Monday, August 12, 2013

A Disciplined Approach to equities


An earlier piece that has appeared in Moneylife EQUITIES – A DISCIPLINED APPROACH When it comes to equities, each of us has a different experience, though we are perhaps all in the same “market”. Dig deeper and you will find that each of our journeys are separate, originate at different times, we take different vehicles and yet all of us seem unhappy with the “market”. Is there some safe way to be in the market with the objective of creating long term wealth? More often than not, the disillusionment is solely on account of a lack of thought behind the reasons for being in the market. Yes, all of us want to double our money each day. But do we sit back and think about the probabilities or possibilities? Take a look at the data below: Jan1-2012 to date- Sensex 20%, midcap 14%, small cap 0 2013 to date- Sensex -4%, midcap -18%, small cap -25% The above table is interesting. You can go back in time and check for whatever periods. The takeaway is that smaller stocks need a tougher skill set. One other thing has happened, which has not been documented. If one were to form a bucket of stocks with high ROE, businesses that are solid and have been around for a few decades, a different story comes through. Since the panic of 2008, when the broad markets fell, there has been a rush in to these stocks (for example, HUL, ITC, Nestle, Asian Paints, etc). Even in a falling market these stocks have trended higher. At the same time, some of the mid cap stocks are below what they were quoting when the Sensex was below 10,000. Thus, there is a huge difference in one’s experience of the stock markets even in same time frames. We all know that timing makes a difference. Yes, stock selection also matters. But this safe haven story seems to be a development of the last five years. This also means that these great stocks are priced to perfection and leave no room for disappointments. Yes, the street may tolerate one weak quarter, but a perceived slowdown or drop in expected profitability will lead to a severe de-rating of these stocks. The levels at which they are priced, limits the upside potential. Yes, they are great stocks to have in one’s portfolio, but the risk one runs is of prices stagnating in that portfolio. Let me tell you what a basket of five high quality stocks have delivered over the last ten years: Time Cummins HUL HDFC ITC Nestle Total Sensex Bank RD 1 year (7) 17 9 14 5 8 6 4 2 yrs (2) 38 15 34 9 19 11 9 3 yrs (4) 62 19 53 19 30 9 13 4 yrs 14 78 29 82 39 49 12 18 5 yrs 49 91 51 116 76 77 25 23 10 yrs 177 157 207 321 312 233 91 53 ( Absolute return in percentage terms, NOT COMPOUNDED) start date is June 2003/ In the above table, I have assumed that each month, on the first business day, we put up to a maximum of Rs.5,000 in each stock. Actual amounts would be slightly below 5,000/- to avoid buying fractions. Thus, maximum commitment of Rs.25,000 per day. Against each stock, the time wise returns are indicated. “Total” refers to the total returns from all the five stocks together. 1% brokerage on stocks is considered. In effect I am doing a SIP of 5,000 per month in five stocks, 25,000 per month in the index and a like amount in a bank recurring deposit, monthly compounded at 8% p.a. The above basket is a matter of choice and returns will vary widely based on what stocks one chooses. Clearly, the start and end period would make a difference. To make a basket of your own, just pause and think about which five or ten businesses you would like to own. That can help you prepare a list. Financial analysis can come later. I am using this table for a limited illustration. My point is that a basket of good quality stocks will beat the sensex returns comfortably. The risk of choosing just one stock is high, and hence I have chosen a bundle of five stocks. To me, it is also a function of discipline in investing. What is also evident from the table above is that if we look at the ten year window, the latest five have not provided great returns. And whilst a bundle of handpicked stocks have beaten the index in each year, the index has even lagged the bank recurring deposit investment over the latest three and four year periods. Of the stocks chosen above, I would have had difficulty in ranking one over the other even five or ten years ago. Same would be the predicament if I were to look five or ten years in to the future. My reasonable expectation is that in the next five or ten years, these companies would still be around and the businesses would continue to be great. This basket need not be the ‘perfect’ basket and five is not the only number. This kind of a basket may not give you great returns or multi baggers, but can provide you with a healthy equity portfolio that goes to create wealth. Mutual funds in India have so far done a decent job in equities. Nearly half of them have beaten the index. However, as the size of the funds increase, this will become more and more difficult, given the illiquid nature of our market. There are hardly 200 stocks with a market capitalisation of more than Rs.5000 crores. In essence, our entire market is a mid cap or micro cap market. So, any large fund will tend to mimic the bigger indices more and more. At best they will be overweight or underweight on a few stocks. So, investing in mid caps pays off when the size is small. A fund like HDFC Top 200 is a great example. Its great performance in the early days made money pour in. Today it has bloated to nearly Rs.12,000 crore! Finding 200 stocks to deploy the money is not easy. Now the performance is slipping badly. The fund should have closed out at around 2000 crores or so to sustain performance. So as the mutual fund industry grows in size, it would find it harder and harder to match indices. It would be a good exercise to go back to all your equity investment decisions and analyse them. Often, disappointment is the result of inadequate time and thought given at that point. I firmly believe that equities are a valuable investment vehicle. So, think hard. Equity investment is not a short cut to multiplying your money. First try and create a corpus through a long term plan. Then, take what risks you want, with money that is really surplus and where the loss is not going to hurt you. The chance for big rewards will always be with big risks. You may buy ten penny stocks and maybe if you are lucky one will become a big winner. The key to success in equities is your ability and willingness to acknowledge and accept the risks attached to it.

3 comments:

Bhushan said...

Hi Bala,
Would it be possible to split the long article into multiple Paragraphs. It will reduce strain on eyes when reading.
Thanks,
Bhushan

Umesh Kudalkar said...

Hi Bala,
Excellent Theme and Observations. Holding high quality stocks is likely to prevent permanent loss of capital and at the same time has allowed one to earn >3% post tax return over the rate of inflation in the past decade. If one is disciplined enough to have such SIPs in say... 20 high quality stocks, then even a salaried person could probably achieve his / her dream of being financially independent. As you said, penny stocks investing entails a significant risk. Thanks.

Umesh Kudalkar said...

Hi Bala,
Excellent Theme and Observations.
Investing in High Quality Stocks is likely to prevent permanent loss of capital. Moreover, such SIP investments in High Quality Stocks have allowed investors to earn >>3% post tax return over the rate of inflation in the past decade. Such disciplined approach may allow even a salaried person to achieve his / her dream of financial independence. As you said, investing in penny stocks entails significant risk and possibility of permanent loss of capital. Thanks a lot. - Umesh