What no one told you about the mind blowing mid and small cap returns

Lately, I have been receiving a lot of mails on whether this is the right time to invest in mid and small caps.

The reason why some of you think I might be able to predict is because of this earlier warning that I had given during January in my post –

Seat Belts, Condoms and the Indian Equity Investor

Now to be honest, I had no freaking clue that such a sharp mid and small cap fall was coming post that. If you read that article, I had just indicated that people were forgetting the risk part and focusing only on the returns which is not a great place to be. Inevitably when people forget risk and become aggressive something always goes wrong. The timing was luckily correct but that has nothing to do with my ability to forecast.

If the crash had come say 2 years later (which was of course possible) I would have looked really dumb. The tough part of risk is that you can only approximately and qualitatively evaluate the extent of risk but cannot exactly time the trigger which will cause it to play out.

So now that you know my capabilities to predict and that I was just plain lucky, let us delve into some interesting but often ignored aspects of the mid and small returns of the past 5 years.

Why is everyone interested in only Mid and Small Caps?

Have a look at the below table which indicates the past 5 year returns in Mid and Small cap funds

5Y returns.png

Source: Value Research

Now we are like..

business-2836658_640.jpg

Wow! That’s 25% returns every year for the last 5 years!

My bloody FD gives me 7-8% and that too the government puts a tax and takes a portion away!

It’s time for equities and let me jump into mid and small caps!

Hang on..Pause and take a deep breath

Let us revisit our mind voice again

Wow! That’s 25% returns every year for the last 5 years!

This conclusion from our impatient mind is the single most important reason why most of us end up having a bad experience in equities.

The real question to ask:

Is it really 25% every year?

Let us explore..

Mid Cap Fund Returns.png

Just take a minute to go through the returns of each and every year which led to the 24-27% returns in mid and small cap funds.

Do you see the catch?

The mind blowing returns of mid and small cap returns were primarily driven by the returns in 2014 where they had outperformed every other category by a huge margin.

To put that in perspective, a return of 73% and 87% in single year contributes ~20% to 23% CAGR for all 3 year periods which include 2014. Similarly, the single year return contributes 12-13% CAGR for all 5 year periods which include 2014!

Now to make things clear, let us see what happened if you missed out on 2014 and started to invest only from 2015.

Mid Cap Fund Returns -1.png

Oops! What happened to the mind blowing out performance?

The returns of mid and small cap category is almost in line with large and mid, multi cap and large cap category!

So the key here is that, to really have experienced the 25% returns on which you are being sold, you must have invested in 2013.

Back to 2013..

Let us rewind back to 2013,

Mid Cap Fund Returns in 2013.png

At the index level, mid and small cap segment had been hammered.

The newspapers scared the shit out of you.

Scary Headlines.png

The past mid and small cap fund returns while not as bad as the index, weren’t great either (an FD would have given better returns – your mind voice would have argued).

2013 mid cap fund returnss.png

Now do you seriously think you would have invested in mid and small cap segment just before the 2014 rise.

As expected, all of us were running out of equities leave alone mid and small caps in 2012-13 which in retrospect seems to be the best year to invest.

Past performance always needs to be put under context

This is the reality of equity investing.

The actual mid and small cap out performance came when everyone had given up and the past returns were pathetic.

Misled by the poor past returns, unfortunately most of us didn’t invest in mid and small caps when it really mattered.

This holds an important lesson for us as investors:

No investment style or approach will outperform at all points in time. The sooner we accept this, the better our investment experience would be.

Based on the changing market conditions, various investment styles usually find favor at different points in time.

Mid and small caps after several years of dismal performance had finally found favor in 2014 as the market conditions favored that particular style.

But as we all know, market conditions inevitably change and some other different style or approach will find favor. Last year was an example for this as mid and small caps have corrected while the large caps did well.

Thus, to predict the future winners, the real ask is to identify the future market conditions and not the past market conditions which led to the current winners.

Unfortunately, the future market condition has several possibilities (what ifs) and no one knows, which of the market conditions will really play out, when it will play out and how long it will play out.

Let us take the example of mid and small cap segment.

In 2014, the returns were primarily driven by valuation multiples expanding as BJP won the elections and there were huge expectations of reforms.

In 2017, the returns were again primarily driven by valuation multiples expanding as demonetization led to money moving away from real estate and gold to equities.

Now honestly it is not possible to have predicted both these events.

So what do we do?

Now while we cannot predict the future market conditions, not everything is lost.

Instead of trying to predict the future market conditions, we can evaluate for signs of where we are in the cycle (partly art, partly science) and take a call on when to increase our exposure to mid and small caps.

Usually bad past returns, scary headlines, weak earnings growth over the past few years, no investor interest and attractive valuations are a good starting point to evaluate a particular investment style. The vice versa case holds good as well!

The mid and small cap category ticked all of the above in 2013 –

  1. Valuations were very attractive
  2. Earnings growth was yet to play out
  3. Headlines were scary
  4. Investor interest was zilch
  5. Past returns were bad

We were somewhere close to the bottom of the mid cap cycle and this was the time to be aggressive.

A lot of fund managers such as Kenneth Andrade , Sankaran Naren, Krishnakumar etc were able to identify this cycle.

In fact in the mid of 2013 at my organization we had asked our clients to invest in mid and small caps and had invested in a lot of the closed ended series which came at that point in time.

We knew the “Why” but not the “When”.

We were lucky that the call immediately played out and looked like we were extremely smart. But who knows, in an alternate version of history BJP may have not won the election and the mid cap rally could have been delayed. The trigger might have been something completely different. But since we had the odds in our favor we just had to patiently wait for a positive trigger to strike.

However post that we started reducing our allocation starting mid of 2015 as valuations were becoming unattractive (at least according to us). Unfortunately it took 3 years for our call to play out. And we looked extremely dumb till 9 months back.

This is the tough part of investing.

In the short run, there are hundreds of parameters which impact the markets and decide the investment environment. However in the long run, eventually it boils down to valuations and earnings growth.

Summing it up

So the whole idea is to keep this in mind and..

  • Diversify across various styles – large, mid and small + value/growth/quality + international/domestic etc. Across shorter time frames inevitably there will be few styles which will find favor and will keep alternating. In the long run, the returns across proven investment styles will mostly work out to be close to each other and will provide you with a comfortable journey.
  • Do not take exposure to various investment styles or approaches purely based on high past returns
  • Keep looking out for risk (read as pockets of overvaluation) and start reducing exposure
  • Valuations, earnings growth expectation, investor sentiments, flows can be used to calibrate the proportion of investments to these various investment styles or approaches

As for what to do with mid and small caps, that’s a topic for another day.

Happy investing!

If you loved what you just read, you can check out all my other articles here

Also do share it with your friends and don’t forget to subscribe to the blog along with the 5000+ awesome people. Look out for some fresh, super interesting investment insights delivered straight to your inbox.
If in case you have any feedback or need any help regarding your investments or want me to write about something, feel free to get in touch at rarun86@gmail.com
Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments.

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How to select equity mutual funds the Eighty Twenty Investor way – Part 3

10 minute read

In the first two articles of this series (part 1, part 2) we had selected fund managers for both the investment styles – Value and the Growth/Quality bucket.

Final List

In today’s article, we will choose fund managers for the “Blended” investment style bucket i.e a mix of both value and growth/quality.

UTI Mutual Fund – Vetri Subramaniam – UTI Value Opportunities Fund

th18BUUTI.jpg

Vetri Subramaniam is the CIO of UTI Mutual Fund and he manages the fund UTI Value Opportunities. He is a veteran with 24 years of work experience. Phew, I was an 8 year old kid playing video games when he started his career!

Prior to joining UTI in January 2017 he was the Chief Investment officer at Invesco Asset Management Ltd. He was part of the start-up team at Invesco (then Religare Asset Management) in 2008 and helped establish the firm’s investment process and the team. During his tenure, the firm established a strong track record.

The firm also launched several offshore funds investing into India from Japan, Mauritius & Luxembourg.

4  Vetri Subramaniam   LinkedIn.png

Source: Linkedin Profile

We need to keep in mind that he joined UTI only in the beginning of 2017 and hence UTI Value Opportunities fund’s long term performance won’t be relevant to evaluate his style.

What is his investment style?

  • Core Philosophy – Buy something cheap relative to expectations
  • Focus on two types of “value” (read as mix of value and quality/growth)
    • High quality companies with slightly higher valuations – as market may be under appreciating the sustainability of competitive advantages and/or the length of the growth runway for the company. These companies defy the norm of cyclicality and reversion to mean.
    • Companies experiencing temporary challenges due to cyclical factors, changes in the environment or their own past actions. But if the core business is healthy and a path to a better future (cash flows, return ratios) is visible then their depressed valuations offer an attractive entry point.
  • Combines both stock level analysis and sector level calls to build portfolio

Investment Strategy

I prefer to manage the portfolio with all positions carrying an active positive weight. That is to say if the fund owns a company that is in the benchmark index – the position in the fund would be in excess of the benchmark weightage i.e overweight. Otherwise the position would be zero. In other words the strategy would either be overweight an index stock or have a zero position. As for stocks that are in the fund but not in the benchmark, it is by definition an overweight position.

As a result the active risk in the strategy is high and performance deviation relative to the benchmark can also be high. This higher risk is consistent with a strategy targeting a higher Alpha.

For a detailed understanding you can refer the below links..

https://www.utimf.com/articles/q-a-with-fund-manager-vetri-subramaniam

http://beyondbasics.wai.in/the-investment-philosophy-of-vetri-subramaniam/

You can also refer to all his interviews here

Wow Factors

  • 24 years of experience
  • Clearly defined strategy – active position weights (refer above)
  • Clear communication via the AMC website
  • Strong performance track record in his earlier fund – Invesco Contra fund

Performance across market cycles

Since he managed the Invesco Contra fund from Jun-2008 till Jan-2017, I have listed the top performers for that period (excluding mid and small cap funds)

Point to Point Returns   Vetri.png

Now unfortunately, all funds in the list except Mirae Asset India Opportunities, BNP Paribas Multicap, Invesco India Contra Fund and Reliance Multicap were running mid/small cap strategies due to which their performance is not comparable.

So if we exclude them and consider only the flexi cap strategies, the fund was the amongst the top 5 performers.

Invesco India Contra Fund Growth   Mutual Fund Performance Analysis.png

Further the performance has also been reasonably consistent.

Also he has started to turn around the performance of UTI Value Opportunities fund which he has recently taken over.

UTI Value Opportunities Fund Regular Plan Growth   Mutual Fund Performance Analysis.png

Communication

All communications on the investment philosophy and strategy is available in their website thereby making our life easier
https://www.utimf.com/articles/?filter-type=category&filter-value=blog

Concerns

  • Top Management is unstable: The leadership is still not stable, with a divided board on who should take control. The CEO also quit this month. Read here.
  • Contrarian bets might take longer than expected to play out

My View

  • This fund will fit perfectly in the blended portion of the style spectrum as it combines both the value and the quality/growth styles.
  • The fund manager has been in the markets for 24 years and has experienced several cycles.
  • The fund house clearly communicates its strategy and I hope they will continue to proactively communicate even while the style is out of favor
  • The track record in the earlier fund (Invesco Contra Fund) has been very good and there are signs of performance turnaround in his currently managed fund – UTI Value Opportunities
  • Summing it up, Vetri is a solid and grounded fund manager with tremendous experience and good track record. Hence I am adding him to my final list in the blended style bucket.

IDFC Mutual Fund –  Anoop Bhaskar – IDFC Core Equity Fund

0b6b4fb1284eb6ca7886287f3d1a8a56_385_650.jpg

For those hearing his name for the first time, here is a detailed article on his investment journey.

https://i1.wp.com/www.forbesindia.com/media/images/2013/Jun/img_70387_uti.jpg

Post this, he joined IDFC Mutual fund in Feb-2016

What is his investment style?

  • Quality stocks + Stable growth + moderate valuations (you can read about the logic behind this thought process hereIDFC Core Equity - Stock Selection Process.png
  • Flexible in moving across Large, mid and small caps based on the market environment
  • Key focus – To limit downside and still participate in market rallies
  • Usually has very diversified portfolios with large no of stocks – earlier portfolios used have more than 80-90 stocks.
  • Let us hear it in his own words “The way to look at concentration is to look at the number of sectors in the portfolio, rather than the number of stocks. Now, if I decide to own tyre companies, I may prefer to own three-four tyre stocks at 2-2.5 per cent each instead of one stock at 9 per cent. That controls liquidity risk” Source: Value Research Interview

“I try to buy companies where the growth is higher than what the market is forecasting and where valuations on a relative basis are comparable” – Anoop Bhaskar

Wow Factors

  • Has been managing mutual funds since 2004 – 14 years of real time fund management experience (one amongst the longest in the Industry)
  • Solid track record in his previous tenures at various AMCs- Sundaram Mutual Fund, UTI Mutual Fund
  • Conservative by nature – never takes concentration bets in stocks + he does not push his luck too far by staying overexposed to a high-performing stock – Source: Forbes interview)

Performance across market cycles

He joined UTI AMC in April 2007 and served till January 2016

Anoop Bhaskar - UTI Equity.png

Source: Value Research

As seen above, both his funds UTI Value Opportunities (started managing from mid of 2011) and UTI Equity Fund have been in the top 10 flexi and large cap funds during his period in UTI.

In his earlier stint in Sundaram AMC, he managed the Sundaram Mid Cap fund. Between 2003 and 2007, the Sundaram Select Mid-Cap Fund’s NAV grew on average by 74% every year and was amongst the most popular funds of that time.

Thus he has built a solid long term track record across his career.

Communication

  • Anoop gets interviewed regularly and the interviews are easily found via ValueResearch, Morningstar, Outlook Business etc.
  • IDFC AMC website communicates reasonably well on the investment philosophy and strategy
  • The best part is, they are extremely pro-active and communicate immediately if in case of any performance issues

Concerns

  • Difficult to track: While it has worked historically, the fact that there are a large no of stocks means, it is impossible for us to understand the strategy (unless communicated). If in case of an under performance it is too difficult to pinpoint the cause unlike a concentrated fund where it is much easier to track. So our ability to hold the fund is based on the faith on the fund manager and the trust that they would communicate in plain english if something goes wrong
  • AMC might get sold: There is a possibility that the AMC might get sold. So the continuity of the fund management team will be the key to watch out for if in case something like that happens. You can read more about it here
  • The investment philosophy is not static and adapts to market conditions
    • “I don’t have a core investment philosophy that remains stagnant across different market phases. Instead, I would rather say that my core philosophy is based on a few principles; the importance given to each individual principle varies across different market phases.”
    • “One has to decide what percentage of the portfolio they want to take a higher risk on. And depending on the 6-12 month view on the market, that percentage can change up or down.”
  • This is a lot easier said than done as constantly evaluating the next 1-2 years and positioning the portfolio is very difficult. Their recent note highlights this

Source: https://www.morningstar.in/posts/46379/anoop-bhaskar-relevant-money-manager.aspx

My View

  • This fund will fit perfectly in the blended portion of the style spectrum as it combines both the value and the quality/growth styles
  • The fund manager has been in the mutual fund industry managing funds for 14+ years and has successfully navigated several cycles.
  • The fund house clearly communicates its strategy both during good and bad times
  • The track record in the earlier fund (UTI Equity) has been very good and there are signs of performance turnaround in his currently managed fund – IDFC Core Equity Fund
  • Summing it up, Anoop is a grounded fund manager with tremendous experience and solid long term track record. Hence I am adding him to my final list in the blended style bucket.

Now that we are done with selecting fund managers for all the style categories, let us see the final list

Eighty Twenty Investor - Final Fund Selection.png

Thus we have 5 funds representing various investment styles.

Now typically a good equity portfolio will need 3-4 funds. So you can pick your funds from each of the styles and create your own portfolio.

In the next week, I will choose a few funds from the above list and will be starting a live SIP portfolio where I will be investing my own money every month. (otherwise all this will still remain mumbo jumbo)

Till then, cheers and happy investing 🙂

If you loved what you just read, share it with your friends and don’t forget to subscribe to the blog along with the 4500+ awesome people. Look out for some fresh, super interesting investment insights delivered straight to your inbox.

If in case you have any feedback or need any help regarding your investments or want me to write about something, feel free to get in touch at rarun86@gmail.com

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

Dude, Shall I cut my equity exposure?

5 minute read

Last week a friend of mine, who had read my recent rants on the need to focus on risks over returns at the current juncture called me up.

Dude, shall I cut my equity exposure? Looks like the markets are correcting and as you mentioned valuations are also expensive!”

I am sure most of us are grappling through the same issue. Let us see if we can find an answer to this million dollar question..

I personally think the markets are slightly expensive and the global interest rate scene is extremely uncomfortable for me. So there is an inherent itch in me to play it “cute” – Should I take out some money and park it into safe assets such as debt funds and get back in post a correction.

My first investment mistake..

Thankfully, I have already gone through this question 5 years back during the 2013 crash due to taper tantrum. And this is also when I made my first it-can’t-get-dumber than this mistake.

SENSEX    BSE Sensex  Sensex Index  Live Sensex Index  Sensex Stocks.png

In 2013, around May the US Fed had announced that they were planning to gradually reverse their quantitative easing programme (read as no more money printing).

The Indian equity markets were down by 10% and the Indian currency had moved from 53 to 66 levels! India was classified as fragile 5.

It was the “shit-hit-the-ceiling moment” for me.

Being the dumb me, I poured over various brokerage reports and not to be surprised, all of them scared the daylights out of me.

And if you haven’t guessed it till now – yours faithfully panicked!

Yep, despite all the support system I had in terms of a great organization, access to best fund managers, intelligent colleagues, sophisticated market data and analysis subscriptions which cost a bomb, still I panicked!

I sold of 30% of my equity allocation and stayed in cash. And you know what happened next.

The markets recovered!

And thankfully, I did enter back. But by the time I entered back all my stocks were above my selling price 😦

What was the learning?

Look out for a better market timing model and figure out various factors which impact the equity markets..blah..blah

Grr..not again..but thankfully, common sense prevailed over my intellectual enthusiasm.

The solution was not a better timing model. It was far more simpler as a how-did-it-not-strike-me-earlier-kinda insight stuck me.

I realized that I was still in my 30’s and had a hell a lot more years of earnings and savings to be invested!

This meant that my current corpus was a paltry amount compared to the expected corpus 15-20 years down the line. So the real question was – why all this market timing drama at this stage?

Understanding Human Capital vs Financial Capital..

To help you appreciate the true dumbness of my blunder, let me introduce you the concept of – Human Capital vs Financial Capital

Human Capital is simply the amount of money you are yet to earn using skills, knowledge and experience, over the course of the rest of our lives. The more skills/knowledge/experience you have, the higher your human capital.

In Indian context, assuming most of us retire at around 60 to 65, human capital is what we are yet to earn till we are 60 to 65. So your human capital is at the maximum when we start working and diminishes as we near our retirement.

 On the other hand, financial capital is basically the sum of all of your assets minus your debts – i.e your net worth. In my case since I don’t have debt or real estate, my financial capital is in effect my entire investment portfolio value.

Financial capital is the inverse of human capital where usually, it’s lower when you’re younger and gradually grows till you reach retirement.

pharmacits-human-capital-chart-v31.jpg

Source: http://pharmacistsfirst.com/pharmacists-most-overlooked-asset/

Now you can clearly see that, my real blunder was that, I had completely ignored the invisible part of my portfoliomy human capital – i.e the savings from my earnings over the next 20-30 years!

If I had framed my portfolio value taking into account my overall potential future portfolio (taking into account my future earnings), my current portfolio size would have been minuscule compared to the 30 years of earnings and savings left.

Suddenly I would have realized that, all I needed to do was to shut the f**k up and focus on saving and investing regularly in the initial stages.

This would have allowed me to keep it simple and stick to a 100% equity portfolio – instead of trying to time the market.

Re-frame your portfolio..

The table tells us how an investment of Rs 10,000 every month which is increased by 5% every year and provides a return of 15% will fare over different time periods.

Future Portfolio Estimates.png

Refer here for a detailed explanation

The first thing for you to do if you are young is to roughly approximate your  portfolio value 15-20 years down the line. (Assuming you want to become financially independent a lot earlier than your 60s)

If you do a monthly investment of Rs 10,000 and assuming that you increase it by at least 5% in every year at 15% expected returns (from equities), you will end up with Rs 80 lakhs in the next 15 years and Rs 1.8 cr after 20 years.

So based on your monthly savings that you currently do, you can have a rough estimate of the portfolio value after say 15-20 years.

This would put in perspective your current portfolio and will help you put possible market corrections in the right perspective.

For Eg: The moment I put my current entire 100% equity portfolio as a % of the final value after 15 years it works out to be just around 6%.  With this sudden shift in frame, the answer to “Should I act cute and try asset allocation strategies with just 6% of my targeted corpus” becomes obviously simple.

A lot of us (I am no exception) end up doing this mistake of overthinking, analyzing and trying to act extra cute during the initial years of wealth building where in reality, its predominantly our ability to earn and save which really matters initially.

Keep it simple..

Since my friend is in the same boat as me, our solution became a lot simpler.

Let us not act cute. We shall just stay put and ride the volatility out (however painful it may be).

Also if we don’t test and understand our behavior (ability to withstand declines) now at a smaller corpus, then at a larger corpus it may become too late.

But obviously as our portfolio grows in size, we will reach a point in time, where the returns from our portfolio is much larger than the incremental savings. This is the point where an SIP or monthly investing does little to address overall portfolio volatility (as the 100% equity portfolio has significantly grown in size and a 50% temporary decline like that in 2008 can emotionally derail us from equities forever. You can read more about this here)

So I have a simple thumb rule – only when my portfolio size crosses 5 times my yearly salary will I start attempting to be cute and implement an asset allocation strategy. (You can fix your own cut-off no based on the no of years of salary you wont mind seeing in red during a temporary (hopefully) market decline). Logic being at a larger size, protecting my existing portfolio becomes as important as making it grow!

Till then, let the people with large corpus of money worry about asset allocation, market timing etc while we relax, focus on our careers and continue investing regularly.

Image result for simple

Summing it up

  • In your 20’s and 30’s, a long investment time horizon & large human capital are the biggest advantage you have
  • To take advantage of this, go for a equity heavy portfolio (assuming you have your short term requirements sorted through safer avenues such as fixed income funds, FD etc)
  • A high equity allocation also comes with the caveat that you must be mentally prepared for a 50% correction once in 5-7 years, 25-30% correction once every 3 years and 10% correction every year (all these are rough estimates and not cast in stone)
  • Your portfolios might look risky because of high equity exposure, however, if you take into account the potential future portfolio size, the current portfolio will usually be minuscule in the context of future portfolio size
  • So even if your investment capital falls by 50%, if you frame it as a % of your total expected future portfolio, the fall would only be a few % points because you still have another 20-30 years of human capital left
  • Your ability to earn and save dwarfs the loss in your portfolio
  • So, in the initial stages of your investing, focus on things under your control – career & earnings, spending & savings pattern, regular investing and hanging on to the portfolio (not getting knocked off by intermittent scary declines)
  • During initial stages of wealth building, don’t complicate life by getting into the nuances of market timing, asset allocation calls etc (which you will save for another day when your investment portfolio has grown reasonably large)
  • Try and automate your savings & investing habits to large extent – keeping decisions to the minimum

Happy investing folks 🙂

If you loved what you just read, share it with your friends and don’t forget to subscribe to the blog along with the 3500+ awesome people. Look out for some free super interesting investment insights delivered straight to your inbox. Cheers 🙂

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

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

10 minute read

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

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

Source:AMFI, Link

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

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

All this is good.

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

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

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

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

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

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

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

And yes, here is the shocker –

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

How is that possible?

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

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


Never forget the underlying equity portfolio

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

Untitled.png

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

But what is the blue and green component?

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

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

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

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

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

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

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

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

Progression.png

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

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

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

SIP Returns.png

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

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

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

Let us check..

CY Returns.png

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

What does this mean for us?

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

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

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

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

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

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

Unlucky SIP Investors

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

Let me guess your magic words..

“Boss..Hang on for a few more years”

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

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

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

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

Any other solution?

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

Summing it up

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

 

 

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