Equity Investing – Importance of Time !!

In our last post, we understood that investing in equities is a reasonable proxy to entrepreneurship as you get to have part ownership in a business. So intuitively entrepreneurs on an average should have made reasonably good returns over the long run, and as a corollary, equity investors should have also made good returns in the long run.

Let’s see some historical data on how equities have performed.

Sensex - Returns Max,Min,Avg.png

Sensex - Distribution Probability

Source: BSE

I have refrained from referring to a point to point return starting from 1979 till 31-Mar-2016 and instead taken a more practical approach and have analysed all time periods of 1Y, 3Y, 5Y, 7Y, 10Y and 15Y covering each and every day since 1979.

As seen from the table, the one year return for Sensex has ranged from a high of 265% (in 1991-92 period when Indian economy was liberalized) to -56% (during the 2008 US Sub prime crisis). The range of return outcomes is extremely wide for a 1Y time frame. Similarly the probability or the odds of a negative return is also 30% i.e 3 out 10 times historically, an investor would have made negative returns if he had invested in Sensex with a 1Y time frame.

Thus our first conclusion is that,
It is extremely risky to invest in equities for a short time frame given the possibility of a negative return and an extremely wide outcome range.

As seen from the table, the odds of negative returns improve from 30% on a 1Y time frame to 9% on a 5 year time frame and to almost nil on a 10Y time frame.

Our second conclusion is that,
The odds of a negative return gradually reduces as we extend the time period of investing 

Over time periods of 5 years and above equity returns have averaged around 15-16% historically. While this average no of around 15% is what is commonly quoted everywhere as the long term returns, we also need to be aware of the chances of getting those returns as equity outcomes are always in a wide range. The probability of making the expected returns of >15% also improves with higher time period for investing i.e 50% odds in 5 year time frames which improves to 62% in 10Y time frame.

In equity investing, as the outcomes (returns) are not certain our key objective is to improve the odds of a higher return and at the same time reduce the odds of a negative return

From a quick glance at the above data, we know that increasing the investment time horizon is the simplest way towards this endeavor.

Once we get a sufficient time frame in place, the odds of higher returns can be further improved by evaluating the two primary drivers of equity returns (earnings growth and valuations). I will be covering this in a separate post in the coming weeks.

Thus to start of as an equity investor, the bare minimum time frame we will be needing is at least 5 years. Of course, the longer the time frame the better. You may argue that even with a 5 year time frame the odds of 15% return is only 50% and odds of negative returns are ~10% (add to it 30% odds of less than 8% return – remember the purchasing power !!). But all is not lost, as we will be improving these odds by using asset allocation (evaluating valuations and earnings growth + combining other asset classes) and mutual funds (active stock selection as against the passive index).

And, most importantly, if you need money in less than 5 years, then its better to avoid equities.

P.S – Geek alert !!
The tabulation also has standard deviation provided along with averages. Generally its a good practice to evaluate averages along with standard deviation which gives an indication of “how spread out the outcomes are”. A smaller standard deviation indicates a tighter outcome band (think of fixed income or F.D returns) and higher standard deviation indicates a wider outcome band (think of gold, equity returns etc).

The way to interpret a standard deviation is :
68% of the times the values have been between average+ standard dev and average-standard deviation

Eg: From the table we can see that, equity returns on a 5Y basis have been between 3% and 29% for around 68% of the times

If you find this a little complicated, no worries and kindly ignore this and it wouldn’t make too big a difference to your investing !!

 

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Equity Investing – getting the basics in place

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Out of all asset classes, Equities (stocks) are unfortunately the most misunderstood. My mom thinks it’s gambling, my friends think it’s something which lets you make money without working hard and unfortunately many of them who did try their hand at equities lost money and have vowed never to get back into this again. The grapples are many..

On the other side, you will see a lot financial advisors and mutual funds coming up with ads showing “equities have been the best asset over long term”, “they have given around 15%” blah blah..

So what is the truth ? Who is right ?

Now before we start analysing the past returns and the veracity of the statements surrounding equities, let’s take some time to understand what “equity investing” really means.

Equity investing essentially means “You become a partial owner in a business”. Period !

If you don’t intuitively understand this, you will most likely end up having a poor experience investing in equities.

Let’s understand this with an example. Assume you are running a restaurant business. You need Rs 50 lakhs to expand the business. But you have managed to save only Rs 25 lakhs. You need Rs 25 lakhs more. I have a spare of Rs 25 lakhs which I am looking to invest. Now you have three options

1) Borrow from me and promise to repay me back the entire amount in 5 years and pay a 12% interest every year

2) You borrow it from a bank at 14% interest rate while I invest my money in bank F.D for 8% (this is similar to the 1st transaction except for the fact that now you have an intermediary called the bank !!)

3) You sell a part of your company ownership to me in exchange of Rs 25 lakhs (lets say 25% assuming both of us agree that your company is valued at Rs 1 cr). The interesting part in this deal is that I will have no say in the day-to-day operation or the management of the company. You will be free to operate the company and you don’t need to pay me a salary or a part of profits (sometimes you and me can get paid through dividends).

But hang on..there are some issues with this arrangement.

One, you may find it difficult to find someone like me to provide you with the entire Rs 25 lakhs for 25% of your business. Two, I too have a problem. While I own 25% of the business I don’t get to participate in the management and don’t get an interest or salary. Dividends are provided by some companies but are generally too low. So the only way I make money is to sell my stake in the business after some years (inherent assumption being that the company’s value would have increased). So assuming the overall business value improves whom do I sell the 25% and get the corresponding higher value. So this makes me like the venture capitalist or the angel investor who will have to wait for a long time and needs to have the resources to find a suitable investor to exit from the investments.

So how do we solve this ??

Stock markets to the rescue !!

Instead of trying to sell the entire 25% for Rs 25 lakhs in one shot, you can split your entire company’s worth i.e 1 cr into 10 lakh shares worth Rs 10 each. Now you can retain 7.5 lakh shares with you i.e 75% of company’s ownership. And the remaining 2.5 lakh shares can be issued for Rs 10 to many people. This is called an IPO (Initial public offer). So someone might just buy 1 share for Rs 10 while someone else might buy 100 shares for Rs 1000. Now all of them are owners of the company (technically referred to as shareholders). So you end up getting the same Rs 25 lakhs in exchange of the shares (read as part ownership) to several shareholders. The ownership share is therefore proportional to the no of shares that someone owns. So this essentially solves your problem of raising money for your business. But the ones who bought your company’s share still have the issue of “how do I sell my ownership stake when the time is right”. So a market place is created (read as BSE and NSE) where the people who own the shares can offer to sell their shares to other people who would like to become a part owner of the company. The best part here is that you, as the company owner, need not return the Rs 25 lakhs, and can peacefully deploy it in business as you have already exchanged a part of your ownership in the company for the amount. So everyday there are different people who offer to buy and sell shares and based on the balance between the buyers and sellers the share price keeps fluctuating. Now while the price changes on a daily basis, there is no impact on the actual cash flow or the running of the business. However as the share price changes the value of shares owned by the owner and the shareholders also changes, implying that both the stock buyer and the owner’s incentives are aligned – to increase the overall value of the company

Now unfortunately what happens is that most people eventually forget all this and get anchored to only the prices. So they start understanding a company’s share price as a number which magically keeps moving up and down every day. Unfortunately, the basic fact that a share price reflects the market’s opinion on the value of the underlying business is conveniently forgotten.

So the gist is that when you buy a share, you basically become an owner of the business. Now if you buy Infosys for INR Rs 2000, both you and Mr Narayana Moorthy will see the same return % in the next 5 years. The only difference being that he holds a larger number of share. So if you are worried that Infosys shares might come down Mr Narayana Moorthy must be even more petrified given his huge exposure. Thus the first and most important step is to start viewing equity investing as a “proxy to entrepreneurship”. You get a chance to own a portion of a business.

So your participation in equities will depend on your belief that entrepreneurs will continue to make more money than an apartment, a gold jewellery or a loan given to entrepreneur for a fixed interest (read as F.D, Bonds or Fixed Income Mutual Funds).

Now till you start getting comfortable with the powerful concept that “stocks are essentially partial ownership in businesses” no amount of past return data can convince you to invest in shares.

For me personally, buying equities is the closest I will ever come to entrepreneurship. So I am personally significantly biased towards equities as I believe in humans – the ability to generate ideas, convert them into viable products/services, employ people, deploy land, borrow money and generate a higher return more than the input costs.

The most important thing to remember when you invest in stocks is :

Buying stocks = Partial ownership in a business

Gold Returns – my futile attempt at predicting the future !!

In the earlier article (Gold Returns – Making sense of history), I had discussed on the historical returns from Gold for Indian investors. Now the most important question is what should investors expect from Gold going forward.

First and foremost, let me start with an honest submission. It is next to impossible to exactly predict the returns of gold or for that matter any asset class. But that being said we need to have an approximate idea on the broad direction and possible returns, which would allow us to reasonably plan our investments.

For Indians,

Price of Gold = International price of gold (denominated in USD) * USD INR Exchange rate

So, for us to have a sense of future gold returns (in Rs) we need to have a view on the International Gold Prices and USD INR.

USD INR:

Generally over long-term, the currency weakening or strengthening vis-a-vis another currency is primarily based on the inflation differential between the two countries. The crude version of the logic is that, price of an item should be approximately equal across countries (i.e if a pen costs 65 in India and 1 USD is equal to 65 Rs then the pen in US must cost USD 1) . So if the price of the same item is increasing at different rate (read as inflation) then there has to be some adjustment mechanism to bring the prices to same level. This adjustment mechanism is what leads to currency weakening or strengthening.

See the below example for a better understanding
USD INR - Driven by Inflation Differential

Therefore people will start importing from the US rather than buying from India. This will lead to increased demand for dollars and reduced demand for Rupees and therefore the rupee will weaken and adjust to become Rs 67.55 per dollar (compared to last year exchange rate of Rs 65 per dollar) to ensure the price of the pen is the same in both the countries. This is an extremely simplified version of what actually happens, but the broad idea is that “USD INR movement will be significantly influenced by the inflation differential between both the countries over the long run”.

So let us analyse what has historically been the inflation differential across both the countries:
US vs India - Inflation Difference
Source: http://www.usinflationcalculator.com/inflation/historical-inflation-rates/

The average differential in inflation between US and India has been around 4%. Lets us make an assumption that this trend will continue and therefore whenever we buy gold for the long term, one of its return component, USD INR exchange rate can be expected to add around 4% annual returns. (USD INR annual depreciation was around 3% in the last 25 years)

Gold Returns:

As I had earlier mentioned, since gold has no underlying cash flows it is extremely difficult to come up with a prediction for gold. Generally gold tends to do well when there is a major crisis in the global economy. It’s perceived to be a safe asset and has been a store of value for several centuries. Hence whenever there is a significant crisis like event, investors move towards gold leading to higher Gold prices. Gold price also to a certain extent are inversely proportional to US interest rates i.e if US interest rates go up then gold price generally comes down and vice versa. This is because US Government bond (read it as lending to the US govt for a regular interest payment) interest rate is perceived to be the closest alternative for Gold in terms of safety. So when interest rate of US govt bond moves up , people will find US govt bond more attractive vis a vis Gold and hence might prefer to move towards US Government bonds.

Historically Gold prices in USD terms have averaged around 5-6% returns, but the returns have a wide variation between -4% to 19%.

One simple way to evaluate the possibility of decline in gold prices, is to find out how much it costs to produce an additional ounce of Gold at the current level. The cost according to various estimates is around 1000-1100 USD/ounce. This implies if the prices go below these levels then gold producers will be forced to cut gold production and eventually lower supplies will lead to demand supply mismatch which will force the prices up. Hence at the current price levels of around 1200 USD/ounce levels there is some comfort in terms of not much downside potential for Gold.

Assuming 5% from actual gold returns and 4% from currency returns, I would expect around 9-10% from Gold over the long term. If there are crisis events, the expectations will be surpassed and gold will have higher returns. And if the global economy recovers and international stock markets perform extremely well then you will find gold returns to be lower than our expected returns.

Gold Returns – Making sense of history

Out of all the asset classes, Gold is the most difficult one to understand. This is primarily because Gold doesn’t provide an underlying cash flow like the other asset classes ( Dividends in Equity, Interest payment in FD and Fixed Income, Rent in Real estate). Hence valuing gold is extremely difficult.

However Gold for several centuries has been perceived to be a store of value and as long as the perception remains, investing in gold should work fine. So for the purpose of investing, we will evaluate gold as a currency.

When we in India invest in Gold, there are two factors which determine our returns.

  1. The global price of Gold which is denominated in US Dollar
  2. The exchange rate:  USD-INR
Thus,
Gold price in India = Gold price is USD * USDINR
Lets first understand what has been the returns from Gold in INR (Indian National Rupee)
Gold Price in INR

The average gold returns over a 10 year period has been ~10 to 11%. But hold on. As seen below, averages also hide a lot of the underlying periods where returns have been significantly low (4% annualized returns between 1992-2002) and significantly high (20% between 2002 to 2012).

Gold Price - 10Y Rolling Returns

Source: RBI

Hence it is extremely important not to get carried away by the returns of the recent years. Instead of being fixated by a single average return number, our expectations of return from gold for the next 10 years going by history should be anywhere between 4 to 20%.

We also realised that Gold returns are contributed by the change in actual gold prices in USD and the change in USD INR. So let us further investigate and figure out what was the contribution of actual gold prices and the currency for gold returns in INR.

Gold Price - 10Y Rolling Returns

As seen above the periods between FY81 to FY06 were characterized by low actual gold returns – 585 USD per ounce in FY81 to 477 USD per ounce in FY06 . However for Indians, the Rupee weakening came to the rescue as USD INR moved from INR 8 per dollar in FY 81 to INR 45 in FY06

Chart - Gold Return - Drivers

For investors who invested in Gold post FY 99 the returns were primarily driven by the rally in actual Gold prices(USD) from USD 292 per ounce in FY99 to USD 1654 per ounce in FY13. The USD-INR for the same period moved from INR 42 per dollar to INR 54 per dollar

So now we have a fair idea about history and our key take away is that:
  1. Gold returns have been in a range of around 4 to 20% historically
  2. The returns will be a factor of a) the actual change in gold prices (USD) b) change in currency – USD-INR

But the real question that matters to us what will happens to gold returns in the next ten years.

Hang on..This post is getting a bit too long ..so I will do a separate post on that next week..