You Won't Beat the Market if You're Doing This...

Oct 13, 2015

In this issue:
» Corporate FDs seem relatively attractive at current juncture
» 1HFY16 sees a five-fold bounce back in IPO market
» ...and more!

It has been more than two years since the market bottomed out in August 2013 and nearly one and a half since the Modi government came to power. Dalal Street does not have too many complaints at this time. Brokers and advisory firms of all sizes are doing good business.

But what about you, the aam investor? Is your portfolio up by 50% since August 2013? The BSE Sensex has gained that much. Most people I talk to do not know the answer. Sadly, that is just the start of their ignorance.

Every bull market draws in retail investors. This is not necessarily bad. Unfortunately, they are always late to the party. Think back to 2007. This was a very bad year to start investing in stocks. Yet, investors pumped a record Rs 470 billion (net) into mutual funds in FY 2007-08.

Many of these people were new to stocks. They suffered horribly during the bear market that followed. Many of them may never invest in stocks again. This is sad but not surprising. The same thing is happening again.

A friend from my college days started trading a few months ago. I asked him about his trading methods. I was appalled when he said that he only brought stocks that trade below Rs 100. He said this was because these stocks were cheap.

I knew I had to intervene. I explained that the price of the stock has nothing to do with how cheap it is. It took me a while to get this message through to him. I told him how to calculate the P/E ratio. But he did not understand why it was important. So, I gave him an example.

My monologue went something like this. You have some money in the bank. You want to earn more than 4% in a savings account. You have the option of putting the money in a fixed deposit (FD). It is safe, and the bank will pay you a fixed interest.

But interest rates are falling. And you don't want to lock up your money for a few years in a FD. You have heard of people making 'quick profits' in the market. So you choose stocks over the FD. But remember, the FD will give you a safe 8% per year. Therefore, you would want to earn much more than that in stocks because stocks are riskier.

You can only do that if you buy stocks that are yielding more than 8%. How do you calculate this yield? By using the P/E ratio of course. In simple terms, the P/E ratio is a measure of how much people are willing to pay for the stock. The more they like a stock, the lower the yield they are willing to accept.

The P/E tells you what the yield is. All you have to do is invert it. For example, if the P/E of a stock is high, let's say 20, the yield is just 5% (i.e. 100/20). Do you really want to buy a risky stock that yields less that a safe FD?

I finally got through to him. He said he would check the P/E ratios of the stocks in his portfolio and see if the yield was above 8%. I don't know if he did. I never asked him. But I hope he learned something from our conversation.

My explanation was not detailed. It did not cover the potential for added value through earnings growth. Serious investors, of course, will need to look at a lot more than just the P/E ratio. The quality of the business matters just as much, if not more.

In the long run, high quality businesses will compound investor wealth enormously. It makes sense to pay up for such stocks. But I figured this would have been too much for him at that time.

I managed to tell him the main reason investors do not do well in the markets. If you buy high P/E stocks, you will get a low yield. You could be paying too much for growth. You are buying what is already popular. And as Warren Buffett would remind us, 'You can't buy what is popular and do well.'

What do you think? Do you think buying high P/E stocks is a bad idea? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
With market valuations still not in the comfort zone, let us take a look at the debt market. However, with bank deposit rates coming down as a result of the RBI's recent rate cut, it has made corporate fixed deposits relatively attractive. As per Mint, rates on bank deposits for instance have declined substantially over the years. Currently, they are in the region of about 7% to 7.25% for deposits of longer than five year periods. Two years ago, rates hovered around the 9% to 10% region.

In comparison, corporate FDs are providing returns in the range of 8% to 14% - rates vary as per the rating.Today's chart of the day indicates the rates provided by some of the highest rated deposits in the market.

Corporate FDs seem attractive...

Considering the higher risks involved in corporate FDs as compared to bank deposits, the high rates do make sense. However, the risk of default always remains. Interested investors would do well to keep this in mind when blindly chasing higher interest rates. Not to mention that taxation of returns is another factor to consider. Hence, while comparing return differential, investors should consider after-tax returns of all such instruments; especially to the tax-free instruments that are floating around.

'Woah! Lifting this would be as good as lifting dumbbells.' said a colleague of mine recently, reacting at the thickness of the offer document of a company whose IPO opens soon. 638 pages! That's how thick it is.

Well...going by the news making rounds, IPO documents are likely to be trimmed down to as few as ten pages. As per Sebi's Executive Director, the abridged prospectuses will include information sufficient for investors to base their decisions on. The full prospectus would however be available on its website.

Continuing the discussion on IPOs, turns out that 1HFY16 was a good year in this regard; as there was a five-fold jump in funds raised through this route. As reported, Indian companies raised almost Rs 50 bn during the period. Last year, the comparable figure stood at Rs 10.2 bn. In total there were 39 (with 12 of them being the major ones and balance coming from the SME segment) IPOs that hit the market during the current year as compared to 25 a year ago. Two IPOs - those of UFO Moviez and Navkar Corp - were the biggest ones with the size of Rs 6 bn each.

Given the market buoyancy over the past two years, there are some high profile IPOs that will be hitting the market soon. Investors would do well not to easily get swayed by their stories and prospects without understanding what they are buying into. Not to mention that usual traits such as long term track record, earnings quality and indebtedness should be given due importance as well.

The Indian stock markets were hovering below the dotted line in the morning session. At the time of writing, the BSE-Sensex was trading lower by about 100 points or 0.4%. Losses were led by information technology and energy stocks. Mid and smallcap stocks were nevertheless in favour today, with their respective indices trading higher by about 0.1 and 0.3% respectively.

 Today's investing mantra
"Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share." - Warren Buffett

Early today, Asad Dossani released the 3rd and final video of his latest Master Series - Income At Will.

In video #3 Asad has answered some of the toughest questions that were sent across to him over the last few days. Plus, he has also announced a special gift (worth Rs 25,000) specially for his attendees. So, if you still haven't seen the 3rd and final video, all you need to do click here. Asad actually believes that this is The Most Important Video of this master series and you should not miss here to view video #3. (If you prefer read the complete transcript instead, you can find that on the video page as well.)

This edition of The 5 Minute WrapUp is authored by Devanshu Sampat (Research Analyst).

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Engineering stocks have been the victims of the economic recovery not taking shape.
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