What’s common between investing in China and these mid-cap stocks?

Why? Well, to watch Charles Thomas Munger display his wit and wisdom with a dead-straight bat.

Charlie Munger is a shareholder and a board member at DJCO and every year, he entertains questions from the audience on topics ranging from investing, politics, psychology, and even architecture.

I know that Munger speaks at the Berkshire Hathaway AGM as well. However, there, he is content playing second fiddle to his more sociable partner Warren Buffett.

But at DJCO AGM, it is all Munger and you get to see him in his element.

The latest DJCO AGM was held last week and as expected, Munger had a lot of food for thought on offer.

From calling crypto investors idiots to preferring BYD over Tesla to the importance of good judgement, Munger offered opinion on a range of topics and of the kind that will force you to sit up and think hard.

However, the one that impressed me the most concerned the difference between China and the US. It gave me a fresh perspective on how he thinks about risk and reward and how you can incorporate the same into your own investing process.

On being asked why he preferred Chinese stocks over the US, Munger’s answer had pragmatism written all over it.

He opined that given a choice, he would of course like to invest in US stocks. However, he is having a hard time coming across good quality US stocks that are available at attractive valuations.

China on the other hand, has plenty of good quality companies. In fact, they are better, stronger companies than in the US and above all, available at cheaper valuations in general as compared to the US companies.

He is willing to take the risk of investing in a foreign country and that too a communist regime like China as he is being compensated well enough by way of greater potential returns.

I think this is a great way to assess potential risk and reward and I will have to agree with Munger here.

A lot of us don’t like to get out of our comfort zones and like to stay invested in the larger, good quality stocks even though there are other options available that look better from a risk-reward perspective.

I am happy to say that I am taking the Charlie Munger approach to recommending stocks in my brand new stock recommendation service, Midcap Value Alert, and subjecting every potential recommendation to the risk-reward criteria that Munger is advocating.

In fact, my first ever recommendation in the service i.e. the first of three stocks that I have already recommended, is a great example of this approach.

The stock under discussion is a midcap pharma company that has run into some rough weather recently and the stock has almost halved from its top.

I like the company and its management. However, there is another pharma company that has also come down a lot from its top and is also believed to be a better quality stock than the first one.

In fact, this second company has consistently commanded premium valuation than the first due to its better earnings as well as management quality.

It is not as if the first pharma company is bad. Its earnings have been more volatile as compared to the first and also has a slightly higher debt to equity ratio. But its management is equally proactive and is taking all the efforts to reduce volatility in earnings.

So, when it comes to choosing between the two, there are many investors who would prefer quality over anything else and settle for the second stock.

However, I have not recommended this stock to my subscribers. I have recommended the first one because it is trading at a significant 33% discount in terms of its PE ratio as compared to the second one.

Like Munger, I also feel that I am being compensated well enough for the extra risk I am taking in going for the more volatile albeit equally good quality stock and over time, I may end up with better risk adjusted returns.

In fact, even for my next batch of recommendations, which will be out next month, I may look for a similar attribute and go for the stocks with a better risk reward proposition.

To be honest, it feels great that my approach is being endorsed by someone of the calibre of Charlie Munger.

Few weeks ago, I found the following gem in Ben Graham’s classic Security Analysis, which seem to be also echoing Charlie Munger’s thoughts.

Graham has spoken about two kinds of investors, the first one, who is an untrained investor and the second one, who is a proper trained security analyst.

Here’s the principle for an untrained security analyst.

Do not put money in a low-grade enterprise on any terms.

And here’s the one for the trained analyst.

Nearly every issue might conceivably be cheap in one price range and dear in another.

The gist of what Graham is trying to say is that there are investors, usually untrained ones, who wish to buy only the best quality stocks. They refuse to come anywhere close to stocks that are not the topmost quality.

Then there is the other kind of investor and a trained one at that, who believes that nearly every stock might conceivably be cheap at a certain valuation and expensive at a higher valuation.

So, if you want to minimise your losses over the long term and do not want to put in the time and effort to study stocks, then perhaps the first approach is your calling.

However, if you want to earn the extra returns and have the emotional discipline to buy only if you are being compensated with extra returns, the second approach is what you should adopt.

I think I have made it quite clear that it is the second approach that I will settle for in Midcap Value Alert where I am trying to capitalise on India’s third giant leap.

If you are on board with this principle, then I invite you to join me on this exciting new journey.

Already, nearly thousand people have hopped in for the ride and your time could be fast running out.

Please click here to know all the details.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.

This article is syndicated from Equitymaster.com