This 2-minute video of the legendary investor Parag Parikh has been watched by many of us.
There are certain universal principles in life which don’t change even if people change, times change, technology changes, geography changes. There is one thing, like the law of the farm. You cannot sow something today and reap tomorrow. Every seed which is sown will have to go through different seasons. It will take time before the seed becomes a fully grown tree.
While Mr. Parikh has made a very important point about the law of the farm, I believe most investors make the mistake of taking the wrong lesson from it. And I have no shame in admitting that I have been one of them in the past.
We will get to the wrong lesson in a bit.
First, let’s try to understand how the law of the farm works.
Wikipedia says this about farming:
The agricultural cycle is the annual cycle of activities related to the growth and harvest of a crop. The main steps for agricultural practices include preparation of soil, sowing, adding manure and fertilizers, irrigation, harvesting, and storage.
If I have to explain stock market investing in the same manner, I would say this:
The stock market investing cycle is a long term cycle of activities related to buying and selling of stocks. The main steps for investing practices in that order would be
- Research on an investment idea and initial due-diligence (Preparation of the soil)
- Buying the stock in your portfolio (Sowing the seeds)
- Maintenance Due-diligence of businesses, management and Valuation (Adding manure and fertilizers, and irrigation)
- Selling the stock and keeping the cash ready for re-investment opportunities (Harvesting and storage).
As long term investors, we are good at the first two steps. It’s the latter two where most of us falter. Because we often fail to differentiate between Buy and Hold and Buy and Forget in investing.
This is where I believe we need to understand what Mr. Parikh says in the video. He asks us to be ready to wait for long periods before the harvesting time comes (when the time to sell a stock comes). But he never asks us to stop the maintenance due-diligence.
And the wrong lesson which we often take is this:
That we can hold stocks for a very long period and expect them to generate good returns on investment all the time.
I have learned it the hard way that not all seeds in the stock market can be watered until the time of harvest. You have to be alert and more careful in the third stage where you continue to do your maintenance due-diligence on the business you own. Some stocks deserve to move out of the portfolio even before the harvesting time comes. The reasons could be internal or external.
Internal reasons could be:
- A mistake at the soil preparation stage (you fail to recognize the red flags during the initial due-diligence)
- A mistake at the sowing stage (buying the stock at high valuation)
External reasons could be:
- Maintenance due diligence reveals that facts related to business, management, or valuation have changed for the worse.
- A sudden change in the weather condition has led to a situation where growing that particular crop is difficult (example- COVID-19 scenario for some companies or industries)
Moreover, even the seeds, that grow into high yielding crops, need to be harvested at some time. This is an important lesson which we do not take and become complacent with our current holdings in the portfolio.
We must understand the subtle difference between farming and investing. In farming, the steps are clear to farmers. And they get instant feedback on failures. If a crop is destroyed due to adverse climate conditions or pests and diseases or due to some poor farming techniques, the result is visible to the farmer.
However, in investing we take movements in the price of the stock as the only feedback to validate our hypothesis. And there have been many cases of stocks lying undervalued for a long period of time despite having very good fundamentals. Similarly, there are cases of fundamentally weak companies where the stock price continues to move upward for a long time. The law of the farm catches up eventually. So, the good company gets rewarded by the market and the bad get punished at some point in the future. But this may take a lot of time to happen.
A smart investor should be able to differentiate between the two and not get enamoured by only the movement in the stock price.
So, as investors, we should take the right lessons from the law of the farm.
Plan well. Do thorough due diligence.
Select the right seeds to sow.
Wait for the right time to sow the seeds.
Post sowing, be alert, and don’t forget the Maintenance Due-Diligence.
Be aware and be bold to take the right decisions.
Some stocks will have a longer shelf life in your portfolio. And many stocks will not.
Your job as a farmer/investor is to observe on a constant basis and act accordingly.
As investors we can learn a lot about the law of the farm here:
Your initial due diligence might get you into a position but your maintenance due diligence is what will make you the big money and save you from big losses. Don’t rely on yesterday’s analysis. Companies are always evolving in good and bad ways. Know what you own at all times.
~ Ian Cassel, microcap investor.