I think the next 2-3 years are not going to be easy, just because we are in a bull market. A few of you who decided to invest when India was supposedly going down the drain, must be feeling good about it. It is fine to feel good about it, but one should not get carried away by it.

More noise
In a bear market, as we had in the last 3-4 years, almost no one spoke about the stock market except as a place to avoid. Unless you turned on one of the financial news channels, it was easy to avoid any talk about it.

The advantage of this comparative silence was that you could think investing without too much distraction. The situation has changed quite a bit in the last few months. We now have friends, colleagues and relatives, all getting excited about the market. If like me, your acquaintances know that you invest in the stock market, I am sure you must get badgered with tips for the top ten hot stocks which will double in 21 days – small caps especially.

In my case you can imagine the disappointment – recommending people to invest in 2013 when no one wanted to, and being cautious now when everyone and his dog thinks we are at the start of a multi-year bull run.

Feeling envy
It is easy to feel envy when you see others do better during such times. The media adds fuel to the fire by publishing the list of stocks which have gone by 50 or 100 times in the last 4-5 years. Ofcourse, they were silent when these stocks were starting the journey.

In addition, you now have friends and other investors boasting how they doubled their money in the last six months, by buying the hottest idea.

One can abandon his or her approach and start chasing such stocks which have worked well for others in the past. From personal experience, I can tell you that this never works out (atleast for me).

Unnecessary churn
As the market touches new high, I think some people get itchy to sell stocks which have given high returns and recycle them into new positions, which ‘appear’ to be cheap.

I am looking for new ideas too, but will not do it for the sake of ‘doing something’, unless I think it will add to the overall returns. If this means doing nothing for long periods of time – so be it.

Let me explain further – I currently have around 19-20 positions in my portfolio. I am constantly looking for new ideas. As I am close to fully invested, I will have to sell an existing idea, incur the brokerage and taxes (if any) and then buy the new position. The implication of this decision is that I expect this new idea which has been analyzed for a few weeks, will do better than an existing company which I have analyzed and followed for more than a year.

There are people who are smart enough to do this consistently – I am not one of them. I do not want to take these decisions lightly. If the time horizon is 2-3 years and more in my case, it is really important that I take a little more time to think through this decision.

Being patient is never easy
I have found bull markets to be far more difficult to handle than other times. For starters, it involves doing nothing for long stretches of time, when stocks are going up and you are missing out on easy money ( that the easy money is lost in the end is a different matter).

Let me ask a few rhetorical questions (which I keep asking myself too) – is it really important to have all the hottest stocks in your portfolio? Is it really necessary or even possible to have the highest possible returns at all times, if a lower rate of return at much lesser risk will meet your goals ? Is this investing or just showing off?

The main challenge we will face in the coming months and years is to keep our heads amidst the euphoria. It is very easy to get carried away and starting buying marginal companies showing profit and stock price momentum – I have done that a bit in the past and it has always come back to bite me.

Let me suggest a few activities to keep you busy while waiting for the right opportunity

-          Watch TV soaps, especially the family dramas. They have a lot of twist and turns too (or so I have heard)
-          Take up body building or weights. You will have chiseled body if the bull market turns out to be a 10 year one :)
-          Go for long walks and walk a little more every day. If this a long bull market, you may be walking the whole day
-          If you are single, go to parties and have fun. If you have been investing in the past and not partying, shame on you anyway – what a waste of youth!

For those of you who like me, cannot do any of the above – keep faith and hope. This too will pass. The skies will turn dark again, and they will be gloom and doom. You will get your chance then :)

 
 

How to reject a stock?

Is this a crazy idea? Why should you have a checklist to reject stocks?

You will generally find ten tips to select the next ten bagger, but not many write on how to reject stocks.

Let me first try to convince you why this a sound idea –

The problem of abundance
A typical well diversified portfolio tends to have 15-20 stocks (anything more does not reduce risk any further). Let’s assume that the holding period is 2-3 years per stock. So in effect one needs to find and replace 5-7 stocks per year in the portfolio.

Even if one assumes a much higher level of diversification, I cannot see a scenario where one is replacing more than 10-12 stocks per year (as an investor and not as a trader).

We have around 5000+ companies listed in the stock market and a selection of 10-12 stocks means that you will reject 4990 stocks (if you were able to have a look at all the companies each year). That is around a 99%+ rejection rate. Even if you were to play around with the number of stocks you can analyze each year and the number you end up selecting, I cannot envisage a scenario where you will reject less than 95% of the stocks you review.

If you are rejecting stocks most of the time, does it not make sense to have a checklist to make the process more efficient and robust?

Finally a corollary to my point –The main problem is that we are not limited by choice, but by time and effort.

Building the framework
To design a rejection checklist, it’s important to understand what we are looking for and identify factors which negate that.

At the risk of oversimplication, I would say a long term investor is looking at high rates of return for a long period of time. Putting it quantitavely, I would say that I am looking at a CAGR of 26% per annum for 3-5 years or longer if possible.

So what are some of the characteristics of a company which can deliver these kinds of returns?

-          The company operates in an industry with above average growth rate which means that the industry is growing atleast at 15%+ rates (higher than the GDP).
-          The company is able to earn a high rate of return on capital (atleast 15% or higher) for a long period of time (sustainable competitive advantage)
-          Company is led by a competent and ethical management
-          The company is selling at reasonable valuations

Easier to reject stocks
You must have noted that I have omitted a lot of factors which go into selecting a winning stock and that’s precisely my point. Selecting a profitable stock is a complicated Endeavour and one can write books on it and still not cover all the points needed to identify a profitable idea.

On the contrary if one inverts the idea and looks for an approach on how to loose money on stocks, the list becomes surprisingly small. This is also called the Carl Jacobi maxim on inversion

So let’s look at how we can select stocks to loose money
-          The company operates in an industry which is in a terminal decline (fixed line telephony) or is highly cyclical, commodity in nature and with very poor return on capital (metals, sugar, airlines etc)
-          The industry is subject to a lot of change (regulatory, competitive or technological) which causes several companies to fail or loose money due to sudden change in the competitive scenario (telecom, mining etc)
-          The company is managed by an unethical and incompetent management (do you need examples here?? – just look around )
-          The stock is purchased at high valuations in a cyclical industry right at the peak of the business cycle. To add insult to injury, the company is managed by an unethical and incompetent management. This combination of factors is guaranteed to loose atleast 50-60% of your capital if not more

That’s it! I think the above four factors will help you weed out 80% of the stocks in less than an hour

Is it comprehensive and works 100% of the time?
Of course, this list is not comprehensive. I can come up with a lot of additional points, but I can say that these broad criteria can be used to eliminate a lot of companies at the first glance.

Some of you may point out that you are aware of a company XYZ with above characteristics, which gave a 50% upside or has even been a multi-bagger.

My counter point is – Do you really want to search for a needle in a haystack when there are often gems lying around? If your idea of fun is to find that nugget of gold in a pile of manure, then welcome to my world. I have engaged in it often and the results are not great compared to the effort put in. In addition if you are not a full time investor, then it makes all the more sense to focus your limited time on good opportunities.

The benefit of my mistakes
The list I have shared is not something I have just dreamed up while sipping coffee. I did a small exercise of listing of my failures for the last 15+ years and found a few common threads among all of them. If I boil it down, it comes down to the four points listed above.

Now, I know some investors who are able to make good returns by investing in cyclical or commodity stocks. Some others are able to do well, even if the management is not great. However I am quite sure that a majority of investors cannot achieve superior results if they decide to ignore one or all of the four points listed above.

Let me make another bold claim – if you want to loose 90% of your money, buy a highly cyclical and commodity type company at high valuations at the peak of the business cycle and run by an incompetent and crooked management. You will be guaranteed this result. How do I know – I tried it a few times and have never failed to loose my shirt (and other garments!)

 
 

Cost is an important, though poorly understood aspect of investing. It is important for the simple reason that costs reduce the overall return one makes from an investment option. It is also poorly managed as people focus too much on explicit costs (cost of brokerage or fees) and ignore the hidden ones (such as opportunity costs).

As an investor, you have the following few options

  1. Fixed deposit : cost 0, likely return : 8-9% (pre-tax)
  2. Index fund ETF: cost 0.6% to 1%. Likely return : 14-15% (pre-tax)
  3. Mutual funds (HDFC equity fund): cost 2%. Likely return : 20-21% (pre-tax)
  4. PMS: usually 2% of asset and % of gains. Likely returns: Who knows?

The options

Fixed deposit and index funds are zero or low cost options with the FDs having no volatility, but much lower returns. IF you want to build wealth, an FD is not going to get you there. Index funds are a decent alternative, where the risk of active portfolio management is removed. You don’t have to worry if your portfolio manager is an idiot who will underperform or worse lose money over the long term.

The third option is ofcourse a well managed, diversified mutual fund with a long operating history. We can quibble about which mutual fund to choose, but I prefer one which has been conservatively managed for a long time. HDFC equity has been around since 1995 (almost 20 yrs) and has delivered good performance over the years. I am not recommending HDFC equity fund, but using it as an example of a well managed fund which has returned above average returns over the long term.

The last option is private vehicles such as PMS (portfolio management schemes). These involve high costs, and in some cases deliver good returns. However they have a mixed record and are generally not a good option for most investors due to a high minimum investment.

The math

Let’s take a hypothetical case

Let’s say you have 9 lacs to invest. It is Jan 2011 and you are looking for some avenues. You decide to invest equally in the three choices I have discussed above (lets ignore PMS for the time being)

At the end of 3.5 years, you will have following sums with you

Fixed deposit (pre-tax): 4.05 Lacs (pre-tax) and 3.84 Post tax
Index fund (pre-tax and post tax): 4.18 Lacs (net 1% as cost)
Mutual fund (pre-tax and post tax): 4.62 lacs (net 2% management fee )

The last 3.5 years have not been really that great for the stock markets (around 10% CAGR). Inspite of that, the index fund was able to do better than the FD on a post tax basis. The same held true for a well managed mutual fund too.

The explicit costs

In order to make the higher returns, an investor had to contend with all the volatility and noise in the market. In addition to the emotional toll, there was an explicit cost of around 3% for the index fund and around 6% for the mutual fund.

Most investors tend to ignore these costs unless it is pointed out to them. If someone told them upfront that a 3 lac investment in a mutual fund would cost them 18000 over three years, they would balk at it and run towards FDs , real estate or gold.

Inspite of these costs, if an investor could stomach the volatility, he or she came out ahead during one of the lousy periods in the stock market.

Implicit costs

If you think explicit costs are bad, I would say the hidden costs are even worse.

So what is the hidden cost for an FD? It’s the opportunity cost to create wealth. In the above example an FD would cost 20% more than a mutual fund over a 3-3.5 year period (difference between the amounts after 3.5 years between the two options).

This difference only increases over time and would be even wider once the market performs close its long term average (15-17%) and interest rates drop.

I am sure I will get a counter point – how about real estate or gold. Let’s look at each of them –

If you bought 3 lacs of gold in Jan 2011, you would have around 3.78 Lacs of gold now (at pre-tax). I don’t want to discuss taxes as paying taxes on gold is different issue altogether. So gold did barely as well as an FD. Keep in mind that gold over a 20 year or longer period has delivered 9-10% per annum despite the recent runup (excluding transaction and holding costs)

Let’s move onto the next darling – real estate. So what returns can one get here? Well all of us have stories about how person xyz made 10X the capital in 5 years. Well, that is the equivalent of saying some investors made 20X their capital in page industries.

The returns on a specific investment – a stock or a property is not same as the return of an entire investment class. If you want to look at the average returns, look at this table by NHB. The returns vary from -15% for a Kochi to 249% returns for Chennai over a 7 year period. So we are talking of -2% to 15% per annum for different locations. This does not even include taxes, brokerage, and maintenance fee (For property).

Now the final argument would be – I was able to find a property and invest in it for a 10X gain in the last 5 years !

Congrats – but then you are missing the final point. The final point is the cost of time and effort – if you are a full time or even a part time investor in RE, you are using knowledge/ skill/ time to dig out such deals and investment in them. As you do this, you are not using your time do XYZ (spend time working, with your kids, play – whatever you can think of)

Compare all costs

IF you truly want to compare multiple investment options, compare all the costs – implicit and explicit

The explicit costs are fees and taxes. These are generally obvious and laid out to an investor (though still ignored). The implicit costs are usually hidden and often bigger – they are the opportunity costs of money (not investing in equity) and of time (spending time on investing versus other pursuits)

It is foolish to look at some costs and declare a particular option as better. Maybe I value peace of mind and time with family more than returns – in that case an FD is better. My own dad valued these attributes more than returns and spent his spare time with his kids and on his own hobbies (without ever depriving us of anything in life)

On the other hand, there are people like me who love the process of investing and enjoy the higher returns. In my case, the vehicle is stocks and some other cases, it is real estate. There is an implicit cost (time and energy) involved in earning the higher returns, which we don’t mind incurring, but it is a cost all the same (my wife can vouch for it !)

In addition to these costs and corresponding returns, I would say there are emotional and bragging benefits to various options which will be the subject of the next post.