"Gentlemen prefer bonds."
- Andrew Mellon (US Businessman, financier, philanthropist, US Treasury Secretary 1921-32. For some readers, Carnegie Mellon University might ring a bell)
It is 'common wisdom' that stocks are better investments than bonds, especially over long periods. After all stocks have earnings that grow over time while bonds only yield interest.
This might be true for single investments made over long periods. Many investors however make investments periodically, like a Systematic Investment Plan (SIP). Of course, SIPs are much advocated by the financial advisers as a prudent tool for market out performance over long periods. I had published 2 posts on this blog showing how SIPs in fact do not generate great returns even over long periods (http://shashankjogi.blogspot.com/2008/06/do-sips-really-work.html and http://shashankjogi.blogspot.com/2008/07/comparing-5-investing-strategies.html.)
But do SIPs even beat investment in debt? It will depend upon returns from equities and the prevailing interest rates. Looking at history, I tried to compare two SIPs.
-The first was an investment of Rs 10000 in the BSE Sensex on the first trading day of every month.
-The second was an investment of Rs 10000 in a 1 year Fixed Deposit of the leading bank in India every month.
The time period for the study was from January 1991 till December 2008. i.e. a period of 18 years.
Since exact data for fixed deposit interest rates is not available, I took at these as the yield on a 10 year Government of India security plus 1%. (Currently, this yield is around 5.5% while 1 year bank FDs are giving an interest of 8.5-10.5% depending upon the bank. So 1% above G-sec yield is a realistic assumption).
The results were surprising!
(1). BSE Sensex SIP:
A total sum of Rs. 2160000 was invested.
This became Rs. 5575010 (as of 30 Dec 2008)
This implies a return of approximately 9.3% per annum
Add about 1.5% in dividends and the return comes to 10.8%
(2). SIP in Bank Fixed Deposit:
A total sum of Rs. 2160000 was invested.
This became Rs. 8076625 (as of 30 Dec 2008)
This implies a return of approximately 12.5% per annum.
The SIP in Bank FD beat the SIP in BSE Sensex!! Over a period close to two decades, SIP investing in debt beat SIP investing in equities!
Many of you might recall the high interest rates in the 1990s. At their peaks, FD rates had gone up to 17% while staying in double digits for the entire 1990s decade.
Post 2002, interest rates softened and fell into single digits. So one would have expected returns from FDs to be significantly lower compared to Sensex since the start the latest bull market in 2003. So how do the two compare?
(1). SIP of Rs 10000 per month into BSE Sensex since Jan 2003 done on the first trading day of the month:
A total sum of Rs. 720000 was invested.
This became Rs. 955836 (as of 30 Dec 2008)
This again implies a return of approximately 9.3% per annum
Add about 1.5% in dividends and the return comes to 10.8%
(2). (2). SIP in Bank Fixed Deposit:
A total sum of Rs. 720000 was invested.
This became Rs. 921566 (as of 30 Dec 2008)
This implies a return of approximately 8.3% per annum
Even in a mega bull market, Sensex SIP could not significantly outperform the SIP in Bank FDs! FD SIP investors would have got returns somewhat lower than Sensex SIP but with no volatility and no risk...and would have slept much better than equity investors.
(Note that Bank FD returns are pre-tax figures)
The future is never like the past and conditions always change. Maybe in the future equities significantly outperform debt. Maybe this does not happen. We don't know, though I would tend to lean on the side of equities outperforming debt. But the study made above throws some points:
(1). SIP investing in equity is not necessarily a great tool for wealth building.
(2). Investing into equities is buying parts of businesses. Businesses are subject to competition and also have their ups and downs. Investing makes sense when businesses are available cheap. Investing makes sense when conditions for businesses are favourable. Stock prices reflect future business prospects and when prospects start appearing weak, equity investing loses money. Unless someone seeks mediocre returns, investing should not mean buy-and-hold-till-you-die. If someone wants to practice SIP investing, the same principle should apply. Do not get taken in by glib talk by some talking head in the media
(3). Learn to sell intelligently. It is selling that counts.
Sometimes, everyone should prefer bonds!
Wednesday, December 31, 2008
Sunday, December 21, 2008
Cheap Stocks and Value Traps
When stock prices fall, people tend to buy. Since prices have come down, stocks become cheaper and hence in the future they are expected to go higher again. Investors perceive value in stock prices that have fallen. There is a breed of investors called value investors who specialise in picking value stocks.
In the current stock markets meltdown, so many stocks have fallen 60-80% or more. Value investors are perceiving this to be a good time to pick stocks. But amidst value stocks abound many other 'value traps' - stocks that have fallen a lot but are destined to languish at low levels for really long periods. Investors should avoid such value traps since they block investor capital indefinitely without generating returns.
The reasons a stock is perceived as a value stock are (1) the share price has fallen and the stock is cheap (2) future earnings prospects are good so the company/stock would bounce back.
In contrast, a value trap is a stock whose (1) share price has fallen and the stock is cheap (2) future earnings prospects are bad and the stock/company would not bounce back.
So how does one go about distinguishing between a value stock from a value trap? There is no right or infallible answer. Even seasoned investors make the mistake of buying a value trap that looks like a value stock. Detecting a value trap is not a easy task. But can we at least have some parameters that could guide us in such an endeavour? Here are a few questions that you could answer before you try to seek value in stocks.
(1) Is the company cheap based not on trailing earnings but on future/forward earnings?
Quoted valuation metrics like PE ratio are based on historical earnings, mostly on the trailing 12 months earnings. What really matters is what earnings are going to accrue in the future. If future earnings are going to fall and future earnings down the road are not coming back to current levels again, the stock is only optically cheap and is a value trap. For example, Unitech quotes at a PE of 4.3. It looks very cheap. But if next year's earnings are going to fall by say, 90%, the forward PE is 43, which is quite expensive.
(2) Does the company have a lot of debt on its balance sheet?
Debt works both ways. In good times it boosts earnings. In bad times, it becomes a stone around the company's neck. Debt needs to be serviced in good times as well as in bad. In bad times interest payments takes up a large chunk of earnings. Beware if there is a lot of debt on the balance sheet, especially if you see an economic slowdown coming.
(3) Does the company operate in a cyclical industry?
Cyclical industries, true to the name, are subject to up cycles and down cycles. Typically, such companies have a large fixed cost of operation (usually are capital intensive and hence are loaded with debt). In an up cycle, their product prices are rising, operating efficiencies set in and profits zoom. In down cycles, product prices fall, operating leverage works in reverse and profits plunge. So SAIL might look cheap at a PE of 4.3, but if the steel cycle is down, earnings going forward could be dismal and hence the stock could be a value trap.
(4) Does the company generate free cash flow?
Cash flow is like blood flowing through the body. Stop the cash flow and the body dies. Earnings are different from free cash flow. Earnings can be massaged and managed. Not so for cash flow. Does the company have stable or growing free cash flows? Lack of cash can starve a business and you dont want to be in a company that suffers starvation.
(5) Is the company losing market share?
All businesses go through down cycles and face slowdowns and recessions. But market shares should not suffer recessions. When faced with a slowdown (and when not faced with a slowdown either), does the company maintain or increase its market share in its industry? A company that loses market to its competitors indicates a possible problem. An exception though is if competition is moving out of an industry because the industry has no future. In such a case increasing market share is not a good thing; the industry might not survive at all! Who uses typewriters? Who uses floppy discs today? (In any case you dont want to be invested in an industry that has no future).
(6) Is the stock liquid enough?
While there is no single figure to qualify a stock as liquid or illiquid, stocks need institutional (mutual funds, hedge funds, insurance companies, etc) interest to propel them higher beyond a certain level. Typically, institutions will not buy stocks that have low liquidity. Without the potential for institutional buying, a quick rebound is generally unlikely.
(7) Is the company itself/insiders buying?
It is said that insiders know best the prospects of their company. Is the company itself issuing a share buyback (suggesting that the management thinks that the shares are cheap)? Are insiders buying? Now management optimism could be misplaced and they could be wrong in their judgment of value too. Also, lack of management buying does not necessarily mean lack of value. But when the company itself is buying back its shares or insiders are buying, the share deserves a look.
Make no mistake, identifying a value trap is no mean feat. Well known investors often fail in doing so. The above points are in no way all you need to know. But they can act as a filter in weeding out value traps.
Happy Investing!
In the current stock markets meltdown, so many stocks have fallen 60-80% or more. Value investors are perceiving this to be a good time to pick stocks. But amidst value stocks abound many other 'value traps' - stocks that have fallen a lot but are destined to languish at low levels for really long periods. Investors should avoid such value traps since they block investor capital indefinitely without generating returns.
The reasons a stock is perceived as a value stock are (1) the share price has fallen and the stock is cheap (2) future earnings prospects are good so the company/stock would bounce back.
In contrast, a value trap is a stock whose (1) share price has fallen and the stock is cheap (2) future earnings prospects are bad and the stock/company would not bounce back.
So how does one go about distinguishing between a value stock from a value trap? There is no right or infallible answer. Even seasoned investors make the mistake of buying a value trap that looks like a value stock. Detecting a value trap is not a easy task. But can we at least have some parameters that could guide us in such an endeavour? Here are a few questions that you could answer before you try to seek value in stocks.
(1) Is the company cheap based not on trailing earnings but on future/forward earnings?
Quoted valuation metrics like PE ratio are based on historical earnings, mostly on the trailing 12 months earnings. What really matters is what earnings are going to accrue in the future. If future earnings are going to fall and future earnings down the road are not coming back to current levels again, the stock is only optically cheap and is a value trap. For example, Unitech quotes at a PE of 4.3. It looks very cheap. But if next year's earnings are going to fall by say, 90%, the forward PE is 43, which is quite expensive.
(2) Does the company have a lot of debt on its balance sheet?
Debt works both ways. In good times it boosts earnings. In bad times, it becomes a stone around the company's neck. Debt needs to be serviced in good times as well as in bad. In bad times interest payments takes up a large chunk of earnings. Beware if there is a lot of debt on the balance sheet, especially if you see an economic slowdown coming.
(3) Does the company operate in a cyclical industry?
Cyclical industries, true to the name, are subject to up cycles and down cycles. Typically, such companies have a large fixed cost of operation (usually are capital intensive and hence are loaded with debt). In an up cycle, their product prices are rising, operating efficiencies set in and profits zoom. In down cycles, product prices fall, operating leverage works in reverse and profits plunge. So SAIL might look cheap at a PE of 4.3, but if the steel cycle is down, earnings going forward could be dismal and hence the stock could be a value trap.
(4) Does the company generate free cash flow?
Cash flow is like blood flowing through the body. Stop the cash flow and the body dies. Earnings are different from free cash flow. Earnings can be massaged and managed. Not so for cash flow. Does the company have stable or growing free cash flows? Lack of cash can starve a business and you dont want to be in a company that suffers starvation.
(5) Is the company losing market share?
All businesses go through down cycles and face slowdowns and recessions. But market shares should not suffer recessions. When faced with a slowdown (and when not faced with a slowdown either), does the company maintain or increase its market share in its industry? A company that loses market to its competitors indicates a possible problem. An exception though is if competition is moving out of an industry because the industry has no future. In such a case increasing market share is not a good thing; the industry might not survive at all! Who uses typewriters? Who uses floppy discs today? (In any case you dont want to be invested in an industry that has no future).
(6) Is the stock liquid enough?
While there is no single figure to qualify a stock as liquid or illiquid, stocks need institutional (mutual funds, hedge funds, insurance companies, etc) interest to propel them higher beyond a certain level. Typically, institutions will not buy stocks that have low liquidity. Without the potential for institutional buying, a quick rebound is generally unlikely.
(7) Is the company itself/insiders buying?
It is said that insiders know best the prospects of their company. Is the company itself issuing a share buyback (suggesting that the management thinks that the shares are cheap)? Are insiders buying? Now management optimism could be misplaced and they could be wrong in their judgment of value too. Also, lack of management buying does not necessarily mean lack of value. But when the company itself is buying back its shares or insiders are buying, the share deserves a look.
Make no mistake, identifying a value trap is no mean feat. Well known investors often fail in doing so. The above points are in no way all you need to know. But they can act as a filter in weeding out value traps.
Happy Investing!
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