While most market experts are busy forecasting how 2013 might be for markets, Amay and Swanand decided to do something different for their Dec 2012 piece of Connecting The Dots : they decided to look back at 2012 and draw on the key insights that the year gone by has taught them. A retrospective glance, as they say, which in Sanskrit is known as Simhavalokana. Amay and Swanand share in this piece the 10 key insights they imbibed from an eventful 2012 - insights that we all will do well to reflect on and imbibe ourselves.

Simhavalokana

As we bid adieu to the year 2012, it is time for our very own form of Simhavalokana. Wildlife enthusiasts, or should we say Indian philosophers, may well know the fact that as the lion walks some distance in the jungle, it looks back to examine the path it chose and how it covered that distance. This retrospective glance in Sanskrit is known as Simhavalokana.

It is human nature to obsess about the future. We don't blame market forecasters for being pre-occupied in attempting to look at the crystal ball while trying to predict index targets for 2013. After all Charles Kettering¹ once said, "My interest lies in the future, because I am going to spend the rest of my life there". However, as lifelong students of the stock market we think it is as important to reflect on the year gone by, as it is to try to make forecasts. We often get so absorbed in the daily noise surrounding investing, that we tend to forget the importance of reflective Simhavalokana. In this year-end edition of Connecting the Dots, we make an attempt to summarise ten lessons learnt from the markets in 2012.

1. Market timing is dangerous

As investors, our holy grail for generating alpha is to look for through-cycle winners, who we call The Dependables (refer CTD: The Dependables). We don't categorise stocks or sectors as defensives or cyclicals, but rather as those with dependable growth and capital allocation characteristics versus those without. We think market timing is a dangerous game and in 2012 we refrained from trying to time the market by avoiding tactical trades in high beta stocks in anticipation of a rally.

As Vitaliy Katsenelson² said, "It is hard if not impossible to create a successful market timing process. Aside from the fact that it demands that you be correct twice - when you buy and when you sell - emotions are in the driver's seat of the market especially at the tops and bottoms".

2. Don't let the consultants dictate

We are wary of investing in companies whose senior managers tell us that they relied on consultants advice before taking strategic decisions. The same applies to our business of investing. While intuitively we always felt India was the most over-researched market in the world, we recently stumbled across a very interesting statistic. There are only 51 stocks in the world that are rated by more than 50 sell-side research analysts. Of these 49 are in India. The only two stocks outside India are Apple and Intel. We will listen to the army of consultants, but do our own bidding.

3. Read the odds

Investing is all about understanding starting point expectations, reading the odds and then making your bet. In our edition of CTD: Great Expectations, we looked at how expectations play an important role in investing. A great company might not always be a great stock if the embedded expectations are going to be difficult to meet.

4. Know who you are

Adam Smith³ famously said, "If you don't know who you are, the stock market is an expensive place to find out." It is important to define what you will and won't do and stick to that discipline. Any attempts to chase momentum in 2012 led to investors getting whipsawed. We had our gut wrenching moments too. Morgan Stanley Growth Fund had a turbulent start to the year when markets saw a seven week risk-on rally. We stuck to our philosophy and were eventually rewarded as is evident from Display 3.

5. You can't win everyday

Like any investor, we often rue the stocks that we miss but console ourselves with the thought that even the greatest of investors don't make money everyday or on every bet. It is important to remember that you can't win 5-0 against the markets, a score-line of 3-2 is good enough to win this game, if you have sized the bets well.

6. High quality - Necessary but not sufficient

Buying high quality stocks purely because they meet all the criteria of quality is not the only consideration in building a good portfolio. If growth characteristics and valuations of these stocks are not supportive, they may not outperform, as the re-rating to factor for quality might have already played out. For the stock to sustain outperformance, it needs to score well on all the three facets - quality, growth and valuations.

In the chart below we compare two companies in the consumer sector - stock A is a company that the markets did not put on the same pedestal as stock B which was considered the gold standard in quality. If you compare the relative performance of both stocks over the year it is evident that stock A was re-rated as the underlying fundamentals were stronger, whereas stock B had a slowdown compared to its own historical track record.

7. Be Patient

Market in its own style tests the patience of investors. At any point of time, there will be stocks in the portfolio that are not firing. It is important to be patient here, ensure that your original rationale is being borne out and then wait for the story to play out. It is almost impossible to perfectly time stock purchases and sales. We usually work with much lower churn ratios than the average of our peer group, as we think high portfolio turnover rates eat into portfolio returns and investors miss the big stock moves if they trade too frequently.

8. Mean reversion is never automatic

Investors show signs of impatience when a sector outperforms or underperforms for a few months. They start believing that markets should mean-revert and start itching to sell the winners and buy the losers. It is difficult for us to buy or sell stocks and sectors based on the sole rationale of divergent relative valuations. Mean reversion does not happen unless supported by an underlying change in dynamics. More importantly, trends can last for longer than you expect, as is evident in Display 7.

9. Don't gamble

Market participants often spend disproportionate time and effort in trying to predict binary events. These range from trying to guess when the Government might announce subsidy reduction measures to forecasting M&A activity. We resisted the temptation of participating in binary events such as chasing stocks on the back of rumoured M&A in the airlines and liquor sectors. While hindsight vision is a perfect 20-20 and some of these "event plays" might seem like misses in our portfolio, writing a convincing rationale without factoring in the event would have been difficult for us.

10. Bad Macro ≠ Bad Stock returns

Market indices are up 30% ⁴ this year as this edition of Connecting the Dots goes into print. If we look back at all the gloomy economic commentary at the beginning and through most of the year it would have been almost impossible to predict such respectable returns. Year to date, India is among the best performing markets in the world. Amongst the 45 countries included in the MSCI All Country World Index, India this year ranks at #5 in US Dollar performance. So while macro factors play an important role in defining the regime in which companies operate, it is incorrect to give up on a country just because its macro environment is challenged. We strongly believe that despite the macro vulnerabilities, India's allure for investors lies in the bottom up micro stories.

We recently watched the movie Life of Pi⁵ and it set us thinking about the deeper philosophical message from a seemingly simple story. The protagonist who goes by the nickname Pi survives a shipwreck on a boat with a Bengal tiger. After narrating his bizarre, almost implausible story, he says to the doubting officials who are investigating the shipwreck, "I know what you want. You want a story that won't surprise you. That will confirm what you already know. Th at won't make you see higher or further or differently." He then tells an alternate, far more gruesome and tragic story about his survival. Even the hard-nosed officials in the end believe the fantastic yet happy narrative. Isn't the India story similar? While the problems are well known, we need to dream of a story that does not confirm what we already know. In a year where doubt and skepticism abound, the Indian markets are likely to end 2012 at the top of the heap. While there are multiple excuses for not investing in the market, we continue to believe that a well-constructed portfolio can give decent returns. Investors need to choose what they want to believe. As Pi says "To choose doubt as a philosophy of life is akin to choosing immobility as a means of transportation." Happy investing.

¹ An American inventor, engineer, businessman, and the holder of 186 patents; Credited with the invention of the electric motor.

² The Little Book of Sideways Markets by Vitaliy Katsenelson.

³ The Money Game by Adam Smith (George Goodman)

⁴ YTD return for BSE 100 as on December 6, 2012

⁵ The movie Life of Pi is based on a book by the same name by Yann Martel.

Important Disclosures:

As a part of Compliance disclosure, Amay Hattangadi and Swanand Kelkar hereby declare that as of today, [including our related accounts] we do not have any personal positions in the securities mentioned above. However, one or more Funds managed by Morgan Stanley Investment Management Private Limited may have positions in some of the securities mentioned in the missive.

The information provided above speaks only as of its date. We have not undertaken, and will not undertake, any duty to update the information contained above or otherwise advise you of changes in our opinion or in the research or information. It is not an offer to buy or sell any security/instrument or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates, foreign exchange rates, default rates, securities/instruments prices, market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance.

Investors are advised to independently evaluate particular investments and strategies, and are encouraged to seek the advice of a financial adviser.

The opinions expressed in the articles and reports on the website are those of the authors as of the time of publication. The authors views are subject to change at any time due to market or economic conditions. The views expressed do not reflect the opinions of all portfolio managers at Morgan Stanley Investment Management, or the views of the Firm as a whole, and may not be reflected in the strategies and products that the Firm offers.

© 2012 Morgan Stanley