ideas to have fun, make money

The Indian stock market ended 2016 at 8185.80, which is just 3% ahead of last year.  

The returns from stock markets are not linear. You cannot expect fixed stream of cash flows from equity; for that you have to go to bonds. Alas, returns from bonds are almost always lower than equities. And in present times, man, it is going to be just equities, if your aim is to make money. 

What amazes me is that people expect stock market returns to be always, always positive. That shows lack of knowledge about what really equities are. 

When you start a business, you are ready to wait for years to make it worthwhile for you. You are aware that some years will be good, and some will be not as good. Yet, you expect the business to be viable in the longer run. When you are a businessman, like many that I know, you are also a highly concentrated investor; that is, most of your wealth is tied to your business. It is because you know that you are making a career out of your business, and want to stay that way for a long, long time. That is great. 

But then, why do you see your stock market investments any differently? When you buy a share in the stock of, say, Nestle, why do you expect it to increase in value every day, week, month, quarter and year? Do you think the value of Nestle as a business should change significantly by the day? Just like your private business, Nestle is also in a business, which is going to be good some years, and not as good in some. This is the crux of investing. The earlier you get it, the wealthier you get in life. 

People who invest in properties do not check price quotes on a daily basis, do they? They are crazy, if they do. There aren't quotes anyway, unless a transaction takes place. Just because there are quotes for your stocks, you are tempted to check. That's crazy too.

The resolution for the coming year is about taming your wild behavior. Stock investing is as much about human emotions as it is about intelligence. If you are not dumb, and are in control of your emotions, you are more likely to be a winner in this game. 

I have four ideas to share which are just enough make someone have fun, and make money at the same time. Don't forget to enjoy life. 

Hate those guys; the crooks

Stop listening to the pundits. Oh yes, stop listening to all those self-proclaimed value investors who write blogs, make up stories, quote Buffett and Munger, and then charge you for their offerings. They quote some philosophers as well just to spice it up. Know that they cannot teach you anything about stock market investing. If they knew, they would have invested for themselves and made money. There would be no need to charge you for their products. I know some of them who also invest in mutual funds; which means they give their money to others to manage. How ironic for someone who claims having knowledge to teach people about equity investing to trust someone else to manage money? It is because they have to pay their bills, they have the need to coin stories to tempt the gullible. Don't get swayed by their morally corrupt thoughts.

Don't care market prices investing

Invest in equities on a periodic basis. The best way is to invest in a broader index in good times and bad. Buying the index each month either in fixed units or fixed currency is good. Here you are not bothered about market prices because the prices average out in your favor in the long run. 

Market prices are the key investing

Then wait for the right opportunity to invest in individual securities. If you think that Nestle is a good business, you analyze the business and come up with a value. You buy the stock only when price is much lower than value. Here you do care about market prices. Your returns are directly proportional to the price that you pay. 

Caution: You cannot play this game if you are not interested in equity analysis or simply have no time. Then you are much better off investing in the index itself. You are guaranteed to earn returns equivalent to the market returns. You would be crazy again if you consider that is not enough. Equities outplay all other investment alternatives if played long enough. 

Control

The promise you have to make is to have a check on yourself, always. Control your emotions: greed, fear and envy. You will not only be having fun in life, but also be wealthier than you ever think you will be.

Speculate in moderation

On a side note, I am also an advocate of speculation. I am aware of the kick it gives; so some more fun is alright. But it should comprise an insignificant portion of your net worth. So if you are so keen, play along. 

8% government bonds

With interest rates falling, and projected to fall in the coming months, for investors in debt instruments, it has become a matter of importance. The 10-year government treasury is now at 6.46%; and 1-year treasury is yielding 6.32%. Bank deposit rates for one year are currently less than 7%. 

When safer debt instruments are below 7%, you tend to check out debt funds, which can probably give returns in the range of 8-9%; not assured though. 

There is one more option for the investors seeking risk-free debt. That is the government's 8% bonds. These were issued in April 2003, and yield a return of a little more than 8%. The catch, however, is the lock-in period of 6 years. 

With the brokerage fee of 1% on purchase, the pre-tax return on cumulative comes to 7.98% and on non-cumulative, 7.94%. At least, these are assured returns. If you estimate that inflation and therefore interest rates are likely to be lower during the period, these are better options compared to bank deposits, especially if you are in the lower tax rate.

For someone, who is in the tax rate of 0%, the returns are not bad to lock-in for 6 years. But then of course, all depends upon the opportunity cost of the investor. 

value of property

Many financial advisors consider that house property where one lives is not an investment. This is because the house is not going to be sold at all as the family lives in it. Great. They also advise that since the property has annual payments such as taxes and maintenance to be made, that should be included as a liability. Super. The value of the house would not be part of one's net worth. 

What if there is an investment made in an equity instrument, which the investor inherited from parents, and does not intend to sell ever, but wants to pass on to the children? Going by the earlier logic, the investor who owns shares of Coke, which are planned to be passed on to the next generation, should not include them in the calculation of net worth. 

Let's fix that conception. Any item that has value in the market should be included as part of net worth. Even car, expensive watch, etc. can be included. However, as a cautious analyst, I do not include any asset whose value depreciates over time. So the car goes out. I don't like the idea that an expensive watch has any meaningful value. I don't have the stupid habit of buying watches anyway. The more assets without having cash flows one owns, the more speculative the net worth becomes.

Back to the property. Even when the investor has only one house property where the family lives, and intends to live forever, there could be occasions where the family may decide to sell. This may be due to cash problem, or may be due to the idea of cashing in. When the property price becomes quite high in the area, the investor may decide to sell and move to an area where the price is low. Of course, house property is part of your net worth. 

Value of the property: Most buyers of house property do not think about its value. For them, the value and price of the property are just the same. I don't blame them per se, especially in India, where if someone really looks at the value of the property, it is difficult to buy at all. Nevertheless, it makes sense to at least understand the gap (the premium) that is being paid when it is bought. 

Value of any cash flow generating asset is the present value of all cash flows discounted at an appropriate rate. House property is not an exception. The cash inflows are rents, and cash outflows are taxes and maintenance. The value of the property is then the present value of annual net cash flows attached to the property. That is true even when the family intends to live in the house because if not, the investor would have rented the property. 

Let's consider an example. An apartment with annual rentals of Rs.360,000 has a market price of Rs.17.50 m in a suburban Mumbai. The annual costs are minimal; so I will ignore them in the calculations. That is a rental yield of just 2%. What the market is saying is that any expectation above that rate should come from the market itself. The 10-year government treasury has a yield of 6.50%. So to match that, the market price has to appreciate by 4.50%. It is a bit simplistic because there is growth in rentals too. Yet, if the investor wanted 6.50%, government treasuries would be the option, not house property. The expected rate of return for the property is some points above that rate. 

Assuming that rentals will grow at 7% annually (they may not if inflation remains lower) for the next 10 years, and after that they will grow at 5% on perpetuity (they may not), we have all the cash flows available to bring them to the present value. The value of the property now is a function of the expected rate of return. 

At the market price of Rs.17.50 m, the investor will get 7.562%. If the expected rate of return is 10%, the buy price has to be Rs.8.83 m, a markdown of 50%. There is no question that the market price would go that far down in Mumbai. At least they have not so far. That is why I consider that rentals and property prices in India are not aligned. To have an expectation of a reasonable rate of return, either the rentals will have to go up, or the prices will have to come down. Neither has happened in the past 20 years or so that I have seen. 

So what will the investor do? Owning a house is always a dream; so it is easy for the investor to make the decision. Just look around and track a few properties. Buy the one that is most liked in terms of its design as a trade off with the market price. The investor and the family moves in. There is no time to think about intrinsic value of the house property. 

There is another way of calculating value of the house property, It is how most equity analysts calculate the value of stocks. Take the cash flows for 5-10 years, and plug a multiple for the stable growth value.

This is how it works for the house property. All cash flows for the 10 years remain the same. Year 11 value is the expected sale price of the property. The value (is that price?) of the house property then becomes a function of both the expected rate of return and the expected sale price at year 11. 

If the investor reckons that it will be sold for say, Rs.27.50 m, the value of the property becomes Rs.13.70 m at 10% expected rate of return. At the market price of Rs.17.50 m, the investor will have to sell the property for Rs.37.34 m in year 11 in order to get a rate of return of 10%. With all the speculation about market prices after a decade, it becomes murkier. 

There isn't much choice for the investor. A better gamble would be this: Buy the property at the market price, with limited application of timing (i.e. buy when the prices are generally lower); live until the working life; upon retirement, sell the expensive property and move to a place where the prices are more reasonable on a relative basis.