Luck vs Skills

What could be more exhilarating than to participate in a bull market in which the rewards to owners of businesses become gloriously uncoupled from the plodding performances of the businesses themselves. Unfortunately, however, stocks can’t outperform businesses indefinitely, Bull markets can obscure mathematical laws, but they cannot repeal them.

Warren Buffett

The pandemic and financial markets recovery in 2020 is nothing short of miracle. No body expected it except few folks on twitter who somehow manage to get all calls right.

Michael Mauboussin’s in his book, The Success Equation gave us a very easy test to identify whether an activity involves luck or skill

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There’s a quick and easy way to test whether an activity involves skill; ask whether you can lose on purpose. In games of skill, it’s clear that you can lose intentionally but when playing roulette or the lottery you can’t lose on purpose
He says that for probabilistic activities like investing, luck plays an extremely large role, much larger than we would like to believe. Thus even the ‘expert’ is not really in control of the outcome.
This post is not to dishearten active stock pickers (like yours truly) but to build a measured approach towards celebrating multi-baggers. One thing that I do often in my year end reviews is to understand how much of return is due to business growth (Earnings expansion) vs how much of return is due to market exuberance ( PE expansion), doing this over a long period (say 3-5 years) you will get an idea on how much role luck played in your success and hence keep you grounded.
Here is sample from scorecard companies
Aug’2016 Dec’2020
Company Net Profit (Cr) Share price Net Profit (Cr) Share price Returns(X) Earnings Expansion (X) PE (X)
AIA 430 730 570 2000 2.74 1.33 1.41
CERA 60 680 120 3200 4.71 2.00 2.71
GRANULES 90 88 430 390 4.43 4.78 -0.35
Needless to say that in above table for AIA and CERA , PE expansion contributed equally if not more to returns along with earnings expansion.
What are some lessons for active stock pickers?
  • Focus on getting earnings expansion right, in many cases that will lead to PE expansion as well adding a blitz to your overall portfolio
  • Focusing on earnings expansion and business would also help in stomaching ups and downs that come with staying invested in equity markets
  • Stay within what you know you can do and avoid things that you don’t know much about. I think when we see others succeed wildly with something, we are tempted to wade a bit beyond what we’re comfortable with. And that typically doesn’t work out very well.
While it is immensely fantastic to get a 7x in year like I did with Aarti Drugs or Avanti Feeds but deep down I know that it was luck (everything falling in place at right time) and not my super power. But I do hope they keep happening again and again in my investing life 🙂
Happy Investing – Share your thoughts on how are you managing this bull run by going to our new facebook group – I post exclusive short content there so dont miss to join 

3 comments

  1. kamalgarg1958 says:

    Perfectly agreed. In fact the role of “luck” during good times and successes is much discounted (leading to lot of self-bragging and chest thumping giving way to illusory self-confidence). And it is perfectly right to do a 5 or 10-year analysis on how much is on account of change in profits/ROE, etc and how much is on account of PE and PB expansion.
    While this looks perfectly ok to do this exercise, the problem is that in a success-scarce world, the big successful companies keeps on getting re-rating (essentially PE expansion) , like for example, HUL, quoting at 76 PE and more than 11 PB. Now, if we do this exercise, then, probably, companies like HUL will never fit into our investment model. And that’s a dilemma. Many analysts have started telling during the last 4-5 years, it is better to stick to successful / more successful because it brings stability, predictability and of course PE expansion. There is a whole list of such companies including the likes of HDFC, HDFC Bank, Asian Paints, Pidilite, etc.
    Request your elaboration and input on this.

    • admin says:

      Thanks Kamal. Big is better is current theme, it may change to Small is beautiful who knows. As a buyers we have to buy what we are comfortable with. In above example as well on PE side Granules is slightly below the entry price. Also PE is not the whole and sole determinant of value. If a company is heavily investing then its PE may look optically high so horses for courses.

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