A stock picking method you should not ignore - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

A stock picking method you should not ignore 

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In this issue:
» Has the commodity super-cycle come to an end
» Another well known foreign brokerage turns bullish on India
» Now Moody's downgrades France
» China's incoming President warns of rising corruption
» ...and more!

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    We are sure you would have watched one of those rom-com movies where a girl gets dumped by every boy she comes across. But she does not give up. She goes through many more such sad experiences only to realise later that hers is an average story and not the exceptional one. That a relationship ends in a near perfect manner only in the rarest of rare cases. For in the majority of instances, turbulence prevails.

    Well, we believe the girl could have avoided a lot of emotional trauma had she known the all important concept of base rate. Base rate is nothing but a term given to identify the probability of a future event after studying the past success rates. In the girl's case, the base rate of a boy liking the very first girl he meets was certainly on the lower side. Thus, had she approached the whole thing with the idea that she may have to go through a lot of trial and error before finding her soul mate; she would have perhaps kept her expectations lower.

    However, what the girl has suffered is a pretty common psychological bias or error that goes around with the name of insensitivity to base rates. When certain compelling information is presented to us, we tend to give more weight to that information. And forget the long term base rate of the event under consideration.

    Can this bias lead us astray in the field of investing? It certainly can we believe. Take the case of IPOs. Historically, IPOs haven't been the best of investments. In other words, they have a pretty low base rate. Thus, if one is investing in an IPO, the probability of success is on the lower side. But people still fall prey to them because of all the marketing and the promise of high returns from the issuers of the IPO.

    Then there's the case of investing in highly leveraged companies. Even here, the base rate is pretty low. But people still tend to invest in them on the premise that they will make huge returns.

    At the other end of the spectrum are investments that have pretty high base rates. Take equities for example. History has shown that equities tend to have the best long term returns of any asset classes. But people still fall for the gloom, boom and doom stories and shun equities.

    Then there are certain industries like FMCG, IT and pharma where again base rates has been high. Thus, it would do your portfolio no harm if majority of your portfolio is comprised of companies from these sectors rather than sectors like airlines or textiles that have pretty poor base rates.

    Thus, before getting carried away by any sales pitch, it will help if you take into consideration the long term base rate of the stock under discussion. Investing where the base rate is in our favour is a huge long term advantage to have we believe.

    Do you think investing by taking the base rate into account makes sense? Do share your comments with us or post your views on our Facebook page / Google+ page

    01:29  Chart of the day
    India has a lot of things going for it in its bid to be the economic power house. Its demographic advantage is certainly the most important of these advantages we believe. However, if report by a United Nations body is to be believed, this advantage would run out sooner than expected. As per the body, India's median age is projected to go up rapidly to 31.4 years by 2026, a huge jump from the 20.2 median age witnessed in 1981. Falling fertility rates and increased longevity are the key reasons being cited for this trend. If this is indeed true, then it is time policymakers start factoring demographics into their policymaking we believe.

    Source: LiveMint

    Edward Morse may not be an influential name on Wall Street. But this Citi economist certainly has some well timed calls to his credit. His latest one being that the commodity super cycle has come to an end. Morse argues that the investment led Chinese growth is over. And this is likely to have a negative impact on the demand for industrial commodities. Also, the fact that there has been booming supply for some commodities (example US Oil) the bull run does not seem to have enough legs from here on.

    So, the question is, will Morse's prediction come true? While one could easily buy his logic, the question here relates to timing. And he has been pretty much on the bulls eye as far as predicting cycle reversals is concerned. Rewind back to 2008. Oil was at its peak then. And was rising everyday with no signs of correction. At that time Morse was the lone contrarian who predicted that the oil bubble will burst soon. And we all know what happened to the oil price after that. So, if history is anything to go by, the commodity bull run is perhaps nearing an end. But still we need to remember that this is a game of prediction. And anything can happen here.

    Ever since the government started to show interest in policy reforms, foreign investors have started to show interest in India. The latest to join the list is JP Morgan. In its recently released report, the excerpts of which were carried by Economic Times, the group has indicated its bullishness on India. The optimism is based on improving policies and hopes of monetary easing. In fact India is its top market for 2013 amongst the BRIC nations.

    On the other hand, the group is pessimistic on the prospects of China. The reason is that the subdued demand in the dragon nation. China has been expanding its capacity at a break neck speed.

    Unfortunately, demand both from the domestic front as well as the export front has not really kept up pace. As a result, the profits of most companies have seen headwinds. If capacity continues to outpace demand, margins would get compressed further thereby hurting returns to investors. While it is good to note the optimism from foreign investors regarding India, it is important to note that most of it is based on continued policy reforms. Hopefully the government hangs on to its changed stance and continues with it.

    It doesn't feel very good when your teacher gives you a lower grade in school than what you got previously. This is exactly what a certain European nation must be feeling right now. France is the latest nation to face the humiliation of a debt downgrade. Credit rating agency, Moody's recently downgraded France's credit rating from Aaa to Aa1. The agency cited three main reasons. These include a weak long-term economic growth outlook, uncertain fiscal outlook and inability to withstand further shocks within the zone.

    The nation has seen a sustained loss in economic competitiveness and structural rigidities don't help matters much. France also doesn't have access to a national central bank for debt financing in the event of a market disruption. Given the current negative outlook on the nation's sovereign rating, an upgrade is unlikely over the medium term. However if France successfully implements reforms and fiscal measures, this may strengthen growth prospects. The protracted Euro debt crisis needs a resolution. Soon.

    If there is one thing that history has taught us then it is that unchecked corruption and abuse of power is a breeding ground for revolutions. Classic examples of this case across the world range from the French revolution in the 1700s to the recent Arab uprisings in the Middle East. We Indians are no strangers to corruption either. The last few years especially have only seen more and more politicians misusing their positions of power.

    And the situation is no different in China either; the world's fastest growing economy at present. Indeed, Vice-President Xi, who assumes Hu Jintao's job as head of state in March, opines that corruption is a problem in the dragon country. He states that if corruption goes unchecked in the country, it will only build up public anger and discontent over time. All of which will lead to a collapse of government. As it is, the country has already received flak for lack of transparency with respect to various data and way most of its banks are run. China's prominence may be growing in the international arena. However, it will need to resolve some basic issues back at home first. This is before it can lay claim to the kind of respect that the developed countries such as US and Europe command.

    Do you run to the doctor every time you sneeze or have a headache? Not really! Because the body is endowed with self-healing properties. In fact, some amount of disorder is actually vital for the body to develop. For instance, if you don't expose your bones to some stress, they will become brittle. In essence, the human body or for that matter any living organism tends to be 'antifragile', a characteristic that is also the title of Nassim Taleb's latest book which deals mostly with building systems.

    Economists and policymakers delude themselves thinking that the economy is a problem that ought to be constantly solved and corrected. They try hard to smooth out volatility, to bring stability. But this does nothing but delay and magnify the problem. Aren't we seeing this already happening in the US and the Eurozone? It would do the world economy a hell lot of a good if they take Mr Taleb's suggestions seriously. In other words, they should let the economy heal itself and do away with frequent interventions.

    Meanwhile, indices in the Indian equity markets have been hovering around the dotted line with the Sensex lower by around 30 points at the time of writing. Realty and IT stocks were seen facing the maximum brunt. Asian indices closed mixed today whereas Europe has opened mostly on a positive note.

    04:56  Today's Investing Mantra
    "I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful." - Warren Buffett

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    3 Responses to "A stock picking method you should not ignore"


    Nov 27, 2012

    The base rate concept is infact true. if we try the concept, it will denifinetly benifit us. Warren Buffett Mantra is also excellent.



    Nov 22, 2012

    Loved the "base rate" paragraph -very well written and backed by solid numbers. 5 Min Wrapup continues to surprise with the freshness of its writings. Thanks !


    Pulin Barthakur

    Nov 20, 2012

    Sorry, I don't agree at all with this patently chauvinistic view that equity investment has such a huge edge over IPO; over the long-shot IPOs are actually as profitable as the equities; only taking a worm-eye view of an IPO with its performance can often be positively dicey. That anyway is bad investment culture to have.

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