index: falling prey to the numbers

Have a look at the below table for Sensex:

We can see that over 22 years, the compounded growth of the Sensex has been at a respectable rate of 14.53% pa. This means Rs.100,000 invested directly in the market would have grown to about Rs. 2,000,000. No stress, no trades, no commissions, no research, no-nonsense.

During this period, too many events have taken place - trade deficit crisis, currency crisis, terrorist attacks, IT bubble, policy scams, financial crisis, the global meltdown; and the policy reforms, growth in corporate earnings, growth in the GDP and the global recognition.

It looks like in the final analysis, positive events driven by the fundamentals beat the negative events. Hence, the march of the Sensex.

We have seen it before in Dec-2011 and Oct-2012. Where do we stand today?

We saw the peak values of 52.6 P/E, 9.4 P/B and 0.51 Dividend yield in April 1992; and the low values of 10.2 P/E, 1.7 P/B and 2.2 Dividend yield in October 1998.

While we do not know when we will see those values in future, today it looks like this:

17.4 P/E, 2.9 P/B and 1.5 Dividend yield.

Compare this to the average values:

21 P/E, 3.7 P/B and 1.4 Dividend yield.

It looks like we are in the range of average values. Is this the buy time then?

The average values may have to be reworked backing out outliers.

Let's have a look at values when the Sensex peaked at 20509 in December 2010:

22.9 P/E, 3.7 P/B and 1 Dividend yield.

There isn't big difference between P/B and Dividend yield of today and December 2010. P/E was a little higher in December 2010 though.

The Sensex is neither very cheap nor very expensive now.

What we need is a set of assumptions for long term investing:

1. The government will take the right policies for reforms in the key sectors of the economy;
2. The interest rates (and the inflation) will remain at reasonable levels;
3. The corporate profits will grow; and
4. Positive events will outweigh negative events over the period.

I am optimistic about those assumptions. The next decade or so should bring in a lot of opportunities to make money.

Two options are available:

Be very passive and invest in the market itself. Don't trade, speculate, or predict. Don't track or time the market. OR

If interested and time is available, get into equity research business and play the investing game for long term. It can be fun and rewarding.

We don't just need the new year wishes; we need wishes for the new decade.

beat them in the (investing) game

The players and their fate
There are investors. Then there are speculators...traders and punters. And there are mutual funds. All of them trying the same thing. Beat it. Make it.

Investors have noble thoughts though. They want to protect their downside and aim to earn adequate return which is some points over the market return. Some do; some don't.

Speculators, well, want to do what they are good at..speculate. They win some and lose more, much more. Negative-sum game players. Their instincts never let them stop playing. They will play until they are gone. Needless to say, their net returns are poor. They always lag the market. Don't believe them when they say they do.

Institutions (mutual funds and the like) want to beat the market by some solid points. They hire managers with special skills; they talk the jargon; they use presentations; they want to be high profile. But overall, they remain good only at that, crunching numbers. Their result is mediocre. No, the majority is not able to beat the market.

They continue playing the same game
When the large majority cannot even equal the performance of the market itself, it is surprising that none of them think of doing something different. That is, work towards beating the market or at least equaling the market.

A new game: Beat it
Beating the market, though not impossible, requires different skill set. Not the jargon or the gibberish. It requires an acceptable investing framework and rational behavior. It appears simple, but in reality can test anyone.

Key requirements are treating investing as a business by itself (you are the business owner), and devoting sufficient time to learn about it: prepare the framework and develop the right behavior.

This is a lengthy process like any other business. As you go along, you will learn about various securities (businesses) and how to value them under different circumstances.

If you run this business of yours properly, you should be able to aim for market beating returns, that is, some points over market. And over the long run, these additional points should be able to make you rich enough.

Another game: Beat them
Well, if you don't have time and patience to start your own investing business, or you don't enjoy this process since you consider there are better things in life to have fun, it's not a big deal. You can still make money..in the long run. You will not beat the market but you will beat the majority of those players out there.

All that is required is discipline and patience. This game is called index investing which is investing in the market itself. You will get the same result as the market.

If the market goes up by 10% you will see 10% (almost) upside, and if it goes down by 5% you will see 5% downside too. In short, your performance will mirror the market performance.

With this you will beat a vast majority of those so-called investors (individuals and institutions) out there. What more do you need?

It works like this: You invest X amount each month (week, quarter, half-year or year will do) in a broad index fund (exchanged traded or managed) irrespective of the index value. You continue this process for sufficiently long period, say, 10, 20 or even 30 years. The result should be pretty good indeed if you work the math. The magic of compound interest is marvellous.

You should not skip investing; and should not track (worry about) the market in the entire period.

There are detractors to this kind of investing. They argue: Companies in the index change all the time; Index funds invest in only large-cap companies; Index funds have to invest in expensive stocks; As the index value goes up (that is, as market cap of the companies in the index goes up), the large base effect restricts profits.

Consider this: The Nifty value in Jan-1994 was 1083; now it is 5908; The Sensex value in Jan-1991 was 982; now it is 19444. Even at today's weak market conditions (high interest rate and low demand) the market performance has been at a compounded rate of over 10% pa.

There is far lower risk (and stress) in index investing since it goes for a long time. You see much volatility in the mean time, but over the long period the risk is virtually not there.

There is no reason why we cannot see market return of about 10-15% pa compounded over the next 10-20 year period.

This is certain if two things hold good: reasonable interest rates and higher corporate profits. India has virtually no choice in its policies. The reform policies may be delayed but they will have to come lest we will be in debt and danger. The potential for growth is there with so much to be done in infrastructure, energy, agriculture, manufacturing and services.

That points that index investing is, after all, not that bad. Do the math with your choice of monthly investment, number of years and a return of 10-15%, and check.

So for all those beach lovers or what have you, there is a choice to have fun in life, do the favourite day job and make money.

Wonder if those institutions are listening. If they aren't, you will be beating them at their favourite game in their field in the next 20 years.

Low risk, low stress, more fun and more money. Too good to be true, but it is true.

business that needs capital

All businesses need capital: Capital is required to start a business; for it to continue as a going concern, it needs capital; and for it to grow, it needs capital. There isn't anything new to this story.

what we don't want
However, there are businesses which unfortunately require loads of capital to start, then loads of it to continue, and loads of it again to grow. It is the nature of the business, that's it. These will then have to look for sources of capital: equity and debt combinations. This continuous look out for large capital can make the firm vulnerable to circumstances.

Take for instance, capital goods manufacturing and heavy transport companies.

There are at least two characteristics, arising out of leverage, that stand out in such a capital-intensive business:

It has a high percentage of property, plant and equipment compared to its total operating assets. Due to this, it is exposed to operational leverage. In good times, with rising output, the profits will be higher. However, with a very low portion of variable costs, in a downturn the business will suffer.

Because of its capital needs, the business will have to borrow more compared to its equity. The firm will be able to (required to or tempted to) borrow based on its physical assets. The result is a high debt ratio.

Due to higher operational and financial leverage, a capital-intensive firm will find it very difficult to adapt to changes required by market conditions. Changes in technology or in consumer demand could challenge the firm's fundamentals.

A slump in the economy could lead the smaller firms to question their survival and the larger firms to question their prominence.

An investor has to be careful in investing in these type of businesses. Assessment of long-term survival is vital.

what we want
But how about a business that requires capital, but not that much, to grow? And how about one that generates its capital on its own?

Enough cash is generated by the operations which is used for reinvestment purposes, and excess cash is returned to shareholders.

These firms largely run on the strength of their brand created by high quality management and top quality products purchased more often (customer satisfaction; high demand). These businesses generally provide higher return of investment.

There are enough of these type out there, if not plenty; we just need to explore!

Let's get on to that. 

making millions...the hp way

It is not that difficult to have a business with a valuation of millions of dollars. It is easy if you start off with a business worth billions, and then continue losing some billion here and some there regularly; slowly but surely, your business would be worth millions.

It looks like HP has taken this strategy rather seriously; you can see it from HP's style of running the business. Buy assets for billions and then write them down. HP's value has fallen from $60 b to $25 b in less than a year.

Loss of wealth over the years:

Physical growth does not necessarily translate into profits. For growth to add value, it has to generate return in excess of cost of capital. When this does not happen, it is destruction of wealth. Key to achieving excess returns is to ensure that purchase price is not heavy. Often, synergy effects are pointed out as value drivers to justify whatever the price paid.

When things fail, the blame-game begins. There are investment banks and audit firms, who gain fees irrespective of the deal. Then there is the board, who is supposed to oversee the proceedings and approve acquisitions before management can complete it. And the management, who does it. Collectively, these parties can destroy shareholders' wealth in the name of acquisition, control, growth and synergy. DCF presentations are made in support of any (acquisition) price. Cheery consensus.

Good corporate governance is what matters in the end for shareholders to see their wealth grow. If there are conflicts of interest among the managers, shareholders and others, it does not bode well.
 

towering bucks...bharti infratel

The upcoming IPO of Bharti Infratel aims to raise about Rs.4,500 crores at the price band of Rs.210-240. Representing a public offer of 18.89 crores shares (about 10% of total shares outstanding), the market value of the company will be almost Rs.45,000 crores.

If the issue becomes successful, the promoters will be richer instantly - some of them will cash out some part of their holding at some (significant) profit. Bharti Airtel, reportedly holding about 86% of Bharti Infratel, will see its shares worth Rs.38,700 crores.

Just for comparison, Reliance Com equity is currently worth about Rs.15,000 crores. This means Bharti's tower business itself is supposed to be 2.5 times more valuable than Reliance Com. It is best left to the investors to ponder over this matter than anyone else.

What is uncertain at the moment is how much the (potential) investors will make out of this IPO. This game is best played on batting-first-hitting-quick basis - those who start off first and get out early stand any chance of benefiting from the momentum, if there is any. History suggests that on average the late comers haven't had much to gain.

Let the play begin!