Why value investing is all about being humble... - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Why value investing is all about being humble... 

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In this issue:
» What has made Pharma sector investors' favourite?
» Have gold prices been manipulated over the past decade?
» Why are real estate funds not gaining momentum?
» SEBI set to get stricter with share pledging
» ...and more!

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One of the biggest reasons why investors fail to achieve what they have set out to is misconception. Certain books, media, 'talking heads' or gurus and famous investors often create these misconceptions in the minds of investors. That investing requires a very high IQ or expert knowledge and a very high success rate are some of the common misconceptions. So much so that parties with vested interests like banks, brokers, advisors etc endorse such misconceptions so as to make their clients perpetually dependant. The result being that investors resign themselves to bad advice and vested interests despite being very capable of taking smart and independent investment decisions.

Thankfully there are at least a handful of investors who have devoted their lives quashing such misconceptions. Warren Buffett and his partner Charlie Munger lead this tribe. And they have consistently maintained that 'value investing' is a discipline that can be practiced by the by ordinary individuals and the process does not even warrant very high degree of 'expertise' and 'accuracy'. In his forthcoming letter to shareholders, Buffett is expected to re-emphasize the same.

However, one would wonder whether Buffett and Munger are just being too humble by claiming that value investing does not require high IQ, expertise and accuracy. Well, the secret is that 'humility' is exactly the trait value investors need to possess. Rest all is taken care of by the process itself.

Investors need humility to recognize that they are not experts in the businesses (stocks) they own. Hence there could be several unforeseen risks. And by not being experts, they have a big handicap against recognizing bad businesses. Hence to tackle the 'unknowns' investors need to seek sufficient discount in valuations. Further, according to Buffett, by investing in a business that even a fool can run, investors can negate the degree of risk to a great extent.

What else is a pre-requisite for successful value investing? We have some very interesting discussion on this thread in the Equitymaster Club. It is essentially a platform for long term value investors - new and seasoned - to come together and share their knowledge, ideas and views on all things investing - be it equities, derivatives, financial planning, mutual funds, commodities, amongst other things.

And we must say, that sharing experiences and learning from fellow investors is one of the best ways to become better value investors!

How else, according to you, can value investors shield themselves against the unknown risks, besides seeking deep discount valuations? Share your views in the in the Equitymaster Club. Or post your comments below.

01:35  Chart of the day
Investor sentiment about cyclical and defensive stocks is often guided by the state of the economy. When the economy is in a downturn, investors tend to stay away from sectors like auto and banks, that are by nature cyclical. It is defensive sectors like FMCG sector and pharma sector that become investor favourites. However, over the past year, as the economy has offered very confusing signs, investors too have shown some strange investing patterns with regard to cyclical and defensive stocks. Despite the sluggish rate of GDP growth, the auto sector index has outperformed the benchmark Sensex. Meanwhile, despite the robust balance sheet and high return ratios of FMCG companies this sector has not found much favour. Thus it all boils down to invidual business and investors are better off focusing on stock specific fundamentals and valuations than judging future sector preferneces.

Sectors in favour in FY14: Cyclical vs. Defensive

Pharma stocks have caught the investors' fancy in recent times outperforming the Sensex. Indeed, while the Sensex has gained 0.4% so far in 2014, the healthcare index has risen by 8%. One of the reasons for this is the strong set of numbers reported by most of the top pharma players in the recently concluded December 2013 quarter earnings season.

The key driver for this healthy performance has been the US generics market. A slew of new launches in niche areas as well as price increases in existing products have not only driven sales but have contributed to the expansion in margins. This is even as growth in the domestic market moderated on account of the impact of the new drug pricing policy. Going forward, exports will continue to remain the key growth driver for the sector. And in this, the US will feature as the top growth driver given that US$ 92 bn worth of drugs are going off patent over the next 3 years as reported in Business Standard. That said, it will be important for the sector to follow good manufacturing practices (GMP) norms of the USFDA. This is so that there are no more warning letters and import alerts issued that could negate the growth potential for these companies in the US sector. As far as investing in pharma is concerned, we are of the view that investors need to follow a stock specific approach while investing in the sector.

Just when the memories of LIBOR manipulation were about to fade, it seems another scandal of rigging benchmarks has come to light. And this time the commodity in question is gold. As per news reports, London Gold Fix, a benchmark used to value gold may have been manipulated by five banks since decades. This is perceived to have happened due to unregulated processes. The traders of these banks typically receive calls from their clients on buying and selling gold. Based on various orders a fix is set by the banks. This exposes banks to price sensitive information and puts them in an advantageous position. In fact, past price behavior of the benchmark has given an indication of manipulation by these banks.

If it is proven that the benchmark was indeed manipulated, this would be yet another instance of inappropriate oversight where a windfall was made by an institution at the expense of general public. Regulatory controls are a need of the hour in the finance industry. Sub-prime crisis was a result of poor risk controls. Else how can an inefficient borrower get loans sanctioned from a bank with minimal paper work? Even LIBOR scandal was an outcome of ineffective controls. We believe that unless controls are strengthened, we may continue to see such instances of wide spread manipulation.

No one can deny that real estate is perhaps the most preferred asset class in India. This is besides the traditional banking channels. So given this, one should have already seen a huge number of real estate funds active in the market. However, that's not the case. While many real estate funds are indeed entering the market now, it can be considered a slow start at best given the popularity the sector enjoys.

So, what is it that's holding this whole concept of real estate funds back? Well, there are a whole host of issues that need to be looked into. For starters, it is out of bounds for ordinary investors currently as the regulator has mandated a minimum investment of Rs 10 m. Secondly, the funds are typically closed ended and therefore one's investment horizon should match the life of a fund. Then there is ambiguity over the nature of taxation for which more clarity is needed. Lastly, for most funds launched in 2006, the performance track record has been nothing to write home about and this is making new investors wary. Having said that, there are quite a few funds out there that are witnessing strong demand, indicating there can hardly be shortage of capital if it can go into able hands. But again, it is only the high net worth individuals that can benefit from such products. For the rest, they will have to wait until REITs (Real Estate Investment Trusts) become a reality we reckon.

If you recall, the Satyam scam brought to the fore the problem with share pledging by promoters. Let us first understand what is share pledging and why it can be a risk factor. Share pledging is nothing but borrowing against shares as collateral. Typically, a shareholder may be able to borrow upto 50% of the value of his shares. Now say the price of the shares that are pledged falls more than 50%. The lenders may either ask for additional pledging of shares or they may sell off the pledged shares. Because promoters hold a large stake in the company's equity, any such sell off by the lenders could severely hammer the stock price.

In order to protect the interest of all investors, SEBI had mandated all companies to report all encumbrances under share pledging in 2013. As per an article in mydigitalfc.com, the market regulator may now even make it mandatory to disclose the reason for the share pledging. The aim is to bring in more transparency in the disclosures made by the companies. It must be noted that as of December 2013, the total value of the pledged shares stood at about US$ 23 bn (Rs 1.44 trillion).

The global markets remained largely optimistic in the past week led by markets in India, US, France and Germany. In India, stock markets managed to post a 2% rise despite GDP growth coming a below average 4.7% for the December 2014 quarter. Even US market was able to overcome Ukraine concerns as well as a weaker than expected estimate of its GDP growth rate for the fourth quarter and end 1.4% higher. The country's GDP growth in the fourth quarter slowed down to 2.4% from 4.1% growth logged in the third quarter. Among other developed economies, France and Germany also ended on a positive note.

Shrugging off weak economic cues, the Indian equity markets remained in an uptrend on hopes of a stable government at the centre that will kick start the reform process and revitalize the economy. Majority of the sectoral indices ended in positive territory for the week with capital goods (up 5.3%), pharma (up 4.5%) and auto (up 3.5%) being the biggest gainers. Metal (down 3.4%), power (down 1.2%) and realty (down 0.5%) were the only losers for the week.

Performance during the week ended February 28th, 2014
Data Source: Yahoo Finance

04:50  Weekend investing mantra
"You should invest in a business that even a fool can run, because someday a fool will."- Warren Buffett
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1 Responses to "Why value investing is all about being humble..."

Rajiv Ahuja

Mar 1, 2014

Nice article. Appreciate it.

Equitymaster requests your view! Post a comment on "Why value investing is all about being humble...". Click here!


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