»5 Minute Wrap Up by Equitymaster

On This Day - 18 APRIL 2013
Which investor are you? A Hedgehog or a fox

In this issue:
» A student finds error in the work of world famous economists
» Don't invest in a value stock before reading this
» Still early to cheer falling crude and gold prices
» Gold retailers doing record business in both US and India
» ....and more!

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Bulls, Bears, Zebras, Elephants, Chimps. We believe that the financial industry has made its love for animals pretty clear. And just as we felt that the list won't get any bigger, we came across two more additions to the list. Hedgehogs and Foxes.

We believe it was the Greek poet Archilochus who first introduced these animals into the world of philosophy. 'The Fox knows many things but the hedgehog knows one big thing' is what he is believed to have said. So very true. Simply because for Hedgehogs, it doesn't matter who the enemy is. They will always roll themselves into a ball of spikes and get ready to charge at the predator. Thus, all they know is just one thing. Foxes however are Foxes we believe. Wily operators, there's hardly anyone more opportunistic than them in the animal kingdom. Any wonder that they are totally opposite to what Hedgehogs are.

We believe the investing world too is split into hedgehogs and foxes. There are investors who revel in knowing the one big thing and will bet their entire fortune on it. These are Hedgehogs of the investment industry. Then there are the Foxes that are as flexible as they come and just don't mind taking different bets at different times.

Any famous investor that can come the closest to being a Hedgehog? How about Warren Buffett? Since the time he first came in contact with it, Buffett has been a zealous practitioner of value investing. Barely have we seen him follow something else. Thus, it can safely be concluded that most of his fortune has been made by being a Hedgehog of the investment community i.e. doing just one thing and doing it better than anybody else.

At the other end of the spectrum is someone like George Soros. When it comes to changing opinions as fast as one can say fast, there isn't anyone better than Soros we believe. As opportunistic as the Fox, he has excelled in pursuing trends across asset classes and across economies. Thus, he is easily one of the most successful hedge fund managers in the world.

Thus, the question that begs itself is what should one aspire to be, a Hedgehog or a Fox? Well, we believe it pays to have characteristics of both these animals. Let's go back to Warren Buffett. You really think he's been a Hedgehog all his life? That's not true. Anyone who's followed him closely knows he changed his style over time. From being an investor in just statistically cheap companies, he switched over to buying quality companies by paying small premium for the quality involved. Besides, he's not been averse to making some unconventional investments whenever opportunities have presented themselves. Like his investments in derivatives and even commodities like silver. Thus, he's not just a Hedgehog but a fox as well. Similarly, there have been many a occasions where Soros has suffered reverses simply because he would have been better off being a Hedgehog but instead chose to become a Fox.

Thus, as Bill Gross of PIMCO once pointed out, the secret is to be both a hedgehog as well as a fox because the combination produces successful long term outperformance with risks that are market-like. We cannot help but agree.

Do you believe that it pays to be both a Hedgehog as well as a Fox in order to be a successful investor? Please share your comments or post them on our Facebook page / Google+ page

 Chart of the day
The fact that MNCs have commanded premium valuations over their Indian counterparts is certainly quite well known. The premium, many investors argue, is simply because of the superior quality of these firms. However, a big hole has been bored across this argument in recent times. Simply because the promoters of a lot of these MNCs have shown characteristics not in the best interest of minority shareholders. Top on the list would be the issue of royalties. Many MNCs have entered into agreements to hike royalties that they remit abroad to their foreign promoters. And while Indian investors continue to see red over this, today's chart highlights those MNCs from the BSE 500 universe that pay the highest royalties to their parents on a % percentage of sales basis. Well, we don't know what the exact number should be but it should certainly not be something that makes MNCs earn supernormal returns on their investments in India at the expense of minority shareholders.

Source: Ace Equity

A dog biting a man makes no news. But it would if it happens the other way round, that is, a man biting a dog. A very analogous situation happened recently. An article in Reuters reports how a student of economics found major errors in a famous research paper by two Harvard economists.

The two economists in question are Carmen Reinhart and Kenneth Rogoff. In their 2010 research paper, they had found that economic growth tends to slow drastically when a country's sovereign debt exceeds 90% of its annual economic output. This study has been influential across the world. Many policymakers have cited this study to defend cuts in government spending.

But here comes Thomas Herndon, a 28-year old student at the University of Massachusetts Amherst's doctoral program in economics. He found some very basic errors in the spreadsheet used for calculations. At one instance, he found that a few countries were omitted from calculations of the average. Moreover, in the case of New Zealand, the two economists had used data for just one year, 1951. This skewed the results quite a bit. In fact, Herndon did his own calculations with the same data and found that the impact of high government debt on GDP was much milder than what the report projected.

The two famous economists have admitted to a "coding error" in the spreadsheet. But could such basic errors be purely a result of oversight? We certainly are not convinced. Moreover, the student's findings also put a question mark on their central thesis on debt and economic growth. And this in turn would lead to an entirely new debate on this pressing issue.

When it comes to picking stocks for investment, we believe that value investing is the best way. It requires investors to thoroughly study the company's fundamentals and invest only when they are available at attractive valuations. To do this, we need to look at quite a few metrics. These include some of the popular financial and valuation metrics. Some such metrics are EPS (Earnings per Share) growth, ROE (Return on Equity), P/E (Price to Earnings) and P/B (Price to Book) multiples. So if these metrics are attractive, you should invest in the stock, right? If you say yes, then you are actually wrong. A recent blog on value investing talks about the mistakes investors make while using these popular metrics.

For instance EPS growth and high ROE could be misleading. That is if they are not examined for what has caused this growth in earnings. Or what has caused the higher ROE. If these are driven by non-operating and non-recurring items, then the growth could be misleading. Again when it comes to using valuation multiples, we need to keep in mind that multiples in general are relative. So if we say that a P/E multiple of 20 is expensive, then as an investor we need to question "as compared to what"?

Valuation multiples should be used as relative multiples. It is better to use an acceptable valuation band to say what is high and what is not. This band should be derived using long term growth rates and returns. Most importantly, valuation multiples should not include the value of intangibles and non recurring items. If you follow these simple rules, there is a higher probability of getting fundamentally strong companies in your portfolio.

The recent plunge in gold prices saw the yellow metal witnessing its biggest drop in 30 years. Considering the steep fall in prices, even the gold fanatics believed that the long lived rally was over. The belief was with prices declining, more people will liquidate the inventory, putting further pressure on prices. However, the opposite seems to be happening. With prices declining, most gold bugs seem to view this as an attractive buying opportunity. As a result, most gold retailers, both in domestic and international markets are failing to cope up with the sudden rising demand. In fact, volumes in the Indian market have doubled in the last 2-3 days.

In the international markets, most companies are facing issues to clear the pending backlog. Some have also run out of inventory. In fact, in overseas markets some retailers have started charging premium due to inventory shortages. Thus, in effect, only a customer who is willing to pay slightly higher than the prevailing market price can get gold there. We believe this proves the yellow metal's value as an investment avenue. A slight correction in prices and you see investors flocking to buy the same. Thus, the faith in the metal and its safe haven status seems intact. In fact, situations like these help investors to pick up the metal at more affordable prices.

Are PM Manmohan Singh and FM Chidambaram rubbing their hands in glee? After all, the crash in commodity prices across the board has given them a reason to be jubilant. Without their tweaking a finger, it appears as if India's current account deficit problem (CAD) could get solved. Lower inflation could also mean lower interest rates. This will offer the much needed stimuli to India's GDP growth rate. To top it, the cloud over the country's sovereign rating could evaporate.

But things are not as rosy as they appear to be! As an article in Firstpost rightly suggests, falling commodity prices do not mean we are out of the woods! For the CAD problem can be solved only if the rupee dollar rate remains stable. If the rupee stays weak, or it declines, India's imported oil gets pricier. Again, the falling prices of gold in international markets have meant higher demand in India. This too could pressurize the CAD. The metric to look out for is therefore foreign capital inflows. If these get attracted to India's fundamentals, only then could there be a meaningful impact on the currency rate and CAD. Until then, it would be too early to rejoice!

Meanwhile, indices in the Indian equity markets have traded strong today with Sensex higher by 150 points at the time of writing. Consumer durables and capital goods counters were seen generating the maximum interest. Most other Asian markets however closed the day in the red.

 Today's investing mantra

"You can't predict, but you can prepare"- Howard Marks

Editor's Note: Please note that The 5 Minute WrapUp will not be published on 19th and 20th April, 2013 on account of holidays at Equitymaster

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