Long Term Investing: The Rules Have Changed

Isn't it funny that when the US gets downgraded by one of their rating agencies and the ripples are felt in the Indian stock markets?

Some analysts are talking about how the Indian stock markets sold off 11% in the month following the US downgrade by rating agencies in 2011.

Well, if past data or statistics was a strong indicator of future stock market performance, trust me, librarians and statisticians would have been the richest people in the world.

While I believe the US rating downgrade is just a trigger, the markets are falling under its own weight.

I came across something which summarises the current scenario aptly...

French geologists recently discovered that a Himalayan mountain suffered a massive landslide 800 years ago. Massive may be an understatement. The landslide moved enough earth to bury Manhattan as high as the empire state building.

Annapurna IV used to be one of the top-five tallest mountains in the world. After the landslide shaved a third of a mile off its top, it's merely a big mountain.

The amazing thing is that the landslide wasn't caused by a glacier gnawing at the mountain, which is usually what keeps a mountain's height in check. Annapurna IV just got too big.

As anyone who's built a sandcastle knows, there comes a point when the whole thing comes crashing down on its own accord, crushed by the weight.

If you relate this analogy to the stock market, the benchmark indices went up too fast. The problem was too much money chasing too few stocks which led to over valuations.

To put it in a crude way, when stocks like Suzlon and Brightcom hit upper circuits every day and SME IPOs listed at obnoxious valuations, it was definitely time to be cautious.

As I have mentioned in my previous articles, I still don't think the stock market is in a bubble. It's just the velocity of the move that worried me. That is what is getting corrected, the froth.

Now as a long-term investor, shouldn't a falling market make you happier?

The answer should be yes unless you're already fully invested. As a smart long-term investor, you should not only to make the most of a bull market but also use a falling market to your benefit.

The problem with a lot of investors is that they tell people they are investors and talk about stocks and fundamentals...but deep down inside they are medium term traders. People who want strong returns in a matter of months are nothing but medium-term traders.

I have seen a lot of people ask me about multibagger value bets but a 5-10% fall rattles them. These are the medium-term traders in my view.

Before I tell you how to navigate the fall in the stock markets, let me talk about two principles which will help investors prepare for a fall.

Cash Component in Your Portfolio

The opportunity cost of staying fully invested when the markets correct is the same as keeping cash when the markets are rising.

Generally, the amount of cash which you should have liquid depends on the valuations of the stocks which you hold.

To illustrate, the wires and cables sector is the hot topic these days. Let's say, you were smart enough to invest in stocks like Polycab or KEI industries at lower levels. When I say lower levels, I mean at lower valuation multiple.

Polycab India in 2020 was available at 14-15 PE while KEI industries was available at 10-12 PE. The next two years led to a massive re-rating in valuations along with support from earnings growth.

After a 5x price return in both these stocks, Polycab and KEI Industries are now trading at a PE multiple of 50. I'm sure earnings growth will be strong but most of the earnings upside is already priced in these stocks.

This is the sector call a long-term investor should take. Rasing cash should be done if a sector's or a company's PE multiple has run ahead of its time.

Now selling is always going to be difficult. Raising cash is not as much a call you take on the market but on individual stocks you own. When the markets were at all time highs last week, specialty chemical stocks were at 52-week lows.

So, assuming you have a decent cash component, the next focus should be on long term investing.

Long Term Investing

While I agree long term investing is the only way to create sustainable and compounding wealth, it doesn't always mean buying and forgetting.

Long term investing means buying good quality stocks at reasonable valuations.

Let's assume the stock you invest in based on certain growth assumptions doesn't play out. The earnings growth doesn't pan out the way you expected. But if you bought the stock at a reasonable valuation, then the valuation comfort will limit the downside.

The key to making money in long term investing is respecting valuations.

Let me give you an example of how selling your stocks at the right time is the most important part of long-term investing.

The two sectors which in my view are at an inflection point as India surpasses its basic per capita GDP is the diagnostic space and the electronic contract manufacturing space. As a long-term investor, the opportunity looks very attractive.

Dr Lal Path Labs and Dixon Technologies are two of the best stocks in their respective sectors.

Dr Lal Path is one of the leading diagnostic chains in the country while Dixon is the largest contract manufacturer for phones, TVs, washing machine, LED Lights in India.

As a long-term investor, let's say you got your call right and bought both these stocks in 2019.

Dr Lal Path was available at 35-40 PE and Dixon too was available at roughly the same valuation multiple. This valuation is not cheap but fairly reasonable for high quality companies growing their earnings annually by 40-50%.

Fast forward to 2022...

PE of Dixon rose to 150 times. The earnings, which were to grow at 50%, started to moderate because of the high base.

The same is the case with Dr Lal Path where the PE reached 80 in 2022. Earnings moderated as the Covid boost waned.

Even as a long-term investor, how would you justify these sky-high multiples? Wouldn't it have been prudent to sell these good quality stocks at those high valuations?

I stated that a fall in the stock market is a good opportunity for long term investors to add good quality stocks. However as long-term investors, we are often fixated with the idea of being fully invested.

Long term investing isn't all about buy and hold.

Warm regards,


Aditya Vora
Research Analyst, Hidden Treasure
Equitymaster Agora Research Private Limited (Research Analyst)