Learn Trading Under The Guidance of Vivek Bajaj + 4 Mentors - Know More

The Joys of Compounding by Gautam Baid

The Three Most Important Words In Investing

Time and again, the market teaches us that a significant difference exists between a great company and an outstanding stock.


A stable investor who earns 20 percent for two consecutive years comes out ahead of a flamboyant newcomer who makes 100 percent in a bull market year and loses 30 percent or more in the following year. 

Most inexperienced investors realize this harsh math the painful way when junk stocks finally start crashing after a bull market, and only then do they begin to appreciate the significant importance of investing in quality.


There always seems to be a strong divide within the investing community between “deep value” (statistically cheap securities) and “growth at a reasonable price” (high-quality compounders). Indeed, many investors do well by buying great businesses at fair prices and holding them for long periods. In contrast, other investors prefer to buy cheap stocks of average or mediocre quality and sell them when they appreciate fair value, repeating the process over time as they cycle through multiple new opportunities. The styles are different but not as diverse as most people describe them to be. The tactics used may differ, but the objective is the same—that is, trying to buy something for less than what it’s worth. 


Both strategies are just different versions of Graham’s margin-of-safety principle.


The former offers a more significant margin of safety because the higher-quality compounder is worth a lot more over a long-term holding period than the lower-quality business.
One way to reduce unforced errors in investing is choosing the businesses we decide to own carefully. Investors are better off with a few solid long-term choices than flitting from one speculation to another, always chasing the latest hot stock in the market. 


The gap between price and value ultimately will determine our returns, but picking the right business is possibly the most crucial step in reducing errors. Improving pattern recognition skills increases the probability of successfully identifying the right companies to invest in. Over time, companies with increasing intrinsic value are the clear winners.


The Graham and Dodd investor believes in mean reversion—that is, bad things will happen to good businesses, and good things will happen to bad companies. Buffett–Munger–Fisher investors invest in companies with fundamental momentum, that is, a high probability of sustaining excess returns over long periods. These two ideologies often clash (mean reversion versus fundamental momentum) in the value investing community.

 For most businesses, mean reversion applies, but for some exceptional ones, it starts using after a prolonged period, and until then, fundamental momentum applies.


Corporate profitability is sticky. Outstanding companies tend to remain wonderful, and poor companies tend to remain stuck in the mud. Our empirical evidence suggests that sustainable corporate turnarounds are difficult to execute. Companies in defensive industries exhibit more stickiness in corporate profitability than firms in cyclical industries. However, the persistence in performance remains highly significant, and thus the reputation of the business tends to stay intact regardless of industry. 

Firms with excellent profitability tend to outperform those with the worst return on capital. The outperformance improves if high-quality firms are purchased at a fair price. 


This has been proven empirically not just in this study but in many others. Financial economist Robert Novy-Marx looked founded the same persistence of high performance, not just in business fundamentals but also in stock market returns: 
“More profitable companies today tend to be more profitable companies tomorrow. Although it gets reflected in their future stock prices, the market systematically underestimates this today, making their shares a relative bargain—diamonds in the rough.”


High quality always beats a bargain over time. Although there are certainly exceptions, in the long run, bargains never outperform solid investments. This simple yet profound principle can be applied to virtually every area of life. 
For instance, crash diets, predatory pricing, dishonesty, and shortcuts can work well for a while, but they are never sustainable.

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