Why the odds are against you when it comes to good financial advice

All of us are regularly making decisions of varying degree of importance, for most part of our lives. This may include serious ones like how to improve sales in your company, buying a new house, evaluating a new job etc to day to day ones like which route to take, which restaurant for dinner etc. While simple decisions don’t require much of an effort as the stakes are pretty low, however in situations where the stakes are high, the decisions that we take, need to be taken after some reasonable analysis.

Though the situations and problems will be different, if we can develop a set of thinking tools which we can apply selectively to various problems, it would help us to improve our decisions dramatically. In essence, you don’t want to start a bike repair shop with only one spanner, you essentially want to have various tools which you can use based on the nature of problem in the bike.

So with the same premise, we are going to slowly build our own mental tool kit which will help us both in our day to day lives and investing. Our first tool that we will be adding to our mental tool kit is called “Incentives”

Most of economics can be summarized in four words: “People respond to incentives.”  The rest is commentary. – Steven E Landsburg

The basic idea is to ask the simple question “What’s in it for the fellow on the other side of the table”

Let’s apply this simple question to the financial industry and investing.

Most of us or someone in our family would definitely have an investment linked insurance product sold to us. But when it comes to mutual funds, most of us have hardly heard about them, leave alone buying them. Intuitively, our first line of reasoning goes – a better product gets more popular and hence insurance products must be better than mutual funds. But if you have held on to any investment linked insurance product (except for pure term insurance which in my honest opinion is the only decent product in the insurance industry) for more than 5 years and you do the calculation for returns, you realize the sad truth 😦

But what explains their popularity ??

You guessed it right. Incentives !!

When you are sold a mutual fund, the distributor commission is generally around 1% for equity mutual funds and around 0.5% for debt funds. So if you invest Rs 1 lakh in an equity mutual fund, your advisor will make just Rs 1,000 for the entire year.

But when you sell an investment linked insurance product, the first year commissions (including rewards) can be as high as 49% (see the below chart). So if your premium is Rs 1,00,000 then upto Rs 49,000 may go into the pockets of your agent or the bank. Then,the charges are capped at 7.5% of the premium till the 5th year and thereafter it is 5% of the premium. If you had a heart attack looking at this, hang on, these charges were even more exorbitant a few years back and the current rates are post the regulatory intervention putting a cap on the charges. You can imagine the “gala” times that your friendly insurance agent had those days.

You can see below the maximum commission charges for various plans and tenures. (Link)

Source: http://www.livemint.com/Money/AbOyobTzU0KrpbTSGEpysM/How-to-grab-70-of-a-premium.html

This has led to significant mis-selling in investment based insurance products. Since the incentives are front loaded the focus is on churning your insurance products given the high 1 st year commissions. This behavior is evident as seen from the low persistence of holding an insurance product beyond 5 years. Refer to this article for a detailed explanation  (Link)

Excerpts from the article,

“According to figures of financial year 2015, as reported by the insurance regulator in its handbook of statistics, the industry, on an average, reported a persistency of 59% in the 13th month, i.e., after a year of sale. In other words, out of 100, just 59 policies got renewed. In fact, the average persistency for the 61st month is about 22%, which means by the end of the fifth year, only 22 policies got renewed.

India compares badly with the rest of the world. The 13th month persistency in member countries of Organisation for Economic Co-operation and Development is above 90% and about 65% for the 61st month.”

Source: http://www.livemint.com/Money/wkeodGRDFxDjPYP3TtSWGJ/Life-insurers-selling-policies-that-die-early.html

This is a clear case of how incentives of our friendly insurance agent which are not aligned to our interests generally leads to a bad investing experience.

Quick take away:
At the current juncture, given the opaque cost structure, just-about-average investment managers who manage our money and not-in-our-favour commission structure avoid any insurance product which promises returns. Don’t confuse an insurance product with investments. If you need insurance, opt for pure term insurance which promise no investment returns but provide the insured value in case of your death within the term.

So, now let us assume you are just about 2-3 years into your career and you decide to save around 10,000 per month. Mutual funds are perhaps one of the best investment vehicle available for you (given their low costs, simple structure, high transparency, investor friendly regulator and the presence of seasoned fund managers). But you hardly have any knowledge on the markets and wish to work with an advisor. As you are relatively inexperienced, you also have a lot of queries and often get shit scared when markets go down. This means an advisor will also have to spend a lot of time hand holding you, meeting you, explaining to you about markets and stopping you from making hasty decisions. You would also like to meet your advisor regularly every month and discuss your various financial plans and queries. On top of it you are averse to paying your advisor. After all who pays for financial advice in India. We get it free of cost from our beloved news channels and friends 😦

So the advisor has to work on the wafer thin commissions that the mutual fund pays him which is approx 1% for distributing their funds. If your SIP is 100% equity, then the advisor gets around 1% of 1,20,000  (i.e 10,000 * 12) and it works out to Rs 1,200 !! Yup you read it right ..Lets assume the advisor remains patient and works with you for 5 years and your SIP of 10,000 each month has compounded at 15% and has increased to a value of Rs 9 lakhs. And how much does your advisor get paid for all this effort, honesty and persistence.. Rs 9000 !! Add to it the risk that the % of commission might further reduce after 5 years.

I hope you get the picture. Now you know why those lousy insurance products get sold to you (why in the world would anyone let go of an opportunity to make 30% plus 1st year commissions..to hell with long term client relationship). Did mutual funds not have a problem of incentives. Of course they did. The recent selling of closed ended funds (which had one time commissions which went as high as 7%) is a classic case. But the difference is you have an extremely investor friendly regulator by the name SEBI who regularly keeps a check on any possible investor unfriendly activities. While in insurance, the regulator IRDA continues to have its eyes closed on the high commission driven insurance sales.

For a good advisor, it generally makes sense to cater to larger clients where the efforts and time spent, while is the same as spent on a small client, provides him with a far better remuneration (a 1 cr client, with a 50% in equity and 50% in debt would provide an income of around Rs 75,000 per year)

So they key implication, is that if you are a small investor its extremely difficult to get decent and honest advice. 

Now given this practical reality, the safest choice for all of us is to educate ourselves on the bare minimal basics of investing. Sounds boring. But think about this, in a career spanning 38 years from the age of 22 to 60, you end up working approx 79,000 hours in exchange for all the money you make. Don’t you think should spend just about 2 hours a month, which works out to just 1% of your overall work hours, on making your money work equally hard as you.

“Give me six hours to chop down a tree and I will spend the first four sharpening the axe.”  – Abraham Lincoln

This blog is a small attempt from my part to ensure that all of us get good financial advice, and hopefully have a reasonably good investing experience. (intelligent folks should interpret these lines as shameless marketing 🙂 )

Now for those of us for whom investing sounds like greek and latin, and that’s the last thing on which you want to spend your well earned free time, don’t worry, all is not lost. To your rescue comes the new breed of online based advisors called robo advisors (Eg Scripbox, Arthayantra, Advicesure, Fundsindia etc) which are slowly gaining popularity. These guys provide advice through apps/websites with bare minimal human intervention and address the main issue of cost to service us, as most of the investment advice is standardized and can be easily scaled (think of uber, airbnb etc). While this is still at an initial stage and most of them are very basic, my sense is that in another 2-3 years we will have some really solid and evolved online advisory models for people like us. Till then let’s keep learning !!

Summary

  • Keep an eye on incentives – Always ask what’s in it for the guy on the other side
  • Investment-linked-Insurance products are injurious to your financial health
  • Tough to find good financial advice for small investors – the incentives for advisors are tilted towards the larger investors
  • Invest in improving your investing knowledge – no two ways about it !!
  • Robo-Advisors, while currently at a nascent stage, may be the solution to decent financial advice for small investors in the coming years

 

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Equity Investing – Just 2 things to remember

In our previous two posts, we had covered in detail, the two key factors to evaluate when investing in equities. In case you haven’t read them, do take some time out to read them here – Link 1  Link 2

Now for those who don’t have the time and would like a “no-nonsense” summary of those posts, hang on, this post is just for you folks !!

Quick Summary

  1. Equity market returns are driven by
    • Earnings growth
    • Increase or decrease in Valuations
    • Dividends (In India, this component is not too significant and adds to around 1 to 1.5% additional returns for the Sensex annually)
  2. Earnings growth and Valuations are cyclical
  3. Earnings growth is the key determinant of long term equity returns
  4. So always evaluate which part of the cycle are we in terms of earnings growth
  5. Valuations = weighted average market opinion on the value of companies
  6. Valuations are a key contributor to the short term volatility seen in equity markets
  7. Evaluate if valuations are expensive, cheap or neutral (degree of difference with the long term average – ~15-16 times 1Y forward PE for Sensex)
  8. Do this evaluation once in 3 months
  9. Based on your evaluation, decide on whether you have to adjust your overall allocation to equities within your portfolio


Musing no 1: Stock prices are slaves of earnings growth in the long run !

Now to understand the role of earnings growth and stock prices better, lets take the help of investor Ralph Wanger who has come up with an interesting analogy between the stock market and a man walking a dog.

“There’s an excitable dog on a very long leash in New York City, darting randomly in every direction. The dog’s owner is walking from Columbus Circle, through Central Park, to the Metropolitan Museum. At any one moment, there is no predicting which way the pooch will lurch. But in the long run, you know he’s heading northeast at an average speed of three miles per hour. What is astonishing is that almost all of the dog watchers, big and small, seem to have their eye on the dog, and not the owner.”

The dog in our case is the stock price and the owners walking speed and direction is the earnings growth !!

Earnings vs Valuations

Musing no 2: Starting Valuations matter !

While earnings growth is the dominant driver of equity returns over a long investment horizon (let’s say >5 years), the starting valuations also play an important role as an increase in valuations can provide additional returns over and above earnings growth and vice versa. Generally valuations tend to revert to their long term averages . Think of valuations as tied to a pole called “long term average” with a rubber band. The farther away the current valuations of the market moves away from long term averages the higher is the force from the rubber band to bring them closer to the long term averages.The mean reversion effects of valuation have a significant impact on the overall returns in the near term and gets gradually evened out in the long term.

Starting Valuations = Low
Mean reversion in valuations will provide additional returns over and above earnings growth

Starting Valuations = High
Above normal earnings growth & Long investment time frame needed to nullify the impact of mean reversion in valuations

In order to appreciate the impact of starting valuations, I have calculated the annualized return impact over different time horizons due to valuations returning  to their average ( 16 times 1Y Fwd PE) assuming no contribution from earnings growth (i.e assuming it to be 0%)

Valuation Kicker

As seen above, higher starting valuations have a significant impact over returns in the short term if they were to mean revert (which is most often the case). For eg if you had invested at 24 times PE and it mean reverts to 16 times in 5 years it would have provided ~negative 8% annualised impact on the overall returns (read as earnings growth). Long investment time frames & above normal growth are required to subdue the impact of overvaluation.

Lower starting valuations, provide the potential for significant upside in case of mean reversion. For eg if you had invested at 12 times PE and it mean reverts to 16 times in 5 years it would have provided ~positive 6% annualised impact on the overall returns (read as earnings growth).

Thus summing it up..

  1. Stock prices are slaves of earnings growth in the long run !
  2. Starting Valuations matter !

PS:

For those who are still with me, check out how the actual 10 Year sensex returns have been impacted by earnings growth and valuations

Earnings growth + Valuation IMpact

Source: MOSL

A layman’s guide to equity valuations

In the last post (Link), we had discussed on how equity returns are driven by earnings growth and valuations. We had further detailed on how to evaluate earnings growth. In this post we will move to the second part of the equation – Valuations.

Let’s start with a basic question – How do you put a value to a company?

Sounds kinda geeky . Lets try and simplify.

Imagine this. One fine morning you wake up and you suddenly  see a “number” blinking in red across your dad’s forehead. It reads Rs 2,10,00,000 (Rs 2.1 cr) and keeps blinking and strangely, also changes each and every minute. A little confused, you turn around and to your surprise see Rs 50,00,000 (Rs 50 lakhs) blinking across your brother’s forehead . Throughout the day, each and every person whom you happen to see has a number on their forehead and the same phenomena continues. And just when you are contemplating if you have a serious mental disorder, your phone rings. The display reads “Almighty”. What the heck. A thundering voice orders”I am extremely pleased with your devotion to me. And as a token of love, you and several of my other devotees have been given the special power to receive the entire life time salaries/earnings (as and when they get) of anyone you choose to buy. The price that you will have to pay for buying someone, will have to be bid and its latest bid price will be flashing across their head. I have deposited Rs 10 cr in your account which you can use only for this purpose”…

Take a minute and think of how you will go about choosing the people for the Rs 10 cr?

In order to decide whom to buy, we need to evaluate two things

  1. What can be the possible future earnings i.e salaries in the future and how much are they worth in today’s terms (adjusting for the returns you need)?
  2. Is the current price which is flashing across their forehead, below your calculated price or above your calculated price?

You see the challenge right. How in the world can you accurately estimate the future earnings of someone. Leave others. To be honest, I would find it extremely difficult to predict my own salary 5 years down the line, leave alone for my entire life. On top of this, imagine that millions of people are trying to do this exercise on valuation, each and every day and are bidding for different people based on the valuation that they arrive. No wonder the prices are going to keep fluctuating.

So we know for sure that we cannot come up with a “precise and accurate” value for the people around us because of the simple fact that we are dealing with the future and the future is uncertain. But by analyzing their educational and professional qualifications, skills, current job, salary, industry prospects, talent etc and making some reasonable assumptions we can try to come up with an “approximately right kind of range” for estimating the value. Since we know that the future is uncertain and our assumptions can go wrong, we decide to

  1. Buy around 10-20 people so that even if we go wrong in valuing a few we can still take advantage of the remaining ones that we got right (this in investing parlance is called diversification)
  2. Buy them at a price which is at a sufficient discount to our estimated range (this in investing is called “margin of safety” or rather a humble acceptance of the fact that “We can go wrong”)

Some will come up with the valuation based on

  1. The evaluation of earnings for the future based on fundamentals like – industry growth, current position, salary, skill set etc (in investing this is called fundamental analysis )
  2. Movement of prices at which people are available and decide based on the demand and supply ..etc (in investing this is called technical analysis )

The interesting thing here is that, each and every one may have a different way or method to evaluate the future. Some are sanguine, some pessimistic, some pretty balanced and so on. Hence the final price at which a person is quoting (read as the valuation) is a weighted average opinion on the value at which various people are willing to buy and sell (weighted average in crude terms takes into account that the guy with 100 cr will have a greater impact on the price than the one with 1 lakh).

Now replace the “people” in our imaginary story with “companies” (i.e stocks). Yep..

Welcome to the world of stock markets !!

This is exactly what happens in stock markets, where partial ownership in several companies are available to be bought or sold, each and every day, by millions of people. Further, each and every one has their own way of evaluating the value of the company based on their outlook for the company’s future. Whether we like it or not, the weighted average opinion of market participants are extremely unpredictable and keep changing. There are times when everyone is convinced of an amazing future and valuations are extremely high factoring in high growth in company’s earnings and there are times when everyone believes the world is coming to an end and valuations are extremely low painting a “doom & gloom” outlook for the future. The valuations thus keep altering between periods of optimism, pessimism and balance !!

Now let’s go back to our basic framework which we spoke about in our earlier post,

Sensex = Earnings per share * PE ratio (i.e Price earnings ratio)

Each and every day, or rather to be more precise each and every minute, the Sensex value changes. By this time you would easily be able to guess the culprit who is responsible for that. More often than not, the fundamentals of a company do not change every day, but rather the weighted average opinion of market participants on the future of the company (read as valuations) changes .

The weighted average opinion unfortunately gets driven by news flows, quarterly results, macro economic data, global and Indian events, elections, rainfall ..blah blah. Often, the weighted average opinion, gets carried away and builds a lot more pessimism or optimism than necessary.

Our task is not to become an astrologer and predict each and every event which will affect the weighted average opinion (which is what unfortunately most people think you need to do in investing) but rather to identify periods where the weighted average opinion is building in excess pessimism or optimism. Then all that we need to do, is to take a simple call on human nature – humans will always oscillate between the emotions of greed and fear.

Valuations are the proxy for evaluating the position of the weighted average market opinion moving between optimism (greed) and pessimism (fear). So in reality, the intent is to reduce equity allocation when valuations are very high and vice versa.

Lets see some actual data on valuations in Indian Equities

Sensex Valuations - 1Y Fwd PE

Source: MOSL Research Report
1Y Fwd PE is the sesex value divided by the estimated next 1Y earnings i.e at how many times the next 1 year earnings is the market currently evaluating Sensex. I have not used other metrics of valuation in this post as I will cover them in detail in my future posts.

You can see that the valuations have oscillated in a wide range between 10.7 to 24.6.

In Jan-2008, at the peak of last bull market, the Sensex was trading at 24 times its expected next year earnings and in Oct-2008, close to the bottom of the bear market, the Sensex was trading at 10.7 times its expected next year earnings. How fast the market opinion changes !!

Our idea as already stated, is not to predict the next recession or catch the exact bottom, but to monitor valuations and be conservative when valuations are expensive (i.e reduce equity exposure) and be aggressive when valuations are cheap (i.e increase equity exposure). I will delve into the exact mechanics of how to increase and decrease allocations in future posts. But generally, if you are looking for a simple rule of thumb, while investing in Indian equities we need to be extremely cautious when Sensex 1Y Fwd PE is more than 18 (earnings growth will have to be extremely strong to support such valuations) and be extremely aggressive when Sensex 1Y Fwd PE is less than 13.

Currently, the Sensex is trading slightly lower than its long term average at 15.7 times its 1 year earnings. The valuations indicate a weighted average market opinion which is neither too optimistic nor pessimistic and earnings growth will have to be the primary driver of returns going forward (if valuations rise and become optimistic, then we have a chance of making added returns over the earnings growth and vice versa).

Thus summing it up,

In the long run, equity markets will be a slave of earnings. Period.

But in the short run, valuations cause significant ups and downs in the markets.
Thus an eye on valuations in addition to earnings growth, will help us take advantage of these frequent bouts of extreme pessimism and optimism.

Equities – dismantling the returns !!

When investing in equities, the most common question is “what returns will I get?”. As seen in the earlier post (Link), equity returns are extremely volatile in the short run (sample this- the 1Y returns for Sensex has ranged from 256% to -56%) and tend to become less volatile with increasing time frame. In order to have an idea on what returns to expect, first and foremost, we need to understand the drivers of equity returns.

Let me use Sensex  as a proxy for equities. The value of Sensex can be broken down into its two components:

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

or in exact 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
  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. 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 from now on, every time we decide to invest in equities we must essentially try to answer two questions

  1. What can be the earnings growth for the next 5 years?
  2. Will the valuations move up (increasing returns) or move down (reducing returns) or stay flat (not contributing to returns)?

What can be the earnings growth for the next 5 years?

Now as I have always stated, I don’t think anyone can exactly predict the future earnings growth. In fact, most of investing is about the future and the future always remains uncertain !!

But the paradox is that, we need to have some sense of the possible earnings growth in order to set some reasonable expectations on equity returns. So how do we solve this catch-22 situation.

The answer lies in a simple yet profound statement from one of the greatest investors Howard Marks

“Just about everything is cyclical“.

Instead of me explaining. Let us listen to what Howard Marks has to say..

I think it’s essential to remember that just about everything is cyclical. There’s little I’m certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever. Trees don’t grow to the sky. Few things go to zero. And there’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future.

Always remember:

Rule 1: most things will prove to be cyclical

Rule 2: some of the greatest opportunities for gain and loss come when other people forget rule number

If you find time, do read his letter – Link

Let’s check the historical earnings growth for Sensex

Sensex Earnings Growth

 Source: MOSL

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

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

So as seen above, earnings growth tends to move in cycles. While its impossible to exactly predict when a cycle turns from high growth to low growth or vice versa, we can form a view on approximately which part of the cycle is playing out now. So while we don’t predict, we are rather preparing ourselves for an eventual change in cycle by evaluating our position in the cycle.

Now comes the million dollar question – Theory is fine. But how in the world do I find out where in the earnings cycle we are currently ??

Lets start with what drives earnings growth:

Earnings growth = Return on Equity *(1-dividend payout)

The dividend payout in India as seen below, has roughly been around 25% (Link) and hence we can assume that 3/4 th of ROE or Return on Equity will translate into earnings growth. For eg if ROE averages 20% for the next 5 years, then earnings growth will average around 3/4*20% i.e ~15%. Any additional growth will have to be driven by increasing debt or leverage.

Dividend Payout.jpg

By the way,  in case you are wondering what this return on equity is, think of it as the % of returns (profits) which the owners of the business (i.e shareholders) make on the capital invested. For a detailed understanding refer to the below articles Link1 and Link2

Return on Equity can be further broken down into:

ROE = Profit Margin (Profit/Sales) * Total Asset Turnover (Sales/Assets) * Equity Multiplier (Assets/Equity)

In simple terms the equation means you can target a good ROE through:

  • A low margin product combined with a high volumes ( think Maruti cars, Fast food restaurants)
  • High margin product combined with low volumes (think Mercedes Benz cars, Five Star restaurants/Fine Dining)
  • Higher leverage i.e taking a higher debt (relative to shareholder’s equity) as you have more capital in play compared to your own investments ( caveat being your returns from the business is greater than interest rates for debt say >12% at least)

Now that we have come this far, let’s not forget out original intent – to figure out where we are in the earnings cycle – which led to ROE – which further led to profit margin, asset turn over and Debt levels

So now our task is to figure out, where in the cycle are we in terms of profit margin, asset turnover and debt levels.

BSE 500 (Ex Financials) Summary

Source: Capitaline, IDFC Mutual Fund Presentation

The above table shows a glimpse of the data for BSE 500 (Ex Financials) companies. As seen above the ROE is currently at a 15 year low of ~10% versus its 15 year average of 15%. The primary underlying drivers of ROE – Profit Margin and Asset Turnover are also at their 15 year lows.

Profit Margin Cycle:

Let’s first evaluate the profit margin cycle:

PAT Margin

Profit margins are currently at a 15 year low. Profit margins have always been cyclical and tend to mean revert over long periods of time. We can clearly see from the above table that in FY15 the profit margin for BSE 500 companies were at historical lows of 5.0% versus the last 15 year average of 7.7% . Hence while we don’t know exactly when it will start to improve  we can reasonable assume that the margins are close to their lows and in the next 5 years they should in all likelihood be better. 

Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.” – Jeremy Grantham

Margins improvements will have to occur through these 4 levers.

  1. Higher operating margins
  2. Lower interest rates and hence interest charges
  3. Lower depreciation charges
  4. Lower direct taxes

So what can possibly be the triggers for profit margin expansion in the next 5 years?

  1. Higher operating margins – lower costs due to 1)subdued commodity prices 2)possibility of higher capacity utilization leading to fixed costs being spread over a larger sales (think of a flight where % of seats booked improves from 70% to 90% and since most of the costs remain the same, the incremental revenues do not incur corresponding costs thereby leading to higher operating margin. This is also referred to as operating leverage )
  2. Lower interest rates and therefore interest charges – Interest rates have started to gradually come down led by RBI rate cuts and lower Inflation
  3. Lower depreciation charges – New capacity is not being created given that the system is still running only at a 70-75% capacity utilisation rate and further the high debt levels also don’t allow borrowings to expand
  4. Lower direct taxes 

Asset Turnover:

Asset Turnover
Asset turnover is the sales generated by a company’s total assets – this no is at its 15 year low indicating excess capacity, low demand scenario, stalled projects and weak pricing power (negative WPI inflation). This scenario is also expected to gradually improve given the government focus on kick starting the stalled projects and eventual pick up in demand.

Equity Multiplier:

This is probably the only component which will reduce over the next 5 years and hence can have a mild -ve impact on the overall ROE. The last 10 years has been characterized by companies taking up significant debt to expand, put up new capacity etc. In this period the debt equity ratio went up from 0.58 to 1.0. Thus ROE had some positive support from the Equity Multiplier component. However given the high levels of debt and bad shape of the banking system, the debt levels will have to start gradually coming down.

Evaluating earnings growth:

So as seen above, the gist is that – ROE’s over the next 5 years will improve supported by PAT margins expansion and higher asset turnover while the equity multiplier component may slightly pull it down.

So what earnings growth should we expect:

Earnings Growth Projection

The historical average for Net Profit Margins is 7.70%. Lets make a reasonably conservative assumption that Net Profit Margins will gradually improve to 6 or 7% over the next 5 years from the existing 15 year low of 5.00%. Sales growth is generally in line with Nominal GDP growth (real GDP growth + Inflation). So assuming a real GDP growth of around 6-7% and Inflation of around 5-7% we can expect Net Sales to grow between 10% to 15%.

Conclusion

Hence plugging these assumption ranges, my expectations for earnings growth is around the range of 14% to 23% CAGR over the next 5 years. (You are free to build your assumptions based on your own evaluation of Sales growth and margins). Thus the return expectations for the next 5 years will be a combination of earnings growth (which we expect to be around 14% to 23%) and the change in valuations.

In our next post, we will use a similar framework to evaluate valuations.

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. The stocks, mutual funds and other investment ideas discussed on the blog and each post are for educational and discussion purposes only and are not recommendations to buy or sell. I may or may not have a position in the securities discussed on this blog. For any investment decision, please contact a certified investment advisor.

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 !!

 

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.