Learning to make tradeoffs: An essential part of investing

As in life, and as in investing, we will come across times where we would need to choose one vs. another. The choice we make relies not only on our rational self but also the situation we make the decision in. With the same information available we are prone to making different decisions in time when we are feeling great and not so great both in life and in investing. Our emotions continue to impact day to day decisions we take. But even our rational self is affected by multiple behavioral biases we develop over time and hard to let go while making decisions.

Through this piece, I intend to focus on the choices our rational self has to take, with a promise to come back on the behavioral aspect in the future piece of writing.

Ideally, most of the investors including me, who focus more on investment than trading, tend to believe, that it’s very important to have an investment philosophy that you identify yourself with and can sleep peacefully at night. Its absolutely ok to be in the process of understanding one or making changes to it as we all keep learning with every market cycle and all our individual investments. Thinking about your philosophy not only helps us make trade off decisions during investing but helps us stay patient during not so rosy times.

Having evaluated multiple stocks for investments and taken a few investment decisions over the last year or so, there have been multiple times where choices (consciously or unconsciously) will need to be made which will involve trade-offs. Let’s look at select 7 choices I came across in the past 1-2 years. I hope you relate to them.

1.     Revenue growth vs. Margin growth:

As one would expect in a market like India where growth is give a high premium, a lot of investment stories these days, especially in bull markets, rely on growth in revenues. Revenue growth stories revolve around but not limited to company launching new products (like FMCG companies), entering new segments (financial institutions entering housing finance), entering new markets (export oriented companies), high unit prices (commodity companies), expanding manufacturing capacity (chemical companies), shift from un-organized to organized sector (jewelry companies) or even inorganic growth through acquisitions (pharma companies).

On the other hand, there will be margin growth stories (although rare in my sample set), on account of operating leverage (almost all capex heavy companies where capex has been done), entering high margin products (FMCG or consumer durables companies), reduction in raw material costs (industries using oil based raw materials).

While each story is different and might excite grey cells to a different level, we sometimes forget to ask basic questions for e.g. how will company get new customers to sell more, how sustainable will the growth be, how much time realistically will it take for the margins to improve, will margins be sacrificed for growth etc. It is rightly said “First step to understanding something is asking the right questions, answers only make sense later”. Which story one chooses might depend on multiple things, conviction and investment philosophy, unfortunately hardly one of those things.

More the elements in a story, more the level of conviction needed for believing in the story. And developing conviction requires research, both secondary and primary research. Choose a story which is simple and where you have knowledge of possible risks either through previous investment or necessary research, and one that matches your investment philosophy.

2.     EPS growth vs. Low PE:

This is classic choice of growth vs. value stock and this choice comes way too often for value investors especially in bull markets.

One would either spot a company with high EPS growth but trading at expensive valuations, or a company with moderate / volatile EPS growth, and trading at cheap valuations (with valuation methodologies differing across investors). Each story can be justified with equal no. of pro’s and con’s.

While EPS growth can come from revenue or margin growth as detailed in point 1, understanding if valuations are low are no easy game. As it is commonly said, valuation is an art not a number game.

What is the correct PE multiple that a company should trade at is probably the most difficult question to be answered in investing. One can justify it by absolute PE (earnings yield), EV / EBITDA, trading comparable, DCF, or even past peak valuations in few cases. Different valuation choices might point in different directions leaving investors in conundrum.

Which side of the trade-off the investor takes in most situations between growth and valuation defines what kind of investor one is, whether one is looking for a high margin of safety, what kind of uncertainty is an investor wanting to have in the portfolio, level of conviction on understanding valuations

3.     Free cash flow vs. Capex for growth:

Its commonly said that cash flow is the king in any kind of business, and supersedes any other metric. The job is again easier said than done, one will come across companies that are generating healthy FCF but no outlook on that growing, while there will be companies which have FCF -ve (most of them) that are planning to do a significant capex for expanding capacity, acquisitions etc. for future growth. Should one prefer a positive but stable FCF or one should have a long-term view and accept the -ve FCF in the near future for possible future +ve cash flows. Apart from being comfortable on management capability of capital allocation decisions reflected in ROCE trend over time, detailing out the economics of the project on which future cash flows are dependent and underrating uncertainties associated with it might be key to gain conviction in companies that possibly will have -ve FCF in near future.

4.     Build conviction on existing stock vs. exploring new ideas

Its rightly said, an individual and an investor is defined by where and how they decide to spend their time, time allocation skills being super important for an investor in parallel with capital allocation for management.

We live in time of exuberance in prices beyond rationality where there are no dearth of investment ideas with brokerage houses expanding coverage and giving out more buy recommendations.

As an investor we have a choice to explore new ideas for investment or spend more time on existing ones to build deeper conviction. What would you prefer your portfolio to look like, 5 strong conviction stories or 10 medium conviction stories?  While in an ideal scenario answer shall be the former, in reality, it is almost always the latter, why our rational minds make these choices is again a topic of interest. Regular reflection and stepping back to take a stock of things shall help move to the desired outcome.

A relevant quote that comes to me from one of the greats:

“The most difficult portfolio strategy is to do nothing”

5. Staying out of the market vs. invested

A lot of us probably decided that when Nifty crossed 9500 or 10,000 it’s probably a bubble waiting to burst with valuations not matching on-ground fundamentals, with increase in prices purely drive by liquidity, both domestic and global. How many of us despite believing in this, chose to stay out of the market and regret to miss the rally of Nifty to 11,000, and how many of us wanted to ride the wave till the end.

Each of us had a choice despite having the same information available to us, how we chose to act on it makes all the difference to portfolio returns.

One quote remains very near and dear to me apt for this choice to be made:

“It’s one thing to think, it’s another thing to do, and it’s completely another thing to do what you think”

6.     Short term bets vs. a long-term stories investment mindset

While most of my peer set who I am in constant touch with and who have influenced wants to be long term investors (with definition of long term varying from people to people), what do we do when we are presented with an opportunity to make quick bucks from short term ideas that are more speculative in nature and ride on some privy information. We also might get excited about stocks making new highs every day and week with a desire to participate in them to avoid the feeling of regret. This mostly is a function of long term investing being boring and requiring patience with most of us looking for excitement from markets than a compounding machine.

While we might justify this action by restricting these kinds of investments to 20% of our portfolio, it usually takes up a lot more mental space than that.

A quote from Vijay Kedia’s speech that stuck with me, that I find relevant:

“If you treat markets as gambling, be rest assured that the returns will be of similar kind”

7.     Understand a business vs. predicting the market tops and lows

A lot of us, especially the ones active in the market, while like to believe are bottom up investors, spend a lot of mental space of discussing the market direction, predicting the highs and the lows, giving reasons to every big fall and rise, when probably most of it is not only difficult but impossible to predict and more importantly not useful in deciding which companies to buy.

As an investor we again have a choice, should we spend time to understand a new business, read a new annual report or listen in to CNBC all day. The kind of conversations we spend time on with colleagues and peers in this space also define your individual personality.

While we would all want a picture perfect ideal stock (high growth, strong profitability and returns, robust cash flows, great management and cheap valuation), in my experience there hardly exists any. Hence, which side of the trade-off we take, where we spend our time define our personality both in life and in investing, and also remain a key factor of our investment returns.

Probably we are not as rational as we would like to believe.

Happy to hear you stories as well that we all can learn from.

Abhishek Gupta, 6th Feb 2018