Suresh Sadagopan
If you dig in the same spot long enough, you'll eventually find water, goes an old saying. But many people dig in one place for a while, and then get impatient or distracted and start digging in another place, and then another... When they don't find water in any of those, they blame their luck. It's surprising that more people haven't figured out the simple trick. Of course, there's no denying the importance of choosing the best place to dig in the first place.
Many people dart in a new direction randomly. Many get caught up in the latest investing fads. There are broad trends like equity and mutual fund investing. Then, real estate, commodities, and gold. And then there are micro-trends - read 'fads' - like going overboard on mid-caps, banking stocks, the communications sector, and infrastructure. In pursuit of the latest trend, investors churn their portfolio.
These are the people you find glued to the TV, watching business channels, where post-mortems and predictions are doled out incessantly to viewers who wait with bated breath for the latest, as if they could get the news and act on it before anyone else. But what's on the TV channels is 'news ' only to the retail investor. The rest of the investing world usually not only knows about it, but has often also acted on it. The result is that retail investors are often the last to rush in, and get the empty shell, after the kernel has already been eaten by those higher up in the investing food chain.
The investing topography also has its share of whirlpools and quicksand. These feature things like rumors floated by vested interests, and often aimed at retail investors. Trusting investors follow the trail laid out for them. Then the cowboys who floated the rumours unwind their positions and move on to the next pasture, leaving trapped investors bleating plaintively.
Retail investors are fascinated by day trading. Who hasn't heard a story about someone's neighbor or cousin who makes money hand-over-fist on a daily basis? Isn't it remarkable that one hardly ever hears stories about the losses made by these legends? Many investors have great faith that there exist fail-proof methods to become really rich really quick.
They underestimate the risks they take, and rely too heavily on the instincts of themselves and of others, often at the expense of plain logic. The tide of optimism exposes their gambling streak, and they end up making bets that may not be as sound as they first appeared. Fact is, it's very difficult to predict equity markets, because there are simply too many variables involved
For those who want to get rich fast, investing time frames are measured in days rather than years. All those talk about wealth creation over time - how boring! What could be tamer than returns of 12-15 percent a year? The hot-blooded investor will settle for nothing less than doubling his money in six months. But the fact is that risk and return normally have a direct correlation - the higher the risk, the higher the returns. However, the chances of good returns increase - while risk does not - when one gives one's investment time to perform.
When investors burn their fingers, they leap to the conclusion that investing is dangerous, and swear they will never return to it... until the next fad comes along. Drifting from one investment to another without any strategy will not help anyone reach their long-term goals. It amounts to digging in too many places for water.
If there's no strategy for achieving goals, it may never happen. Many simply chase money. But that money is required for achieving certain milestones, fulfilling aspirations and meeting goals. Making money is fine - who could argue against that! But just chasing money, and letting oneself be led in any direction that seems appropriate at a given moment, will render the whole exercise futile.
Investors need to work with goals in mind, and work towards reaching them in the appropriate time frame, which is what financial planning is all about. There is no compelling reason to arbitrarily gun for some high threshold of return (say 40 percent a year) which will only drive the investors towards riskier options. Responsible investments made over a period help in achieving goals, even if they give modest returns. Investors need to give them time. Like everything else in life, it takes time for an investment to bear fruit.
Less is more. There's no need to keep moving your money around. If you have invested in good options in a diversified manner, just let it be. That way you don't have to constantly look around for options to shift to.
Remember, if something seems too good to be true, it probably is. Schemes which promise stratospheric returns deserve your skepticism.
So do those who claim to be sure about which way the stock market will turn, which stock will do well this year, and the like. When someone is that sure, take their views with a proportionately big pinch of salt.
As for knowing where to dig for water, you would consult a hydrologist, engineer, or some other professional, wouldn't you? Why should it be different with money? Find a consultant you can trust, who will guide you responsibly
Sunday, 25 May 2008
5 not to do's in stock market
1. Not to give in to greed and fear: This is an important point, which you, as an investor, must keep in mind owing to its great influencing ability in equity investment decisions. This point simply means that in a bull run - control the greed factor, which could entice you, the investor, to compromise with your investment principles. By this we mean that while an investor could get lured into investing in penny and small-cap stocks owing to their eye-popping returns, it must be noted that these stocks have the potential to wipe out almost the entire invested capital. Another way greed affects investor behaviour is when they buy/hold stocks above the price justified by its fundamentals. Similarly, in a vice-versa scenario (bear market), investors must control their fear when stock markets turn unfavourable and stock prices collapse. Panic selling would serve no purpose and if the company has strong fundamentals, the stock is more than likely to bounce back. It is apt to note here what Warren Buffett, the legendary investor, had to say when he was asked about his abstinence from the software sector during the tech boom, "It means we miss a lot of very big winners but it also means we have very few big losers.... We're perfectly willing to trade away a big payoff for a certain payoff".
2. Not to time the market: This is one factor, which many experts/investors claim to have understood but are more often wrong than right. We believe that it is rather impossible to time the market on a day-to-day basis and by adopting such an approach, an investor would most probably be at the losers' end. In fact, investors should take advantage of the huge volatility that is witnessed in the markets time and again (and will be in 2008). In Benjamin Graham's words, "Basically, price fluctuations have only one significant meaning for the 'true' investor. They provide him an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times, he will do better if he forgets about the stock market".
3. Not to act based on rumours and sentiments: Rumours are a part and parcel of stock markets, which do influence investor sentiments to some extent. However, investing on the basis of this could prove to be detrimental to an investor’s portfolio, as these largely originate from sources with vested interests, which more often than not, turn out to be false. This then leads to carnage in the related stock(s) leaving retail investors in the lurch. However, if we consider this from another point of view, when sentiments turn sour but fundamentals remain intact, investors could take the opportunity to build a fundamentally strong portfolio. This scenario is aptly described by Warren Buffett, "Be fearful when others are greedy and be greedy when others are fearful".
4. Not to attach emotionally with stocks: It is very much possible that the company you have invested in fails to perform as per your expectations. This consequently gets reflected on the stock price. However, in such a scenario, it would not be wise to continue to hold onto the stock/buy more at lower levels on the back of expectations that the company's performance may improve for the better and the stock would provide an opportunity to exit at higher levels. Here it is advisable to switch to some other stock, which has promising prospects. In Warren Buffett's words, "Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks".
5. Not to borrow and buy stocks: This behaviour is typical in times of a bull run when investors invest more than what they can manage with the hope of making smart returns on the borrowed money. Though this move may sound intelligent, it is smart only till the time markets display a unidirectional move (i.e. northwards). However, things take a scary turn when the markets reverse direction or move sideways for a long time. This is because it leads to additional margin calls by the lender, which might force the investor to book losses in order to meet the margin requirements. In a graver situation, a stock market fall could severely distort the asset allocation scenario of the investor putting his other finances at risk.
2. Not to time the market: This is one factor, which many experts/investors claim to have understood but are more often wrong than right. We believe that it is rather impossible to time the market on a day-to-day basis and by adopting such an approach, an investor would most probably be at the losers' end. In fact, investors should take advantage of the huge volatility that is witnessed in the markets time and again (and will be in 2008). In Benjamin Graham's words, "Basically, price fluctuations have only one significant meaning for the 'true' investor. They provide him an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times, he will do better if he forgets about the stock market".
3. Not to act based on rumours and sentiments: Rumours are a part and parcel of stock markets, which do influence investor sentiments to some extent. However, investing on the basis of this could prove to be detrimental to an investor’s portfolio, as these largely originate from sources with vested interests, which more often than not, turn out to be false. This then leads to carnage in the related stock(s) leaving retail investors in the lurch. However, if we consider this from another point of view, when sentiments turn sour but fundamentals remain intact, investors could take the opportunity to build a fundamentally strong portfolio. This scenario is aptly described by Warren Buffett, "Be fearful when others are greedy and be greedy when others are fearful".
4. Not to attach emotionally with stocks: It is very much possible that the company you have invested in fails to perform as per your expectations. This consequently gets reflected on the stock price. However, in such a scenario, it would not be wise to continue to hold onto the stock/buy more at lower levels on the back of expectations that the company's performance may improve for the better and the stock would provide an opportunity to exit at higher levels. Here it is advisable to switch to some other stock, which has promising prospects. In Warren Buffett's words, "Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks".
5. Not to borrow and buy stocks: This behaviour is typical in times of a bull run when investors invest more than what they can manage with the hope of making smart returns on the borrowed money. Though this move may sound intelligent, it is smart only till the time markets display a unidirectional move (i.e. northwards). However, things take a scary turn when the markets reverse direction or move sideways for a long time. This is because it leads to additional margin calls by the lender, which might force the investor to book losses in order to meet the margin requirements. In a graver situation, a stock market fall could severely distort the asset allocation scenario of the investor putting his other finances at risk.
Monday, 5 May 2008
Systematic Transfer Plans (STPs)
The functioning of STPs is quite similar to that of SIPs in terms of depositing a fixed sum into a fund at regular intervals. The difference here is that a lump sum can be invested in debt funds with nominal risk, and periodically, a specific amount can be transferred to a diversified equity fund.
STPs score over SIPs in a situation where you have the money to invest, but are wary of the turbulence in the market. In such a scenario, it’s better to park your money in debt funds that give decent returns, rather than opting for short-term fixed deposits/savings accounts that earn lacklustre interest. Also, the regular flow of your money into equity funds will ensure that you don’t lose out on the attractive returns they offer.
STPs score over SIPs in a situation where you have the money to invest, but are wary of the turbulence in the market. In such a scenario, it’s better to park your money in debt funds that give decent returns, rather than opting for short-term fixed deposits/savings accounts that earn lacklustre interest. Also, the regular flow of your money into equity funds will ensure that you don’t lose out on the attractive returns they offer.
Sunday, 4 May 2008
Ten golden rules of Dalal Street
Dinesh Thakkar
Currently, the Indian markets are in doldrums and nobody is talking of stocks or investments. You may think justifiably so, as the markets are headed in no direction. Is it not exactly the opposite of the exuberant times we were witnessing a few months back. Conversely, bottoms are made in turbulent times.
It is difficult, if not impossible, to say when the markets will halt their southward journey and change direction for the better. Who knows, we might have already hit the bottom and the markets may soon return back to their upward trajectory.
My empirical observation and research have proved it that wealth making in the market has more to do with discipline and the power of time to compound growth than being smart at stock picking and timing the markets just right. To help you in your quest to make wealth in our markets, I suggest you follow the 10 golden rules of markets that will virtually ensure reasonable, steady wealth appreciation.
Bear in mind, you cannot have your cake and eat it too. Saving and consumption do not go hand-in-hand. You need to plan today for the lifestyle you want after you stop working, i.e. the finances you will require after you retire. Accordingly, save the necessary portion of your income to invest in equities. Equities, or stocks, may appear risky, but they are just volatile, they go up and down, and time is the perfect hedge against volatility.
Therefore, Rule No 1: Plan for tomorrow, today. Start saving for it now! Stagger your investments throughout your earning phase. Invest regularly and invest for the long term to buy in at an average price that includes both markets’ up and down ticks.
Never wait until you have large amounts of money to invest. However small the amount you are able to save, start early. The earlier you start, the better are your chances of making great wealth. Remember to make great gains. Time is a crucial factor, as wealth creation is a factor of both the power of compounding and the returns on your investments.
Accordingly, Rule No 2: Start early so that the power of compounding begins sooner; time is the magic that converts paise into rupees. In exuberant phases, when we have earned good money from our investments, most of us get greedy, and derivatives and futures provide an outlet for the expression of human greed. While such instruments often satisfy the whims of human greed, if taken to unrealistic levels, irresponsible investment in these securities can lead to financial ruin.
Hence, Rule No 3: Do not leverage, it is difficult, if not impossible, to predict short-term trends. Buy markets, not stocks. We all know that our economy is in a secular phase of rosperity and the stock market is the best proxy for the growth of an economy. To benefit from our oaring economy, buy the market as a whole and not any single stock.
Consequently, Rule No 4: Buy stocks that mirror the broader indexes, but never buy a single, or a handful of stock exposures. This means that you need to spread your risk across various market segments in the event a particular stock does not perform for reasons beyond the company’s control. It is easier to predict company earnings, but difficult to predict stock prices of the same company in the short run. Ironically, over the long term, stock prices mirror growth in a corporation’s earnings.
Therefore, Rule No 5: Look at company earnings, not at stock prices. Stock prices may tempt or give the wrong impression of a company’s welfare. But to build real wealth in equities, you must always rely on declared profits and facts, rather than make decisions based on stock movements. We all tend to sell stocks when we have made profits and keep the ones that have not appreciated. Eventually, we end up holding a portfolio of companies that are not performing! It is only human to sell for profits and not to want to take losses.
Hence, Rule No 6: Keep the winners, sell the losers. Stay on top of your investments. Check constantly for stocks that are not performing and eliminate them from your portfolio if the outlook does not seem promising. This way, you will have all winners left in your portfolio to take you to your goals.
In exuberant times, we all tend to believe that the good times will last longer than they actually will. And before D-day, we will be able to sell our investments that were bought at unjustified levels. Just then, it happens that the markets turn and before we can sell out, we are left holding the bag.
For this reason, Rule No 7: Avoid being the “Bigger Fool;” it is imperative that you recognise the difference between price and value. Buy value and not momentum. When investing in stocks, your head should prevail over your heart. Resist the urge to get consumed by market chatter. Ignore hot tips from dealers and friends. It is advisable to do your own home work.
As the result, Rule No 8: Pick stocks with your brain, not your heart. Large-caps are the ones that have already proven themselves over longer periods of time and have the balance sheet acumen, strong cash flow and brains to manage businesses effectively according to prevailing situations and realistic opportunities available.
Hence, Rule No 9: Prefer large-cap stocks to small- and medium-caps. Investment in small and mid-cap stocks requires expertise and strong tracking abilities, that without, your portfolio will under-perform. Do not short sell a stock just because it is going up, and thus, one day it must come down. Newton’s law is not applicable to the markets. What goes up does not necessarily come back down! If companies are able to sustain earnings’ growth for long periods, then its stock may go up, up and up, or it can even remain high without any reason for a long period of time.
Because of this, Rule No 10: Markets can remain irrationally up, or continually climb for the right reasons. Therefore, never go short. It will expose you to unnecessary risks.
Currently, the Indian markets are in doldrums and nobody is talking of stocks or investments. You may think justifiably so, as the markets are headed in no direction. Is it not exactly the opposite of the exuberant times we were witnessing a few months back. Conversely, bottoms are made in turbulent times.
It is difficult, if not impossible, to say when the markets will halt their southward journey and change direction for the better. Who knows, we might have already hit the bottom and the markets may soon return back to their upward trajectory.
My empirical observation and research have proved it that wealth making in the market has more to do with discipline and the power of time to compound growth than being smart at stock picking and timing the markets just right. To help you in your quest to make wealth in our markets, I suggest you follow the 10 golden rules of markets that will virtually ensure reasonable, steady wealth appreciation.
Bear in mind, you cannot have your cake and eat it too. Saving and consumption do not go hand-in-hand. You need to plan today for the lifestyle you want after you stop working, i.e. the finances you will require after you retire. Accordingly, save the necessary portion of your income to invest in equities. Equities, or stocks, may appear risky, but they are just volatile, they go up and down, and time is the perfect hedge against volatility.
Therefore, Rule No 1: Plan for tomorrow, today. Start saving for it now! Stagger your investments throughout your earning phase. Invest regularly and invest for the long term to buy in at an average price that includes both markets’ up and down ticks.
Never wait until you have large amounts of money to invest. However small the amount you are able to save, start early. The earlier you start, the better are your chances of making great wealth. Remember to make great gains. Time is a crucial factor, as wealth creation is a factor of both the power of compounding and the returns on your investments.
Accordingly, Rule No 2: Start early so that the power of compounding begins sooner; time is the magic that converts paise into rupees. In exuberant phases, when we have earned good money from our investments, most of us get greedy, and derivatives and futures provide an outlet for the expression of human greed. While such instruments often satisfy the whims of human greed, if taken to unrealistic levels, irresponsible investment in these securities can lead to financial ruin.
Hence, Rule No 3: Do not leverage, it is difficult, if not impossible, to predict short-term trends. Buy markets, not stocks. We all know that our economy is in a secular phase of rosperity and the stock market is the best proxy for the growth of an economy. To benefit from our oaring economy, buy the market as a whole and not any single stock.
Consequently, Rule No 4: Buy stocks that mirror the broader indexes, but never buy a single, or a handful of stock exposures. This means that you need to spread your risk across various market segments in the event a particular stock does not perform for reasons beyond the company’s control. It is easier to predict company earnings, but difficult to predict stock prices of the same company in the short run. Ironically, over the long term, stock prices mirror growth in a corporation’s earnings.
Therefore, Rule No 5: Look at company earnings, not at stock prices. Stock prices may tempt or give the wrong impression of a company’s welfare. But to build real wealth in equities, you must always rely on declared profits and facts, rather than make decisions based on stock movements. We all tend to sell stocks when we have made profits and keep the ones that have not appreciated. Eventually, we end up holding a portfolio of companies that are not performing! It is only human to sell for profits and not to want to take losses.
Hence, Rule No 6: Keep the winners, sell the losers. Stay on top of your investments. Check constantly for stocks that are not performing and eliminate them from your portfolio if the outlook does not seem promising. This way, you will have all winners left in your portfolio to take you to your goals.
In exuberant times, we all tend to believe that the good times will last longer than they actually will. And before D-day, we will be able to sell our investments that were bought at unjustified levels. Just then, it happens that the markets turn and before we can sell out, we are left holding the bag.
For this reason, Rule No 7: Avoid being the “Bigger Fool;” it is imperative that you recognise the difference between price and value. Buy value and not momentum. When investing in stocks, your head should prevail over your heart. Resist the urge to get consumed by market chatter. Ignore hot tips from dealers and friends. It is advisable to do your own home work.
As the result, Rule No 8: Pick stocks with your brain, not your heart. Large-caps are the ones that have already proven themselves over longer periods of time and have the balance sheet acumen, strong cash flow and brains to manage businesses effectively according to prevailing situations and realistic opportunities available.
Hence, Rule No 9: Prefer large-cap stocks to small- and medium-caps. Investment in small and mid-cap stocks requires expertise and strong tracking abilities, that without, your portfolio will under-perform. Do not short sell a stock just because it is going up, and thus, one day it must come down. Newton’s law is not applicable to the markets. What goes up does not necessarily come back down! If companies are able to sustain earnings’ growth for long periods, then its stock may go up, up and up, or it can even remain high without any reason for a long period of time.
Because of this, Rule No 10: Markets can remain irrationally up, or continually climb for the right reasons. Therefore, never go short. It will expose you to unnecessary risks.
Saturday, 19 April 2008
Investing & the theory of inversion
"66", muttered the grocer to himself as he reached out to his cash counter at one of the corner grocery stores and pulled out few notes and coins totaling Rs 66. He settled the transaction by promptly handing over the money to the customer who had bought goods worth Rs 34 but had paid Rs 100 for lack of change.
While the grocer moved onto other activity with nonchalant ease, we were impressed by how quickly he managed to mentally calculate the difference between 100 and 34. After watching him settle few more of such transactions, it finally dawned that rather than subtraction, he relied upon a quicker and a less error prone technique of starting with the base amount and then continuing adding to it until he reached the amount that the customer actually paid him. Like in the case of the customer who gave him Rs 100, he started with 34 and kept on adding until he reached 100. '66', the number struck to us at lightening speed and we had just discovered a technique that is sure to save us few hours over the course of our lifetimes.
Little did the grocer realize that he was relying upon a mental exercise that the famous mathematician Carl Jacobi had made immortal with his words, "Invert, always invert". Jacobi had reasoned that it is probably in the nature of things that a lot of problems in the world can be solved by thinking backwards. This phrase has been made more famous in recent times by Charles Munger, the lesser known but an equally erudite partner of Warren Buffett and who is believed to have had one of the greatest influences on him.
Let us try and find answers to few simple questions like 'What does it take to be successful?' or 'What should I eat to remain healthy?' While the answers to these questions can definitely be worked out, exactly opposite queries to the above set of questions will most likely lead to new insights and make our job that much more easier. Thus, if we now try answering questions like 'What qualities makes a man unsuccessful and how should I avoid them?' or 'What food will make me fat and unhealthy?' These questions are exactly opposite in nature to the ones posted above and rely upon the theory of inversion. To test the efficacy of the method, additional sets of questions, one proper and one inverted should be framed and indeed analysed. After going through the results, we don't think that there would be doubt in anyone's mind that this technique is indeed a very important tool to solve many of the life's problems.
Now, how do we use this theory of inversion in the field of investing? We believe that inversion works just as fine in investing as any other field and if properly adhered to, is likely to result into much better investment results. Say for example, after an investor has carefully analysed all the reasons for investing in a stock, he should resort to inversion and ask himself, "What are the reasons that will make me not invest in the stock?" More often than not he is likely to stumble upon something he had not known previously and hence, would help him take a more informed decision.
Another way in which the technique can be used effectively is by questioning the price that a stock commands in the market place. Normally, while analyzing the investment worthiness of a stock, an investor makes some assumptions about future cash flows and discount rates and then arrives at a fair value. This fair value is in turn compared with the stock price and depending upon the premium or discount, one chooses to invest or not to invest in the stock. How about inverting the analysis and starting with the market price and then questioning ' What kind of future cash flows does the current market price imply?' The results that such kind of analysis throws will be no less than startling.
Let us consider a company ABB, which as per our database is currently the most expensive stock on the Nifty with a trailing twelve-month price to earnings ratio of 50 times. Now if you are the one looking to invest in 5 baggers with an investment horizon of five years then is the stock a right bet for you? Let us assume that in five years time, the stock will come down to a more realistic and the broader market like P/E of 20 times. Thus, for the stock to become a five bagger in five years, it will have to grow its earnings at a CAGR of around 66% (explanation given below), a feat that is really difficult if not impossible to achieve for most of the well-established companies like ABB.
This wonderful insight was made possible because of inversion. We started with the price and the P/E ratio and then went on to check whether it is really possible for the stock to become a five bagger, realising that the probability of such an event happening is indeed low. Hence, the next time you come across a good stock to consider for investment, do not forget to pass it under the screen of the inversion theory and as mentioned before, the results might surprise you.
Explanation - Assume that ABB's current EPS is Re 1. So, at 50 times P/E, the company's current stock price will be Rs 50. If the stock were to become a five bagger in five years, the price has to touch Rs 250. Now, assuming that after 5 years, the stock's P/E were to come down to a more realistic and the broader market like P/E of 20 times, the EPS thus calculated will be Rs 12.5 (Rs 250 divided by 20). Compared to the current assumed EPS of Re 1, for the same to grow to Rs 12.5 in five years times would require it to grow by 66% CAGR.
While the grocer moved onto other activity with nonchalant ease, we were impressed by how quickly he managed to mentally calculate the difference between 100 and 34. After watching him settle few more of such transactions, it finally dawned that rather than subtraction, he relied upon a quicker and a less error prone technique of starting with the base amount and then continuing adding to it until he reached the amount that the customer actually paid him. Like in the case of the customer who gave him Rs 100, he started with 34 and kept on adding until he reached 100. '66', the number struck to us at lightening speed and we had just discovered a technique that is sure to save us few hours over the course of our lifetimes.
Little did the grocer realize that he was relying upon a mental exercise that the famous mathematician Carl Jacobi had made immortal with his words, "Invert, always invert". Jacobi had reasoned that it is probably in the nature of things that a lot of problems in the world can be solved by thinking backwards. This phrase has been made more famous in recent times by Charles Munger, the lesser known but an equally erudite partner of Warren Buffett and who is believed to have had one of the greatest influences on him.
Let us try and find answers to few simple questions like 'What does it take to be successful?' or 'What should I eat to remain healthy?' While the answers to these questions can definitely be worked out, exactly opposite queries to the above set of questions will most likely lead to new insights and make our job that much more easier. Thus, if we now try answering questions like 'What qualities makes a man unsuccessful and how should I avoid them?' or 'What food will make me fat and unhealthy?' These questions are exactly opposite in nature to the ones posted above and rely upon the theory of inversion. To test the efficacy of the method, additional sets of questions, one proper and one inverted should be framed and indeed analysed. After going through the results, we don't think that there would be doubt in anyone's mind that this technique is indeed a very important tool to solve many of the life's problems.
Now, how do we use this theory of inversion in the field of investing? We believe that inversion works just as fine in investing as any other field and if properly adhered to, is likely to result into much better investment results. Say for example, after an investor has carefully analysed all the reasons for investing in a stock, he should resort to inversion and ask himself, "What are the reasons that will make me not invest in the stock?" More often than not he is likely to stumble upon something he had not known previously and hence, would help him take a more informed decision.
Another way in which the technique can be used effectively is by questioning the price that a stock commands in the market place. Normally, while analyzing the investment worthiness of a stock, an investor makes some assumptions about future cash flows and discount rates and then arrives at a fair value. This fair value is in turn compared with the stock price and depending upon the premium or discount, one chooses to invest or not to invest in the stock. How about inverting the analysis and starting with the market price and then questioning ' What kind of future cash flows does the current market price imply?' The results that such kind of analysis throws will be no less than startling.
Let us consider a company ABB, which as per our database is currently the most expensive stock on the Nifty with a trailing twelve-month price to earnings ratio of 50 times. Now if you are the one looking to invest in 5 baggers with an investment horizon of five years then is the stock a right bet for you? Let us assume that in five years time, the stock will come down to a more realistic and the broader market like P/E of 20 times. Thus, for the stock to become a five bagger in five years, it will have to grow its earnings at a CAGR of around 66% (explanation given below), a feat that is really difficult if not impossible to achieve for most of the well-established companies like ABB.
This wonderful insight was made possible because of inversion. We started with the price and the P/E ratio and then went on to check whether it is really possible for the stock to become a five bagger, realising that the probability of such an event happening is indeed low. Hence, the next time you come across a good stock to consider for investment, do not forget to pass it under the screen of the inversion theory and as mentioned before, the results might surprise you.
Explanation - Assume that ABB's current EPS is Re 1. So, at 50 times P/E, the company's current stock price will be Rs 50. If the stock were to become a five bagger in five years, the price has to touch Rs 250. Now, assuming that after 5 years, the stock's P/E were to come down to a more realistic and the broader market like P/E of 20 times, the EPS thus calculated will be Rs 12.5 (Rs 250 divided by 20). Compared to the current assumed EPS of Re 1, for the same to grow to Rs 12.5 in five years times would require it to grow by 66% CAGR.
The right track
Index funds track the broad market, and thus make for a good investment in a rising market—but watch out for the tracking error.
Narendra Nathan
6 Jul 2001
SEASONED INVESTORS know that the best time to buy is when everyone else is selling. Which should make it a good time to invest in equities now. That, however, has its own associated difficulties—stock-picking is not easy.
There is, however, a special class of mutual funds—index funds—that are designed to track the market's every move. That makes them an attractive investment in a market recovering from a bear run.
No fund-manager risk. Mutual funds have historically offered lower returns than the broader market. That is because fund managers, in their attempts to beat the market, often go overboard and deviate from their mandates. LIC’s Dhanasamrudhi Fund, for instance, has a portfolio that is heavily skewed in favour of just four stocks: ITC (37 per cent), Hind. Lever (27 per cent), Bharat Petroleum (18 per cent) and Sterlite (17 per cent). Others are heavily concentrated on just one sector. For instance, ING Growth Fund is biased in favour of ICE (Information, communication and entertainment) stocks, which constitute 92 per cent of its portfolio. Not surprisingly, the fund’s NAV has fallen 67 per cent as compared to the broad market’s fall of 28 per cent.
Managers of index funds, on the other hand, have a simple mandate—to closely track a chosen index. That precludes any attempts to beat the market, and therefore the low returns that most mutual funds are prone to. It also makes for a well-diversified and balanced portfolio. The table below details the four index funds available in India.
Beware of tracking error. Theoretically, returns from index funds should not deviate at all from the indices they are based on. In practice, however, there is a slight variance, known as the tracking error.
For an illustration, take the returns from a fund based on the Sensex. Rs 100 invested in a Sensex index fund (on 1 April, when the index was launched) should now be worth Rs 3,457. This works out to a reasonable long-term return of 17.15 per cent per annum. A tracking error of 1 per cent would mean that returns from this fund would vary from the Sensex by 1 percentage point on an yearly basis. If that 1 percentage point tracking error is on the negative side (that is, the fund’s returns have lagged the Sensex by 1 percentage point year-on-year), the index fund would have grown at 16.15 per cent since its launch. The Rs 100 investment would now be worth Rs 2,867—a gap of Rs 590. So, the lower the tracking error, the better the index fund.
Index funds in India typically have higher tracking errors than the ones in developed markets. For instance, the tracking error of UTI Nifty Index Fund exceeds 5 per cent—that’s more than 10 times the average figure for index funds in developed markets.
Causes of tracking errorExpenses. Expenses are the biggest cause of tracking error. Fund’s expenses include asset management fees, agents’ commissions, brokerage on buying and selling of shares and stationery expenses. Index funds in developed markets have very low expenses, thus reducing their tracking errors. By contrast, the best index fund in India, IDBI Principal Index Fund, has a tracking error of 0.74 per cent. The figure is even higher for the two index funds managed by UTI, as it charges expenses at the highest level allowed by Sebi. Explains Nilesh Shah, the fund manager, "We have to spend a lot of time and money to educate investors—what an index fund is, what can be expected from them…"
A closer look reveals that the major constituent of the expenses is the asset management fee—all the four available funds charge expenses at the highest permitted levels. (Two of these funds charge 1.25 per cent, the maximum allowed for funds of a size below Rs 100 crore.)
That seems unreasonable, as there is no active trading or stock selection involved—after all an index fund merely tracks the index. Rajat Jain, chief investment officer, IDBI Principal, counters this: "Even though there is no active trading, we still have to manage the funds and we have one person dedicated for this fund." Nilesh Shah, for his part explains: "We have forced to charge the maximum possible AMC fee because of the small corpus. Once the corpus improves, the AMC fee will come down."
Lack of competition is probably the biggest reason index funds charge the maximum allowed fund management fees. As more fund houses enter the fray, these fees should fall.
Dividends. Most index committees do not factor in the dividends declared by companies while computing the index. For instance, the dividend yield of Sensex and Nifty stocks is around 1.5 per cent, but this is not considered in the index calculations. An index fund’s NAV would rise when it receives dividend, and this would introduce a positive tracking error (which is a good thing, as opposed to a negative tracking error). The argument is that dividends represent a very small fraction of a fund’s corpus, and so are not worth the trouble.
The index committee at the NSE (National Stock Exchange) is now working on the Total Return Nifty (inclusive of the dividend), which would be used as the benchmark to compute the tracking error. Such a reworked index is not available for the UTI Master Index Fund, the only fund tracking the index.
Trading expenses. Tracking error is the difference between a fund’s NAV and the index’s closing price on any given day. Both the NAV and the index are calculated at the end of each trading day, based on the closing prices of stocks. However, funds have to do their buying and selling throughout the day, and their prices may vary from the closing prices.
The NSE’s post-closing session enables funds to buy and sell at the closing price, thus eliminating one constituent of the tracking error.
Market lots. Assume that an index fund receives an inflow of Rs 5 lakh in a day. This can’t be parked on the same proportion on the same day, as the exact division will leads to investment in shares in fractions, which is not possible. The allotment has to be rounded off to the nearest whole number, which introduces another element of tracking error. This problem used to be even more severe before the introduction of dematerialisation, when stocks had to be traded in market lots of 50 or 100 shares.
Index futures have helped funds reduce this element of tracking error. Explains Rajat Jain, chief investment officer, IDBI Principal, "What we can do now is park these small (residual) amounts in index futures and convert them into actual shares on a later day."
Cash component. Being open-ended, index funds have to keep a fraction of their corpus ready in the form of cash. This cash component adds to tracking error. For illustration, assume an index fund with 4 per cent of its corpus in cash. If the index rises by 5 per cent, this fund’s NAV can rise only by 4.8 per cent. The tracking error will be directly proportional to the cash component of an index fund.
Frequent trading by punters. Index funds are usually favoured by long-term investors, but punters often trade in and out to profit from short-term fluctuations. Frequent trades increase transaction costs, thereby increasing the tracking error.
All index funds have entry and exit loads to deter frequent trading. IDBI Principal charges an entry load of one per cent. UTI and Templeton funds do not charge entry loads, but have an exit load of one per cent for withdrawals before six months from the date of entry.
How is tracking error measured?The tracking error is the difference between the return generated by an index fund and those by the index it is based on. Assuming that the return generated by an index fund on a given day is 5 per cent and that by the underlying index is 5.13 per cent, the fund’s tracking error for that day would be 0.13 per cent. These errors are squared and added up for the last one year; the square root of this sum is the tracking error value for the full year. Another way to arrive at the tracking error is to calculate the standard deviation of the daily errors. This standard deviation is then annualised by multiplying it by the square root of 250 (on the assumption that there are 250 trading days a year)
Sunday, 13 April 2008
SIP or ....
Vivek Kaul
With the stock market down from its recent highs, one comes across a lot of half-baked analysis suggesting one-time investing is better than systematic investment plans (SIPs).
The primary reason for this may be the newspaper editors' craving for sensational headlines. Surely, "One time investment better than SIPs" makes for a much sexier headline than say "Continue with your SIPs." But, that doesn't quite make a good investment strategy any bad, or vice versa.
Let us consider four schemes, which have done very well over the last three years — Sundaram BNP Paribas Select Focus, SBI Magnum Contra, Kotak Opportunities and DSP Merrill Lynch India Tiger Fund.
Had you had started an SIP of Rs 5,000 every month in any of these schemes around three years back, you would have invested Rs 1.8 lakh (Rs 5,000 x 36 months) by now. You would have managed to accumulate around Rs 2.8 lakh by now, at an annual rate of return of around 30%.
Instead if you had invested Rs 1.8 lakh into any of the schemes on April 1, 2005, i.e. around three years back, your corpus would be anywhere between Rs 4.83 lakh and Rs 5.2 lakh depending on the scheme chosen.
Now, consider a situation where an investor started an SIP in any one of these schemes around one year back. An investment of Rs 5,000 per month would mean he would have invested Rs 60,000 over the year.
Now, in 2 out of the 4 schemes, he would have lost money. In comparison, had he made a one-time investment in any one of these four schemes, the value of his Rs 60,000 would be anywhere between Rs 80,000 and Rs 84,400.
Clearly, over both three-year and one-year periods, one-time investments would have worked better than SIPs. So why are we suggesting that SIP is the better option?
Let us sample the reasons.
First, you would agree that an individual has a better chance of investing Rs 5,000 every month, compared with putting in Rs 1.8 lakh at once.
Second, the SIP investor has also earned a return of around 30% per year and that is not bad by any stretch of imagination when compared with other modes of investment in the market.
Third, one-time investing works very well when the market is on its way up, as it was for the last three years, until the slide began. Thus, all the news highlighting the better performance of one-time investment vis-à-vis SIPs has the benefit of hindsight.
Now, let us take two investors, one of whom invested Rs 60,000 and the other Rs 1.8 lakh on January 8, 2008, when the stock market peaked. The investment of Rs 60,000 in any of these schemes would currently be valued anywhere between Rs 39,000 and Rs 43,000 a loss of around 33%.
Similarly, Rs 1.8 lakh invested in any of these schemes would currently be valued anywhere between Rs 1.19 lakh and Rs 1.24 lakh.
Now tell me, who would be better off? An investor who puts in Rs 5,000 every month over a period of one year or three years, or one who invested Rs 60,000 or Rs 1.8 lakh at one go, on the day the market peaked?
To reiterate, one-time investing works very well when the markets are going up. But, does anyone really know how long they will keep going up, or for that matter, whether they will from a certain point? Nobody does, for sure.
This is why it makes sense to keep investing in mutual funds regularly through the SIP route.
SIPs also help the investor buy more units in a falling market and thus decrease the overall cost of purchase of each unit, a phenomenon known as rupee cost averaging. Needless to say, that benefit is not available to the one-time investor.
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