Investing’s False Positives

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It was sometime in early 2009 that, as I was running my screeners to find investment-worthy businesses, I came across a Delhi based packaging firm Uflex Ltd.

The company was involved in the flexible packaging business, was doing well in terms of growth, and expanding globally. What’s more, the stock was available at a single-digit P/E.

In all, it sounded like a great investment that was available cheap. Anyways, while I was busy preparing my rosy predictions for the business and the stock, I was warned by an analyst friend about some shady land dealings he had heard of about the company’s promoters. What is more, the promoters had pledged a large amount of their shareholding.

I had made up my mind on this being a great investment, and thus nothing in the world could have shaken my thesis. And so, I invested in the stock at around Rs 75 in mid-2009. Over the next fifteen months, the stock touched Rs 275. My thesis seemed correct, especially because I was in the money.

Or so I thought, because just as I was rejoicing at my intelligence in picking up a great business, news broke that Uflex’s Chairman and Managing Director was sent behind bars for a land scam. The stock cracked around 30% in no time.

I managed to sell my holding around Rs 200, a near 165% gain in eighteen months, which was not a bad deal at that time.

As I look back at my investment in Uflex and the profit I managed to eke out of the stock, I credit my entire gain to luck. This wasn’t the case when the stock was going great guns before the news of the scam broke out. I then thought it was my skill, not luck, that had caused me such large gains in quick time.

Anyways, Uflex was just one of the few such embarrassing jewels I had owned during those years. Embarrassing now in hindsight because I did not deserve to earn profits on such businesses that either suffered from bad economics, or bad managements, or overvaluation.

Investing’s False Positives
The field of medicine has a term called “false positive.” It is an erroneous result that indicates that a given condition is present when it is not. An example of a false positive would be if a medical test designed to detect cancer returns a positive result (that the person has cancer) when, in reality, the person does not have cancer.

While medicine’s false positives often create panic about things that turn out to be nothing to worry about, investing’s false positives create euphoria about things that should have been worrisome in the first place (like my gains in Uflex did to me).

And the underlying reason is that most people out there in the stock market judge the quality of their investment decisions by one single factor – the short-term price movement of the underlying security. And that’s exactly what they are looking forward to while making the investment, even while talking about the virtues of long-term investing and the need to ignore short-term price movements.

Noted French writer and philosopher Voltaire said –

It is dangerous to be right in matters where established men are wrong.

Probably nobody understood the risks of going against time-tested fundamental truths better than Voltaire. I had not heard much of him during my adventures with Uflex and the likes. But I got lucky to have learned it over years without paying much in tuition fee to Mr. Market. Now the situation is that I won’t enter a kitchen (business/stock) even if I see just a single cockroach in there. And questionable managements are a completely no-go area for me, for years and experiences have taught me that people, of all things, rarely change.

Now the biggest problem with a false positive in investing is that it encourages the investor and reinforces risky behaviour (which is accepted only later). This ultimately leads to even more reckless behavior, till the going remains good.

It’s important to remember that you can be wrong (in your underlying thesis about a business) and yet markets can make you look right in the short term. But such a false positive is a foundation for dreadful losses in the future.

This is where the important aspect of investing, that is discipline, comes into the picture.

German writer and playwright Carl Zuckmayer said –

Half of life is luck; the other half is discipline – and that’s the important half, for without discipline you wouldn’t know what to do with luck.

Discipline is the backbone of successful investing. But such is the perversity of a quick but undeserved and risky gain in the stock market that it charms even the most disciplined and intelligent of investors. Even such investors, knowingly, surrender to this temptation at times.

With new and inexperienced investors, a false positive usually extracts a price that is not merely the monetary losses they incur when the falsity comes to fore, but it also leaves a deep scar on their psychology. This scares them away from investing in an intelligent and positive way thereafter.

Someone wise once said that real heroes are made by the paths they choose, not the powers they are graced with. This is true in investing as well.

Imprudent risk-taking may lead you to one-off success, but the consequence of failure could be huge.

The idea is to never bet against the fundamental, time-tested rules of intelligent investing. The idea is to never rejoice on or indulge in investing’s false positives simply because, by nature, they are false.