I’ve had the following conversation many times with novice investors in the past, but it became all too common in 2020, with so many first-timers entering the markets.
Investor: “I think Company X is gonna do quite well over the next few months (or years). They have quite a few new products lined up for launch and there are many newspapers talking favourably about the companies prospects.”
Me: “Have you looked at the past financials of the company?”
Investor: “How does the past matter? Isn’t investing all about figuring out what’s gonna happen in the future?”
After that it’s basically me just struggling to explain that if you don’t know where the Company’s been, how can you predict where it’s going to go? And usually it’s all in vain. I persist, however, because its encouraging to see the one person (out of 20 maybe?) who does get it and then tries to actively analyse companies by studying its Annual Reports.
I’ve been thinking about this and I’ve come up with an analogy which I’m gonna be using henceforth, in all such conversations.
Roleplaying, anyone?
Think of yourself as an Admissions Officer at a prestigious university. There’s a huge pile of applications lying in front of you, and it’s your job to decide who gets in. You need to be really selective, because the University’s performance and reputation depends on it. If you let in a bad cohort, the research quality really suffers, and so does the employability of students.
Each student has to submit only 2 documents – their past exam scores and an essay written by them.
Student A has written a great essay, showing plenty of ambition and a desire to go places. He doesn’t have the grades to back it up though, with a few failures here and there. Student B, on the other hand has written a very mediocre essay but has great scores to back up her application.
Who would you choose? I’m sure most people would agree on Student B. Some people might even vote for Student A, reasoning that he has shown plenty of passion for the subject even if the grades don’t back it up.
One thing people will unanimously agree upon is that this decision is impossible to make without knowing the scores of the student. The scores put everything in perspective. Without that you’re basically just shooting in the dark. Everyone would discard an application that doesn’t submit the past scores.
Back to the Investor
The huge pile of applications is the choice of companies available to you, the past scores are the financials of the Company and the essay is the media releases and PR material put out by the Company.
If in the above case it’s easy to see why past scores are important for reaching a knowledgeable decision, why don’t people think the same way when evaluating companies? I used to think it’s a matter of how comfortable a person is with accounting and finance, but I’ve also seen plenty of accountants who buy stocks based on tips and newspaper articles, and no due diligence of their own.
There’s just something about equity investing that makes people think they can make easy money without putting in the effort. Just like the University, the performance of your portfolio depends on the selectivity you show when you add a company to it.
Apar Invests 