Lesson #6: How to Think About Stock Market

Value Investing Masterclass - Safal NiveshakAfter having discussed the psychology of investing, and how the understanding of biases play a big role in the development of an investor’s character, let’s now turn to a more fundamental question about stock market investing.

How to think about the stock market and the entire art of picking stocks?

Before you can buy stocks, its important to have some insights about the marketplace where you’re planning to operate i.e. the stock market.

Just because one has a demat account doesn’t mean that he/she understands the stock market.

“Well, it’s a place where you can buy and sell your share of a business i.e. the stock. That’s stock market, right?” Perhaps this is the first thought that crossed your mind right now.

You’re right but that’s an incomplete picture. As far as value investing is concerned, you need to model the stock market in your head using some fundamentals.

The first thing you need to keep in mind is that investing requires a businessman’s mindset.

Warren Buffett often says that he is a better investor because he is a business owner and a better business owner because he is an investor. It is valuable to think from both perspectives.

But most investors don’t think the same way business owners do. It isn’t unusual for a business owner to buy a new machine, or upgrade the fixtures in his retail store with an eye on the long term. A long term mind set is the first thing that an investor needs to cultivate.

Anyways, before we move towards understanding how you, as an investor, must think about the stock market, it’s important to understand how most people really think about the stock market.

Is Stock Market Efficient?

The prevalent theory, especially taught in management schools, about stock market is The Efficient Market Theory (EMT). Most MBA schools still teach EMT as one of the most important ideas in finance in the Security Analysis class.

EMT says …

Security prices accurately reflect available information, and respond rapidly to new information as soon as it becomes available.

In other words you can never make money in the stock market because stock prices always reflect what everyone else knows and stocks don’t sell cheap or expensive as compared to their fundamental realities. So the current price of a stock is supposed to be the most accurate estimate of its value.

If this theory was true Warren Buffett wouldn’t have said, “I’d be a bum on the street with a tin cup if the market was always efficient.”

Robert Shiller, author of Irrational Exuberance says …

Despite still being widely taught in business schools, it is increasingly clear that the efficient market hypothesis is “one of the most remarkable errors in the history of economic thought”

Peter Lynch agrees too …

The huge bubble build-ups and burstings we’ve seen in the stock market over the years are evidence that the efficient market theory is nothing more than “a bunch of junk, crazy stuff”

So to summarise, here are the biggest reason the efficient market hypothesis is flawed is because it believes…

  • Everyone in the stock market has access to the same information.
  • Investors always behave rationally.
  • Price of a stock always reflects the best estimate of its true value (so, in a bull market, if Suzlon hit Rs 500 per share, that was the true value of the company’s business. Utter junk!) In short, the slogan of efficient market hypothesis is “Trust market prices!” which goes against rationality.
  • Since you always get what you pay for and must pay for what you get, you cannot reasonably expect to do better than anyone else in the market when you buy and sell stocks (I have seen several small investors prove it wrong by earning better than inflation over the past five years when markets have done badly).

Seth Klarman in his amazing book Margin of Safety writes…

Yes, the market does tend to incorporate new information into prices – securities prices are neither random nor do they totally ignore available information – yet the market is far from efficient.

There is simply no question that investors applying disciplined analysis can identify inefficiently priced securities, buy and sell accordingly, and achieve superior returns.Specifically, by finding securities whose prices depart appreciably from underlying value, investors can frequently achieve above-average returns while taking below-average risks.

Taking about the nature of stock market, Charlie Munger in his speech “A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business” that he gave at the USC Business School in 1994, says ..

The question…”What is the nature of the stock market?”…gets you directly to this efficient market theory that got to be the rage—a total rage—long after I graduated from law school.

And that gets you directly to this efficient market theory that got to be the rage—a total rage—long after I graduated from law school.

And it’s rather interesting because one of the greatest economists of the world is a substantial shareholder in Berkshire Hathaway and has been for a long time. His textbook always taught that the stock market was perfectly efficient and that nobody could beat it. But his own money went into Berkshire and made him wealthy. So, like Pascal in his famous wager, he hedged his bet.

Is the stock market so efficient that people can’t beat it? Well, the efficient market theory is obviously roughly right—meaning that markets are quite efficient and it’s quite hard for anybody to beat the market by significant margins as a stock picker by just being intelligent and working in a disciplined way.

Indeed, the average result has to be the average result. By definition, everybody can’t beat the market. As I always say, the iron rule of life is that only 20% of

the people can be in the top fifth. That’s just the way it is. So the answer is that it’s partly efficient and partly inefficient.

And, by the way, I have a name for people who went to the extreme efficient market theory—which is “bonkers”. It was an intellectually consistent theory that enabled them to do pretty mathematics. So I understand its seductiveness to people with large mathematical gifts. It just had a difficulty in that the fundamental assumption did not tie properly to reality.

Again, to the man with a hammer, every problem looks like a nail. If you’re good at manipulating higher mathematics in a consistent way, why not make an assumption which enables you to use your tool?

The model I like—to sort of simplify the notion of what goes on in a market for common stocks—is the pari-mutuel system at the racetrack. If you stop to think about it, a pari-mutuel system is a market.

Everybody goes there and bets and the odds change based on what’s bet. That’s what happens in the stock market.

Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that it’s very hard to beat the system.

And then the track is taking 17% off the top. So not only do you have to outwit all the other betters, but you’ve got to outwit them by such a big margin that on average, you can afford to take 17% of your gross bets off the top and give it to the house before the rest of your money can be put to work.

Given those mathematics, is it possible to beat the horses only using one’s intelligence? Intelligence should give some edge, because lots of people who don’t know anything go out and bet lucky numbers and so forth. Therefore, somebody who really thinks about nothing but horse performance and is shrewd and mathematical could have a very considerable edge, in the absence of the frictional cost caused by the house take.

Unfortunately, what a shrewd horseplayer’s edge does in most cases is to reduce his average loss over a season of betting from the 17% that he would lose if he got the average result to maybe 10%. However, there are actually a few people who can beat the game after paying the full 17%.

I used to play poker when I was young with a guy who made a substantial living doing nothing but bet harness races…. Now, harness racing is a relatively inefficient market. You don’t have the depth of intelligence betting on harness races that you do on regular races. What my poker pal would do was to think about harness races as his main profession. And he would bet only occasionally when he saw some mispriced bet available. And by doing that, after paying the full handle to the house—which I presume was around 17%—he made a substantial living.

You have to say that’s rare. However, the market was not perfectly efficient. And if it weren’t for that big 17% handle, lots of people would regularly be beating lots of other people at the horse races. It’s efficient, yes. But it’s not perfectly efficient. And with enough shrewdness and fanaticism, some people will get better results than others.

The stock market is the same way—except that the house handle is so much lower. If you take transaction costs—the spread between the bid and the ask plus the commissions—and if you don’t trade too actively, you’re talking about fairly low transaction costs. So that with enough fanaticism and enough discipline, some of the shrewd people are going to get way better results than average in the nature of things.

It is not a bit easy. And, of course, 50% will end up in the bottom half and 70% will end up in the bottom 70%. But some people will have an advantage. And in a fairly low transaction cost operation, they will get better than average results in stock picking.

How do you get to be one of those who is a winner—in a relative sense—instead of a loser?

Here again, look at the pari-mutuel system. I had dinner last night by absolute accident with the president of Santa Anita. He says that there are two or three betters who have a credit arrangement with them, now that they have off-track betting, who are actually beating the house.

They’re sending money out net after the full handle—a lot of it to Las Vegas, by the way—to people who are actually winning slightly, net, after paying the full handle. They’re that shrewd about something with as much unpredictability as horse racing.

And the one thing that all those winning betters in the whole history of people who’ve beaten the pari-mutuel system have is quite simple. They bet very seldom.

It’s not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it—who look and sift the world for a mispriced bet—that they can occasionally find one.
And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.

That is a very simple concept. And to me it’s obviously right—based on experience not only from the pari-mutuel system, but everywhere else.

The problem with most of us investors is that, too often, we scatter money around while saying to ourselves, “Okay, let me throw a little money in this stock and little in that stock and then see what happens. At least, one of the stocks will work!”

Now, that’s a sure shot road to a hell lot of risk – first you don’t know where you are scattering your money, and then you think you are investing while the reality is that you are speculating in the hope of hitting the “right” stock.

So as Munger and Buffett suggest here is how you must think of the stock market if you want to do well in the long run…

1. Know that Odds Change Constantly and Best Bet is Never Obvious

While buying a stock with the view of holding it for the long run is a good idea, you must not buy anything, however great it may sound, without considering the odds of earning an adequate return from the same.

And how do you ensure that the odds are in your favour? One, buy businesses with god underlying economics, and two, buy them cheap.

We will study both these concepts in the subsequent lessons, but it’s important for you to remember that you cannot buy what’s glamorous (like a horse on which everyone is betting) and still expect to win big.

2. Keep Your Costs under Control

Another important point is that the stock market, like the horse betting scenario, involves the house taking a cut off the top by way of trading commissions and fees.

The 17% in horse racing seems onerous but, fortunately, the commission/fee in stock investing is usually in the 1% to 2% range. Nevertheless, if you want to beat the inflation after factoring your trading costs, you must aim to earn at least 15% annual return from your stocks.

This can be done if you trade less and keep your costs (broker fee etc.) as low as possible. Always remember that it is difficult for most investors to beat the market or inflation by 1-2% in the long run, and thus you must attempt to minimize what the house takes from you.

It is also important to realize that, like horse racing, the house takes its cut even if you lose money. When you buy a stock, you pay a commission even if your investment turns out to be a dud; if you buy a mutual fund or an ETF, you pay a management expense ratio even if the fund lost money.

So be careful, avoid trading much, and keep your costs low.

3. Bet Occasionally

Munger adds…

To me, it’s obvious that the winner has to bet very selectively. It’s been obvious to me since very early in life. I don’t know why it’s not obvious to very many other people.

This video says it all..

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