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Investing in India - Honest Truth by Ajit Dayal
Don't confuse "bouncing" share prices with "risk" A  A  A
PRINTER FRIENDLY | ARCHIVES
4 APRIL 2012


The most respected and sophisticated investors confuse the tendency of share prices to bounce or buzz up and down with risk. A bounce suggests a natural sequential down-up-down pattern and may only interest those who study technicals - the chartists. The random buzzing movement interest the more mathematically inclined.

Give me "Vol", baby!

Firstly, "bouncing up and down" or "buzzing around" are terribly unsophisticated phrases to describe the upward or downward movement that share prices are subject to every second. So there is a better name for it: "volatility".

Volatility sounds a lot more respectable. In fact, if you say "vol" it sounds even more sophisticated.

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Having added a new word to the lexicon of investing, the creative financial engineer then starts to work out "standard deviations", "mean", "variances" and many other data points. I confess that most of these data points cause me, as a boring long term investor, to lose interest. Not being a CFA and not being schooled in the new "science" of investing, my eyes tend to glaze and my brain tends to fuzz over these concepts. I tune off.

However, these data points assume a lot of significance if you are a short term engineer trying to "eat", "neutralise", or "buy" volatility. When broached with such subjects, I try to picture a child trying to catch a fly as it buzzes randomly around. Or punch the fly in the face as it dashes all around in seemingly endless directions - changing course at will. Since share prices tend to buzz around I figure it must be difficult to predict how to eat, buy, or trade the "vol".

TABLE 1: "Vol" of ICICI, HDFC, and Gold
Security Annualized Standard Deviation*
ICICI Bank 47.70%
HDFC 41.80%
Gold 20.70%
This note is only for the mathematical investors: Annualized Standard Deviation calculated using standard deviation of daily returns and assuming 250 trading days in a calendar year. Period used for calculation is from January 2005 to March 2012.

Graphically, all the means is that ICICI jumps around more than HDFC and they both have jumped around a lot more than gold.

Graph 1: ICICI's volatility (day on day change in price)
ICICI's volatility
Source: Bloomberg

Graph 2: HDFC's volatility (day on day change in price)
HDFC's volatility
Source: Bloomberg

Graph 3: the lower volatility of gold (day on day change in price)
The lower volatility of gold
Source: Bloomberg

Don't give me risk

Long term investor should not worry about this bouncing and buzzing around of share prices (I find it difficult to use that sophisticated "v" word - bouncing and buzzing sound so much more lively!). Long term investors should only worry about risk. And risk can broadly be categorised as:
  1. Ability of managements to handle any business environment:
    As a long term investor, I am investing in a business - in the management's ability to grow that business across different economic cycles. There may be periods of high economic growth, or low economic growth. There may be periods of high inflation or low inflation. There may be periods of high interest rates or low interest rates. There may be periods of intense competition or low competition. There may be periods when a country is led by jelly-like leaders or there may be a period when a Minister stands up and says he is "doing this for India" and gets eliminated ruthlessly. Basically, the business environment changes frequently and I have one overriding question and concern: does the management know how to steer their ship across these changing business environments?

  2. The risk of taking on debt to fuel growth:
    In addition to the steadfast hand of the management team, I am keen to know their long term business plans and how much debt they are piling on to show future growth. Many companies like Pantaloon, Suzlon, and the real estate developers took on a lot of debt to grow their businesses. All this was fine and dandy when money was plentiful and cheap for the small companies. But these days money is only plentiful for the big financial institutions and those with connections - they cannot be allowed to fail. Money is not so plentiful for the small and less-connected and, if available, money is expensive. A company taking on debt may not show up in any "vol" chart but it should raise a red flag for further examination if you are a long term investor.

  3. How sustainable is the profitability:
    So even if we have good managements running low-debt companies, investors need to evaluate how profitable the business can be in the long run. Is there a risk of new competition that could lead to a price war and margin pressure? Is there a risk of new innovations that can destroy the business and hurt long term margins? Will the Nano kill the demand for 2-wheelers? Will a focus on trains and trams kill the demand for cars? Will the desire to dress like westerners create a demand for jeans and kill the demand for dhotis? The "vol" charts do not show these risks.

  4. Will the management be fair with minorities and share profits equally once they exist?
    There are quite a few managements that use our capital to help build businesses but then, once the business is built, they feel it is their birth right to get something extra. For example, the founders of Ranbaxy got a higher price for their shares than all the other shareholders. Why? The day their father did the IPO, we all took on the same risk by being owners of equity shares. As people working in the company, the "shareholder manager" is fully entitled to earn a salary and bonuses. But nothing beyond that. All shareholders must get the same dividend and the same price for their shares. Sometimes managements take money as marketing fees or sometimes they take it in purely fraudulent or questionable manners. No "vol" chart shows that.
HDFC, ICICI, and gold?

Which of the two financial firms (HDFC or ICICI) is "riskier"?
Well, in my opinion it would be ICICI. I think Mr Kamath did a wonderful job of trying to break away from the 3-pack team of the Development Financial Institutions (ICICI, IDBI, and IFCI) which had given loans to dead industries with live hot political connections. Since these loans had turned "bad", ICICI was basically bust. Kamath took a U-turn and charted ICICI on a course to make it a big retail and corporate bank. It is now a power house in the financial field.

But, in the process of focusing on growth, it is possible that the quality of ICICI's loan portfolio may have suffered. True, since its near-escape in the aftermath of the Lehman crisis, ICICI is steering a course to ensure better quality of loans. But the past is still there in its loan books and needs time to work itself out. The thousands of people empowered to aggressively sell you a pre-approved loan to buy a home are still on the company's employment rolls. Their aggression may be tamed in action, but is it tamed in spirit?

HDFC, on the other hand, was willing to lose market share and not chase businesses that could potentially become bad loans. Growth in loans given and market share was not their objective; risk-adjusted profitability was their goal. HDFC has a lower "vol" than ICICI Bank but, in my opinion, it has far lower risk than the "vol" suggests.

Gold, on the other hand has the lowest "vol". Does that mean it has no risk? Much as I am a believer in gold and still suggest that investors must own a decent chunk (see the table at the end of the article), it would be wrong to ignore the risk of owning gold. Recently the Indian government has increased the import tariffs on gold. The Finance Minister has said that gold is wasteful. Everyone in power says it is "unproductive". Could they ban owning gold? Could they limit how much gold we own? They have done so in the past via the Gold Control Act. And in Mao's China, the ownership of gold was banned. There is a less extreme risk to gold than banning its ownership: what if central bankers in the US and Europe actually reduced the supply of their paper currencies? It may happen. Anything is possible: even a jelly-filled leader of a nation can find a spine to stand up and re-introduce a hike in passenger fares. So, yes, it is also (im)possible for central banks to behave more respectably and protect the value of their sovereign currencies.

So enjoy the "vol" charts but don't let them fool you into believing they capture "risk". They are just as deceptive a gauge of true love as a husband telling his wife, "Yes, dear" or a wife promising to stand by her husband!

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Disclaimer: The Honest Truth is authored by Ajit Dayal. Ajit is a Director at Quantum Advisors Pvt. Ltd and Quantum Asset Management Company Pvt. Ltd. The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and has not been authenticated by any statutory authority. The author, Equitymaster, Quantum AMC and Quantum Advisors do not claim it to be accurate nor accept any responsibility for the same. Please read the detailed Terms of Use of the web site. To write to Ajit, please click here.


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1 Responses to "Don't confuse "bouncing" share prices with "risk""
vaichanka
Apr 4, 2012
Even a long term has to sell sometime. If at such time, the stock is down due to 'buzz up and down', he stands to realise much lower sum. This is particularly important for a stock having high 'vol'.
I therefore feel that it is important to invest not only in good companies run well by managements but also to reduce risk of receiving much less than one should get by choosing stocks with lower 'vol'
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