An Equity Investment
Model for the Common Investor
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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: |
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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:
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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. |
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