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)

 

 

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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

Practical guide to choosing Equity mutual funds – Part 1

There are several categories in Equity Mutual Funds..

  1. Diversified Equity Funds
    • Diversified across various sectors and stocks
    • Further split into Large Cap, Mid Cap and Multi Cap funds (i.e mix of both large and mid cap funds)
  2. Sectoral/Thematic Equity Funds
    • Concentrated towards a particular sector or theme
    • Eg Pharma, Financials, Infrastructure, Consumption etc
  3. Global Funds
    • Funds which invest in global companies listed outside India
  4. Index/ETFs
    • Replicate the index
  5. ELSS
    • Its simply a diversified fund but with a 3 year lock in period and can be be used to tax deduction of up to Rs 1.5 lakhs under Section 80C
  6. Closed Ended Equity Funds
    • These funds are locked in for a particular period (generally between 3 to 5 years) and can belong to any of the above categories – Diversified or Sector/thematic or Global

There are also other equity oriented categories such as

  1. Balanced funds (70% Equity + 30% Debt)
  2. Dynamic equity allocation funds (which automatically adjust overall equity allocation based on some valuation framework)

We will stick to Open ended Equity Diversified Schemes for our fund selection process as this will form the core of the portfolio.

The other categories if required can be layered on top of this based on our risk appetite and requirements.

Oops..a mind numbing 160 open ended diversified funds ..How in the world do we pick the right ones?

In fact in my opinion, this is one of the primary reasons why many of us don’t invest in mutual funds.

It’s simply too overwhelming to decide amidst so many choices!

Psychologist Barry Schwartz calls this choice paralysis.  He argues that more choices make us less likely to take action, and to be less satisfied with our eventual decision.

So the key is to ensure that we don’t get into this trap of “The Paradox of Choice”

Hence the idea is:

Image result for precisely wrong approximately right

Remember,

  1. We will not be exactly able to identify the top performing funds of the future
  2. But our intent is to put together a reasonable team of funds which will help us earn superior returns
I have attempted to provide a simple common-sense approach to picking funds. Instead of adopting the method as it is, I would recommend you to see if the overall logic makes sense to you (else do feel free to throw your brickbats via the comment section). You can then modify the method to suit your requirements.
I understand that there are more rigorous analyses that can be done. But again, these extra variables only add to the complexity of the task without much incremental value add. So let us stick to “practical” over “perfect” mindset.

So let us get to work and reduce the number of choices..

The simplest way to begin is to start with Large Cap Mutual Funds.

For our analysis let us download the MF daily score card provided by Motilal Oswal here (You may need to register to get access. But no worries it is free.)

There are a total of 52 Large cap funds (according to MOSL classification). A lot better than the earlier 160!

Large Cap.png

as on 17-Mar-2017

But how do we reduce?

Applying filters..

Filter 1: Remove all the funds with 10Y performance below the Nifty 50 and Nifty 100

Logic: If the fund hasn’t been able to beat even the index in the last ten years, why bother?

10Y Returns Below Nifty 100

That knocks off 11 funds!

Filter 2: Remove funds which are extremely small

Logic:
1) Given the small contribution from the fund to the overall revenues of the fund house, the focus logically will be predominantly towards the larger funds (of course not a rule cast in stone, but its a simple behavioral bias of “incentives”)
2) In periods of under performance, withdrawal of money from investors may put the fund under severe redemption pressure (sample this in the last 1 year, approximately 1700 cr was withdrawn from Reliance Equity Opportunities Fund)
3) The fund house may try some aggressive calls in the fund to improve performance. (Since it is small in size even if the call goes wrong it won’t impact the overall revenues of the fund house)

Size below 500 crs
That knocks off another 17 funds!

Filter 3: Remove funds with less than 5 year track record

Logic: We would want to know how the fund has done over a reasonably long period covering both the bullish and bearish phases of the market. Ideally the longer the better but from a practical point of view at least 5 years is needed to get some hang of the consistency in the fund performance

In this case, all the remaining funds have more than 5 years track record

That leaves us with 24 funds..

Remaining Funds

Filter 4: Check for recent fund manager change

Now comes the slightly trickier part. While all the funds have more than 5 years in existence, we also need to check if the fund was managed by the same fund manager to ensure that the evaluation of returns is appropriate.

The fund houses may argue that they have robust processes and the change in the fund manager will not have an impact, but I think it would be extremely naive of us to believe that. All said and done, in my opinion fund manager is the biggest factor responsible for superior returns from a fund. (Think Warren Buffet,  Charlie Munger, Ray Dalio, Howard Marks, Seth Klarman etc)

This becomes all the more relevant at the current juncture given the significant shift of fund managers across mutual funds.

Sample this:

  • Kenneth Andrade who was the CIO of IDFC Mutual Fund left in 2015 to start his own PMS.
  • Anoop Bhaskar replaced him as he moved from UTI to IDFC in 2016.
  • Vetri Subramaniam (earlier the CIO in Invesco Mutual Fund) in turn replaced Anoop as the CIO in UTI.
  • Taher Badshah who was the fund manager at Motilal Oswal has replaced Vetri as the CIO of Invesco mutual Fund
  • Axis Asset Management Co. Ltd lost two of its senior-most fund managers -Pankaj Murarka and Sudhanshu Asthana
  • Shreyas Devalkar – the fund manager in BNP Paribas Mutual Fund has moved to Axis Mutual Fund
  • Gopal Agrawal, the CIO of Mirae Asset Mutual Funds quit recently

Confused!! So am I. But please hang on..

So let us remove funds where the fund manager has changed..

Fund Manager Changes

This is not to say that the fund performance will decline post a fund manager change. This simply means we have to evaluate the fund in the context of the new fund manager with respect to his earlier track record (which may be in a different fund) and investing style/strategy (which may or may not be similar to the current fund’s historical style/strategy). As I had earlier mentioned, the intent is to keep it “practical” over “perfect” and hence I will filter out these funds. (having said that you are free to include  funds from the filtered out funds based on your evaluation of the fund manager)

Phew..That leaves us with a manageable 15 funds!

Final 16

I guess this post is becoming too long. So let us take a pause here and continue the rest next week.

In our next post,

  • We shall analyze these 15 large cap funds in detail
  • Evaluate each and every Fund manager (this is the most critical)
  • Understand the fund investment style and strategy
  • Check for consistency in performance and risk taken
  • Based on the above, gradually drill down to 3-4 funds

And here comes the most important part:

I understand it’s a busy world. So thanks a ton for dropping by and if you liked what you are reading, do consider subscribing/following the blog so that you don’t miss out on the upcoming posts in this series.

As always, Happy investing folks 🙂

Disclaimer: 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.

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 !!