Spotlight

Unreasonable expectations cause most people to make terrible mistakes when it comes to stock market investing. We share varied thoughts on what makes for reasonable expectations

What do we want out of life? To be healthy, happy with our families, in our work, etc? What interferes with this? Isn’t it often emotions like fear, anger, worry, disappointment, stress, and sadness caused by problems, mistakes, losses, and unreasonable expectations?

Well, that last one – unreasonable expectations – is what causes most people to make terrible mistakes when it comes to stock market investing.

Consider the period of January 2006 when Google announced its financial results for the final quarter of 2005. While the company reported a sales growth of a whopping 97%, its net profit had surged by 82% over the same quarter of previous year.

Now, you would consider this to be a magnificent quarter, right? Well, investors in Google didn’t! As a reaction to these phenomenal figures, Google’s stock tumbled 16% in a matter of second. Trading in the stock had to be interrupted. When it resumed, the stock plunged another 15%. Absolute panic!

Let’s now head to April 2003, when Infosys had announced its fourth quarter and full year results for FY03. I still remember that day, because I was just a week into my new job as a stock market analyst, and was in charge of handling the software sector, and thus Infosys came under my coverage.

The company had just announced its result for the quarter and full-year ended March 2003. For the full-year, it had recorded 39% and 19% growth in sales and net profit respectively. Now you would imagine that these were pretty good growth numbers, right? I did too. But to my horror, the stock crashed by 37% over the next two days.

Imagine losing one-third of your capital in a span of two days. How would you feel? While I was not an investor in Infosys then, but being new to the stock markets, and in charge of research on Infosys, I was utterly confused, and at the same time, scared seeing such a sharp fall in the stock price.
“What’s wrong with the markets?” I asked my senior colleague. “Infosys has reported such a good result, so why has its stock been punished so badly?”
[Read more…] about Spotlight: Reasonable Expectations

Valuing stocks seems like a tough task in itself and more difficult is drawing a line between paying up and overpaying. Here are some insights on this topic I draw from investing legends and their experience.

Charlie Munger said this in his landmark speech titled – A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business…

Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return—even if you originally buy it at a huge discount.

 Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.

Now, if I were to look at some of the high quality businesses in India, it surely seems that investors are taking Mr. Munger’s idea about paying an “expensive looking price” very seriously. Here are, for instance, the P/E ratios of some high quality businesses…

 

In Lewis Carroll’s “Through the Looking Glass”, Alice’s finds that she has to run faster and faster just to stay in place.

Well, in our country,” said Alice, still panting a little, “you’d generally get to somewhere else if you run very fast for a long time, as we’ve been doing.

Here’s the advice Red Queen, an antagonist in the story, offers Alice…

A slow sort of country!” said the Queen. “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!

In sum, the Red Queen advises Alice to exert ever more effort just to maintain her current position.
Evolutionary biologist Leigh Van Valen took inspiration from the Red Queen’s words and proposed a principle called the Red Queen Effect in 1973 to explain how, for an evolutionary system, continuing development is needed just in order to maintain its fitness relative to the systems it is co-evolving with.
In biology, this means that animals and plants don’t just disappear because of bad luck in a static and unchanging environment, like a gambler losing it all to a run of bad luck at the casino.
Instead, they face constant change – a deteriorating environment and more successful competitors and predators – that requires them to continually adapt and evolve new species just to survive.
This theory has been applied to explain the relatively high speeds of rabbits and foxes, each of which developed faster running abilities in an attempt to gain respective advantage in the predator-prey relationship between these two animals.
[Read more…] about Spotlight: The Tyranny of Valuations