»The Honest Truth by Ajit Dayal

Why I worry
26 OCTOBER 2017

An equity investor, by nature, is an optimist.

After all, when we look at the future of a company and the outlook of its business we are projecting into the unknown and trying to envisage what is likely to happen to the business, its profitability and - by extension - its share price.

If we have invested in a company's share after having examined all these "if's" built into the unknown, unseen, and unpredictable future, we have to be optimists!

Hence, the above statement: An equity investor, by nature, is an optimist.

And, yet - though I am an equity investor - I am worried.

It's possible that the style of investing that I adhere to ("value investing") for my core portfolio follows the cautious let-me-pinch-and-check style and yet willing to make a bold leap into the unknown.

But, there is that constant pause for a pinch - the time it takes to reach out and check the reality markers along the journey into the unknown.

What makes it even more complicated is the fact that no one really knows the true meaning of "value investing". There is no single, clear, agreed definition of "value investing". As Wes Freeman, my marketing colleague at Hansberger Global Investors, used to say in his very southern drawl, "Value, like beauty, lies in the eyes of the beholder."

For now it seems that the beholder is smitten less by earnings and more by passionate fantasy. In the Indian context, a flood of money sloshing around the world, low interest rates globally, and India-specific factors including blind faith in a Modi Magic wand have overwhelmed the disciplines of "value" investing.

Table 1: India does well, but does not outshine; Quantum Long Term Equity Fund has a dull year (all returns in USD; from Nov 2, 2016 till October 18, 2017)
Dow Jones 30, USA32.1%
MSCI Emerging Markets29.9%
MSCI World Markets25.0%
BSE 30 Index22.9%
Quantum Long Term Equity Fund17.2%
Gold ETF-1.4%
Silver ETF-8.5%

Source: Bloomberg

So, as we start yet another Indian new year beckoning us to the future, I weigh the positives and the negatives of what could happen....

The headlines of flows.

The one known is that Indian households will continue to save a lot.

About Rs 40,00,000 crore or some USD 650 billion every year. To put that in perspective, that is enough money to build maybe 80,00,000 apartments across various cities in India. These could house maybe 3.2 crore people and, in 5 years, could ensure that every Indian lived in a 1,000 square feet apartment or home! Yes, we have that ability to use our savings to solve a national housing problem!

We also know that money invested in real estate in most cities in India has been a terrible investment for much of the past 3 years.

And the bank deposit or the FD rate is so low that it will barely pay for your weekly aloo paratha or idli dosa.

Since real estate and FDs have not been good avenues for your savings, gold would be a natural place to park your money. But the government keeps on changing the rules to buy gold - from PAN card details to import tariffs. In addition there is a fear that the government could ban the ownership of gold to root out black money. We have a government that was stupid enough to believe that a Rs 500 note is a "High Value" note (when is the last time that any Minister or their spouse went shopping for vegetables with a single Rs 100 note in their pocket?) as opposed to the fact that a Rs 500 note is a necessary note to carry in your wallet the moment you step out of the house? And, rather than admitting that demonetization was a stupid idea which has cost the nation billions in loss of output, the government has announced that they will celebrate November 8th as Black Money Day.

Just as President Bush was confused between Iran and Iraq, our government was confused between "High Value" and "High Denomination". Zimbabwe had a Million Dollar note. It was certainly "High Denomination" but you could buy a loaf of bread with it - so it was not "High Value"!

The Honest Truth is that there were / are far better ways to knock off black money and/or encourage Digital India.

We must live with the fact that demonetization was probably a political move to wipe out the cash hordes of the hapless opposition parties prior to the state elections in UP: a political nasbandi.

Gold investors fear that a kursi-focused government could, ahead of the May 2019 elections, call in all the gold on the logic that every Indian owns the yellow metal and, therefore, that gold must be black. The same logic that assumed that if every Indian has a Rs 500 note, it must be black. Or the same logic that every criticism of the BJP is equal to love for the Congress.

According to RBI data the counterfeit notes (one of the 2 original reasons for the demonetization announced on November 8, 2016) accounted for Rs 41 crore or 0.000027% of the notes returned. So tens of millions of people stood in lines and stopped working so that the RBI could catch maybe a thousand people with fake currency notes?

The point being that, knowing how badly planned this whole demonetization thing was, as an owner of gold I am nervous and susceptible to the election winning whims of a government that has remained in election mode since 2014. Hence, gold - which should shine when things look confusing - is relatively sluggish. There is an aura of fear around the yellow metal: not a Laxman rekha of respect as a safe haven. So, gold is not a preferred place to invest too much of your savings.

Which brings me to stocks.

Of all the asset classes, stocks are the most liquid, the most tax-friendly, and - most importantly - the one that is shining brightly!

Every household must own stocks.

We have said that before - and will say it again: If Mr India, median age 27 years, were a client of a typical financial planner then Mr India would typically - and rightfully - be advised to invest over 40% of their savings in equity.

Sadly, everyone is rushing in to buy stocks at a time when the "value investor" in me says one must be in stocks but...

You buy stocks for two reasons:

  1. The companies are making a profit and/or are expected to make more profits, or
  2. There is another, bigger fool willing to buy the stock from you.

Please note the use of the words "another, bigger fool".

It suggests you are a fool to buy it in the first place.

In finance, this is called the Greater Fool Theory.

Let's take the "earnings growth" reason to buy shares. For the Index as a whole, some companies make money and some are not making money; some are showing a growth in the earnings and some are not.

The research analysts who work for brokers - and who make money by ensuring that you buy or sell stocks or mutual funds - have started the forecasts for estimated earnings at a very high level every year since 2014. By the end of every year - when the year-end reported dawns on their powerful, imaginary xl sheets - they have to report the fact. In April 2016, they can estimate what earnings will be in March 2017 (see the brown line in Graph 1).

By March 2017 it is what it is and the actual, reported EPS numbers are declared - they can no longer get you revved up with an "estimate" for that 2017 number; they have to start the lies/estimates/guesses again for the next year.

Graph 1: Reported earnings for March 2017 lower than that of March 2014.The sell-side perpetuates the myth of higher EPS.

If a normal person working in a normal business was to tell his boss every year for 4 years that actual reported numbers for each of those 4 years were 40% lower than the estimates that employee had made at the start of the year, chances are that this "normal person" would be handed out a pink slip and fired immediately!

In the field of finance, the analyst who is wrong gets a higher salary and a higher bonus - because they used their charm to get you wound up into buying shares or mutual funds! That is good for their revenues. That is good for their salary hikes. That is good for their bonus payments.

Of course, it is a free market with choices and, pulling off this magic act, requires a trusting believer at the other end.

Or a person blinded by the light.

The fact that Prime Minister Modi's name is lit in neon and the BJP was believed to be a party that can only do right, helps in the story-telling to you and the subsequent bonus entitlement to them.

No excuses. You are an adult investor. Learn to think. SEBI cannot protect greed.

Eventually, the truth of lower earnings finds its way into the PER chart. Earnings of Indian companies that constitute the various stock market indices are lower by 5% to 10% from the time when Prime Minister Modi rode to power on a plank of economic development in a well-deserved, stunning majority in May, 2014. (Please recognize that the UPA-2 was probably one of the most corrupt and/or irresponsible governments to ever misrule India.)

With EPS declining and flows ensuring a surge in stock markets, the outcome is a higher PER - nearing an all-time peak (Graph 2)!

Graph 2: PERs driven by "price" not earnings" don't suggest an 'overweight' but, rather, caution. EPS not likely to surge to catch up!

SIP is not a sure shot way to make money.

Since we are already busting myths of the Indian stock market riding a wave of growing earnings of companies, let's look at the other myth of why an SIP is the best way to invest in shares.

I want to distinguish between "best" and the assumption that, because it is "best", it is profitable.

The SIP flows are a good, measured way to get invested in stock markets via mutual funds - but they don't necessarily mean that you will prevent an erosion of your wealth in case of a stock market decline.

And nor is it a given that you will always make a sensible return for the risks taken of being invested in equity.

Let's assume that by January 2014 you knew that the BJP would win the general election.

And you decided to start an SIP of Rs 10,000 every month for the next 48 months.

The money would be invested in an Index fund replicating the BSE 30 Index on the last trading day of every month.

So, by September 30, 2017 - 45 months after you made your first investment, where do you stand?

The assumption here is that dividends, which can add about 1.2% per annum to your returns, are offset by transaction costs and fund expenses. Someone has to pay for the high costs of the fund management industry which SEBI is rightfully trying to control. In case you have not realized it by now, that someone is you. And SEBI is trying to protect you.

Table 2: SIP gave you an average buy-in price of 26,859 level of the BSE-30 Index
DateBSE 30 INDEXSIP, monthly INRBaskets
Avg cost per unit26,859
Current Value524,133
Total Return16.47% 
Recognising timing over 45 months, nearly 4 years

In a nutshell:

  1. Total Investment: Rs 450,000 (Rs 10,000 x 45 months);
  2. Total Units of this Index fund which represents the BSE-30 Index: 16.77 units.
  3. Average cost per unit: 26,836 (consider this to be the breakeven number of the BSE-30 Index; if the Index declines to this level then you have no profits. If it declines to a lower level, then you have losses);
  4. As of September 30, 2017 the BSE-30 Index was 31,284; therefore, your 16.77 units are worth Rs 524,590.
  5. You have a potential profit of Rs 74,590.
  6. That is a 16.58% return if not adjusted for the timing of your investments (note that you invested Rs 10,000 every month so you did not have Rs 450,000 invested in the market from January 30, 2014). This is not an accurate was to judge your returns, though.
  7. Adjusted for the timing of your investments, your return would be 8.44% per annum over 45 months. Nearly 4 years. This is a more accurate way to measure your true returns.

For the risk you have taken, you have gotten a reward better than the FD rate. This SIP has probably done better than the property investments you may have had since January 2014.

Table 3: For all that risk you have got a fair reward.
Below FD or negative48.5%42.9%0.0%

So, if we were to look at the SIPs and ask:

  1. For every investment made, what was the return 12 months later? The answer is that 48.5% of the time the return was either negative (a loss) or lower than a FD rate;
  2. For every investment made, what was the return 24 months later? The answer is that 42.9% of the time the return was either negative (a loss) or lower than a FD rate;
  3. For every investment made, what was the return 36 months later? The answer is that all the returns were far more than a FD. Clearly, the fact that the BSE-30 Index has been above the average buy-in price of 26,859 for every end of month period for the year 2017 has helped in arriving at that very positive outcome.

The point really is that while SIPs is a great way to pace your entry, the outcome or profit number is a function of where markets are. In Calendar Year 2016, an SIP investor who had poured in money every month in Calendar Year 2015 lost money on a 12-month return basis - or earned far lower than an FD - for every single month in 2016.

The foreign investors are a little more wary of the Indian stock markets now. They have alternatives: China has seen 7x more inflows into its stock market than India has this year.

If Indian investors start seeing losses, how will they behave?

Or should the SIP investor pause in their allocation?

Or book some profits and wait to restart an SIP later?

Or, are local investors buying stocks only because of the TINA factor?

TINA = There Is No Alternative.

In which case, all they are doing is waiting for the Bigger Fool to come along.

Those stories never have a Happy Ending.

That is why I worry.