Returns are front-ended: Sometimes, the investment thesis plays out faster than expected, leading to front-ended returns. Especially during bull markets, stocks take off as soon as one buys them. Within a matter of a few months or quarters the stock is up 50 per cent, 100 per cent, or even more above the buying price. At this point, prices run ahead of fundamentals. The risk-reward ratio at the current price is not as favourable as it was at the time of purchase. This can lead to price or time corrections.
Initial thesis is wrong: Sometimes the initial thesis is wrong and hence the investment does not play out as expected. Any investment decision involves making a few assumptions about the company’s future performance, or some event playing out. Many a times, these assumptions do not play out according to expectations. An investment thesis should be thought of as a three-legged stool. If any one of the legs is broken, the stool cannot stand. Investors should be careful about coming up with new points to support a thesis that is patently wrong, barring in exceptional circumstances.
Adverse changes in circumstances: Sometimes the business environment changes, making it unlikely that the expected returns will materialise from the investment, though the stock remains fairly valued.
Sometimes there are adverse changes in government policies, which mar the economics of the business or the company.
Sometimes the actions of the management can make a company less attractive. For instance, it may undertake very high capital expenditure funded with debt and/or external equity, but which does not result in the expected growth. Any other such incorrect capital allocation decision can also make a company less attractive.
Businesses keep changing and evolving due to many dynamic factors. When such developments occur, investors should revisit their original thesis and evaluate it critically, without being influenced by various psychological biases.
A better opportunity arises: Whenever one is fully invested, and a better opportunity comes along, it is logical to replace the least attractive idea in the portfolio with the new one. However, one should be careful before letting in a new idea. An investor is (ideally) much more familiar with his present investments than with a newer one. A new idea should only be included in the portfolio when it presents a significantly better risk-reward proposition than an existing stock in the portfolio.
Investments are like motion pictures rather than still photographs. Business dynamics keep evolving for better or for worse over time. An investor’s job is to keep a tab on these developments. He should remove the stocks whose fundamentals have deteriorated, and hold on to or add to the ones that are on course or improving. In other words, the investor should water the flowers and cut the weeds.
At the same time, investors should remember that business fundamentals do not change as fast as share prices. There will be long periods of time when there will be no actionable insights. Such periods may last for a few quarters or even for a few years. These are the times when one needs to stay patient, confident, alert, and wait for the market to correct the mispricing.
Investors should also bear in mind that stocks may sometimes go up, for the right or wrong reasons, after you have sold them, especially in bull markets.
Mistakes will be made on both sides of the trade. There will be pain. But rather than being bogged down, investors should stick to a sound investment process which over the long run will produce satisfactory results.
The writer is head-PMS and fund manager, Equirus Securities