Preparing a buffer - The Honest Truth By Ajit Dayal
Investing in India - Honest Truth by Ajit Dayal
Preparing a buffer A  A  A
27 OCTOBER 2008

At the start of the year, I had a view that investors should have the following allocation for their investments:
Equity mutual funds: 80%
Gold: 15%
Liquid funds: 5%.

This was based on the assumption that equity markets - as measured by the BSE-30 Index - would not decline below 15,000 levels. A loss of about -30% in the near term.
With an Index struggling to stay above 10,000 - the assumptions have been blown apart.

Graph 1: The fall turns into a free fall.
Source: BSE Sensex daily closing data

In previous writings (see Alphabet Soup - Part 1, 11th September 2007) I had indicated the possible effect on India.
And I had even hinted at a free fall (see Alphabet Soup, The Indian Spice, 30th October 2007) - but never thought that it would actually occur.
I took the view that it was difficult to hold an investment portfolio based on panic and a freefall - but when it did occur - an investor would need to review the allocation.

Well, the freefall is in full swing. In hindsight,this freefall began in late September, 2008. When Lehman declared bankruptcy on September 15th.

Indian companies tap global debt markets
I had failed to recognise the extent - and depth - of the global blow up.
I was not able to connect the dots of the blow up of the hedge funds managed by
Bear Stearns to the blow up of Bear Stearns itself!
Or to the failure of AIG - one of the largest finance companies in the world - Fannie Mae, Freddie Mac, Wachovia, and Lehman Brothers.
And the near collapse of Goldman, Sachs and Morgan Stanley.
And banks in UK and Germany.
And of countries like Iceland and South Korea.
I have always suspected that these large finance companies were hosts to gamblers but never realised that pretty much all that they do is a glorified form of gambling!

While it is true that the real economy in India continues to be quite de-coupled from the global economy, the Indian debt markets - and Indian companies - have built many bridges with the global debt markets. The effects of these bridges are what is troubling some companies and affecting parts of the real economy now.

Ajay Shah has co-authored a wonderful note on liquidity (please click here to read it) which shows how Indian companies and Indian banks became dependent on the availability of money in London and New York to fund their businesses.

In many cases, the businesses of many Indian companies are still solid. These Indian companies are, like most of the banks in India, solvent.

But not every company keeps money in their offices to pay salaries or pay suppliers. Liquidity is often described as the oil that flows through the economy (see Alphabet Soup - Part 1, 11th September 2007).
Banks globally are scared to lend to anyone. They have a lot of money with them - they have been flooded with hundreds of billions of dollars by the central banks.
But they refuse to part with any money: because the company they are lending to may go bankrupt!
If AIG, Wachovia, Lehman, Fannie, Freddie, Bear can all fail - well Dayal & Company may also fail.
So money is frozen to everyone.

Indian companies and banks were relying on this global refinancing to sustain their normal operations and their need for financing some growth.
Instead of being able to roll over the typical 90-day loan, the Indian companies are being asked to return the money.
They had not planned for it.
So the RBI is trying to help them by injecting liquidity into the system. Pouring in oil so that the engine does not seize up.

From Debt markets to Death markets
Meanwhile, the stock markets are in a free fall.
Every morning investors wake up - only to see the red smile of death staring them in the face.

If companies have no money to function on a daily basis - what guarantee is there that they will exist tomorrow?
In normal time, companies that are listed on a stock exchange are priced on a going-concern basis: the value of the business assuming the company will be functioning tomorrow.

But these are not normal times - many companies are now being priced for bankruptcy.

Some companies deserve lower share prices - because they were in bubble territory (real estate, finance, and commodity companies are a typical example).
There were some companies that required continuous debt and equity financing to grow. That business model - and the valuation it led to - is suspect.
But there are some companies that are being punished because the environment is bad - not because they are in a bad business.

It is sort of idiotic that the US stock markets - and the US economy and financial system created this mess - are down -40% when priced in US dollars.
But the Indian stock market - which operates in a much healthier economic environment - is down -60% when priced in US dollars.

Graph 2: Comparative Returns: BSE Sensex and Dow Jones

Source: Bloomberg

The short term foreign money dashes out
While India - and the share prices of many Indian companies - did deserve a hit, there is something else out there that caused this massive sell-off in India.
Probably the selling by the P-Note crowd - the short-term pools of capital that have crept into India through a terrible policy-making loophole. Before anyone points a finger at this government, let it be known that this P-Note was a miscalculation made by many successive governments since 1994.

This exit of the foreign investor - the short term foreign investor - has exaggerated the decline in the Indian stock markets.

When will this nightmare end? The honest answer is that no one knows.

Governments, central banks, and finance ministers have repeatedly created "bail-out" packages.
But, just after one bail out package is announced over a weekend, a newly discovered financial mess-up pops up.

Governments are printing money.
The problems are getting larger.
The domino effects - due to the global financial linkages - are overwhelming regulators and finance ministers everywhere.

Gold should have been way above USD 1,000 per ounce by now (over Rs 16,000 per 10 grammes).
In times of crises, gold is seen to be the ultimate safe haven.

Companies are going bust; banks are going bust; stock markets are being shut down; countries are going bust.
And we have a lot of political uncertainty globally - with elections in the US likely to throw up a totally untested political leader.
Flashpoints and wars still exist, globally.
We are in crises - and gold should have benefited.

Gold is also a hedge against inflation - all that money being printed for the bail outs should be inflationary.
If the world is not perceived to be in crises, maybe we can make a case for rampant inflation?
Even that is good for gold.

If you connect the dots that originate from crises or from inflation, gold should be benefiting.
But gold is struggling to stay between USD 700 and USD 920.

Graph 3: Gold in a range - pressured by sales from central banks?
Source: LBMA website.

Some "gold bugs" allege that the central banks and the IMF are selling gold to keep the price down. To ensure that people still believe in the US Dollar and don’t dump the US currency for gold.
Governments could also be using the sale of gold as a source of cash to fund their extravagant, but required, bailouts.

So, the world is in a strange situation.
With many unknowns.
With this background, what should an investor do today?

Your next steps
Well, when there is uncertainty of this magnitude, cash is king.
Cash in the form of money in the bank; at home; in a liquid fund; and in gold.
Don’t get me wrong - stocks are cheap - really, really cheap.
But they could get cheaper tomorrow - which is fine if you are investing for the long run. Like I do.
So, don’t let the daily market movements scare you.

But, what worries me is the overall financial mess we are in.
"We" means anyone in the world.
Even in economically-sheltered India.

How old you are and what stage of life you are in now (single, married, living with parents) should increasingly play a bigger role in your investment decision.

This is what I am doing.
Step 1: seeing how much money I need to live comfortably every month.
Step 2: multiplying that by 24 months (2 years). This is my sacred pile of cash.
Step 3: making sure that this sacred pile of cash is in the mattress, in safe banks, in liquid funds - and available when I need it.
Step 4: the rest of the money should be in equity (80%) and gold (20%).

I, personally, am generally a conservative or balanced person.
But I take risks in life - measured risks.

I like the stock markets for their long term returns (and can live with the short term wallops that occur frequently) - I am invested in the Quantum Long Term Equity Fund.

I don’t like to borrow - but do borrow when I really need to. I don’t use my credit card as a source for any "borrowing" - when the bills come every month, I clear them in full.

I want to make sure that - irrespective of where the world is - I have enough money to pay for my regular expenses for 24 months or 2 years.

Table 1: Living with certainty in an uncertain environment - Planning your investments.
Liquid funds / bank deposits / mattress Equity mutual funds Gold and Gold ETF
Your wealth Rs. 20,00,000
Your monthly expenses Rs. 20,000
Previous recommendation 5% 80% 15%
Rs. 1,00,000 Rs. 16,00,000 Rs. 3,00,000
Seeing where we are... your wealth Rs 20,00,000
Keep 24 months cash; the balance is 80:20 for equity and gold Rs. 4,80,000 Rs. 12,16,000 Rs 3,04,000
The new percentages 24% 61% 15%

Maybe you are okay with keeping 12 months money aside in Step 2 above. Or you are even more conservative and do not mind keeping 60 months money aside in Step 2 above.

That is your individual choice.

As you can see from Table 1 above, there is little impact on gold under this new "formula". The shift is from equity mutual funds to "cash".

But, what if you had already made the 80-15-5 investment in equity mutual funds, gold, and "cash".

A person who was already invested across asset classes at the start of the year has a problem. As you can see from Table 2 below, the wipe-out in stock market values has taken away about 56% from the equity mutual fund investments. Gold has increased by maybe 10% and the "cash" may have earned 4% by now.

Overall, the portfolio has declined from Rs 20 lakh to Rs 11.3 lakh. Using the same formula of 24 months cash, the cash level should be Rs 4.8 lakh. It is currently Rs. 1 lakh.

Table 2: Re-balancing your investments to live with certainty in an uncertain environment.
Liquid funds / bank deposits / mattress Equity mutual funds Gold and Gold ETF
Your wealth - Jan 2008 Rs. 20,00,000
Your monthly expenses Rs. 20,000
Previous recommendation 5% 80% 15%
Rs. 1,00,000 Rs. 16,00,000 Rs. 3,00,000
Current value of your wealth Rs. 11,34,000 Rs. 1,04,000 Rs. 7,00,000 Rs. 3,30,000
Keep 24 months cash; the balance is 80:20 for equity and gold Rs. 4,80,000 Rs. 5,23,000 Rs 1,31,000
The new percentages 42% 46% 12%

Does that mean a person should sell the equity mutual funds and move to cash - so as to reach the 24 months "reserve cash" level?

Well, that depends on you - and your monthly salary.

If you are earning Rs.50,000 per month (after taxes, as an illustration) and your expenses are Rs.20,000 per month then you have Rs.30,000 per month in savings.
It is better that you put this Rs.30,000 into "cash reserves" every month.
Not into any equity mutual fund.
This way, you are not "selling out" of the equity mutual fund at what is a low price.
Rather, you are adding to your cash reserves.

Sure, the markets could fall every day on "global cues" but, if you have a salary and a steady job, you are building your cash reserve.
This means you can survive the troubled times we are in - even if they continue for some more time.

Do your numbers: talk to your financial planner
The tables given above offer a simple framework under which you can ride out the uncertain environment.

The numbers are fiction - you need to input your thinking and your numbers to make the tables relevant for you.

Please do not misunderstand my desire to have a high "cash reserve".
I am not panicking.
I am not scared.

But I recognise that there are 2 extreme situations co-existing in the world today:
1. Tremendous uncertainty, and
2. Fantastic investment opportunities.

From an emotional point, the market is more overwhelmed by fear of how much one can lose tomorrow rather than the greed of the money one can make in the next upswing.

Tomorrow is 24 hours away. Nothing can change that.
But when is the start of the next cycle? No one has any idea when it will start. We can guess - but it remains a guess. My guess: we will already have recovered in 16 to 22 months.

One day greed will come back - with a vengeance. As it always does in these cycles of boom and bust that exist in any market - and in any investment.

Meanwhile, I wish to ride both these chariots.

I will tide over the path of uncertainty with the high cash level (24 months of my expenses) that works well for me. I know I have certain expenses that I must meet every month.

I will ride on the path of the investment opportunity with the 80:20 spilt of my balance wealth with investments in stock markets and gold.

The waters are a lot rougher than what had been expected.
You can accept this fact, and change the course we charted at the start of the year.
Or be stubborn and take your chances.

In investing there is no room for panic or greed.
And there is no room for stubborness.
Happy Diwali and Best Wishes for the New Year.

Suggested allocation in Quantum Mutual Funds
Quantum Long Term Equity Fund Quantum Gold Fund
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 (New) 46% 12% 42%
Suggested allocation (old) 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: The Honest Truth is authored by Ajit Dayal. Ajit is a Director at Quantum Advisors Pvt Ltd and Quantum Asset Management Company Pvt Ltd.. 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.

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

Other Views on News:

» SIPs: A long-term investment strategy
Systematic Investment Plans (SIPs) are much misunderstood. For one, investors often mistake SIPs as an investment avenue rather than a mode of investing in mutual funds. Read on...

» RBI sticks to its guard
Not wishing to let out too many of its cards after having already had a hectic month, the RBI chose to have an in-active stance in its half year review of the monetary policy. Read on...

Read our Privacy Policy and Terms Of Use.
Get The Honest Truth directly
in your mail box.
Just enter your e-mail address» 

Read our Privacy Policy and Terms Of Use.

Equitymaster requests your view! Post a comment on "Preparing a buffer". Click here!