How Much Loss Can You Bear Before You Break? - The 5 Minute WrapUp by Equitymaster
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How Much Loss Can You Bear Before You Break?

May 31, 2017
In this issue:
» Pharma sector's unending woes
» S&P expects bad loans to rise further in FY18
» Market roundup
» ...and more!
00:00
Taha Merchant, Research Analyst

We'll deal with an interesting question today.

Does a good investment strategy mean no losses? That none of your stocks go sour? Is the mark of a smart strategy never having a failed investment?

Not really, if you think about.

Whether we like it or not, the world we live in doesn't always move as per our expectations. It loves throwing up surprises that have zero respect for all that we anticipate.

Rather, the mark of a good strategy is when your gainers outnumber your losers. When the profits from your gainers exceed the losses from your losers by a good enough margin over time.

And as far as losing investments are concerned, different strategies have a different 'threshold for pain'.

Take a moat-oriented, high-concentration portfolio strategy for example. It looks for extremely high conviction bets, and as a result doesn't mind paying full price for stocks and could have as few as just five stocks in the portfolio. But that means, if the unexpected happens in even a couple of stocks, a big chunk of the overall corpus could get wiped out.

On the other hand, one of our premium recommendation services, Microcap Millionaires (MCM), follows a more quantitative strategy. Thus, we've intentionally kept our pain threshold very high.

How?

First, we buy stocks only when they are highly undervalued. That's always a great move when it comes to possible negative surprises.

Second, we ask subscribers to limit their exposure to any single stock to not more than 3-4% of their overall MCM corpus. Works wonders for containing losses.

And we don't stop there. We also have an additional backstop in the form of a varying, and often large, fixed deposit component. When markets get rough, it doubles as both our defense and offense.

So in case some of our companies go off-track, our backs are covered.

Now, despite our ample allowance for losses, our actual loss-to-gain ratio is quite low. If you look at the service's closed positions, you'll see that of the 28 positions we have closed so far in a little under three-and-half years, only four have been at a loss.

That's a success rate of 86% and a failure rate of only 14%. Those are pretty good numbers we'd say.

Of course, depending on future market conditions, this number could change as we go along.

What will remain the same, though, is MCM's high threshold for pain. And this will hold us in good stead as we go through the thick-and-thin of the markets over the coming years.

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02:35 Chart of the day

The BSE Healthcare Index ended at 13,517 yesterday, a 20% decline from the start of 2016. The pharma sector, once considered a safe haven for investors has been on a steady decline over the past two years.

Facing pricing pressures in the domestic and export markets, currency fluctuations, as well as manufacturing issues related to their plant, there is a transformation happening in the overall sector as to how business is done and will be done in the future.

'Safe Haven' Pharma Sector in Decline since 2 Years

Recent disclosure of shareholding pattern at the end of March 2017 indicates the pessimism towards the sector. FII's have reduced their stake in giants like Sun Pharma, Lupin, Dr Reddy's and Cipla. These behemoths have seen a combined market cap erosion of around Rs 9,815.2 billion over the last one year.

But there's always a point after which the downside is limited and stocks become attractive. That's when smart money slowly and steadily starts flowing in. How does one track those superinvestors who patiently wait on the sidelines for such an opportunity? I think, my colleagues Kunal and Rohan might be able to help you out. Right from promoter activity to bulk and block deals, they'll be tracking the well-known and successful names in the Indian stock markets. To know more about these super investors, download a free copy of - The Super Investors Of India.

03:45

S&P Global Ratings, in its recent report indicated that the stressed loans for Indian banks are likely to rise to 15% of total loans by FY18. Most of these stressed assets are likely to be from the public-sector banks. The banks might have to take a haircut in principal and interest payments to resolve stressed loans.

Due to the recent NPA issues, the banking sector's average Return on Equity (RoE) has crashed from 10.4% in FY15 to just 3.6% in FY16. A major reason for this is the profits written off on account of NPA provisions. 70% of them in the books of public sector banks. More importantly, the drag in the ROE is likely to persist in FY18 too.

The government is looking at various measures to tackle this issue. The latest has been capital infusion for 10 PSU banks that include weak and non- performers.

The condition is that banks will have to attain certain quarterly milestones before they avail capital support. The arrangement will include the government, bank management and employees of the concerned bank.

Apart from these measures, it is also necessary to identify the root cause of the problem. That of corporate debt. Apart from the banking sector, corporate debt has serious implications for the overall economy.

Banks with a sizable amount of bad loans on their books are reluctant to lend to even healthy companies. This will adversely impact the growth of the Indian economy going forward.

More than half of the corporate debt belongs to the Infrastructure, power, real estate, oil & gas and construction sectors. If borrowing to these sectors is contained, it will severely hamper India's growth.

04:48

At the time of writing, the Indian share markets were trading on a flat note. Barring information technology stocks and FMCG stocks, all sectoral indices have opened the day in green with oil & gas stocks and realty stocks leading the gainers.

The BSE Sensex is trading higher by 13 points while the NSE Nifty is trading higher by 10 points. The BSE Mid Cap and BSE Small Cap index have opened the day up by 0.5% and 0.2% respectively.

04:56 Investment mantra of the day

"Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Taha Merchant (Research Analyst) and Girish Shetty (Research Analyst).

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1 Responses to "How Much Loss Can You Bear Before You Break?"

Steven Fernandes

May 31, 2017

Breakpoint loss is 25%.

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