Why equity investment must be for the long term?
We have all read two things about equity, long-term and diversified. Often when you are investing in equity, you must have read or advised that invest in this strategy only when you have a long-term focus. In this article, I will explore why equity must be long-term. I will cover the diversified aspect of equity in some other article.
Let’s understand what do you mean by equity? When you own a business, even a small portion, you become the equity holder, owner of the business. Interestingly, the principles of the business do not change based on the scale or geography. Even if you are a salaried person, you should be able to answer this “what is required by a business to survive?”
…profits.
What you put in the business and what you get out of the business is called profit. If you invest more and get less, you will incur losses. If a business is not able to turn losses into profits, it will shut down.
But how is profit or loss linked to a long-term focus on equities?
Let me take the liberty to introduce, the fundamental aspect of investing. Any asset value is the sum of future profits or another way to say is the ‘sum of future cash flows.’ (To maintain simplicity, I am ignoring the discounting of cash flows).
Now you will appreciate why a business with only losses may also have value. Investors expect the losses to turn into profits and assign a value based on those future profits.
A quarter or even a couple of quarters may not have any meaningful implication on the value. However, you would have seen market reactions, not just every quarter but rather every millisecond.
If the value of a company is just a sum of future cash flows, why the market value fluctuates every single day?
If you have gone to a vegetable market, you would have seen so many vendors selling different or similar stuff with different pricing or different quality.
A stock market is also a market of so many people, each with its version of the value and objective. This varied group of people causes prices to fluctuate.
“In the short run, the market is like a voting machine - tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine - assessing the substance of a company.” – A popular saying by the father of value investing, Benjamin Graham
Do you want to see the stock market, flat, or fluctuate? Any person who has a reasonable mind will say fluctuate. Why?
Fluctuations allow you to transact with the market more intelligently.
“Be fearful when others are greedy, and greedy when others are fearful.” – Warren Buffet
As you can see two variables impact share price, future business performance, and stock market behavior.
Future business performance requires assessment of the future and will be filled with probabilistic scenarios. Even the best investor in the world is bound to commit errors. However, a smart investor will ensure odds favor him/her. Therefore, even a 60% success rate is good enough. However, when the probability is high and odds are in favor, an investor must build large positions. This requires massive behavioral training because this requires standing against the crowd.
Stock market behavior over the short term is beyond someone’s control. Watch it and take advantage. Interestingly, the long-term share price movement is fundamental driven, and no one knows why, sooner than later all firms achieve their fair value.
This is precisely the reason; that equity should be treated as a long-term asset class. If you are saving for a short-term goal, equities should never form part of the portfolio.
The last point, which is often missed by investors is that you can’t assess the fair value of a lot of businesses. It is beyond the comprehension of even the best investors. Knowing your circle of competence is a key to equity investment success.
A key to success in equity investing is to allocate to quality businesses that have a long-term cash flow generation potential. Out of more than 6500 companies, there are hardly 60 companies in India that qualify as quality businesses. Subscribe to the strategy that allocates to such businesses. Stock advisory link.