Archive for the ‘Investing Philosophy’ Category.

 

Beta – This is the term used by academics to represent risk. In other words, for them volatility is equal to risk. This definition of risk makes sense, if one is a short term trader, but is completely useless for an investor.

I have never used beta or any such silly measures to evaluate risk and as an individual investor could not care less for an academic definition of risk.

In my view risk is multifaceted, fuzzy and grey and it cannot be boiled down to a single number. It is not even possible to minimize all forms of risk at the same time – for example you can minimize the risk of a quotational loss on your portfolio by increasing the cash component, but that increases the risk of missing out on the gains if the market moves upwards.

In a set of posts, i am going to list some of the risks which come to my mind. I will try to explain these risks and give some example too. In the end, I will share a framework which I use to think and make investment decisions. As always, if you are expecting a magic formulae at the end, you will be disappointed.

I am going to break down an investor’s risk in two sections – Risks faced by investor independent of the company/ stock and the business related risks of a specific investment. This post will cover the risks faced by all investors, irrespective of the type of investments.

Stage of life/ Age risk
This is a widely understood form of risk – As one grows older and approaches retirement, the capacity to bear risk reduces. As a 25 year old, one can afford to lose a large portion of one’s portfolio and can still recover from it as one has a long working life ahead. I personally managed to lose almost 25% of my portfolio in my 20s and although it hurt emotionally, it did not make much of a dent on my long term networth.

I personal think that all kinds of experimentation and trial and error should be done by an investor as early in their working life as possible. However once you cross late 30s or 40s, it is important to focus on risk reduction and avoid losing a large portion of your portfolio (small losses are however inevitable in equity investing)

The duration / cash flow needs
This is usually but not always related to the age of an investor. A younger investor can afford to take a very long term view of his or her investments and think in terms of multiple decades. An investor in his or her late 50s however has several cash flow needs on the horizon such as education for children and hence needs to design the portfolio accordingly. As a result, any capital which is needed in the next 5 years, should not be invested in equities. If you do so, you are exposing yourself to the risk that the market would drop at the time when this invested cash is needed, turning a temporary loss to a permanent one.

The interesting point is that this advantage is usually wasted by the younger investors. I have rarely seen investor in their 20s who are patient and long term oriented. At this stage in life, one usually feels invincible and smart. On top of that if you have graduated from some of the top colleges in the country, you close to 100% sure that you will beat the market in your sleep.

A majority of such over confident guys (and they are mostly guys) get their back side kicked and blame everyone else for their failure. A few however are sensible enough to realize their stupidity and work to fix it over time.

Emotional/ Attitude risk
This is a rarely discussed risk. Let me explain what I mean by this – One can call this temperament or maturity. There are some people who have temperamentally more suited to the stock market as they are calm, humble and eager to learn. In addition these people do not get swept by greed or fear. As a result such people are able to do fairly well over the long term.

On the other hand, you will often find people who are eager to invest in equities but are impatient and bring a level of arrogance to the stock market. They seem to believe that the stock market owes them high returns. As a result a lot of them assume that all they need to do is to buy some random stock touted by a talking head on TV and the money will start rolling in.

This attitude is however not specific to any age or gender, though I have seen it mostly in men. Women either stay away from financial decisions or if they are forced to manage it, are far more sensible as they realize their limitations.

Lack of knowledge + arrogance + greed/ fear is guaranteed recipe for disaster.

Knowledge risk
This is a risk a majority of investors in india face due to the huge amount of misinformation and misguidance by the financial services industry.

A lot of investors have been exposed to the traditional forms of investments such as fixed deposits or gold/ real estate. They are however approached by banks/ brokers and other financial agents from time to time on mutual funds, stocks or insurance and I have personally found that majority of this advice is toxic (see my post here on ULIPs).

The only way to manage this risk is to educate yourself on the basics and never to listen blindly to your friendly broker/ agent whose interest is in the commissions and often not your financial well being.

Inflation/ Cost of living risk
Quite self explanatory, but a very under-appreciated risk. A lot of people assume that if they invest in fixed income options, they have taken care of their investment needs. My own parents were guilty of this mistake in the past.

This risk unfortunately is a very slow and stealthy form of risk where one thinks that his money is growing, but in reality one is falling behind in terms of buying power. This risk comes to bite you at absolutely the wrong time – retirement. At that time, you realize that the nestegg is not sufficient to take care of a lot of your needs. In such cases, in absence of a social safety net, one either has to continue working or depends on others to make ends meet.

I see a lot of educated and young people in my own family ignore this risk to their peril.

Leverage risk
Leverage risk is commonly understood as the leverage taken by an investor in his portfolio. I prefer to expand this further and consider all forms of non –investing leverage too. For example, if you have a big home loan and other forms of leverage in the form of personal and car loans, then your flexibility as an investor is greatly reduced.

Lets say an individual earns around 10 lacs per year and has around 50 lacs as various forms of loans. This individual is paying around 50% of his earnings as debt repayment. If this individual has around 10-15 lacs as savings, can he or she really afford to invest in a highly volatile small cap fund ? If this was the financial profile of an individual in 2008, he or she would have panicked and sold all their stocks at the bottom.

I have personally looked at leverage in the above manner and worked to ensure that my total debt to networth never exceeds 30-40%. This ensures that my debt servicing is within control and any fluctuations in the stock market, will not force me to liquidate my positions to manage this debt.

Professional risk
I have never seen this risk discussed, but I think it influences your investing behavior a lot. If you have a full time profession (job or a business) which will put food on the table irrespective of how the stock market behaves, it is bound to impact your risk appetite.

A stable well paying job allows one to take a long term view and invest without worrying about the market volatility. On the other extreme if your monthly expenses depend directly on the stock markets – either from capital gains or through employment as a financial intermediary, then your risk appetite is greatly reduced.

A combination of risk
It may appear that several of the risks I have pointed out are overlapping in nature. I would agree with that and my point is not provide an exhaustive and non overlapping list of risks faced by an investor. The idea behind this post is to look at some risks which are faced by an investor, outside of the specific investment itself.

A lot of times, it the combination of risks which becomes financially fatal for an individual. Lets say an individual does not save enough early in his or her career, and due to the inflation risk realizes later in life that his nest egg is not going to be sufficient. In absence of sufficient knowledge about various forms of investments, this investor under the influence of a unscrupulous broker may make wrong investment choices. Such an investor can get hurt very badly during a market downturn. I think I may have described the unfortunate situation for a lot of senior citizens.

I have tried to cover risks which are independent of the type of instrument chosen for investing. I think these risks play an important role in determining the nature of one’s investments and the kind of returns one can make. In the next post, I will discuss about the various forms business risks one needs to keep in mind when investing in equities.

I still stand by my post below managing non – investing risks

http://valueinvestorindia.blogspot.com/2014/04/shortest-investment-book.html

 
 

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.