Investing for long-term wealth creation? Remember these 3 important investing mantras

If there’s one thing that gets Indians excited more than cricket or their morning cup of tea, it’s landing a good deal. In the world of investing, every now and then a shiny, fast-growing company catches your eye and grabs your attention. As a smart investor, it’s wise to be cautious. Just because something looks attractive doesn’t necessarily mean it’s a good buy. Sometimes, it can be difficult to distinguish between a growth trap and a real opportunity.

For the uninitiated, a growth trap is a situation where even the most skilled investors end up investing in highly valued companies because of the expected growth and hyped story. Good companies don’t necessarily translate to good valuations. If the story falters, so can the valuation. Sometimes that can be painful.

A good example is Tesla, once the poster child for growth investing and a hot topic at cocktail parties, but the company has fallen about 60% from its peak as its growth trajectory has become less clear.

The Gravity of Attraction: Growth Trap #1

Have you ever noticed that in the business world, the best and the brightest tend to get all the attention? EV, AI, and space-related industries are some recent examples. Fast-growing industries attract many aspiring entrepreneurs, investors, and existing companies. But over time, some of these industries become less profitable due to increased competition, ultimately leading to a decline in the future valuation of those once-brilliant companies.

There seems to be some divergence here. We invest in stocks with the hope that our picks are embarking on a path to potentially increasing earnings from current levels, but in reality, the gravity of attraction leads to a downgrade in the company’s rating as attention on the sector increases.

“Buy at any price” — Growth trap number 2

Market information has become more accessible with each passing decade thanks to advances in technology and data analytics. But improved methods for screening stocks may lead some investors to flock to companies that benefit from high growth rates but at the expense of high price-to-book multiples. This excitement may be further “supported” by the media praising their performance.

Take the recent example of Zoom: During the pandemic, the company certainly experienced high growth rates as a result of lockdowns, and the phrase “Let’s Zoom” became (and still is) part of everyday life. But while usage and stock price soared based on that belief at the time, both have subsided in recent times.

This shows that a lot of long-term assumptions may need to be made to justify the price. From monetization capabilities to expected increases in the rate of return on additional invested capital, great stories don’t always end in glory. And when forecasts are revised downwards, the first thing to be affected is the downgrade multiple, because ultimately, reratings and downgrades are not in the hands of investors.

What’s not funny isn’t necessarily unfunny

Unfortunately, value investors can’t always spin tales of excitement and chaos, and they’re never popular at cocktail parties where investing is discussed, but for us, finding a good deal is plenty exciting.

An interesting example is Nick Sleep of Nomad Partnership, who is known for finding great companies with great values. He bought Costco in the early 2000s, despite its low margins and ROCE compared to its competitors. Nick believed this was in fact a MOAT. With low margins, few would dare change the pricing that Costco offered, yet this allowed Costco to expand and therefore its valuation to grow. Imagine that!

Even in today’s market, it is possible to find great companies whose market value is below the cost of building the business. Sometimes you want to invest in a company when its stock is on sale, and that’s natural. Knowing that you have downside protection in the form of a balance sheet, even if there is a correction, helps you sleep at night, and I would take that any day.

Arun Churani, Co-Founder, First Water Capital