Thursday, October 23, 2008

Kya Kare??

What to do in Today's Market 

Inflation has crossed 12 per cent. Interest rates are rising. Individuals with home loans are struggling to cope with the higher Equated Monthly Installments (EMIs) and simultaneously deal with inflation.

In the stock market, the bulls are constrained by concerns over the macro-economic scenario domestically, the grim global scenario, persistent Foreign Institutional Investor (FII) outflows and the possibility of another round of monetary tightening. That does not mean the bears have a free hand. The correction in commodities, especially crude, provides ample ammunition for the bulls to conduct a short-term rally.

Investors who flocked to gold as the 'safe asset' were disappointed at the way the price dropped in August. Real estate rates too have dropped and by all indications will continue to fall. No asset seems to be a safe haven anymore.

The only asset that beckons is debt with interest rates rising. But would it make sense for an investor to move into debt? While this is a good time to reassess one's portfolio, it would not be wise to simply rush to income funds, Fixed Maturity Plans (FMPs) or fixed deposits. Read on to figure out how to make the best in such a bleak market environment. 

Don't let market conditions determine your asset allocation

Unfortunately, for most investors, it is often the bull or bear run that will determine their preference for a particular asset. During a bull run, they will all flock to equities and when the market crashes, everyone is suddenly paralyzed by market uncertainty and fear. Which is really ironical, since the risk of losing money at 13,000 is much less than when the Sensex is at 20,000. In 2002, when the Sensex was around 3,200 levels, inflows into equity mutual funds were Rs 4,517 crore. In 2007, when the Sensex was in the range of 14,000 to 20,000, inflows into equity mutual funds totalled Rs 1,07,189 crore.* Investors were far more willing to buy equities at higher rather than lower prices!

Right now, when stocks are getting whipsawed and interest rates appear seductive, the instinctive reaction is to run to a safer haven. But abandoning equities now and moving to debt and cash would be a mistake. Those who under invest in stocks are left flat-footed when the market recovers. And equities, as an asset, must have a place in your portfolio. Irrespective of the state the market is in.

In fact, if your equity holdings have been beaten down substantially, then you could make some refinements to your portfolio. Check to see by how much your portfolio has deviated from your predetermined allocation. If your equity allocation has fallen substantially, you should focus on increasing it. Stay focussed on your strategy. Not on the market. 

Now is a good time to consider equity

It would be wise to look at the experience of renowned investor, the late Sir John Templeton. His investing mantra was simple: Buy at the point of maximum pessimism. In other words, as an investor, he relished adversity.

A typical buy-and-hold investor, Templeton identified stocks that were trading below what he estimated to be their actual worth. He then was prepared to wait till the market recognized the value of the stock and the price corrected. In reality, it is always the opposite that takes place. As the market peaks, almost anything is touted as a "can't miss" investment or fund. Consequently, traditional measures of an asset's worth go by the wayside. Instead of running to the hills, investors run in droves to the market. They buy for no other reason than the belief that the investment would go up. When the market tumbles, as it did this year, investors run to debt or hold cash.

The late Shelby Cullom Davis, a New York investment banker, former U.S. ambassador to Switzerland and well known value investor, once said, "You make most of your money during a bear market; you just don't realise it at the time." Wise words for an investor to keep in mind! 

Not every beaten down stock or sector is worth buying

In the phenomenal bull run over the past few years, risk has almost been an afterthought as investors plunged headlong into growth stocks and took heavy sector bets. Now the winning formula is probably a more conservative mix that's mindful of heightened volatility. Investors would do well to gravitate towards large and stable companies that have a better chance of weathering a market storm.

But of course, that does not mean there aren't any great stocks in smaller market caps.

What we are saying is that nothing will substitute smart, bottom-up stock selection.

Ditto for sectors. Between January 8 and July 15, 2008, the sectors that got hammered were real estate, construction, power, capital goods and banking. But that does not mean you should run away from them. Neither does it indicate that you should mindless shop for stocks within these sectors. Only if you find good undervalued picks, go ahead and buy them.

But, if you have not done your homework on investing in a stock, you should not be investing in it.

And, don't just dump your fund if it has performed miserably. Check its performance regularly with its peers. Keep track of the portfolio to see if the fund manager is making any significant changes. 

Don't try to time the market

It's difficult to predict when a bull run will peak. By the same measure, it is impossible to call the bottom. All bull and bear markets will exhibit periods that look like reversals, but are just momentary before the bull or bear regains control.

There are three things you should be absolutely clear about.

  1. The first is that you do not know when it is "safe" to get into equity. No one knows that. No one knows when the bull run is ready to resume its pace.
  2. The second is the wrong assumption that it is alright to change your asset allocation guidelines as and when it pleases you, with no regard to a change in your personal situation but with sole reference to the market situation.
  3. The third is that your gut-level feel about the end being near is a good recipe for disastrous investment decisions. 

If you have been investing via a Systematic Investment Plan (SIP), please continue. There is no reason why you should stop. If you have not been investing via a SIP, please start.

Don't try to invest lump sums when you think the market is at a low. 

The same goes for timing the cycles of other assets. When equities are down, investors tend to find solace in what's perceived as "safer" - recently that was gold. When the price fell recently, they were a dismayed lot. If you do not have a valid reason for investing in a particular investment or asset, stay away. 

You will be rewarded for staying cool

It's not easy to step back for perspective when you are gasping for air as your portfolio value plummets. But any sensible long-term investor will tell you that bear markets are setting up the next bull market. They are also keenly aware that bull markets don't run forever.

So it is only natural that in a volatile market investors should expect some short-term losses in their portfolios. Even a great company's stock can get banged around in a tough market. But that does not make you a loser (though you may look like one). While the old "buy and hold" mantra may seem like cold comfort at times like this, rest assured that it has a better long-term record than market-timing.

Once again we reiterate our earlier point. Now is a good time to get into equity and you will be rewarded if you have a time frame of at least three years. With the near 30 per cent fall in the market from January 2008, Forward P/Es have fallen sharply and are now at reasonable levels. India's Fwd P/E is now 14.2x (July 2008), down from 20.4x (January 2008). Over the past 20 years (July 31, 1988 -July 31, 2008), equities, as measured by the Sensex, have given investors a return of 17.16 per cent per annum* inspite of the Kargil, famines, change in governments, assassinations etc.  Do we any reasons to believe that the next 20 years will be any different? The problem is not with the asset class but with the approach to equities and the investing strategy of individuals. 

This too shall pass!

However bleak the scene appears, it is not here to stay forever. Bargain valuations are available only in such times. But the key is to understand whether "such" times are temporary or long lasting.

The current bearish phase has been the result of the spike in the price of crude and steel and commodities. The result was inflation, higher interest rates and the worsening of the fiscal deficit. Over time, these issues will be resolved. But as long as fundamentals remain strong, we have nothing to fear. If the fundamentals deteriorate significantly, the reverse will take place. The structure of the economy, the strong corporate balance sheet, increasing household income without too much debt on their books, rising consumption levels, high savings rate - will ensure that the slowdown in India is not severe.

Equities have fallen before and they will fall again. The last bull run ended in March 2000.

The three-year bear market that followed was pushed by the tragedy of 9/11 and a recession. Finally, the market bottomed out in October 2002. From then on, it scaled impressive heights. Along the way, there have been some significant dips followed by a continuation of upward pressure. But in the end, companies with good fundamentals will weather the storms that sweep the market and the economy.

The lesson here is straightforward. Stocks are excellent long-term investments, but dangerous short-term bets.


*These figures have been provided by HDFC Mutual Fund.


Wednesday, October 15, 2008


Over the last few days, the standard investing punditry that is available on business TV and newspapers has turned fiercely negative. The consensus view is that we're doomed. The line-up of problems that are going to ruin us all is impressive indeed. Not only is the inflation rate rising, but so are inflationary expectations and that's supposed to be worse. The government seems set to transition from a principle-driven ally that was blackmailing it to an unprincipled ally that will blackmail it. Growth is slowing down. There is a genuine fear in the air.

Among people who to invest in equities and equity-based mutual funds, the natural question to ask is what they should do now. In response, the best thing I can think of is to quote the great investor Warren Buffett. Buffett is fond of saying that one should be fearful when others are greedy and greedy when others are fearful. It sound like such an overly cute thing to say that you may feel that it's good only for printing on inspirational posters but actually, like everything else that Buffett says, it's deeper than it looks.

Clearly, others are fearful now. Does that mean that it's time to be greedy? It probably is. In a recent interview he said something very interesting in response to a question about what investors should do now that stocks have started declining. Here's what he said. “The answer is you don't want investors to think that what they read today is important in terms of their investment strategy. Their investment strategy should factor in that (a) if you knew what was going to happen in the economy, you still wouldn't necessarily know what was going to happen in the stock market. And (b) they can't pick stocks that are better than average. Stocks are a good thing to own over time. There are only two things you can do wrong: You can buy the wrong ones, and you can buy or sell them at the wrong time. And the truth is you never need to sell them, basically. But they could buy a cross section of American industry, and if a cross section of American industry doesn't work, certainly trying to pick the little beauties here and there isn't going to work either. Then they just have to worry about getting greedy. I always say you should get greedy when others are fearful and fearful when others are greedy. But that's too much to expect. At a minimum, you shouldn't get greedy when others get greedy and fearful when others get fearful”.

Just change 'American' to 'Indian' in these words and then read them carefully. It's so far removed from what most people think investing is all about that it takes time to figure out what this amazingly successful old man is saying. What he is saying that long-term success of investing is based not on the fact that the investor will be able pick the 'little beauties' but on the fact that country's economy is going to grow. What is happening now, (the short-term news flow) is not important because regardless of what you hear, what is happening in the country and the economy in the short-term may not be a good indicator of what is going to happen in the stock markets in the short-term. There are too many factors, too much noise, that affect the markets for the average investor to figure out.

However, in the long-term all the noise gets cancelled out and you are left with one single question. Is the country's economy going to grow? If you think the answer is yes, then that's a good reason to go ahead and own a broad cross-section of stocks. The bonus is that because it is a time when others are fearful, a lot of investments are cheaper than they were just a short while back.

Let me prove it with facts. To do it we will have to go back in time.

I turn to history and begin with the growth rate in the Indian economy as defined by the growth rate in
India’s GDP.

The data indicates that - over the 28 year period from 1980 to 2007 - the rate of growth in real GDP was 6.2% per annum. The "real" means after inflation - after the fake increase in wealth caused by an increase in prices.

I add back inflation - which averaged about 7% for the past 28 years. This allows me to get a sense of how the Indian economy grew at "nominal" prices. Combining the two, I broadly see that the Indian economy grew by more than 13% every year for the past 28 years. Not bad!

And the BSE-30 Index increased by 18% every year since 1980.

That is the past.

This growth has come inspite of the famines, wars, assassinations, bankruptcy of our economy et all. Is there anything to suggest that the next 30 years will be different from the last 30 years?



Tuesday, October 7, 2008

Past Perfect, Future Imperfect

You must have often heard parents lament how their once dutiful children went astray after going to college. Kids who were well-behaved and studious in their school years suddenly seem to go berserk as soon as they hit college, leaving the poor parents bewildered. Same kids, radically different behavior. It’s unfortunate that children, unlike investments, do not come with the warning, ‘Note that past performance of a child is not indicative of future performance’.

 Anyone who has invested any money in mutual fund has read a variation of this statement often. While it sounds reasonable for the regulatory authority to demand a similar statement, I wonder what else can one base an investment decision on. Since the future is unknown and the past is known, all investment decisions have to be based on the past. 

No, that’s not meant to be a joke. Take a look at any newspaper, magazine, report, website, whatever. All analysis of future potential is based on the past. This is not wrong, and nor is it avoidable. When I say that this fund is likely to be a good investment, I can only judge it on the basis of its past. Sure, I’ve made some estimates about its future, but those are based on the past. It could be the fund’s past, the fund manager’s, the fund company’s past or whatever, but it’s still the past. 

Clearly, all such estimations are implicitly based on the assumption that the future will resemble the past in a significant way. Past patterns of business--of companies, consumers, markets and economies--will in some way be useful in predicting the future.

Or at least, that’s what we believe. Is this belief justified? To answer that question, we should go back to our innocent schoolchild who went wild as soon he entered college. When the environment that drives behavior changes radically, then all bets are off. 

That’s the point at which the past becomes history and the future unknown. When we look back at the history of Indian businesses over the last few decades, this point proves itself. We’ve lived through times of great change. Moreover, the change has come in waves. Whenever a wave has come, past performance of businesses has become almost irrelevant to the future. Just fifteen years ago, the idea that Infosys would be a more important business than Hindustan Motors (a Kolkata-based auto company that may still be making cars) would have seemed bizarre. Just 16 years ago, there was a massive stock market boom in which one of the starring roles was that of Premier Automobiles (a Mumbai based auto company that definitely does not make anything anymore).  

Why were investors so excited about these companies in 1992? Because they didn’t realize that the economic reforms that had just started would change India. The past was no longer a reasonable guide to the future. Indians would stop buying half-century old car designs and the world would start buying software services from Indian companies. The year 2003 was probably another such break with the past. In practical terms what that means is that both these years were choke points when the patterns of past performance had trouble extrapolating into the future.  

My feeling is that we are standing at the cusp of another such break with history, one that may be far stronger than the one in 2003. From small domestic factors to big global ones, almost everything is in a state of great flux. Don’t be surprised if the pre-2008 past turns out to be a poor guide to the post-2008 future.