growth Trap (Growth Stocks)

Signs & Symptoms: Stocks that have grown exponentially in the past.
It’s a product of the bull market.
Most of the times these are indeed the businesses that are actually good, have really good fundamentals and have created a good amount of returns for the investors. Unfortunately, this leads to excessive greed and speculative growth and eventually the price of this stock skyrockets and it becomes a bubble. By the mechanics of it, one day this bubble will burst. And that's when, after the bubble is burst, an Intelligent Investor will buy the stock.
Growth stocks will always sell at a premium i.e. high PEs because of high speculative growth. So, compare with historic PE and Industry PE to make a calculated decision to buy. Use high PEs to identify opportunities.
Buying Growth Stocks. i.e PE >25 is Not good for Defensive Investors says Ben Graham. But, this is too hard of a restriction for quality stocks as they always sell for a premium.
If you buy only because a stock is growing, sooner or later you’ll be sorry
Financial Physics: The bigger they get, the slower they grow
Every once in awhile growth and value stocks alike go on sale.
Exit a growth stock immediately once it loses steam of growth due to fundamental changes.
The greatest risk doesn’t come from low quality or high volatility. It comes from paying prices that are too high. — Howard Marks

The biggest wealth-creating opportunity lies in quality small-caps.
A low PE Ratio and high ROE is a beautiful combination of fundamental analysis.

When to sell

Buffet: Buy Quality companies and then hold them forever.
When the reason that you bought the stock is not valid anymore.
Business deteriorates, share becomes overvalued or a better investment is available
Exit at first sign of trouble
Don’t sell to re-enter at a lower price point.

SIP

Buy periodically in an index fund.
Philosophy — I don’t know and I don’t care
You will never be able to buy on extreme dips and sell on extreme highs. Invest regularly via SIPs
Dollar-cost averaging is the only formula based investing that has ever worked!

On Liquidity

Having loads of liquidity lets us sleep well.
Equity Exposure percentage = 100 minus age.
You don’t get opportunities every day and one must be prepared and ready with the money when opportunities come.
Have loads of cash in reserve, so that when stocks are on sale, you can go shopping.

On Debt

Zero debt is the biggest asset.
To own is freedom. To owe is slavery.
Debt is financial death.
The problem of leverage is that you are borrowing it from the future. And when you are borrowing it from your future you pay for it with your future.

On Savings

For early financial independence, compete with others on savings and not on spending. — Muthuk

Bargain Opportunities

Relatively Unpopular Large Companies — Companies going through a period of temporary unpopularity. Example: Infosys in 2019
Neglected and Out of Favour companies. Example: Syngene in 2019
Buying Distressed Assets. Example: Yes Bank in 2019

On Timing the Market

The low point for share prices is when most people are expecting bad news, not after the bad news comes out.” Sir John Templeton

On Activity, Lethargy and Patience

Be Lethargic.
Fourth Law of Motion: For investors as a whole, returns decrease as a motion increases.
Great investors wait patiently for a bargain price
Relax! One hurriedly made investment can kill your 10 good investments.
Most successful investors do nothing most of the times.
In investing, it is not the effort that counts. It is patience. — DMuthuk
Initial years of compounding are very boring. Despite slogging and saving, corpus would grow only slowly. Big wealth would seem to be a distant dream. The effect of compounding kicks off only after a decade and then it picks up momentum. Patience and persistence is the key. — Muthuk

What not to do

Say no to Trading. No short term horizons.
Say no to Derivatives
Never Use Leverage
Never invest on Tips. Always do your own fundamental analysis.
Don’t constantly watch your portfolio

Bargain Issues | Graham Style Investing | Cigar Butt Investing

Buying distressed assets available at 2/3 of Intrinsic Value.
If a business is worth a dollar but is available at 40 cents, something good may happen.
Don’t buy a business worth $83 for $80.

Longer the stock takes to come back to its true intrinsic value, lower the CAGR. Hence, this is a very risky strategy. Also, goes against the long term investment philosophy.
Shopping Strategy
Graham goes to a Mall and buys anything thats cheap irrespective of its useful to him or not. On the contrary, Munger and Fisher first decides what they want and prepare a Wishlist. They go to Mall only if something on their Wishlist is on Sale.
→ Munger and Fisher only buys business with Superior Economics!

On Dividends

Dividend payout ratio signifies a company’s intent towards distributing profit.
Dividend yield tells you the returns on invested money.

What doesn’t work

Fancy formula based investing
Wall street failed doing it. Don’t use your python skills please!

Moats

Build a portfolio full of Moats!
Companies with Competitive Advantages like strong Brand, Patent, Licences, High switching costs
Exp: FMCG with strong Brand Recall, AUMs and Adobe — High switching cost
https://www.morningstar.in/tools/wide-moat-stocks.aspx

Golden Principles

Diversification — This is how you reduce Risk without reducing returns.
Margin of Safety — Never Overpay
Avoiding loss should be the primary goal of every investor. The way to avoid loss is by investing with a significant margin of safety. A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and make mistakes.

Businesslike Investing

Owning a stock is like owning a part of a company.
Buy shares of a company which have long term profit generating capability.
A stock is worth the present value of all the cash it will generate in the future.
Buy shares in companies which are stockholder oriented. Dividend payouts, stock buybacks etc are good.

Consistency

Every investment style goes through both good and bad times. Consistently sticking to a style ensures that you reap the benefits when good time happens. Frequently changing the style may make you miss all good times and possibly can even make you go through all bad times.
What is the best investment strategy? The one we can stick with through ups and downs. — Muthuk