Investing in Forests

Investment Query: I came across an interesting article. It unfolded a new path of investments to me. Now I understand that this is not a practical idea, but is it possible in the future that people will start investing in forests?

http://www.businessesforsale.com/search/articles/The-benefits-of-investing-in-real-assets

Mr. Gerard Colaco: Throughout the history of investment, various individuals and institutions have come out with, what on paper at least, appear to be attractive alternative investment avenues. The only problem with these avenues is that their long-term track record and many times even their intermediate track records are dismal.

The very sentence of the article sent by you is faulty. It states that unlike stocks and shares, timber growth is not affected by economic circumstances. Nonsense. Timber growth can be affected by disease, climate change, forest fires, storms, amendments to government regulations relating to forestry, acquisition or sudden declaration of certain areas as ‘protected’ with a ban on felling trees, etc. Companies offering schemes based on forestry are often poorly regulated and there can be any amount of mismanagement and fraud in these outfits.

In fact in India, there have been numerous investment schemes based on agriculture, teak plantations, etc., all of which have failed, creating huge losses for their investors in the process. There are some false statements made in the article. Values of all real estate properties, including timber plantations can fluctuate and have fluctuated in the past. The mere fact that the trees grow is not sufficient to insure against the possibility of a downturn in timber prices in the event of a global recession or real estate market fall. Timber growth and timber property prices are two entirely different things.

The statement that physical assets are safer than financial assets is also false and indicates a flawed understanding of investment. It is true that a physical asset can be seen to exist and continue existing. But so can almost all companies in a diversified portfolio of blue chip stocks. Equity has also proved itself to be a very safe investment over the long term. We have 410 years of stock market history testifying to this.

The argument of growing population in developing countries providing demand for timber can be applied to other asset classes as well. For example, the growing Indian population, has added to the demand for gold, medicine, healthcare facilities, food, banking services, automobiles, telecom services, etc., etc., and not just the demand for timber.

Returns on timber are also region-specific. You need not get the same returns in all countries. In fact, timber returns in developing countries are higher than in developed countries. When you invest across geographies and countries, there is also the foreign exchange risk to be taken into account. Costs of registration fees on the acquisition of timber properties and agents' fees on the sale of timber can also eat into returns. If the forestry investment is packaged through a collective investment scheme, the managers of this scheme would charge their fees and expenses, thereby affecting returns.

Demand for timber can also be affected by wood substitutes. There is a great variety of timber products. Some may be in demand at a particular time. Others may not. The case of softwood in the US is illuminating. During the global financial crisis, when housing construction reduced drastically, the demand for softwood plummeted. Several sawmills turned sick and even closed down. Timber, like all other investments, is not magically exempt from risk.

One point on which I fully agree with is that an investment in forestry is non-correlated to other types of growth investments and offers an opportunity for diversification. But only people with a very high net worth can indulge in the luxury of an investment in forestry, and that too, if this kind of investment is well regulated. Most other investors would do well to stick to a sensible programme of investment and allocation to normal avenues of debt, equity and real estate.

New Pension Scheme (NPS)

Investor’s Query: Can I have your advice on NPS? Is it worth investing?

Mr. Gerard Colaco: In my opinion, the New Pension Scheme (NPS) is not worth investing in, for the following reasons:

1. Even for a very long time horizon, a maximum of only 50% allocation to equity is permitted, even if the investor wants a higher equity allocation.

2. While much is made of the very low fund management charge, there are multi-level charges at various offices and levels of the NPS system, the cumulative effect of which is that the NPS is a far more expensive system than appears at first glance.

3. Liquidity is a cardinal principle of any investment. In the NPS you will not be able to withdraw until the age of 60 except if you contract a critical illness or you are buying or constructing a house.

4. The worst clause is that even if you have invested for decades and built up a big corpus, when you withdraw, 40% of that corpus has to be compulsorily used to purchase an annuity from a life insurance company, when withdrawal is done after the age of 60. But, if withdrawal is done before that, then a staggering 80% of the accumulated capital is to be used to buy a life annuity and the balance of 20% can be utilised by the account holder for any purpose. Annuities are high-cost, low-return products of life insurance companies, excellent for the agents and companies that sell them, and terrible for the poor wretches who buy them.

5. The entire income stream from the NPS - the lump sum and the pension - is fully taxable, except the portion actually used to purchase the annuity. Contrast this to investments in equity and equity mutual funds which at least at present are exempt from long-term capital gains tax. The PPF also does not suffer any tax on withdrawals.

A N Shanbhag, one of India's finest writers on personal investment, has this opinion of NPS in the 31st edition of his book "In the Wonderland of Investment": "The disadvantage of taxability on withdrawals and annuity receipts, or on death, is so overwhelmingly large that it is difficult to accept that the advantage of low cost will counterbalance this."

I will not touch the NPS in its current form or recommend it to anyone.

A word about Award!

Issue: Dear Mr. Gerard Colaco, congratulations on winning an award in the Karnataka Association of Mutual Fund Advisors (KAMFA) Convention. You fully deserved it and wished you were present to collect it.

Mr. Gerard Colaco: Sorry to disappoint, but I do not believe in awards at all! I was also not informed in advance that I had won any KAMFA award. Had I been, I would have politely declined it and the next Individual Financial Advisor (IFA) would probably have been given the award in our place, with our good wishes.

My allergy to awards is shared by the venerable Mr. Reginald Aranha, my cousin and partner of Colaco & Aaranha for the last 27 years. We prefer to be low-profile and publicity-shy. Let me tell you about one particular kind of award that I accept.

Some years back, an NRI client of ours had come down to Mangalore on his annual holiday. He was immediately assaulted by various salespeople from the insurance, mutual fund and stock brokerage outfits. During one call from a mindless tele-caller from a stock brokerage casino, he was asked whether he was dealing with any stock broker. He replied: "Colaco & Aranha."

The salesperson then asked him, "Do you know what brokerage they are charging you?" The client replied: "No." The tele-caller told him: "One percent." The client replied: "So?" The tele-caller said: "Do you know that this is perhaps the highest in India?" The client's reply was: "Even if Colaco & Aranha charges me two percent, I would still go to them."

Now that I consider to be an award from the only category of 'judges' rightfully authorised to give my firm any awards. During our career, we have been privileged to receive these awards with undeserved and slightly unnerving regularity!

RAJIV GANDHI EQUITY SAVINGS SCHEME (RGESS)

The new tax saving scheme called "Rajiv Gandhi Equity Saving Scheme" (RGESS), exclusively for the first time retail investors in Securities Market. This Scheme would give tax benefits to new investors who invest up to Rs. 50,000 and whose annual income is below Rs. 10 lakh.

The Scheme not only encourages the flow of savings and improves the depth of domestic capital markets, but also aims to promote an 'equity culture' in India. This is also expected to widen the retail investor base in the Indian securities markets.

Salient features of the Scheme are as under:

1. Scheme is open to new retail investors, identified on the basis of their PAN numbers. This includes those who have opened the Demat Account but have not made any transaction in equity and /or in derivatives till the date of notification of this Scheme and all those account holders other than the first account holder who wish to open a fresh account.
2.  Those investors whose annual taxable income is ≤ Rs. 10 lakhs are eligible under the Scheme.
3. The maximum Investment permissible under the Scheme is Rs. 50,000 and the investor would get a 50% deduction of the amount invested from the taxable income for that year.
4. Under the Scheme, those stocks listed under the BSE 100 or CNX 100, or those of public sector undertakings which are Navratnas, Maharatnas and Miniratnas would be eligible. Follow-on Public Offers (FPOs) of the above companies would also be eligible under the Scheme. IPOs of PSUs, which are getting listed in the relevant financial year and whose annual turnover is not less than Rs. 4000 Crore for each of the immediate past three years, would also be eligible.
5. In addition, considering the requests from various stakeholders, Exchange Traded Funds (ETFs) and Mutual Funds (MFs) that have RGESS eligible securities as their underlying and are listed and traded in the stock exchanges and settled through a depository mechanism have also been brought under RGESS.
6. To benefit the small investors, the investments are allowed to be made in instalments in the year in which tax claims are made.
7. The total lock-in period for investments under the Scheme would be three years including an initial blanket lock-in period of one year, commencing from the date of last purchase of securities under RGESS.
8. After the first year, investors would be allowed to trade in the securities in furtherance of the goal of promoting an equity culture and as a provision to protect them from adverse market movements or stock specific risks as well as to give them avenues to realize profits.
9. Investors would, however, be required to maintain their level of investment during these two years at the amount for which they have claimed income tax benefit or at the value of the portfolio before initiating a sale transaction, whichever is less, for at least 270 days in a year. The calculation of 270 days includes those days pursuant to the day on which the market value of the residual shares /units has automatically touched the stipulated value after the date of debit.
10. The general principle under which trading is allowed is that whatever is the value of stocks/units sold by the investor from the RGESS portfolio, RGESS compliant securities of at least the same value are credited back into the account subsequently. However, the investor is allowed to take benefits of the appreciation of his RGESS portfolio, provided its value, as on the previous day of trading, remains above the investment for which they have claimed income tax benefit.
11. For the purpose of valuation of shares, the closing price as on the previous day of the date of trading will be considered so that new investors are certain about their debits and credits into the account.
12. In case the investor fails to meet the conditions stipulated, the tax benefit will be withdrawn.

Like all financial products which have reached out substantially to the retail investors (post office savings, life insurance policies etc) through tax benefits, this tax break for direct investment in equity is expected to substantially encourage the retail participation in securities market as well as to enhance their participation in the growth of Indian industry.
Entry of more retail investors are expected to further deepen the securities markets as they bring in long-term stable funds, which can counteract the volatility created by the liquidity providers of the market. The Scheme, thus, also furthers the goal of financial stability and promotes financial inclusion. Since Exchange Traded Funds and Mutual Funds have also been brought under the Scheme, the Scheme should provide encouragement and re-assurance to the first time investors.

The broad provisions of the Scheme and the income tax benefits under it have already been incorporated as a new section 80CCG of the Income Tax Act, 1961, as amended by the Finance Act, 2012.

Department of Revenue will notify the Scheme and SEBI will issue the relevant circulars to operationalize the Scheme in the next two weeks.

Mr. Gerard Colaco: The donkey who conceived of the Rajiv Gandhi Equity Savings Scheme must have obtained his post-graduation degree from the Indian Institute of Idiots.

Query: The BSE Brokers Forum (BBF) informed the Finance Ministry that it would be a non starter. However any suggestions on how and what has to be done for Financial Inclusion. Your inputs and suggestions would be really helpful?

Mr. Gerard Colaco: Crap like ‘Financial Inclusion’ is for the politicians and babus in the government. I do not bother myself with this nonsense. I am concerned with simple, sound investment, which everyone can practise. Of course I believe in incentives to nudge people into building up savings for the long term.

When incentives are given across the board and are simple and straightforward, you will be surprised at how many people make use of them, regardless of whether they are from urban areas or rural areas, wealthy, middle class or poor, financial literate or not.

I would put all tax-advantaged investments under one section of the income-tax law. Let us take the present section 80C. I would give incentives for investment in 3 broad areas – debt, equity and real estate. I would have an attractive limit of say Rs. 3,00,000/- per year in the present context.

For debt, I would choose the Public Provident Fund (PPF).

For equity, I would choose Index Funds that track either the NSE or BSE 100 indices, or purchases of stocks that are in the said indices at the time the purchases are made.

For Real Estate, I would include the repayment of principal and payment of interest on housing loans as well as amounts directly invested in real estate by the purchaser of an apartment or houses, whether constructed or to be constructed. I would not include the purchase and holding on to vacant plots of land.

I would permit no withdrawals from tax-advantaged for a period of 5 years for any reason whatsoever. After that I would impose a penalty of 10 percent on the amount withdrawn in the 6^th year, 9% on the amount withdrawn in the 7^th year and 8% on the amount withdrawn in the 8^th year and so on. In short, as a reward for substantial tax saving, an individual would have to remain invested for a minimum of approximately 15 years in order to be able to withdraw without any penalty whatsoever. There would be no penalty for withdrawals by senior citizens, even though the minimum lock-in period of 5 years would apply to all.

These are my quick reactions. I am sure I can come out with much better ideas for tax-advantaged long term investment. But since I have immense faith in the Indian government‘s penchant of rejecting anything good, I am not going to waste further time on this.

 

 

Discontinuing Monthly SIP Equity Investment when Stock Market is going down!!!

Investor’s Query: With the euphoria of this dyeing UPA II (>18000), I think that we should take a break from my Monthly SIP equity investment   of Rs. 40,000/- and wait till things settle down? What do you advise..

Mr. Gerard Colaco: Once you have embarked upon a systematic investment programme, whether in stocks or through mutual funds, the most important factor is to stick to your investment programme, regardless of market levels. If you alter the program you are trying to time the market. This may not be a good idea.

I will certainly agree that when investing a lump sum, it is certainly advisable to invest only when there is a margin of safety. Our thumb rule for the margin of safety is when any popular diversified stock index is at least 25 percent below its last peak. But the margin of safety is applicable only to lump sum investments, not systematic investments.

Charlie Munger, Warren Buffett’s partner of long standing, puts it well when he states: “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."

John Bogle, who is probably the ultimate authority on mutual fund investment, says: “Stay the course. No matter what happens, stick to your investment programme. 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."

On 25^th April 2003, the BSE Sensex was 2,924 points. Just nine months later, in January 2004, the index crossed 6,000 points. Never before in the history of the Indian stock market, had the index doubled in a period of slightly less than 9 months. A number of stock market pundits urged investors to book profits. Many did so. Several systematic investors also stopped their SIPs. Most of these then missed the spectacular bull run in the next four years, which propelled the index from 6,000 points to 20,873 on 8^th January 2008.

So my advice is simple – stick to your investment programme. If you think that there is some risk in the market because of political or other reasons, you may scale down your Rs. 40,000/- commitment to a Rs. 20,000 commitment. This is not my advice - it is only that I have no problem if you halve the monthly investment. But I would certainly not advise stopping the investment programme totally.

 

FII’s Outflow from Indian Stock Market

Investor’s Query: Please refer to the article in the latest issue of ‘The Economist’

http://www.economist.com/node/21562227

"In April alone, foreigners sold almost $1 billion of portfolio investments in listed shares and debt. Such outflows are scary. India runs a current-account deficit, which it aims to plug with portfolio inflows and foreign direct investment. After a record deficit relative to GDP of 4.2% in the year to March 2012, the deficit this fiscal year is expected to be 3-3.5% of GDP, or $50 billion-60 billion. To fund that kind of gap safely, India needs the world to be bullish about it most of the time"

With this kind of deficit, what is your thought on the potential mid-long term impact on Indian Stock Market?

Mr. Gerard Colaco: I do not know what the potential mid- to long-term impact on Indian stocks of foreign investments being withdrawn from India will be, as mentioned in the excerpt from 'The Economist' referred to by Mr. ABC.  Personally, I hope it has a seriously negative impact because I always like lower prices since we have a huge number of investing clients eager to make investments in 'margin of safety' situations.

As Warren Buffett states: "The most common cause of low prices is pessimism - sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism, but because we like the prices it produces. Its optimism that is the enemy of the rational buyer."

The sad truth is that neither Mr. ABC nor 'The Economist' nor I nor anyone  can predict what is going to happen either in the short, medium or long term to stocks in India. In the long term, history teaches us that the probability of good returns on stocks in general is high.

There have been far greater scare stories than mere uncontrolled fiscal deficits in the more than 33 years that the BSE Sensex has been calculated. Despite this the Sensex has risen from 100 points in April 1979 to 18,000 points as of yesterday giving a compounded annual return of close to 17 percent. As for the acrobatics of foreign fund inflows and outflows, they do not worry me in the least. They may happen for reasons we cannot figure out. For example, if there is a desperate liquidity crisis in the US and FIIs need money there, they will liquidate their Indian investments even if the Indian economy is in the pink of health.

I agree that 'The Economist' is probably the best news magazine in the world. In fact it is the only magazine that I read cover to cover. That does not mean their analysts can calculate the potential mid to long term impact on Indian stocks that the budget deficit may cause. Foreigners may have sold $1 billion of portfolio investments in April 2012. But today’s Business Line states that the markets have hit 18,000 because of foreign investment inflows.

Between April and now, the Indian fiscal deficit has worsened, if anything. Would 'The Economist' care to explain the U-turn in foreign capital flows? There are things that cannot be explained by 'The Economist' about the movement of stock prices. My favourite example to prove this is of the stock Mangalore Chemicals & Fertilizers Limited (MCF).

When I joined the stock market in 1985, the Rs 10/- paid share of this company was quoted at around Rs 64/- even though the company had a carried forward loss in its balance sheet of Rs 187 crores or so, a huge amount for those days. The company had not paid a dividend for since inception. No one could explain why the Rs 10/- share was quoted at Rs 65/-. But this is only the beginning of the story.

Fast forward, to 2012. The company is still in existence. Over the years it has returned to profits. It is now paying dividends pretty consistently. It has a book value of Rs 45.18 per equity share of Rs 10/- face value. The dividends paid during the last 5 years are 6%, 7%, 10%, 12% & 12%. Yet the stock price is approximately Rs 43/- per share.

I hope the irony is not lost on anyone. If you had purchased the stock at Rs 65/- in 1985 when the main achievement of the company was a remarkably consistent track record of losses and held on for a period of approximately 27 years, taking delight in the sterling performance of the company as it returned to profits, wiped out its carried forward losses and declared consistent dividends, your delight would be sadly diluted by the fact that you would suffer a long term capital loss if you now sold your shares at Rs 43/-!

The day someone can explain this, I will start worrying about fiscal deficits and their stock market impacts. Until then, I will continue with my advice for lump sum investments in the stock market only when there is a margin of safety and systematic investments into well diversified equity portfolios at any time. There are things we can control and things we cannot control. We cannot control the fiscal deficit. We can control diversification and systematic investment. I would focus on the things we can control.

The final word on the impact of economic dangers such as uncontrolled fiscal deficits should come from John Bogle: "In investment terms, risk is to reward, what breadth is to length in spatial terms: the lesser of the two sides of the plane. That is not to say that risk is unimportant. It is crucial. But I simply do not accept its being counted equally with reward. Faith in the future, an essential element in investment, entails the implicit assumption that return will exceed risk. If potential return does not exceed the potential risk, why invest at all?"

Whole Life Insurance Policy

Investor Query: Please let me have your advice on Whole Life Insurance Policy?

Mr. Gerard Colaco: Viewed from any angle, whole life insurance is a poor choice. First and foremost, the very concept of life insurance is not properly understood. Life insurance is a protection against sudden, unforeseen and unexpected loss of earning power. Clearly therefore, life insurance is not needed during a person’s entire life, only during a person's financially productive life.

For example, a housewife who is not working and earning money out of her own efforts or toil does not need life insurance. Similarly, well after retirement, life insurance is not required. Whole life insurance opens up certain ridiculous situations such as a person having a life cover when he / she is not earning out of his own employment or business or profession.

Premiums are much higher than term insurance. If and when this policy acquires a surrender value, I think it should be surrendered. Anybody who goes in for a whole life insurance policy discloses to the world that he/she has no clarity about the role of life insurance. Insurance is for protection. Investment is for wealth creation. Rubbish like whole life policies attempt and fail to marry the two.

Recommended Reading

 Burton G Malkiel:

1.     The Random Walk Guide to Investing: Ten Rules for Financial Success, (2003, publishers: W W Norton & Company)

2.    A Random Walk down Wall Street, 10th revised edition, 2011, (Publishers: W W Norton & Company)

3.      The Elements of Investing (co-authored by Burton G Malkiel & Charles D Ellis). First published in December 2009 (Publishers: John Wiley & Sons, Inc.)

Charles D Ellis:

1.     Winning the Loser’s Game, 5th edition, October 2009, (Publishers: McGraw-Hill).

Dr William J Bernstein:

1.     The Intelligent Asset Allocator (Publishers: McGraw Hill)

2.     The Four Pillars of Investing (Publishers: McGraw Hill)

3.     The Investor’s Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between (First published 2010. Publishers: John Wiley & Sons, Inc.)

Benjamin Graham:

1.     The Intelligent Investor, 2003 revised edition, with commentary by Jason Zweig and an introduction by Warren E Buffett (Publishers: Harper Collins)

John C Bogle:

1.     Common Sense on Mutual Funds, 2010 edition. (Publishers: John Wiley & Sons, Inc.)

Thomas J Stanley & William D Danko

1.     The Millionaire Next Door: The Surprising Secrets of America’s Wealthy (Publishers: Pocket Books, a division of Simon & Schuster, Inc.)

Websites:

1.     www.berkshirehathaway.com - for the investment philosophy of Warren Edward Buffett, mainly contained in his annual letters to shareholders.

2.     www.travismorien.com - Choose the “Investment FAQ” section

Indian authors:

1.      In the Wonderland of Investment, 30th edition, by A N Shanbhag & Sandeep Shanbhag. (Publishers: Popular Prakashan, Bombay)

2.     In the Wonderland of Investment for NRIs, 12th edition, by A N Shanbhag & Sandeep Shanbhag, (Publishers: Popular Prakashan, Bombay)

3.     Tax Payer to Tax Saver, 18th edition by A N Shanbhag & Sandeep Shanbhag. (Publishers: Vision Books, Delhi)

 

An Equity Investment Model for the Common Investor

Mr. Gerard Colaco: Common investors in the stock market routinely rely on tipsters and manipulators, little realizing that most ‘experts’ are sadly innocent of sound investment knowledge. Our view of stock market investments 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 cannot 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 and real estate are the only two avenues of investments that have consistently beaten inflation and genuinely enhanced wealth of investors in the long run. It would be difficult to find another avenue of investment that offers better returns, to a sensible, patient and disciplined investor, than the stock market. The problem is, stock markets also provide facilities for speculation. Often, we pervert this genuine investment avenue into a purely speculative avenue. Most investors fall prey to the temptation of quick riches via speculation. In the process, they almost always encounter quick poverty. Today, day traders, margin traders and punters in the derivatives markets embody the essence of what a genuine stock market investor should not be! No one can predict the stock market in the short term. In the long run, predicting the market is absurdly easy. In the long run, the market always goes up, and the rate of growth beats inflation by a comfortable margin. Therefore, for long term investors, the stock market is a genuine avenue of wealth enhancement. So how do you invest in the stock market? The following model may be worth a try: SIX RULES AND A RECOMMENDATION 1. Diversify across 10 to 20 major economic/industry sectors. 2. Select only the top blue chips from each sector, aiming for an ultimate portfolio of approximately 60 stocks and 20 sectors. The BSE-200 index provides a basic basket for stock and sector selection. 3.Allocate equal amounts to each sector. 4.Reinvest dividends, don’t spend them. 5. Review the portfolio at least once in three months, making additional purchases upon a drop of 25% in the index from the date of investment, and if need be, liquidating the portfolio wholly or partially, when targeted returns are achieved. 6. The time horizon for equity investments is at least five years. Recommendation: Systematic investment and systematic transfer plans are highly recommended, both for equity as well as equity mutual funds. RATIONALE BEHIND THE RULES The first rule employs the risk management tool of diversification. It does not mean that an investor must start equity investment with 10 to 20 major sectors straightaway. However, an equity investor must build a portfolio across 10 to 20 major economic or industry sectors over a reasonable period of time. Why 10 to 20 sectors? Up to 2,800 stocks are traded on the Indian stock markets, daily. These companies can be divided into 100 to 120 sectors. Our equity model argues that a sample of 10 to 20 per cent of these sectors is more than enough to build a good equity portfolio. The model also stipulates that the sectors chosen should be major sectors, e.g., steel, cement, power, engineering, pharmaceuticals, software, banking and finance, fast moving consumer goods, automobiles, etc., rather than minor sectors like aquaculture, cigarettes, dyes and pigments, glass products, leather products, moulded luggage and so on. The second rule is equally important, because most investors have a problem of stock selection. They always ask a broker which share to buy. Instead of this, it is better to choose only blue chips from the BSE-200 index. Why only 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 the highest standards of corporate governance. They focus on enhancing shareholder value. They are adept at managing rapidly changing 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. Having said this, it must be remembered that blue chips are in no way insured against failure. Hence the need for adequate diversification, which protects an investor from the failure of individual companies. The third rule is also very important. Investment should be made uniformly across sectors. Why this uniform allocation? Because, at any given time in the stock market, the spotlight is on just one or two sectors which are fancied at that time. Most stock market players dabble only in these fancied sectors. However, the spotlight can shift to other sectors, without warning. It is very difficult for an individual investor to predict these changes in market fancy. It is also difficult for ordinary investors to predict how changes in business, economic and tax policy will affect the collective psyche of the stock market. The common investor is generally unable to gauge the impact of such changes on the various sectors of the economy. The first two rules of this model stipulate that only major sectors and top blue chips be chosen. Once this is accomplished, it is better to allocate equally between these major sectors, because in a time horizon of five years or more, all major sectors and blue chips have an even chance of performing well and therefore hogging the limelight. So, a prudent investor would do well to spread his investment uniformly across a minimum basket of 10 to 20 major sectors. The fourth rule encourages investors to reinvest dividends. Equity is a growth avenue, not an avenue that is designed to provide regular returns. 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. The fifth rule is about reviewing equity investments. Regular reviews keep an investor constantly aware of the state of his portfolio and the risk and return thereof. Reviews also alert the investor to opportunities for further investments which can enhance the value of a portfolio. Finally, ‘reviewing’ is not ‘tinkering.’ Long-term equity investment with regular reviews makes investors wealthy. Tinkering makes brokers wealthy, often at the cost of investors! ‘Reviewing’ is being aware of one’s portfolio and its performance on a regular basis. From our experience, additional investment needs to be made only upon a drop of at least 25 per cent in the index, from the date of original purchase. The sixth rule cautions the investor that equity is a long-term investment avenue, with a minimum time horizon of at least 5 years. Why at least 5 years? History shows that generally, a boom and recession cycle in the stock market takes an average of 5 years to complete. That is why a period of at least 5 years has been estimated to be a reasonable minimum time horizon for equity investment. Of course, if an investor makes substantial profits before the time horizon runs out, he can always liquidate his investments, if need be. A time horizon of at least five years only means that the money reserved for equity investment, should be money that the investor does not ordinarily need for at least 5 years. In our opinion, too much importance is given to booking profits and market timing. Investors are constantly exercised about when to sell. Legendary stock market investor Warren Buffet remarked that his “favourite holding period is 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 now earn dividend income and have long-term capital appreciation that is more than enough to see them through retirement very comfortably! Systematic, regular or recurring investment helps the investor to average the market, by making purchases when the market is low, high, as well as somewhere in between. This is an important risk management tool; because we have observed that virtually all common investors invest only when the market is at its peak, and withdraw from the market, often in panic, when it crashes. Actually, investors should enter the market when it is low and exit from the market when it is high, which is not done. Systematic investment helps the investor to obtain better market pricing, automatically, by buying more stocks when the market is down and less when the market is up. Systematic investment also makes investment a habit, through regular, disciplined investing. There is great value in cultivating such a habit. AN EXAMPLE OF HOW OUR MODEL WORKS A test of one of our standard portfolios is given below. The portfolio consists of 15 sectors and 30 stocks, two stocks in each sector, with equal amounts invested in each stock. The investment was made in a lump sum on 11th February 2000. On this day, the BSE Sensitive Index closed at a historic peak of 5933 points, at the height of the ‘technology’ boom, making it one of the worst days you could invest in the stock market. The portfolio selected on 11th February 2000 was:

No. Sector Companies 01 Steel, Metals Tisco Hindalco 02 Cement L & T Guj. Ambuja Cement 03 Power Tata Power ABB 04 Petro-products Indian Oil Corpn Castrol 05 Automobiles Tata Motors Bajaj Auto 06 Engineering Ingersoll Rand Bharat Forge 07 Pharmaceuticals Ranbaxy Dr Reddy’s 08 Paints & Chemicals Asian Paints Tata Chemicals 09 F.M.C.G. Hindustan Lever Procter & Gamble 10 Agro Industries I.T.C. Tata Tea 11 Confectionery & Food Nestle Britannia 12 Banking & Finance State Bank of India H.D.F.C. 13 Software Infosys Wipro 14 Hospitality & Travel Thomas Cook Indian Hotels 15 Diversified Grasim Reliance

Dividends and rights issues have been ignored, to create a deliberate bias against the model. The portfolio once invested, was not tinkered with, regardless of the state of the market or performance of individual stocks. The portfolio was only reviewed at quarterly intervals over four years from 11th February 2000 to 11th February 2004. The performance of the portfolio in absolute terms, expressed in percentages, and compared to the performance of the Bombay Stock Exchange Sensitive Index, is as follows:

Date of Review value Change in the BSE Sensex Change in portfolio 12 May 2000 - 28.35% - 24.78% 11 Aug 2000 - 29.34% - 22.41% 13 Nov 2000 - 35.61% - 28.13% 12 Feb 2001 - 25.74% - 6.83% 11 May 2001 - 40.01% - 22.73% 13 Aug 2001 - 44.60% - 23.87% 12 Nov 2001 - 47.85% - 24.13% 11 Feb 2002 - 40.76% - 17.32% 13 May 2002 - 41.99% - 13.84% 12 Aug 2002 - 49.32% - 19.19% 11 Nov 2002 - 50.31% - 21.86% 11 Feb 2003 - 45.04% - 13.90% 12 May 2003 - 50.41% - 10.62% 11 Aug 2003 - 34.38% + 20.96% 11 Nov 2003 - 15.22% + 56.47% 11 Feb 2004 - 0.27% + 86.11%

USING OUR EQUITY INVESTMENT MODEL The total risk in the stock market can be of two types: Systematic Risk and Unsystematic Risk. Systematic 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 systematic risk. Unsystematic Risk affects a particular company or sector or industrial group only. Accounting frauds, family squabbles in family-owned businesses, mismanagement, poor prospects, intense competition or gluts, government policies unfavourable to a particular sector or company are examples of unsystematic risk. Unsystematic Risk can be very effectively managed by deploying the risk management tool of diversification. If a portfolio is diversified across 30 blue chip stocks spread over at least ten major economic or industry sectors, unsystematic risk gets substantially reduced. But if the portfolio is diversified across at least 60 stocks spread over twenty or so major economic or industry sectors, unsystematic risk can be virtually eliminated. Systematic Risk is much more difficult to manage, but can be very successfully tackled by systematic 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 from our recommended list of stocks. 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 60 stocks. For systematic investment, buy one stock a month from the recommended list of stocks, investing at least Rs 20,000/- each time. It does not matter if it takes five years to build your portfolio. Investors, whose investment surpluses are less than the sums indicated above, would do well to choose mutual fund investment strategies instead of direct equity investment.