Introduction

About the book 

This book 'The Joys of Compounding: The Passionate Pursuit of Lifelong Learning' demonstrates the superiority of the value investing approach and provides an intellectual toolkit for achieving a comprehensive understanding of the world around us, including ourselves. It teaches a holistic approach to investing that incorporates self-improvement, knowledge acquisition and investing wisdom. This book contains many timeless investing and life lessons.

The summary is divided into five major sections: 
(1) Achieving Worldly Wisdom
(2) Building Strong Character 
(3) Common Stock Investing 
(4) Portfolio Management 
(5) Decision-making

About the author 

Mr Gautam Baid is a Chartered Financial Analyst and the author of the book- 'The Joys of Compounding' is an international best-seller. He worked as a senior analyst in Citigroup and Deutsche Bank's healthcare investment banking teams in Mumbai, London, and Hong Kong.
He then worked as a portfolio manager at an SEC-registered investment advisor in Salt Lake City, Utah. In India, he has a SEBI-registered investment firm called Stellar Wealth Partners.

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Investment In Yourself

The Best Investment You Can Make Is an Investment in Yourself

An hour spent learning about an essential principle in depth pays off in the long run. That is why good books are considered the most undervalued asset: the right ideas can be worth millions, if not billions, of dollars in the long run.

The author advises reducing the commute time to work and outsourcing all time-consuming menial tasks to free up valuable time for self-development.

Become A Learning Machine

Mr. Gautam Baid discusses the significance of lifelong learning. We can become better investors and, more importantly, better thinkers by reading and developing a mental models framework.

Everything in life can be a teacher if you have the right mindset.

“The best investment you can make is in yourself.” - Warrren Buffet 

The author gives some principles to understand and practice the following if one wants to become a good investor:

• Look at stocks as part ownership of a business.
• Look at Mr. Market—volatile stock price fluctuations—as your friend rather than your enemy. View risk as to the possibility of permanent loss of purchasing power and uncertainty as to the unpredictability regarding the degree of variability in the possible range of outcomes.
• Remember the three most important words in investing: “margin of safety.”
• Evaluate any news item or event only in terms of its impact on (a) future interest rates and (b) the intrinsic value of the business, which is the discounted value of the cash that can be taken out during its remaining life, adjusted for the uncertainty around receiving those cash flows.
• When evaluating new ideas, consider opportunity costs and keep a very high hurdle rate for incoming investments. Be unreasonable. When you look at a business and get a strong desire from within, saying, “I wish I owned this business,” that is the kind of business you should be investing in. An excellent investment idea doesn’t need hours to analyze. More often than not, it is love at first sight.
• Think probabilistically rather than deterministically because the future is never certain, and it is a set of branching probability streams. At the same time, avoid the risk of ruin when making decisions by focusing on consequences rather than just on raw probabilities in isolation. Some risks are just not worth taking, whatever the potential upside may be.
• Never underestimate the power of incentives in any given situation.
• When making decisions, involve the left side of your brain (logic, analysis, and math) and the right side (intuition, creativity, and emotions).
• Engage in visual thinking, which helps us better understand complex information, organize our thoughts, and improve our ability to think and communicate.
• Invert, always invert. You can avoid a lot of pain by visualizing your life after losing a lot of money trading or speculating using derivatives or leverage. If the visuals unnerve you, don’t do anything that could get you remotely close to reaching such a situation.
• Vicariously learn from others throughout life. Embrace everlasting humility to succeed in this endeavor.
• Embrace the power of long-term compounding. All the great things in life come from compound interest.

Obtain Worldly Wisdom

Obtaining Worldly Wisdom Through a Latticework of Mental Models

The author advises making numerous decisions in our lives. Building mental models assist us do the job better. 

What exactly are Mental Models?

Each discipline's key ideas are represented by mental models (e.g., mathematics, physics, accounting, etc.). It's a mental framework or worldview that helps us to understand how the world works.

Traditionally, we studied subjects separately in school. In our brain, information about each topic is organized into distinct folders – Math, Science, Arts, and so on. As a result, there is frequently a lack of synthesis between subjects.

This learning style, however, does not reflect the complexities of the real world. Forces from various fields of varying magnitudes shape our outcomes.

We can see the many forces at work by combining information from various disciplines. This enables us to solve problems effectively.

The interaction is referred to as a "Latticework of Mental Models" by Charlie Munger.

What is the significance of Mental Models?

The stock market is made up of more than just numbers and equations. Fundamentally, the market is driven by humans, who experience a wide range of emotions. As a result, taking a purely quantitative approach while ignoring human nature will not succeed as investors.

Increasing the mental model repertoire allows the investors to think critically. Avoid human biases and common psychological pitfalls when making investment and life decisions.

Harnessing The Power Of Passion

“I fear not the man who has practiced 10,000 kicks once, but I fear the man who has practiced one kick 10,000 times.” —Bruce Lee.

In this unit, the author highlights the importance of passion and practice.

1) Identify your interests and strengths and allow them to guide you

Experiment with new activities and hobbies to find those that bring you joy and motivate you to improve. Allowing the interests to guide your choices will bring you more satisfaction and success.

2) Deliberate practice leads to perfection

Excellence is not something we are born with; it is something we achieve through practice and perseverance. To be successful, the practice must be deliberate: one must set a goal for themselves and devise a plan to achieve it. One should also consider finding a mentor from whom they can learn firsthand.

The Importance Of Choosing The Right Role Models

In this unit, Mr. Baid emphasizes the importance of choosing the right role models, teachers, and associates in life.

It is critical in life to find the right mentors and peers. They can assist you in accelerating your life and overall growth. 

Trust and dependability are crucial. Establish trust with others by having open and honest conversations. Be genuine and show your true self.

Always be dependable, and never overpromise and underdeliver (do the opposite). When actions meet words, trust is earned.

Humility Is The Gateway To Attaining Wisdom

"The more successful you are at something, the more convinced you are that you are doing it correctly. The more confident you are that you are doing everything correctly, the less open to change.”Morgan Housel 

The less open you are to change, the more likely you are to trip in a world that is constantly changing. There are a million ways to get rich. But there is only one way to stay rich: humility, often to the point of paranoia.

The irony is that few things squash humility more than become wealthy in the first place. It's why the composition of Dow Jones companies changes so dramatically over time and why the Forbes list of billionaires has a 60 percent turnover every decade. But, of course, humility does not imply taking fewer risks. Sequoia Capital (Venture Capital Company) takes just as many risks today as it did 30 years ago.

But it has taken risks in new industries, with new approaches, and new partners, cognizant that what worked yesterday isn’t what will work tomorrow.

The Virtues Of Philanthropy And Good Karma

The author shared an incident when his senior warned him regarding one of his investments. It was about to default. It was trying to defraud his lenders by artificially inflating its asset  size, on its books of accounts to get bigger loans from the banks. 

Before the news broke in the media, the author could exit the stock a few days earlier at a handsome profit.

When the author called his senior to thank him and ask why he had helped him by sharing such sensitive information, these were his words: “Because you always used to share helpful company and industry data with me from time to time, even when I never asked you for it. You helped me then; I helped you now.”

The author emphasizes doing good karma.

Simplicity Is The Ultimate Sophistication

The author emphasizes simplicity as it helps us make better decisions by breaking down complex problems into parts. 

For example, one should ask four inverted questions whenever they are looking at a stock. These questions break the mindset of finding supportive bullish reasons and force you  to seek out disconfirming evidence actively. 

1. How can I lose money? Versus How can I make money? 

Again, if you focus on preventing the downside, the upside takes care of itself. 

2. What is this stock not worth of? Versus What is this stock going to be worth?

If you can identify the floor price or a low price for a stock. 

3. What can go wrong? Versus What growth drivers are there?

Rather than focusing on the growth catalysts, think probabilistically about a range of possible outcomes, and contemplate the potential risks, especially those that have never occurred. 

4. What is the growth rate being implied by the market in the current valuation of the stock? Versus What is my future growth rate assumption?

a reverse discounted cash flow fleshes out the current assumptions of the market for the stock. Then the investor can compare the market’s assumptions with their own and make a decision accordingly.

Achieving Financial Independence

Financial independence is essential. Saving and investing are crucial steps towards financial independence. It is attainable by anyone.

For example, Warren Buffett's business partner, Charlie Munger, was not born wealthy, but he is now rich. It should be noted that financial independence does not imply a lack of employment.

Using Munger’s life as a blueprint, one can observe a pathway toward achieving financial independence.

• Work hard, get an education, develop valuable skills. 
• Use that worked career and save up to ten times your living expenses. 
• To accelerate wealth accumulation, you can take some risk and start some sort of business. You need something that scales, something that is not paid by the hour or the month. 
• At some point, your investments will earn enough passive income to support your living expenses. This is when you achieve financial independence. It doesn’t matter what you do during the day, because you earn enough money while sleeping. 

Many people choose to continue along with one of the paths above:

(1) Employee-based career 
(2) Active business management
(3) Actively managing their investments

Living Life According To The Inner Scorecard

The Inner Scorecard comes from within and speaks your truth. It defines who you are and how you operate based on your values and beliefs. In a nutshell, it's taking the higher road to success.

Buffett lives by his Inner Scorecard, which is one of his defining characteristics. He also believes that living with our Inner Scorecard can bring us happiness. 

1. Make sure that it is passed down to your children

The author emphasizes to learn from Buffett the importance of teaching your children the Inner Scorecard principle, which his father taught him.

2. Surround yourself with people who are better than you

One of the most valuable lessons the author has learned is the opportunity to learn from my mentors, who are more experienced entrepreneurs and leaders further down the road. 

3. Recognized when to walk away

The author shares his learnings from Buffett that he learned to say no to things and opportunities that did not speak his truth. He then concentrated on saying yes to the few things that were truly important to him. "The difference between successful people and really successful people is that really successful people say no to almost everything.”

4. Make the most important decisions with integrity

When leaders make decisions with integrity, you can see their true character. You don't question who they are or whether they are looking out for your best interests (because they always do).

Another lesson he learned from Buffett was that he would agree that integrity is the most essential trait to look for in a job candidate, especially during the interview process. 

As he has previously stated, "When we hire people, we look for three things. We look for intelligence, initiative, or energy, as well as integrity. And if they lack the latter, the first two will kill you because if you're going to get someone without integrity, you want them to be lazy and stupid."

Delayed Gratification

The Key to Success in Life Is Delayed Gratification

Most investors are looking for ways to make a quick buck; however, the best investors postpone their gratification to reap more significant returns in the future.To become a good investor, you must learn to manage your emotional ups and downs.

Stock price fluctuations in the short term should not cause you to panic and sell the stock if your thesis and the company's fundamentals remain unchanged.Furthermore, regardless of whether the crowd agrees or disagrees with you, you should not be motivated by it. 

Temperament is essential.

The concept of delayed gratification also applies in business. The ability to "delay gratification" is a crucial characteristic of good management. Today's successful companies have leadership that is concerned with the long-term prospects of the business rather than the short-term metrics.

Most companies' management is under pressure to report good quarterly numbers to meet Wall Street's expectations. As a result, high-profit margins, rapid growth in reported EPS, all of these near-term figures are boosted. On the other hand, some businesses focus on increasing shareholder value.For instance, consider Amazon. It took Amazon 14 years after their initial public offering in 1997 to turn a profit.This would not have been possible if management had chosen to give in to Wall Street pressure and boost their numbers to meet analysts' expectations in the short term. Instead, Jeff Bezos is dead set on making Amazon the most customer-centric company on the planet. Indeed, deferring gratification yields profitable returns; Amazon's early losses are a speck of dust in the grand scheme of things.

Most businesses cannot afford to take a hit to their short-term earnings. 

As an investor, you should consider the following questions:

•Are you investing in a company that can suffer and endure "short-term pain for long-term gain"?

•Is the company able to reinvest to maintain a long-term competitive advantage?

•What is the ROIC (return on invested capital)?

Anshul Khare once said, "In the early years...compounding tests your patience, and in later years, your bewilderment."

Building Earning Power

The author tells when an investor buys a stock; they should approach it as if they are running the business. Purchasing listed stocks has several advantages such as, investors have the freedom to buy and sell stocks whenever they want. It only takes a small amount of money to invest in stocks and become a business owner. 

As an investor, your money works for you 24 hours a day, seven days a week. Moreover, you’re getting richer by the second, thanks to the increasing intrinsic value of your businesses. As businesses expand and become more profitable, stockholders benefit from increased profits and dividends. 
Therefore, Invest for the long term.

Investing Between The Lines

The author shares a few ideas from a book that can help you decode CEO communication in this unit.

Capital Stewardship

Companies that earn superior long-term returns are concerned with stewarding or managing investor capital. Rittenhouse expresses himself as follows:

As an investor, the goal is to find companies led by leaders who are good managers of capital and hold themselves accountable for their actions. Capital stewardship reveals whether a CEO's actions are motivated by a desire to be entrusted with or entitled to investor capital.

To ensure the presence of capital stewardship, look for clues in shareholder letters and other executive communications about the following topics:

• Capital discipline - Good capital allocators will typically comment on "returns on investment (ROI)," "returns on invested capital (ROIC)," or "returns on assets (ROA)." Commentary about "book or market value" expresses the strength or weakness of a CEO's capital discipline. 
• Cash and cash flow - Strong recurring cash flows are critical for a company's long-term viability. Given its significance, investors may anticipate that each shareholder letter will include commentary on operating and free cash flow. However, most letters fail to mention this point. Most CEOs only give it lip service. Look for CEOs who place a high value on cash flows and have written extensively about them. Examine a company's balance sheet and cash flow financial statements to see if the cash flow numbers listed in the financial statements correspond to the numbers in the communication.
• Operating and financial goals - Meaningful financial goal statements show that a CEO is serious about capital allocation efficiency. Good CEOs provide meaningful context that is quantifiable rather than making a subjective remark. Therefore, Capital stewardship is demonstrated by CEOs who publish meaningful financial and operational goals and focus on capital discipline, cash flow, and balance sheet management.

Candour

Candour is the language of trust, and it entails more than simply telling the truth. It entails being genuine with your words. Candid communication reduces the risk of self-deception. 

You don't need special access to "insider" information to evaluate the management's quality. The secret is written in black and white in every shareholder letter, annual report, and corporate correspondence you receive from management. You can make an educated guess about management quality and intentions once you learn how to read between the lines in the annual letter.

Keep in mind that analysing words is just as important as analysing numbers.

Decision-Making

Checklists are helpful when making decisions. They also assist us in avoiding overconfidence in our abilities. When it comes to investing, investors must ask the right questions. Good answers will only come from asking the right questions, which will aid in decision-making.

Learn about the company and its competitors from company websites, filings, and information on the Internet. Read the past ten years’ worth of annual reports, proxies, notes, and schedules to the financial statements, and management discussion and analysis  also observe the recent trends in insider shareholding.

After the investor has concluded the initial groundwork, the author advises studying the following parameters in a checklist fashion.

1. Income Statement Analysis

Sales growth - The higher sales growth is, the better (provided it is profitable). Over the long term, stock returns are highly correlated to sales growth. Organic growth driven by internal accruals is most desirable. Be cautious of high growth driven primarily by big-ticket acquisitions.

Gross profit margin - Focus on the trend over the years. If it fluctuates a lot in a cyclical manner, it means that the company does not have pricing power over its customers and cannot pass on the increase in raw material costs. 
On the contrary, if it is high and stable or improving over the years, the company in question may have an economic moat. 

Interest income (usually shown as “other income”)- Check the cash and investments figure on the balance sheet. If the interest income is not at least equal to the bank’s fixed deposit return, then analyze it deeper to see where the company has invested its cash.

Interest expense - A low-interest expense or a high-interest coverage ratio should never be taken at face value. Always check whether the company has been capitalizing on the interest cost. 
Multiply the total debt figure by the prevailing rate of interest for similarly
rated corporations and compare that figure with the total interest expense number used to calculate the interest coverage ratio.

Employee cost - The reported figure may be grossly out of line in fraudulent companies when evaluated against the existing number of employees stated in the company filings or on the website.

Other expenses - Several miscellaneous expenses are aggregated under this heading, making for a rich conduit for leakage. A sharp rise in “other expenses” in a depressed market or slowing economy could symbolize money is being siphoned off.

Taxes - The tax payout ratio should be near the standard corporate tax rate. If it is low, check whether the company has accumulated losses from the past or is enjoying tax incentives from operating out of a special economic zone or other tax-advantaged jurisdictions.

Net profit margin - The higher this margin is, the better. Be aware of companies that show high sales growth with declining profit margins. Companies that chase growth at the cost of profitability usually do not create sustainable wealth for shareholders.

2. Cash Flow Analysis

Cash flow from operating activity (CFO) - The higher the CFO is, the better. Compare the CFO with net profit over the years to see whether the funds are getting stuck in or released from working capital.

Capital expenditure (CAPEX) - Compare CAPEX with the CFO to see whether the company can fund its capital expenditures from its operating cash flow. Companies that show high sales growth without much CAPEX potentially could be capital-light compounders.

Total debt - The lower the debt is, the better. High debt (for non-finance businesses) signifies living beyond one’s means. Avoid companies that heavily depend on the kindness of strangers.

Cash balances - Extremely high cash levels in companies that do not pay dividends should be viewed with caution. The cash shown on the balance sheet may be fictitious.

Free cash flow (FCF)- It is the discretionary surplus that can be distributed to reward shareholders. The higher the proportion of FCF out of the CFO, the better. If FCF is negative and the dividend is continuously funded by debt, the investor should not take any comfort from a high dividend yield. If a company cannot generate FCF, then it may be the equivalent of a perpetual Ponzi scheme. 

Remember, intrinsic value is derived from the cash taken out of a business during its lifetime. When a company reports profits but bleeds money, believe the money. The most common symptoms of falsified earnings are negative free cash flow accompanied by rising debt, increasing shares outstanding, and bloating receivables, inventory, non-current investments, and intangibles.

3. Return Ratios Analysis

Self-sustainable growth rate (SSGR) - This represents the debt-free SSGR potential of a company. Companies growing at a higher rate than SSGR use more resources than their inherent operations generate, and they experience increasing debt levels.

An SSGR higher than the sales growth rate is desirable. 

Profit before tax/average net fixed assets 
The higher this ratio is, the better. A company should earn more on its tangible assets ( tangible equity and capital employed) than the bank’s fixed deposit rate. 

Pretax Return on tangible equity 
The higher the pretax return is, the better. Tangible equity is calculated by subtracting intangible assets and preferred equity from the company’s book value. 
Be cautious of companies for which the high return on equity figure is being primarily driven by higher leverage.

Return on capital employed 
The higher this return is, the better. This is calculated as earnings before interest and taxes, divided by capital employed.

4. Operating Efficiency Analysis

Net fixed asset turnover ratio - The higher this ratio is, the better. A high ratio shows that the company efficiently sweats its fixed assets.

Receivables days - The lower the number of days, the better. A higher number means that the company is giving customers a more extended credit period to generate sales. In the case of fictitious sales, in which cash is not received from customers, the number of receivables days will constantly increase.

Inventory turnover ratio - The higher this ratio is, the better. Lower inventory turnover means that the company is accumulating a lot of inventory (which might become obsolete later).

5. Balance Sheet Analysis

Net fixed assets
Look for sharp increases in this figure on the balance sheet. These increases signify that the company has completed a CAPEX program, which could drive higher sales and profits in the future.

Capital work in progress 
Look for sharp increases in this figure on the balance sheet. These increases signify that the company is currently undertaking a CAPEX program, which may be on the verge of completion.

Share capital 
Ideally, the share count should be constant over the years or decrease because of buyback. An increase in share capital that is not due to bonus shares represents a dilution of existing shareholders. 
Keep in mind that stock splits and bonuses affect only the liquidity of a stock, not its intrinsic value.

Debt-to-equity ratio - The lower this ratio is, the better. Check for off-balance sheet exposures like underfunded pension liabilities, disputed legal claims, non-cancelable operating leases, and contingent liabilities like corporate guarantees for loans taken by promoter-owned group entities. 
Test the debt serviceability through interest coverage (earnings before interest and taxes/interest) and FCF. A company may have a low debt-to-equity ratio but still face financial stress if the cash is insufficient to meet the near-term payment obligations.

6. Management Analysis

Study the background and credentials of promoters and search the Internet for any corporate governance issues. 

Management red flags include exorbitant salaries, perks, and commissions (most worrisome if paid during a period of losses); a high percentage of insider holdings being pledged; promoters merging their weaker privately-owned companies into their publicly listed company; engaging in significant related-party transactions; appointing relatives who lack adequate qualifications; using aggressive accounting practices; frequently changing auditors; changing the company name to include buzzwords from the hot sectors currently in high demand; and engaging in overly promotional activities, such as quoting broker reports for its revenue or profit guidance and issuing frequent but meaningless press releases and announcements. 

Always read the “Liquidity and Capital Resources” section in annual and quarterly SEC (Securities and Exchange Commission) filings to assess the capital-raising needs of the business you are researching.

Checklist For The Standard Causes Of Human Misjudgment

Charlie Munger prepared a psychological checklist for the standard causes of human misjudgment. They are: 

Bias from mere association
This bias automatically connects a stimulus with pain or pleasure. It includes liking or disliking something associated with something good or bad and seeing situations as identical because they seem similar.

Underestimating the power of rewards and punishment 

People repeat actions that result in rewards and avoid actions for which they are punished. If people don’t have to pay for a benefit, they tend to overuse it. After success, we become overly optimistic risk-takers. After a failure, we become overly pessimistic and risk-averse. 

This happens even in cases in which success or failure was merely a result of chance. We do not improve the man we hang; we improve others by him. 

Tie incentives to performance. This ensure that people share both the upsides and downsides. Make them understand the link between their performance, their reward, and what you want to accomplish. Reward individual performance, not effort or length of time in the organization. 

Underestimating bias from one’s self-interest and incentives 

Persuade others by asking them questions that highlight the consequences of their actions—appeal to interest, not to reason. 

Self-serving bias 
This bias encourages an overly positive view of our abilities or being overly optimistic. Successes always draw far more attention in the media than failures. The more we think we know about a subject, the less willing we are to use other ideas. We solve a problem in a way that agrees with our method of expertise. Always ask, “How might I be wrong?” 

Self-deception and denial 
When we practice denial, we engage in a distortion of reality to reduce pain. This includes wishful thinking. 

Bias from consistency and commitment tendency
This bias causes us to remain consistent with prior commitments and ideas, even in the face of disconfirming evidence. This includes confirmation bias—that is, looking for evidence that confirms our beliefs and ignoring or distorting disconfirming evidence to reduce the stress from cognitive dissonance. We tend to double down on our failed efforts because of the sunk cost fallacy. The more time or money we spend on something, the less likely we are to abandon it. When we have invested, we seek evidence to confirm that we made the right decision and ignore information that shows we made the wrong one. 

The more publicity a decision receives, the less likely it is that we will change it. Rigid convictions are more dangerous enemies of truth than lies. It is better to be correct than to be consistent. 

You are more likely to be suitable if you try to prove yourself wrong. Based on what you learn along the way, you should hold and explore conflicting possibilities in your mind while steadily advancing toward what is likely to be the truth.
 If you find yourself in a hole, stop digging. 

To admit you are wrong means you are wiser today than yesterday. The greatest enemy of the truth is the innate desire to win every argument. Learning is what happens when you end up justifiably agreeing with people who disagree with you. Welcome criticism when you see it is sincere, founded on knowledge and given in a spirit of helpfulness. Growth requires a steadfast commitment to pivot and adapt. Be open-minded and always triangulate your thesis with people who see things differently from you. By engaging them in thoughtful disagreement, you will better understand their reasoning and allow them to stress test your thoughts. In this way, you will raise your probability of being right. Remember, you are looking for the correct answer, not merely the best one you can come up with on your own. Just try to be right—it doesn’t matter if the correct answer comes from someone else. 

Bias from deprival syndrome 
This strong reaction comes when something we like and have is taken away or lost. It includes desiring and valuing more of what we can’t have. People respond to immediate threats. Anything that happens gradually tends to get ignored. If compliance practitioners want a person to take a risk, they try to make him feel as if he is behind.

Status quo bias and do-nothing syndrome
This bias keeps things the way they are. It minimizes effort and supports a preference for default options. 
Our unconscious mind rules our behavior. Our senses send our brains roughly 11 million bits of information per second— vastly more than our conscious processing capacity, which maxes out at an estimated fifty bits per second. 

Research studies show that this bias could be because challenging mental activities require more of the body’s essential fuel, glucose. When we avoid hard thinking, we save mental energy. We are programmed to be lazy and naturally inclined to follow the path of least resistance, that is, doing what is easy rather than required.

Impatience
When we are impatient, we value the present more highly than the future.

Bias from envy and jealousy
People will do many things to feel loved. They will do all things to be envied. 

Distortion by contrast comparison
This bias involves judging and perceiving the absolute magnitude of something not by itself but rather based only on its difference from something else when presented closely in time or space or from some earlier adaptation. This includes underestimating the consequences of gradual changes over time (low contrast).

Bias from anchoring
When we anchor, we overweigh certainly information (often arbitrary and meaningless) as a reference point for future decisions. Overinfluence from vivid or recent events. Always back up “stories” with facts and numbers. Many times, the data refute the anecdotes, but people still prefer to believe the latter. 

People’s minds usually don’t change with data when the subject matter is emotional or political.

Omission and abstract blindness 

When we experience this bias, we see only stimuli we encounter or that grab our attention, and we neglect important missing information . Today, millions of people do not win the lottery. We don’t see the quiet losers. We don’t see those who didn’t predict well. Missing information doesn’t draw our attention. This bias includes inattentional blindness.

Bias from reciprocation tendency 
We repay in kind what others have done for or to us. This bias includes favors, concessions, attitudes, and information sharing.

Bias from over influenced by liking tendency 
We believe, trust, and agree with people we know and like. This includes bias from excessive desire for social acceptance. It also provides bias from disliking—our tendency to disagree with people we don’t like, even though they may be right.
A reasonable person can make a flawed argument. An evil person can make a good argument. Judge the argument, not the person. Practice intellectual integrity. 

Bias from over influenced by social proof
We imitate the behavior of “similar others.” This bias includes crowd folly. When all are accountable, no one is accountable.

Bias from over influenced by authority
We tend to trust and obey perceived authorities or experts.

Sensemaking 
When we construct explanations that fit an outcome, we may act too quickly to draw sound conclusions, thinking events that have happened were predictable in advance. In hindsight, everything seems obvious. Constantly assess the quality of previous decisions in the context of the time at which they were made.

Reason respecting
We often comply with requests merely because we have been explained. If you always tell people why they will consider it more meaningful, and they will be more likely to comply. People are moved more by what they feel than by what they understand. 

Believing first and doubting later 
Unfortunately, it can be easy to believe what is not true when in a distracted state.

Memory limitations 
This causes us to remember selectively and wrongly. This bias includes influence by suggestions.

Do-something syndrome
We may be prone to take some action just for the sake of being active.

Mental confusion from the say-something syndrome
We often feel a need to say something when we have nothing to say. But, as the saying goes, “Better to remain silent and be thought a fool than to speak and remove all doubt.” 

Emotional arousal 

It is easy to make hasty judgments under the influence of intense emotions. This includes exaggerating the emotional impact of future events.

During the research process, conduct an honest emotional self-check. Write down how you are feeling and the main reason you want to buy the stock in question. Are you buying just because of the large amount of research and effort you have put into the stock? Are you reluctant to accept differing opinions? Resist the urge to buy first and study later. Avoid buying just because others are buying the stock and making a lot of money off of it. Do not fall prey to the fear of missing out. If necessary, take a break and clear your mind. 

Every investor needs to build a checklist based on personal experiences, knowledge, and previous mistakes. A checklist created in this manner would be most beneficial. 

Journaling

Journaling Is a Powerful Tool for Self-Reflection

A  journal allows you to collect accurate and honest feedback on what you think when making decisions. This feedback enables you to recognize when you were simply unlucky. Sometimes things work out well for reasons other than what we expected. This feedback loop is critical because the mind cannot provide it on its own.

 We don't know as much as we think we do. We are duped into believing that we understand something when we do not, and we have no way of correcting ourselves. To preserve our sense of self, our minds revise history. The story we tell ourselves conjures up a linear cause-and-effect relationship between our decision and the actual outcome. 

A  journal is the most effective treatment for this cognitive malfunction.

Conducting a premortem in investing allows us to take appropriate corrective action on time in the future. 

For example, imagine that a year has passed since the date of your purchase and that you have lost money on your investment, even in a stable market. Now, write down what went wrong in the future on a piece of paper. This "prospective hindsight" technique forces you to broaden your thinking, consider a wide range of outcomes, and focus your attention on potential sources of downside risk that did not intuitively come to mind the first time you considered buying a stock. 

Visualizing various scenarios for variables beyond one's control also helps investors make better decisions about individual position sizing and portfolio construction.

Writing is not only a communication tool; it is also a thinking tool. It is nearly impossible to write one thing while thinking about another. When you force your hand to write something, it channels your thoughts in the same direction. So journaling turns out to be a tool for thinking and a highly effective medium for focusing our thoughts. It has therapeutic benefits as well. 

We are writing to aid self-reflection, which is a great way to alleviate any unhappiness in our lives. Writing also improves our memory because we remember more when we write down our thoughts and learning.

Power Of Incentives

One should never underestimate the Power of Incentives.

This demonstrates how the interaction of multiple behavioral biases leads to extreme, irrational outcomes. Financial incentives include prestige, freedom, time, titles, power, and admiration. All of these are strong inducements. 
According to Munger, few forces are more powerful, than incentives:

 "Anytime you create large differences in commissions where the guy gets X percent for selling A, which is some mundane security, and ten times X for selling B, which is something toxic, you know what's going to happen."

Because incentive-caused bias occurs automatically and subconsciously, you may be led to believe that what is good for you is also suitable for the client.

Avoid Physics Envy

Always Think About the Math, but Avoid Physics Envy

Munger teaches us how to think about arriving at a potential future value, which we can then compare to the current market value of the business to calculate expected return. 

In this instance when calculating potential future value, we are forced to think in terms of the math implicit in our assumptions. This method is commonly referred to in finance as performing a "reverse discounted cash flow" operation. 

Let's use a simple hypothetical example to explain:

Assume that, we want to buy stock in Company X, which has a market capitalization of $1 billion. We assume that there are no dividends, stock options, debt, or off-balance-sheet obligations for the sake of simplicity.

The company has $40 million in owner earnings and a ten-year average annual growth rate of 10%. (the explicit forecasting period in this example). This equates to $104 million in owner earnings in year ten.

Assume that the market pays an average multiple of 15 on owner earnings for this type of business and that no valuation rerating or de-rating occurs during the interim period. In year 10, this equates to a market value of $1.56 billion. In comparison to the current market value of $1 billion, this implies a 4.5 percent annual return. Simply compare this to the expected returns on the other investment options available to you. If the expected return over the next ten years is not even equal to the yield on the top-rated sovereign bond, then owning this stock at the current price would be irrational.

A business may have great economic characteristics, but if the expected returns are greatly inferior when compared with existing alternatives, investors should avoid it. Suppose we want to know under what scenario we could earn a 15 percent annual return from this stock. 

What assumptions would be required to hold true to achieve this—and, more important, are they reasonable?

A present market value of $1 billion and an annual return of 15 percent leads to $4 billion in market value in year 10. An exit multiple of 15× suggests owner earnings of $270 million in year 10. This implies an average annual growth rate of 21 percent in owner earnings (on the initial starting point of $40 million). A hypothetical profit margin of 15 percent suggests sales of $1.8 billion in year 10. This implies a 21 percent annual growth rate in sales for ten years. 

Now we can work with the various assumptions regarding required sales volume growth, trends in sales realization per unit, market share, and so on, and we can assess whether these are reasonable, given the past trends and track record of volume growth, pricing power, profit margins, market size, market share, and competitive advantage. 

We also can find out which factor has the greatest impact on future owner earnings and under what circumstances it could change. We then could engage accordingly in a constructive “pre mortem” exercise.

To build in multiple redundancies to act as sources of margin of safety, we should always use conservative assumptions. 

We should avoid assuming future growth rates significantly in excess of historical growth rates (both long term and short term), use a reasonable exit multiple at the end of the explicit forecasting period, and apply the method only on stable business models.

The benefits of thinking in terms of long-term expected return rather than a precise current intrinsic value are numerous. This method forces the mind to consider future value drivers. It assists us in determining the appropriate position sizing by comparing the competing investment alternatives available within our circle of competence objectively. It enables us to select only simple businesses with relatively predictable futures. This model cannot be applied to fast-moving technology businesses, but it can be applied to moated businesses that meet basic human needs and aspirations in a relatively unsaturated market with a long growth runway. The rate of change in these businesses' business models is typically slower.

Intelligent Investing

Intelligent Investing is all about understanding Intrinsic value

Warren Buffett has described intrinsic value as private owner value, the price that an informed buyer would pay for the entire business and its future stream of cash.

The earnings used for valuation purposes by  investors are the owner’s earnings. 

Net income and EPS are figures reported according to accounting principles, but the actual cash that the business owner can withdraw differs. Owner earnings tell us how much money comes into the business owner’s pockets, which is supposed to be actual, spendable cash, not inventory and receivables. 

This is why Buffett refers to it as "owner earnings."

The longer the competitive advantage period (CAP), the more likely a business is worth a lot more than what the market thinks. “Durability” of the moat is the critical factor.

Ten dollars of earnings from a capital-light business like Moody’s, with its low reinvestment requirements, is worth a lot more than the exact earnings figure from a capital-intensive industry like General Dynamics, so investors should capitalize each of them differently. 

Investors have to look at each business’s earning power, along with the company’s prospects, to decide how much they are willing to pay to acquire that business’s future cash flows.

The traditional “value investor” mentality of buying cheap securities, waiting for them to bounce back to “intrinsic value,” selling and moving onto the next opportunity, is flawed. 

In today’s world of instant information and fast-paced innovation, cheap securities increasingly appear to be value traps; often, they are companies ailing from technological disruption and long-term decline. This rapid recycling of capital also creates an enormous drag on our after-tax returns. In addition, by focusing on these opportunities, we incur substantial opportunity costs by not concentrating instead on the tremendous opportunities created by the exceptional innovation.

Another Important thing which the author focuses on is switching from a high P/E stock to one with a low P/E which proves to be a mistake. 

Value traps are abundant and all pervasive. Everything trades at the level it does for a reason. High quality tends to trade at expensive valuation and junk or poor quality is frequently available at cheap valuation. 

It took him many years to learn this big market lesson: expensive is expensive for a reason and cheap is cheap for a reason. In the stock market, prices usually move first, and the reported fundamentals follow. 

(For instance,  debt issued by listed companies, stock price behavior usually turns out to be a more accurate barometer for gauging the probability than ratings given by the credit rating agencies.)

 A plummeting stock price (in an otherwise steady market) often turns out to be an accurate harbinger of deteriorating fundamentals for a company. Think about this before you jump in to buy. 

Avoid investing in melting ice cubes. What appears to be cheap or relatively inexpensive can continue becoming cheaper if industry headwinds intensify. An irrational fall in price makes a stock cheaper. A rational fall in price makes a stock more expensive. Many of the high dividend-yield stocks in expensive markets eventually turn out to be value traps and destroy wealth.

When you see a deep value stock suddenly break down on high volumes with no visible explanation, take notice. You are likely observing a value trap. Value traps are businesses that look cheap but actually are expensive. This could happen for a variety of reasons:

Cyclicality of earnings
 A low P/E stock may look cheap because the business is enjoying cyclically peak earnings, but the normalized P/E may not really be low if adjusted for cyclicality.

App risk
A taxi company may look cheap based on past earning power, but that may have existed only until Uber arrived.

Bad capital allocation by the management 
The market may correctly be punishing a business by assigning a low multiple to its earnings because the managers keep burning cash in bad projects and there is no prospect of such misallocation to be stopped.
 

Governance issues
A business run by a crook may appear to be quite cheap relative to the large amount of cash reported on its books, until that cash is completely siphoned off. Give zero valuation to the cash held in the books of a business being run for social purposes or owned by shady promoters. Gains in intrinsic value often are not reflected in realized returns for investors because insiders channel the gains to themselves.

Avoid partnering with such forms of management even if it comes at the cost of missing an opportunity. The notional loss from not capitalizing on an opportunity can be made up any time, but the eventual realized loss from partnering with a crook is permanent and irrecoverable.

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.

Investing Is All About Capital Cycle

A stock hitting a new high has no overhead supply to contend with and has much more of an open running field. Everybody has a profit; everybody is happy. In contrast, a stock near its fifty-two-week low has a great deal of overhead supply to work through and lacks upside momentum because it is vulnerable to fresh bouts of selling by the old investors at every higher level.

Even if you do not invest in any of the breakout stocks, the positive take away from this exercise would be that your mental database will have expanded by studying the annual reports, presentations, and conference call audio recordings and transcripts of the various companies in the industry. (Conference calls are a vital component of any serious investor’s research activity list.) 

For truly passionate investors, researching new companies is just delightful and never gets old. The importance of insatiable intellectual curiosity, along with a deep passion for continuous learning, cannot be overstated in the investing profession. 

In investing, all knowledge is cumulative, and the insights we acquire by putting in the effort today often serendipitously help us in the future. 

So work hard today to let good luck find you tomorrow.

Analyzing Special Situations

A global study conducted by consulting firm The Edge and accounting firm Deloitte examined 385 global spin offs involving parent companies with a market cap of $250 million or more from January 2000 to June 2014. To qualify, transactions had to be pure spinoffs, with parent company shareholders receiving shares in newly listed companies. The study discovered that during their first twelve months independent of the parent, the global asset class of spinoffs generated more than ten times the average gains of the MSCI World Index.

Consumer, health-care, utility, and energy sectors delivered the best results. Importantly, value creation was independent of economic growth or analyst coverage of the company. Within two years, two out of every ten spin-offs were acquired or taken private.

The performance of spinoffs in India is even more impressive. SBI Capital examined 154 spinoff transactions in India from 2002 to 2016 and demonstrated how spinoffs outperform broader market indices across market cycles. According to their research, spinoffs generate an average excess return of around 36% over the market index (Sensex).

When a promising but small-cap company demerged from a large-cap parent is listed and has residual institutional holding, a profitable opportunity often arises. During the first few weeks and months of trading, you will frequently see forced selling by institutions that are unable to hold the new stock in their portfolios due to certain rigid institutional mandates, such as being allowed to invest only in certain sectors or having market cap restrictions, and you will end up with significant paper losses on your existing holdings of the demerged company's shares.

Spinoffs are live case studies in time arbitrage, in which the patient investor is compensated for simply waiting and allowing the procedural formalities to play out. 

In India, a demerger typically consists of six steps: 

(1) Board approval
(2) Stock exchange approval
(3) Secured and unsecured creditors' and shareholders' approval
(4) National Company Law Tribunal final approval
(5) Record date announcement by the board 
(6) Listing of the demerged entity

When the listed conglomerate entity trades at a low valuation multiple, some of the most profitable demerger opportunities arise. However, once separated, the demerged entities would have traded at a much higher multiple, which is sometimes based on completely different valuation parameters than the currently listed parent entity.

Greenblatt then goes over five reasons why a parent might spin off a subsidiary:

1. Conglomerates typically trade at a "conglomerate discount." Management can "unlock" value by separating unrelated businesses. In other words, the total of the parts is greater than the sum of the parts.
2. To distinguish between a "bad" and a "good" business.
3. To generate value for a subsidiary that cannot be easily sold.
4. To recognise value while avoiding a large tax bill that would be incurred if the parent company pursued a sale rather than a spinoff.
5. To overcome a regulatory hurdle. A company, for example, may be in the process of being acquired. To address antitrust concerns, it may need to spin off a subsidiary.

The Holy Grail Of Long-Term Investing

A core test of success for a business is whether every dollar it invests generates a market value of more than that amount for the shareholders. 

Warren Buffett calls this the one-dollar test. He explained:

“Unrestricted earnings should be retained only when there is a reasonable prospect—backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future—that for every dollar retained by the corporation, at least one dollar of market value will be created for owners.

This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.”  

For an increase in earnings to be evaluated properly, it always should be compared with the incremental capital investment required to produce it.

When Buffett talks about a dollar of retained capital creating a dollar of market value (he prefers to apply this test on a five-year rolling basis), he talks about a dollar of intrinsic value. He implies that the stock market will be a fairly accurate judge of intrinsic value over time. 

A simple way to do a quick one-dollar test is to compare the change in a company’s beginning and ending market value over some time to the change in its beginning and ending retained earnings values. 

Buffett said the market, over time, will reward those companies that create high returns on the dollars they keep (by giving them a higher valuation multiple) and will punish those whose retained dollars fail to earn their keep (by giving them a lower valuation multiple).

According to Charlie Munger, “Over the long term, it is hard for a stock to earn a much better return than the business which underlies it earns.

 For example, if the business earns 6 percent on capital over 40 years and holds it for that 40 years, you’re not going to make much different than a 6 percent return even if you originally buy it at a huge discount. Conversely, if a business earns 18 percent on capital over 20 or 30 years, even if you pay an expensive-looking price, you’ll end up with a good result.” 

The math behind Munger’s assertion is easy to follow. An 18 percent return on invested capital (ROIC) over a multi decade period will dominate a 6 percent ROIC in shareholder returns. 

One of the biggest challenges in investing is determining the competitive advantage of a business and, more importantly, the durability and longevity of that advantage. 

Competitive advantage is defined as a company’s ability to generate “excess returns,” that is, ROIC less cost of capital. A sustainable competitive advantage is defined as a company’s ability to generate excess returns over an extended period, which requires barriers to entry to prevent competitors from entering the market and eroding the excess returns. This, in turn, enables excess returns on invested capital for extended periods (also known as the competitive advantage period, CAP). 

Growing companies with higher returns and more extended CAPs are more valuable in terms of net present value. This is because the value of a company's CAP is the sum of the estimated cash flows generated solely by these excess returns, discounted for the time value of money and the uncertainty of receiving those cash flows.

Buffett emphasized "moats" as the central pillar of his investing strategy. 

"The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors." 

Great businesses have an ever-increasing stream of earnings and almost no major capital requirements. As a result, they generate extremely high returns on incremental invested capital. All genuinely great businesses are constantly drowning in cash. They have infinitely high returns on capital because they require little tangible money to grow and are driven by intangible assets such as a company's brand name with "share of mind," intellectual property, or proprietary technology. Great companies typically have negative working capital, a low fixed asset intensity, and real pricing power.

Customers who pay cash upfront for goods or services delivered later have negative working capital. Customers are essentially financing the company's growth through prepayments, a powerful catalyst for a growing company. The best part is that the interest rate on this financing is 0%, which is challenging to beat.

Negative working capital is common in subscription-based business models where customers pay in advance for recurring services or access. Because revenue is recognized when the service is rendered, these companies typically have operating cash flow that exceeds net income after cash is received.

The franchisor business model involves the franchisor collecting royalties from franchisees in exchange for using the brand name, business plan, and other proprietary assets. As franchisees contribute capital to the construction of new locations, the overall system expands, allowing the franchisor to increase revenue and earnings without deploying additional capital. This business model is great if it can be scaled up because it is capital-light and generates a lot of free cash flow by simply leveraging the franchisor's brand-name equity.

This is why, Buffett said, "The best business is a royalty on the growth of others that requires little capital itself." Firms with low fixed asset intensity outsource their core manufacturing activities while focusing on design, marketing, and branding.

If the company offers a differentiated product or service, has high switching costs, or is critical to customers (while accounting for a negligible portion of the overall cost), it may consistently raise prices above inflation. Because the flow-through margins on price increases are typically relatively high, this method is the simplest way to grow earnings without additional capital.

 Companies like Bloomberg and See's Candies have a long history of raising prices at or above inflationary rates, and Buffett considers this to be one of the most important factors to consider when analyzing a business: "The single most important decision in evaluating a business is pricing power." 

“If you can raise prices without losing business to a competitor, you have a great company."

Great companies are uncommon, scarce, and thus valuable. When the market predicts the longevity of growth with a high degree of certainty, they are usually given rich valuation multiples. Indeed, in today's world of rapid change, the longevity of development is becoming increasingly scarce. In the 1960s, the average time a company was in the S&P 500 was about sixty years. Today's average is only ten years. Fewer than 12% of the Fortune 500 companies in 1955 were still on the list in 2017, and 88% of the companies in 1955 had either gone bankrupt or merged with (or were acquired by) another firm. They are no longer among the top Fortune 500 corporations (as ranked by total revenues) if they still exist. 

This is the epitome of Joseph Schumpeter's "creative destruction."

The market places a high value on certainty. Stocks that promise years of predictable earnings growth tend to overvalue for a long time until they can no longer grow earnings steadily. The market values predictability of long-term growth more than the total rate of near-term growth, so a stock that promises to increase earnings at 50% for the next couple of years with no clarity after that receives a lower valuation multiple than a stock that has slower but highly predictable growth over a much more extended period.

Consistent growth raises valuation while constant disruption lowers valuation.

The market always gives longevity of growth more weight than the absolute growth rate, so stocks with 12 to 15 percent predictable earnings growth for the next ten to fifteen years often have current year price-to-earnings (P/E) multiples of 40 to 50. Most new investors are perplexed by this phenomenon, but they learn to appreciate the market's finer nuances and respect its wisdom with time. Because investors in such stocks are generally willing to sit out periods of high valuation until earnings catch up, the expensive, high-quality secular growth stocks tend to remain at elevated valuations for extended periods. Markets reward companies that can promise years of consistent earnings growth at a disproportionately high rate.

The scarcity premium principle applies to the number of high-growth stocks available in a given sector as well as the overall market. 

For example, suppose only a few companies in the market can achieve such high growth rates. In that case, a company with a perceived sustainable growth rate of 30% to 35% often ends up with a P/E of 40 to 50 (or an even higher valuation that generally keeps expanding throughout the entire duration of the bull run, as long as the high growth expectations are intact). In contrast, a company growing at 20% may not get more than 15% to 20% P/E if many 20% growers are available. (This is why focusing solely on the P/E-to-growth ratio, also known as the PEG ratio, can result in suboptimal return outcomes.)

When growth is scarce, market breadth narrows, and demand-supply dynamics take over. Investors want the assurance that change will occur (whereas they are ready to take a leap of faith). During such times of uncertainty, the market's focus becomes exceptionally narrow, and valuations of a select few high-quality growth stocks continue to expand until their growth rate remains above-average in comparison to the majority of the market's stocks. (Most investors remain in denial during this stage, as these expensive stocks continue to rise in price.) When growth finally slows, the valuation de-rating begins.

The actual threat to a bull market stock is not excessive valuation but a sharp correction in the investor community's growth expectations. Valuations remain high until the company achieves above-average growth rates, at which point they become excessive. Markets adore companies that can persuade them that they can consistently provide above-average rates of change over more extended periods of year's high return, and they reward them with rich valuations.

Investors who have a bias against high P/E stocks miss out on some of the most outstanding stock market winners of all time. Over ten years or more, a high P/E company that grows earnings per share at a much faster rate will eventually outperform a lower P/E company that grows at a slower pace. This is true even if there is some valuation depreciation in the interim period for the former. So, when choosing between a 15% grower at 15 P/E and a 30% grower at 30 P/E, investors always go with the latter, especially when longevity is highly likely.

As investors, we are constantly looking for "emerging moats" to capitalize on the company's initial high growth years and subsequent valuation rerating. A lower-margin and higher-capital-intensive business-to-business (B2B) company transitioning into a higher-margin business-to-consumer (B2C) company with better terms of trade is an example. So even if we miss the initial high growth phase but identify these emerging moat businesses during their intermediate stages, we can create a lot of wealth over time.

To grow and produce reasonable returns on incremental invested capital, good businesses require significant reinvestment of earnings. As a result, many companies fall into the put-up-to-earn-more category.

Gruesome businesses earn less than their cost of capital while still striving for rapid growth, even if that growth necessitates large sums of additional money and destroys value. These companies are typically capital-intensive and subject to rapid technological obsolescence.

They never make any real economic profits because they are subject to the "Red Queen effect," which means that they either keep investing more and more capital in keeping up with competition and maintain their starting position or stop investing in new technology obliterated. (Debt, intense competition, and high capital intensity combine to form a lethal cocktail.)

 "The worst business of all is the one that grows a lot, where you're forced to grow just to stay in the game at all, and where you're reinvesting capital at a meager rate of return,"  Warren Buffett. Sometimes people are involved in those businesses without even realizing it."

As a result, the management of these companies frequently mindlessly mimics their competitors after succumbing to what Buffett refers to as the "institutional imperative." They are oblivious that they are constantly attempting to run up a down escalator whose pace has accelerated to the point where upward progress has ceased. As a result, they are caught off guard by the industry's rapid growth rate and fail to heed Benjamin Graham's caution: "Obvious prospects for physical growth in a business do not translate into obvious profits for investors."

Buffett learned this vital lesson from his teacher. "The key to investing is determining the competitive advantage of any given company and, above all, the durability of that advantage." So, be wary the next time an analyst or so-called market expert touts an industry's rapid growth rate as justification for investing in stocks within that industry. When all other factors are equal, a higher ROIC is always preferable. Unfortunately, the same cannot be said for expansion. Individual stocks and their economic characteristics are central to investing.

If you want to participate in the high growth rate of an industry with low profitability, do so indirectly through an ancillary industry with better economics and lower competition (the best-case scenario would be if it's a monopoly business and the sole supplier to all of the primary industry's players).

 For instance, the organized luggage industry in India (characterized by moderate competition) could be used as a proxy to profit from airline traffic growth (characterized by hyper-competition).

Buffett summarises the discussion with an excellent analogy: 

"To summarise, think of three types of savings accounts.”

The great one pays a highly high-interest rate that will rise as the year progresses. 
The good one offers a competitive interest rate, which is also earned on additional deposits. 
Finally, the dreadful account pays a pitiful interest rate and requires you to keep adding money at those pitiful returns.

We prefer businesses that drown in cash.

 An example of a different business is construction equipment. “You work hard all year, and there is your profit sitting in the yard. We avoid businesses like that. We prefer those that can write us a check at the end of the year.” —Charlie Munger.

The author adores that Munger mentions, which sends him a check from its owner's earnings every year. However, ideally, he looks for a company that will forego a review because it has appealing internal reinvestment opportunities. In other words, the author prefers a company that consistently generates high returns on invested capital and reinvests a significant portion of its earnings at similarly high returns. This is the long-term value investor's holy grail.

True internal compounding power produces two factors: 

Return on incremental invested capital and reinvestment rate. This compounding power creates enormous value over time.

Reinvested profit and compound interest are the two main concepts. Typically, "compounding machines" have a niche positioning or a long-term competitive advantage that allows them to achieve high returns on capital over time. The key to investing in these reinvestment moats is the conviction that the growth runway ahead is long and that the competitive advantages that generate those high returns will last or improve over time. When the author wants high-ROIC companies, he looks for a return on incremental invested capital (ROIC), a company’s return on its total investments over time.

Its returns on total invested capital determine the growth of an organization’s intrinsic value. ROI determines whether the susceptible change is good or bad. High growth is beneficial and adds value to companies with a large spread between ROIC and the cost of capital. All else being equal, faster growth translates directly into a higher P/E multiple for such companies. The value of high-ROIC companies is sensitive to changes in perceived growth rates.

In most cases, investors mix up incremental ROIC with ROCE (return on capital employed) or ROIC. Value creation is driven by ROI (return on investment less cost of capital). Even if legacy moat businesses with established franchises and few or no growth opportunities have a high return on invested capital, it is unlikely that you will achieve exceptional returns if you buy their stock today and hold it for ten years.

The company's high ROIC, in this case, reflects returns on initial invested capital rather than the incremental invested capital. In other words, a 20% reported ROIC today is not  worth as much to an investor if there aren't anymore 20% ROIC opportunities to reinvest the profits. Mature legacy moat businesses with high dividend yields may preserve capital, but they are not particularly good at compounding wealth.

The author prefers businesses that increase their intrinsic value over time. This type of growth provides a margin of safety in the valuation and the gap between price and intrinsic value, which widens over time as the business value grows. 

For example, if two businesses (Company A and Company B) have the same current ROIC of 20%, Company A can invest twice as much as Company B at that 20% rate of return. As a result, company A will create much more value for its owners over time than Company B. Both businesses will produce a 20% ROIC, but one is superior to the other. As a result, company A can reinvest a more significant portion of its earnings, resulting in more intrinsic value over time. As a result, the longer you own Company A, the greater the disparity between Company A's and Company B's earnings.

This is a crucial point that cannot be overstated. Although valuation is more critical in the short term, quality and growth are more important in the long term (seven to ten years and longer). The longer you own a stock, the more important the company's quality becomes. Your long-term returns will almost always approximate the internal compounding results of the company over time. It is far more important to invest in the right business than worrying about paying 10 or 20 or even 30 percent of current-year earnings. 

Many mediocre companies are available for less than ten earnings, resulting in mediocre long-term results for long-term owners.

The intrinsic value of the quality business increases over time, thus increasing the margin of safety in the event of a stagnant stock price. This is a pleasant situation because it creates antifragility for an investor. In contrast, if a business is shrinking its intrinsic value, time is your enemy. Therefore, you must sell it as soon as possible because the longer you hold it, the less it is worth.

You may wonder how to predict whether the attractive returns of the past will continue in the future. Buffett shared his insights on long-lasting businesses "The Fortune champions may surprise you in two ways." 

First, in comparison to their interest-paying capacity, most use very little leverage. Outstanding businesses rarely need to borrow. 

Second, except for one "high-tech" company and several others that manufacture ethical drugs, the companies are in industries that appear to be rather mundane on the whole. 

Most non-sexy products or services were sold the same way ten years ago (in more significant quantities now, or at higher prices, or both). The track record of these 25 companies demonstrates that maximizing an already strong business franchise or focusing on a single winning business theme is what typically produces exceptional economics."

In terms of percentages, the "statistically cheap" securities category is likely to have fewer errors—that is, fewer permanent capital losses—than the "high-quality compounder" category. This does not imply that one will perform better than the other, as a higher winning percentage does not always mean higher returns. However, focusing on high-quality businesses is more beneficial if you reduce "unforced errors" or lose investments. When you invest in high-quality compounders, your life as an investor becomes so much easier.

Buffett advises: “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually sure to be materially higher five, ten, and twenty years from now. Over time, you will find only a few companies that meet these standards—so when you see one that qualifies, you should buy a meaningful amount of stock. 

Consider that ₹20,000 invested in great companies (Hawkins, ITC, Titan, and HDFC Bank) increased nearly fivefold to ₹100,000 in five years. In contrast, the same money invested in gruesome companies (Reliance Communications, Reliance Capital, DLF, HDIL, and GMR Infra) was destroyed and would have been worth only ₹3,000. This led the author to one of the most important discoveries of the author’s investing career: great businesses created a lot of wealth even when measured from the peak of the previous bull market to the end of the subsequent bear market.

To achieve significant wealth creation, an investor-only needed to be disciplined and stay the course during turbulent times in the stock market. In the short term, liquidity and sentiment drive the market index, whereas individual company earnings drive stock prices over time. As a result, great businesses generate enormous wealth over long holding periods across market cycles, even in the face of negative macroeconomic headlines about high inflation, rising interest rates, geopolitical tensions, weak macroeconomic data points, and political uncertainty. But, on the other hand, whether the news is positive or negative, gruesome businesses eventually destroy wealth.

Connecting The Dots

We arrive at investing nirvana by combining the critical insights from this chapter: long-term ownership of competitively advantaged businesses with significant reinvestment potential, managed by excellent capital allocators and shareholder-friendly management teams.

Competitive Advantage 
Capitalism is ruthless. Excess returns entice competitors. Only a few select businesses have enjoyed excess returns by establishing structural competitive advantages or economic moats for many years. Excess returns over a long period increase the value of a business. Competitive advantages can be derived from various sources, including intangible assets such as brands, patents, and licenses, switching costs, network effects, and low-cost benefits.

Intangible Assets

Some companies (such as Apple) simply provide a far superior product or service to their competitors' products. In contrast, others offer a product or service of comparable quality to their competitors' products but are simply better at telling a story about that product (such as Tiffany & Co.). Businesses that rely primarily on telling a story are much more vulnerable to changes in consumer behavior. (The most lethal substitutes are less expensive and have at least one superior feature.) Branding has traditionally served two essential functions: ensuring minimum assured product quality and allowing people to express their identity in a social context.

Brands thrived in an environment of limited information, resulting in an asymmetrical relationship between customers and businesses. However, there are clear indications that this trend is coming to an end. Because there are few veils between a company and the public, brands must be authentic. In today's information age, everything is always on the record. In today's highly connected and well-informed world, the essential factor to consider when analyzing a company is its value to the customer.

Patents are another type of intangible asset. Patents grant legal monopolies (in the case of innovator companies), and a portfolio of patents is preferable to over-reliance on a single patent. Some regional or national monopolies sell products that customers find difficult to avoid, such as a toll road. (Buffett has frequently expressed his affection for toll roads in figurative terms, such as newspapers in one-newspaper towns.) Similarly, licenses and regulatory approvals confer legal oligopoly status (as with rating agencies) through regulatory fiat.

Switching Costs
Switching costs come in many forms and may be explicit (in the form of money and time) or psychological (resulting from deep-rooted loss aversion or status quo bias). These costs tend to be associated with critical products (such as Oracle’s SAP software) that are so tightly integrated with the customer’s business processes that it would be too disruptive and costly to switch vendors or products with high benefit-to-cost ratios (such as Moody’s).

Network Effects

The network effect advantage stems from providing a product or service that increases in value as the number of users increases, such as Airbnb, Visa, Uber, or the National Stock Exchange of India. This serves as a strong moat as long as pricing power is not abused and the user experience does not deteriorate. Creating a two-sided network, such as an auction or marketplace business, necessitates both buyers and sellers, and each group will show up only if they believe the other side will be present. Once this network is established, it becomes more robust as more participants from either side participate.

As more buyers arrive, more sellers are drawn in, attracting even more buyers. Once this powerful positive feedback loop is in place, convincing either the buyer or the seller to leave and join a new platform becomes nearly impossible. This type of business grows more robust as it expands and demonstrates accelerating real momentum.

Low-Cost Advantages

Low-cost advantages can be attributed to various factors, including process, scale, niche, and interconnectedness.

Process. Advantage occurs when a company develops a less expensive delivery method that cannot be easily replicated, as with Inditex (a Spanish multinational Clothing Company), GEICO (an American insurance company), or Southwest Airlines. 

Scale Advantage is gained when a company spreads fixed costs across a large base, as Costco and Nebraska Furniture Mart do. This is because the relative size in a market is more important than absolute size in isolation.
It gains a niche advantage when a company dominates an industry with a large minimum efficient scale relative to the total addressable market, such as Wabtec Corporation or Spirax-Sarco Engineering.

The relationship between new initiatives and existing lines of business. Companies benefit when their product lines or business segments are interconnected and reinforced (as with Hester Biosciences). Markel Corporation's Saurabh Madaan refers to this as the "octopus model." In the past, Phil Fisher has discussed this source of competitive advantage: "The investor usually obtains the best results in companies whose engineering or research is to a significant extent devoted to products having some business related to those already within the scope of company activities."

Because of their large customer base, low-cost producers can sell their products or services at a lower margin than competitors while still operating profitably. GEICO, the direct seller of automobile insurance to Americans, is an excellent example of a low-cost producer. GEICO has the lowest operating costs in its industry because it sells directly to customers rather than through insurance agents. "Others may copy our model, but they will be unable to replicate our economics," Buffett has said of GEICO's cost advantage over competitors. In addition, the more customers who buy from a low-cost producer, the broader its surgery cost advantage becomes over time, resulting in a "flywheel" that accelerates as the business grows.

Culture as a Moat

The author has spoken about the traditional competitive advantage sources, but culture is a much-underappreciated source of long-term and difficult-to-replicate competitive advantage. Companies like Berkshire Hathaway, Amazon, Costco, Kiewit Corporation, Constellation Software, and Markel Corporation, to name a few, best exemplify culture.

Consider the following example to demonstrate the critical importance of an organization's culture: Buffett did not use the word "culture" in his letters from 1957 to 1969; from 1970 to 2017, he used it more than thirty times. Businesses with a strong culture are more focused than their competitors on delivering an excellent customer value proposition and communicating about it effectively. Firms should ask customers what they want to achieve and measure success and failure to develop strong value propositions. (Instead, far too many businesses continue to ask customers what they want.) Customers are not solution experts.)

As investors, we seek companies that are obsessively concerned with the well-being of their customers and empathize with them more than their competitors. In addition, long-term investors care about culture because it empowers employees to perform their day-to-day tasks slightly better than their competitors. Over time, these minor advantages add up to much more significant benefits that can last far longer than conventional wisdom predicts.

When investing in businesses that are widening their moat, these businesses invariably turn out to be much cheaper than what our initial valuation work would have resulted in.

A large absolute market share (think GM) is not a moat. Without customer lock-in, great technology products (think GoPro) are not a moat, as commoditization and disruption are unavoidable. Hot products (such as Crocs) can generate high returns quickly, but long-term excess returns create a moat. When evaluating a company's moat, simply ask yourself how fast a competent competitor with unlimited financial resources could replicate it. If your competitors know your success formula but cannot replicate it, you have a strong moat.

Capital Allocation

Capital allocation serves as a link between the intrinsic value and the value of its shareholders. If a company has internal high-return investment opportunities, it should reinvest heavily. However, maturing companies frequently continue to invest despite declining or low returns on capital. (Aging is difficult for both businesses and individuals.) So instead, these companies should return the money through dividends or share buybacks. Dividends are essential not only for the apparent reason of idle cash but also as a discipline—for a company to pay a dividend, the profits must be genuine.

Remember that dividends aren't always a good thing if they're poorly funded (sometimes management takes on debt just to pay dividends) or if they're paid out instead of investing in high-net-present-value projects, which represents a significant opportunity cost.

The time to evaluate quality is before the price action begins, not after it has begun. Making the correct qualitative judgment about a business, including the long-term sustainability of its success attributes, is more important than the entry valuation over a long holding period. Overpaying for a growing high-quality franchise is acceptable within reason. If you must make a mistake, make it in terms of valuation rather than quality.

Market Is Not Efficient All Time

Small businesses face an interesting paradox: they are less well researched but also easier to study. Accounts are simpler, management is more accessible, and business segments are limited compared to larger companies. The market frequently misprices Small-cap companies because they are relatively illiquid and often ignored by larger participants.

Buying low and selling high is always a good strategy, and Mr. Market continues to provide us with plenty of opportunities to do so, even with long-lasting, well-established, and widely followed businesses. These companies are referred to as "stalwarts" by Peter Lynch. This is because they are large corporations with little room for expansion. However, you can occasionally buy them at a discount and sell them after a 30% to 50% increase, owing to the valuation multiple reverting to the mean rather than the business value increasing. 

Always keep in mind that stock prices fluctuate randomly every day, sometimes wildly on either side, whereas business value changes very slowly. Therein lies the abundance of opportunity. It is part of our evolutionary instincts to focus on what is moving. This explains why market participants are more concerned with stock prices, which fluctuate, rather than business values, which change slowly.

The primary factor we consider is liquidity, which is a combination of an economic overview. Contrary to popular belief, looking at the great bull markets of this century, the best environment for stocks is a very dull, slow economy that the Federal Reserve is attempting to kick-start.

Because of the tense environment, investors usually increase their efforts during a bear market, becoming complacent during a bull market. Instead, dream big, manage risk and increase your efforts to achieve financial independence early in life during a bull market. If you are fortunate enough to experience a bull market, make sure it makes a significant difference in your life. Make the most of a bull market to increase your earnings. Make the most of a downturn to learn.

The Dynamic Art Of Portfolio Management

The primary goal of any investment operation should always be to put together a portfolio that is best suited to meet the individual's personal life goals and financial needs. The only metric that any investor should be concerned with is whether they are on track to meet the objectives they set for their portfolio in the first place.

Investing is all about expectations, and the outcomes are influenced by changes in expectations, which cause changes in stock prices. As a result, the ability to correctly read market expectations and anticipate revisions to those expectations serves as the foundation for superior returns. To do so successfully, an investor must have "variant perception," that is, a well-founded view that differs significantly from the market consensus.

The Kelly Criterion

The Kelly criterion, developed by John L. Kelly and popularised by Ed Thorp's practical success, is a formula used to determine the optimal bet size for a given set of probabilities and payoffs. Although the formula can be expressed in a variety of ways, the following expanded version was published in Thorp's interview in the book-‘Hedge Fund Market Wizards’:

 
where:
F = Kelly criterion fraction of capital to bet,
PW = probability of winning the bet,
PL = probability of losing the bet,
$W = dollars won if bet is won, and
$L = dollars lost if bet is lost.

The Kelly criterion bet size will maximise capital in the long run if an individual knows the odds and payouts of a given bet with precision. One major issue is that people don't get precise odds, and they only get a reasonable picture of the payout in the rare special situation or arbitrage. Another difficulty is that, when using Kelly, the long run is based on the number of events rather than on a time frame. An investor who bets infrequently will find it difficult to make enough investments to reap the full long-term benefits of using Kelly.

Another significant limitation is that people tend to underestimate the importance of infrequent, high-impact events, also known as Taleb's black swans. When investors look to apply the Kelly criterion, the probability and magnitude of negative black swans may not be given the necessary consideration, and thus the formula, when applied by the human mind, may tend to overestimate “F”, and constant overestimation leads to disaster. 

So, anything greater than the optimal bet size will result in a total loss sooner or later.

Despite the practical difficulties and impediments in applying the Kelly criterion to real-world investing, the underlying logic behind it is extremely useful as a way to consider whether to establish a position in a given situation and, if so, what proportion of capital should be invested in that position.

Individual allocations in the author's portfolio are sized based on his assessment of potential risk, with the largest holdings having the lowest likelihood of permanent capital loss combined with above-average return potential. He starts new positions with a minimum weighting of 5% and then averages up if management outperforms my expectations. Individual position sizing is critical because of the impact it has on overall portfolio performance and mental peace of mind. If an individual position becomes an uncomfortably large percentage of his portfolio value, he sells down to his "sleeping point." 

So, always put more weight into companies that have a long track record of success, solid growth prospects, and disciplined capital allocators.

To Finish First, You Must First Finish

Without a doubt, some people have become extremely wealthy through the use of borrowed funds. However, it has also been a means of becoming extremely impoverished. When leverage works, your gains are multiplied. Your spouse thinks you're brilliant, and your neighbours are jealous. However, leverage is addictive. After benefiting from its wonders, very few people return to more conservative practices. As we all learned in third grade—and some re-learned in 2008 financial crisis—any series of positive numbers, no matter how impressive, vanishes when multiplied by a single zero. History has shown that leverage, even when used by very smart people, frequently results in zeroes.

Leverage, of course, can be lethal to businesses.

Companies with significant debts frequently believe that these obligations can be refinanced as they mature. In most cases, this assumption is correct. Occasionally, however, due to company-specific issues or a global credit shortage, maturities must be met by payment. Only cash will suffice for this. Borrowers then realise that credit is similar to oxygen. When either is plentiful, its presence is unnoticed. When either of them is absent, that is all that is noticed. Even a brief lack of credit can bring a company to its knees.

Maintain adequate liquidity (cash reserves) so that you are not forced to sell assets during times of market turbulence and sharp drawdowns. Create an emergency fund equal to two years of living expenses and gradually increase it to five years as your exposure to equities increases over time. Risk exists when you need to spend money but are unable to do so.

Nothing is worse for an investor than selling an asset at rock-bottom prices in order to raise funds for a necessary purchase. This is the primary distinction between those who become wealthy and those who do not—the wealthy invest in assets that generate recurring cash flow for them.

After recovering from a bear market, how much you can retain is far more critical than how much paper profit you make during a bull market. But the quality of business matters the most in maintaining long-term wealth.

Businesses with staying power have stable product characteristics:

• Substantial competitive advantage  
• Fragmented customer and supplier base 
• Prudent capital allocation
• Growth mindset with a razor-sharp focus on long-term profitability and sustainability.
• Corporate culture of intelligent and measured risk-taking  
• Cash-rich promoter family or parent company that can infuse capital during periods of high stress  
• Highly liquid balance sheet, and both the willingness and the capacity to suffer by investing for the long term at the expense of short-term earnings. 

These companies thus have higher longevity, higher duration of cash flows, and therefore higher intrinsic value.

From the perspective of an investor, staying power stems from a strong passion for the investing discipline; a constant learning mindset; a long remaining investing life span; low or no personal debt; frugality; discipline; a solid understanding of human behaviour, market history, and cognitive biases; a patient, long-term mindset; and a supportive family whose importance is greatly appreciated during the market's periodic rough patches.

The author says that an investor may have a good chance of making money if he clones and "copies" someone else's investment ideas, especially if they have a track record.

It's only natural for us to act in this manner, especially when we are under the influence of an authority figure. 

For example, copying trades of fund managers is because an investor admires them and has a track record of past success.

The issue arises when investors blindly imitate what others do.

It's OK to admire and respect other investors, but one should only buy a stock if the company is within the area of expertise of an investor and has a high margin of safety.

Instead of buying a stock based solely on a recommendation, the author advises developing to think independently and conduct own research and due diligence.

Even when someone invests based on their original ideas, mistakes are unavoidable. But, at the very least, they own them, and there's a good chance they will be able to learn something valuable from them.

Read More History And Fewer Forecasts

Uncertainty and randomness are two things that humans despise. As a result, we attempt to make predictions. We make forecasts and projections about the economy and businesses' future.

But predicting is pointless because the world is far too complex, and things do not move in silos and, like many other things in life, the markets move in cycles. There are a few factors that have a direct impact on the outcome of every decision you make. One factor is linked to other factors, resulting in a network of factors. 

There are most likely millions of moving parts that could influence your decision. Each has a different magnitude, but we have a skewed perspective and can only see the first five. The current COVID-19 pandemic appears to be a never-ending battle.

When we look back in history, we see that humanity has survived great atrocities. The swine flu, the Black Death, and other threats In the future, humanity will learn from COVID-19 and better manage viruses and pandemics. Faster and more accurate contact tracing, faster vaccine development, and we will never run out of ventilators and masks.

So, through this the author is emphasizing that in today’s disruptive world, forecasting doesn’t makes sense, rather one should learn from history.

Updating Your Beliefs In Light of New Evidence

The author advises to strike a balance between conviction and flexibility when investing.

Change your opinions when the facts change. Whatever your strong opinions are, be open to changing your mind when new facts and situations emerge.

Expose yourself to opposing viewpoints and opinions to avoid confirmation bias. Discuss a stock with others to learn about their perspectives. Request that a friend play devil's advocate and challenge your assumptions.

Good investing requires a unique balance of conviction in following your ideas and flexibility in recognising when you have made a mistake. You must believe in something while also accepting that you will be wrong a significant number of times over the course of your investing career. This is true for all investors, regardless of their position. The ability to strike a balance between confidence and humility is best learned through trial and error.

Opportunity Costs

Life is a Series of Opportunity Costs.

Opportunity costs are based on the most fundamental economic concept: trade-offs. 

When you make a decision, you eliminate all other possibilities (at least for the time being). Sometimes the option you did not select turns out to be the wiser choice, which is why opportunity cost is best measured in retrospect. The best way to understand opportunity costs is to consider what would have been lost if certain trailblazing individuals had chosen to do something else.

The term "opportunity cost" refers to a decision that alters your personal landscape in the future.

Opportunity costs can have a significant impact on many aspects of your life, including money, career, home and family, and other aspects of your lifestyle. In general, it means having to choose one option over another, whether it's a matter of money, time, or lifestyle - and then living with the consequences. 

If you own a business, you will encounter opportunity cost on a regular basis. You will have to spend a significant amount of time determining whether the unavoidable consequences of a given decision are outweighed by the benefits that decision will bring. 

Whether in business or in life, opportunity cost is frequently a measurable figure.

Pattern Recognition

Investors who primarily rely on screening tools to generate ideas end up missing such opportunities. If the leading stocks are falling sharply even after reporting solid earnings or going up even after bad earnings, the market is trying to tell you something important.

Fear of the unknown is one of the most potent kinds of fear, and the natural reaction is to get as far away as possible from what is feared. Unknown  make most of us withdraw from the game. These, however, are also the circumstances in which extraordinary returns are possible.

Based on the author's personal investing experiences over the years, He had found that buying a good company in a significant sector is better than buying a great company in a bad sector.

The author advises to not fight the trends, especially the long-term, inevitable ones.

In other words, invest in companies with tailwinds, not headwinds.

The author uses his portfolio holdings to demonstrate this important investing principle:

1. Aavas Financiers, CreditAccess Grameen, Bandhan Bank, AU Small Finance Bank, and Ujjivan Small Finance Bank are examples of India's secular growth in the housing finance, microfinance, and private banking industries.
2. Vinati Organics: a gradual shift in chemical manufacturing away from China and toward India.
3. Long-term structural urbanisation and financialization of savings in India: PSP Projects, HDFC Life, and HDFC Asset Management Company.
4. The Food and Agriculture Organization of the United Nations has planned to spend $7.6 billion over the next 15 years to eradicate PPR disease: Hester Biosciences.
5. Bajaj Finance, Dixon Technologies, and SBI Cards are examples of secular growth in aspirational India's discretionary consumption.

Role of Luck, Chance, Serendipity, And Randomness

Stock market investing is an activity in which luck plays a significant role. 

The author takes the opportunity to acknowledge the significant role of luck in his investing journey. Luck was responsible for his multiple big winners during the 2014 bull market in India. At the time, he had hardly any investing expertise to speak of, but still, within his portfolio, Avanti Feeds went from ₹ 500 to ₹ 2,410 (~382 percent), Gati went from ₹ 60 to ₹ 275 (~359 percent), Symphony went from ₹ 700 to ₹ 1,200 (~71 percent), VST Tillers went from ₹ 800 to ₹ 1,740 (~118 percent), Ajanta Pharma went from ₹ 650 to ₹ 1,350 (~108 percent), Mayur Uniquoters went from ₹ 230 to ₹ 440 (~91 percent), Astral Poly Technik went from ₹ 250 to ₹ 400 (60 percent), and Atul Auto went from ₹ 350 to ₹ 600 (~71 percent).

With the exception of Gati, all of these stocks were purchased on borrowed conviction from some intelligent-sounding discussion on ValuePickr, a prominent investing blog in India. The primary reason for his purchase of all of these stocks was his allegedly brilliant personal belief that because these stocks had delivered fantastic returns during the previous five years of tough economic conditions, they should logically deliver even better returns during an economic recovery. In terms of Gati, he naively assumed that if e-commerce grew rapidly in India, Gati's courier business would do well. He didn't even look into the company's earnings quality.

Value Investor

In 2016,the author bought a stock solely based on the rationale of a peer who he admired and looked up to for his investing skills. A few weeks later, the stock fell sharply, posting weak quarterly earnings, and he exited his position at a 14 percent loss because he lacked the personal conviction to hold. To rub salt into the wounds, the stock then doubled in less than ten months.

The author uses an analogy of a seven-hundred-year-old temple in Japan by Thomas Russo to explain a concept. The temple is made of wood, and none of the wood is seven hundred years old, as the pieces have been replaced numerous times over the years. But people still talk about the temple as if it is seven hundred years old. 

In the stock markets, people see the effect of change in similar ways. Consider the S&P 500, one of the most frequently cited market indexes. On average, over the past fifty years, more than twenty companies are swapped out each year. Yet investors cite and treat the S&P 500 as if it were a monolithic, unchanging object. The constituents of the S&P 500 of 2020 are entirely different from the S&P 500 of 2000, even though the language infers otherwise when investors say things like, “The S&P 500 is trading at a premium/discount to its ten-year average.”

If the story has gone wrong, simply book your losses and move on to a better opportunity. Continuity of compounding is the key to success in this long-term game. After buying a stock, forget what you paid, or this knowledge will forever affect your judgment.

Another faulty anchor is a stock's one-time price—that is, the point at which an investor considered buying it but did not act on it. Following this point, the stock has increased significantly. Missing out on an early opportunity leads to remorse. However, that regret is frequently unwarranted because there are numerous opportunities to purchase stock in a truly outstanding company. A hundred-bagger is, by definition, a ten-bagger multiplied two times. Even if someone bought it after it reached 10x, it rose another 10x.

This demonstrates the importance of actively following a company's story even after it has exited it. Consider investments to be ongoing sagas that must be reevaluated on a regular basis to account for new plot twists and turns. Unless a company declares bankruptcy, the story never ends.

This also applies to selling. Selling a big winner from our portfolio is never easy because we develop an emotional attachment to it over time. After all, it is responsible for the creation of our wealth. A stock, on the other hand, is unaware that we own it. We cling to these stocks because we are fixated on meaningless anchors such as our lower original price, just as we cling to outdated beliefs. However, today's investor does not benefit from yesterday's growth.

When investing, always keep the stock separate from the individual's personality at the helm of the company. Concentrate on the underlying business's merits and economics. Examine the facts and make an objective assessment of the situation.

Conclusion