The # 1 Mindset Shift that Makes You a Great Investor

How has your portfolio done over the last 12-15 months?

If you are a smallcap investor and you are up 70-80% in the last 12-15 months, then you have done an average job.

Yes, that's correct. A return of 70-80% in recent months does not qualify you as a great investor.

Why?

That's because even the BSE Small Cap index has returned more than 80% in the last 12-15 months. You have actually underperformed the BSE Small Cap index if you have made a return of 80% or lower.

But if you've got these returns from a portfolio of largecaps, then you are a genius. This is because the large cap index i.e. the Sensex, has returned only 33% over the last 15 months.

You see, outperforming the market is not easy. Especially over a 5-7-year period.

The 5-year CAGR of the Sensex is in the region of 14-15%. So, if you haven't earned at least a CAGR of 20% over this time period from largecaps, then you won't be considered a great investor.

The BSE Small Cap index has given an impressive CAGR of 28% over the last 5 years. Thus, if your picks from the small cap space haven't compounded at a rate of at least 33-35%, then once again, you are not a great investor.

You will have to be content with being an average investor or try becoming a great investor by adopting a different strategy.

Do you know why Warren Buffett and Peter Lynch are considered great investors? Why are they legends of the investment world?

Well, it's simply because they have earned returns that are significantly higher than the benchmark index over a prolonged period.

Take Warren Buffett for instance. He has compounded money at a CAGR of almost 20% while the US benchmark index has earned only 10% CAGR.

If this is not astonishing enough, Buffett has managed to maintain his edge over a period as long as 60 years. Let that sink in. For almost six decades, the Oracle of Omaha has managed to keep the benchmark index at bay. Truly a great investor by any stretch of imagination.

Although Peter Lynch's period of outperformance lasted only 13 years because he decided to retire, the magnitude of his outperformance is also quite impressive. He has also done twice as better as the US benchmark index.

Back home in India as well, there are many investors who've managed to outperform the index by at least 5% per annum over a very long period.

But what makes investors like Warren Buffett and Peter Lynch great? What is their secret sauce?

I recently came across an article by Howard Marks that threw some light on this puzzle.

Howard Marks has argued that truly successful investors are neither overly aggressive nor defensive. They excel at both market timing and picking good investments.

Let me repeat that. Great investors strike a fine balance between aggression and defence. They correctly adjust the market exposure at the right time and their stock picks are such that their win-loss ratio is much better than most of the investors.

One of the reasons investing is hard is because it requires a quick mindset shift. One minute you are defensive and the next minute you may have to turn aggressive. And it is this shift that takes a toll on most investors. You must be prepared to change your mindset at a moment's notice.

This is why I love Warren Buffett so much. He has this remarkable ability to go from one mindset to another. He will stay defensive not for days or months but for years together, and then suddenly, when the opportunity presents itself, he will rapidly turn aggressive. This quality is largely responsible for making him such a great investor.

Therefore, if you want to be a great investor, you will have to be neither overly aggressive nor defensive. You will have to look at the broader market, the sentiment, the valuations and then take a call whether you should be aggressive or defensive.

And of course, you will have to be ready for a mindset shift at a moment's notice.

So, that's one of the qualities that you need to be a great investor.

Now, Warren Buffett is all about individual stocks. He uses his aggression-defence mindset extremely will for picking great quality stocks at attractive valuations.

However, you can apply this skill to the broader market as well. You can try to be a great investor by adjusting your market exposure based on the broader market valuations.

Let me explain further.

You see, in the 21st century so far, there have been 11 years where the Sensex PE ratio or the price to earnings ratio was below 20x at the start of the year.

There were 11 occasions in the last 23 years when Sensex was trading at a PE multiple of 20x or lower. And the average return the Sensex has given over the next one year is 29.2%.

This means that taking a larger exposure to stocks when the Sensex PE was 20x or lower would have proven to be a good decision as it would have given you an average return of 29%.

Now, let's take a look at another chart.

As you can see, there have been 8 occasions since the year 2000 where the Sensex had a PE multiple of more than 22x at the start of the year.

The average annual return, when the Sensex has traded a PE of more than 22x at the start of the year, is a poor 3.9%. The Sensex has earned only 4% on average when the starting PE multiple has been more than 22x.

And finally, there are two calendar years (2001 and 2017) where the Sensex PE multiple has been between 20x and 22x and the average return has been 5%. I've have not considered 2020 and 2021 for the study due to pandemic related disruptions.

Now, here's the takeaway from this study.

The quality of a great investor is to know when to be aggressive and when to be defensive.

So, if an investor has Rs 100 and he has a portfolio of stocks and bonds then I think it will be a great idea to turn aggressive and invest Rs 75 in stocks when the Sensex PE is below 20x and the remaining Rs 25 in bonds.

Likewise, when the Sensex PE goes above 22x, he can do the reverse i.e. he can turn defensive and have only Rs 25 in stocks and the remaining Rs 75 in bonds.

And when the Sensex is between 20x and 22x, he can be 50:50 in both.

Right now, the Sensex PE multiple is 23x. This means that it is perhaps time to turn defensive and take a meaningful sum out of stocks and into bonds.

Now, what are the kinds of stocks that one should invest in?

Well, you should have a portfolio of 25-30 stocks where not only is the business quality is decent, but the valuations are also not stretched. In other words, don't invest in stocks that are loss making or have a lot of debt or both.

Also, the stock should either be trading at single digit to low double digit PE ratio if it is a microcap or a small cap or a maximum 25-30x PE ratio if it is a midcap or a large cap.

Consider these basic filters and I believe you will have a portfolio that is not only resilient but also has a good upside potential.

Ok, time for a quick recap.

You are not a great investor if you haven't outperformed the appropriate benchmark index by at least 5% per annum.

To be a great investor, Howard Mark believes that you should be good at market timing and should also pick winning stocks. Correct market timing involves knowing when to be aggressive and when to be defensive.

Deciding your asset allocation based on the Sensex PE multiple has proven to be a reliable method of market timing. You can be aggressive when the Sensex PE is below 20x and defensive when it goes above 22-23x.

As far as stock picking is concerned, stay away from bad quality stocks as well as highly expensive stocks.

So, there you are, a roadmap to become a successful investor.

Now, is success guaranteed with the approach that I have just highlighted?

Well, there are no guarantees in investing. However, by following this approach, you will be forced to buy more after the market has fallen and sell more after the market has risen.

And this is the right thing to do from a long term perspective. Most investors can't even do this. They usually end up buying after the market has risen and selling after it has fallen.

So, this is definitely a framework to do the right thing from a long-term perspective. However, getting superior results from this framework depends on your own effort and the intelligence you bring to the table.

Let me know what you think.

Happy Investing.

Warm regards,


Rahul Shah
Editor and Research Analyst, Profit Hunter
Equitymaster Agora Research Private Limited (Research Analyst)