Long term ownership of businesses / investments, inevitably requires high conviction as even the best of businesses tend to go through bouts of weakness, testing the investor’s patience.
For instance, if we were to examine Apple's journey from its inception, it serves as a classic example of a company that has encountered numerous challenges throughout its history, including product failures, leadership transitions, and intense competition, where volatility persisted for several months. Nonetheless, investors with unwavering conviction in Apple's brand strength, innovation capabilities, and ecosystem have been handsomely rewarded over the long term, witnessing over 1000% growth in the past 30 years.
But what exactly do we mean by conviction? And how can we go about building it?
Conviction is essentially a strong belief. It can be explicit and implicit, and it's crucial to have a blend of both.
Explicit Conviction: Explicit conviction is backed by analysis, while implicit conviction is more intuitive, especially when analysis falls short. In investing, one can develop a thesis that a particular company captures X% market share, generate Y revenue, achieve Z% operating margins, and therefore has a potential intrinsic value within a certain range. With all numbers backing up, one might also have high confidence because of the presence of competitive advantages and management with a very good track record. All of this would fall into the explicit category.
Implicit Conviction Sooner or later, the investment would encounter a confounding surprise. Perhaps execution becomes choppy, a new competitive vector emerges out of nowhere, an exogenous crisis turns the world upside down, etc. Old projections are now in doubt, previous plans and strategies are being reworked. And we are living in the least predictable world where this happens all the time!
In such an environment, only genuine and well-placed implicit conviction, a qualitative knowing, that the company/an investment strategy will excel at what it's good at, becomes crucial.
The recent volatility in the small caps...
For example, the recent volatility in small-cap stocks caused many investors to question their holdings in this sector. However, after just a single month, the same market began touching new peaks. During this period, numerous investors succumbed to short-term market panic and either moved or liquidated their holdings.
However, the market continued to rise. Given the government's long-term vision of creating self-reliance independent of global market price volatility with schemes like Make in India, Capex+1, and Capex Infusion PLI schemes, the growth in small caps over the long term is inevitable. Moreover, this growth is not necessarily captured by numbers in a company’s balance sheet.
Further, to some extent, it is visible in its consistent earnings metrics. The aggregate Net Income for this index’s constituents has jumped 3.3x from INR 201 billion in FY20 to INR 660 billion for CY23.
Though the valuation was reaching new peaks because of rising optimism fueled by the rise in its earnings margins, it required a correction in the movement, which led to regulatory bodies controlling it. But that is nowhere to hamper the long-term growth of the small-cap companies.
And thus the two kind of convictions moves together
Where the explicit conviction is
Increasing emerging business intrinsic value, based on discounted cash flows, considering its expanding customer base, product portfolio, and potential for geographical expansion.
Potential increase in earnings in terms of market operating margins, considering efficiencies in operations, cost management, and PLI boost.
Implicit Conviction is
The government envisions the country becoming self-reliant to mitigate global market price fluctuations. This vision is supported by schemes such as the Make in India initiative, PLI subsidies, and the China +1 strategy, where the government is increasingly establishing manufacturing hubs within the country. For example, the shift in Apple's manufacturing operations.
Capital expenditure infusion in India, supported by private capital, is set to penetrate the economy. This will benefit emerging businesses by enabling them to capitalize on rising market demand, facilitating easier access to technology, and leveraging consumption demand.
Specialized businesses are emerging to cater to the increasing demands of the country's infrastructure plans.
Unlike analysis-based explicit conviction, implicit conviction comes from a holistic macro perspective, which can be both analytical and, crucially, intuitive.
Adding such conviction to each investment product you hold adds quality and purpose to what you are holding, why you are holding it, and how long you should be holding it. - mapping out a financial plan!
It's also implicit conviction that helps pivot quickly when changes are observed from what was expected, avoiding fixation on rigid frameworks and steering away from strictly algorithmic approaches to investing. Such analysis can sometimes involve subconscious pattern recognition, rooted in holistic experiences with the subject matter. Of course, the ability to intuitively recognize patterns in a specific domain is earned through experience and feedback.
As Jason Voss expresses in 'The Intuitive Investor,' - 'its intuition that lets us know, what unique set of data are relevant from a nearly infinite set of information that bombards us every day.' Intuition is nothing but the outcome of earlier intellectual experience. Thus, experience in the market is required to make the right set of choices when making a decision in any inexperienced field, which goes the same for investing.
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