Should You Be an Active Investor, Or a Passive One?

Sep 1, 2016

In this issue:
» India's GDP grows the slowest in the past five quarters
» It's raining share bonuses this year
» ...and more!
Rahul Shah, Co-Head of Research

A wave is sweeping across America. As per reports, the assets under management (AUM) of actively managed mutual funds (MFs) have increased 49% since 2008.

But that's not the interesting bit. Compare this to the growth in passively managed index funds - a whopping 267% - and you quickly realise that investors have been moving towards passive investments in hoards.

This this begs the question: Is the passive investing trend worth following? Should you really ditch picking individual stocks and just buy a diversified list of prominent index stocks?

For a clue to the answer, let's take a look at the kind of analysis ace stock-picker Warren Buffett uses to pick stocks:

  • When Charlie and I buy stocks - which we think of as small portions of businesses - our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out, or more.

    If the answer is yes, we will buy the stock if it sells at a reasonable price in relation to our estimate. If, however, we lack the ability to estimate future earnings...we simply move on to other prospects.

So the very heart Buffett's stock-picking success comes down to one all-important principle. To know whether 'stock A', and not 'stock B', is worth buying, you must have a good grip on what the future looks like for the underlying businesses.

And if you don't?

Here's Buffett again:

  • Most investors, of course, have not made the study of business prospects a priority in their lives. If wise, they will conclude that they do not know enough about specific businesses to predict their future earning power.

The conclusion is simple. If you are like most investors, your priority is your profession or business. You do not have the time to make the study of other listed businesses your priority. And even if you did, stock picking isn't your forte. If you lie in this category, you have two options:

  1. Don't even try to pick winners. Rather, your goal should simply be to own a cross-section of Indian businesses that in aggregate are bound to do well. Buying a well-diversified index can help you achieve this. That's what passive investing is all about. (However, do note that unlike in the US, in India, the top stocks in the benchmark indices here have very high weightage. The Nifty's top-ten stocks account for 54% of the index; whereas for the S&P 500, the top-ten stocks account for 20%. This means in the Indian scheme of things, by investing in the benchmark indices, investors could be exposing themselves to the risk of being overinvested in just a few stocks.)
  2. Find someone who's occupation is to study businesses. If this is someone you know to be reliable...someone you can trust...then you can let them do the dirty work for you. If you can't find such a person, stick to option one.

Now, there is a lot of money to be made in picking winning stocks. And getting better-than-average results is simple...but that doesn't mean it is easy. There are many dangers to this endeavor, and you must be sure you have the level of understanding to know around which corners they lurk.

But if the second option interests you, you should know that we at Equitymaster have been in the business of recommending stocks since 1996. In our various services, we have a strong track record of being right. Bear in mind that we are talking pretty long-term here. In fact, we recently completed ten glorious years of one of our services. This particular service happens to have a very impressive track record of 77%. In other words, for every ten recommendations, nearly eight have gone on to hit their target within the stipulated time.

I have a little surprise for you. You can now try our publication, StockSelect, which follows a conservative approach to recommending stocks, for a full 30 days! Full details are given here...

02:30 Chart of the day

As we write this, the markets are flat for the day. This is perhaps in reaction to the GDP growth in the country off to a shaky start. As today's chart of the day highlights, the GDP has grown at its slowest pace in the past five quarters at 7.1% on a YoY basis. The key culprits seem to be the mining, construction and the farm sectors. While agriculture and construction grew at 1.8% and 1.5% respectively during the quarter, mining registered a fall to the tune of 0.4%. On the positive side, there were sectors like public administration and other services which did really well and grew 12.3% and also financial, insurance and real estate that were up 9.4% YoY.

Where does the GDP go from here? We are sure the Government won't losing sleep over the first quarter numbers as things like pay panel award and good monsoons would ensure that the June quarter growth is just an aberration and we touch the targeted 8% growth that's so crucial if we are to reduce poverty and create jobs. As for investors, the long term India growth story remains intact and any investor overreaction should be seen as an opportunity to enter to fundamentally great stocks at attractive valuations.

India's GDP Grows the Slowest in the Past Five Quarters


Looks like it's raining bonuses this year. As per a leading daily, during the entire previous financial year, a total of 59 companies had declared bonuses. However, we are not even past the halfway mark yet in this financial year and 41 companies have already issued bonus shares. Besides, there are four PSUs in this year's list as opposed to just one PSU declaring a bonus last year.

Now, bonuses as well know are given to existing stockholders in proportion to the number of shares they already hold. The move is aimed at increasing liquidity in the stock and is seen as a way to utilize the excess reserves.

Make no mistake, the word 'Bonus' has a positive connotation to it. Whenever a listed company announced a bonus, it is usually followed by a surge in the company's share price. However, this reaction is totally out of place in our view. While bonus shares lift the stock price in the short term, there is no addition to the stock's intrinsic value which is based solely on fundamentals. And this is something that investors should always keep in mind while looking to invest in companies solely on the basis of them being a bonus candidate.


Meanwhile, the Indian markets were trading flat at the time of writing with the BSE Sensex up only marginally. BSE Mid and Small Cap indices were also displaying a pretty similar behaviour. Amongst sectors, while auto stocks were seen in favour, telecom was the worst hit, with the index down 4.6% at the time of writing.

04:56 Investment mantra of the day

"Risk comes from not knowing what you're doing." - Warren Buffett

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

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