Intelligent investing in the Sri Lankan stock market
Updated: May 15
How I think about the Colombo Stock Exchange or Sri Lankan ‘share market’ while determining value and adequate returns when investing capital. This article is part of a series of posts documenting my reasoning, methodology, and logic evaluating securities. If you would like to read more about my investment philosophy, be sure to check out my post about ‘The Intelligent Investor’ here or ‘Good Businesses’ here.
In this post, I will talk about how I think about investing and risk with regards to the Colombo Stock Exchange or what is commonly referred to as the Sri Lankan ‘share market’.
“The stock investor is neither right or wrong because others agreed or disagreed with him; he is right because his facts and analysis are right.” ― Benjamin Graham, The Intelligent Investor
As I write this, a fast-moving global pandemic, the coronavirus, or what is now called COVID-19 has taken global markets by storm in relation to the uncertainty of its implications on the global economy.
This uncertainty seems to have trickled down to Sri Lanka and I think this is a great opportunity to re-evaluate what investing is really about.
Here is what this article will cover:
What is investing really about?
What qualifies as an investment?
Who should you trust with investment advice?
What is risk?
Why investing isn’t easy
What is investing really about?
“An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” — Ben Graham, The Intelligent Investor
Reading Ben Graham’s ‘The Intelligent Investor’ had a profound impact on the way I view finance, markets, and reality. I had no prior knowledge of markets, finance, and related activities prior to reading the book. It provided amazing clarity to an otherwise complex subject and I immediately resonated with most of what Ben Graham advocates in the book. To me, investing at its core is about laying money down today so you have more money in the future — more money in real terms, after taking inflation into account.
I want to first make sure my principal capital is conserved and not put deliberately at risk (I elaborate on risk further below).
What qualifies as an investment?
Once I determine that a loss of my principal will not occur (to the best of my knowledge), I would look for an adequate return by investing capital only into an asset that has the ability to produce cash. This can be a business, an estate or farm, apartment, house or building, etc.
When I think of an investment I think about how much cash I may be able to derive conservatively from the asset. The quality of the investment largely depends upon the ability of the asset to generate this flow of cash now and in the future.
Eg. A business like the John Keells Group could be considered a great business because of its ability to create large profits for shareholders through its various subsidiary businesses. It then gives out some of those profits to shareholders and retains a bit more to further expand and grow the business. By growing and expanding in size over time, it is then able to generate even greater cash for shareholders and hence becomes more valuable.
If the asset does not have the ability to produce cash flows, and a return is determined by the price that is paid by someone else to acquire the asset who thinks he may be able to sell it even higher to someone else —is termed ‘speculation’ and not investing.
There is much debate about the points made above, however, speculation and its related activities do not interest me, as I do not think it is an intelligent way to grow capital conservatively and instead encourages awful behavior like gambling (which I’d much rather avoid).
Who should you trust with your investments?
“With enough insider information and a million dollars, you can go broke in a year.” I have seen several investors lose everything because they followed what they thought was trustworthy inside information. — Warren Buffett
My observations of the behavior conducted by brokers, analysts, and salesmen make my stomach churn. Much to my surprise, perfectly decent people actively wait on ‘tips’ provided by these people and act on them, thinking this is an intelligent way to ‘invest’ (this is a form of speculation or gambling — but what is most troubling is most of them don’t seem to think so).
My problem with this type of investor and his advisers is that the underlying incentives of his adviser (may it be a broker, analyst, portfolio manager, etc) do not align with the interests of his client. Investment banks are incentivized to sell certain stocks irrespective of underlying value and brokerage houses need fees, and commissions to make a living, they don’t really need to care about the value of their client's portfolio increasing in value in the long run as long as the client continues to trade. An advisor may even feed his client’s instinct to speculate.
I’ve come to understand a person's underlying incentives cause him to act a certain way even if he may not completely recognize it to be wrong. Basic psychology calls this subconscious bias and it is dangerous for your financial wellbeing. You can’t entirely rely on their advice, I wish I had an easier answer for investors, here’s some advice from legendary investor Phil Fisher from his book ‘The path to wealth through common stocks’.
Only consider an investment advisor who is fundamentally interested that a particular transaction is to your long-range beneﬁt than they are in the fee, commission, or proﬁt they will make from that transaction.
Ask any prospective ﬁnancial adviser about his basic investment philosophy, that is, what he is going to try to do for you and how he proposes to go about it. Eliminate anyone whose long-range objectives are different from your own.
Ask for speciﬁc details of how the man you are considering or the organization behind him gets the data he uses as the basis for making his investment recommendations. Dis-qualifying anyone acting upon meager and inadequate knowledge.
If you already own a group of securities, see whether a prospective investment adviser has equally positive opinions about whether you should sell or hold each of them. Eliminate an expert claiming to know all the stocks listed on the various exchanges or commonly traded over the counter.
Learn what you can of the record of any investment man under consideration. Eliminate those whose performance appears to have been poor in relation to the action of the general market for the period under study.
If you’d like to read more (I highly suggest you do!) be sure to check out Phil Fisher’s wonderful book ‘The path to wealth through common stocks’.
How should I think of risk?
There are all sorts of ways modern finance seems to treat risk, usually in terms of beta that denotes volatility. I do not subscribe to this view of risk and it does not make sense to me as someone trying to allocate capital. Risk to me is the loss of permanent capital, and it should be the primary objective of any investor to deliberately avoid it.
Risk to an investor is not when the quoted price is extremely volatile, it is when the underlying asset may seriously deteriorate enough to permanently destroy shareholder's capital or not generate enough cash back to the owner relative to his risk-free alternatives like a Government bond or Government-backed bank deposit.
Too many investors overlook the permanent loss of capital by thinking only about the reward. It is a misguided view, and a reward should be considered only when the investment offers safety of principal and an adequate return.
Thinking about risk should always be at the core of an investor’s decision-making process.
No investor no matter how good can eliminate the risk of being wrong, which is why Ben Graham formulated the ‘margin of safety’ principle in chapter 20 of his book ‘The Intelligent Investor’. You can read more about it by buying the book here or read about my review of the book here.
Why investing isn’t easy
“Investing is simple, but not easy.” — Warren Buffett
For just a moment, think of yourself as a private businessman with ownership stakes in multiple private businesses. If someone (let’s call him Mr. Market) comes up to you offering to buy you out or sell you a stake in multiple private businesses multiple times a day at various prices, how are you going behave?
Have you made up your own mind in terms of the value of these businesses or are you going to let this Mr. Market dictate the price you are willing to pay or accept?
As a private businessman myself, the idea of receiving a quote for the business every day would be irritating. You want to be concerned about what the business will produce for you as the owner over the long term, and buy when this is attractive when compared to your risk-free alternatives at the time. This is a more intelligent way to think about the Colombo Stock Exchange as well.
A stock is not just a ticker symbol or an electronic blip; it is an ownership interest in an actual business, with an underlying value that does not depend on its share price. (Source: The Intelligent Investor — revised edition by Benjamin Graham).
In capital markets, you are better off adopting the mindset of someone inquiring about the whole business like a private businessman would. Once you have calculated the value of the underlying asset and its cash flows, the most important trait an investor should practice is temperament and behavior based on rationality.
Human psychology being what it is, this is easier said than done. It is not the way most people think. Investing is not easy because you have to largely bet against the consensus and you need to keep in mind all sorts of human misjudgment subconsciously influencing your decision.
If you enjoyed what you read here, check out all my articles related to investing here.