How to beat markets by being right just 30% of the time... - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster
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How to beat markets by being right just 30% of the time... 

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In this issue:
» The crux to generate market beating returns
» NPA woes for PSU banks continue...
» Can the FM convince Dr Rajan to cut rates?
» Will banking see some major changes going forward?
» ...and more!


00:00
 
Investment success is measured with respect to benchmark. And in the Indian context BSE-Sensex is the most preferred benchmark for large cap stocks. Hence, a successful large cap fund manager would be the one who is able to generate Sensex beating returns consistently. But the fact is - in the quest to generate higher returns, most end up parting with their initial investment. And nothing can be a bigger disadvantage in investing than this.

However, what if we say we have a relatively low risk strategy to generate market beating returns. A strategy where you require just 30% of your calls to be correct to beat the market! Yes, you read it right. You need to be right in one out of three occasions.

We are sure you are eager to know more on how this can be done. But before we reveal anything let us tell you that this strategy is very simple to understand but difficult to enact. The thrust of the whole idea is capital protection. We came across it over a blog on OddballStocks.com.

Now, let us see how it can be done.

Let's assume you have an equal weighted portfolio of Rs 10 m comprising 10 stocks. Each stock has an upside potential of 50%. But of course we would not know which stocks would outperform when. We just bought on the premise that the stocks have an upside potential and are value buys.

Now let us assume that 3 stocks out of 10 gave a 50% return over the next one year. So, your total return is Rs 1.5 m (Rs 0.5 m per stock * 3 = Rs 1.5 m). Also, the other 7 stocks in the portfolio remained flat. They neither appreciated nor depreciated. In that case, the total return of your portfolio would be Rs 11.5 m/Rs 10 m-1 = 15%! This is probably equal to or a notch better than mean Sensex returns over cycles depending upon the period chosen. Outperforming is as simple as that.

You may say how silly! However, the crux here is neither the school grade math nor the return assumption of 50%. The key point is how the portfolio consisting of other 7 stocks has moved. We assumed a flat return from the balance stocks. That is the key to beat the markets. Had the other 7 stocks moved down, your return would have been much lower. Let us assume that the other 7 stocks lose 5% each. In that case, the return on your portfolio would be 11.5%, a direct erosion of 3.5% from earlier levels.

In summary, the crux to beat the markets lies in capital protection. If you are able to protect your capital, you can still generate a healthy return over longer period even if small portion of stocks (3 in this case) in your portfolio outperform. This is where we at Equitymaster focus the most on. For us, downside protection is as critical as upside potential or perhaps even more. Probably, our The India Letter subscribers know this best. We consciously took the decision of not giving outright buys in this service initially just for the want of valuations.

Though some of the businesses that we identified had good upside potential (and have appreciated since our recommended price) valuations were a bit expensive. Hence, we chose to be conservative. We protected the downside risk here by not asking subscribers to put the entire money at one go.

Always remember Warren Buffett's two cardinal rules of investing:-

Rule 1 # Don't lose money
Rule2 # Never forget rule no. 1

What do you think? Between capital protection and upside potential which is the most critical factor when buying stocks? Let us know your comments or share your views in the Equitymaster Club.

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02:20  Chart of the day
 
Let us say you plan to beat the markets by investing in banking stocks. You have two options. One is private banks and second is PSU banks. If you choose to invest in the latter probably you may attain disappointment in your quest of outperforming. The reason being some PSU banks are plagued with deteriorating financials. As can be seen in today's chart, the NPA ratio in the home loan segment for some PSU banks is in a threatening zone. Punjab & Sind Bank and UCO Bank lead the pack with NPAs of 6% and 5.5% respectively as of 1HFY15. What is even more discouraging is the fact that the asset quality has worsened for all 5 banks when compared to FY14 with the exception of United Bank of India. For the latter, the NPA ratio has improved from 3.5% in FY14 to 3.3% in 1HFY15.

If the PSBs continue to face pressure on home loan portfolios, their asset quality may weaken further. Hence, they have to be extremely cautious when it comes to lending more money in the home loan segment now. Further delinquencies can hurt profits and valuations. Probably investors looking for market beating returns should exercise much more caution when investing in this space.

Asset quality worsens for PSBs in home loan space
PSB=Punjab & Sind Bank; UBI=United bank of India; IOB=Indian overseas bank


03:22
 
Now how will the NPA problem in the home loan segment pan out if interest rates are cut? Indeed, in recent times, the noise for a rate cut has only gotten louder. In the previous two fiscals, even though GDP growth was below 5%, the RBI refused to cut interest rates. And very rightly so given that inflation continued to reign high.

For this fiscal, while the June quarter logged in a GDP growth of 5.7%, growth is expected to moderate for the September quarter at around 5%. Having said that, inflation appears to have cooled off considerably. The wholesale price index eased to a five-year low of 1.77% in October. At the same time, retail inflation fell further to 5.52%, a historic low, for the same month. Softening fuel and food prices primarily contributed to this.

Not surprisingly, a leading financial daily has reported that the Finance Minister Mr Arun Jaitley is bound to coax the RBI governor Dr Rajan to cut rates. The RBI's policy meet is scheduled for December 2. Expectations of reforms have certainly enthused corporates of a pickup in GDP growth. However, the recovery so far has been gradual and there are hopes that a rate cut will provide the much needed impetus. Whether the RBI governor takes the bait though remains to be seen.

04:01
 
Now whether the RBI will cut interest rates is something we will come to know on December 2. But that has not stopped it from bringing about some changes in the way banking is done in the country. Indeed, if one takes a closer look at its new rules, even telecom companies such as Bharti Airtel and Idea Cellular can become banks. Not just them, banking activities can be carried out by India Post and Indian Railways as well.

How is that possible? RBI essentially has come out with new rules for the entry of small finance banks and payment banks. Now the guidelines for the latter have received a tepid response. This is because for the business of payment banking to become effective, the transactions would need to be very high.

That said, telcom companies, retail chains and the like can form joint ventures for payment banks. And this is being seen as a welcome step. Just to clarify, a payments bank can undertake most operations that a normal commercial bank would. However, it cannot offer loans and credit cards. Further, certain other terms have also been outlined by the RBI with respect to payment banks.

Small finance banks will be allowed to carry out all operations of a bank but on a smaller scale. This is an opportunity for NBFCs, micro finance companies and local area banks to obtain licenses for small finance banks and then steadily grow into larger banks later on.

With Dr Rajan at the helm, the RBI had already caught the interest of corporates and investors when it had earlier announced the issuance of new banking licenses. Now with these latest set of guidelines, the RBI certainly wants to reform the country's banking system. At the same time, it will need to ensure that it continues to follow prudent practices which essentially prevented Indian banks from facing the kind of crisis that its global counterparts did.

04:43
 
The Indian stock markets continued to make inroads into the positive territory in today's trading session. At the time of writing, the BSE Sensex was trading up by around 271 points, while the NSE-Nifty was up 99 points. Gains were seen across sectors with auto and banking stocks leading the pack. Most Asian stock markets were trading in the green with China and Hong Kong finding favour. European markets have, however, opened the day in the red.

04:56  Today's investing mantra
"Chains of habit are too light to be felt until they are too heavy to be broken" . - Warren Buffett
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This edition of The 5 Minute WrapUp is authored by Jinesh Joshi and Radhika Pandit.

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7 Responses to "How to beat markets by being right just 30% of the time..."

v.vijayamohan

Dec 2, 2014

Nice analysis. Capital appreciation and capital protection must go hand in hand. With over 500 stocks in BSE SENSEX, one needs a reasonable grip on well-performing Sensex stocks, why some are slipping, why some are zooming and so on. Being right 30% of the time is perhaps the Minimum achievable. One can better the tally a little more by better analysis and practical portfolio management. The 2 rules cited by you (1) Don't Lose Money (2) never forget Rule No.1 should always be practiced scrupulously - with no sentiments playing the part.

Like 

Raghuveer Singh Rathore

Dec 1, 2014

Well, had I been so expert of the stock market I wouldn't have lost my hard earned money in many lacs. Now hesitate to invest even in recommended stocks against subscription, because - Doodh kaa jalaa, chhaach foonk-foonk kar peetaa hai.

Even today I'm afraid, at least I don't know which way the market would move or take a turn. However, I feel that its movement can be on the basis of some trivial sentiment itself merely ignoring the major sentiment globally. Buffet is clever and expert of the line and as such, his both the rules favour him only and no one else, because practically it is not at all possible. If I have to lose the money let the scripts be the real Blue Chips, no one can prove a helping hand. That's all.

Beside above, I'm sure if any one invests in real estate, he/she can never be loser at all.

Like 

ravishah

Nov 28, 2014

yes,capital protection should be the primary goal rather than buying stocks on just charts or news.I admire your view of recommending sound companies which will not destroy capital of buyers.I m also looking forward to the technical aspect of Mr Apoorva shah.Pl donot compromise on your good solid stock picking methods in pursuit of more subscribers to Eqty Mstr.Never compromise on values.

Like 

kr.subramanian

Nov 28, 2014

The news about Bank's NPA is really very useful

Like 

SundaraVaradan

Nov 28, 2014

Hi,

Even I was fooled by the Example, initially!
But the key assumption in the argument is that the 3 Large Cap stock will give ......50% return PER YEAR (?)????
Has the conservative EQM ever suggested a large cap Stock giving Returns of 50% ........p.a.???

Even, If 3 Large cap stocks give a max of 20% per Annum(very Good return) (and 7 Stocks are Flat), the whole argument is FLAT!!!

Can you please rethink & give better argument??????

Like 

Rajanikanta Verma

Nov 28, 2014

Capital protection is more important and, in fact, that is why one should always have a "stop loss" - to protect one's capital from getting seriously eroded if the market has gone against one's judgement (as it is bound to do from time to time).

I have always felt that absence of "stop loss" is a serious flaw in your "Stock Select" recommendations.

Like 

Vijay Jain

Nov 28, 2014

Upside Potential

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