Is something more important than stock selection?October 22, 2021 2023-09-25 6:56
Is something more important than stock selection?
Is something more important than stock selection?
Letter # 61
Social media had a field day this week when Apple, the technology giant instrumental to transforming music devices and mobile phones, launched a cleaning cloth for USD19. Memes took over when Apple added a compatibility list to this product’s information – that is, the devices that ‘the cloth’ can potentially clean. As if that weren’t enough in and of itself, a lot of us gasped when we realized that ‘the cloth’ is sold out until late November 2021! (1)
Sounds bizarre, doesn’t it? A technology company launching a commodity cleaning product, at ten times the price of competition … and people lining up to buy it. It later dawned on me that it happens more often than we realize – and not just for consumer products, but everywhere, including with investments.
Daniel Kahneman, THE authority on behavioural economics, neatly sums up this bizarre behaviour with what he calls the ‘focusing illusion’ (2). He says, “nothing in life is as important as you think it is, while you are thinking about it.” When people believe that they “must have” a good, they greatly exaggerate the difference that the good will make to the quality of their life, he explains.
Kahneman asked a few people – given that the weather is beautiful in California – would they be happier if they lived there. Most people said yes. But when Kahneman asked Michiganders and others a different question (not focused on weather), they appeared just as contented as the Californians. Relationships, work, and recreation are broadly similar no matter where one lives. Also, once you settle in a place, you do not think about the climate that much. When specifically prompted however, ‘the weather’ assumes a bigger role in decision-making, simply because one is paying attention to it.
We can apply this framework to investments as well. We had argued in ‘Discipline Eats Timing for Lunch’ (3) that while people pay immense attention to timing the market, the difference in returns between disciplined investing and timing the markets is not large. But when markets are galloping, all we focus is on how little we are invested in markets. And when it dramatically corrects, all we focus is on how we could have sold more. Because one constantly observes the market rises and falls, ‘timing’ assumes far more importance than the fact that disciplined investing brings similar returns.
We also argued in ‘Being Vaguely Right Rather than Precisely Wrong’ (4) that the disciplined investing works with individual stocks as well, provided one is in the right theme. Our focus is too often on the timing the current theme ‘precisely’, rather than getting the next big trend ‘vaguely’ right.
In the third and final part, we take his line of thought forward. (a) Yes, discipline is far more important than timing (b) and yes, it must be in the right themes, but (c) today we argue that sector selection is of paramount importance.
Let’s assume that you are the Chief Investment Officer of a large Indian fund with total autonomy to run it as you deem fit. Between December 2007 and February 2009, your call on asset allocation (say debt vs. equity) would contribute close to 90% of the fund’s total returns. The decision, then, to avoid Realty and invest in FMCG would contribute close to another 9%. Lastly, within FMCG, the decision on whether to invest in ITC, or Dabur, or Nestle, in the overall scheme of things would be responsible for just 1% of your overall portfolio returns.
The table below lists the different market cycles in India with best and worst returning sectors and relative performance of similar-sized businesses at that time.
Historically, sector selection has had a far larger impact on investment returns than stock selection within that sector. It is true that occasionally one embarks upon a company that cuts through these ‘sectoral cycles’ and outperforms across. But we focus an inordinate amount of time looking for those. A great company in a sector that underperforms often generates much inferior returns to an average company belonging to a sector that outperforms.
But since we interact with, and focus on companies (stock prices, analyst calls, management calls) and not directly on sectors, we form the illusion that the right company is far more important than the right sector. In what we consider a logical conclusion to the arguments we made over the previous letters, we humbly submit that over the longer term, a focus on discipline, themes and sectors is likely to yield a far superior return than the illusion of timing the markets and getting the company selection right.
(1) Apple’s New $19 Polishing Cloth is Sold Out Until Late November – MacRumors
(3) Discipline eats timing for lunch… every single time! – Buoyant Capital
(4) Being vaguely right rather than precisely wrong – Buoyant Capital
Information in this letter is not intended to be, nor should it be construed as investment, tax or legal advice, or an offer to sell, or a solicitation of any offer to make investments with Buoyant Capital. Prospective investors should rely solely on Disclosure Document filed with SEBI. Any description involving investment examples, statistical analysis or investment strategies are provided for illustration purposes only – and will not apply in all situations and may be changed at the discretion of principal officer. Certain information has been provided and/or based on third-party sources and although believed to be reliable, has not been independently verified; the investment managers make no express warranty as to its completeness or accuracy, nor can it accept responsibility for errors appearing herein.