Investing in Equity during Margin Of Safety (MOS) in the Stock Market

Question: As advised by you on investing in Equity at one shot/ lump sum, we are strictly following the 'Margin of Safety' (MOS) concept given by world's best equity investment thinker and Investment Writer, Mr. Benjamin Graham who is also the Investment Guru of Legendary Investor of the century Mr. Warren E Buffett. The Principle of MOS says that, in India to invest in equity at one shot/ lump sum, the major index (Sensex/Nifty) must be at least below 25% from the historic peak and also PE Ratio of the major index (Sensex/Nifty) must be below 20. Needless to say that, Equity Investment Time Horizon is at least 5 years and above.

As on 05-07-2012, the closing Sensex was 17,538.67 and the PE Ratio of Sensex was 17.08. According to the MOS principle, the PE Ratio is below 20 but the Sensex is not below 15,750 (25% down from 21,000 Sensex levels). Therefore, at present there is NO MOS. Hence it is advised not to invest at one shot/lump sum in equity at all. Therefore, it is advised to invest in Equity by following a investment strategy called, Systematic Transfer Plan (STP). In STP investment strategy; our existing funds with an investment time horizon at least 5 years and above will be parked in a Debt mutual fund scheme and monthly 1% or 2% (as per the profile of client) of the original corpus will be transferred to Equity mutual fund scheme on a particular date every month. Let's assume, the Sensex reaching 15,750 points or below which exactly 25% is down from the historic peak and PE Ratio is also well below 20. At this juncture, what would be your advice to all investors? First, are we advice to double all the existing STPs or switching 25% corpus from debt fund to equity fund?

Mr. Gerard Colaco: My thumb rule for the margin of safety in equity investments requires the following:

1. The popular indices (Sensex or Nifty) must be 25 percent below their last peak.

2. The price earnings ratios of the popular indices must be 20 or less.

At present, the second condition has been met, but not the first, indicating that prices are still high when compared to earnings.

For me, both conditions must be met and met strictly. Twenty-five percent below peak means twenty-five percent below peak. I will not take any action even if the index is 24.5 percent below peak.

There are several options available when there is Margin Of Safety (MOS) in the stock market.

First, an SIP investor can be encouraged to register one or more SIPs when the margin of safety is reached, subject of course to his cash flow allowing this. Cash flow is important. For example, an investor may have one or more SIPs totalling Rs 5,000/- presently. He may not be able to increase the SIPs because of cash flow constraints. This is fine. Let him just continue his existing investments. Another scenario is where he may not be able to double his SIPs but he may be able to go from Rs 5,000/- per month to say Rs 7,000/- per month. This too is fine.

Second, there are options available to an STP investor. In the case of 5-year STPs, where 2% of the corpus is being transferred per month, there is really no need for any major change at the 25% below peak level. But in the case of zero-risk STPs where one percent of the original corpus is being transferred per month, the STP can either be doubled or something like 25% of the original corpus can be switched one time from debt to equity, when the margin of safety is reached.

Third, identify the investors who have resources large enough for direct equity investments and put them into our direct equity model the moment the margin of safety is reached.

Fourth, if the fall in the index is 50% from peak, everything can be switched from debt to equity, regardless of whether it is a 5-year or 10-year STP.