Anyone who believes that investing in share markets is simply a game of beliefs and emotions is bound to fail miserably.
Investing in stock markets can be rewarding but only when conscious efforts are taken. Today we will talk about the views of an investor who took these conscious efforts and has drawn a roadmap of success for investing in stock market.
He’s none other than the inventor of the magic formula – Joel Greenblatt.
Joel Greenblatt is the managing principal and co-chief investment officer (CIO) of Gotham Asset Management, an investment firm he founded in 1985.
He is also a director of Pzena Investment Management, a global investment management firm.
Joel Greenblatt has written a couple of books over how to put a strategy in place to buy undervalued stocks with higher yields. His writings touch base on formula type investing.
He is often regarded as the creator of the famous ‘Magic Formula’. His famous formula involves buying undervalued stocks based on two parameters – high earnings yield and return on capital (RoCE).
Here are some of his famous sayings…
#1 Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.
In this quote, Joel Greenblatt talks about the basics of investing. He emphasises that when you’re investing in the stock market, you should be very clear about your ultimate investment goals.
You should clearly decide whether you want small but regular gains or irregular but huge gains.
If an investor does not know what his end goals are, he will not have any direction to start investing.
Investing in stock markets without making these decisions is like going into a restaurant and saying ‘I would like to have one plate full’ without actually saying what dish you want. In the stock market, being vague can be dangerous.
Imagine not having an ultimate end goal, but having just one intention to earn huge profits. What an average investor would do is select stocks that seem to have a good future. The problem here is the investor may end up buying five different stocks that run in five different directions.
One maybe from the blue-chip segment, while other may be a PSU, a smallcap stock, or from rapidly developing and changing sectors. PSU stocks will give regular dividends but the growth will be laging here. Blue-chips will make sure you don’t lose much but they will come at expensive valuations. Similarly, smallcap stocks could rise quickly but even fall at a faster rate.
After divesting from these five stocks, the investor may end up in profit but it doesn’t mean this is a correct way.
Investors who have no idea of what they want in stocks, can face huge wealth destruction.
Joel rightly compares it to running in a dynamite factory with a burning matchstick.
#2 When it comes to long-term investing, doing “less” is often “more.”
One of highest earning strategies in stock markets is buying a stock and then forgetting it for a long time. This is the most successful strategies keeping in mind human psychology.
Human minds tend to react immediately in case of unfavourable results. Share markets are dynamic and volatile. They keep changing due to various factors beyond human control. Hence, even the stocks which are good for long term may fall in the near future.
In these times, if a long term investor keeps looking at the share price constantly or keeps it comparing with various other stocks or keeps analysing the future, and ends up selling a good stock at a discounted price.
However, if he had done nothing in that phase and just trusted his researched stock, that one stock could have made him a crorepati. Take the classic example of ITC.
ITC share price did not move for a long time. It was the joke of social media platforms. But those that stayed calm and did nothing were able to earn strong returns during a period when the bluest of bluechips suffered.
Long term investing is like cooking rice with a closed lid. After one has put in just the right amount of water and set on the flame, sit back, and let it cook. If he keeps checking it between for water or keeps removing the lid or if he keeps stirring it, he will end up spoiling the dish.
However, one should also be careful not to overcook. If he smells that something is burning, he should react immediately.
The main explanation here is one should be able to differentiate between problems that are temporary in nature and problems that are permanent. People often tend to overreact to temporary problems and thus sell in panic. This shouldn’t be the case. Good quality companies know how to bounce back from a setback and should be persisted with.
#3 Stock prices move around wildly over very short periods of time. This does not mean that the values of the underlying companies have changed very much during that same period.
The above quote is absolutely relevant for recent market behaviour.
In 2021, due to lockdowns and increased liquidity, money flowed into the share markets like people flow the local trains in the financial capital city. Resultantly, the share price of so many companies were shooting through the roof.
It was like falling asleep one night and waking up as a millionaire. I know this story sounds ridiculous but this actually happened in 2021.
Let us take an example. In 2021, a stock was listed on 7 April at Rs 140, and the same stock closed at Rs 9,928 on 31 December 2021. It’s a massive increase of 6,654%! That too in such a short time frame.
If you’re wondering whether this is a penny stock, you couldn’t be more wrong!
The stock we are talking about is EKI Energy.
EKI Energy left cryptos behind and stunned with its performance.
However, as soon as early 2022, the winds changed. Tightening liquidity, geopolitical tensions, supply chain disruptions, took a toll on the market and the bloodbath affected EKI.
On a YTD basis, EKI Energy has eroded 45% of its marketcap.
Surprisingly, except for the fluctuating share price, rest of the things are almost the same for the company. Beginning from its shareholding pattern to its latest quarterly results, there haven’t been any major or extreme changes.
This proves that sometimes even if the share prices rallies or tumbles, there are no real reasons behind the movement. It can be just market sentiments that cause the share price to fluctuate.
#4 The market’s very emotional but over time, doing something logical and systematic does work. The market eventually gets it right.
Like we mentioned above, sometimes it can be market sentiments that cause the share price to fluctuate.
When something bad or good happens to us, our emotions are all over the place. We often make impulsive and wrong decision when we are emotional. Similarly, stocks behave in a wayward manner when markets are emotional.
However, this fluctuation in share price is not permanent in nature. After the emotions of the market have cooled down, share price will either rise or fall to come close to its fundamental value. Take the example of Zomato…
When Zomato came out with its IPO, valuation guru Aswath Damodaran after using valuation and important metrics predicted that the price band of the stock is very high.
According to Damodaran, Zomato’s share price should not be more than Rs 44.
Now, Zomato is very famous for its discounts and marketing strategies. Hence, the general market sentiment was bullish. As a result, shares were listed at a much higher price.
However, the share price came down quickly as month progressed and came down at Rs 44! At the exact fair value that Ashwath Damodaran calculated. Markets sentiments drove the share price for a while but ultimately it came down to the fundamentals of the stock.
Hence, while adding a stock to your portfolio, carefully keep in mind the fundamentals and take decisions accordingly without worrying about the market sentiment. If the research is strong, then the markets will eventually follow.
#5 The secret to successful investing is relatively simple: Figure out the value of something and then pay a lot less.
Investing in share markets is all about asking two questions:
1. Is it a good stock?
A stock with strong fundamentals, bright prospects, robust past performance, high ROE, promoter backing, etc. is a good stock.
Investor has to keep in mind various factors and results to know whether it is a good stock. It is a tedious task. It is like finding a needle in a haystack.
However, this is just work half done. Even after performing the behemoth task, an investors, your job is not over. You have to answer one more question.
2. Is it a GOOD TIME to buy the stock?
The problem with good stocks is that they are often overbought which means they are trading at a price much higher price than their actual worth.
Hence, the real key here after finding a stock is to wait. To wait for the right time to buy the stock.
The market emotion does not always work against the investor. It’s the market sentiment that brings the value of a good stock down, which in turn creates buying opportunities.
The logic behind these questions is simple… it is the execution of these questions that is difficult.
Buying a stock just because it available at discount makes no sense at all so be careful there too. Make sure that the stock you are planning to buy has the potential to go up and bounce back.
There are two basic rules here: don’t overpay and do sustained research. Your returns will depend on how well you stick to these rules.
No matter what the stock market is doing, ignoring these basics will almost always lead to poor returns. Joel Greenblatt’s magic formula method may not be right for you, and that’s perfectly fine. But you should at least understand why he values stocks the way he does. It will help you place individual stocks into their proper context.
Following these principles will definitely help you in your journey to get rich slowly and steady without taking much of a risk.
(Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.)
This article is syndicated from Equitymaster.com