It is a very common characteristic of players in financial games to predict the current & future state by using easy to calculate statistical indicators. As like any cause-effect relationship, we surrender ourselves to survivorship bias and give heavy weight to most recent successful outcomes which had different prevailing economic conditions by using those indicators. The game of investing is to be always played by looking at interest rates offered. It is like a gravitational force to any object in the financial world.
I am not better at suggesting what level of interest rates need to be, the job best to leave to economists. As minority retail investors, a 10 yr gsec bond yields 5.90%. Now, the rules of investing are simple as laid out by the oracle of omaha:
1) Never lose money
2) Never forget rule no.1,
Now, I would like to add one more rule – Time in the market is important than timing.
Many retail investors look for tips, coat tail big investors,etc.. that might have a success rate that looks minimal to error rate over long term and has a risk of getting wiped out of the game.
With base interest rates available and considering them as risk-free, all we want to do is to pick companies bottom up that have return over equity and assets employed greater than gov. sec yield as the retained earnings in the addition of assets post dividends will be used to generate a higher return go forward. Once we obtain this list – we can do further research into the quality of the assets employed and managements, growth in sales and conversion of sales to profits and profits to cash and cash deployed wisely over a good time period. The quality of business and management is a multiplicative factor and not additive to consider in a decision bucket. However good a business be, with a crooked management there is nothing left to eat for retail shareholders. We are on the lookout for friends with integrity with an avg IQ rather than higher IQ with wrong intentions. The examples where investors lost wealth is a never ending one and I prefer to not name them.
As time goes and we all learn, the ever growing list of traps can be eliminated in many ways and a few are –
Cash traps- Good businesses with a good ROE and cash surplus on balance sheet are prune to a decline in returns go forward as the cash piles up but the business or management lacks capital deployment opportunities due to surplus capacities existing or managements lending to family subsidiaries or parking them in bonds in a lowering int. rate scenario pre tax will be reducing return on equity as they go into the future and to add if inflation also picks up they will start to lose returns on core operating assets if they are producing a commodity which has a low entry barrier.
Receivable Traps- Companies unable to convert their sales into cash. As they say, “Cash is always a King”. We need to keep a check on cumulative cash flows to profits.
Terms of Trade- Identifying businesses with very good terms of trade with suppliers and customers is the best as even a pandemic could impact very little to companies with good terms of trade as supply chains across the world were disrupted.
Considering above factors, I will reserve my right to modify to – “Cash is Queen and Asset itself is a King to a castle”. It is the relationship between king and queen that will define returns going ahead. Last but not least – Valuation is key to any portfolio as “bhav bhagwan che”. We get what we pay for.