8 key lessons a fund manager has learned about investing in stocks over the past 15 years

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As an institutional investor and fund manager, I have researched and invested in a number of companies across all industries, witnessed multiple cycles and made my fair share of mistakes, for realize that they made me a better investor. Here is what I have learned about investing in stocks over the past 15 years. Investors are putting too much emphasis on the price-to-earnings (PE) ratio. But I learned that “the result is vanity, the result is reason, and the money in the bank is reality.” To build a strong business, cash flow is far more important than profits. There are countless ways to manage profits, but it is very difficult to manipulate cash flow. Companies that have created long-term value are making it clear that cash flow and profits matter most.

Firms with good earnings but low cash flow get a lower multiple of the markets and vice versa. I avoided big mistakes by looking not only at the income statement, but also the cash flow statement. Beware of companies that are obsessed with generating quarterly profits and meeting street expectations without worrying about cash flow.

  • Growth is good, but not at any cost

No business can create long-term value if there is no growth. However, not all growth is good growth. If a company’s return on equity (ROE) remains below the cost of equity for long periods of time, high growth is toxic and destroys the value of the business because the business must constantly raise capital to meet its growth needs.

Growth only creates value if the ROE is greater than the cost of equity. Also, in high ROE companies (30-50%) where growth is the most important lever for valuation, further improvement in ROE does not add much value. Many growth stocks can remain expensive for long periods of time, and valuations shouldn’t be the only reason to sell the winners.

  • Meditate to maintain balance

Spiritual grounding is essential for a successful investment. Meditation helps to align the mind, body and soul so that one can stay grounded and focused. Investors are either too obsessed with the future or worry about the past while forgetting the present. Meditation brings mental clarity, improves emotional quotient and reduces stress. The market intoxicates us with success but also exhausts us with failures. Meditating for 15 to 30 minutes a day can help maintain a balance in both times.

  • Invest in quality companies

Warren Buffett says “A really great company has to have a sustainable ‘moat’ that protects great returns on your investment.” Invest in businesses that can generate superior returns on capital employed over sustainable periods and growth that allows it to reinvest the cash flow into the business. This leads to the composition of the company’s value and the share price. Focus on the profitability of the business rather than the profits themselves.

A company may report declining profits, but its long-term earning power may not be affected. Likewise, a company may report an increase in its profits, but its competitive advantage for obtaining higher returns on capital in the future may weaken. Consider the theory of inversion. Knowing what not to do is more important than knowing what to do.

  • Don’t just pick stocks, build a portfolio

Build a portfolio that can withstand steep drops and avoid a permanent loss of capital. It is important to know if you were successful in an upward cycle, but what is more important is how you fared during the corrections. There are two schools of thought regarding portfolio construction. My favorite approach is a diversified portfolio, which I call the “Gorilla to King Kong” strategy. You invest in a diversified basket of 50 to 60 industry-leading franchises (Gorillas). Some of them would turn into big mega caps (King Kong).

Even though some call options do not work, the portfolio does not experience severe underperformance for long periods of time. The other approach is to have a concentrated portfolio in which you invest in a dozen stocks and hold them for long periods of time. The strategy you adopt is a personal choice. Choose the approach that suits your temperament, then adhere to it religiously.

  • Read avidly and meet new people

“I didn’t know a wise man who didn’t read all the time” —Charlie Munger. There is no substitute for reading. Read books from various disciplines because everything has something new to teach us.

For example, reading books on psychology can give you a perspective on human behavior. In the context of the stock markets, reading the annual reports of the companies in which we invest or on which we research gives good insights. Another important learning has been to meet and network with smart people in all disciplines. Quite often I get great ideas when talking to people from across the business and investment ecosystems.

  • Cut the noise and be patient

To generate long-term outperformance, filter out noise and stay focused. Some investors get carried away by short-term stock price fluctuations, which offers a long-term advantage to serious investors. If a quality business experiences a temporary setback, now is the best time to invest, especially if the setback has no real impact on the intrinsic value of the business.

Much of our success does not depend on choosing the best stocks, but on our behavior in the worst and the best times. To experience real wealth creation, you have to be patient. According to Chris Mayer (author of 100 Baggers), the average time it took to get 100 bagger returns was 26 years, with the fastest company taking 16 years.

  • Work on processes and inputs

We have to accept the harsh reality that the results are not in our control. What is under our control is our process, our inputs, our stock selection filters and our temperament, which go a long way in achieving the desired result. Build a solid investment framework and philosophy that suits your investing style and temperament and keep improvising on it as you go along.

(The author is Senior Executive Vice President and Fund Manager at Kotak Mutual Fund. Opinions are personal.)

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