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.

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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

SIP in Equities – don’t forget this ignored component !!

SIP is the new “in” thing..

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In recent times there have been several ads and articles focusing on the benefits of SIP (systematic investing plan) in equities (via equity mutual funds).

Systematic investment plan or SIP as it is commonly referred to, is a disciplined investing process where you keep allocating a predetermined amount every month irrespective of the market conditions.

The key advantage is the fact that you don’t need to time the market and it aligns with the income pattern (monthly salary) for most of us.

The basic idea behind SIP is that since we consistently invest over a period of time, we are able to average out both declines as well as upside movements (assuming markets continue to remain cyclical as they have been historically.

Now the overall intent behind an SIP is good – i.e to make investing in equities simple and to address the behavioral biases of investors.

However I believe there are few important caveats which are not being discussed and might lead to a sub optimal experience for investors. Let us see them in detail below:

But remember “Equity returns are non linear”..

The most important thing in my opinion for any investor while investing in equities is to understand the fact that

“Equity returns are non linear”

i.e the returns in equities are not equally spread across years and are extremely volatile. The returns fluctuate between high and low significantly and as seen below while the overall average returns are good, they hide the intermittent sharp declines and sharp up moves which occur in intermittent periods regularly.

Sensex Returns
Source:BSE

And there is the ignored 100% equity exposed portfolio which keeps growing with time..

An SIP addresses the volatility issue reasonably well during the initial years. But however what is being ignored is the fact that as the time period of an SIP increases you also end up with a reasonably sized corpus which remains 100% invested in equities and hence exposed to the volatility of equity markets.

Lets assume you had planned an SIP of Rs 10,000 in HDFC Top 200 (a popular equity mutual fund) every month for 15 years starting from 01-Jan-1998.  The value of SIP as on 01-Jan-2008  would have become Rs 94.5 lakh. But one year later, on 01-Jan-2009 the value of the SIP would have become 53.3 lakhs (remember the 2008 subprime crisis , the Sensex fell 52% while the fund fell 45%) . Basically in one year your corpus has come down by a whopping ~41 lakhs.

That’s a huge decline from an absolute perspective and behaviorally it becomes extremely difficult to remain in equities. (Now before you go blaming equities..Relax, the SIP value recovered to Rs 1.03 cr as on 01-Jan-2010 ).

The same SIP had it been started on 01-Jan-2005 you would have ended with Rs 7.4 lakhs in 01-01-2008 and a year later would have declined to Rs 5.0 lakhs as on 01-Jan-2009. Here the impact on corpus is not that high, with the decline being ~ 2.4 lakhs.

Do you see where we are getting at??

In the initial years the SIP corpus is small and while the volatility of equities continues to keep the corpus volatile, the impact on an absolute basis is to a great extent manageable provided you have a long investment time frame and reasonable confidence on the fund.

But as time progresses, the compounding effect comes into play and your corpus also becomes sizable. The sizable corpus is 100% invested in equities irrespective of the market conditions which implies a 2008 like crisis can have a significant impact on the overall portfolio and most importantly to your sleep 😦

As portfolio crosses the threshold, shift to an Asset Allocation Strategy

So the key is to decide a threshold corpus beyond which we will move the existing corpus into an asset allocation strategy (a mix of debt, equity and gold based on the time period left).

While a temporary loss (provided you don’t panic and sell) of 50 lakhs might be ok for someone, I might be able to withstand only say Rs 30 lakhs.

The ability to withstand a decline is different for different people..

So how do we decide the threshold level ??

As a thumb rule, equity investors must be prepared for a temporary decline of 50%  as evidenced for the Indian equity market history and as seen in other global markets. Now generally losses for human beings are not in % terms but in absolute value terms. So a 50% decline on Rs 10,000 is qualitatively significantly different from the same 50% decline on Rs 10 lakhs.

I personally would like to evaluate my investment corpus in terms of my annual income.

So let us assume someone earns Rs 5 lakhs per year. He has managed to save around Rs 30 lakhs. Now a 50% decline will imply a Rs 15 lakh fall. But a better way of appreciating the true impact is to view it as his 3 years of hard work vanishing on a computer screen in just 6 months !!

I would be ok to handle a temporary loss of up to 2.5 years of my annual income in promise of higher returns in the future. So that implies I am ok with a 100% equity exposure till my corpus reaches 5x my annual salary.

Now different people will have different tolerance levels.

You can decide on your tolerance levels based on years of your annual income which you don’t mind seeing a temporary loss.

Summing it up,

As a quick rule of thumb, you may keep approximately 5x your annual income as a threshold for your equity SIPs (or adjust it based on your risk taking ability).

The moment it crosses the threshold you will need to start actively managing the equity exposure i,e follow an asset allocation with debt, equity and gold (will write a separate post on how we can do that). So when you are running an SIP in equity mutual funds, make sure you set your threshold.