How to invest when the markets are at a high?
“Based on personal experience rarely do more than three of four variables really count. Everything else is noise” – Martin Whitman
The above lines by Martin Whitman is one of the most important lessons to remember and internalize when we are looking to invest in the stock markets. This is because there will always be a lot of noise especially during times of euphoria or panic and as investors it is important to cut through this noise and focus on what is important, no matter where the market levels are.
Over the last 5 years the markets have seen COVID-19, oil shock of 2020, Russia-Ukraine conflict, interest rate hikes and Hindenburg report on Adani. All through this there was a looming commentary of global economic slowdown.
In spite of all these ominous events corporate India reported earnings growth. The Sensex EPS grew from INR 1,572 to INR 2,825 which led to strong flow of money from domestic investors as the charts below depict. The domestic institutions have put in ~7 lakh crores into the markets over the last ~6 years which is more than twice of what the FIIs have put in.
The earnings growth coupled with flows led to the markets almost doubling in the last 5 years (not counting the COVID low) and delivering ~16.6% CAGR (as on April-24). This shows that market returns is a function of both earnings growth and PE expansion (which is a function of flows).
Where do these returns come from?
If we do a cross sectional analysis to understand where these returns came from over the last 1 year we see that:
The Real Estate, Power, PSU Banks, Capital Goods and Metals were the top performers in terms of sectors
Companies with promoter stake 75% or higher delivered a return of ~106%
The most pertinent question to ask as an investor is “will this rally continue?” and to which no one has answer. In terms of valuation both NIFTY and BSE200 are trading at their 20year average Trailing Twelve months PE and the Sensex is trading at ~1.4x India’s GDP. These pointers convey that markets are either cheap or expensive depending on which indicator you would want to look at. but the truth is neither of them would actually help us in gauging the cheapness or the “expensiveness” of the “market”.
But, the larger point to take home for investors is that market returns are driven by earnings growth and flows.
As an corollary we can also say that no matter what the market conditions, companies with a strong moat, pricing power and long runway for growth will continue to perform and deliver strong returns. As an investor our endeavor should be to identify these companies and stay invested in them. So, focus on the music and make it last.
“I’m here for one reason and one reason alone. I’m here to guess what the music might do in a week, a month, a year from now. That’s it. Nothing more” – John Tuld, Margin Call
So, how do you identify good stocks? The best way to do it would be run a quantitative screener that shortlists companies that satisfy your criteria. A typical filtering process would be something like the process below:
This was the process that I followed in Aug-2021, when the markets were taking a breather from the COVID-19 bounce back when it realized that the world isn’t going to come to an end.
What were the results that I got when I ran this screener?
The best part about using screeners is that the parameters can be tailored to an investor’s comfort but the disadvantage is that the parameters by themselves do not tell us anything about the companies except that they have been fundamentally strong. But we do not know if this performance would continue in the future and to assess this we need to learn about the quality of the management which would give us a fair idea about how the company could perform in the future.
Now that you have done your home work and arrived at the investable list and you’ve invested. You have to wait but the markets do not stay still
“It’s worth reminding ourselves from time to time that gyrations in a stock price may tell us absolutely nothing about the prospects of the company involved” – Peter Lynch
If the index can have drawdowns like these what could happen to individual stocks? lets look at a few of them.
So, volatility is your companion and try to make him your friend or at least learn to live with him if you want to make the most of investing in the markets. That is why, Identifying the stock is only half the task, buying and holding it through times of uncertainty without losing conviction and exiting when the fundamentals of the stock are no longer favorable is the larger part of the investing journey which is really under rated and not a focus area for many.
So, to sum it up:
The markets will be filled with noise
The noise increases during times of euphoria or panic
Filter out the noise by focusing on what drives market returns
Focus on picking stocks no matter what the market condition is
Returns are driven by earnings growth and PE expansion (driven by flows and free float/free-float).
Corollary: Even if you do not have PE expansion, a steady earnings growth will give consistent returns from a stock
You could suffer near term negative returns if you invest at the peak but in the long run good companies will perform well
The investing principle that you need to always remember is:
“All there is to investing is picking good stocks at good times and staying with them as long as they remain good companies” – Warren Buffett
If you do not want to go through the process of picking stocks then you could invest in either Mutual funds or even better you can pick ETFs that will give you index returns.
Happy Investing!!