Why Do People Buy Stocks? - Equitymaster.com

We buy, or invest in, stocks to create a pool of funds for, let's say..

• Traveling around the world with our spouse on our 25^th anniversary;
• Paying for our children's education and marriage expenses;
• Live well even after retirement;
• Live up to our other financial commitments.

Some people shy away from buying stocks because they believe investing in the stock markets is risky. And it is. But over the long term, the stock markets have gotten through the toughest of troubles, and no matter what happens, there is reason to believe that stocks will always rise again.

Which means if you have an investible surplus that you will not need for the next 5 to 10 years, then you have an opportunity to build your wealth in stocks.

The most successful style of Buying stocks...

The secret has been out for 50 years, ever since Ben Graham and Dave Dodd wrote Security Analysis, yet I have seen no trend toward value investing in the 35 years that I've practiced it. - Warren Buffett, 1984.

It has been 33 years since Warren Buffett made this statement. And it still rings true. He is now even more famous than before. The number of books on him have multiplied and business channels now have divisions that track his activities on a daily basis.

And while Buffett is the most famous, there are others who are successful value investors in their own right and receive muchmedia attention.

But if you looked around to see how professional money managers go about their business, you won't find too much value investing there.

Why not?

Because there are certain behavioral stumbling blocks that explain why there are very few value investors despite all the media coverage the discipline receives.

Because knowledge doesn't translate to action

Unfortunately, knowledge doesn't always translate to behaviour. It is common knowledge that we should use helmets, exercise, buckle up our seat belts, avoid smoking, buymedical insurance, etc. but we don't strictly follow them.

It takes deliberate action on our part for us to form habits, mere knowledge is not enough. If we are not always able to do the right thing in such important matters, it is not surprising that we don't choose the best path when it comes to investing.

One size doesn't fit all

The general tendency of investors is to find a magic formula - a method that applies to all situations. In fact, the one time everyone asks for stock tips is when there is market euphoria. The right answer during such times is - 'don't buy anything'. But that's a difficult answer to digest. On the other hand, when markets are unduly pessimistic, there are value picks everywhere. Value investing often doesn't offer picks when we are most interested. That makes it a hard discipline to follow.

Patience in the internet age?

A few months ago Bharti Airtel had come out with a campaign called the 'impatient ones'. That seems to be an apt description of most investors. The way we have evolved, we are hard wired for short term rewards. Short term thinking comes naturally to us. It takes training and mental conditioning for us to shake off the habit and reorient our investment horizons.

Value investing requires long term time horizons because there is no guarantee that out-of-favour stocks that value investors prefer investing in, will suddenly come back in favour.

Standing out from the crowd is difficult

As explained above, the best value picks come exactly at the time when there is pessimism all around.

As Buffett himself said, "The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.'

Unfortunately, that means one has to do the exact opposite of what others are doing. Buy when others are desperately selling, and vice versa. Since we are hard wired to stick with the crowd, it is inherently difficult for us to do the exact opposite.

Theme-based Investing

First we need to pick the theme that welike and that we feel can deliver good growth over the medium to long term and then, of course, do the requisite stock picking. We believe that two themes have a strong chance of playing out over the next few years - 'domestic consumption' and 'outsourcing'.

However, it must be noted that identifying a theme is easier said than done. Markets latch on to 'the next big thing' very quickly and very soon, the theme plays out. Investors must have the foresight to be able to identify themes.

But then, the next step is equally important, if not, more so - that of stock picking. Investors in technology stocks were on the right track when they picked the theme (the fact that it turned out to be a huge bubble is another matter). But then, investors who went for stocks like Pentamedia Graphics and DSQ Software would have ended up losing most of their investments. This is because these kind of companies did not have stable and robust business models, unlike Infosys or Wipro, which is why they are still languishing at low stock prices.

The main point here is that, while theme-based buying stocks is undoubtedly a good way to make money, we must be able to spot a theme that is likely to give good returns over a long period of time, and then choose the right stocks that will benefit from this. If not, then relying on a good fund manager or research house would be the appropriate thing to do.

Wait! Don't buy these stocks!

As for equities, one often tends to get swayed by 'market momentums' and 'swings' and buy into anything that is rising, not really understanding the reason why a particular stock(s) is on its way up - fundamental reasons or plain speculation?

While people spend a lot of time discussing the companies (stocks) that could be bought, they do not give heed to the red signals that indicate why something should 'not' be bought! In this article, we present a small 'do not buy' list that shall help you in staying clear of potential duds.

Do Not Buy...

...Companies with large borrowings

Avoid such companies! Calculating the current debt to equity ratio of a company (as also studying its historical numbers) can show you when to stay away. Strong businesses generally do not need large amounts of external borrowings (debt) to achieve an acceptable return for shareholders. So, if a company needs debt to achieve reasonable returns, it is less likely to be a great business.

Debt is generally used by companies to perk up their 'return on equity' ratios, as a high amount of debt lowers the net asset position (Total assets minus current liabilities & debt). This needs to be a critical judgement point for investors before investing in a company, which has an 'artificially' high return on equity position.

Also, while in good times large amounts of debt mean that cash could be put toward growing the business or rewarding shareholders instead of servicing the debt, in a crisis situation, debt greatly limits a company's options and can sometimes lead to bankruptcy.

Investors also need to study the interest coverage ratio (profit before interest and taxes divided by interest payments) to understand whether a company is generating enough pre-interest profit so as to repay the cost of debt.

...Companies with consistent requirement of growth capital

This factor usually comes along with the one mentioned above. Skip companies that do not generate adequate return on capital (debt plus equity). Companies that constantly need additional capital to keep business growing do not actually generate enough 'bang for the buck' for each incremental rupee employed in the business.

Against this, companies that do generate high 'return on capital employed' can use these extra returns to reward shareholders by way of either buying back shares, or paying dividends, or for that matter reinvesting in future growth.

...Companies with no 'competitive' edge

Ever imagined 'why Infosys is what Infosys is', or for that matter 'why HLL is what HLL is'?

What is that 'edge' that separates these companies from the rest in their respective industries?

What 'competitive advantages' do these companies hold, and hold them tight, which have helped them grow in both good times and bad?

Competitive advantages can come from ethical leadership and execution strengths such as those held by Infosys, or from distribution systems and scale like those enjoyed by HLL, which also enjoys a recognisable brand. All of these qualities allow companies to maintain high returns on capital and equity, and stay profitable over the long term (while there might be occasional blips in performance due to changing dynamics of the company/industry in which they operate).

To make strong long-term investments, stay away from companies that do not have any 'competitive advantage' to sustain growth year after year. A company's gross and operating margin profiles can be a starting point here as these indicate if the company holds any pricing power, cost leadership or a differentiation advantage over its peers.

...Companies with questionable management

Too much has been said about management quality and its importance in judging a good investment from a bad one. We strongly recommend avoiding companies where investors can sense that management lack honesty and integrity. Read the management's vision statement for the company and its thoughts on the company's performance and prospects in the annual report to find more on this issue of management strength.

When Buying Stocks, Remember...

...To cautiously evaluate each of these factors. As Warren Buffett has said time and again - "Buy businesses (represented by their stocks) with consistent earnings, good returns on equity, able and honest management and at sensible prices."

These will make sure that when the great global tide of liquidity finally ebbs into reverse, you will be one of the forward-looking swimmers dressed for the occasion.

Reference:

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