1 - Do Long Term Investing requires mindset of Stop Loss?
Key Excerpts from the Article (Emphasis Ours)
. Stop loss is a simple yet extremely powerful concept. It can protect you from major catastrophes that can completely erode your portfolio to protect a large part of gains made (when used as protective stops).
. Trending stocks are those that follow a trend (it keeps going up or down over time - since we are usually all long-only investors I will talk about price rise trends). The rising price trend is usually but not necessarily improving fundamentals like earnings. Examples are many like Pidilite, Asian Paints, HDFC Bank
. Mean reverting stocks are those where the prices keep oscillating about a mean position (which also tends to slant upwards but at a much lower slope). Practically, most stocks belong to this category.
.If you have bought a trending stock, a stop loss is a must. It helps in preventing massive losses in case your thesis is wrong or there is a major market correction. It also prevents in locking in gains by the use of a trailing stop loss.
. A trailing stop loss is one where you keep raising the stop price as the price of the stock keeps going up.
. On the other hand, if you have bought a mean-reversion stock, where you are expecting a change in fortune, then a stop loss initially is a STUPID idea. This is precisely why Warren Buffett or any other value investor do not use stop losses. Value investing, by definition, is a mean-reversion strategy
. let's say you have bought it at 100 and expect it to revert to its intrinsic value of 150 in some time period. Now if the price falls to 80, ideally your philosophy should drive you to buy more at the lower price since you are now getting a better bargain and potentially more profits when the stock does mean revert.
. Some basic strategies to apply stop loss are:
1) Using a fixed percentage stop loss (say 10% or 20% from buy price)
2) Based on technical chart patterns (support levels, breakout levels, gaps etc)
3) Based on statistical indicators (Fibonacci levels, moving averages, ATR etc)
4) Volatility based
5) PE based (exit at x PE)
6) Growth level based (if earnings growth falls below x% for 2 quarters in a row)
. Stop levels need to be in line with your capital and time horizon. If you keep a 5% stop loss and your a long term investor, you will get stopped out 99% of the time. You need to understand the volatility of the particular stock and make sure you do not get stopped out under normal market gyrations.
. The next problem is whether to have an individual stop loss for a stock or a stop at the portfolio level. Again, like in nearly everything in life, the answer is "it depends". Individual stop loss, in my opinion, should be more liberal, if you are a long term investor. Something like 30-40% or even 50%. But if you combine it with a market level stop loss, then it could get triggered at a lower combined level.
. You can use either single stop loss to get out of your entire position or graded stop loss to get out gradually. Example: Sell 50% at a 20% stop, and then 10% every 5% fall.
. Stop loss in my studies, nearly always, reduces returns.Obviously, there are many assumptions that have gone in the data studying primary amongst which is that you are not a very poor stock picker and you make reasonable profits when the markets are doing well. If you are not sure if you are a good stock picker, then use a stop. It is like a helmet. It will save your life if you crash.
. However, if you are a good stock picker and have a good track record, 9 / 10 times your stop will get hit and the stock will recover ground post that. Only in very very rare cases like a DHFL or a Yes Bank would it protect you immensely. But then again, if you were a good stock picker you would have gotten out of those even without a stop loss.
Read More: https://blog.intelsense.in/2020/04/using-stop-loss-in-investing.html
2 - Does a normal investor invest strictly low P/E or high Quality Companies even available at high P/E?
Key Excerpts from the Article (Emphasis Ours)
. What is quality? Is it defined only by high PE stocks? Does quality exist in midcaps and small caps or is only large/mega-cap companies’ quality? Can quality exist in companies whose stocks are cheap? Are all expensive stocks good quality businesses?
. When Investors are scared - Return of capital has taken precedence over return on capital. That is why stocks of companies which investors think are safe trades at a premium even when everything else is relatively cheap.
. People talking about high PE are ignoring the interest rate reduction. All things equal, if you reduce interest rates from 12% to say 6%, the fair value that a DCF will throw up is about 4 times. Now, you might argue that if interest rates fall, all other things can’t remain equal. Fair point. So, lets discount that 4x to 3x. Heck, let's reduce it some more, say 2x or 1.5x. The broad point I am making is that the median PE of stocks as a whole rise. And we have seen this play out in real life as well. The NIFTY PE, for example, has moved up from 16-17 a few years back to now about 26-27.
. 10 years back, people were ready to pay a 2.5-3x premium on median PE for the so-called high-quality companies. Now, my contention is that that multiple for perceived quality will not change. Even now investors would pay a similar markup. So, a high-quality company used to be available at 30-40 PE when the market was at 15-16PE.
. the most important thing is for those who can identify great companies at cheap prices, then they should do precisely that. But a vast majority of people can’t do that and end up buying mediocre or poor companies just because they fixate on cheapness.
. As the good quality smaller companies come up on governance as well as consistency of results, the premium for others will reduce. People will then not take refuge in only a handful of stocks.
. Quality comes as the first filter and cheapness next. I am willing to compromise on cheapness but not on the quality of the business. Because history and my personal experience tell me that buying and sticking to good quality does not hurt.
. Another example of holding on to quality that most people often cite is HUL’s flat returns for 10 years. Trust me, I was there. I bought and finally sold HUL at about the same price after a decade. Now, as a retail investor, the way I look at it is this.
I did not only have HUL in my portfolio, but there were also other stocks which did much better (or worse).
I kept getting good dividends and also a good debenture,
I did not lose money. I know a lot of people who put money in JP Associates, DLF, Unitech and other similar companies and lost 40-50% or more during the same period,
If I had put a basket of 10 such strong business companies, I would actually have done quite well. I actually did this exercise much later after found that even well discovered fundamentally sound strong businesses have given exceptionally good CAGR returns over 20-25-year periods.
. If you are in the market for the next 20-30-40 years, you are much better off with a collection of great businesses than trying to get in and out of iffy companies because they are cheap by some arbitrary parameter. For example, one approach to this is to just pick 9-10 industries you like and which have long term growth characteristics and pick either the best or two best companies in that industry and build a portfolio. And then do nothing. Re-look at the portfolio once every year. If you think the businesses are doing well in their respective industry, again, do nothing.
Read More: https://blog.intelsense.in/2019/11/the-quality-conundrum.html
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