Archive for the ‘Portfolio management’ Category.

 

I recently got an email asking my views on investing for dividends, especially for retirement planning. I have never quite understood why there should be a difference between investing for dividends v/s for capital appreciation. My response (with light editing) follows the question below

Hi Rohit,
I have analyzed and concluded that a growth-based, active portfolio is not very suitable for retirement planning. One would have to shift towards a dividend-based, passive portfolio when one approaches retirement.

That way, one would not have to bother about the market gyrations and one can still receive an (almost) inflation-proof income flow. (Basically, I found that if the markets stay depressed for 5-7 years or more, one may have to sell a portion of the portfolio at unattractive price and that can start eroding the capital base very fast.)

I will be happy to know your views.

My response
Your question is very important.

I personally don’t subscribe to the view of investing for dividend v/s growth as I think they are two sides of the same coin. Let me explain

When selecting a company for the long term, we are looking for the following
a)    Company earning high return on capital with good cash flows
b)    Reasonable valuations
c)    Good capital allocation policy by management

if you are able to achieve  the above three criteria, you are assured of reasonable returns either through capital appreciation or dividend (and often both).

Let’s say the company is growing rapidly and able to invest the entire cash flow in the business. If the company makes 20%+ return on capital, then in such a case the company is growing at 20%+ rate if the re-investment rate is 100%. In such a case the value of the company will be increase by 3X time in 5-7 year. The market usually will not ignore the company and its stock price will increase too and you can always sell a small bit for income purpose.

The above case is usually in theory…high quality companies generally invest a large portion of their profits in the business and give a part out as dividend. If they can keep reinvesting the profit at a high rate of return, then they will hold the payout ratio constant (percentage of profit paid out). In such a case the dividend will grow at the rate of the profit growth, which is generally higher than the rate of inflation. An investor is thus getting an increasing dividend and should get a reasonable amount of capital appreciation too.

In case of some slow growing companies, if the company cannot re-invest a big portion of the profit into the business, then the amount paid out as dividend will start increasing at a rate faster than the profits. In such cases, one is making returns via dividends (assuming stock price remains constant). These companies are the equivalent of a high yield bond. This is what one may call investing for dividends, as one need not worry about the price of the stock (the dividend yield takes care of the income requirement)

In all the above cases, you are making a good return either through capital appreciation or dividend or in most cases, both. This again is not theory, as you will find this to be the case with a lot of high quality companies in India such as asian paints, nestle, Hero motors etc

What is required in the above cases is that the business is of high quality and management has good capital allocation skills (if it cannot use the profit, it returns it back to shareholder). If these conditions are not met, the stock price will start reflecting the poor performance and the dividends will weaken too.

If you accept what I am saying, you will understand why I don’t believe in dividend or growth investing. I would rather focus on the source of the returns (high quality business with good management and decent price) than the form of the returns (dividend v/s capital appreciation)

Regards
Rohit

I did not cover some points in the email, which I am covering below

Issue of volatility and retirement
How should one manage the market volatility near retirement, when there is a possibility of a large drop in the portfolio at the time of need.

The iron rule of investing in stock markets (if there are any to begin with) is that one should never put that portion of capital in the market which may be required in the near future  (next 3-5 years). If you need the money for your kids education or marriage or some other purpose in the near future, put it in a fixed deposit ! period – there is no other sensible option. You should never be forced to sell at the wrong time (when the markets are weak)

Once you are closer to retirement, as any sensible financial advisor will tell you, you should start reducing the equity component to reduce the volatility in your portfolio. The exact calculation and approach is a bit detailed and beyond what I can cover in this post.

How am I planning for retirement? I don’t plan to retire 🙂

I am not joking. If you love what you do (in my case investing), why would you want to retire. If I retire, I will drive myself and my wife crazy.

 
 

A few of you may have noticed updates on my portfolio page. I don’t update this page on a real time basis, but it roughly reflects my current positions except for one stock.

I have been reviewing the Q2 numbers of most of my positions and have been satisfied with the performance of most of the companies. The results have come as expected in most of the cases. However there were a few surprises. Let me give a brief rundown on some of the changes in my portfolio and the quarterly results

The reductions
As I wrote in some of the previous posts, I have more or less exited most of the IT stocks such as NIIT tech, Patni computers and Infosys. Infosys performed better this quarter, growing in double digits. However I personally feel the stock is fairly priced and have exited the stock completely.

NIIT tech came out with decent numbers after a long time – mainly due to their BSF order. In addition they have been able to reduce the impact of their hedge positions. As a result the hedge related losses have reduced and the company posted decent results. I personally think the stock may be undervalued by around 20% at best. However I have reduced my position substantially.

In addition I have sold off Concor completely as I think the company is now fairly valued. I have been reducing the position for the last few years. This is a very interesting position for me. I bought this stock in 2003 when the company was selling at a PE of 5. I had been investing for a few years and could not figure out why the stock was so cheap when it was doing so well.

I created a position inspite of all the doubts. In hindsight I was too timid.

I have also started reducing ashok Leyland as I think the stock is now approaching fair value. The company is doing extremely well and firing on all cylinders. I remember looking at this stock at 11-15 levels and wondering how it could not be cheap?

I closed out my position in mayor uniquoters as I feel it is fully priced and my position was too small to begin with anyway. I have also been reducing my position in clariant chemicals as it is now close to fair value

Finally, I have started reducing one of my largest positions – Lakshmi machine works. The company is doing well, but is now close to fair value.

In case of all the above stocks, it is not divorce, but a temporary separation. If the price drops or the valuation becomes attractive, I will buy again.

The additions
This is a small section. I have been adding to my positions in Balmer lawrie, hinduja global, Patel airtemp, Ricoh india and FDC. The additions have happened over the last few months. However I have been a net seller than a buyer. The only major buying has been for Diwali 🙂

The disappointments
BEL (bharat electronic limited) had a fairly poor quarter where their topline and bottom line dropped by double digits. I am however not too disturbed as they have quite a bit of a monopoly in the defence business and the revenue is not evenly distributed in each quarter (due to projects nature of the business).

I was also disappointed after I read the annual report of facor alloys. The company has passed several special resolutions to invest to the tune of 300+ crs in other sister firms, which are expanding into power and other businesses. I get fairly mad with this kind of diversifications. Needless to say, I plan to exit the stock in time irrespective of what happens to the business or the stock.

I had written about mangalam cement recently. As I was not confident enough, I never bought the stock. I was quite surprised to see a sudden 90%+ drop in the bottom line for the second quarter. This was a learning for me – companies with high operating leverage can see huge spikes in their bottom line. The fundamentals of the company are still intact, except that I would like to buy the stock at a time of extreme pessimism

Response rate
A few of you may be disappointed with my response time to emails and comments. Unfortunately like others, I also have a limited time and hence cannot devote more than a few hours a week on responding to comments and emails.

I will definitely read and respond to your email, but would ask you to be patient with me on that count.

A happy Diwali to all the readers

 
 

I recently conducted the following poll on the blog. The results of the poll for the 205 responses are given below

What do you expect to make from investing in stocks in a 3-5 yr time frame?
10-15% per annum – 16%
15-20% per annum – 33%
20-25% per annum – 25%
25-30% per annum – 9 %
30%+ per annum – 14%

What was the idea behind the poll?
I had the poll for two main reasons. The first reason was to gauge the return expectations of the readers from stock market investing. The second reason was to discuss what I think would be required to get these returns

Comparing against market returns
The above return expectations are for a portfolio and hence it makes sense to compare it with index returns which serves as a benchmark. Why consider index returns? Well, it’s a passive form of investing. You can invest in the index and go to sleep and still make these returns. So one can call the index returns as zero effort (not zero risk) returns.

So what can one expect from the index? One cannot predict where the index will be in 3-5 years (though there are more forecasters than we need), but one can try to make an intelligent guess. The index is currently at a PE of 23 which is fairly above average. The index EPS has grown at an average of 14% for the last 17 years with 20%+ growth in some years and negative in others.

 For the sake of argument let’s assume that the EPS growth will be 14% for the next 3-5 years and lets also assume the PE will remain the same (though I will not really bet on it). If one makes these simplifying assumptions, then the index returns would be 14%. If the EPS growth is higher or PE increases further, then the returns could be higher. On the other hand if the EPS growth is slower or PE contracts, then the index returns will be less than 14%.

So in conclusion one can say that the index returns are likely to be in the first option of the poll. By the way, almost 86% of those who participated expect to beat the market by a decent amount J. High expectations indeed!!

First option: 10-15% per annum
This is an easy one to achieve as long one does not try to get too clever. One needs to create an SIP (systematic investment plan) in an index fund or ETF and put a fixed amount of money into the fund every month. The SIP should give a return of 1-2% in excess of the index (due to cost averaging). So if one were to follow this plan, these returns are quite achievable.

Second option: 15-20% per annum
This was my choice of expected returns . This choice means that index investing alone will not help. If the index were to return 14% or so (which is not destined to happen), then achieving these kind of returns would require a combination of the following

  • An ability to pick high quality companies at slight undervaluation. These companies have to do well to give the 15-20% returns for the next 3-5 years
  • An opportunistic pick of a few companies which are in temporary distress. If one is able to identify such companies and buy them before a turnaround, then you can add a few extra percentage point returns.

So this option looks doable, but would require more than average, but not extraordinary effort to achieve it. A reasonably diversified portfolio of 12-15 stocks should help one to achieve these kind of returns

Third option: 20-25% per annum
Now we are getting into an interesting area. A 20-25% return means one would be able to triple his or her money during this period. At the current PE levels and an optimistic expectation of 14% returns, getting 20-25% would require quite an effort. I can think of the following

  • An ability to identify some out of favor stocks and being able to bet heavily in a few of these ideas. For example if you think that sugar stocks are going to do well and are able to pick some cheap stocks before the turnaround and sell after the turnaround happens, then the returns are likely to be good.
  • A core portfolio (50-60%) of high quality companies which will give above average (more than 14%) returns

This option is not a low risk, low effort option. It would require a decent amount of work to research underpriced stocks and bet heavily on them. I don’t think you can make these kinds of returns unless you have a decent amount of experience in stocks and can devote ample time to investing. Almost 25% of the poll participants think they will fall in this category of real superior investors

Fourth option – 25-30%
As expected only 9% of the participants selected this option. A 25-30% return means making 3-4 times your capital. If you have not made these kind of returns in the past for a 3-5 year period, then expecting such returns would be risky. One can make these kind of returns only if

  • One picks undervalued picks, holds till they hit fair value and then sells them. In addition one will have to find such ideas consistently
  • One will also have to be a bit lucky to make these kind of returns. A mid size to large market crash would certainly help. If the market were to crash, an investor should be able to commit a lot of money.
  • A focused portfolio (less than 10 stocks) would be required with a decent turnover in the stock holdings.
  • A small amount of portfolio will have to dedicated to options or arbitrage kind of ideas where one should be able to make 30%+ returns

These kind of returns are not easy to get, especially if investing is not your full time work. A lot of guts, some amount of luck and sufficient investing experience would be required to make these returns.

Fifth option: 30%+ returns
This option was voted by 14% of the participants. I can think of some reasons behind these fairly high numbers. Some of the participants voted for the sake of it without giving much thought or are getting delusional about the returns. One can expect these returns only if one is very new to the market and has no clue of what to expect or has been around for quite some time and is a superior investor

I really don’t have specific ideas of how one can achieve these kind of returns at low to moderate risk. One can make these kind returns only by being aggressive in the market and through a decent amount of leverage via options or otherwise. A 30%+ returns for the future would mean beating the market by more than 16-20%. These kind of high returns are not achievable by buying index stocks. One can make these returns by having a highly focused portfolio (3-4 stocks at best) of great ideas or by investing in other kind of instruments such as options.

The problem with such expectations is that unless one has made these kind of returns for some time, it is likely that the investor would take on high risk and could thus get wiped out. I hope these investors know what they are doing.

By the way – if you expect to make 25% or above, please share your thoughts via email or comments as I would really be interested in knowing how you plan to achieve these kind of results.

Why no negative returns
Someone mentioned in the comments on the absence of an option for below 0% returns. I think that is quite possible, but would be an uninteresting option. If one believes below 0%, then it is an easy decision. Put all your funds in cash or FD and get on with other things. A 0% or less return would mean a PE drop of almost 50% in the next 3-5 years.

An optimistic bunch
I have to say the participants of the poll are a very optimistic and confident bunch. I personally think a 15-20% would be a very good return for me and more likely to be around the 15% level than the 20% mark.

Final point: If you were expecting me to provide an 8 point or 10 point plan to achieve 15%+ returns and have voted for option higher than 15%, please re-think your expectations. If you need someone else to show you how to beat the market, then you could be in for an unpleasant surprise over the next 3-5 years.