A GUIDE TO
EQUITY INVESTMENT
By
Mr. Gerard Colaco
Foreword
Sometime in 1988,
we wrote what we hoped was a simple paper on investment in the Indian stock
market. The paper was intended to help
beginners to invest effectively in stocks and seasoned investors to reinforce
certain crucial equity investment fundamentals.
In 2013, this paper will complete 25 years of its existence. During this period, we are gratified that it
has helped a larger than expected number of investors who made an honest
attempt to implement the strategy it advocated.
Much
has changed in the Indian stock market over the last three decades. We are happy that none of these changes have
hindered the implementation of the ideas in this paper. On the contrary, the wonders of modern technology
and better regulation have worked in favor of a genuine equity investor, who is
willing to use a little common sense and self-discipline in equity
investment. Our paper said nothing new
when it was first published. It says
nothing new now. It merely invites
investors to focus on certain valuable ideas culled from the world’s finest
writers on equity investment.
Essentially, we
urge investors to choose investment over speculation; to invest in the Indian economy by
constructing a well-diversified portfolio of blue chip stocks; to buy and then hold on to these stocks for
the long run; to reinvest
dividends; to invest with a margin of
safety; to have a regular programme of
investment during their financially productive years; to ignore the noise in the equity
markets; to eschew day trading, margin
trading, trading in derivatives, commodities and currencies, and other assorted
forms of financial market madness; and to aim for optimum returns, rather than
attempt to get rich quick.
This is an
up-to-date and thoroughly revised edition of our guide to equity
investment. We thank all financial
professionals and investors who have over the decades contributed to its
evolution.
Is the stock
market an avenue of investment?
Common investors in
the stock market routinely rely on tipsters and manipulators, little realizing
that an overwhelming majority of ‘experts’ are sadly innocent of sound
investment knowledge. Most stockbrokerages
flaunt ‘research’ departments that are of questionable value. Their raison
d’etre appears to be to make investors trade more and more, so that higher
brokerages are earned. Our view of stock
market investment is that in a boom, you do not need the advice of experts to
make money. Any trash you buy will
appreciate. In a recession, the advice
of the best experts will not prevent you from losing money.
Should then, a
self-respecting investor keep away from the stock market? The answer is an emphatic NO! The stock market is a legitimate avenue of
investment. Equity, real estate and your
own business are three avenues that have consistently beaten inflation and
genuinely enhanced wealth in the long run.
Business of course, is not for everyone.
But it would be difficult to find another avenue of investment that
offers better returns than stocks, to a sensible, patient and disciplined
investor.
Is the stock market an avenue of investment?
Don’t take our word for it!
Warren Buffett, chairman, Berkshire
Hathaway, astute businessman, and probably the world’s most successful investor
ever, says: "The best protection against inflation is your own earning
power. If you are the best teacher, you
will command earning power and get your share of the national economic pie,
regardless of the value of the currency. The second best investment is in a
good company." Buffett has it right.
The most profitable investment is human capital. Equity capital comes second.
Investment & Speculation
Why then, do so many
“investors” lose in the stock market?
The answer is simple. Those who
lose are not investors, but speculators.
The stock market provides opportunities not just for investment, but
also for speculation. Most investors
fall prey to the temptation of quick riches through speculation. In the
process, they almost always encounter quick poverty. Today, day traders, margin traders and
punters in the derivatives, currency and commodities markets embody the essence
of what a genuine stock market investor should not be!
If speculation were
an activity of enduring value, we would support it. The sad fact is that it isn’t. In the short-run, speculative actions affect
market sentiment hugely, leading to distortions in stock prices. But in the long run, reality rules, says John
Bogle, founder chairman of Vanguard Mutual Fund and author of the investment
classic “Common Sense on Mutual Funds”.
Most ordinary stockbrokers (and most of them are indeed ordinary!) fear
long-term equity investment because they think it means little or no business
for them.
So, insiders in the
stockbrokerage business never tire of repeating to their employees that “The
more you churn, the more you earn”. That
is why the stockbrokerage industry harps on the “virtues” of tips, research and
frequent trading. John Bogle succinctly
summarises the game that is being played on often unsuspecting investors, when
he states: “Much of the (investment)
industry is engaged in a hell-bent mission to take hold of the finest
instrument ever created for long-term investing (equity), and transform it into
a vehicle for intermediate-term, and even short-term speculation.”
So let us sound a
simple caution at the very outset: If
you try to ‘play’ the stock market, you’ll soon discover that it is the stock
market that’s playing with you.
Investment & Speculation - don’t take our word for it!
Jason Zweig, internationally renowned author
and writer on financial matters, states:
“Day trading – holding stocks for a few hours at a time – is one of the
best weapons ever invented for committing financial suicide. Some of your
trades might make money, most of your trades will lose money, but your broker
will always make money.” He also
says, “Speculation becomes mortally dangerous the moment you begin to take it
seriously”.
John Bogle, in a
remarkable piece of research, reminds us that, “Stock market returns in the
long-term are remarkably consistent. The
root cause of these consistent returns is fundamental: corporate dividends and
corporate earnings growth. Using data we have
available from 1871 to 1998, we can measure the extent to which these two
financial fundamentals have dictated the returns earned on equities. The sum of real corporate earnings growth
plus dividend yields from 1871 to 1998, averaged over rolling 25-year periods,
produces a real fundamental return on stocks of 6.7% per annum. This figure precisely matches the actual real
stock market return of 6.7% per annum during the same period, meaning that
the role of speculation over time, was neutral! This precise equality of the two
returns during this 127-year period is a remarkable tribute to the long-run
rationality of the financial markets.”
So when you get the urge to speculate,
remind yourself that you are undertaking an activity whose role over time is –
well, nothing from your point of view, but everything from your stockbroker’s
point of view. Jason Zweig warns that
“People who invest, make money for themselves.
People who speculate, make money for their brokers. And that in turn, is why Wall Street
perennially downplays the durable virtues of investing, and hypes the gaudy
appeal of speculation.” No wonder Warren
Buffett states that “Risk comes from not knowing what you are doing.”
The Real Risks in Equity Investment – Stockbrokers & ‘Researchers’ (or
should we call them ‘Risk Searchers’?)
One of the most
poorly understood concepts in the stock market is RISK. The risk in stock speculation can be far
greater than you imagine. The risk in
equity investment on the other hand is far less than you fear. In fact, as an old stock market saying goes,
“The great long-term risk of stocks, is not owning them.”
No one can predict
the stock market in the short term. In
the long run, predicting the market is relatively easy. Long-term stock market
returns are a total of the current dividend yield and the rate of growth of
corporate earnings. As Charles D Ellis,
author of ‘Winning the Loser’s Game’ mentions: “The stock market is fascinating
and quite deceptive – in the short run.
Over the very long run, the market can be almost boringly reliable and
predictable.”
In stock
investments, the uncertainty of return reduces with time. In most other investment avenues, the
uncertainty of return increases with time.
So you can reduce risk, eventually eliminate it, and earn returns from a
diversified portfolio of quality stocks, by the mere activity (or inactivity!)
of holding on to it, and reinvesting the dividends you earn along the way.
Do you think the
worthies in the stockbrokerage industry do not know this? Of course they do! Then why do they give advice contrary to
long-term, buy-and-hold investing?
Perhaps the answer lies in this statement of author Upton Sinclair: “It is
difficult to get a man to understand something, when his salary depends upon
not understanding it.” Remember this the
next time you have the misfortune to encounter a tele-salesperson,
‘relationship manager’, insurance agent, mutual fund distributor, stockbroker’s
salesperson, portfolio manager (‘damager’?!), wealth manager, equity researcher
or any other financial salesperson.
There is an old English saying that is apt here: “Never buy from someone who is out of
breath.” Anything hard sold is not worth
buying. Something authentic and valuable
does not need to be sold. It will be
bought. Likewise, the top financial
professionals will never stoop to selling.
They do not need to, because people will flock to them for their
expertise. You will have to approach
them on their terms if you want their services.
So reflect for a moment on what the calibre of those who actively sell
financial products is likely to be.
The menace of stockbrokers, ‘researchers’ and forecasters - don’t take our word
for it!
“A stockbroker is
someone who invests other people’s money until it is all gone.” – Woody Allen, American actor and comedian.
“The stockbroker’s real job is not to make money for you, but to make money from you.”
- Burton G Malkiel, Chemical Bank professor of economics, Princeton
University, USA, and author of the investment classic ‘A Random Walk Down Wall
Street’.
“While everyone recognizes that brokers make their living by charging
commissions, Wall Street still manages to conceal one very nasty secret: The financial ‘experts’ know precious little
more than you know. In
fact, I will go out on a limb and tell you that the experts have no idea what
stocks you should buy to provide superior future returns. A blindfolded chimpanzee throwing darts at
the stock pages can select individual stocks as well as the ‘experts’.”- Burton
G Malkiel
“Wall Street people
learn nothing and forget everything.” - Benjamin Graham, author of ‘The Intelligent
Investor’, arguably the only book on stock market investment worth reading.
“Those who have
knowledge, don’t predict. Those who
predict, don’t have knowledge.” - Lao
Tzu, sixth century Chinese philosopher
“We’ve long felt that the only value of stock forecasters is to make
fortune tellers look good. Even now,
Charlie (Munger) and I continue to believe that short-term market forecasts are
poison and should be kept locked up in a safe place, away from children and
also from grown-ups, who behave in the market like children. - Warren
Buffett
“Stupidity, well packaged, can sound like wisdom.” - Professor Jeremy Siegel, Wharton Business
School, author of ‘Stocks for the Long Run’
And this one by Burton G Malkiel remains my
all-time favorite about equity researchers and forecasters: “There are only three kinds of financial
prognosticators: Those who don’t know, those who don’t know they don’t know,
and those who know they don’t know, but
get paid big bucks to pretend they know.”
So how do you invest in the stock market?
Frank L Netti, who has authored a good book on retirement planning,
says: “Poor investors seek the highest possible returns, while great investors
seek the highest probability of good returns.”
If you are one of those who would like to invest in the stock market, here are a few ideas that have proved
themselves useful and effective over not decades, but centuries.
Diversification
Remember that in
personal finance and investment, there is no such thing as a free lunch. What comes closest to a free lunch, is
diversification. More than three decades
ago, when the writer of
this paper was
being trained in public speaking as a college student, he was taught that there
were three rules for effective public speaking - the first was preparation, the
second was preparation and the third was preparation! The same can be said of diversification in
effective equity investment.
Diversification
- don’t take our word for it!
“Successful
investing is about managing risk, not avoiding it.” - Jason Zweig
“The only
investors who shouldn’t diversify, are those who are right one hundred per cent
of the time.” - Sir John
Templeton
“Diversification is
a protection against ignorance.” -
Warren Buffett
“To keep investing
from decaying into gambling, you must diversify.” -
Jason Zweig
“The investor who’s
wise, diversifies.” - Burton G Malkiel
How much should you diversify?
The total risk in
the stock market can be of two types: Systemic
Risk (formerly called Systematic Risk) and Non-Systemic Risk (formerly called Unsystematic Risk). Systemic
Risk affects the stock market system as a whole. For example, if war breaks out or corporate
income-taxes are increased sharply, the entire market will be affected
adversely. These are examples of systemic risk.
Non-systemic
Risk
affects a particular company or sector or industrial group only, and not the
entire market. Accounting frauds, family squabbles in family-owned businesses,
mismanagement, poor prospects, intense competition or gluts, and government
policies unfavourable to a particular sector or company, are examples of
non-systemic risk.
Non-systemic
Risk
can be managed very effectively by diversification.
If a portfolio is diversified across 30 blue chip stocks spread over at least
ten major economic or industry sectors, non-systemic risk is substantially
reduced. But if the portfolio is
diversified across at least 60 stocks spread over twenty or more major economic
or industry sectors, non-systemic risk can be virtually eliminated.
Systemic
Risk is
much more difficult to manage, but can be tackled with reasonable success, by systematic or recurring investment, which
is nothing but diversification across time.
Therefore,
you can easily implement our investment model by simply investing equal amounts
(a minimum of Rs 20,000/- per stock would be viable in today’s conditions) in
each of the stocks listed at the end of this paper. In order to build a satisfactory portfolio
therefore, you would need a minimum of Rs 6 lakhs, for 30 companies. The ideal portfolio will be Rs 12 lakhs for
60 companies. You can start with smaller
amounts, provided your ultimate objective is to build a portfolio of
approximately 60 stocks.
Lame excuses for avoiding diversification and why they are bogus
Our list of stocks
may go way beyond 60. That does not mean
you have to diversify beyond this limit.
But if you do diversify beyond sixty stocks, there is certainly no
harm. These days, it really does not
matter if you own a large number of good stocks. Your demat account enables you to track the
movement of your portfolio online. Your
bank account can be mandated to receive all your dividends. You can opt for receipt of all company
communications by email.
Changes of address, residential status, bank accounts, and on- and off-market
transfers, transmissions and other operations can be done at a single point,
that is at the demat account/depository participant level, regardless of the
size of the portfolio. So a large portfolio will not be an annoyance. On the other hand, it will promote
diversification. In fact, the world’s
finest authors on investment recommend a total stock market index fund for US
equity investors – a mutual fund that buys and holds all the stocks in the US
stock market in the same proportion as their weightage in the index!
How much to
diversify – don’t take our word for it
Dr William J
Bernstein, neurologist and author of some excellent books on personal
investment such as ‘The Intelligent Asset Allocator’, ‘The Four Pillars of
Investing’ and ‘The Investors’ Manifesto’ writes:
“You’ll hear –
often from reputable sources – that you should limit your stock picks to a few
well-chosen names, so as to maximize your returns. Hogwash!
A list of 5 or 10 stocks – even one chosen by the best money managers –
is as likely to become an all-clunker portfolio as the ticket to riches. So yes, like a lottery ticket, a small,
focused portfolio does maximize your chances of getting rich. Unfortunately, it also maximizes your chances
of dying poor. By contrast, the worst
that can happen to you with a 60/40 portfolio, in which the stock portion is
spread prudently and widely around the investment universe, should be a loss in
the 30 to 35% range. Bad news, to be
sure, but not as catastrophic as taking an unlucky draw of a handful of names
and adding it to a bear market.”
Psychologist Glynis Breakwell puts it beautifully when she says, “Risk
surrounds and envelops us. Without
understanding it, we risk everything, and without capitalising on it, we gain
nothing.” Diversification helps you
capitalise on risk and gain from your investments.
Equity investments are for the long run – the importance of the time horizon
An investment time horizon is a time element attached to each avenue of
investment, which if adhered to, eliminates risk and delivers optimum
returns. The lure of speculation
misleads most ‘investors’ into seeking maximum returns. Sadly, they end up with minimum returns or,
far likelier, substantial losses. On the
other hand, there is such a thing as an optimum return, a concept investors
ignore at their peril.
Stock markets have a history of more than 400 years. We need not calculate the average return for
that period. But being aware of average
stock market returns for the last 30 to 60 years is a useful indicator to gauge
optimum returns. Most investors who
seek to obtain optimum returns from their equity investments find that in the
long run the actual return they get is very often appreciably greater than
optimum.
History shows that
generally, a boom and recession cycle in the stock market takes an average of
five years to complete. That is why a period of at least five years has been
estimated to be a reasonable minimum
time horizon for equity investment. A
time horizon of ‘at least five years’ only means that the money reserved for
equity investment should be money that the investor can afford to block for at least 5 years.
Legendary investor
Warren Buffet remarked that, where stocks are concerned, his favourite holding
period was forever. The most successful
investors we have seen are those who have followed Buffett’s dictum, accumulated
equity investments over thirty or forty years or more, and never sold! These
investors ultimately find themselves in the happy position where dividend
income comfortably takes care of their normal living expenses. In addition, the long-term capital
appreciation on their equity portfolios is more than enough to see them through
retirement very comfortably, and also leave substantial legacies. All this, despite several companies in their
well-diversified portfolios having fared badly, and several having been liquidated!
The equity time horizon - don’t take our word for it!
“Adding time to investing is like adding fertilizer to a garden. It makes
everything grow.” - Meg Green, CFP
"Wall Street makes its money on
activity. You make your money on
inactivity." - Warren Buffett
“If you are not willing to own a share for ten
years, then don’t own it for ten minutes.” -
Warren Buffett
“If, after checking the value of your stock portfolio at 1.24 p.m., you
feel compelled to check it all over again at 1.37 p.m., ask yourself these
questions:
Did I call a real estate agent to check the market price of my house at
1.24 p.m.?
Did I call back at 1.37 p.m.?
If I had, would the price have changed?
If it did, would I have rushed to sell my house?
By not checking, or even knowing the market price of my house from
minute to minute, do I prevent its value from rising over time?” - Jason Zweig
“The stock market is a mechanism by which money is transferred from the
impatient to the patient.”
Warren Buffett
Buy and hold a well-diversified portfolio of blue chip stocks from major
economic segments and industry sectors
The ‘buy-and-hold’ is the simplest, oldest and best
strategy ever invented for equity investment.
What must you buy? Focus on blue
chips. Blue chips are stocks that are
the best in their class or sector. Blue
chips need not necessarily be large-cap companies. Where should you choose stocks from? The 200-stock indices of either the Bombay or
National stock exchanges should be a more than adequate basket from which to
construct your portfolio.
Why major economic sectors? Because these sectors have a significant role
to play in the economy of the country.
They are under constant scrutiny of the government, regulators, the
press, the public and a gaggle of economists, all of whom have a stake in
ensuring their healthy growth. Neglect
of major economic sectors could mean recession, which no government in its
right mind would want to usher in.
Why blue chips? Because blue chips are liquid. They
are generally around for the medium to long-term. They attract the best
management talent. More often than not, they have high standards of corporate
governance. They focus on enhancing shareholder value. They are adept at
managing rapidly changing business, economic, fiscal, tax and political
environments. They generally contribute heavily to the state exchequer through
both direct and indirect taxes. They provide considerable employment.
These qualities give blue chips significant economic impact. Economic
impact simply means the strength to lobby effectively with the powers that be
for legislative and policy changes required to meet challenges during
recessions and other difficult times. Economic impact also means that the
sector or company or industrial group is so important that its failure will
have an adverse effect on the entire economy.
John Bogle says,
“The price of a stock is perception, and acting on that perception is
speculation. The value of a corporation
is reality, and acting on that reality is investment.” When you choose blue chips, you choose
tremendous value. Having said this, it
must be remembered that blue chips are in no way insured against failure. Hence
the need to choose not just blue chips, but a very well diversified
portfolio of blue chip stocks, which protects an investor from the failure
of individual companies.
Buy and hold – don’t take our word for it!
“Buy right and hold tight.” - John Bogle
“Inactivity strikes us as intelligent behavior.” - Warren Buffett
“Lethargy, bordering on sloth, remains the cornerstone of our investing
strategy.” - Warren Buffett
Terence Odean and Brad Barber, two professors at the University of
California, published a study of 66,400 investors between the years 1991 and
1997, to learn how trading affected those investors’ returns. They found that buy-and-hold investors
outperformed the most active traders by a whopping 7.1% per annum. The results of the study were as follows:
Trading
Strategy Turnover Returns
Most active
trading
258%
11.4%
Average
trading 76%
16.4%
Buy-and-hold
investing 02% 18.5%
Quick question: Which of the
above three categories of investors do you think were most profitable for their
stockbrokers?!
Now you may realise why John Bogle says, “The way to wealth for those in
the (investment) business is to persuade their clients, ‘Don’t just stand
there. Do something’. But the way to wealth for their clients in
the aggregate, is to follow the opposite maxim: ‘Don’t do something. Just stand there’.” There is a wealth of wisdom behind these
words. When dealing with your
run-of-the-mill unfriendly neighbourhood stockbroker, your plan of action
should be simple – listen to everything he says. Then do the exact opposite.
Reinvest Dividends
Equity is a growth
avenue, not an avenue that is designed to provide regular returns, except
perhaps in a retirement scenario after several decades of regular
investing. Dividends received, even
though they may be relatively small sums, should be collected and reinvested in
the stock market, whenever they accumulate to meaningful amounts.
So, have a separate savings bank account registered with the depository
participant where you have your demat account.
Dividends will be credited to this bank account. Do not use the said bank account for any
other purpose. This helps you to easily
collect, account for and reinvest dividends.
The critical importance of dividend reinvestment – don’t take our word for it!
According to research by Crandall, Pierce &
Company, USA, an investment of one US dollar in the S&P 500 stocks on 31st
May 1946 would have been worth $ 47.53 on 31st July 2002, had dividends not been reinvested. Had dividends
been reinvested, the said dollar would have grown to $ 405.92 in the same
period!
Seth Klarman, gives us these
insights on the vital importance of dividends, in his classic work on value
investing called ‘Margin of Safety’:
“Just as financial-market
participants can be divided into two groups, investors and speculators, assets
and securities can often be characterized as either investments or
speculations. The distinction is not
clear to most people. Both investments
and speculations can be bought and sold.
Both typically fluctuate in price and can thus appear to generate
investment returns. But there is one
critical difference: Investments throw
off cash flow for the benefit of the owners; speculations do not.
“The return to the owners of
speculations depends exclusively on the vagaries of the resale market. Investments, even very long term investments
like newly planted timber properties, will eventually throw off cash flow. A machine makes widgets that are marketed, a
building is occupied by tenants who pay rent, and trees on a timber property
are eventually harvested and sold. By
contrast, collectibles throw off no cash flow; the only cash they can generate
is from their eventual sale. The future
buyer is likewise dependent on his or her own prospects for resale.”
No wonder Benjamin Graham
enlightens us that, “Far from being an afterthought, dividends are the greatest
force in stock investing.”
Implementing an equity investment programme
All investment must form part of a well thought out
strategy. Stock market investments are no different. There are two questions that arise when
investing in equity. The first is what
strategy to follow? The second is when and how to invest in stocks? Let me
answer these questions one by one, because they are fundamental to effective
equity investment.
The strategy – investing in the economy of a country
The list of stocks at the end of this paper is not
compiled randomly. The stocks in the list appear in a particular order. The
world’s finest writers on equity investing will tell you that the stock market
is not some magical mechanism where stock prices fluctuate of their own accord.
The stock market is nothing but a mirror of the economy. It reflects the
present state of the economy and future expectations of economic performance in
general, and corporate performance in particular.
Therefore investing in the stock market is investing in
the economy of the country. No one can
call himself/herself a stock market investor unless he/she invests in the
economy of the country. Anyone doing anything else is a mere speculator. That is why the world’s best writers on equity investment will
always urge you to “buy the market”. That is another way of saying, “buy the economy” or “invest in the economy.” In
this era of globalisation, the time will not be far away when equity investment
will mean investing in the global
economy through the medium of equity. In
the US, you can already do this, by choosing low-cost, no-load, world stock
market index funds.
John Bogle brilliantly
describes stock market investing as follows: “Successful investing is about
owning businesses and reaping the huge rewards provided by the dividends and
earnings growth of our nation’s – and, for that matter, the world’s –
corporations.” If you
accept this, then the basis of your equity investment strategy must in the
first instance be an examination of the economy of the country in the stock
market of which you are investing.
The Indian economy consists of three major segments that
contribute to its gross domestic product:
Services, Manufacturing and Agriculture, in order of the size of their
contribution to the economy. Within these three segments, there are distinct
sectors. For example, in the services
segment, you have sectors like telecom, banking and finance, software and
hospitality. In the manufacturing segment, you have sectors like
automobiles, pharmaceuticals, cement, petro-products, and steel.
Now look at the way the stocks are arranged in our list of
recommendations. The first stock is from services, the second from
manufacturing, the third from services, the fourth from manufacturing and the
fifth from agriculture/agrochemicals/dairy products/food. So by the time you have purchased five
stocks, you have made one round trip of the economy. You will find that the next lot of five
stocks is similarly arranged, and that’s how the strategy progresses, to the
extent it can.
Once you invest in the economy through a well-diversified
portfolio of blue chips, don’t worry about the performance of individual
stocks. Diversification and an
adequately long time horizon will work at both risk reduction as well as return
optimization. As Dr William J Bernstein
says, “Appreciate that diversified portfolios behave very differently than the
individual assets in them, in much the same way that a cake tastes different
from shortening, flour, butter and sugar.
This is called portfolio theory and is critical to your future success.”
We hope we have demonstrated that there is a huge
difference between random picking of stocks and investing according to a well-defined
strategy. We now turn to the second
question of when to invest.
When to invest
You may have a lump sum to invest in equity. Or you may be one of those individuals with a
steady income in the form of salary or rentals, and desire to invest regularly. These two situations are not the same. They need to be addressed using different
strategies.
Lump Sum Equity Investment – Invest only with a ‘Margin of Safety’
Benjamin Graham insisted that lump sum equity investment
must be made only with a 'margin of safety’. Graham's calculation of the margin
of safety was quite complicated. Reduced to a thumb rule however, the
margin of safety cautions
investors to ensure that they do not pay too high a price for stocks.
After the Great Depression of 1929-32 in the US, the
largest falls in the world's equity markets have been approximately fifty
percent from peak to bottom. Falls of this magnitude occur rarely. Ever since 1st April 1979, from
which date the Bombay Stock Exchange 30-stock Sensitive Index has been
calculated, falls of fifty percent have occurred only on three
occasions - in financial years 1992-93, 2000-01 and 2008-09. Half of this
maximum fall, that is twenty-five percent from peak, can be a sensible margin
of safety. Falls of twenty-five percent
from the last peak happen significantly more often than falls of fifty percent.
The last peak for the BSE Sensex was 21,005
points on 5th November 2010. The margin of safety would therefore kick in
at 25 percent below this level, at 15,754 points. So lump sum investment in the
stock market should be attempted only at this level. One additional safeguard is advised.
Ensure that the price-earnings ratios of the leading indices such as the
BSE Sensitive Index and the NSE-50 Index or Nifty are below 20, in addition to
these indices being 25% below their peak.
Don’t take our
word for it!
“We simply attempt to be fearful when others
are greedy, and to be greedy only when others are fearful.”- Warren Buffett
“The most common cause of low prices is pessimism. We want to do business in
such an environment, not because we like pessimism, but because we like the
prices it produces.”- Warren Buffett
“Bear markets are when stocks are restored to their rightful owners.” - J P Morgan
“From Graham’s class, Warren (Buffett) took away three main principles that
required nothing more than the stern discipline of mental independence: A stock
is the right to own a little piece of a business. A stock is worth a certain fraction of what
you would be willing to pay for the whole business. Use a margin of safety. Investing is built on estimates and
uncertainty. A wide margin of safety
ensures that the effects of good decisions are not wiped out by errors. The way to advance, above all, is by not
retreating.
“Mr. Market is your servant, not your master.
Graham postulated a moody character called Mr. Market, who offers to buy
and sell stocks every day, often at prices that don’t make sense. Mr. Market’s moods should not influence your
point of view of price. However, from
time to time, he does offer the chance to buy low and sell high. Of these points, the margin of safety was
most important.” - From ‘The
Snowball’ by Alice Schroeder
Systematic or recurring equity investment – a strategy for all seasons
We now come to a very important point. The Margin of Safety is applicable only to
lump sum investment and not to systematic, recurring or periodic investment,
provided the systematic investment programme is continued regularly and without
interruption for at least five years.
In short, systematic investment into equity can be started at any
time. The only stipulation is that once started, it must be continued
uninterrupted, for a minimum of five years, and preferably for much longer
periods.
We have observed that virtually all common investors mainly invest when the
market is at its peak, and withdraw from the market, often in panic, when it
crashes. Actually, investors should do the reverse, but some psychological
self-destruct switch seems embedded in all of us! Systematic investment enables the investor to
obtain better market pricing automatically, by buying more stocks when the
market is low and less when the market is high.
The result is that erratic investor behavior is controlled and corrected
without the investor even being aware of it! Systematic investment also makes
investment a habit, through regular, disciplined investing. There is great value in cultivating such a
habit.
Finally, whether for systematic investment or lump sum
investment, there is always a minimum viable amount. In the present
scenario, the minimum viable investment in our opinion is at least Rs 20,000/-
per month. You must first see whether you are comfortable with this
amount before embarking upon direct equity investment. If not, stick to
equity index mutual funds or well diversified equity mutual funds.
Don’t take our word for it!
“It's in the nature of stock markets to go way down from time
to time. There's no system to avoid bad
markets. You can't do it unless you try
to time the market, which is a seriously dumb thing to do. Conservative investing with steady savings,
without expecting miracles, is the way to go.” -
Charlie Munger, director, Berkshire Hathaway
“Persistent saving in regular amounts, no matter how small, pays off.” - Burton Malkiel
“A winner is not one who never fails, but one who never quits.”
“Stay the course. No matter what
happens, stick to your investment program.
I’ve said ‘Stay the course’ a thousand times, and I meant it every time. It is the most important single piece of
investment wisdom I can give you.” -
John Bogle
When & How to invest in Equity – Conclusion:
To summarise, where investments in the stock market are
concerned, you have two options. The first is to invest a lump sum. If you are
investing in a lump sum, invest only with a "margin of safety."
Remember that the objective of the margin of safety is not to enable
purchase of stocks at the bottom of the market. No investor can achieve
this consistently. The purpose of the margin of safety is only to ensure that
you do not pay too high a price for stocks. And this is more than enough
for an investor to obtain attractive returns in a period of five to ten
years.
The second option is to invest systematically. If you are investing systematically, the
minimum amount must be Rs 20,000/- per month.
You must be able to sustain this investment for a minimum of 60
months. If you want to invest more than
Rs 20,000/- per month, that is fine. If you want say Rs 30,000/- of a
stock per month, go right ahead. But if
you can afford Rs 40,000/- per month, it is better to purchase two stocks of Rs
20,000/- each at intervals of a fortnight, for better diversification. Once you complete investing in the entire
list of recommended stocks, you can start again from stock number one.
By all means review your
portfolio and benchmark it, but don’t make benchmarking a fetish
The purpose of this
paper is not to magically enable you to pick stocks like Warren Buffett. The only person who can do that is Warren
himself – that’s why there’s only one Buffett.
As a stock market becomes more efficient, and the Indian stock market is
on a slow but sure path to efficiency, it will become increasingly difficult to
outperform the indices.
You may be taken aback to learn that in the US, more than 80 percent of
large-cap diversified mutual funds underperform the S&P 500 index over a
10-year period. It is good to review
your portfolio periodically. If you are
mathematically or statistically inclined, benchmark it against a comparable
popular index. But don’t get elated if
your portfolio outperforms the index at a given time, or depressed if there is
underperformance on some other occasion.
Be happy if your long-term performance is more or less in line with the
performance of any popular diversified index like the BSE Sensex or NSE Nifty.
If you keep reinvesting your dividends and do not stray from the path of
investing in the economy, and if you employ diversification, and are regular in
your investment, do not be surprised if you equal the performance of your
chosen index over a period of time, or even slightly exceed it. You may be astonished that there are fund and
portfolio managers who would kill for such performance, because most of them
incur huge costs on research that is highly suspect and also indulge in
frenetic churning of the portfolios that have the misfortune to be entrusted to
their ‘care’.
So be very happy if your long-term equity investment return approximately
matches the performance of a diversified stock index. As Wharton Business School professor and
author Jeremy J Siegel says,
“Keep your expectations in line with history.”
And Benjamin Graham, in his investment classic ‘The Intelligent
Investor’ writes:
“We have seen much more money made and kept
by ‘ordinary people’ who were temperamentally well suited for the
investment process than by those who lacked this quality, even though they had
an extensive knowledge of finance, accounting and stock market lore.”
Booking profits
When do you sell an
equity portfolio? Many books of dubious
value with titles like “It’s When You Sell That Counts” have been
published. Let’s rely instead, on Warren
Buffett’s advice here. Buffett has
repeatedly said that, “The correct holding period for stock market investments
is forever”. Profits in quality equity
portfolios need never be booked. A
lifetime of steady investing will probably provide more than enough dividend income
to comfortably take care of ordinary needs in later years.
Dividends are also
much more stable than stock prices. They
increase over time, generally at a rate that is in excess of inflation. Undoubtedly, companies, like human beings
also have a lifespan. The concept of
‘perpetual existence’ that is supposed to be a cornerstone of the corporate
structure is a highly iffy notion.
Companies can be taken over, merged, amalgamated, sold. They may dispose of certain divisions, change
their names and ownership structures and may even go into liquidation.
In your portfolio there will be stocks that do extraordinarily well, stocks
that lag behind in performance and other stocks whose performance is
middling. This is normal portfolio behaviour.
Never get exercised over the returns of individual stocks, once you
have constructed a quality portfolio.
Remember, it is portfolio returns that are important, not the returns of
the individual stocks in the portfolio. Your equity portfolio can certainly be
realigned to a model portfolio like the one that appears in the list at the end
of this paper. Your equity portfolio can
also be realigned to a well-diversified index.
The 200-stock indices of either the Bombay or National stock exchanges
should do nicely here.
However, do not undertake portfolio realignment often, as you will only incur
expenses and run the risk of developing a trading mentality. Realignment once in five years is more than
enough. Until then, give time a chance
to work for you. To be a truly
successful stock market investor, you must one day reach the stage where
dividend income takes care of your normal expenses and your equity portfolio
will pass on to your descendants or be left to charity.
Conclusion:
A few concluding
thoughts from the greats. Warren Buffett
says that investing is a marathon, not a hundred meter sprint. He also mentions that it is not necessary to
do extraordinary things to get extraordinary results. An old investment saying reminds us that the
ultimate objective of good investing is to obtain above average returns, with
below average risk.
Frank Netti says
that sound investment will decrease the time during which you work for money,
and increase the time during which money will work for you. We hope this paper has given you some
insights into what genuine equity investment is all about. We have tried our best to remain true to our
mission of translating the ideas of the finest equity investors and advisers
into a practical plan of action for the common investor. Our list of recommended stocks appears
overleaf.
Contact Simplus for
our list of recommended stocks.
