Stock Investing: From Risky to Safe

Oct 10, 2015

In this issue:
» Public sector banks see big FII sell-off
» Should you avoid companies with such independent directors?
» How the markets performed during the week
» ....and more!

While most endeavours in life have some element of risk attached to them, investing in stocks is considered a particularly risky affair. Does this surprise me? Not at all!

The market crashes, the scams, the gut-wrenching swings in stock prices, stories of huge losses...all these have a way of scaring away even the most courageous of souls. It is little wonder that the average person considers the stock market amongst the most perilous of places.

But what if I told you that there was a way to significantly cut down the risks in stock investments? And that investors who have stumbled upon this technique have been able to make pots and pots of money consistently over decades without much risk...

Warren Buffett has been using this technique for more than 60 years. Buffett learned the technique from Benjamin Graham and incorporates it into every single investment decision he makes. It's indispensible for him. For the uninitiated, Buffett studied and later worked under Graham. Buffett has time-and-again said that if you pay special attention to Graham's invaluable advice in this regard, you will not get a poor result from your investments.

Just what is this technique? Let me warn you: It's deceptively simple yet astonishingly powerful.

Simply put, this is how it works: You value a business's stock to the best of your understanding based on what its future will to look like. However - and here's where many investors go wrong - you do not buy it at such a value! Why is that? Because, like our own lives, the life of a business is not predictable to any high level of precision. Thus, you buy the business only when it is available at a price well below what you've valued it at. That difference between the price and value is your safety margin. As Graham says, 'It is available for absorbing the effect of miscalculations or worse than average luck.'

Yes, it is that simple. But sticking to this principle with discipline is not. Not letting yourself get tempted to stray from it, especially during the good times when every tom-dick-and-harry is making money, is not simple. But for disciplined investors, investing in the stock market can become a whole lot safer. Over the long term, it will keep your capital safe from most of the nasty stuff that goes on in the market.

Always invest with Graham's 'margin of safety' technique in mind. As simple as the concept is, you will come to realise its power to deliver profitable results over your investing lifetime. Buffett surely did!

Do you think you can use this technique to keep your investments in stocks safe? Let us know your comments or share your views in the Equitymaster Club.

 Chart of the day
Given that 40% of the free float shares are held by foreign institutional investors (FIIs), this category of investors highly influences the market. And considering FIIs sold nearly US$ 2.6 billion (net) worth of shares in the quarter ended September 2015 (the most since 2008) - a period in which the BSE-500 index fluctuated between 11,386 and 9,990 points in a matter of weeks - it gives an indication of how they can influence stock price movements in the short term.

When it comes to sectors, it seems that the PSU banking stocks are being less favoured by this category of investors. FIIs are believed to have trimmed down stake in the major PSU banks in the range of 50 to as much as 500 basis points in a matter of one year. As reported by the Mint, the sharpest decline was seen in Andhra Bank (494 basis points), Bank of Baroda (491) and Punjab National Bank (440 basis points). As the business daily points out, the lack of improvement in NPAs is the key reason for investors' losing faith in such stocks.

Vivek Kaul, the India Editor of the Daily Reckoning, had recently pointed out the two key issues that are lurking in this area. First being the high proportion of restructured loans becoming bad loans; second being the strong need for capitalisation, which the government may find difficult to do. In short, a comprehensive plan is required to solve the mess in the Indian public sector banking space.

FIIs file out of public sector banks

India, has not had a clean record, when it comes to misdoings in the corporate world. The Harshad Mehta scam and the Satyam fiasco are some of the biggest scandals that immediately come to mind. The good news though is that regulatory authorities both for the stock markets and for corporate India are looking to plug holes and make the system more conducive in protecting the interests of minority shareholders. One such area is the role of the independent director and the maximum tenure for which he can hold this position. An interesting article has been published in the Mint regarding this. The article has highlighted how Mr Rajendra Ambalal Shah, 84 years old and senior partner at Crawford Bayley and Co (one of India's oldest law firms) has been on the board of 10 publicly listed companies. More importantly, for a lot of these companies, he has been on the board for more than 30 years.

In such a situation, the first thought that naturally springs to mind is whether Mr Shah can be really called independent. When you are associated with these companies for so long you are bound to be labeled as an insider. And with such a long association with the management, does the minority shareholder end up getting a raw deal? Further, being a lawyer for these companies, Mr Shah also ends up being an adviser, which then raises the point of conflict of interest. Mr Shah thinks otherwise and believes that ultimately what matters is personal integrity.

Yes, integrity matters a lot. And one need not worry if all independent directors believe in it because then minority shareholders can breathe easy. But, unfortunately, in India making that kind of a blanket assumption is tricky.  Just last year, the new Companies Act came into effect and limits the tenure of independent directors to two terms of five years each. And, in our view, it is a step in the right direction.

The week gone by was quite strong for most of the global equity markets. US markets posted their biggest weekly gains since December 2014. The recent US Federal Reserve meeting indicated a lower probability of a rate hike in the near future. This too spurred the rally across the indices.

European stocks saw strong gains for the week. The stock markets in the UK (up 5.8%) and Germany (up 5.7%) were the top gainers in the weak gone by.

The dovish signals from the US Fed fuelled a rally in the Asian markets too. After a long holiday break, the China stock markets closed the week on a firm footing. On the other hand, crude oil price, capped its biggest weekly gains since August 2015. The crude prices climbed up by around 12% in a week's time.

Back home, the Indian markets too closed on a positive note, posting the highest weekly gains since June 2015. The BSE Sensex was up 3.2% for the week. After the sharp outflows during August and September, the FIIs have infused around Rs 20 billion so far this month.

Among the sectoral indices, stocks from the consumer durables and metals were the top gainers. Stocks from Software sector closed marginally down for the week.

Performance during the week ended 9 October, 2015

 Weekend investing mantra
"You have to have the knowledge to enable you to make a very general estimate about the value of the underlying business. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don't try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing."- Warren Buffett

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This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst).

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2 Responses to "Stock Investing: From Risky to Safe"

K Venkatasubbu

Oct 10, 2015

Hi Rahul, Good guidance on safe investing and how to minimise he risk with margin of safety. Thanks. But please guide us on how to arrive at the a,punt of margin of safety.


T Chakravarty

Oct 10, 2015

Can you illustrate Graham's margin of safety technique with a real life example?

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