Which type of investor are you: Noah or Nostradamus?
(Jun 22, 2015)
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In this issue:
» How value investing deals with unpredictability
» A bigger challenge than policy rate cuts
» Inflation indices are coming down. But does the common man agree?
» ...and more!
Last week was quite a breather for the Indian stock markets. After being in the correction zone, the markets reported the highest weekly gain in five months.
So what suddenly changed over the last few days to bring the bulls back to the bourses?
One was the dovish stance by US Federal Reserve chairperson Janet Yellen in the recent Federal Open Market Committee (FOMC) meeting.
The other key trigger was an unexpectedly good start to the monsoon.
Since quite some time, a key issue that has been worrying economists, policymakers, investors, farmers, among others, is the likelihood of a bad monsoon this year. Since monsoons have a strong linkage to farm output, food prices and rural incomes, it is one of the key factors that is widely monitored.
Most of you must have seen on news channels how the heavy downpour in Mumbai brought the entire city down to its knees. On Friday, the city witnessed the wettest June day since 2005.
Stranded at home, watching the rains and sipping my tea on Friday evening I got thinking about some things. And I felt it would be worthwhile to share it with our readers and see what they have to say about them.
Mr Monsoon and Mr Market
What is the one big commonality between weather and economic systems? Both are highly complex, non-linear systems that are practically impossible to model with any level of precision. But both these systems are critical and many important decisions depend on their behaviour. What to do then? One of the greatest flaws of the modern human mind I believe is that it fails to see and accept its limitations. When confronted with complexity and uncertainty, the modern man perseveres to predict it instead of accepting it. Particularly, rains and stock markets are highly uncertain in the short to medium term. It is often a futile exercise to predict them and base decisions on such predictions.
We need Noah more than we need Nostradamus
While it seems reasonable to have economists forecast economic variables and weathermen chart out weather patterns, one must sit back and question if they really serve any real purpose. Well, one can say that they do perform some important functions. But can we rely on them in times of crisis? Could the economists save the global economy from the financial crises? Can the weathermen predict and save us from floods and droughts?
Here is an interesting anecdote from Warren Buffett's Berkshire Hathaway. On account of the terrorist attacks on September 11, 2001, Berkshire's insurance arm General Re suffered a massive loss of US$ 2.4 billion. In his annual letter to shareholders at the time, Buffett made an interesting confession. Here is an excerpt of the same (as reported by Insurance Journal): "Why, you might ask, didn't I recognize the above facts before September 11th?" he wrote. "The answer, sadly, is that I did-but I didn't convert thought into action. I violated the Noah rule: Predicting rain doesn't count; building arks does. I consequently let Berkshire operate with a dangerous level of risk-at General Re in particular."
Hope for the best, but be prepared for a disaster
On the 26th of July 2005, Mumbai was in the throes of its worst nightmare after being flooded by a torrential downpour. It's been ten years since then. And the city came to a grinding halt at the very onset of the rains. It does speak a lot about the city's preparedness for rains.
On the other hand, how prepared is Indian agriculture against drought-like situations? What have policymakers done to reduce our heavy dependence on monsoon rains?
Until when will we leave our lives and livelihoods to the vagaries of nature?
I think the points raised above are just as relevant to investing. How often do investors leave their fortunes to the vagaries of Mr Market? Instead of predicting where the markets will go, do you take enough care to protect your portfolio from downside risks?
The greatest and the most successful investors are not experts at predicting market movements. Instead they invest in a way that they do not have to worry about market movements. Consider 'margin of safety', one of the foundation pillars of value investing. What is the reasoning behind this principle? When faced with uncertainty, value investors humbly accept that there are things that are beyond their thinking mind and that they may fail to recognize potential risks. And so, it is better to keep a margin of safety and to be prepared to deal with downside risks, than trying to accurately predict when and how much it will rain and where the markets will go.
It turns out value investing is simpler and effective. Why makes things complicated then?
According to you, does it make sense to predict disasters or rather to be prepared to deal with them? In other words, what type of investor are you: Noah or Nostradamus?Let us know your comments or share your views in the Equitymaster Club.
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Much of the discussion around reviving the Indian economy out of the slowdown has been centered around interest rate cuts. The problem with popular public discussions is that they get more or less trivialized and oversimplified around one big topic. And it begins to appear as if rate cuts were all there was to firing up the economy.
We came across an interest article in Livemint that raises another major challenge in the banking sector. The issue of capitalization! As you would be aware, banks are required to follow certain minimum total capital requirements. In case, banks are not able to fulfill these requirements, their ability to lend gets curtailed.
As per the article, the RBI's timeline for implementing Base III norms requires banks to provide for a capital conservation buffer of 0.625% of risk-weighted assets by the end of financial year 2015-16 (FY16). As such, the minimum total capital requirement will increase to 9.625% in FY16. In FY17, this will increase by another 0.625%.
Are Indian banks ready for this? While large public sector lenders like State Bank of India, Bank of Baroda and Punjab National Bank are well-placed as far as capitalization is concerned.
But the mid-sized public sector banks (PSBs) are in a tricky spot. An important thing to consider is that the mid-level PSBs account for one-third of bank credit. And to meet the Basel III requirements, they need a massive capitalization of Rs 1.6 trillion over the next four financial years. This is certainly going to be a big challenge at a time when credit is not cheap and the economy is still sluggish.
The chart of the day shows the likely credit growth under different scenarios of capital infusion. Certainly, a matter of worry not only for the banks but for credit-starved sectors of the economy as well!
Capitalisation Of Mid-level PSBs A Worry
So as we said, there continues to be a very strong pitch for policy rate cuts. In fact, RBI's adviser Arvind Virmani is reported to have said last week that there was room of another 125 basis points (1.25%) for a policy rate cut. Wholesale and consumer price indices have been trending lower. As per an article in The Hindu Business Line, the wholesale price index reported negative growth for the seventh consecutive month in May 2015.
But well, has the benefit really reached the common man in the form of lower prices? The answer seems to be a big no. Leave aside lower prices, many daily consumption items, particularly food continue to witness inflationary pressures. As per the article, food and beverages index in the consumer price index (CPI) went up 5.1% year-on-year (YoY) in May. But many food items witnessed a much steeper hike, the sharpest being in prices in pulses. Unless food prices show some reprieve, the pockets of the common people are going to keep hurting.
The Indian stock markets started the day on a firm note and have continued their march upwards. At the time of writing, the BSE-Sensex was trading higher by 427 points (+1.56%). The sectoral indices that led the gains were realty, banking and consumer durables.
"Noah did not start building the Ark when it was raining." - Warren Buffett
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