Investing is not for the weak hearted

Image courtesy of Nutdanai / FreeDigitalPhotos.net

This year has been an absolute nightmare for investors in general.  While the Sensex stocks which is just 30 stocks index has held its ground better, overall stock market has lost anywhere around 15% to 25% depending on the market cap.  For example, if you look at CNX Midcap index, it has lost about 18% as of date since the beginning of the year.  Bond investors were not safe either. Due to rupees free fall, RBI has taken some drastic measure on liquidity which made most the yields shoot up driving the bond prices down.  Even money market liquid funds reported negative returns in the last week.  Anyway, who said investing is easy?

While the stock index has been down 18% to 25%, some individual stocks have been down 50% or more in some cases.  A correction of this kind would make may investors lose sleep and that is the reason there is very minimal retain participation recently.  Why do majority of us cannot handle this while some of the investors like Warren Buffet or  Mohnish Pabrai can handle even 50% contraction with ease?  To understand this we need to get into biology a bit. 
All of us have a small almond shaped nuclei deep in our brain called amygdala.  This little piece was very crucial for our survival when we lived in forests.  Amygdala processes fear and pain and triggers reflex reactions without involving our analytical brain which is slow.  When we confront a lion, it would fire in all cylinders and ask us to just run without thinking.  Imagine if we have to use our rational brain to analyze the pros and cons of confronting a lion.  We would be his lunch before we come to a decision.  While this natures gift to us work fine for us to confront physical dangers, unfortunately it is not wired or equipped to handle dangers/risks that are not physical like the stock crash or the fear or losing money.  Our amygdala would fire the same way in this case and that makes the investor to just sell the stock and run away without thinking.  It also stops the retail investor from using the opportunity of low prices to stock them up to sell later when everybody is euphoric and bidding the stock price to crazy levels.  If we take investors as a whole, majority of them are weak hearted and short term thinking.  They are weak hearted because they do not know what they are doing.  Most of them trade because someone in the business channel said this is multi bagger or they have the proverbial insider tip. When suddenly hell breaks loose, they just drop and run.

Is there an antidote to make our heart strong?  Yes, and the anti dote is ‘Know what you are doing’.  As Buffett said ‘Be greedy when others are fearful and fearful when others are greedy’.  You can be fearful or greedy independent of what the market does only when you know what you are doing and what your expectations are.   This does not mean contrarian investing where you buy any stock that goes down in price.  It is fundamental based investing which is also called value investing.   If you have assessed the quality of the business and also have assessed the average earning power of that business over long term and you have paid a sensible price for it, all you need to do is buy more of it if the price crashes.  I had already covered this part of the aspect in my previous post of buying stocks like grocery.

While the amygdala fires for value investors as well, they have the tool or the anti dote called as fundamental evaluation and valuation tools which they use to calm their fears. Being aware of our weakness (fight or flight mode of our brain) solves half the problem.  I will just give an example of one of the stock that I continue to hold and in fact add at these levels.  I have started investing in BHEL in Nov 2011. The highest price I had paid is around 275 and my average price is now 231.  I paid around 10 times earnings of BHEL when I bought it which is not cheap but a fair value.  My thought was even if BHEL does not grow its earnings at all for the next 10 years, I get 10% return on my investment while the GOI bond will (risk free) would give me around 8% for 10 year bond.  I knew that capital goods are cyclical and there could be downtrend of earnings in between but I was looking at average and I am not counting growth here which provides me the margin of safety.  Currently, the stock is trading at 158 rupees.  My loss based on the peak price paid is around 44%.  Should I exit the stock and run?  If I apply my rational mind to evaluate the fundamentals, I do not think so.

 

While the price of BHEL has corrected so much, the profit did not go down by that percentage.  Profit was down just 6% last year.  So, market expects this to keep going down much more. Let us now see the macro factors. India as a country continues to have power shortages and if India has to grow even at 5%, it needs electricity.  Those entire fridges, TVs, ACs and other cool gadgets that we have cannot run on water and we need electricity to run those.  Todays India consumes about 96kWH in rural and 288kWH in urban area against world average of 2600 kWH.  To provide electricity we need power plants which are supplied by companies like BHEL.  So, in a way there is always a market as electricity is a basic necessity with increasing usage.  More than 57% of our electricity is based on coal (thermal energy) and BHEL is the leader in this space.  BHEL has now increased its capacity to 20000MW. So, the capex is already over and that should take care of any orders for future as well as increasing the free cash flow for the coming years due to low capex.  While power is still the major contributor to its top line and bottom line BHEL is diversifying into other areas to diversify its earning stream.  BHEL is currently debt free and it can ride the downturn by taking some debt on books if there is a need.  So, there is very little chance of going bankrupt.  Current pricing by the market suggests that market expects the earnings would probably go down by half (forever) and that just shows the short term thinking and fear of the weak hearted.  So, right now I am applying the golden words of Buffett and that is to be ‘Greedy when others are fearful’.