A lot of people are celebrating these days and patting themselves on the back. We have a parade of investors touting their returns and claiming that 100% CAGR is for chumps. Multi-bagger could soon be a new name for kids 🙂

A bull market feels good and should be the best of times, right? How can one argue with that?

It feels great when your stocks are going up, making you richer by the day. You feel smart, on top of the world and in some moments can even see that retirement on the horizon when you stop working and live on the beach < insert additional fantasy as needed>

By my own estimates, I have lived through around 4 major and a couple more minor bull runs. It felt great during those periods as I  felt vindicated for sticking it out during the drops when everyone was rushing to the exits. It is only in hindsight, I have realized that bull market are dangerous in their own way and I was lucky to have survived the full cycle.

Let me explain

A confluence of factors

A typical bull market usually coincides with decent economic numbers when most companies are doing quite well. As a result, most participants become over optimistic and bid up the stocks of these companies. We thus have a confluence of factors – companies performing better than usual and being valued at higher multiples of peak earnings.

In addition to these factors, there are several psychological factors which come into play at this time. Let’s go over some of them

– Social proof: At such times, you see people around you getting rich and more reckless the person, higher the returns. It is not easy on the psyche to watch your friends get rich , whereas you sit around doing nothing.
– Scarcity: During bear markets, waiting helps. As the numbers are bad or getting worse, stock price for most companies stay stagnant at best. As a result, if you like to dig deep into a company, you have all the time in the world. No such luck during bull market. Any company with a half decent results gets bid up. As a result, you can either forgo an opportunity or buy the stock with lesser due diligence
– Confirmation bias: A bull market gives a positive signal and makes you feel that you are doing something right. As a result, there is a tendency to ignore risks and not look for disconfirming evidence
– Authority bias: If you switch on a channel, every other talking head and self-proclaimed guru on TV is painting the vision of a glorious future where all of us would be rich. This makes you feel as the only idiot who does not get it

In effect there are multiple psychological and other factors, which conspire to get your guard down and ignore the risks

A bad hangover

I can recall the emotional roller coaster in the previous cycle, with the only difference that these cycles used to run over a period of 3-5 years. The years 2001-2003 (which is ancient for most investors) was a grinding and slow bear market.

It was the exact opposite of what we see now. I can remember buying companies selling for 5 times earnings, growing at 15-20% per annum and still going down in price. If you think these were low quality stocks, then that was not the case. I am talking of companies like Marico and pidilite which are the darlings of the quality school of investing now.

A new investor like me just could not understand why the market was behaving in this fashion.

The market started turning in 2003 and from there it took off for the next 5 years. A lot of my personal holdings went up multiple times (no one used the term multi-baggers as often then) and it was great to feel vindicated/ smart.

The problem with feeling smart was that is that you also feel invincible. The net impact of all these emotions is that I made a few picks, which were marginal at best.  These sub-par picks came back to bite me during the next downturn when they performed far worse than the overall markets.

A fight against instincts

The natural instinct for any investor is do the opposite of what should rationally be done.  When the markets are dropping due to poor fundamentals and bad sentiments, the tendency of most investors is to withdraw into a shell and wait for the sky to clear up.

This is usually the wrong action. Unless you believe that the world is going to end (in which case, stocks should not be your worry), it makes sense to buy attractively priced companies as markets usually have a tendency to extrapolate the recent trends into the future.

The same tendency is also visible during bull markets which leads investors to buy at the wrong price. The right action at such times would be to sell or do nothing, if the company is not overpriced. I personally think that one should go one step beyond – use this period to clean up your portfolio. If you hold some companies, which you are not as confident about, sell them down and increase the cash holding. A bull market is a good time to  swallow the bitter pill when the overall portfolio is doing well.

It is not easy

I wrote this a year back after the market dropped by 15% and this still holds true, except the circumstances have changed to a bull market.  Instead of courage to manage the fear, one needs the same courage to manage greed and euphoria.

It requires an equal amount of effort (or even more) to watch everyone around you make easy money, while you stick to your principles and refuse to take part in the madness.


This is a term I like to use to represent the time, and mental energy devoted to each position in my portfolio. I would also add mental stress to the equation.

I have realized that in a lot of cases the percentage of mental capital allocated to each position does not match with the allocation of financial capital. On the contrary, some of my top position have needed the least amount of mental energy on an ongoing basis and caused the least amount of stress. This has been mainly due to the quality of the business and management.

On the other hand, some of the smaller positions in my portfolio have resulted in a much higher allocation of mental capital and that could be also the reason why I never raised the size of these positions.

Not a mathematical exercise

Unlike the amount of financial capital, one cannot calculate the percentage of mental capital allocated to a position. However there are several pointers one can use to see if a particular company is taking a dis-proportionate amount of your mental energy

– You are regularly surprised by the quarterly results
– The management makes your stomach churn and causes you to worry about the safety of your capital
– The industry is undergoing a substantial amount of change and you have no means of evaluating the economics of the business even for the short to medium term
– You keep coming up with new reasons to hold on to your position, even after your original thesis has been invalidated. The word ‘hope’ keeps coming up in your thinking
– You ‘worry’ about the position for any of the above or other reasons

The killer combination

If the financial and mental capital allocated to a position is too high, then we have a deadly combination. This is kind of an extreme situation can make you act irrationally and in the end be injurious to both your financial and mental health, if the position turns against you.

I have realized over time, unlike financial capital which can compound, mental capital is limited and does not increase much beyond a limit.  It is important to use it smartly both for your financial and mental health and finally for your quality of life.

A certain level of mental capital has to be invested when investing directly in stocks (instead of an index or mutual fund), but in some cases the level can go much beyond the amount of financial capital allocated to it. In such cases, I have usually found that selling down or completely exiting the position has freed up my mind to look for new ideas and devote more time to other stocks in the portfolio.

The tail (portfolio) should never wag the dog (your life).


Some excerpts from my annual review to subscribers. Hope you will find it useful

Sources of outperformance

Superior performance versus the indices can usually be broken down into three buckets

– Informational edge – An investor can outperform the market by having access to superior information such ground level data, ongoing inputs from management etc.
– Analytical edge – This edge comes from having the same information, but analyzing it in a superior fashion via multiple mental models
– Behavioral edge – This edge comes from being rational and long term oriented.

I personally think our edge can come mainly from the behavioral and analytical factors. The Indian markets had some level of informational edge, but this edge is slowly reducing with wider availability of information and increasing levels of transparency.

We aim to have an analytical edge by digging deeper and thinking more thoroughly about each idea. However in the end, it also depends on my own IQ levels and mental wiring, which is unlikely to change despite my efforts.

The final edge – behavioral is the most sustainable and at the same the toughest one to maintain. This involves being rational about our decisions and maintaining a long term orientation. If you look at the annual turnover of mutual funds and other investors, most of them are short term oriented with a time horizon of less than one year. In such a world of short term incentives, an ability to be patient and have a long term view can be a source of advantage.

How does patience help?
Take a look at the 5 years history one of our oldest positions – Cera sanitaryware.

The company has performed quite well in terms of profits in the last 5 years and grew its net profit by 30% in FY 15 and 23% in FY16. Compare this with the stock price – The stock dropped from a peak of around 2500 in early 2015 to a low of 1500 in the span of one year, even though sales and profit continued to grow at a healthy pace.

These swings are usually due to short term momentum traders who want to move from company to company to catch the incremental 10%. I am glad that we have such investors in the stock market as it gives us an opportunity to buy from time to time when the price drops below our estimate of fair value.

We will continue to get such kind of opportunities in the future. The key is to be patient and act when an opportunity is presented.

Skin in the game
It is not easy to remain focused on the long term. In my case, I do not feel any pressure to negate this advantage and let me share why.

The reason for holding onto this approach is that this is something which has worked for me over 20 years and for others over a much longer period. If one can identify good quality companies at a reasonable price, then the returns over the long term will track the performance of the business (more on it later in the note). The value approach works over time, even if it does not work all the time

In addition to the above, my own net worth and that of my close friends and family is invested in the same fashion. I will not take the risk of blowing up to show short term results. Nothing focuses your mind, when your own net worth and that of friends and family is invested in the same fashion.

Let’s try to understand the math behind my expectations of the long term returns. This is a repeat for some of you, but is worth reading again.

The math behind the returns
At the time of starting the model portfolio, I stated 3-5% outperformance as a goal and this translated to around 18-21% returns over time. How did I come up with this number and more importantly does it still hold true?

Let’s look at the math and the logic behind it. The outperformance goal ties very closely with my portfolio approach and construction. We typically have around 15-18 stocks in the portfolio, bought at 60-70% discount to intrinsic value on average. Most of the companies we hold have an ROE of around 20-25% and are growing around 18-20% annually. These numbers may vary, but on average they will cluster around the above figures over time.

Let’s explore a specific example based on these numbers. Let’s say a company valued at 100, growing at around 20% is purchased for 70. Let’s assume I am right in my analysis and the stock converges to fair value in year 3. If this happy situation comes to pass, the stock will deliver around 34% per annum return.

Now in year 3, we could sell the stock and buy a new one again and make similar returns. This may occur from time to time in individual cases, but is not feasible at the portfolio level unless the market is in the dumps and stocks are selling at cheap prices. It is unlikely that our positions would be in a bull market and selling at full price, when other stocks are available at a discount.

In such a case,  if the quality of the company is high and we continue to hold on to it, it will deliver a return of around 20% per annum in the future (assuming the stock continues to sell at fair value going forward). If you add 2 % dividend to this 20% annual increase in fair value, the stock could deliver around 22% for the foreseeable future.

The portfolio view
The math, explained for a single stock, works at the portfolio level quite well. As per my rough estimates, the model portfolio has grown at around 22% per annum in intrinsic value. It was selling at around 27% of intrinsic value when we started and is at a 20% discount now. You have to keep in mind that there are just estimates on my part and I cannot provide any mathematical proof for it. However I have found that these two variables have worked quite well in understanding the performance of the portfolio over the long run – discount to intrinsic value and growth of the value itself.

As the intrinsic value has grown over years and the gap closed, we have enjoyed a tailwind and hence the returns have been a bit higher than that of the intrinsic value. The returns are often lumpy as can be seen from the performance.

Where will these returns take us?
If you talk to some investors, they would scoff at 20% returns. Let look at this table for a moment

I am sure a lot of you have seen the above table. It shows how much 1 lac will become if you allow it to compound at a certain rate of return for 10, 20 and 30 years.

There is something different in the table, from what you would have normally seen. The rate of return numbers seem to be random – 7%, 13% etc., but they are not. Let’s look at what they signify

7 % – This is normally the rate of return one would get from a fixed deposit in the bank
13% – This is the average rate of return from real estate over long periods of time. I would get eye rolls when I quoted this number in the past. The recent and ongoing experience is changing that now.
16% – this is roughly the kind of return you can get from the stock market index over long periods of time
20% – This the level of returns we ‘hope’ to achieve in the long run.

There are a few key implications of the above table

– A small edge over average returns adds up to a lot over time
– The key to creating wealth in the long run is not just super high returns, but to sustain above average returns over a long period of time. It is of no help if you compound at 30% for 20 years and then lose 80% of your capital in the 21st The key is to manage the risk too.

If we achieve our stated goal over the long term, the end result will be quite good. There are two risks to this happy end – avoid blowing up (which I am focused on) and early retirement (mine), which you have to hope does not happen either involuntarily (I get hit by a bus) or voluntarily (I head off to the beach).