If one wants to be rich, one should learn how to invest on your own…right ? that way you can compound your capital and retire rich ! Isnt that obvious ?

If I am asking this question, you can guess I don’t believe it to be the case.

I get asked this question in different shapes and forms and a typical email goes like this

Rohit – I am currently X years old and want to become financially independent in the next 10 years so that I can purse XYZ (insert a dream here). Can you suggest how to become a better investor so that I can have enough money in a decade to pursue my dream ?

What does it take to be an active investor ?

It takes a  few hours a week for a year or so to become financially literate, which involves having a reasonable understanding of various investment options such as fixed deposits, mutual funds, stocks, and insurance etc. Once you reach this level of understanding, you can with a moderate amount of effort,  identify a mix of assets which will help you earn around 12-14% return per annum (depending on the mix of debt and equity)

In effect, you can spend a few hours a month and earn 12-14% on your assets over the long term. We can call this a baseline level  of effort.

Now lets assume that you are not satisfied with the above returns and would not settle for anything less than 20%+ levels (around 10 times in the 10 years). If you wish to achieve these level of returns, then you  need to invest atleast 15+ hours a week on learning various aspects of investing and in finding new opportunities on a regular basis.

What is the return on time in case of active investing?

So what do I mean by the term – Return on time ? Let me illustrate with an example.

Let’s look at a typical case of a young professional who has a full time job. Let’s assume the following

Annual salary in year 1 = 10 lacs

Annual savings  in year 1 = 5 lacs (I know this is too high, but we are considering an optimistic scenario)

Salary increases each year by 10% and so does the savings. This individual has two options for his/ her savings. They can be financially literate and spend minimal time (a few hours a month) and earn around 12-14% per annum or spend 15 hrs or more on investing and earn a much higher return.

Lets also assume the individual works around 40 hrs each week in his / her job  (would be higher in reality)

So whats does the return on time (money earned per hour spent) look like for the person in terms of active investing ?

Lets look at the table below

I have plotted the savings, the extra returns earned by putting in  extra hours each week (15 hrs per week) and the per hour return

A few things standout,

In the initial years when one has a small level of savings and is just starting out, the per hour ‘salary’ from investing  is way below the per hour salary from a job. The higher your education or skill, the larger the gap.

This is the best case scenario. The above picture worsens if one gets hit by a bear (a certainity in a 10 year period). The last column shows that this ratio becomes favorable only after  8-9 years

Implications of the analysis

The above analysis though silly,  lead us to a fairly important conclusion. If the only reason you want to become an active investor is to make more money, then it is not a very smart way to do it.

For starters, all the time spent in the initial years will appear to be a complete waste of time. Most of the people soon realize that the extra returns are really not worth the time.

In addition, if you start late in a bull cycle (as most individuals do), the quick and easy returns are soon lost in the subsequent bear market. In most cases, such individuals throw in the towel and move on to other pursuits in life.

Finally, the additional hours spent on investing means that one does not have time for any other pursuits like having girlfriends or other hobbies  at the prime time of their life (early to late 20s).

My personal story

The above table and discussion is not theoretical. I have personally lived it for the last 15 years. I started investing in the late 90s (around 1997). I think I was financially literate by around 1998 and around that time came across the book – The warren buffett way. I read about this person who had become the second richest person by investing in stocks and was completely mesmerized by it.

I read the biography of warren buffett (Making of an American capitalist) and his letter to sharehlolders and anything else I could find about him. It was in late 1999 , early 2000 that I finally turned to active investing.

As you can see, my timing was perfect. I made some money for around 3-4 months of 2000 and then lost all the gains by the end of year – some on paper and some of it was a permanent loss as I had put money in IT/ Internet oriented mutual funds (don’t ask what I was thinking).

The years from 2000-2003 was one long bear market, where the market slowly went down from 4000 levels to around 3000 in a period of three years. If I put the numbers in the earlier table, my ‘salary’ from investing was negative, whereas I was making a good income from my full time job.

Any rational person after three year of losing money, would have given up investing and move onto something else in life. I did not even think of it as I was extremely passionate about it and inspite of mediocre absolute returns, I was still beating the market by a large margin.

The market turned in mid 2003 and as it took off for the next 5 years, so did my portfolio.

Better way to do well

As you can see from my personal experience and from the analysis, that investing is definitely not a quick or easy way to becoming rich.

Let me suggest an alternative – If you are really passionate about something or good at your full time job, focus on it and get better at it. You will have fun doing it and over a decade you will make a decent amount of money out of it. Invest the money saved, sensibly by becoming financially literate and you will realize that not only is your life more pleasant , but  that you also have enough tucked away for a rainy day.

I know this is not the conventional wisdom and we have a cottage industry of people  encouraging others to invest on their own. I would rather follow my interest/ passions and become good at it (the money usually follows then), than do something just for the sake of a little extra money.

In case you wondering about the life I had outside work and investing early on …I am not going to disclose than on my blog and get in trouble with my wife 🙂

 
 

I am going to discuss a new term –value trading in this post. It is a very interesting concept and it was first mentioned by my good friend – arpit ranka.  I cannot claim any originality on this concept, but once it was mentioned  by arpit, I started thinking about it and found a lot of validity and relevance to my style of investing

What is value trading? (my definition)

Value trading is best described as buying a stock with the expectation of selling the same (hopefully with a gain) in a short period of time based on the realization of a single or multiple triggers. This trigger can be fundamental in nature such as normalization of sales/ profit margins (from a temporary low), business event such as launch of a new product or new capacity or change in the business environment for the better such as moving from extreme  to moderate pessimism .

In addition to the fundamental issues, the trigger could be technical in nature such as short term overselling of a stock due to unexpectedly poor results or some temporary event such as elections which do not really impact the fundamentals of the business

In all these cases, one is expecting that the trigger will occur in the short term and the stock price will get a quick bounce (10%+) and one would be able to exit with a nice little profit

How does it differ from value investing

The above definition may sound a lot like value investing and I have been guilty of mixing the two for all these years. However as I think back, I have come to realize that they are not strictly the same and confusing the two can actually be harmful (as I will explain later in the post)

If one invests  with a long term horizon in mind, then it is critical to have a good idea of the intrinsic value of the company. In addition this intrinsic value should increase over time, if one is to make above average returns in the long run.

So in effect, one is playing a short term trigger in the case of value trading versus betting on the business in the case of value investing.

Examples of value trading

Lets look at some example I have posted in the past and look at which bucket these ideas fall into

  1. Patels airtemp

I would call this ideas as a value trading idea as this company is in a highly cyclical industry. At the time of buying the stock, I was expecting that the downturn in the capital goods industry would not be deep and the fundamentals of the company and  its stock price would soon bounce back.

The trigger has yet to happen and as result the stock has slid further since the time I wrote about it.

  1. Ashok Leyland

I started looking closely at this company in mid 2008 and by the end of the year the bottom had fallen out of the commercial vehicle market (the company stopped production for a month in dec 2008 to reduce the inventory). I purchased the stock in early 2009 at highly depressed prices.

The trigger – normalization of commercial vehicle sales happened quite quickly towards the end of 2009 and the stock turned out to be a four bagger.

In both cases, I expected a normalization of  the fundamental performance and a bounce back in the stock price. In one case it happened faster than expected resulting in a large gain and in the other case the downturn has been deeper than expected and hence the stock price continues to languish

  1. Amara raja battery

The company is a no.2 player in the battery industry and operates in a close duopoly. The key insight in this idea is that the company is expanding its competitive advantage (brand and distribution) and also benefiting from  migration of demand from the un-organized to organized sector.

I would tag this as a value investing idea as i don’t expect a specific trigger other than the fact that the company is improving its competitive position and hence should see an improvement in profitability and growth.

The first two examples I have discussed should bring out the following key point – In a value trading idea, the intrinsic value may not expanding or could be declining too. However the stock is undervalued and a set of triggers could close the gap with the intrinsic value. You can call this mode of investing as deep value investing or graham style investing too.

The last example of amara raja is more of a buffett style, high quality stock where although  one is expecting the gap with the intrinsic value to close, the bigger gains come from an increase in the value of the company itself.

The differentiating factors

The two modes of investing differ on several factors. The first factor is time – Time works against you in the case of value trading. If the trigger happens quickly,  the price rises quickly to the fair value and one can exit with a nice little profit. On the other hand if trigger gets delayed, then the overall returns may remain the same, but the annualized return is much lower.

In case of value investing, time works in your favor. As the company continues to grow its intrinsic value, the stock price should hopefully follow it (some times in spurts) and thus the idea becomes a buy and hold kind of idea.

The second factor where these two approaches differ is the nature of the business. The value trading approach works better in commodity  and cyclical industries. If one can catch the bottom of the cycle and bet on a tier 2 or tier 3 company in the sector, then the gains are very high when the cycle swings back to a normalized level. At the same time, one needs to also ensure that the stock is sold once the cycle has turned .

Value investing approach works where the economics of the business is good and the company has a competitive advantage. In such cases, if one buys the stock at reasonable valuations, then returns are good over a long period of time

Do not mix the drinks !

I would say that value investing or long term investing should occupy a larger portion of the portfolio. If however you have the time and energy to look for  value trading kind of ideas and can play them well,  the portfolio can get an extra boost from time to time

The danger is really from mixing the two approaches as I have done in the past. I have bought  trading kind of ideas and held on to it for a long time (assuming it was a long term investment). In such the cases the absolute returns came through, though the annualized returns were mediocre due to a delay in the key triggers.

The correct approach would be to keep in mind the nature of the idea (trading v/s investing), identify the triggers and the time it would take for the same to play out. If the triggers change or get delayed , then one should exit a value trading kind of idea. In contrast in a value investing idea, time is working in your favor and temporary hiccups are sometimes a good time to add to the position. In all such cases, one should just sit tight with the position.

 
 

Let’s do a thought experiment – Let’s say you are going on a multi-year cruise or journey around the world and need to invest your or your retired parent’s money. Let’s also assume that you want to ensure that the money is secure, but at the same time earns a decent rate of return (Which beats inflation).

Investments of this type should have the following characteristics

  1. The portfolio of such investments should be reasonably secure – low probability of long term loss of capital, though temporary fluctuations are fine
  2. Above average rate of return – The investments should beat the inflation and possibly earn a few percentage points above it, so that your family can withdraw a small portion of the capital without a reduction in principal
  3. Low maintenance – should not require your family or you to run around, doing tons of paperwork or other tasks to manage it

Let’s invert the question and look at what will not be good options

  1. Fixed deposit – Safe and low maintenance, but the rate of return barely beat inflation. As a result, if you use up the interest , the capital base will get eroded by inflation
  2. Real estate – May be secure and give above average returns, but requires constant work (maintenance, repair, payment of taxes etc). In addition, you cannot really invest small amounts of money into it.
  3. Gold – If you have been following me for sometime, you know my distaste for it. It is not an income producing asset and I cannot think of any family selling gold for meeting expenses – Remember the old Hindi films, where the family sells gold when it is in dire circumstances? We are too conditioned by those images.

I know you would have realized where I am going – equities!, but then not all types of equities. The above criteria eliminate some types of companies from the consideration set.

  1. New companies with a short operating history – Sure, the company is going to be the next titan or  ITC  (fill in the name), but if the companies goes down the drain while you are away then your family is in trouble
  2. Speculative companies – Loss making or penny stocks which have performed poorly in the past but have a very bright future.
  3. Companies with poor management – I don’t want to hand over my money to a crooked management who could cheat me in my absence (remember we are away for a long period of time)

If you think through all these options, you will realize that you are left with a small list of companies which meet the following criteria

  1. Durable competitive advantage – The company has done well in the past and you are assured that it will do well for a long period of time in your absence
  2. Good management – You can trust the management to be good caretakers of your money in your absence
  3. Reasonable prospects – The Company may not have phenomenal growth prospects, but should deliver above average growth.

If you put all these points together, I hope you can see a picture forming. We are talking of companies such as

Asian paints
HDFC ltd
HDFC bank
Crisil
ITC
Titan etc

A portfolio of such companies would be fairly safe as one is talking of good companies with above average economics and decent management. These companies may not be the next multi-bagger, but it is easy to see that they will give one a 15% or higher annualized return for a long period of time.  Even if you consume 3-4 % of the return (via dividend or sale), your capital will still compound at 10-11%, which will take care of the corrosive effects of inflation.

If the above makes sense, then why am I not following it? Let me tell you why – The desire for higher returns! I think I can make higher returns than what I can get from these companies.

Please note the word – ‘Think’ and not would. Anyone who decides to invest on their own in all kinds of midcaps, small caps and other equity options is implicitly assuming that he or she can do better than these proven ‘blue chips’.

I am not saying that some people cannot do better, but I don’t think the lay investor who chases the current fad and hot tips, will do better than a basket of such companies. It is often smarter to make a sure 15% than chase the dream of 100% returns.