Investment Strategy: Investment And Speculation

There are two major sources of returns in stock markets: 

1. Capital gains 
2. Cash flow from dividends and buybacks.

In order to find companies that can generate good cash flows, look for those with:

1. Good fundamentals 
2. Sustainable business model
3. Competitive market position
4. Good quality management 

A company possessing such attributes can provide shareholders with higher cash flows over the investment period. 

Cash flow investing is what the author states are actually for long-term investing. The stock’s value is the present value of all the future dividends. On the other hand, investors who prefer buying stocks for capital gains, i.e. who want to sell the stock on price appreciation are in fact speculators or traders. One should have a long term vision to be an investor and only focus on the cash flows that the company can generate. Warren Buffet has a similar philosophy and buys stocks based on the fundamentals.

The author has given an example of Infosys here. During the tech bubble, Infosys went up from 2,000 in January 1999 to around 12,000 in March 2000. There was no spectacular change in the fundamentals of the company during this period. The stock again went down to 7,000 in September 2000. Again, with no change in fundamentals.

Now, let's see how the market creates exuberance. In FY2000, Infosys reported a revenue of 882 crores and the market was expecting a very high rate of growth of 100% per annum. If we were to compound this even at 85%, it would create a revenue base of 414,000 crores by the end of year 10. Now, comes the valuation part. Infosys was trading at a Price to Sales ratio of 10 during FY2000. An investor buying Infosys at this price, would basically want the valuation multiple to at least remain the same.

Keeping the valuation multiple the same for 10 years would mean a market capitalization of USD 9.2 trillion, higher than the US GDP. That’s insane. No company can be of such high value. Therefore, Parekh was of the view that the so-called investors, who buy a company just for capital appreciation would end up getting disappointed if they buy at such high valuations. However, investors who stayed with the company have been rewarded very nicely. 

According to the author, there is nothing wrong with speculation per se, however, it is dangerous when people:

• Do not understand the difference between speculation and investing
• Speculate without proper skills
• Speculate beyond one's capacity to take a loss.

The stock market is all about managing the rewards associated with the risk undertaken. This means that for earning a reward, investors have to take the risk, however, the key term is manageable risk. If we delve deeper into the author’s philosophy, we can see that he is biased towards investing only in good quality stocks with:

• Sustainable business model
• Right price
• Good management quality for the long term

The management of risk can be covered through two aspects. One is position sizing or allocation to the portfolio and the other is by investing in a good company. According to Parikh, if we invest in the right stocks with the right business model and fundamentals, over the long run we are assured of optimum returns.

The author is convinced of the fact that some speculators do make a killing in the stock markets. They are able to sell the stocks at the peak and buy it at the bottom, thus beating the long term CAGR (which investors track and boast about) by a huge margin. However, not everyone can do that. 

For investors, on the other hand, the most important aspect is to balance the risk and reward. During the IT boom, people were buying IT stocks with little consideration for the risks. Investors should look for events, such as the Iraq war (2003) or the US recession (2008) when stocks were available at very cheap valuations.

Thus, he concludes that the strategy to play the stock market should be chosen as per one’s mental attitude, discipline, risk-taking ability and patience.