5 blind men and the equity markets

One of the best pieces of advice that I received from my boss goes like this –

“Arun, there are two periods which will define you and your career…

How you behave during times of success and

How you behave during times of failure.

The other things mostly will get taken care of..”

On similar lines, I believe being a good investor is all about two things –

How we behave during the best of times (bull markets) and the worst of times (bear markets) will eventually define us as investors

In other words, this means we need to be able to evaluate the degree of risk in equity markets at various points in time so that we can manage our behavior correspondingly.

Unfortunately, there are several moving parts in evaluating equity markets and for a large part of my investment career I have been guilty of taking only one perspective (based on whichever was the popular narrative at that point in time) and missing out on the bigger picture.

Image result for the blind man and the elephant

This was exactly how I was evaluating equity markets!

Anyway, better late than never..

While I proclaim no sudden  “enlightenment” on what drives the market, the attempt here is to share with you a slightly more holistic framework on evaluating equity markets.

I believe, there are 5 perspectives or vantage points, that we need to take while evaluating the equity markets.

are Organics

Since this is an evolving topic, I shall update corresponding articles underneath these topics as and when I write.

1.Valuations

Focus will be on various valuation parameters to evaluate on how expensive or cheap the equity markets are..

What returns will I get from equities going forward?

What returns will I get from equities going forward? – Part 2

A layman’s guide to equity valuations

2.Earnings Growth

We will track the fundamental long term driver of equities i.e earnings growth in this section. We will also see various methods to evaluate earnings growth.

What returns will I get from equities going forward? – Part 3

Equities – dismantling the returns !!

Equity Investing – Just 2 things to remember

3.Demand and Supply

This vantage point is based on the The Law of Supply and Demand.

It simply states that when demand for a freely traded commodity exceeds the supply of that commodity, its price will rise and vice versa. And, since common stocks are a freely traded commodity, their price movements are dictated by the Law of Supply and Demand.

In this section, we will be analysing FII flows, DII Flows, MF Flows, IPO issuances, market breadth indicators, other asset class returns such as real estate, fixed deposits, gold etc

4.Interest rate

Interest rates act like gravity on asset values – The higher the rate, the greater the downward pull. That’s because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line.” – Warren Buffett

In this section we will evaluate our outlook on domestic interest rates..

5.Global Markets

To get an approximate sense of global markets via global market commentaries from popular investors, valuation parameters etc

 

Book mark this post, and hopefully a few years down the line as we put the pieces of this jigsaw puzzle together we should have a much better understanding of the equity markets.

As always let us keep learning and sharing.

Happy investing folks and don’t forget to subscribe to the blog:)


Disclaimer:
 All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog.
No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments

 

 

 

 

 

 

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Long term SIP is not risk free, yet you can workaround it

10 minute read

In recent times, there has been a significant interest in equity markets thanks to the strong returns of the last few years. The best thing to have happened is the new culture of SIP (systematic investment plan).

INDIAN MUTUAL FUND INDUSTRY'S AVG.ASSETS UNDER MANAGEMENT (AAUM)

Source:AMFI, Link

A SIP is a simple investing process, where you invest a particular amount each and every month regularly. This is extremely convenient as the SIP amounts are automatically debited every month and also coincides with our cash flows (monthly salary). The SIP also supposedly solves the major issue of trying to time the equity markets as the investments are equally spread out and hence average out the ups and downs in the equity market.

Be present and mindful when purchasing new items. Ask yourself: do I need this? If I want this, do I have a place to store it? Do I own many of the same already?

All this is good.

But going by the numbers above it looks like a lot of us are entering the equity markets for the first time and SIPs seem to be the preferred route for many.

Given the great returns of recent times, there is a possibility of misplaced expectation if SIPs are not understood or sold properly.

Hence before you jump in, it is extremely important to understand some of the underlying nuances in the SIP concept (which are not generally talked about) so that you end up with a good experience and most importantly decent returns over the long run.

Expectation: I will continue my SIP for 10 years in a few equity funds. Life is taken care!

Here is an interesting article, which explores this question – Link

This is the long term 10Y SIP returns for Sensex over different periods as per the article.

Long term SIP does not remove risk and other important lessons from historical equity returns

And yes, here is the shocker –

There are periods when the Sensex 10Y SIP returns have been negative!

How is that possible?

  • Doesn’t an SIP stagger my investments thereby saving me from volatility?
  • Isn’t 10 years a reasonably long horizon for equities?

Now before you panic and redeem your SIPs, let us explore this further..


Never forget the underlying equity portfolio

Let us start with an hypothetical example. Assume I invest, Rs 10,000 every month for the next 10 years in a few equity funds and my returns are 15% annualized. This is how my portfolio would have grown.

Untitled.png

I end up with around 27.5 lakhs at the end of 10 years.

But what is the blue and green component?

The good part of an SIP is that as we invest our money across several months, even as equity markets go up or down we end up averaging our buying price. And hence the notion that we don’t need to be worried about market ups and downs as the SIP will take care of it and in fact take advantage out of volatility.

A quick glance at the above chart and you know what we are missing.

The green bar represents 1.2 lakh invested via SIP (Rs 10,000*12 months) into our portfolio every year. The blue bar is our overall portfolio which grows in size.

Now the key is to realize that as time progresses, the incremental amount which gets invested via an SIP over a year becomes small compared to the overall portfolio (Sample this – In the above example, the incremental SIP component after the 6th year contributes less than 10% to the existing portfolio).

And hence, while the incremental amount is staggered across 12 months, the existing portfolio is completely exposed to equity markets. 

Thus the larger portion of the portfolio will be susceptible to equity market ups and downs in the later years and SIP will have little impact in reducing overall volatility.

Now armed with this simple insight, let us get back to solving the problem of 10Y SIP returns in equities sometimes being low.

Key Insight: The equity market returns in the last 3 years become very critical in a 10Y SIP calculation as almost 50% of the final portfolio value gets created in the last 3 years.

Progression.png

Going by this logic, the periods of low 10Y SIP returns should mostly be the ones where the last 3 year equity returns were dismal.

But nothing like concrete data. So let us check our thesis with actual evidence..

Given below are the SIP returns for different holding periods (7Y to 20Y) in Sensex across different starting dates starting from 1980 till date covering almost 28 years.

SIP Returns.png

The SIP returns below 10% has been shaded in red, 10% to 12% in yellow and above 12% in green.

Now if you are like the rest of us, you must have switched off seeing the complex table above. No worries, just relax, take a deep breath and focus only on the 10Y column. Take a note of all the periods where the returns were lower than 10Y (i.e the ones shaded in red)

You would have noticed that, 10Y SIP returns have been low for investors who started their SIP between mid of 1990 to 1994.  Going by our last 3 years being bad logic, most of the returns between 1997 to 2004 must have been really bad for Sensex.

Let us check..

CY Returns.png

As expected, the returns of Sensex has been poor between 1995 to 2002 – which has led to weak performance in the 10Y SIPs started between 1990 to 1994.

What does this mean for us?

For all those who have started or are planning to start their SIPs now – the Sensex returns of 2025-27 will be the critical determinant of overall returns (the previous 7 years of course do matter but of slightly lower significance).

So at this juncture, don’t break your head over near term concerns of whether the market is expensive or not today as your overall portfolio has not yet been built and your incremental money via an SIP will get averaged out over the ups and downs of equity market..

But what if we end up as the unlucky lot and the returns of 2025-27 goes for a toss?

Unfortunately, we have no way of predicting what will happen to the markets after 7 years.

But, all is not lost..there are a some investors who have actually experienced this situation earlier..Maybe we might find some clues there..

Let us go back and find out what happened to to the unlucky 1990-94 SIP investors.

Unlucky SIP Investors

Now with the benefit of hindsight, what would have been your advice to them?

Let me guess your magic words..

“Boss..Hang on for a few more years”

I know it sounds outrageously simple and dumb. But truth be told it is, perhaps emotionally the most difficult to pull off.

As seen above, the unlucky investors by simply extending their time frame to around 11-15 years, could have reversed their fortunes!

Takeaway: When doing a long term SIP in equities a time frame of 10-15 years is required for reasonable returns (and always be prepared to extend your time frame)

Even if you manage anything above 10% in Sensex, funds managed by good fund managers should be able to provide an outperformance of around 2-4% which implies a 12-14% return which is good enough.

Any other solution?

The other way especially for large portfolios, is to practice asset allocation (i.e allocate between equity, debt and gold and re-balance based on market conditions. This is easier said than done. But no worries I will address them someday in the future.)

Summing it up

  1. SIP will take advantage of equity market ups and downs only in the initial years, when the underlying equity portfolio is just about getting built
  2. As years progress, the underlying portfolio in most cases will grow and will be subject to equity market ups and downs
  3. Even 10Y SIPs can have lower returns as equity market returns in the last 3-4 years have a large bearing on overall returns
  4. Simple solution is to be prepared to extend your investment time horizon (to around 11-15 years)
  5. For large portfolios, asset allocation while behaviorally difficult to implement is a great solution (if you have a good advisor to help you out)

 

 

What returns will I get from equities going forward? – Part 3

In the first part of this series (Part 1) we had explored the impact of valuations and in the second part (Part 2) the impact of earnings growth on estimating future equity returns.

We still have some missing pieces and in today’s post let us take a deeper dive into valuations.

While doing my first post on valuations, I had accidentally chanced upon an interesting insight..

PE Ratio.png

Sensex valuations mean revert!

Grr..That’s too obvious right..

True, I was just kidding. Now look at this chart below

Sensex Min PE 2Y data.png

Take a few minutes to analyse this chart.

In this chart I have plotted the minimum PE valuations of the Sensex recorded in all possible 2 year periods in the last 17 years.

Now that I have given you the required data, its time for the detective in you to decipher the insight..

And just in case it helps, let us take the guidance of the great detective Mr Sherlock!

main-qimg-1f4952e53e4d26d6a4f6ab794cfde249-c.jpg

Are you able to OBSERVE…

Not got it, yet. Here is a clue

  1. The maximum of the minimum PE recorded in every possible 2 year period of the last 17 years is 17.4 times
  2. Current PE valuation is 23.5 times

There you go. Now you can connect the dots..

The insight is simple:

If you take any two year period in the last 17 years,
The Sensex valuation has always ended up falling to a PE valuation of at least 17.4 times during some point in the 2 year period.

For convenience and being a little conservative, let us round it off to 18 times.

So this means, if history repeats, in the next 2 years, Sensex valuation at some point during the next 2 years should at least fall to 18 times from the current 23.5 times.

This works out to a bare minimum valuation decline of 23% sometime during the next 2 years!

Wow! This is getting interesting.

This also means if you have a large sum of money today and want to invest in equity, we have some tough decisions to make.

This 23% valuation decline will have to be offset by earnings growth for us to make actual returns.

Let us take the best case where we assume this decline happens only at the end of 2 years, thereby giving earnings growth 2 years time to offset the decline.

Assuming if earnings growth clocks an above average 20% growth for the next two years, we end up with around 44% absolute earnings growth (if you are wondering why it is not 40%, remember the compounding effect).

Knocking off 23% decline from this, we end up with an absolute returns of around 11% for 2 years.

That translates to a compound annualised returns of around 5.3% !!

Oops. Isn’t this what we get from FD or debt fund returns.

Let us check the equity returns at various earnings growth expectations due to this valuation decline:

earnings growth vs returns

Even at 25% earnings growth, the equity returns over the next 2 years will just work out to be around 10%.

One thing is pretty clear, the earnings expectations being built in today’s valuations are pretty high (around 25-30% earnings growth).

So this means, given the requirement of a staggering earnings growth even historically it must have been extremely tough to notch up good returns if the starting valuations were this high.

As always, let us put our conclusion to test.

Any guesses what the future 2 year returns looked like historically, whenever the Sensex valuations traded above a valuation of 22 times ..

fwd 2Y Returns vs Starting PE

I have plotted the month end valuations (only for periods where PE>22) from 2000 till date and compared it with future 2 year returns.

Good. As expected, except for one occasion (Apr 06 to Apr 08 where it gave 20% CAGR) every other time the Sensex valuation has crossed 22 times the 2 year annualized forward returns has been less than 10%.

Even in the case of Apr-06, the starting valuation of 22.8 at the end of Apr-08 had declined to 18.4 – which implies an annualised valuation loss of 10%. However the earnings growth was extremely strong at around 34% annualised. So the overall returns adjusting for valuation loss still stood at 20%!

Thus our framework holds good and hence for the next two year returns even to be 10% and above we need earnings growth over & above 25%. That’s definitely a tough ask.

All this is fine boss. I have money now. How should I invest?

Now if you are someone who has just started investing in equities and is in the wealth building stage (i.e your total assets are still less than 5 times your salary), please ignore all the above ramblings. Simply continue with your SIP. In 10 years the outcome will be

Image result for all is well

For the others, whose overall equity investments are more than 5x your annual salary (this is just a random no to imply that the value is reasonably large for you), you need to seriously consider an asset allocation framework. (runs beyond the scope of this post)

How to invest currently into equities if you have a large one time amount to be deployed

As in life, there are millions of possible solutions. This is mine and you are free to improve upon it.

You want to invest a large amount in equities with a >7 year time frame

  • 25% of the money – Deploy Rs 25 in Equity Funds
    • Humble approach
    • “I don’t have a freaking clue where the markets are headed. And no one can predict or precisely time the market. So I will have a long time frame to mitigate the valuation risk. Time in the market is more important than timing the market”
    • Prefer value oriented fund managers like Sankaran Naren while selecting equity funds
  • 25% of money – Dynamic equity allocation funds
    • Funds which auto adjust equity allocation
    • I don’t trust myself. I might panic when market falls and fail to reallocate back to equities. So let me automate my asset allocation.
    • Eg: Motilal Oswal MOSt Focused Dynamic Equity Fund, ICICI Prudential Balanced Advantage Fund etc
  • 50% of money – Stay in liquid funds and deploy only when PE valuations come below 18 times over the next 2 years
    • Valuation based approach based on our findings above
    • I hope to start with a reasonable framework and keep evolving & improving it based on the feedback

The idea is to strike a balance between our insights (which can go wrong, thanks to the greatest humbler – the markets) and a “Time in the market is all that matters” approach.

Where can we go wrong?

While historically PE ratio has always gone below 18 times in a 2 year period, what if it doesn’t repeat.

What if it goes to 35 or say 50 times and stays there. Who decides where the PE value must be? Why should it mean revert?

Are we missing something..

Maybe..

This means we need to introduce a 3rd lens to evaluate future returns
(1st being valuations, 2nd being earnings growth).

And what would that be?

Hang on till the next post…

Till then happy Diwali and happy investing 🙂

 

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Let us all help each other in becoming a better investor version of ourselves.

Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments

What returns will I get from equities going forward? – Part 2

10 minute read

In the first part of this series here, we discussed on how to evaluate valuations and plug it into our future returns estimates.

Today, we shall solve the next part of the future returns puzzle – Earnings.

Let me be honest upfront. I don’t think I know an exact method to predict earnings growth. In fact I don’t think I ever will 😦

So acknowledging this inability of mine, the idea here will be to work around with a simple framework which is not intended to be precise, but rather can be a good starting point in our conversations about equity return expectations.

Now that we are done with all caveats, let’s dive in..

How do we estimate future earnings growth?

Carl Jacobi to our rescue

Jacobi, a German 19th-century star mathematician, believed that the solution for many difficult problems could be found if the problems were expressed in the inverse – by working backward.

Image result for invert always invert

He was fond of saying, “Invert, always invert”

So instead of asking what will be the future earnings growth, what if we invert our problem and ask –
“For my expected returns from equities, what is the earnings growth required?

Let me explain..

Assume you need at least 15% from equities in the next 5-7 years.

In our earlier post, we found that

Returns from equity = Change in earnings + Change in PE valuations + Dividend Yield

The current trailing PE for Sensex is 23.5. As we had seen in our earlier post here historically we have always got the opportunity to exit above a PE valuation of 17x in the last 2 years of our investment time horizon.

Assuming we get to exit at 17 times PE, this implies a 28% absolute decline due to PE value coming down from the current 23.5 times.

This negative 28% spread across 5-7 years implies a compounded annual loss of ~5-6%.

The dividend yield of Sensex has historically hovered around the 1% to 1.5% range.

I intend to make around 15% from equities. (You are free to have a different return requirement)

Thus putting all this together,

Returns from equity required = 15%

= Earnings growth + Change in PE valuations (- 5 to 6%) + Dividend Yield (1%)

= Earnings Growth – (4 to 5%)

So for getting 15% returns from equities, the Sensex earnings growth should grow by around 20% for the next 5-7 years!

Phew, that gives us a fair idea of the expectations being built in. But how easy or difficult is this 20% number to achieve.

Let us take a look at history..

  • FY 93-96 : 45% CAGR
  • FY 96-03 : 1% CAGR
  • FY 03-08 : 25% CAGR
  • FY 08-16 : 6% CAGR
  • FY 16-21 : ????

You can clearly see that Sensex earnings growth has remained cyclical and alternates between low and high growth periods.

So going by the historical trend, it seems reasonable to expect better growth over the next 5-7 years.

But let us dig further..

Earnings Growth details.png

Source: MOSL

As seen above the Sensex earnings growth over a 5-7 year period has crossed 20% only in the FY93-96 period and FY 03-08 period.

  • FY 93-96 is when Indian economy was opened up for foreign investments and its a one off event.
  • FY 03-08 was primarily led by a strong global growth, domestic investment cycle and commodity bull run.

Now that means, there has only been 2 instances in the past where 20% expectations have been met. Out of which, one of them was led by a one off event, so technically it’s just one instance in the entire 23 years!

So while earnings growth, given their cyclical nature is expected to improve going forward, 20% growth is definitely not an easy ask.

What should happen for this 20% earnings growth to materialize?

A simple way to evaluate where we are in the earnings growth cycle is by using the corporate profits as a % of GDP equation.

corp pat as a % of GDP.png

Source: MOSL, Livemint

In order to arrive at our approximate estimates for the next 5 year earnings growth, we need to project these two parameters

  1. Nominal GDP Growth (i.e Inflation + Real Growth)
  2. Corporate Profits as a % of GDP

Assumptions

  • For nominal GDP growth, let us go by RBI estimates which is around 6-7% real growth + 4-5% inflation = 10 to 12% Nominal Growth
  • We will assume that the corporate profit as a % of GDP moves closer to the long term average (5% of GDP) over the next 5 years. (to around 3.5% to 4.5% as a % of GDP)
  Final 3.0.png

Going by this, our reasonable estimates of earnings growth for the next 5 years can be around 15% to 21%.

But do corporate profit as a % of GDP mean revert?
Let us see what happened in the US where we have the data spread across a large period

Screenshot-2017-10-1 Corporate Profits After Tax (without IVA and CCAdj) Gross Domestic Product

Great. The long term data clearly shows that Corporate Profits as a % of GDP is cyclical in nature. Thus our assumptions for mean reversion of Corporate Profits as a % of GDP in India is reasonable.

Ok, so where that does leave us with

  1. Earnings growth can be around 15% to 21% over the next 5 years
  2. Valuations will lead to a negative impact of 4-5% over the next 5 years
  3. Dividends will add around 1 to 1.5%

Thus overall return expectations for the Sensex over the next 5 years can be approximately around 11% to 17%

Mutual funds historically have done slightly better (by capturing higher earnings growth due to stock selection) and can be expected to provide ~1-2% out performance over the Sensex.

Now that we have a reasonable framework, depending on how reality evolves and we can improve or adapt our existing process.

All this is fine. But how in the world, do we convert all this mumbo jumbo into an executable framework?

Hang on till the next week..

Till then, happy investing as always 🙂

And, just in case you found what you just read useful, share with your friends and do consider subscribing to the blog along with the 1400+ awesome people, so that you don’t miss out on the next week’s post. Of course additionally you also get loads of free, interesting investment insights delivered straight to your inbox.

Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments

What returns will I get from equities going forward?

This is the million dollar question for which all of us are seeking an answer..

My honest answer:  I don’t know.

Possible Truth:  No one really knows..

bcf30bc4e90838a0b5ae4a23bc242593--economists-investing

While I humbly acknowledge my inability to predict the future, the other side of the view i.e “I can’t predict. So I will just hang on to equities and well just..Pray!” somehow just doesn’t seem to be a great stance either.

So let us see if we can come up with a framework to set our expectations on equity returns. And based on how reality turns out, we can always come back to this framework and evolve it.

So here we go..

Anchoring to Sensex levels

One of the common mistakes that most of us do, is to decide based on the Sensex levels. We check for the Sensex levels, listen to what our intuition has to tell on whether it is expensive or cheap and then go ahead based on that.

Today the Sensex is around 31,000 levels. What does your intuition tell you?

“The Sensex has never been around these levels. It looks expensive and I feel it will fall from these levels” – says my intuition.

But unfortunately, this method of trusting our intuition, while holds good in certain other areas of life, is a very bad method when it comes to investing.

In 2008 beginning, the Sensex was around 20,000 levels. And then it crashed by 60% due to the global financial crisis.

Then in 2010 end, Sensex was around 21,000 levels. Again it crashed by 26% on concerns over the Euro debt crisis.

And then as expected, the levels of 20,000 in Sensex had gotten anchored strongly in the minds of all of us as a crash-for-sure-level. As it crashed 2 times earlier, our intuition started to believe that the Sensex at 20,000 levels was the reason for the crash.

Sensex at 20000

And obviously, the next time Sensex hit 20,000 in 2013, no wonder most of us were reluctant to invest.

Today at Sensex level of 31,000, we all know what happened next 😦

Image result for “Did You Lose the Keys Here?” “No, But the Light Is Much Better Here ...

Under the influence of the Sensex value, we were no better than this man searching for his keys.

So now that we know that the Sensex is a misleading number, is there a better way?

Elon Musk to the rescue

Elon Musk touches upon an interesting framework for solving problems called the first principles.

It simply says “to solve any problem, you need to break things down to the most fundamental truths (i.e basic underlying components or ingredients) and then solve up from there”.

What would be the first principles equivalent of equity returns?

Instead of getting carried away by the Sensex number, we are simply going to break down the Sensex into its underlying two components:

Sensex Value = Profit of underlying companies * Valuation (i.e no of times the profit that you are willing to pay)

or in precise geek terms it reads as

Sensex Value = Earnings Per Share for Sensex * PE Ratio

  1. EPS (Earnings per share for Sensex) represents the underlying profits of the Sensex companies per share
  2. PE Ratio (Price Earnings Ratio) – This is the valuation or the no of times the underlying profit that the investors are willing to pay

The key takeaway here is that the
Sensex value can be alternately viewed as the product of two numbers – EPS and PE ratio

(Actually there is also dividends which get added to returns which for the sake of simplicity we won’t consider here. For Sensex it’s mostly around 1.5% range)

So when we want to evaluate future returns for equities we are essentially asking the question “How much will the sensex value change?” or in other words “How much will the EPS and PE ratio change? “

Change in Sensex value = Change in EPS * Change in PE Ratio

So basically predicting equity returns boils down to answering these two questions

  1. What can be the earnings growth?
  2. Will the valuations move up (increasing returns) or move down (reducing returns) or stay flat (not contributing to returns)

Appreciating valuations..

Let us start with Sensex valuations..

PE Ratio.png

What do you notice?

  1. Valuations have generally been cyclical (i.e they go up and down but revert back to their average)
  2. Sensex PE valuations have gone as high as 26 times and as low as 9 times
  3. The average valuations have been around 18 times

The first time I saw this chart when I began my career, I had my Archimedes moment. While I obviously didn’t go around naked shouting “Ëureka”, finally I had cracked the secret code to equity investing. (or at least that’s what the naive-me believed)

Simple..
I buy at low PE – equities will immediately go up and sell at high PE – equities will immediately go down!

Hurray 🙂

The logic as seen above remains simple. Equity valuations keep moving up and down. So whenever it is above average PE it will eventually go down and whenever it was below average it will eventually go up.

And then, as always after all these years of real world investing, I have realized that reality looks a lot different than theory!

My biggest learning:

Valuations are never a timing indicator. They are only a measure of risk!

What the #$%..

Relax. Let me try to explain with the help of an analogy..

Image result for two wheeler driving with cellphone

Let’s say you have a friend Rahul who is a very reckless driver and always over speeds. (pardon the guy-cycling-just-crossed-me kinda implied speed in the picture above)

He is leaving your office and has to travel another 20km back home and as always he is expected to over speed.

Now will he meet with an accident on his way back?

Think for a minute and what would be your answer.

You really can’t be sure about whether he will meet with an accident in this particular journey, right. But if he keeps driving like this, then you can reasonably be sure that sooner or later he will meet with an accident.

This is exactly the same issue with valuations.

A high valuation generally means markets are over speeding. The degree of risk is high.

But as in the case of our friend Rahul, it does not mean markets will go down in the next week, next month, next year. You never know how long it takes!

The only thing you can reasonably be sure is that sooner or later, the chance of a market decline is pretty high.

This distinction is extremely important to view “valuations” from the right perspective.

So now that we are clear on the fact that valuations should be used only to evaluate the degree of risk and not to time the market, let’s deep dive into valuations..

Evaluating degree of risk via valuations

Current PE valuation of Sensex = 23.5

Historical Average = 18

Current valuations look expensive compared to historical averages.

But is there a better way to understand this ?

The basic assumption we will make is that Sensex valuations will revert to their averages gradually.

So if I have a 3 year time frame, I will assume that valuations will revert to their average of around 18 times.

Now let us evaluate the impact of this on future returns..

forward returns

As we saw earlier, returns have two components – valuations and earnings

This table shows the annualized loss in returns due to valuation component if the PE returns back to its historical average for various time frames.

So as seen above, while the absolute loss is 24% if valuations come back to their averages, it gets spread over your investment time frame.

Hence the longer your time frame the lower is the annualised impact of valuation changes.

Going back to the table, if you assume the Sensex gets back to 18X PE and you have a 3 year time frame – this implies a loss of annualized 9% on your overall returns from earnings growth.

This means if the Sensex earnings growth turns out to be 15% annualized for next 3 years, Sensex will only end up with 15%-9%=~6% annualized returns.

But if you extend your horizon to 5 years, then the annualized loss due to valuations reduces to 5%.

Thus as you extend your horizon further, the impact of a valuation decline on overall returns reduces.

This leads us to another interesting conclusion

The longer the time frame, the lesser is the impact of starting valuations – the returns will primarily be driven by earnings growth

Thus based on the current valuations,  as shown in the table you can approximately estimate the impact on overall returns assuming that valuations return back to their averages.

So what do we make out of all this?

  • If starting valuations are high, we need to have a longer time horizon
  • The key to returns going forward will be earnings growth as expecting valuations to go up from here is a tough ask
  • Most probably valuations reverting to their average will imply we will not be able to capture the entire earnings growth as our returns

Sounds good. But I am missing out something here.  Can you take a guess?

Clue: Go back and observe the Sensex PE ratio chart

Yes. The sensex very rarely ends exactly at our assumed long term PE average of 18 times. More often than not it overshoots either way – above or below.

This means even if have a fairly reasonable time horizon, say 7 years, my returns will be impacted severely by the ending valuation. Since the valuation has moved between 9 and 26, what if we end up our holding period at 9 time PE 😦

So as always we are stuck. How do we solve this issue?

No worries. Here is an interesting secret about the Sensex valuations –

Max PE 2Y

Historically in any two year period of the last 17 years, the Sensex has always ended up touching a PE valuation more than 17 times. (actually PE of 17.7 times is the lowest among the various maximum PE it touched in various two year periods)

In simple terms, this means historically, you have always got the opportunity to exit above a PE valuation of 17x in the last 2 years!

This means if we can view our investment time frame as T+2 years, then in the last 2 years, historically we have always got an opportunity to exit at around 17-18 times PE ratio (no certainty that it should continue. But nevertheless has worked out so far)

Eg:

  • Assume you have a 7 year time horizon and you plan to invest in equities
  • Don’t touch your equity portfolio for the next 5 years
  • In the last 2 years, is where we start planning our exit
  • After the 5th year, you can exit immediately when Sensex is above or crosses 17x PE

Phew. This solves our assumption problem of Sensex not exactly reverting to historical average PE.

While the Sensex won’t end up at average, we can always plan to exit near the average at 17 times PE using our secret insight above 🙂

 

  • Now this implies, we can get a better shot at calculating the impact of valuation component on overall returns
  • Your return expectation in the above case of 7 years should be approximately:
    1.    Earnings growth 
    2.    + 1.5% (Dividend Yield of Sensex)
    3.    – 4 to 5% (assuming exit valuations at ~17-18 times PE over the next 5-7 years)

There you go. Using the above logic and based on the time frame, you can evolve your own return expectation framework.

And for those wondering where to find the PE ratio. No worries IDFC mutual fund has a PE indicator always available at this link below

https://www.idfcmf.com/is-it-a-good-time-to-invest.aspx

Great. So one part of the equity returns puzzle is reasonably solved.

But we are left with the next key question..

How in the world, do we set our expectations on earnings growth?

Hang on till the next week 🙂

And as always happy investing 🙂

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Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments

Secret to Long term investing – “See me not”

Equity returns – more common on paper than in real lives..

In the last 5 years, the Sensex has given decent returns of around 82% which works out to a compounded annual return of 13% every year.

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In fact, most of the diversified equity mutual funds have better returns than the Sensex, especially the mid cap funds.

But somehow in real life, we rarely find people who have actually benefited from the equity rally of the last 5 years.

Unlike real estate, where each and every neighbor has a “I-bought-this -land-and-it-multiplied-so-much” story, the stories of huge returns in equities while is true on paper is very rare to see in actual portfolios.

What can be the reason?

As all of us know, equities are an extremely volatile asset class in the short run, with temporary losses historically going as high as negative 56% (2008 when the financial crisis happened).

While this temporary loss looks easy on paper, in reality it is emotionally very difficult to view losses in our hard earned money even if it is expected to be short term (the other issue being you never know how long is the short term).

This “emotionally difficult” part unfortunately is very difficult to quantify.

Thus majority of the times while investing in equities, we only see the past returns (easily available and vivid) and conveniently ignore the “emotional stress” part (cannot be seen, only felt).

So, how do we get a sense of this “emotional difficulty” part??

Dan Kahneman to the rescue..

Thankfully for us, the gurus of behavioral economics, Daniel Kahneman and Amos Tversky have done several experiments to understand how we humans psychologically react to losses vis-a-vis gains.

Their key finding was that:

  • Human beings feel the psychological and emotional impact of a loss more than that of a gain
  • The estimate is that we feel the impact of the pain twice as much as that of the gain
  • This is also called as loss aversion

4d09cba33eec425cbb034d7872dfdfbb--loss-aversion-social-media-marketing.jpg

Source: Franklin Templeton

Now, that’s pretty interesting stuff – Emotional pain from loss is twice that of a similar gain

Let us see if we can use this to evaluate the “emotional stress” of holding on to Sensex.

Emotional Returns of Sensex

The mistake that most of us make when we see the statistics that Sensex gave a return of 82% in the last 5 years is the assumption that we will buy, forget and one fine day we will wake up after 5 years and voila – 82% returns handed to us on a platter!!

Reality is that we keep monitoring our portfolios very frequently. Some do it every month, some every week and some even every day.

Now every time we monitor the Sensex value over these short time periods, we inevitably witness negative return periods and along with it the anxiety of what if this extends and becomes permanent.

And to make things worse, as per the loss aversion theory, these negative return periods are twice as painful as the actual returns. Eg a 5% loss is twice more stressful (i.e like a loss of 10%) while a 5% gain is only as emotionally uplifting as a 5% gain.

1m return.png

While not very scientific, however to get a crude sense of how the returns would feel from an emotional point of view, let us calculate what I call the “emotional return” index (don’t google it..I just made it up)

Here is how I calculate it..

Every monitoring period (eg 1Year ,6 months, 3 months etc) where there is a negative return we will assume twice of it (as per loss aversion theory) and every monitoring period when markets are up we will consider the same gain.

So for eg if we are looking at monthly monitoring, if in Jan-17 my returns are down by 10%, then I will assume it as 2*10%=20%. If it is up by 10% then I will assume it as the same 10%.

Based on this method, for different monitoring periods, the Sensex has been simulated over the last 5 years.

Now let us see how for the same 5 year returns, investors with different monitoring frequency would have emotionally experienced drastically different anxiety levels.

summary.png

(for the purists out there, the numbers are just approximations to visualize and appreciate the emotional stress involved and by no means is of any serious mathematical validity)

While the Sensex in the last 5 years, actually went up by 82% from 17,430 to 31,730, for an investor who had monitored it every day, emotionally it would have actually felt like the Sensex went down -96% to 655!

summary.png

As seen from the table, while the on-the-paper return of the Sensex remains 82% in the last 5 years, the emotional experience of investors in getting those returns would be vastly different based on how frequently they monitored their portfolios.

Takeaway: The lesser you monitor the portfolio, the better your experience

Parting thoughts

So it is easy to say invest in equities for the long term, but the real test is whether we will be able to withstand the emotional stress in the intermediary periods and hang on to equities.

In a world, where portfolio updates are instant and get tracked in your phones, each and every minute, it’s far easier said than done.

So for people entering into equities for the first time, while we know the perils of frequent monitoring, given your anxieties (which is natural given you are entering for the first time), its very difficult for you not to monitor your portfolios frequently in the initial days.

The only choice is to brace yourselves for the emotional roller coaster and while the actual returns might be good over the long run, emotionally it will always “feel” a lot more draining and less exciting.

As you get more experienced, one of the best ways to try attempting at being a long term investor is to stop monitoring your portfolios frequently. I have personally tried this and trust me it makes a huge difference in your ability to hang on.

Once you are past your panicky first time investor phase, you can gradually look at monitoring every quarter and gradually improve to once in 6 months, 1 year etc

And yeah, as always Happy Investing 🙂

P.S: All this long term thinking, is assuming you have done your work and have picked good fund managers or businesses:)

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Create your own financial plan while you are waiting at the traffic signal

Most of us switch off when someone says “Hey..Let’s create your financial plan”. Those dreadful excel calculations, long term projections, future goals, inflation assumptions blah blah…

Yawn.

No worries. I completely get it!

But what if we simplified this whole complicated financial planning business to something that you could just do it in your head while you are waiting at the next traffic signal.

Not a bad deal right. This is exactly what this post is all about. Be with me for the next 5 minutes and you can  create your entire life’s financial plan while you are returning back from office tomorrow.

Image result for waiting in traffic india

A financial plan is simply three things put together:

  1. How much are your future expenses? (adjusting for inflation)
    (for various goals such as kid’s education, retirement, buying a home etc)
  2. How much to save for these future expenses?
  3. Where to invest whatever we save ?

We will explore the first two questions for today and address the 3rd question in our future posts.

1.How much are your future expenses?Image result for inflation expenses

We have already addressed this in detail in our earlier post here.

Here is the quick summary:

In India, historically  rise in costs (i.e inflation) has been around 7 to 7.5%.

Rule of thumb 1:

The rough math for a 7 to 7.5% inflation implies prices will approximately go up by

  • 1.4x or 40% up in the next 5 years
  • 2x in the next 10 years
  • 3x in the next 15 years
  • 4x in the next 20 years

From here you can build for all incremental 5 years using the logic that prices double in every 10 years. So for 25 years, we know that in 15 years prices are 3x and hence for 25 years it is 3×2= 6x. For 30 years it will be 4x (for 20 years)*2 (for the next ten years) = 8x

So if we remember 1.4x, 2x, 3x and 4x we can calculate an approximate value for all of our future expenses!”

2.How much to save for future expenses?

Image result for savings

Assumption 1:
A reasonably well designed equity portfolio
should provide me with ~15% returns for time frames above 10 years.

(This is based on history and your guess is as good as mine when it comes to predicting future returns. So just in case you think my assumption is optimistic then you can refer to the annexure of this post and adjust your calculations accordingly.)

Assumption 2:
I will be able to increase my savings by at least 5% every year

(Assuming a static monthly savings for the next 10 years and more is being a little too conservative as our salaries normally are expected to increase at least to keep up with inflation)

Rule of thumb 2:

We need to spend some 2 minutes and memorize the below numbers. The table tells us how an investment of Rs 1000 every month which is increased by 5% every year and provides a return of 15% will fare over different time periods.

Untitled

(this table will be different based on your return assumptions. Refer annexure)

How do we use this?

If you have an expense of 40 lakhs after 15 years, how much will you have to save every month?

Simple. For every Rs 1000, you end up having Rs 8 lakhs after 15 years. So for accumulating Rs 40 lakhs in need to save 40/8 lakhs = 5 and hence 5*1000 = Rs 5000 every month.

Now this is all we require for our financial plan. Let us put the entire thing into action

A simple financial plan

Let us take the case of Rahul, aged 30. He is recently married, has a 2 year old daughter Sandya and earns around a lakh every month. How does he go about doing his financial plan while driving back from office ?

Traffic signal 1:

Image result for traffic signal

Rahul’s mind voice:
“Let me get done with my daughter’s education first

.Image result for education

A decent 4 year engineering degree roughly costs around 10 lakhs today. My 2 year old daughter will be in college at around 17. So I have another 15 years left.

Now based on the above table, the cost of education will become 3x in the next 15 years i.e Rs 30 lakhs.

So how much will I have to save every month?

Looking at the above table, every Rs 1000 invested per month (and increased by 5% every year) gives me Rs 8 lakhs in 15 years. So I need to save around Rs 4,000 every month which will give me approx 32 lakhs in 15 years.

The traffic light turns green and Rahul is done with the plan for his daughter’s UG education!!

Takeaway: He needs to start saving around Rs 4000 every month for his daughter’s under graduation

Traffic signal 2:

Rahul: “Now let me also decide on her MBA expenses. Assuming she does her MBA at 22. That is around 20 years. An MBA today costs around 25 lakhs. So the cost of an MBA 20 years hence is 25*4 (the inflation multiplier) = roughly Rs1cr.

Looking at the above table, every Rs 1000 invested per month (and increased by 5% every year) gives me Rs 18 lakhs in 20 years. So I need to save around Rs 5,500 every month which will give me approx 1cr in 20 years.

So, Rs 4000 for UG and Rs 5,500 for PG – in total let me round off and start saving Rs 10,000 every month for my daughter’s education.”

Traffic signal 3:

“Now I would also like to buy a home after 20 years. The current cost works out to be around Rs 80 lakhs. This implies the cost after 20 years accounting for inflation would work out around Rs 80 lakhs * 4 = Rs 3.2 cr!

Image result for home in anna nagar

Looking at the above table, every Rs 1000 invested per month (and increased by 5% every year) gives me Rs 18 lakhs in 20 years. So I need to roughly save around Rs 18,000 every month which will give me approx 3.2 cr in 20 years for the house that I am planning to buy.

Traffic signal 4:

“I would also want to save some corpus for retirement. Approximately, the math says I need around 20 times current earnings to create a similar annual income stream which can grow along with inflation.

Image result for retirement

Since my current salary is Rs 1 lakh per month, or Rs 12 lakhs per year, I would need around Rs 12 lakhs * 20 = Rs 2.4 cr if I were to retire today. Thus this implies adjusting for inflation after 20 years I need Rs 2.4 cr * 4 = 9.6 cr for retiring with the current lifestyle.

Looking at the above table, every Rs 1000 invested per month (and increased by 5% every year) gives me Rs 80 lakhs in 30 years. So I need to roughly save around Rs 12,000 every month which will give me approx 9.6 cr in 30 years for my retirement corpus

Traffic signal 5:

Thus summing it up:

  1. Daughter’s education: ~10k per month
  2. Home: ~18K per month
  3. Retirement: ~12K per month

Thus overall, Rahul  will need to roughly save a total of Rs 40k per month for all his goals. And the waiting time in 5 traffic signals is all that it took 🙂

And there you have your simple financial plan !!

What if you have already saved up some amount. No worries, we have a solution for this too.

Thumb Rule 3:
At 15% your money doubles every 5 years
.

So if you have saved let’s say around Rs 10 lakhs, it will be Rs 20 lakhs in 5 years, Rs 40 lakhs in 10 years, Rs 80 lakhs in 15 years and so on..

Do let me know if you found this helpful and if you had any issues while implementing this.

Please remember that these numbers are rough approximations and hence don’t get too obsessed on precision. The idea is to get you started with a simple plan 🙂

Annexure:

If your return assumptions are different from my 15%, then refer to the table below for the appropriate values (and round the values off to make it easy)

SIP at various returns

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