expected return, an incorrect precision

Corporate finance talks about it; investors and speculators talk about it.

When we invest our money, there is a natural expectation that we earn a fair rate of return on it. It is true whether we buy bonds or stocks.

Since debt has a fixed coupon on it, there is no confusion regarding expected return. A 10% bond due whenever, has expected return of 10%, not more not less, unless of course we are keen on investment at discounted prices.

It gets a bit complicated when it comes to equity investment. The world is just confused about what to expect from it. There is consensus that returns from equity investments require extra profits when compared to any other investments. That ends here however. How much extra returns, it's a hot debate out there.

Equity investment expects returns higher than that of cash, money market, government bond or corporate bond; while this expectation is given, there is no guarantee that it will actually provide that. Lop-sided equity investment can yield far lower return compared to the other so-called low-return investments.

Assuming investments are made in a more sensible manner, it will be interesting to analyze how we should expect returns.

We have some alternatives after we ignore the famous risk-return models of corporate finance.

We could find out historical equity returns over a fairly long period of time and expect that rate to prevail in future as well. This is a reasonable assumption even when one can argue that, times have changed. We can consider 10-15% annual compounded rate as a reasonable rate to expect from equity markets.

We could take long-term government bond rate, add a few points to it and consider that as expected rate for equity investment. Corporate bonds are not considered here as they have much higher default risk.

We could estimate long-term inflation rate, add a few points to it and consider that as expected rate for equity investment.

It is important to note certain fundamental and implied assumptions in every equity investment: compensation for postponing present consumption and uncertainty associated with long time period, and expectation to at least (perhaps more) maintain current purchasing power.

If these arguments are accepted, we come to a logical conclusion that equity investors need to be rewarded with a rate that is not less than inflation rate to start with. Once this expectation is met, there should be some additional points for forgoing present consumption and for assuming some uncertainty. Now, there is no exact science to compute these additional points to precision (if there is one, you go for it). Why not add as you deem fit albeit within reasonable boundaries? It does not bother us if investors add 5 to 10 points above inflation rate.

Equity investment fails to be an investment if it does not guarantee a rate at least equal to the inflation rate.

Consider this:

1) Expect market rate of return (hopefully this exceeds inflation rate; we have no particular reason to reject this), if you do not want to work hard either because you have no time or do not enjoy the process or because you think there are better things in life than spending time on equity analysis. Here your best bet is investment in the equity index itself. One thing is guaranteed: no one will question your judgment or rate of return achieved in the long run. For, many so-called sophisticated and well-equipped investors and investment-managers know how difficult it is to beat the market.

2) Expect inflation-plus-some-points depending on whether and how much efforts you are willing to put in. If you are not to be bothered, you need to join those passive investors and expect market rates. If you are more willing to put in time and enjoy the process, you should expect some higher points for your efforts. How much higher is directly proportional to how much time you have spent on analyzing the business and gap between its value and price. However remember this: on a long-term basis, it is not possible to exceed the inflation rate or market return by say, 5-10 points. For an ordinary investor, an additional 5% will have made more than adequate return compounded in the long run. Pick a rate and try its power of compounding over say, 20-30 years, and you will know why.

Now, it amazes me as to why one should think too much about return expectations. As someone once said, it is better to be roughly right than be precisely wrong. So add those points and move on.
 

irrational....exuberance....and not so much..and that crystal ball

[Corporate India's ebitda margins are bottoming out and the risk of any further material decline is limited - a leading rating agency research report.

See the bse sensex at 23000 levels in the next 12-18 months. Expect a 5% up move in the markets before the winter session of the parliament - head of equities of a brokerage firm.

Expect the current level to extend. Support for nifty is seen at 5600 and one can expect it to breach the psychological level of 5850 going ahead - a leading bank and brokerage firm.

Nifty may see 5600; market set for new high in 12-18 months - a leading bank and brokerage firm.

India can achieve 9-10% gdp growth - chairman of a leading global investment bank.

Hold Tata Power; buy Tata Motors - a leading analyst.

Enter Coal India below 350 - a leading analyst.]

These are just a sample...the opinions go on..but did you get the point?

It is amazing to see how people show off their abilities to predict!

There is so much noise in all forms of media that even a rational investor has difficulty in controlling his emotions. The internet and television, in particular, have that mystical ability to (over) influence gullible public and to drive them into maniac..optimists at one point and ....pessimists at another just so easily.

The reason: that so-called greed and fear within humans. Brokers and analysts know this weakness (which is of course within them as well) and try to exploit it. As a wise man said, demand being there, it must be supplied.

Why can't these predictors, if at all they know it all, sell their assets and put all their money into these stocks or market? Why can't they borrow some (or more) and put in their (battle) field? If they did this, they could be so rich that they don't have to come on tv or elsewhere to show their prediction. The reality is they know for fact that they are as ignorant or less knowledgeable as anyone is. If not, they wouldn't be on tv in the guise of helping you to be rich. You can see that their intentions are as bad as it can be: if they knew everything, they would be rich anyway and wouldn't be so large-hearted to tell you their secret; because they do not know it all, they want to take a piece off you.

It does not take so much intelligence to know this simple thing that there is no such thing as a sure thing with foresight. These (predictor) analysts are out there to loot the public, it's nothing but a camouflage.

So next time, if someone tells you to buy this or sell that, you should be asking him this question: why don't you borrow some money yourself and do that transaction if you are so sure of this? And if you are not so sure, why are you telling me to do this?

Consider this: If that person/institution is a broker, he wants to make money irrespective of your buy or sell transaction and your profit or loss as his aim is to get those commissions from you. If that person is not a broker and simply wants to show off his predictive abilities and public image, you should just laugh lightly. It's time for you to do some serious work, watch your favourite movie or take a walk!

It is far better to know that all of us can be super-intelligent with hindsight. If we had done that back then, we would be this by now. But with foresight, you are kidding. 

As another wise man said, what you need is neither hindsight nor foresight, but insight, vision in the moment; what you do at this point of insight determines your future. 

There are exceptions everywhere, but at least you got the point by now. What investor needs to do is to decide what he wants to do - passive investment or active investment. This discussion is for another blog.

Lest we get faraway, I close this saying, caveat emptor! 
 

property prices... and that delusion

We have been witnessing some unprecedented boom in the real estate sector, not only in metros, but also all over the country. Such has been the rise in the prices of land and buildings that it makes one wonder whether this whole thing is rational and justified.

An apartment that was bought, say, 10-12 years back would generate about 17-18% returns compounded annually by now. The one that was bought about 5-6 years back would give about 25%.

Good stuff! But how about if one is to purchase it now? For one, is that kind of money available for investment? Second, is it possible to service that money (debt)? Then, how long one will have to be in the rat-race in order to be able to continue to service that money? And still more, is it really worth it?

Sure income levels have shot up considerably over the years in India. A couple, say, qualified professionals, should be able to afford the mortgage. That does not stop one from asking, is it really worth it?

Is there something through which we can gauge the differences in price and value? There are no earnings projections here for the residential; prices are only perceptions-driven.

Why should prices of residential plots even in small towns should rise to the level that makes us uncomfortable?

Is the real estate bubble in the process of being formed, if not already formed?

It is difficult to understand why one is willing to put so much money in, say, an apartment where one is stuck for life. This is home, which the family considers precious. Fair enough. It is not an investment for that person; he is not going to sell it unless under dire situation. Hence, the rational thing to do would be to buy a house (apartment) which keeps the family cool during summer and warm during winter, and have some fun. Before the purchase just ask 'how much?'

If this is followed the prices might not move so much higher than say, inflation. However, the public frenzy has been so much that, due to various reasons, peer pressure being one, it is ready to pay any price for the property as long as the developer / builder is able to supply it.

No consideration is given to whether the family is going to use the amenities, such as gym, pool, car park, etc. All these come at a cost.

Businessmen know how to make money on their business; they buy low and sell high. These very people, however, are ready to pay any price for a real-estate property.

The problem with real-estate in India is that it is very difficult to assess its value. Prices are all over but value is not to be seen on many occasions. Property market here is unregulated (unlike the developed markets); it is not possible to consider rental yields as the basis for assessing value, unfortunately. Due to this, it is left to the developers to fix the price and the buyers to be in the frenzy and envy (wants it better than friends) to accept it. The market then goes in that direction, up.

Justifications are given: growing economy; increasing income; aspiring youth - India shining. However, history suggests that all booms end in busts! It is just that no one knows when.

Absence of quoted prices provides some kind of relief to the buyers as they do not have to keep thinking about it.

What if the prices fall? Well, since the property is not meant for sale (but to live) one could probably live with it. But in hindsight one would surely repent. Money lost could have been invested elsewhere to provide additional income. This could be a huge opportunity cost. What about that additional interest paid?

Buyers should be careful enough to check value in advance lest they suffer heavy losses.

If only someone could discover the tool to assess value here or still better if only the government implemented some grand reforms in land and building sector.

Wishful thinking, is that?
 

rate cut; a double edged one

The focus is on how the RBI quarterly monetary policy will look like and especially, what will happen to the rates in the monetary system. There is ample speculation with respect to the repo and the reverse repo rates.

The expectation of a rate cut to boost the slowing economy was evident in the stock market rally (speculation knows no bounds; well, this is for another blog).

The key question is: will a rate cut at this stage help?

The WPI inflation (for June 2012) is at 7.25% and the all India inflation based on CPI new series (2010=100) for June 2012 about 10%; both the trade deficit (difference between monetary values of exports and imports) and the current account deficit (which includes trade deficit, net international income and expenses, expatriate  remittances and foreign aid) are growing as well; the GDP growth rate is contracting.

The repo rate (the rate at which RBI lends to banks) is at 8% and reverse repo rate (the rate at which RBI pays banks when they deposit funds) is at 7%. Cash reserve ratio (the proportion of deposits banks have to keep with RBI) is at 4.75% and the statutory liquidity ratio (SLR - minimum holding of deposits in government bonds, gold and cash) is at 24%.

Any downside move in the rates will boost the economy but will impact the inflation severely, a situation we cannot afford right now. Increase in rates is not an option either.

A better option would be drastic policy actions (infrastructure, energy, subsidies, foreign investments, ...) by the government which should improve the economy.

mistaking oil prices and subsidies

Brent at under $100 was the news - it is refreshing to see falling oil prices, or is it really? Since these prices have direct impact on the government finances, industrial output and obviously, our day-to-day life, it would be nice to see crude rates falling all the way, or so we hope. Unfortunately, we cannot predict these prices, being so volatile.

People have come to believe that as international oil prices rise, the government will eventually increase all related prices, viz. petrol, diesel, LPG and the like. But is this the most rational thing to do?

Let us work out the economics. As oil prices go up, oil-refining and marketing companies will bear higher production costs, which they will seek to transfer to end users, industries and the common man. However, the regulation will not let this happen in order to protect the common man from the brunt. In doing so, it subsidizes these prices for public consumption and promises to compensate the marketing companies, i.e. through combination of oil bonds (are they really?) and subsidies from oil-upstream companies (we don't know who has to compensate the oil-upstream).

As we shall see, let's say, petrol prices need not be as high as we pay for it. Let us say, the crude price is Rs.4,800 per barrel (approx 160 litres). This translates to Rs.30 per litre of import cost; add to this refining costs of, say, Rs.7 per litre and transportation and dealer's commission of, say, Rs.7 per litre. The total cost per litre should then approximate to Rs.44. Now, we wonder why the headlines: petrol to cost Rs.78 in Mumbai, Rs.80 in Bangaluru.....It is because of the taxes that the central (excise and customs) and state (sales) governments levy.

As a result, nearly 50% of the pump cost goes to the government in the form of different taxes. It is another thing that the dealer (shop owner) gets a paltry 1-2% of the pump price as his earning.

In general, the government owns, a large majority controlling interest in both oil-refining and marketing and oil-upstream companies. There could be a nullifying effect or even a profitable situation here, at least for the government: the much profitable higher taxes, lower prices (under-recoveries), oil bonds and oil subsidies.

We do not know the rationale behind first to levy taxes and increase prices on petrol; there is tax on diesel as well, and then to provide subsidies on diesel, kerosine and LPG. It should rather be kept separate. When we compare the tax rates on petrol and diesel in India with that of other countries the results are very interesting.

Subsidizing domestic fuel is both a social and (more of) a political matter. So it can be a bit touchy. We can understand regulating domestic consumption oil, such as, kerosene and LPG in order to subsidize those who cannot afford (a large number lives under poverty). It is another matter that this subsidy is being enjoyed by the rich as well which should be dealtwith separately. But for the moment why should commercial consumption and consumption for comfort be regulated?

Petrol prices in India are already one of the highest compared to some developed countries (let's not even compare with other emerging markets). We donot know why the people of the country who have a much lower per-capita income be subjected to this ordeal.

Petrol has been deregulated, but only on paper. We are yet to see that in action. It is time that we let  prices of petrol and diesel be market-driven rather than policy-driven.

Oil-upstream companies should be allowed to do what these are supposed to do - find fuel. Earnings of these ventures should be invested in the business for maintenance and acquisition rather than filling the subsidy kitty for subsidies are not operating expenses. This would help increase oil assets of the country resulting in lower import bill. A large part of dividend payouts go the government anyway.

Pricing of domestic fuel and its under-recovery should be worked out on a more systematic manner; certainly there should be ways to bring them to a more reasonable and rational level.

This should surely result in lower, rather than higher, oil prices in the market; no under-recoveries for the oil-marketing or subsidy-holes for the oil-upstream. The government should look for something else to compensate for the lower taxes revenue.

falling rupee; failing economics

For the past several months we have been witnessing a steady fall of the rupee against the dollar. While there is all the harp around why it is falling, when it will stop and what should be done, it is time we come to the realities.

When there is mounting import bill chasing dollars and fleeing foreign capital what else do we expect to happen?

While we do not have control over the prices ruling the main components of imports, viz. oil and gas, there is plenty of room on the other side. We can not go around talking about how good our economy is and sending invitations to foreign capital when the reality is quite different. When the country is reeling under pressures from policy failures the economics for investors is not warranted. Two of the most important - power sector and infrastructure policies seem have remained only on paper; subsidy issues, land scams, coal shortages, telecoms scams and project implementation delays, among others, have been the key reasons for lower economic growth. Fiscal deficits and rising inflation only make the matters worse.

In this environment why would an investor put money in an asset when he is not sure of his return? Leave aside the foreign investors, even the local investment appears tentative. So sending invitations to individual foreign investment would not make much difference. Road shows aside, what we need to show is a decent growth rate.

While we acknowledge that there are external factors, such as weak developed markets and rising oil prices, affecting the local economics, there are a number of things that can be and should be done in-house. Only then invitations for foreign capital make sense. Rather we do not need to invite as investors from the developed markets are ever alert in looking for opportunities especially when their own local market is not yielding their expected returns.

What foreign capital is currently asking is: show me the policies, governance and the growth, and I will come running, not for your sake, but for my own.

India has a lot of potential to grow, if only right policy decisions are taken. The more we delay, the longer we will talk about how rupee is falling, how we have fiscal problems and wonder why foreign capital is not coming.

All said, it appears that none of the decision-making would come until the elections are over. So let's talk about something else until then rather than keep giving free advice.

how attractive is the market?

Europe crisis, US recession and fear of a global meltdown have been the topics of discussion these days. Indian growth rate has been lowered to less than 7% going forward. Market has taken a beating from 20k to 16k as noted below.

Month	Open	High	Low	Close
Sep-10	18027.12	20267.98	18027.12	20069.12
Oct-10	20094.1	20854.55	19768.96	20032.34
Nov-10	20272.49	21108.64	18954.82	19521.25
Dec-10	19529.99	20552.03	19074.57	20509.09
Jan-11	20621.61	20664.8	18038.48	18327.76
Feb-11	18425.18	18690.97	17295.62	17823.4
Mar-11	17982.28	19575.16	17792.17	19445.22
Apr-11	19463.11	19811.14	18976.19	19135.96
May-11	19224.05	19253.87	17786.13	18503.28
Jun-11	18527.12	18873.39	17314.38	18845.87
Jul-11	18974.96	19131.7	18131.86	18197.2
Aug-11	18352.23	18440.07	15765.53	16676.75
Sep-11	16963.67	17211.8	15801.01	16453.76
Oct-11	16255.97	17908.13	15745.43	17705.01
Nov-11	17540.55	17702.26	15478.69	16123.46
9 Dec11	16555.93	17003.71	16142.32	16213.46

The fall has created panic in the market only to fear more fall. But within these parameters, is the market attractive today at this absolute figure?

Does not appear so if we have a look at the following table showing sensex yields over the years.

Year	Open	High	Low	Close	Price/Earnings	Price/Bookvalue	Dividend Yield
1991	1027.38	1955.29	947.14	1908.85	22.3	3.58	1.24
1992	1957.33	4546.58	1945.48	2615.37	36.19	6.35	0.8
1993	2617.78	3459.07	1980.06	3346.06	31.78	4.81	0.98
1994	3436.87	4643.31	3405.88	3926.9	45.45	6.07	0.68
1995	3910.16	3943.66	2891.45	3110.49	23.63	3.81	1.13
1996	3114.08	4131.22	2713.12	3085.2	16.07	3.02	1.5
1997	3096.65	4605.41	3096.65	3658.98	14.45	2.8	1.53
1998	3658.34	4322	2741.22	3055.41	13	2.25	1.8
1999	3064.95	5150.99	3042.25	5005.82	17.35	3.07	1.38
2000	5209.54	6150.69	3491.55	3972.12	24.48	3.81	1.14
2001	3990.65	4462.11	2594.87	3262.33	17.6	2.51	1.83
2002	3262.01	3758.27	2828.48	3377.28	15.22	2.3	2.14
2003	3383.85	5920.76	2904.44	5838.96	15.02	2.49	2.14
2004	5872.48	6617.15	4227.5	6602.69	17.26	3.28	2.01
2005	6626.49	9442.98	6069.33	9397.93	16.21	3.94	1.58
2006	9422.49	14035.3	8799.01	13786.91	20.18	4.75	1.35
2007	13827.77	20498.11	12316.1	20286.99	22.25	5.32	1.1
2008	20325.27	21206.77	7697.39	9647.31	18.22	4.2	1.29
2009	9720.55	17530.94	8047.17	17464.81	18.08	3.42	1.43
2010	17473.45	21108.64	15651.99	20509.09	21.71	3.67	1.12
9Dec2011	20621.61	20664.8	15478.69	16213.46	19.38	3.45	1.3

With 19x p/e, over 3% p/b and less than 2% dividend yield it is far from the investors' market. Sure, there are opportunities at individual stock levels. But overall it could be the platform for traders, speculators and the like.

Take your pick!