In the concluding episode of the podcast series with adjunct professor at Management Development Institute, Gurgaon, and Managing Partner at ValueQuest Capital Sanjay Bakshi, the behavioural finance expert talks about emotional biases that make a difference in buying and selling stocks.
Click here for Part 1
Click here for Part 2
Click here for Part 3
Q: Again on the subject of behavioural trends, investors are generally reluctant to buy stocks which are high priced in absolute terms. Stocks that trade at four or five figure prices like MRF, Eicher, to name a few. When you look at the performance of high-priced stocks, most of them tend to do well quite well relative to the market. Of course, there is an opportunity here for other investors when a large section of the market overlooks something. You are both a practitioner and teacher of behavioural finance, so what explains this bias?
A: It’s basic nature, we tend to think in absolute numbers, a Rs 1,000 stock price looks more expensive than a Rs 10 stock price or Rs 20 or Rs 30 stock price. And a Rs 2 -3 stock price looks like really cheap. But cheapness or expensiveness should be seen with reference to something, reference to value. So, it’s a classic anchoring bias, you start thinking about a number and you start thinking, oh my god this is like so expensive, it’s like Rs 2,000 a share and you asked me how do you overcome this. There is a simple way to do this, really speaking. Just think it as the aggregate values, like MRF is worth about Rs 28,000 cr and Eicher is worth Rs 56,000 crore today. So you just take the number of shares and multiply by the shares outstanding and look at the aggregate market value of the company and you have a number, then you compare that number with fundamental factors like total earnings or cash flows or future cash flows or earnings or book values or dividend paying capacity, so many things. And don’t think in terms of per share when you are doing valuation. There are situations when you should think about per share to be sure. For example, when you think about dilution, new shares coming into the market and reducing the stake of the existing shareholders, that was done on terms that are favourable or not favourable and so on, but when it comes to valuation and you should think in terms of whole business, not how many slices are there in that business pizza so to speak.
Q: When the price of a stock is falling, most investors like to average their purchase cost when by buying more shares. But when a stock price is rising, most investors generally do not want to average up their purchase cost. What do you think is the reason for this?
A: So, I do this in class, I ask my students that what are the circumstances in which a stock at Rs 200 is a safer and more lucrative asset to own than when it was at - let’s say – Rs 100 a couple of years ago. And if you force yourself to think about it and ask yourself what are the conditions under which a stock at Rs 200 is better buy at Rs 100, it forces you to think about those circumstances, what could those be, let’s try to think about that. When it was Rs 100 it was an unproven business model, it was a newer company, it had very little track record. At Rs 200, some years have gone by and there is a proven track record. It has gone from a small company to a medium-sized company. It has gone from a levered balance sheet to an unlevered balanced sheet, some of the competitors may have dropped out and you may have gotten a higher market share or dominance in the market. You may have got some pricing power. So yes, to be sure, the stock has doubled, but the value may have tripled. So the marginal safety is actually expanded. So, if put in those terms, it is then a better buy at Rs 200 than it was at Rs 100.
Moreover, when you bought it at Rs 100 because it was a riskier asset you would put only a small position on the name in your portfolio. You don’t want to put like 15% or 10%, you are putting like 2%. But at Rs 200 the business is proven and you have got more conviction and you also have learnt more about it, the moat has emerged and the management has executed and the balance sheet is better and the returns on capital have become better and the scalability is now apparent to you and then you are thinking about that in terms of value and the value is coming out Rs 400 or Rs 500. So you would now be having much more conviction that you might put up a 7% position or a 10% position in that stock. So, the idea of not buying more of a business that is executing brilliantly just because the stock price has gone up a bit is not a good idea.
Q: A lot of value investors tend to avoid companies that raise capital frequently. Understandably, investors don’t like their equity to be diluted, or interest costs eroding profitability. But then, companies do need capital if they have to grow. What are your thoughts on this?
A: So that depends on the business model. My personal preference is towards businesses that can fund all growth - I don’t like businesses that don’t grow, I want businesses to grow, but I also want the ability to grow without the need for outside capital - debt or equity, which means that the internal cash flow generation is sufficient to fund all growth and/or the business is not that capital intensive. Now this condition obviously doesn’t apply in all situation and it certainly doesn’t apply to financial companies for whom money is raw material and they have to keep borrowing money from the markets to lend it forward. But when it comes to having more equity capital in the balance sheet and raising money from outside equity investors you have to be very careful about how to analyse that situation. One way to think about this is, I am not going to do this, I don’t like companies which dilute equity and that’s perfectly legitimate way of thinking about it, but an alternate view could be that okay here is a company that needs to go to outside capital market what are the terms on which they do that. So, some companies are very good at this and when the stocks are selling at high valuations they will go and raise more money and then when stock is selling at low valuation then they won’t. So, all you have to focus is, is the management aligned with the minority shareholders of the company.
Q: It is said that it is easier to analyse companies and decide what to buy, than it is to decide when to sell. Are there any basic rules that one should keep in mind when it comes to booking profits?
A: You tell me. I am still learning this.
Q: You just mentioned the fear of missing out a short while back. Do you think that plays a bigger role in holding back investors from cashing out?
A: Huge role, we are all guilty of this to some extent because we see a bull run and you are participating in that and you see the value of your shares go up a lot and then you start thinking to borrow the famous line from a Hindi song, ‘abhi toh party shuru hui hai’ and you don’t want to loose out on future profits that will surely occur if you sell them and you may have had some experiences in the past that you sold something and it went up and up and up and up and everybody has had that experience and its painful and that nobody wants that. So you stay invested regardless. So, it is a difficult decision, no doubt about it and there are specific psychological reasons why selling is so much harder than buying. When you sell something you are selling something that you have owned for a few years. So, there is this emotional attachment to it. It may have gone up a lot and therefore you think it will go up even more and you don’t want to sell or it may have gone down and you think, my god, if I sell I will have a loss, and you are anchoring to the cost that you paid or there is an emotional aspect that you believe that you are great stock picker. But if you sell it you will have a loss and you don’t like that emotional pain so that prevents you from selling.
Q: Behavioural science has become quite popular among investors. How has it helped you take better investment decisions?
A: Many years ago I came across this talk by Charlie Munger on the Psychology of Human Misjudgement and it was a game changer for me because that is the first time I found that discipline of behavioural economics which you could study from and learn from and in that particular talk, Charlie laid out some 20 standard causes of human misjudgement and he has given a second version of the talk which is even better than the first one. Of course, he was drawing a lot upon his own experience of learning psychology from books like Influence by Robert Cialdini for example.
As I mentioned earlier, there are three big ingredients for being a successful investor. You need to understand accounting, you need to understand business and you need to understand psychology. Those are three things you need and if you don’t understand psychology, including your own psychology and the biases that you have if you don’t overcome them then you are trading against people who may not have those biases and therefore you are kind of kind of patsy in the game. So, if you want to avoid losses you need to have that knowledge, you need to understand psychology, it’s been extremely useful to me.
Q: You are a voracious reader and your reading list is closely tracked by many in the investing community. Tell us something about your reading habits; what do you enjoy reading, how much time do you set aside for reading every day? Also, if there are any books that has influenced you deeply, both as a person and an investor?
A: As to the last one we should have a separate podcast for that. I have read lot of books and there are books of different disciplines which have influenced me and might help some of your listeners to pick up those books and learn from.
As to your other questions, I just love reading and that is one thing which I was always fond of since I was a kid. I used to just love reading, being alone with a book is more pleasurable than being in a party. And some people are like that and some are not. So, I was sort of an introverted person and you just want to be alone and with a book and whatever it is, it could be Hardy Boys when I was a kid, it could be Agatha Christie or whatever. So I just love reading.
Today my reading choices are guided by a lot of book friends that I have - friendship that I have developed over the years. I have a few people who I have never met but who interact with me only on books. I know that the books they recommend are different. So, in a sense I do get influenced by the choices of some of these people who will send me a recommendation or send me a book over the years that I have picked up and it’s a reciprocal kind of relationship. I’ll tell them the books that I like. So today I liked to read books on other discipline because the discipline that I teach and I practice is multidisciplinary and it draws from models from disciplines other than finance and therefore it makes sense to read in other disciplines.
I end up reading maybe four or five books in a month but I would like to read more. My library is bigger than the books that I have actually read and I think that’s again been a net plus for me in many ways. One, it forces me to pick up a book because I have pressure to read it before buying another one. But the other big benefit of having a large library, at least on my Kindle, is that when I am doing research on a specific topic, I could search across all books for a specific concepts. So, it’s interesting because the books that I have bought have been bought after careful research, either I know that this author is great or somebody has told me and I may not read the book, but now I am doing research. So, it’s already a carefully curated selection of books on my Kindle and now I am looking for a subject and I am doing a blog or I am doing a research on some specific topic, I am developing a lecture, I search for a specific term across all books including the books that I have not read but I own and that almost always leads me to discover things that I didn’t know which are very relevant to that particular subject.
So, in that sense that alone is a good enough reason to have a large - in my case - Kindle library or there are other e-readers out there where you have all these books which have been collected over the years and which you will read over a period of time but even if you have not read them they are research resources for you
Q: So do you discuss investments with your children? Are you keen that they know about the basics of investing early on?
A: I don’t discuss investing, but I discuss psychology a lot, because when I got interested in psychology my kids were very small and I was using them as kind of guinea pigs. My little daughter she was six or seven years at that time. She knows concepts like social proof and contrast effect, a lot of concepts that I about in classroom.
So, I don’t talk numbers and finance and professional work is different when I am with my kids. Psychology is fun, with all these lovely experiments which you can do on children marshmallow experiment and all that kind of stuff. So, it’s fun. For me it’s not been talking about investing or money, but its lot about psychology. So the books that I have talked about, the concepts that I have talked about with my kids have almost always revolved around psychology, not investing.
On that note, thank you Professor Bakshi for taking time out for us and sharing your thoughts, experiences and learnings with our listeners. I am sure they would have found it very interesting.