Developing a stock investment philosophy

At a glance

  • Every investor needs a consistent basis for making all her stock investing decisions
  • This basis allows the investor to stay the course in the face of short-term fluctuations
  • Broadly two investment philosophies exist based on Fundamental Analysis and Technical Analysis
  • TCI follows a value-stock investment style that looks for out of favour sectors at reasonable P/Es
  • An investor should pick a style or philosophy that aligns with his temperament and proceed to refine it as he gathers more experience in stock investing

In the last post (Election 2014 fever and deciding when to buy), I introduced Philip Fisher‘s  simple and intuitive framework of Markets, Industry and Company (in that order) to decide on when and where to invest. In spite of the recent surge in buying , we still aren’t at the precarious levels seen in the build up to some of the steep corrections in the past.

Now that we have the overall market level as a criteria out of the way, what stocks should one buy?

Every investor needs a stock investing philosophy

Remember those quaint arcade-style PC games from the late 90’s we’ve all played on our PCs? A typical game has bright pixels representing you at the controls of a spaceship looking to ward off an unending array of asteroids. Who ever bothered reading the instructions? Jump right in, hit an assortment of combinations on the clunky keyboard and see what happened.

Looking to buy stocks without a clear buying philosophy is a bit like that. You make a few random buy-sell decisions but can’t tell what got you the results, dumb luck or making the right moves. And since there’s more at stake than digital lives, the downside tends to be expensive both financially and lost learning opportunities.

So, what is an investing philosophy?

An investing philosophy is simply your rationale for decisions in the stock market: to buy, sell or do nothing. It  frames your investment goals with respect to what you believe drives stock prices and the subsequent actions that you take

For instance, the Calm Investor philosophy could be summarized as “value investing” by buying:

  • relatively low Price-to-Earnings (P/E) stocks
  • with low leverage (debt)
  • a minimum five year track record of stable if not growing earnings and some dividends
  • belonging to sectors that are currently out of favour (ignored by talking heads on CNBC and Bloomberg)
  • at prices that have not run up significantly in the recent past

But why not the high growth companies with high P/E ratios and high double-digit growth prospects? Or consumption-led defensive sectors like FMCG over the last couple of years like the analysts said? There are enough examples of stocks with characteristics opposite to the bullets above that have delivered spectacular returns. Why indeed.

Because it is shaped by how I view the stock markets and that is:

  • Markets are driven by expectations and therefore run ahead of actual business performance but are impossible to predict in the short-term
  • Tend to be almost always overly optimistic or pessimistic about the prospects of sectors and companies
  • When a sector is in favour, prices of even poorly run companies rise. When not, prices of even good companies fall
  • Decent returns on a great company are unlikely if it has seen a sharp run up before you get in, while a good company at depressed levels can offer excellent returns provided a willingness to wait at least a couple of years

The keyword in the buying philosophy is “your rationale”. Meaning one that makes sense to YOU, with your unique combination of ability to take risk and identify stocks, your view of the future and your return expectations.

Note that this doesn’t mean I think there aren’t other approaches to making good returns. Just that they don’t seem as natural to me as the one here, like trying to button a shirt with my non-dominant hand. I know from experience that my temperament makes me uneasy at the prospect of owning ‘defensive’ stocks trading at 40 times earnings or companies that currently pay most of their operating profit to lenders as interest but are growing at triple digit rates or to buy the sector leader because it has outperformed its peers but trades at a significant P/E premium.

On the other hand companies whose price charts show sharp declines a couple of years ago followed by nearly horizontal price movement, with stable financial performance, continuing dividends and made conspicuous by their absence of mentions by the talking heads on CNBC get me very interested.

Lastly, a philosophy is one that you can commit to and stick with for a few years, refining it along the way but not jettisoning for a completely different method of making your investing decisions. For example, there’s no point in adopting Warren Buffet’s “buy great companies at fair prices and hold forever” philosophy if you don’t feel in control unless you’re not churning your portfolio every 12 months.

Where can I get one?

How does a new investor or one who’s largely followed a scattergun approach with dubious results develop a buying philosophy? And how does she know it’s the correct philosophy?

There are hundreds of books on stock-picking approaches that are touted to make you infinitely rich. A large number of them serve to only enrich the author, mostly because they are based on quirks in historical data that have been mined and packaged as “sure-fire” money makers, like the Dow Underdogs. But those are techniques or shortcuts and not overarching buying philosophies. The way to tell the difference between a ‘technique’ and a ‘philosophy’ is what you feel when the returns go negative soon after you started buying? Do you feel the urge to modify and do something different or can you stick with it knowing that the process is inherently sound and needs more time?

A good way to get started to developing your own approach to markets is to start with the basic philosophies that drive most decisions in the market. The post by Motley Fool lists some of the most prevalent in ‘Investing strategies – Your first stock

It’s not sufficient to just read through and pick one at random but to see which approach you identify with the most. Does the idea that stock prices move to reflect company fundamentals make sense or is it more likely that prices move largely based on sentiment and momentum and have little to do with financial performance? Since stock prices reflect expectations on future growth, do you gravitate towards companies with supernormal growth prospects or does the assurance of a high dividend yield but sedate growth help you sleep at night?

An investor can then start to build on their most suited philosophy, refining it as he learns and experiences market movements over the years.

Here on The Calm Investor, I’ll be firmly on the left side of that graphic above, mostly looking for value stocks in the Indian markets, at rare times picking a growth buy or two. Overall, the approach will lack the frenetic activity that characterizes technical and momentum investors. In the next post we’ll look at where the Indian markets stand after the chaos of the election results and what if any sectors offer opportunities over the next few months.

References (External Links)

Taboo talk: Technical Analysis (Morningstar) – How fundamental managers also use technical analysis

10 myths of momentum investing (Morningstar) – For momentum and technical analysis

One thought on “Developing a stock investment philosophy

What do you think?