As expected, my previous post got a lot of good comments and emails questioning my logic (and sanity 🙂 ) . Most of the comments highlighted a lot of valid points against my assertion, that one should ignore the index when investing directly in stocks. I can bet a lot of you must have rolled your eyes when you saw the title and read the post 🙂

The main reason why my previous post may have appeared rash is that I did not explore all the nuances of investing, while ignoring the index. Let me start by highlighting some assumptions behind the previous post

– My key assumption behind the previous post was that the investor is investing for the long term and would not be bothered by short term fluctuations of the market or the stock price.
– The investor is a reasonably informed and diligent investor (a do it yourself kind of person)
– The investor has done his or her homework or analysis and has sound reason for believing that the stock is undervalued. In other words, the investor has evaluated the business well and believes that the company will do well in the long run (increase its intrinsic value).
– The investor is looking at building wealth in the long run and would be satisfied with above average returns (couple of percentage points above the index in the long run) and not looking at beating the index every quarter or year.

Let’s explore further by what is meant by investing while ignoring the index –

Sound fundamental analysis
The first requirement for this type of approach is that the individual has analyzed the company in detail and has good reason, backed by experience, to believe that the company will do well and the stock is also undervalued.

It is common to find undervalued and cheap stock during bear markets and market panics. It is however not a fact written in stone that one cannot find cheap stocks during bull markets and overpriced one’s during bear markets (hint – look at bharti airtel’s performance since Jan 2009 during which period the index has almost doubled).

When I suggested that one should ignore the index when investing in individual stocks, I did not mean that one should stop thinking and buy a stock which does not offer a good margin of safety. My assertion is that the process of evaluating a company and deciding if it is undervalued or not is not linked to the index levels.

A stock is undervalued if the current price is well below the conservatively calculated fair value of the company (which depends on the future performance of the company). This undervaluation or overvaluation does not depend on whether the index is overpriced or if it is raining in Timbuktu.

What if the market drops?
If you believe that company is selling below the fair value and you have confidence in the long term performance of the company, why does it matter if the market and the stock price drops after you have bought? Is it a tragedy that you bought a stock at a 50% discount to fair value and the stock went to 60% discount before eventually reaching fair value and giving you a 100% return in the process?

Is your approach to buy at the very bottom and sell at the absolute top ?

The problem with most of the investors is that they look at the short term price performance to validate their analysis. If you have that mindset, then it is very difficult to hold a stock for the long term as almost every other company which has given good long term returns has had short term spells of absolutely disastrous price performance.

The sole validation of your analysis should be the fundamental performance of the underlying business. If the company does well, the stock price will follow in due course of time. In the short run, the stock price will be influenced by market sentiments, news, liquidity and god knows what other factors. In the long run (usually 2-3 yrs), the price does catch up with value.

If on the other hand, the underlying business performance starts going south, then the best course of action is to sell and cut your losses (easier said than done). You will lose money in such a company even if the index goes up.

Buying the stock cheaper
The other argument I read repeatedly is that the stock price will come down when the market drops and an investor should be patient to wait for such opportunities.

I am all for being opportunistic and keeping some cash on hand to take advantage of such opportunities. I did not recommend that one should be fully invested during bull runs and not have some cash around if an opportunity presents itself. Asset allocation depends on several factors (age, target allocation % etc) and should be made based on your personal preferences.

Let’s say you do have ample cash and have to make a decision on a specific stock. If however you think that the market is too high and would like to wait for the market to drop to pick the stock cheap, then how do you know if the market will drop in 1, 3 or 8 months. In addition, can you be assured that the company will not keep doing well during this period and even if the market drops, the price may never drop to the current levels?

Finally, if you are confident that the market is going to drop soon (based on some logic or intuition), then are you buying index puts to benefit from it? If the market drops as you thought, then you will make money on your puts and also be able to buy the stock cheap !!!

Should you invest blindly during bull runs
I actually got accused of saying this in the previous post ! I personally don’t recall making this statement. Ignoring the index does not mean that you become blind to the valuation of individual stocks and start investing like a monkey.

It is true that stocks are usually overvalued when the market is in a bull run. Usually does not mean always and all the time.

My suggestion is this – disconnect the process of analyzing the stock and deciding whether it is undervalued or overvalued from the level of the market, GDP growth projection and other macro factors. One should focus on the specific factors which will drive the performance of the company and based on this assessment, decide if the stock is undervalued or overvalued.

If it is undervalued start buying! If you think the market will drop, then buy slowly and add to your position when the price drops. If you are wrong, then you would have missed a good opportunity. ofcourse all of this is easy to say and tough to execute.

The most cherished assumption
The market level seems to be one of the most fundamental drivers of buy/ sell decisions for most investors. I personally think it is worth evaluating this assumption and not dismissing it without thinking about it. You can always test it with a single stock or a very small amount of your capital and see if the assumption holds up.

The downside of this test is that you could lose a small amount of your money, but the upside is that it could open up a completely new way of thinking about the market and investing.

I regularly try to understand the assumptions which drive my portfolio decisions, which in turn have a major impact on the long term returns . There is a fancy term for this process – meta congnition or ‘thinking about thinking’.

I have realized (and will continue to discover) that I have made sub-optimal decisions in the past due to various assumptions. One of the most damaging assumptions has been this – One should buy stocks when the market is low and sell when the market is high.

This assumption and way of thinking is more or less a stupid way of investing in the markets. I have engaged in it in the past and have paid a heavy price in terms of opportunity cost

Reason behind this thinking
I think the main reason behind this thinking is due the negative effect of all the media chatter and noise. The commentators on various financial channels are paid by the volume and not by intelligence. If a financial commentator recommended a great stock or great idea and then asked you check back after one year, do you think they will remain in business?

As a result of this bais (towards unnecessary activity), the media and a lot investors have to discuss about something. Now, you can’t discuss about the fundamental performance of stocks every day ..isnt it ? so what better topic to discuss than market levels and price action of various stocks?

Does the market level even matter ?
The first question I am asked after someone comes to know that I invest regularly is – do you think the market is high or low and should they wait for a particular level before they starting putting money into the market ?

What do you people mean by the market level ?

The market level is usually the index which in turn is a weighted average of a fixed number of stocks (for example nifty is an average of 50 stocks). So the notion is that the market is overvalued or undervalued at some number at a particular point in time.

The problem with this question is the market level is immaterial if you want to buy individual stocks. If the stock you want to buy is overpriced, then a low market does not matter and vice versa.

The only case where the market level would matter is if you plan to invest a large sum of money into the index.

How has this assumption hurt me?
I have engaged in this convoluted thinking in the past. As a result, I have slackened during bull runs assuming that most of the stocks would be overpriced. The reality is that even during bull runs there are stocks which are undervalued, but it takes more effort to dig them out.

I abandonded this thinking two years back and have started looking for good ideas irrespective of the market level. If the stock is underpriced, I will create a position in the stock irrespective of the market levels. If the market drops and the stock drops too, then all the better as I am able to add to my position further at a lower price.

A real example
One can have several counter points to the above thought process
– Should one not wait for the markets to drop so that you can buy the stock even cheaper?
– Will the stock appreciate if the market drops and remains at lower levels for extended periods of time?

To the first point – if you can see the future (know if the market will drop in the future), then either you are a gifted person or completely delusional. If you are gifted, then use your talents to do something big or world changing.
One cannot invest based on hindsight and we have to make decisions based on what we know now (the stock is cheap or not based on current facts!)

On the second point – The long term returns of a stock is dependent on the level of undervaluation and fundamental performance of a company and not entirely on the market level. As an example, in early 2008, mid cap IT stocks were among the most ignored group. The future was not bright for them.

I wrote about IT stocks (NIIT tech in particular) in Q2 of 2008 and felt that the market was over discounting the future. Interestingly the future turned out to be worse than anyone imagined. Inspite of that, these companies survived and have done fine.

The market has since then corrected the undervaluation and these stocks have doubled during this period whereas the index (aka market level) has been more or less flat.

Focus on the important and knowable
As warren buffett has said, an investor should focus on the important (fundamental performance of a company) and the knowable (current performance and not future market levels). The rest is noise and a smart approach is to ignore it.