return on investment

Return on investment

There are no set rules to arrive at the required rate of return on an investment. We are excluding mathematical models of corporate finance here.

While we have discussed this in the past, it is interesting to see it in the right perspective.

How have you done

Consider that you are investing in an equity asset with Rs.100, and at the end of the year its value goes to Rs.115. Well done, you have earned 15% on your investment.

But before you give a pat on your back, you need to take note of the inflation, treasury bond rate and the broader market.

Only when the inflation is < 15% you have done fine. That is, you have exceeded your purchasing power. This is the first step in measuring your performance.

Next, you check out the treasury bond rate. If your return has exceeded this rate, you have done well. This is your second measure.

Finally, you come to compare your performance with the market itself. If, say, Sensex or Nifty performance for the year is < 15% you have done well.

You should not compare each rate in isolation; it would be misleading.

For instance, if your performance is 4%, market index is 1%, but the inflation is 8%, you have failed in the fundamental principle of investing, i.e. to increase the purchasing power by postponing current consumption.

When you earned 10%, market earned 9%, treasury did 8%, but inflation was 10%, you are left where you were. The monster of inflation has done you - you are left with nothing at the end of the period.

Similarly, if you are able to beat inflation and market, but treasury rates are better than yours over long term, it would still not make sense in investing in equity.

The rules for the expected return and performance

Therefore, the simple rules for the expected rate of return (you can call it discount rate) should be:

1) First, to beat the inflation - you have increased your purchasing power. Give yourself an A;

2) Then, to beat the treasury rates - you have done better (assuming treasury exceeds inflation). Give yourself a AA;

3) Finally, to beat the broader equity index (not sectoral index) - you have done very well. Give yourself a AAA.

Add some stars to your rating depending on the number of points by which you have exceeded the comparable rate.

If the market has under-performed the treasury or inflation, you still got a AAA.

The discount rate

Let's say, once you have estimated the inflation (don't have to break your head for this; historical rates and future economic prospects should be able to guide you), the treasury rates (same analysis), and the market return (same analysis), you simply have to add a few (you choose) points to arrive at your expected return on investment.

Note that if your estimates of inflation, interest rates or the market return are a bit different from the actual in the long term, it's not a big deal since your discount rate is meant to be an estimate not a precise rate.

Well, your discount rates are in front of you. You don't need CAPM or any other model to estimate your cost of capital. 

aviation fuel and risk

If you are in a bad business, you generally can't help it, or help yourself. Well, if you are in airline business, we wonder who can help you.

There are too many variables which are likely to outsmart this business and its owners. For one, it requires a large amount of capital expenditure just to be where it is. Then are operating costs which are beyond management's control.

Take for example, fuel costs of airlines. If there is no fuel, the fleet can't fly. Common sense. If they don't fly, there is no revenue; no cash to settle obligations. The circle is generally vicious. Aviation fuel is the single most important component of operating costs of an airline business. And Alas, you cannot manage it. The fuel costs are beyond the control of management. The prices fluctuate at random. The steeper they go, the higher the airlines suffer.

Take a look at the historical oil prices:

And the aviation fuel prices in the past year:

 Now, have a look at the airlines' income statements:

At current prices, fuel costs are about 50% of revenue generated. That means, to achieve an operating profit, all other costs will have to be below 50% of revenue. There are employee costs, lease costs, aircraft maintenance costs, airport costs, depreciation, and many other costs. To bring them down to make way for operating profit is a challenge. High interest costs (as the business requires huge capital investment usually there is high debt) can turn operating profit, if any, into much lower net profit or even loss.That's why airline business is such a pathetic business. Too much cash inside, too little or no cash outside.

Getting back to fuel costs, is there anything management can do to tackle it? Some do; they manage their fuel costs. What are the options available? You cannot fiddle with the volume of fuel. Then it's the price we are talking about.

1) Some airlines do nothing about their fuel costs. It is a good choice if you see falling prices. If oil prices keep rising, you can see the pictures above.

2) Some enter into forward contracts for oil. The price of purchase is locked in for the agreed period. It is a good strategy if you see increasing prices. But if the prices fall, airlines take the hit.

3) Instead of forward contracts, some airlines buy call options for oil. The airlines can choose to exercise the option (if prices go up) or buy market (if prices go down). This is a good choice if you don't know what is going to happen to the prices. The cost of the call is the premium paid. The prices have to be good enough to give you a better total cost including the premium.

4) The airlines have another choice, selling put options for oil. Letting someone else have the option to sell, that is. Airlines get the premium upfront. If the prices fall, the buyer (of the put) will exercise the option to sell at the agreed higher price to the airline. If the prices go up, the buyer will not exercise the option; but the airline will have to purchase fuel at higher prices from market. Its total cost is net of premium received. This is the least preferred strategy.

We can see that in one way or the other, the airline is exposed to the fuel price risk.

Let us once again conclude that airline business is such a lousy business to be in. Look elsewhere in the pond, or in another pond, shall we? 

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!