Tag: investing

Beware of Single Factor Investing

Factors are short-cuts

Analyzing financial statements is a cumbersome process for most retail investors. Many don’t have the time, patience or expertise to dig through balance-sheets, income and cashflow statements. Most don’t find joy in reflecting on the many footnotes that accompany such statements. Here lies the attraction of single-factor investing.

Price-to-Earnings (PE) ratio is one such factor. We recently saw how there was no great advantage in investing in mutual funds that use PE to switch between debt and equity. It is a poor market timing indicator even when practiced by professional fund managers.

The ‘E’ in PE

The ‘earnings’ line-item is an accounting driven artifact that is easily gamed and has very little relationship with the company’s value. Here’s what Michael J. Mauboussin has to say about earnings, see appendix for the full note:

… an increase or decrease in earnings does not provide a clear picture of the corresponding increase or decrease in shareholder value. This is because the earnings figure does not reflect the company’s level of risk, does not take into account the investments needed for anticipated growth, and is subject to a wide variety of accounting conventions. Such accounting conventions do not ordinarily affect cash flow and hence do not affect a company’s value.

Even Shiller’s cyclically-adjusted P/E (or “CAPE”) has little predictive value in the short term. Shiller CAPE shows its strongest correlation to nominal returns over an 8-year time horizon, and is actually most predictive of real returns over an *18* year time horizon. (Kitces)

Some investors also look at Price to Book and Return on Capital Employed. These ratios provide a convenient short-hand but are far from adequate in forecasting future earnings.

Besides what does the ratio of total assets to total liabilities measure anyway? Intangibles can’t be quantified. Are inventories adjusted to current market prices? Is the loan loss reserve adequate?

Bottom line: Assets are often overstated and liabilities understated. (Fool)

What does “capital employed” mean anyway?

  1. No general agreement exists on how capital employed should be calculated, on whether initial or average capital employed should be used or on how profit should be defined.
  2. Often, accounting profit rather than cash flow is used as the basis of evaluation.
  3. It ignores the time value of money.

Take away

Every style of investing – value, momentum or factor – depends on finding historical patterns and extending them into the future.

Every valuation metric comes with a “yes, but…”

No single factor is a predictor of future returns.

Appendix

Are Dividends Anti-Shareholder?

Dividends vs. Buy-backs

When firms are left with excess cash, they have the option of distributing money back to shareholders by either issuing dividends or buying back their stock.

All things being equal, investors should be indifferent whether a company pays dividends or engages in a buy-back.

The dividend irrelevance argument

The underlying intuition for the dividend irrelevance proposition is simple. Firms that pay more dividends offer less price appreciation but must provide the same total return to stockholders, given their risk characteristics and the cash flows from their investment decisions. Thus, there are no taxes, or if dividends and capital gains are taxed at the same rate, investors should be indifferent to receiving their returns in dividends or price appreciation. (Source: NYU)

Indian Taxes

In India, long-term capital gains in equity investments attract zero tax. Long-term is one year. However, there is a dividend distribution tax of around 28%. So if a company decides to pay Rs. 100 in dividend, only Rs. 72 reaches the shareholder.

In this scenario, companies that declare dividends are taking a step that is against the interests of the share-holder. Investors are better off if the company buys back stock from the open market instead.

Here are some of the largest dividend payers:

2015 2014
TCS

17020.50
5480.10
INFRATEL

1682.20
566.60
VEDL

3106.30
2214.40
ITC

4875.60
4238.60
WIPRO

2949.00
2327.30
HDFC

2505.90
1939.90
HINDUNILVR

2918.90
2495.60
TECHM

549.60
135.90
ICICIBANK

3084.10
2704.00
HINDZINC

1878.50
1532.50
The figures are in Rs. crores and nearly 1/3rd of this goes to the tax-man.
One wonders if these companies are working for the Indian government instead of the shareholder.

Conclusion

Small investors and fund managers should demand that the boards consider buy-backs over dividends.

Ten years is a long time

Yearly Nifty and Defty Returns

nifty.vs.defty.returns

When you look at the last 24 years of returns, the NIFTY gave negative returns for 8 years – 1/3rd of the time.

Holding period matters

The most frequent advice given to new equity investors is that they should at least have a 3-year horizon. The problem with this is that there have been 7 periods where cumulative 3-year returns have been negative or single digits. This sort of advice does nothing to mentally prepare the investor to stay disciplined.

nifty.defty.3.yr.returns

In fact, dollar investors (NRIs, etc.) have had it rougher.

nifty.defty.5.yr.returns

It is only when you look at 7-years and beyond that you start seeing the kind of returns that begin to make sense.

nifty.defty.7.yr.returns

nifty.defty.10.yr.returns

Long-term portfolio but short-term horizon

Very often, advisors set up portfolios looking at this:

nifty.defty.15.yr.returns

Whereas the media is feeding the investor this:

CNX NIFTY.2015-07-15

Long-term investing works if you have the discipline to ignore portfolio returns over very long time horizons. But how many of us have the discipline to stay the course over decades?

Optimization vs. Maximization

The dog years of 2010, 2011, 2012 and 2013

According to AMFI, these are the 5 largest funds at the end of March-2015:

Scheme Name AUM (Cr.)
HDFC Equity Fund – Growth Option
1,280,287
HDFC Top 200 Fund – Growth Option
1,009,121
Reliance Equity Opportunities Fund-Growth Plan-Growth Option
764,383
HDFC MID-CAP OPPORTUNITIES FUND – Growth Option
715,865
ICICI Prudential Value Discovery Fund – Regular Plan – Growth
645,946

What this means is that there is at least one person in your immediate network who would have invested in one of these funds.

Now let’s take a walk down memory lane. 2010, 2011, 2012 and 2013 were the worst years for the Indian economy. The RBI had messed up monetary policy leading to high inflation (double digits), there was a currency panic (rupee went from 45 to a dollar to 65), a never-ending series of scams and a government hell bent on redistribution. The only two asset classes that were doing well at the time were gold and real estate. GOLDBEES, the gold ETF, returned 13.25% (IRR) during that period. Fixed deposits were yielding around 11%. How would a typical investor react if his actively managed equity investments gave the following returns?

Scheme Name IRR
HDFC Equity Fund – Growth Option
7.00%
HDFC Top 200 Fund – Growth Option
6.74%
Reliance Equity Opportunities Fund-Growth Plan-Growth Option
12.00%
HDFC MID-CAP OPPORTUNITIES FUND – Growth Option
13.24%
ICICI Prudential Value Discovery Fund – Regular Plan – Growth
11.09%

Here is Gold (in red) vs. HDFC Equity Fund (in black):

Needless to say, most investors who dipped their toes into the equity markets in 2010 gave up after a couple of years and still believe that the whole mutual fund business is a scam.

First half of 2015

We are supposed to be in a bull market. But let’s see how the first half worked out for the HDFC Equity Fund:

IRR of -2.39%. And bonds lost money too (in June.) Bull markets are not immune to prolonged periods of a “sideways” market.

Diversification across assets

A standard response to most investing problems in diversification. Invest a little into a variety of asset classes – equities, commodities, real-estate, gold, bonds – and you will be fine.

The problem with diversification is that it always feels wrong. For example, there are “balanced” funds that are supposed to allocate between both bonds and equities. They end up having lower draw-downs because of this. If you compare the ICICI Prudential Balanced Fund with HDFC Equity Fund between 2010-2013, the latter has an IRR of 11.38% vs. 7.00% of the former. But during the bull market of 2014, the balanced-fund gave an IRR of 45.47% vs. the equity fund’s 53.83%. So the lower draw-down comes at the expense of performance. It is a huge cognitive burden for investors to live with.

The kind of assets you pick for diversifying into also matters. For example, there was this big thing back in the day about the “commodity super-cycle.” About how the insatiable appetite for all sorts of commodities from China would keep growing to infinity. Plus, commodities were supposed to uncorrelated with equities. So great for diversification, right? Here’s how Mirae Global Commodity Equity Fund compares to the HDFC Equity Fund:

Commodity stocks did turn out to be uncorrelated but not in a way that you would like. And the commodities themselves are bouncing along multi-year lows right now.

What about bonds? Surely, they are safe. But let’s not forget that in 2009 and 2013, gilts drew-down double digits and their long-term IRRs are between 7% and 10%.

gilt drawdowns

Diversifying across geographies

What if you invested in international funds? After all, the rupee keeps going down, right? Depends on where you look. Between 2010 and 2013 (the dog years) the Birla Sun Life International Equity Fund – Plan A gave an IRR of 16.09% vs. HDFC Equity Fund’s 7%. But before you pat yourself on the back, between 2014 and now, the latter gave an IRR of 3.06% vs. 32.54% of the former. And Religare’s Pan European Equity Fund gave 1.50%.

Diversification means that your overall portfolio will trail behind the best performing asset class du jour. Psychologically, it is a very difficult thing to stick to.

Investing fads and broker recommendations

Of all the poor choices that investors can make, the worst is giving into investing fads. Back in 2004, there was this whole “India shining” marketing slogan. And now there is “make in India”, “smart cities”, “digital India”, etc. And almost every single time, fund houses come out with new schemes that tag along the slogan du jour. Here are some examples:

Morgan Stanley came out with their stock picks if Modi won (Theme created Dec 6, 2013):
morgan stanley strong election result

Here’s one on the Rail Budget (Theme, created Feb 26, 2015)
rail budget 2015 theme

So much for betting on rate-sensitive stocks (Theme, created Feb 3, 2015):
rate sensitive 2015 theme

You can browse through all these recommendations and lists under the “Broker Recommendations” section of our Themes page. We call it Doodh Ka Doodh Pani ka Pani.

Optimization vs. Maximization

The above examples highlight the problems of trying to maximize returns. There will always be an asset class, mutual fund or stock that is doing better than what you own. And there is an entire industry of tip-sheets, newsletter writers and subscription services that promise to pick the next winner.

However, we see investing as an optimization problem. We believe that drawdowns are an inseparable part of investing. Instead, we focus on getting the right mix of assets and strategies based on your risk appetite. And we make it supremely easy to stick to a plan.

For direct equity investors, this means getting Value and Momentum right. We have created Themes based on different approaches to value and momentum investing. Investors can then map our Themes to gain exposure to a specific set of strategies.

For mutual fund investors, this means getting portfolio risk right. We have created Themes based on the risk of the overall portfolio. Investors can now tune out the noise and focus on achieving their life goals.

Investing is not easy, but your journey as an investor will be so much more smoother with us. Get in touch with us now!

Keynes’ key to successful investing: He abandoned forecasting

Read an interesting article in the FT by Tim Harford about forecasting. Was hit by a couple of “aha moments”.

First:

Keynes’s track record over a quarter century running the discretionary portfolio of King’s College Cambridge was excellent, outperforming market benchmarks by an average of six percentage points a year, an impressive margin.

The secret to Keynes’s profits is that he abandoned macroeconomic forecasting entirely. Instead, he sought out well-managed companies with strong dividend yields, and held on to them for the long term. Keynes, the most influential macroeconomist in history, realized not only that such forecasts were beyond his skill but that they were unnecessary.

And here’s the other gem:

Most forecasters aren’t actually seriously and single-mindedly trying to see into the future. If they were, they’d keep score and try to improve their predictions based on past errors. They don’t.

This is because their predictions are about the future only in the most superficial way. They are really advertisements, conversation pieces, declarations of tribal loyalty…

Read the whole thing: How to see into the future