How to pick stocks

Courtesy : Moneycontrol

Q: Can you give me a bio of Peter Lynch, one of the most revered fund mangers of our time?

Dayal: He is a legend. He was the fund manager for the largest fund at that time Fidelity Magellan and wrote a phenomenal book that investors should read is called, ‘One up on Wall Street’. In the book, he just uses common day experiences to explain what stocks could be interesting to own and what stocks may not be interesting to own.

Q: One of his maxims was never invest in a stock, that you cannot explain to a child with a crayon. Explain that to us?

Bhat: It’s very simple because finally it is a market which is a clearing house for all ideas so therefore if the idea has to catch people’s imagination then they have to understand it in a jiffy. Nobody has lot of time to understand because it has got to be in encapsulated form. For e.g. Bharti, which is one of the biggest success over the last 10-15 years in this market. Analysts were not even able to model how many handsets will get sold so they were trying to see whether it a proxy. So, it was completely clean slate but idea was that this is so convenient that almost everybody will probably want to have it over the next two-three years.

Q: Peter Lynch is very famous for doing bottom up stock picking. He once famously said in another maxim that if he spends 13 minutes discussing economic trends and forecast, he wasted 10 minutes. What do you think of that?

Dayal: In the Quantum Long-term Equity Fund, which we have help create and we have a fund manager team for that, it is very much a bottom up stock picking firm which I am sure Lynch would be very proud of. At the same time we do not ignore the macro environment.  I tend to disagree with Lynch on this. I think it’s important to understand what is happening around you and then pick your companies then the stocks and tmanagements that you think can do well across different economic cycles and different market conditions. 

Q: What would you pay attention to? What are the big macro factors that you pay attention to?

Dayal: In this environment that we live, I certainly would look at government policy like interest rates, inflation, government deficits and in the international environment. Also, I would worry a lot about FII flows which means I would worry about the silliness of Ben Bernanke printing out notes all over the world.

Q: Demand and supply are important.

Dayal: Demand and supply are extremely important.

Q: But coming back to UR Bhat’s point investing by explaining in a crayon. Do you follow that practice?

Dayal: Yes and no. I think it’s important to simplify the logic of why you are making the investment but at the same time if you took that little card and you told the little child that there are a billion people in this country and they need homes so buy real estate. You would have lost a lot of money if you would have bought real estate stocks in 2007. It makes a point that people need mobile phones, real estate, cars, scooters, bridges, homes, hospitals everything but the question is can you make money from that investment. To us that’s the management that will tell you whether you can make money or not.

Q: A billion people in India needing this is a great case for India itself, isn’t it?

Dayal: It’s fantastic?

Q: What is your favourite Peter Lynch maxim?

Bhat: I think his logic was that we should take PE and growth together. I think he was the one who propounded PEG theory because I think that is extremely important because the market tends to look at PE in isolation without looking at growth. For example. in the heydays of 1999-2000 in IT sector, people were talking of growth that was probably going to be forever in the IT companies.  All growth is contextual and in fact if that were the case then we should have had companies which have survived for 500 years. There are hardly any companies in the big mainline indices which have survived from more than about 20-25 years. If you see there are only five companies which are there for the last 30 years. So it is that there is always change, sector leadership gets challenged, new sectors emerge, so all these things needs to be factored in so therefore PEG is a very important contribution of Peter Lynch to investment thinking.

Q: One of the things that I always enjoyed thinking about reading Peter Lynch is that you should never water your weeds and cut your flowers. Explain that in Lehman terms and what it means if you do that in a portfolio?

Dayal: What he is trying to say is if you own Zee, Infosys or a company like NEPC Micon. So if Infosys went up which it did after listing in 1992-93-94 you would not be selling Infosys, selling it to strength and buying into the weakness of NEPC Micon, you would have lost a lot of future wealth. So what he is saying is that, ‘don’t do that, don’t make the mistake of selling your winners and then putting the money into junk’ but I think at the same time you have to have a diversified portfolio and no one stock should really dominate your portfolio and effectively have a big influence on your wealth.

We knew someone in the late 90’s who had 95% of their entire wealth in one stock and to us that was silly, it’s not that he own the business, he was an investor. Even though that stock had done very well and I am sure he is very happy about it, it still is very risky because there was a period of time when the stock was not doing well and I am sure his wealth had decimated at that point in time.

Q: What do you think of that? Do you think diversification is good or bad?

Bhat: In a very systematic investment that if you want to follow that I think diversification is important - that is if you are sort of benchmark against, if you are a professional fund manager on your fund. If you are investing your own money I don’t think diversification is a great idea in my view. If you understand a company very well and you know the sort of risk that you are taking I think you get rewarded only for your connection ideas and so just having ‘X’ stock because it represents 10% of the market is not going to make great sense because your interest there is making absolute returns. In that case I think you need to get probably good four or five high conviction ideas and buy into them and hold them.