Buying low priced stocks? Analyse before you do so.

Like it or not, we are all descendants of our earlier hunter ancestors. This clearly shows the different level of skill sets that we possess in areas such as language and math.

 

In the pre historic times, when survival was the sole aim, what mattered was how fast we could run and how loud we could call out for help.

 

Thus, if one was a math whiz kid back then but had very poor running and communication abilities, the chances of him being chewed up by some hungry predator were very high indeed.

 

Since the math whiz kid wouldn't have lived long enough to pass his genes onto us, our math and analytical skills have turned out to be pretty limited.

However, we live in a different world now. In a lot of areas today, especially investing, what matters more is the ability to think clearly about long term horizons and an endowment of strong math skills.

 

But are we doing enough to acquire those skills? 

 

Probably not. Research shows that even super quants and math PhDs find it difficult to appreciate the enormity of the concept of compound growth.

 

Ask someone to what amount will Re 1 doubling every day for a month will rise to and you may get answers ranging from a few thousand to few lakhs. However, at the end of the 31st day, the total amount accumulated could be as high as Rs 107 crores!

The enormous power of compound interest works its magic in the field of stock markets as well. But on account of our mental hard wiring, most of us fail to take advantage of the same.

 

Take the current market environment for example. Thanks to the correction, quite a few stocks have become attractive from a valuation perspective. 

 

Investors would thus be tempted to grab the cheapest among them.

 

But is this the right strategy to have? Certainly not.

 

Rather than going for the one that is the cheapest in valuation terms, we should go for the one that has very good return on capital and is reasonably priced.

 

This is because over the long term horizon, thanks to the power of compounding, a stock with a 25% return on capital will give much better returns than a stock with a 15% return on capital even though the latter is available at a huge initial discount.

 

Of course, what will make or break our out performance is the ability to determine whether the 25% return on capital stock is able to maintain those high returns for a very long time.

 

In other words, the stock should possess a very strong moat.

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