Investment and speculation - The Honest Truth By Ajit Dayal
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Investing in India - Honest Truth by Ajit Dayal
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4 OCTOBER 2008

“When speculation has done its worst, two and two still make four.”
-Samuel Johnson

If you are a speculator, you should panic: a lot.
Because that creative financial engineering that converted "two and two" into twenty-two has vanished.

But if you are an investor, remember that two and two still makes four.
Even if the price of the share you bought is trading at three.

That is, if you have selected your investments carefully - as we believe we have for our investments in the Quantum Long Term Equity Fund

If you are an investor: There is no need to panic.

Price and Value
Speculators generally take short term views on where the price of a stock or the price of a property - or any other asset - is headed.
They have little interest in understanding the underlying businesses or assets that they have invested in.
All a speculator wishes to know is: can I sell this at a higher price tomorrow?
And when all the tomorrows looked good, the speculators are happy and they make money. As they were in January 2008.

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The higher share prices that we witnessed in January 2008 made investors very rich – on paper.
Investors generally tend to hold for the long term and generally do not react to short term movements in share prices.
An investor – by definition – will stay invested till he needs the money.

Speculators, by contrast, love to trade. They have this urge to do something - to zip from one stock to the next. With certainty and confidence of a “guaranteed return”. Two and two must make twenty-two.
In fantasyland, it does – for a short period of time.
But now the speculators are scared.
Because that tomorrow is so uncertain, there is a reason for the speculator to panic.

Investors, by nature, are a little more balanced.
They study the underlying businesses of the companies they have invested in – before they invest in it.
An investor will run through various scenarios in his or her head and try to understand the impact of the various possible scenarios on the underlying business of the company or the underlying asset that he owns.

A constant evaluation of the underlying business leads to what is called the “fair value”.
When the price of a stock falls below the “fair value” an investor buys the shares – recognising that it may take some unspecified time to see the price of the stock reach that “fair value’ level. Similarly, when share prices get crazy and the share price of a company trades above its “fair value”, the investor is likely to sell that share. And when the price of that share does fall (and most stocks tend to rise and fall over time) there will be an opportunity to buy into that stock again – at below its “fair value”.

Investors can make mistakes and bad judgement calls which, consequently, can lead to losses. The losses are due to a bad judgement about the underlying businesses that they have invested in.

The foreign speculator
At Quantum AMC, we are investors.
We don’t panic. We make measured judgements.

But we are working in an environment of intense speculation.

The Foreign Institutional Investor (FII) rules were set up in 1991 to allow Indian companies to access pools of long term capital from approved foreign investors to help finance the long term growth of India’s economy.

Since 2003, over USD 52 billion of FII money has entered the Indian stock markets. Over the same time period, domestic mutual funds have invested about USD 9 billion into the Indian stock markets (see Table 1). For every one rupee that an Indian put into the stock market, the FII pumped in five rupees.
That is why the BSE-30 Index had zoomed by +742% between January 1, 2003 and December 31st, 2007. A rate of return of 40% every year, for 5 wonderful years.

Table 1: Foreign investors dump India, locals keep buying
PeriodForeign Activity (US$ m) Local Fund Activity (US$ m) Total (US$ m) Change in BSE-30
TRI in that period (%)
CY 2003 6,940 93 7,033 + 86.3%
CY 2004 8,958 -261 8,697 + 23.1%
CY 2005 10,896 3,089 13,985 + 42.2%
CY 2006 7,994 3,442 11,435 +53.3%
CY 2007 17,235 3,121 20,357 +68.5%
Cum Total till CY 2007 52,023 9,48461,507 +742.1%
YTD September 30 -9,121 2,400 -6,721 -45.9%
CY = Calendar Year; YTD = Year to Date

But there was a problem
Over 50% of this FII money was from speculators who hijacked the FII route (set up for long term capital, remember) and were basically here for the gamble. The Indian stock market became part of the global financial speculative activity. The P-Notes were their backdoor entry into the Indian stock markets. The casino doors were left wide open.

These FII’s and P-Note holders have bought and sold, on average, USD 1 billion of stocks every day for the past 5 years. But – at the end of the day – if you look at their net positions (shares that they actually buy and pay for – or sell and get money for) is about USD 30 million a day. About 3% of their total daily volume. Sounds like some pretty active speculation, not the actions of long term investor.

But as long as the FII’s were net buyers, no one seemed to care.
The markets rose and the Price-to-Earnings ratio (one metric of valuation) rose pretty steeply.

Graph 1: PER, historical, of the BSE-30 Index now at the lower range

Source: Bloomberg

But now, as Table 1 indicates, the FII’s are selling. FII’s have sold USD 9 billion of stocks in India this year. The local Indian mutual fund is buying – but only USD 2 billion. When there are more sellers (USD 9 billion) and fewer buyers (USD 2 billion) the price of anything will come down. And that is why the stock market is sharply lower. Investors are running for cover.
The Price-to-Earnings ratio of the market has collapsed from over 20x (expensive) to under 15x (not expensive any more).

Screams from Wall Street.
The Indian economy has little to do with the boom or the bust in the US economy.
Ask your friends in USA to walk around the house or apartment they live in and make a list of every single item they own: microwaves, furniture, clothes, cars.
Then ask them to list the country where it was manufactured.
Then ask them to put a price tag to it.
Then ask them to work out how much of the total value of goods in their homes is made in India.
Express that total value as a percentage of the total value of the goods they own.
Chances are less than 1% of what they own will be made in India.
If your friend is an Indian – an NRI – they may have an over-priced Indian painting hanging on their wall.
Conclusion: India had nothing to gain from the years of excessive growth in the US economy. As the economy in USA slips, India has little to lose.

Maybe a few call centre jobs, maybe some slow down in the technology sector.
A fewer number of towels being exported.
Not a lot in a USD 1 trillion economy the size of India.

So, when Wall Street and the global markets fall so sharply, why is India affected?

Wall Street is crying in pain from its excessive greed – and India is linked to this flow of short term capital because we had the P-Notes. The casino players were the king of the Indian stock markets worshipped by our brokers and by our policy makers. The gamblers grew in size with the blessings of successive governments – the only dissent came from the Reserve Bank of India. Shut the P-Notes, warned the conservative RBI, or we will pay a heavy price.

But no one listened.

The creative geniuses – with speculation as their weapon - were insistent that two and two made twenty two.

Alas, two and two – when speculation ends – is only equal to four.
And so that speculation has ended.
The Indian stock markets are being sucked in big time to the end game as this bubble deflates.
But this is a great time for the rational to step in.
To switch off the TV channels and remember: If you are an investor, you can now buy that “four” for less than “three”.

Suggested allocation in Quantum Mutual Funds
Quantum Long Term Equity Fund Quantum Gold Fund
(NSE symbol: QGOLDHALF)
Quantum Liquid Fund
Why you should own it: An investment for the future and an opportunity to profit from the long term economic growth in India A hedge against a global financial crisis and an "insurance" for your portfolio Cash in hand for any emergency uses but should get better returns than a savings account in a bank
Suggested allocation 80% 15% 5%

Disclaimer: Past performance may or may not be sustained in the future. Mutual Fund investments are subject to market risks, fluctuation in NAV's and uncertainty of dividend distributions. Please read offer documents of the relevant schemes carefully before making any investments. Click here for the detailed risk factors and statutory information"

Note: Ajit Dayal, the author is a Director in Quantum Information Services Private Limited and Quantum Asset Management Company Private Limited. Views expressed in this article are entirely those of the author and may not be regarded as views of the Quantum Mutual Fund or Quantum Asset Management Company Private Limited or Quantum Information Services Private Limited.

Mutual Fund Investments are subject to market risks. Please read the offer documents of the respective schemes before making any investments.


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