Absolute vs relative
We are overly influenced by immediacy. To counter this, our investment framework needs to be way more absolute than relative. (4th essay of series on greyness & contradictions)
In investing, absolute vs relative is associated with returns. This is an easy conundrum to resolve. Focusing on absolute returns improves odds of superior relative returns. Focusing on relative returns leads to inferior returns, absolute and relative. Fiddling around the edges of an arbitrarily constructed basket of stocks is a poor way to invest. However, that’s not what this essay is about. This is about absolute vs relative thinking. Investing process, not outcomes.
In my series on Sound Judgment, I wrote about having a historically grounded frame of reference (https://www.linkedin.com/pulse/sense-history-3n-anand-sridharan/). This allows us to answer basic questions in a reliable, consistent manner. What makes for a backable promoter? Good industry? Sustainably good business? What patterns to watch out for, especially on big risks? How to think about valuation? This framework is our investing backbone. It lets us learn from history, predecessors and experience. It guides towards questions that matter. It filters out noise and appropriately incorporates evidence. It helps narrow it down from murky ambiguity into a precise walk-away price. I believe that investing framework has to be absolute rather than relative. By absolute, I mean time-invariant. Context-invariant. Sentiment-invariant. Sector-invariant. Macro-invariant. Theme-invariant. Fad-invariant. Since this is abstract goop, let me get into examples.
In my framework, a good business is one that makes gobs of money. It doesn’t need charity of strangers to compound. Ergo, banks that makes bits of money after gobs of leverage are not good. Their popularity or others’ making money off them doesn’t change this. If I seek high return on capital & no debt, I should be wary of the opposite. Framework doesn’t change from sector to sector. Since conflicts of interest abound, my framework requires an aligned promoter. So, ‘PSU is the new GME’ cannot be a theme for me. I cannot have multiple frames to accommodate misfits, as that’s a slippery slope to standing for nothing and falling for everything.
A sustainably good business has a moat. It may be fuzzily defined, but I know it when I see it. If certain types of basic manufacturing are narrow moat, “China plus one” catchphrase doesn’t change this. If airlines are shitty businesses, they’re shitty even if others change their mind. Good industries don’t suddenly turn bad either. A few years back, analysts soured on IT Services because ‘automation’ was an existential threat. Before I could understand what the hell automation meant, it mysteriously disappeared from analyst reports. Framework doesn’t change with sentiments, business cycle or tail/head winds. Industries also need to be framed in a consistent manner. I struggle with a classification called chemicals. If I don’t club together diverse equipment as ‘mechanicals’ or ‘electricals’, why ‘chemicals’? I’ll have to narrow-frame the latter, just as I do with compressors or turbines, and gauge attractiveness of individual sub-categories.
My valuation framework includes a strict no-forecast rule since humans suck at this. In insurance, how can I accept others’ forecasts just because it’s fancily labelled ‘embedded value’. If a sense of cashflow is crucial to valuation, it should hold across industries. Framework should apply a consistent bar. It shouldn’t vary with macro either. There are arguments around low rates justifying higher valuations. 50 is the new 30 or something like that. While rates are low, no one knows how long they’ll stay down. This reminds me of 2007. A top-tier brokerage justified high PE based on rupee appreciation (yes, you read that right). Foreign investors supposedly lowered expectations of underlying returns due to currency tailwind and could therefore buy at higher prices. Even the infamous BRICS report had EM currency appreciation built into its thesis of catch-up with developed world. Of all variables, changing investing framework because of macro astrology is the worst.
Above examples tell you that my stupid absolutist intransigence has led to many missed opportunities. That’s exactly the point. Any coherent approach will have lots that will not fit into it. Missing opportunities is the price to pay for improved odds in whatever does fit into my framework. If dilute my approach based on what’s trendy, doing worse in the core will overwhelm any illusory upside. At the extreme, I’ll forget what my core is. It’s hard to be good at new things when there’s no coherent basis for anything. It’s what we tell our portfolio companies: know your strengths and only play to those. Since capabilities take years to build, it’s better to view them as fixed rather than conveniently mouldable. There’s a lot of new age bullshit about expanding one’s circle of competence through a lifelong learning mindset. In my view, if it expands fast, competence or circle or both are ill defined. Personally, my circle has shrunk over time as awareness of limitations outpaced possible expansion of abilities.
Social sciences are empirical, as they are not underpinned by universal natural law. Absolute truths or axioms don’t exist. I use ‘absolute’ figuratively rather than literally. It means slow to change and hard to change. If the thought of being absolutist makes you uncomfortable, think of an investing frame as relative, but only vis-à-vis: (a) all history, (b) fundamentals (i.e. business characteristics, risk & quality). A way of thinking based on decades of effort and centuries of history shouldn’t change over quarters, even if some quarters feel life-changing. While I am open to new evidence, that’s a rounding error relative to history that is already incorporated into the framework. Sound investing approaches evolve, but it’s a glacial process. And mine may never evolve enough to handle crypto-mania or not-for-profits (aka unicorns). But that’s ok. My reward from most of messy world is laughter, not lucre.
Framework is also universal in its applicability. It guides thinking, irrespective of industry, company, people or time. While (occasionally) updating framework, it’s worth explicitly applying the update across the board. Buggy humans are good at papering over inconsistencies. For example, if I decide to attach more importance to market share gain, I should be harsher towards portfolio companies that have lost share. Likewise if I decide to be stricter about capital misallocation. If I choose to relax a criterion (e.g. proven track record), it’s not about one exception but about adding a hundred companies to my consideration set. If I am not comfortable with all implications of a change, I am being conveniently hypocritical. A sound framework remains internally consistent after a change.
Psychological reason for my absolutist view is our natural propensity to overweight whatever is recent, loud, repetitive and popular. We’re also wired to notice contrast relative to prevailing background, not absolute levels. There’s a strong, innate relative bias to our thinking. We’re gloomy when others are. We’re excited by whatever excites peers. Our views on boring industries see unholy swings. We overweight recent anecdotes over long history. We sour on timeless businesses because of a bad patch. We view Hardik Pandya as Kapil Dev after one knock. We’re too lax on valuation after a bull run and too strict after getting whacked. We’re born extrapolators.
Aforementioned emotional quirks get magnified in stock markets. Price is never right, but we don’t know what’s right either. Markets overreact at both ends, but we don’t know around what? Markets are clearly inefficient, but most of us can’t beat markets. Problem is that our thinking is overly influenced by proximate market context. It’s too relative. We need a different perspective to see madness for what it is, and occasionally profit from it. We need a deliberate counter to natural bias and institutional distortions. We need an absolute investing framework, grounded in history, yet detached from immediacy.
As always, I am not suggesting my exact framework to anyone. You should make peace with whatever framework works for you. It may even evolve faster than my fuddy-duddy one. Whatever the framework, it’ll need to be internally consistent across its tenets and in its application. This is impossible without an absolutist streak to it. Otherwise, it’ll become Mr Market’s framework, not yours. An absolute investment framework is our True North, to survive stormy seas without getting lost or running aground.
As usual superb and fantastic...."You should make peace with whatever framework works for you.." I love this quote....
On the topic of circle of competence,I would like to quote Siddhartha Lal of Eicher motors. He said that,"We want to be an inch wide and mile deep."