Warren Buffett on Market Fluctuations

From 1997 Letter to Shareholders:

A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.

But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the “hamburgers” they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.

For shareholders of Berkshire who do not expect to sell, the choice is even clearer. To begin with, our owners are automatically saving even if they spend every dime they personally earn: Berkshire “saves” for them by retaining all earnings, thereafter using these savings to purchase businesses and securities. Clearly, the more cheaply we make these buys, the more profitable our owners’ indirect savings program will be.

Furthermore, through Berkshire you own major positions in companies that consistently repurchase their shares. The benefits that these programs supply us grow as prices fall: When stock prices are low, the funds that an investee spends on repurchases increase our ownership of that company by a greater amount than is the case when prices are higher. For example, the repurchases that Coca-Cola, The Washington Post and Wells Fargo made in past years at very low prices benefitted Berkshire far more than do today’s repurchases, made at loftier prices.
At the end of every year, about 97% of Berkshire’s shares are held by the same investors who owned them at the start of the year. That makes them savers. They should therefore rejoice when markets decline and allow both us and our investees to deploy funds more advantageously.

So smile when you read a headline that says “Investors lose as market falls.” Edit it in your mind to “Disinvestors lose as market falls — but investors gain.” Though writers often forget this truism, there is a buyer for every seller and what hurts one necessarily helps the other. (As they say in golf matches: “Every putt makes someone happy.”)

We gained enormously from the low prices placed on many equities and businesses in the 1970s and 1980s. Markets that then were hostile to investment transients were friendly to those taking up permanent residence. In recent years, the actions we took in those decades have been validated, but we have found few new opportunities. In its role as a corporate “saver,” Berkshire continually looks for ways to sensibly deploy capital, but it may be some time before we find opportunities that get us truly excited.

In a Fire Sale Think about Entry, not Exit!

The old adage that the market operates on greed and fear has been well-exemplified over the past few months. It is never savory to witness paper losses, and there are few fears as strong as losing one’s hard-earned money in a violent, abrupt market correction. In an environment where FIIs have been selling their wares at fire-sale prices to meet margin calls and recapitalization requirements in their home countries (or to simply avert bankruptcy), it may seem that the time has come to book losses, exit the market and re-enter at a more opportune time. However, there are several logical reasons why it does not pay to overreact…read on to understand why.

1. Market Timing never wins

A natural human reaction to a sudden plunge in the markets would be to run for safety by reducing or liquidating one’s exposure. The base instinct is to stem loss of capital and eventually re-enter the market at a more favourable juncture. However, repeated studies have shown that market timing, i.e. trying to perfectly time entry and exit points, seriously damages investor’s long-term returns. As the historical long-term trend of the stock market has been upward, one must recognize that there are significant risks with trying to accurately time the market’s peaks and troughs in search of abnormal gains. This strategy typically results in:

i. High exposure to stocks at the peak of bull runs (just prior to a sell-off), and
ii. A reduction of holdings in a deep bear market, just before of a period of stellar appreciation.

Essentially, timing the market puts one at risk of selling low and buying high, and is a sure-fire way of guaranteeing disappointing returns. Perfectly timing entry and exit points sounds good in theory, but usually fails in practice. The direction of the market can change rapidly, and market rallies can occur suddenly and over very short periods. Further, attempting to move in and out of the market can be an extremely costly affair, particularly because a significant portion of the market’s gains over time tend to come in concentrated periods. Missing out on just a handful of the best-performing days in the market may leave investors at a significant performance disadvantage compared to investors who remain fully invested for the long-term.

2. Markets Do Recover

First, one must recognise that no two crises are alike. The paths that each crisis takes, and the institutions they decimate, are always different. In the current scenario, what started out as a boiling over of the U.S. housing market and over-extended banks resulted in a chain-reaction across the globe, claiming victims in diverse places from Russia and Iceland to Argentina. Volatile markets are by definition highly unpredictable, and a case in point is the U.S. Dollar. While one would expect that the currency of the country suffering the most would fall in value rapidly, the reverse has happened. The phenomenon of de-leveraging and unwinding of global assets by FIIs has resulted in huge demand from them for U.S. Dollars to repatriate back to their home countries.

The ensuing liquidity crisis in India, coupled with negative psychology and sentiment, has resulted in tight credit conditions across the economy. But history shows us that corporations learn to tighten their belts, governments induce liquidity and confidence-building measures, pricing re-discovery begins, and eventually the tide turns. Declines in the equity markets are not uncommon, and as mentioned previously, such periods of sudden turmoil have been normal occurrences in the market’s long-term upward trend.

3. Emotions ? Wealth Creation

Fleeing stocks for the safety of Gilts or CDs or Liquid Funds may seem quite appealing at times, especially when the market takes a sudden plunge on a negative news headline. In times of turmoil, it can be difficult to take a long-term view and resist the urge to react to the latest market swing. For short-term financial needs, cash and cash-equivalent investments can be good choices. However, they are not suitable for long-term wealth creation, because the returns are likely to be too low – your investments need to outpace inflationover time, otherwise your purchasing power is eroded. Historically, it’s been equities that have helped investors compensate for inflation by delivering higher average annual returns than cash or debt investments.

The need to keep an investment allocation policy constant is thus necessary for wealth accumulation. One can always alter the allocation to meet changing lifestyle needs and requirements, when it makes sense to revisit your investment plan due to meaningful changes in your life – the change should be driven by something significant and permanent. On the other hand, booking losses or making sudden, abrupt changes in line with market declines would not get you where you want to be. Keep in mind that 21st century technology and medical science advancements may help you live 80, 90 or even 100 years! With extended investment horizons the effects of inflation and the preservation of purchasing power need to be seriously considered. Staying calm can help investors avoid making moves they later regret. And emotional decisions more often than not lead to regrets.

4. Crisis = Opportunity Scale UP, not down!

To paraphrase the old sage of the markets, Warren Buffet, when others are fearful it is time to be greedy and vice versa. As painful as they are, market downturns can serve as reminders of the risk inherent in the market. It is precisely because stocks are a volatile asset class that they have historically provided a higher rate of return relative to other major asset classes, such as debt or cash. Market participants expect higher returns to compensate them for taking on additional risk. As a result, market fluctuations are the norm and not the exception, and short-term fluctuations are inevitable in the long-term upward trajectory of the market.

That is why some of the best periods to have entered the stock market have been during periods of particularly negative sentiment and extreme market turbulence. Hindsight suggests that during challenging economic episodes in history, investing more in stocks has been a prudent decision. While having the fortitude to stay invested provides an opportunity to fully participate in the market’s long-term upward trend, investing additional money has proven to be the kicker that can generate large returns in one’s portfolio. Waiting until sentiment feels positive again to make an investment has typically not been a good method of achieving future returns. Many of the best periods to invest in stocks have been those environments that were among the most unnerving.

5. Technicals vs. Fundamentals

When market technicals and perception start overriding the fundamentals, the question we ask is how is it that a large, blue-chip corporation is suddenly worth 20% or 30% less than a week ago or a month ago? Is the sell-off justified by the underlying economic and corporate fundamentals? Is the market becoming too pessimistic? Or is the sell-off in line with diminished expectations for economic growth, profitability and balance sheet performance in the coming months?

Whenever panic-induced selling begins, prices can become much cheaper than justified by their intrinsic value. This is the reverse of what typically happens in a hyper bull-market run. Valuations can become irrational on both the up-swing and down-swing. This is no doubt a tremendously challenging time for investors, but panics can cause prices to fall further than might be appropriate based on the underlying fundamentals. While nobody has a crystal ball to predict when exactly the bear market will turn around, you can be assured that as long as the entire world’s economy does not collapse overnight, it is low valuations that will eventually set the stage for the next bull-market rally.

Index funds good for passive investors

Index funds have been popular with investors. Over the last year, the returns from index funds have been pretty good - about 30 percent. This is higher than the returns equity schemes posted in the market .

An index fund is a type of mutual fund that invests in securities of the target index in the same proportion or weightage. Index funds are targeted to popular indices like the BSE Sensex or Nifty. There may be index funds benchmarked to sector-specific indices as well. For example, pharma, IT or FMCG sector indices.

These funds are expected to provide returns that closely track the benchmark index and are also subject to all the risks associated with the class of securities invested in. When the market falls, the securities comprising the index fund also fall, and the returns from index funds fall too. Their objective is to ensure that the returns do not vary far from returns from the index that the fund is linked to. These funds do not eliminate or reduce market risk.

Index funds are used by investors who are risk-averse . In comparison to actively managed funds, index funds have lower expense ratio, lower transaction costs, better control of risk through diversification and less prone to risk of fund manager's performance. Among institutional investors, index funds are used by pension and insurance funds.

Among individuals, investors who do have knowledge of the markets or are averse to sector-specific risks prefer index funds. Index funds can be either for equity funds or debt funds. Indexing is popular with investors who prefer steady returns through a conservative, long-term and lowrisk investment strategy.

Indexing is an investment approach that attempts to match the investment returns of a specified stock market benchmark or index. The fund attempts to replicate the investment results of the target index by holding all or a representative sample of the securities in the index. No attempt is made to use traditional stock management, take positions on individual stocks, or narrow industry sectors in an attempt to outpace the index.

Indexing is a relatively passive investment approach. Index funds are generally evaluated on the basis of the tracking error, i.e., the annualised standard deviation of the difference in returns between the index fund and its target index. It is the difference between returns from the index fund to that of the index.

An index fund needs to calculate tracking error on a daily basis. The lower the tracking error, closer are the returns of the fund to that of the target index. The tracking error is calculated against the total returns of the index, inclusive of dividends.

It indicates how closely the fund is tracking the index. It refers to the ratio of how close the weightages of the stocks in the portfolio are to the weightages of the stocks in the index. The more closely the weightage of the stocks are tracked in the index, lower will be the tracking error.

The factors that affect tracking error are inflows or outflows in the fund, corporate actions, change of index constituents, level of cash maintained in the fund, costs that are routinely deducted from fund returns like transaction costs including commissions , bid and ask spread, etc.

The higher the expenses incurred, greater will be the tracking error. Because of the tracking error, the returns from the index funds are usually lower than the benchmarked index. However, in case the tracking error is zero or negative, the index fund may deliver returns superior to that of benchmarked index.

Index funds are primarily meant for the passive investors. The portfolio of the index fund comprises stocks in a particular benchmark index. The composition of the portfolio is similar to the benchmark index, any movement in the underlying index would affect the fund. The NAV of the scheme replicate the underlying index. So the investor can swim and float with the index.

These funds are cost-effective . The schemes are pretty transparent. The investor knows in which companies his money is going to be invested. For example, if one invests in an index fund linked to the BSE Sensex, the investor knows that his money would be invested in the companies comprised in the BSE Sensex only and not in any other company. These funds are ideal for investors having a medium term view of the market.

As presently the stock markets are subdued , and are expected to rise in the times to come - over a time horizon of 1-2 years - one may consider including investments in index funds in his portfolio to get good returns.

Do expenses really matter?

Do expenses really matter?

Having discussed the various costs and expenses involved while investing in a mutual fund scheme, let’s now find out if they really matter. To understand this better, we shall compare two mutual fund schemes, one with a low cost structure (say Fund A) and the other which isn’t quite as charitable (say Fund B). Investments in Fund A attract an entry load of 1.0%, while the number is 2.5% for Fund B. Similarly, the recurring expenses are 1.5% and 2.5% for fund A and fund B respectively. Assume that Rs 100,000 (one-time investment) is invested in each fund for a 10-Yr period and that both the investments grow at 15.0% per annum.

Fund A vs............... Fund B
................................Fund A ........Fund B
...........Entry load................ 1.00% ............2.50%
Recurring expenses............ 1.50% ..............2.50%
Amount invested ........(Rs) 100,000.......100,000
Growth rate (per annum)...... 15.00% ............15.00%
Maturity amount 10 yr (Rs) ...344,331 ........306,217

On maturity (i.e. at the end of 10 years), the investment in fund A would be worth Rs 344, 331, while that in fund B would be worth Rs 306, 217. The differential can be traced to Fund A’s cost effectiveness.

While evaluating a mutual fund scheme, factors like the AMC’s investment philosophy and style, track record across parameters (risk and return) are usually given due weightage. To that list, investors would do well to add the fund’s cost efficiency. After all, as we have observed, over the long-term the costs involved can have a significant impact on the fund’s performance.

Stock market still trading 25-30% higher

In the high-flying world of equities, it’s seldom that investors talk about dividends. This is surprising; given that one of the best things about investing in a well-managed company is that it provides investors with regular tax-free dividend income that also grows along with the company.

In fact, for purists, the truest form of investment is the one that is done for dividends. Everything else is speculation, with varied time frames.

But do dividends teach us any lesson, given the current meltdown? And do they help in our efforts to find the bottom? An ETIGanalysis suggests that the answer to both these questions may lie in the history of dividend payouts of listed companies rather than their forward-earning estimates, as many traditionalists will like to believe.

A historical trend line of the dividend paid out by Nifty companies offers interesting insights — the current bull run began in April ’03 at an all-time high dividend yield of about 3.2% and the correction in January ’08 began at a seven-year low Nifty dividend yield of 0.8%.

Even more interesting is the fact that over the long term, there seems to be a close correlation between the growth in the dividend payout and the movement in the Nifty. To find this out, we indexed Nifty and the dividend-payout of Nifty stocks, beginning January 1999.

As the chart shows, whenever the Nifty has shot past and stayed above this dividend trend line for a sustained period, a correction has followed. And greater the gap, the sharper has been the ensuing correction. This phenomenon was first observed during the May ’04 correction and then, in May ’06.

Interestingly, just prior to that crash, Nifty had overshot its par value by close to 50%. What is striking, however, is that the Nifty started its recovery the very day the two trend lines converged. Even though the Nifty nearly doubled its value from its June ’06 lows over the next 18 months, dividend payments grew by less than 1/6th the rise in Nifty.

No wonder, the gap between these two trend lines had assumed dangerous proportions by January ’08, with the Nifty overshooting its fair value by over 100%! What followed was for every one to see. What’s even scarier is that the gap between these two trend lines continues to be what the gap was at the beginning of the May ’06 correction!

This means that to close the gap, either the Nifty has to fall by another 25-30% or India Inc’s dividend payout has to grow proportionally. With the latter looking unlikely, we seemed to be destined for an extended, painful and bloody bear market.

Mutual Funds: Cost to investor

The utility that mutual funds can offer to investors has been discussed and often eulogised in great detail. However, there is another vital aspect to mutual funds that is rarely spoken about – the costs. Investing in mutual funds entails bearing certain costs on the investor’s part. These costs, in turn have an impact on the returns clocked by the investor. In this article, we take a closer look at the various costs and expenses borne by investors while investing in a mutual fund scheme.

1. One-time charges
Entry/exit loads and initial issue expenses qualify as one-time charges, as opposed to recurring expenses which have been dealt with later in the article. First, let’s consider the case of new fund offers (NFOs). Over the last few years, investors have been faced with a deluge of NFOs. But in recent times, a perceptible trend in NFOs has been a rise in the number of close-ended funds. This phenomenon can be traced to the rules governing initial issue expenses. Close-ended funds are not permitted to charge any entry load; instead 6% of the sum mobilised during the NFO period can be utilised to meet the initial issue expenses. The same can be amortised (charged to the fund) over the fund’s close-ended tenure.

For example, if a close-ended fund were to mobilise Rs 5 billion (Rs 500 crores) during the NFO period, the asset management company (AMC) can utilise Rs 300 million (Rs 30 crores) to meet the sales, marketing and distribution expenses. Furthermore, the stated sum will be charged to the fund. This will impact the returns clocked by the fund. Any amount over the stated 6% has to be borne by the AMC.

Conversely, in the case of open-ended NFOs, funds are required to meet all the sales, marketing and distribution expenses from the entry load. They are not permitted to charge any initial issue expenses. The rules governing entry/exit loads state that taken together, the two cannot account for more than 6% of the net asset value (NAV). Charging an entry load for the entire 6% upfront would adversely affect the fund’s performance in the initial period. Hence AMCs choose to have rather “rational” entry loads in the range of 2.25%-2.50%. Like initial issue expenses, entry loads also eat into the investor’s returns, since the investor has that much less money working for him.

For example, say an investor invests Rs 5,000 in an open-ended fund that charges an entry load of 2.50%. Effectively, only Rs 4,875 is invested in the fund.

It is not difficult to understand why AMCs have a newfound liking for close-ended funds. With the provision for charging 6% of amount mobilised towards initial issue expenses, AMCs are better equipped to compensate the distributors and agents, who in turn help the fund houses in accumulating more assets. Higher assets translate into higher revenues for the AMCs. Of course, close-ended funds do offer advantages as well. For example, the fund manager can make investments from a long-term perspective and investors are given the opportunity to invest for a pre-defined investment horizon. However, investors would do well to factor in the costs involved.


2. Recurring expenses
Investors also have to contend with recurring expenses, which are charged annually to the fund. These expenses are revealed in the form of an expense ratio that is declared twice a year. Recurring expenses (as is the case with amortised initial issue expenses) are “silent” in nature since they don’t necessarily attract the investor’s attention. The reason being that the fund’s NAV is declared after the recurring expenses have been accounted for.

The Securities and Exchange Board of India (SEBI) has laid out guidelines defining the manner in which recurring expenses can be charged; the same is a factor of the fund’s average weekly assets (however most AMCs choose to compute it as a percentage of the average daily assets).

The expense ratio
Average daily net assets........% Limit

First Rs 1,000 m............2.50%
Next Rs 3,000 m............2.25%
Next Rs 3,000 m............2.00%

On balance assets...........1.75%

As can be seen from the table above, the grid for recurring expenses has been structured in a manner to ensure that the expenses charged to the fund reduce with an increase in the asset size. The recurring expenses include marketing and selling expenses (including agents’ commission), brokerage and transaction costs, custodian fees and fund management expenses (paid to the AMC), among other expenses. A typical list of recurring expenses for an equity fund would look like the following:

Recurring expenses for an equity fund
Expenses.........................% Of average daily net assets
Fund Management..................................................1.25%
Marketing & Selling................................................0.50%
Custodian Fees........................................................0.25%
Investor Communication.......................................0.20%
Registrar Fees..........................................................0.15%
Trustee & Audit Fees..............................................0.15%
Total Recurring Expenses..................................... 2.50%

The expense head which merits attention is “fund management”; this represents the AMC’s revenue stream. In other words, the salaries and other compensation offered to the fund management team is charged to the mutual fund scheme under this head. SEBI guidelines explicitly state the manner for computing fund management charges and limits for the same.

Fund management expenses
Average daily net assets............... Limit
First Rs 1,000 m................................1.25%
On balance assets..............................1.00%

Don't exit SIPs in a falling market

Joydeep Ghosh

Sunil Shah is a worried man today. He entered the market in October 2007, when the Sensex was rising by 1,000 points in a single week.

At that time, his already-invested friends advised him to enter the market through systematic investment plans of mutual funds. Since he had never invested in the markets before, he decided to go the whole hog and started four SIPs of Rs 5,000 each.

In the last eight months, he has invested Rs 160,000. However, the erosion in the net asset value of his mutual funds has meant that the value of his invested money has dropped to Rs 120,000. He does not know if continuing with the SIPs makes any sense now.

"In such cases, investors call up to stop their SIPs or exit them. But, we try to convince them as much as possible to the contrary," says a financial planner. And this Monday, when the Sensex slipped by 506 points, Shah did the same. He called his mutual fund distributor to stop his SIPs.

The distributor told him that it does not make sense to do so as he was getting more units of the same fund for the same money.

"So what? My portfolio is already down 25 per cent. This is like throwing good money after bad money," Shah argued.

His fund advisor explained, "When the NAV falls, you are going to get more units of the fund. That means when the market turns around, you will get much more returns."

Suppose the NAV of a fund is Rs 20. When you invest Rs 5,000 in that fund, the total number of units purchased would be 250 (Without considering 2.25 per cent entry load and an annual 2 per cent fund management charge in equity funds).

However, there is no entry load on investors if they approach the asset management company directly.

Now, if the NAV falls to Rs 18, the number of units that can be purchased is 277.7. A further fall to Rs 15 and the number of units in the kitty is 333.3. Let us take Shah's case. If he were to continue his SIPs, the numbers could look something like this.

Suppose, he accumulated 1,500 units in the first six months at the NAV of Rs 20, another 1110.8 for four months at Rs 18 and another 1333.2 units for another four months at Rs 15, the total number of units he got is 3,944.

If the markets were to turn around in, say, six months and the NAV was to rise to Rs 25, his portfolio would be worth Rs 98,600 (on an investment of Rs 70,000).

And the additional 444 units accumulated during the falling market have added Rs 11,100 to the corpus.

Moral of the story: It's a good idea to continue your SIPs in a falling market.