Long-term investors should snap up quality stocks during uncertainty

India’s GDP growth rate, according to estimates, could be less than 5 per cent this year. Many agencies, including the International Monetary Fund (IMF), have lowered their growth estimates. Auto sales are down. Job growth is sluggish. The long-awaited turnaround in corporate profit growth hasn’t materialised yet. Micro, small and medium enterprises (MSMEs) are in deep trouble. Indian banks have not overcome their non-performing asset-related issues, and now non-banking financial companies are also in trouble. Despite all these problems, the Nifty 50 index is trading close to its all-time high valuation. How does one make sense of such an environment and invest confidently?

E A Sundaram, Business Standard
26th February

Learn to live with uncertainty: Uncertainty about the future is an intrinsic feature of equity investing. We can be confident, but we can never be entirely sure about what the future holds. When uncertainty about the future is high, it impacts stock prices. If investors are to wander into “uncharted territory”, they should ensure they do so with strong companions.

Investors can derive confidence from what Warren Buffett has said about uncertainty: “The future is never clear. You pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.”

One needs to recognise that we can’t predict the future. We may make some extrapolations based on our past observations or experiences, but in reality, no one can consistently make correct predictions about what the future has in store. Especially in the stock market, where future stock price movements are a function of literally thousands of variables, it is simply impossible for any investor to correctly predict the interplay of all these variables and their impact on the movement of the concerned stock’s price. So, let us not even try.

Look for companies with strong fundamentals: The next thing is to recognise that what ultimately matters in the stock market is, one, the continued competitiveness of the company concerned, and two, the price at which the stock is purchased.

We can discuss until eternity about slowdowns, political uncertainty, war fears, oil price spikes, elections, foreign exchange woes, and so on. But ultimately, we will be much better off if we spend time assessing the continued competitiveness of the company and assessing the price at which the stock should be purchased. Strong business models, the extent of difficulty competitors would face in competing against the company, the brands it owns, its distribution network, the quality of the people running the company, and the working capital cycle are all indicators of a company’s competitiveness. Such a company would be a good companion when coursing through the uncharted territory — the future.

Buy at attractive valuations: The price paid at the time of entry into a stock is equally important. The return made from an investment in a stock is inversely proportional to the price paid at the time of entry. It, therefore, makes sense to avoid paying an exorbitant price for a stock. It is difficult to buy a stock at the bottom price, but at least we can stay away from those that are exorbitantly valued.

If we want to buy only good-quality businesses (because they make good companions during times of uncertainty), but also wish to avoid paying too high a price (because that makes economic sense), one should bear in mind that such companies are available at a reasonable price only when “fear of uncertainty” is high.

When we can clearly see robust profit growth in a company, so can the rest of the world. When high profit growth continues for several quarters, expectations from the stock rise. These high expectations also drive the stock price up.

That is why it is preferable to buy such a company when profit growth is not robust enough, or when the company is caught in a whiff of “uncertainty”, so that its future appears murky.

If we are confident that the difficulties the company is facing are temporary and not terminal, uncertainty around a stock is a very good opportunity to pick up a good company at a not-too-exorbitant price.

High valuations translate into poor returns: A couple of examples would illustrate these points well. In February 2000, at the peak of the tech boom, stocks in a few sectors were quoting at valuations well above their historical averages. They had also delivered fantastic returns in the years prior to 2000, and that was one of the primary reasons for investors not having “fear of uncertainty” about them. By and large, these stocks gave mediocre returns over the next few years. On the contrary, stocks that were dubbed as “old economy” and those that were gripped by the “fear of uncertainty” did very well in the subsequent years.

The same pattern was repeated in 2007. Only this time the favoured sectors were infrastructure, real estate and power.

As can be seen from the table, stocks that were purchased without any “fear of uncertainty” did worse than the group of stocks where investors were gripped by this fear. With the important caveat of restricting choices to companies with strong balance sheets and business models, almost uniformly, the rule is that when there is no “fear of uncertainty”, investors tend to buy at exorbitant prices. And almost inevitably, such stocks tend to disappoint. On the other hand, stocks buffeted by “fear of uncertainty” (provided they are competitive) tend to give strong returns over the next few years.

Long-term investors should, therefore, welcome the “fear of uncertainty” that affects stock prices. That is when good opportunities arise.

Disclaimer: This information is from a third party—Business Standard—offered through a tie-up to Kotak Securities customers for free for life. The third party content is not created or endorsed by any business offering products or services through it. The provision of this third party content is for general informational purposes only and does not constitute a research call, recommendation or solicitation to purchase or sell any security or make any other type of investment or investment decision. Also, the views and opinions stated in the content belong to Business Standard. Kotak Securities does not uphold nor promote any of the views. These reports do not, in any way, qualify as a Kotak Securities research report.

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