Every investor I meet these days is a business analyst. He wants to invest in the coolest, fastest growing businesses and doesn’t care much for the broader stock market. He is of the view that businesses that continue to grow their profits and perform impressively will continue to do well in the stock markets, regardless of what the broader stock markets are doing. There are two problems with this approach. First, the best businesses are rarely available cheap. Second, these stocks are more correlated to the broader stock market than trade analysts think. (See the list).
The vertical bar is the percentage of the top 500 stocks by market cap that ended the year on a positive note. Of the top 500 stocks, only 9.4% ended the year positive in 2011, 79% in 2012, and so on. Stocks go up and down a lot simultaneously. In fact, it is more the norm than the exception. Thus, when you are investing, focus on the broader stock market. But how do you actually do this? Our one word answer is evaluation. The numbers you see at the bottom of the chart are the earnings multiplier from the Sensex price at the beginning of each calendar year. So, 23.6x for 2011, 16.4x for 2012, and so on. By the way, the long term average PE multiple of the Sensex has been in the range of 20x-22x. Notice how a large percentage of the top 500 stocks went up when the Sensex PE was below 22x. Also see how a large percentage gave negative returns when the Sensex PE was above 22x. The red bars are the years when the Sensex was expensive based on its long-term average. The blue bars are the years where it was at or below its long-term average. By the way, as we had a massive correction and subsequent recovery in 2020, I have divided the year into two parts i.e. January to March (2020A) and April to December (2020B). When the Sensex is trading at or below its long-term average PE of 20x-22x, a larger investment in stocks, such as 75%, is recommended. And when the PE of the Sensex exceeds 23x-24x, it should be reversed or brought down to at least 50%.
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The idea here is to be a securities analyst, not a business analyst. A securities analyst buys an undervalued stock and then sells it when it is 50%-100% above its purchase price. He does not believe in doing a thorough study of his holdings. He will only check whether the stock meets certain pre-determined criteria of quantity as well as quality and if it does, it becomes a part of his portfolio. In addition, a securities analyst also takes a look at the broader market valuation and adjusts his equity exposure accordingly. Therefore, if the markets are expensive, he will reduce his exposure to stocks and when they become cheap, he will increase his risk. You see, most investors take interest in stocks when the market goes high and lose interest after crashing from their highs. But not a real security analyst. Since he focuses on the valuation of the market, he will have more market risk after the crash and will reduce his risk when it has become too high.
Also, a security analyst would not buy high PE stocks as these are rarely undervalued. Their focus is on good quality stocks where balance sheets are strong and where valuation multiples are not too high and include a substantial margin of safety. This way, he avoids the risk of paying too much for the stock and ensures that he does not get stuck in a position for years.
You have an edge in being a security analyst, not a business analyst. This is because a security analyst has more than one wire. Its shares are bought cheaply and usually at the bottom of a bear market. On the other hand, a business analyst can misjudge both his PE multiplier and growth rate and get a double whammy in the process. Thus, being a security analyst is in my view a better way to outperform the market over the long term.
Rahul Shah, Co-Head, Research, Equitymaster.
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