Do you buy stocks like groceries or perfumes?

Apr 1, 2015

In this issue:
» The best and worst performers of FY15
» EPFO to now invest in Indian ETFs?
» Exit US stocks says Saxo Bank's Chief Economist
» ...and more!

"Rule No.1: Never lose money. Rule No.2: Never forget rule No.1. " is a very famous quote by Warren Buffett. What it conveys in simple terms is that investors should be more concerned about the return of capital than the return on capital.

How can investors do so? Well, by buying cheap. This means, one should buy into stocks where the downside is well protected; where the risk-reward ratio is in favour of the latter.

And where can you find such stocks? Well... in every market condition actually. There will always be a set of laggards which underperform the broader market on account of various reasons. These could be specific to the company or the sector on the whole. Usually, this would be occurring at a time when there is a lot of noise around the particular stock or sector. And as such, stocks tend to get beaten down so much that they become good investment cases.

Going by historical data, we have time and again seen that the best returns from stocks have usually come from buying into undervalued or cheap businesses. We have in fact written about this multiple times on our site too. Some of the links are:

The strategy being referred to above is what is otherwise popularly known as 'contrarian investing'. In fact, this is the strategy that Rahul Shah (Managing Editor of the Microcap Millionaires Service, our micro cap initiative) and his team use to identify investment opportunities. I asked Rahul Shah to share his view on the concept of contrarian investing earlier today.

This is what he had to say - "There's literally tons of research out there that suggests that buying cheap works in the long term. However, we would caution investors against using the contrarian approach to buy any and every cheap stock. After all being contrarian does not mean that you stand in the way of an oncoming truck when everyone else is getting out of the way. Please understand that often times, markets do correctly predict stocks that are in a phase of permanent decline and have turned value traps. Therefore while low valuations are important, what is equally important is to figure out that the problems facing the stock are temporary in nature and it has a strong chance of a successful turnaround in its operations."

In a nutshell, the approach involves cutting out the noise, identifying cheap but decent businesses, handpicking the best ones, and diversifying risks (by investing equal amounts of money in a portfolio of up to twenty stocks).

What's more is that all this is done keeping in mind the overall valuations of the broader market too. Rahul and his team suggest that as and when the broader markets begin heating up, the overall exposure to stocks needs to come down. And the investments in fixed income instruments should go up. And in cheap markets, it's the opposite strategy that his team suggests; that is of increasing exposure to equities while investment in fixed income instruments should be reduced.

Why fixed instruments? Again, the same logic applies. Going by historical data, it is seen that returns over a three to five year period tend to be lower in cases when investments are made during expensive markets. And thus, it would make sense for an investor to book profits, keep the capital protected and wait a more conducive market situation.

Let us tell you that this strategy has so far worked very well. While the Microcap Millionaires service is just over a year old, overall returns of the portfolio stand at about 65%, thereby outperforming the BSE-Sensex by as much as 71%. Since the launch of the service, the Sensex has gained by about 38%. Please note that this result has been achieved even after keeping more than 50% of the portfolio in fixed income instruments for most part of the duration of this service.

As per us, this is a strong indication that buying decent business that are out of favour (attractive in other words) is an approach that works well...

After all, it was Benjamin Graham who said "If you are shopping for common stocks, choose them the way you would buy groceries, not the way you would buy perfume." A very simple, yet powerful quote.

We would however like to highlight here that subscriptions for Microcap Millionaires are currently closed. However, we will be re-opening the membership soon. Keep an eye out for the announcement.

What are your views on contrarian investing? Is it an approach you have ever taken in the past? Do share your experience. Let us know your comments or share your views in the Equitymaster Club.

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  Chart of the day
Continuing our talk on out of favour businesses, we thought it would be a good idea to draw your attention to worst (and best) performing stocks and indices of FY15 i.e. for the year ending 31st March 2015.

Today's chart of the day shows the returns of all the sectoral indices over the past year. As you can see, the pharmaceutical and consumer durables packs did well while the oil & gas and metals pack underperformed significantly.

FY15: Best and worst performing indices

Moving on to the best and worst performing stocks of FY15 (from the BSE-200 index only), the list goes as follows:

BSE-200: Best and worst performers of FY15
CompanyYoY change
Best 5
Wockhardt Ltd.308%
Ashok Leyland Ltd.210%
Strides Arcolab Ltd.204%
Bharat Forge Ltd.203%
Bharat Electronics Ltd.192%
Worst 5
Reliance Communications Ltd.-54%
Jaiprakash Associates Ltd.-54%
Jindal Steel & Power Ltd.-46%
The Jammu & Kashmir Bank Ltd.-38%
Cairn India Ltd.-36%
Data Source: ACE Equity

Much has been written of the loose monetary policies of the developed world and the wave of liquidity that it has unleashed in the global markets. A lot of this money has been making its way into emerging markets including India. In 2014 specifically, the Indian stock markets soared as foreign money started pouring into Indian equities. This is despite the fact that corporate earnings had still not picked up pace. And now there is likely to be another catalyst that could drive prices.

As reported in the Economic Times, the government is set to allow Employees' Provident Fund Organization (EPFO) to invest upto 5% of its incremental corpus in exchange traded funds. Once this comes into force, as much as Rs 75 bn will find its way into the Indian stock markets. And this could see the prices and valuations of stocks go up. Prima facie, for investors, this is a welcome move with an opportunity to benefit from higher returns.

However, the case for higher returns will only be stronger when corporate earnings begin to grow at a rate that justifies the rise in valuations. Thus, it will be interesting to see how this scenario pans out in the coming months.

The US is another country where there is a big disconnect between the economy and the movement of the indices. Stock markets over a longer term are considered a barometer for the health of the economy. But the US Fed has distorted the markets so much that stock prices are rising even when the US economy is struggling to recover meaningfully. And it is not just the US. Europe and Japan are battling recessionary trends and China too is slowing down. Thus the rise in stock markets has only been the product of too much money in the system. Now there are increasing talks of late that the US Fed is all set to raise interest rates. Should that happen, most likely stock prices will tank.

That is why as reported in Newsmax Finance, Saxo Bank's chief economist is of the view that investors are better off selling off their stocks and holding proceeds as cash. We agree that stocks in the US appear overvalued given that recovery so far has largely been feeble. But will the US Fed actually raise rates? That remains the million dollar question because so far it has not shown any inclination to do so.

After opening the day on a flat note, Indian stocks gained momentum as the day progressed. At the time of writing, the BSE-Sensex was trading higher by about 170 points (0.6%). Barring IT stocks, gains were seen across, led by healthcare and banking stocks.

 Today's investing mantra
"Accounting numbers are the language of business and as such are of enormous help to anyone evaluating the worth of a business and tracking its progress...Managers and owners need to remember, however, that accounting is but an aid to business thinking, never a substitute for it." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Devanshu Sampat and Radhika Pandit.

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1 Responses to "Do you buy stocks like groceries or perfumes?"

Subhashish Dhar

Apr 1, 2015

While the Microcap Millionaires service is just over a year old, overall returns of the portfolio stand at about 65%, thereby outperforming the BSE-Sensex by as much as 71%.
Isn't one year too little a time to check the returns. Probably after 10 years, if the returns beat sensex by 71%, that's something to be proud of.

Equitymaster requests your view! Post a comment on "Do you buy stocks like groceries or perfumes?". Click here!
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