Warren Buffett’s Letter to shareholders 2012

It’s time of the year when Warren Buffett comes out with his annual letter to shareholders (Letter 2012). As always, it’s full of insights into the mind of Oracle of Omaha. An interesting point (on Value) made by Warren in the latest letter is –

“If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.”

So what can a Stable Investor learn from this quote?

  • If you have time and can invest for decades (if not years), then you should pray for bear markets. Bear markets offer shares of beautiful businesses at delicious valuations! Though short term rise in share prices may make us happy, one must not forget that for a long term investor, these are just paper profits!

You can read key takeaways from the letter here, or if you are an ardent fan of Warren Buffett, then you may like to go through the entire letter yourself (Warren Buffett’s Annual Letter to Shareholders 2012).

You can also read previous letters to shareholders.

Caution – Though these letters may make it look easy to earn high returns in market, the fact remains that we are not Warren Buffett(s)! 🙂

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SIP on Steroids – How to give boost to your regular investments?

(Latest Update) – You can read an updated and more detailed analysis of the PE and other ratios here.

We decided to use this insight to boost our SIPs.

For our analysis, we started with SIP of Rs 5000 every month, from January 2000 and kept on investing till December 2011. A total of Rs 7.25 Lac was invested in 145 instalments. Now we add the Boost. Whenever markets PE fell below 15, an additional Rs 5000 was invested in that month i.e. a total of Rs 10,000 was invested in that particular month. This happened in 23 of the 145 months and an extra Rs 1.15 Lac boosted the normal investment of Rs 7.25 Lac. This took total investment to Rs 8.40 Lac.

So what is the current value of the investment? Did the boost help in earning higher returns? Read further. The investment of Rs 8.40 Lac stands at a Rs 23.8 Lac. And if SIP was not boosted by Rs 1.15 Lac, it would have stood at Rs 19 Lac.

In an earlier post about timing the markets, we saw that it doesn’t make sense in trying to time the markets. If earning a better-than-average return is the aim, it is enough to invest regularly in a disciplined manner rather than trying to time the markets.

Let’s suppose that you as have decided to invest at regular intervals. This type of investment can easily be executed by means of SIP or Systematic Investment Plans.

Systematic Investment Plan (SIP) allows investment in markets at regular intervals. A normal SIP invests once every month.
There are many online SIP Calculators available that can be used to calculate SIP amounts based on your financial goals.
 
SIP is fine…But how to put them on steroids?
Before we answer this question, we would quote an analysis from our previous post on Analysis of P/E Ratios of Indian Equity Markets. Our study suggested that whenever an investment is made with markets trading at a multiple of less than 15 (PE<15), returns over 3 and 5 years have been phenomenal.

Above data shows that on increasing our investment by 15.9% (Investing more when market is trading at lower valuations), our overall investment value increases by 25%.

So to summarize,

  • But even after discussing the benefits of regular investments in markets & redundancy trying to time the markets, if you want to time the markets by investing in direct stocks, you should stick to shares of large & stable companies (Read about how to find Large Caps selling at massive Discounts!)

Warren Buffet’s Rule of not losing money

Known for spreading his financial wisdom by simple rules, Warren Buffet gave 2 really simple rules for investment community –

So why are these rules important for a Stable Investor? It is because if you lose money on an investment, it will take a much greater return just to break even, leave alone turning profitable.
If initial loss is 20%, then an investor needs to earn 25% from lower levels just to break even. And if initial loss is 50%, then the requirement increases to a whopping 100%.
So how can a stable investorreduce his chances of initial losses? Though it is difficult to predict future direction of a stock, what one can do is to stick with quality stocks trading at discounts. By following this approach, an investor may reduce his chances of landing up a multi-bagger, but this ensures that losses due to investment in speculative high growth potential stocks are reduced. Reason for the same is that high growth stocks are more volatile than larger ones. Any adverse news can significantly dent a stock’s price.
But in reality, it is should be understood that we are not Warren Buffett & it is tough not to lose money in markets, even if it is for the initial periods of the investments.

Nifty Dividend Yields – A Long Term Analysis of relation between dividend yields and returns

Dividend Yield is a ratio of dividend paid last year to current market price. A further reading on Dividend Yields can be found here.
 
One of the two metrics used to evaluate over- or under-valuation of markets is Dividend Yield (Other is P/E Ratio). At present (Mid January 2012), Nifty has a dividend yield of 1.6 (find latest data here).
 
So is this a right time to invest? We at Stable Investor decided to look into index’s history to answer this question.
 
Analysis of Nifty’s last 13 years data (from 1st Jan 1999 onwards) reveals a few interesting points –
  • Returns during last 13 years, when segregated on basis of Dividend Yields are –
 
  • This clearly indicates that at current Dividend Yield of 1.6, chances of earning around 20% per annum for next 3 years are quite high! (Caution – The statement is made on basis of historical data. Past performance is no guarantee of future performance.)
  • A graph between Dividend Yields and 3-Year-Returns (CAGR) also shows that there is a high (positive) correlation between the two. Higher the dividend yield, higher the returns over 3 year periods.
Dividend Yield & Return Since 1991 [Click to Enlarge]
  • But one must understand that market does not give enough chances at higher levels. Our analysis shows that out of 2500 trading sessions in last 13 years, markets spent less than 5% (127 days) at dividend yields of more than 2.5 (which offers maximum returns over 3 year periods).
Days Spent on various Dividend Yields
 
So after this analysis, Stable Investor understands that though history shows that investing in markets offering high dividend yields makes more sense, one should never rely on just one mathematical tool to arrive at any investment decision. Any number should be taken with a pinch of salt and should always be looked in conjunction with other ratios and numbers.
We did a similar analysis of PE Ratios and Returns over 3 and 5 year periods and arrived at some remarkably useful results which can be found in the post Relation between PE Ratios and Returns.
If you are interested in further exploring slightly advanced topic of Effective Dividend Yield, please read our post on Dividend Investing in Indian Stocks.

Guest Post: Beware of the Anchoring Bias!


Stable Investor’s note: Today’s guest post by Daniel Sparks covers an important topic of Anchoring Bias in investment decisions. 

The study of how psychology affects our investment decisions is, rightly so, becoming more and more important. It has even been given a formal name: Behavioral Finance. Do we have to get an MBA or take a psychology class to understand the implications of behavioral finance on our investment decisions? Definitely not. We will have a huge advantage by simply recognizing and understanding the most threatening psychological bias to every investor: the anchoring bias.

Consider this common scenario:
John buys shares at $30. 2 months later the same shares are trading at $25. He holds on to the stock because he remembers that he originally paid $30 a share and he doesn’t want to lose money. He keeps holding and the stock drops to $20 a share. He freaks out and sells.
This is a perfect example of how deadly the anchoring bias can be. No matter how smart we are (or think we are!), the anchoring bias can be a serious threat if we don’t show it some reverence.
 
This scenario reminds me of a time when during one of my MBA classes the professor asked the students, “Does the price you paid for your house matter when you are selling your house?” Surprisingly, more than half of those who responded said, “Yes.” This is, once again, a perfect example of the anchoring bias in full affect. No matter how educated you are, it can still affect you.
 
When we are making a financial decision today, all that matters is one thing: value. The price you paid for a house, or the price you paid for a stock 1 year ago means nothing about value today.
 
So what exactly is the anchoring bias?
 
Anchoring bias: focusing too intensely on one piece of information or trait when making decisions.
 
So how can we avoid the anchoring bias in making investment decisions?
 
1.    Show it reverence: studies show that simply recognizing the possibility of human bias and understanding our tendencies to be irrational will help us overcome biases.
 
2.    Ignore what a stock has done in the past: focus on fundamentals and pretend like you are considering the business as a whole as if it is not publicly traded—this applies to selling and buying.
 
3.    Be patient when making financial decisions: If the stock has moved up or down and you are tempted to sell or buy, make sure you are not tempted to make this decision simply because you are anchoring on what the price was before.

About the Author: Daniel Sparks has a passion for Value Investing and is a big believer in investing only in companies with a durable competitive advantage. He has served in US Army and is a part of Colorado State University. Read more about him at Value Folio.

How Luck Helped Me Make 700% in Stock Market Crash of 2008

Exactly 4 years ago, i.e. on 21st January 2008, I bought some shares of Ranbaxy. The day is remembered as one of the darkest days for Indian equities as bell-weather Sensex lost 1408 points in a single trading session. This was the first-ever 4-digit loss for the Sensex at close.
And this big cut was just the start. It was followed by another bloody cut of 857 points on the very next day. (Read more about biggest Sensex falls here).
Now let’s go back a little deeper in past.
In July 2007, I invested some money in A. Ambani’s Reliance Natural Resources Limited (RNRL) at Rs 42. This decision to invest was neither based on any fundamental nor any technical analysis. The only reason which I can now remember is that there was a growing interest in ADAG stocks (herd mentality). Though I always want to believe that I am a sensible investor, the truth is that I have made my share of mistakes in stock markets and have traded in not-so-good companies quite often.
At times I have been lucky to have made some money. And at times not so lucky.
But in this case, I would say that I was quite lucky. Even in 2007-2008, RNRL was widely regarded as a speculative stock and not worthy of holding for long term. It was a stock which was abhorred by long-term investors. Luckily for me, markets continued being irrationally exuberant and started making new highs on a daily basis.
Out of my sheer fear of losing profits, I sold all my shares of RNRL at around Rs 200 each in first few days of January 2008. This investment gave a staggering 383 percent in 6 months and made me feel like a Stock Market Super Hero. 🙂
 
But my luck continued helping me and I used that money to purchase shares Ranbaxy at Rs 340. And as if markets had decided to prove all my decisions correct, the Japanese pharma major Daiichi Sankyo bought Ranbaxy and there was an open offer by the acquirer for shares of Ranbaxy. The open offer came at Rs 737, but I decided not to wait for the same and in August 2008, sold my shares in open market for Rs 552.
 
These two stock transactions gave a 7x return on my initial investment in just under a year! A compounded annual growth rate of close to 700 percent!!

The above is the sequence of events which I personally experienced. And with loads of help from my luck, I made almost 700% in a market which was grinding down every day and was well on its way to crash 50% for the year.

But honestly, it was my sheer luck and nothing else. But this small story also has a few lessons for everyone to learn from market crashes. I have tried to list them out below:
  • Always be a big fan of fear in stock markets. When people become over pessimistic, it should be taken as an invitation to make huge profits. Even Warren Buffett says that “We are fearful when others are greedy and greedy when others are fearful.”
  • Always be ready with a list of stocks to buy in market crashes, i.e. have a list of crash stocks. This list consists of stocks which one regularly tracks and is eager to buy in case prices fall sharply.
  • Courage in Crisis, but without Cash is useless. Always maintain adequate levels of cash to take advantage of such crashes. This can be done by using PE ratio as a tool. There seems to be a definite relationship between PE Ratios and Market Returns. When PEs are high, chances of correction are high and hence an investor should book profits and hold cash to take advantage of probable (but inevitable) corrections.
  • Always use corrections to buy fundamentally safe stocks which have the ability to survive major recessions/downturns/corrections. There is no point trying to find multibagger small stocks which have high mortality rates in downturns. And during corrections, the market gives us ample opportunities to pick large-cap stocks trading at massive discounts.
  • Always understand the difference between shares falling due to weakness in broader markets and those falling due to fundamental issues. A stock like DLF fell alongwith other shares in 2008. But it was not ‘just’ because of fall in broader markets.
  • Always keep an eye on 52 Week Low List. You may find some really interesting & investment-worthy-companies in the list during market crashes.

Nifty Stocks and PEG Ratios

In our previous post, we saw that Indian markets are presently trading at PEG ratio of 0.97. We arrived at this figure by dividing current P/E of 16.7 by average growth rate (in last 18 years)of 17.1%.

For details, please check the post on Historical EPS Growth Rates & PEG Ratio of Indian markets.
In continuation of our analysis of PEG ratios, we calculated PEG ratios of a few Indian large cap stocks –
Click to enlarge
Some details/observations of our analysis are as follows –
  • We have chosen EPS growth rates to represent growth rates of a company. One can also use any other growth rates.
  • For each company, we have calculated 3 PEG Ratios –
    • Using latest EPS Growth Rates (2010-2011)
    • Using Average of all EPS growth rates in last 5 years
    • Using least positive EPS growth rates in last 5 years
  • Afterwards, we calculated another PEG for each company – Average PEG – which is an arithmetic average of previous three PEGs.
 
  • Normally, a PEG greater than 1 indicates an overvalued company, and less than 1 indicates an undervalued company. But we must understand that PEG is just a ratio and it should always be looked in conjunction with other ratios and numbers.
  • For instance, a company like Bharti has an average PEG of 0.33, which is quite an attractive number when looked at on a standalone basis. But if we consider that Bharti operates in a highly competitive industry; has loads of debt due to 3G fee payments and African expansion; has decreasing average revenues per user (ARPU) and has a negative PEG(!) for current fiscal, the number 0.33 may not look so attractive.
  • But there are also few companies like BHEL (0.59), PowerGrid (0.83), Tata Steel (0.40) and Tata Motors (0.42) which have considerable moat (competitive advantage & operations in industries having high entry barriers) and can be said to be available at good valuations. But once again, one should understand that stock like Tata Motors are rate sensitive and cyclical. And under current global circumstances, may slip further.
  • A company like Sterlite Industries (pegged by few as future RIL) is available at a ridiculous PEG of 0.19 (or 0.25, 0.08, 0.26). But that does not mean that it is going to become a future multibagger. Similarly, Maruti is available at PEG of 0.10(!)
  • Then there behemoths like SBI which may be available at outrageous mathematically calculated PEG of 6.6, but are worth investing as there current PEG stands at 0.54. But one should also consider rise in NPAs of SBI and other factors before investing.
So a Stable Investor understands that one should never rely on just one mathematical tool to arrive at any investment decision. Any number should always be looked in conjunction with other ratios and numbers.

Historical Sensex EPS Growth & PEG Ratio

How do market experts predict future index levels? It is done by estimating EPS (Earnings Per Share) of the index and then multiplying it with what they consider a logical multiple (P/E Ratio). In past 18 years, Sensex’s EPS has grown from Rs 81 to Rs 1270 (E) as show below –

As per analyst estimates, Sensex is expected to do an EPS of 1055 in FY2011 & 1270 in FY2012. This information should be taken with a pinch of salt as these are predictions. And predictions can be based on speculation. Capital Mind has an interesting post on senselessness of EPS projections.

A little calculation shows that in last 18 years, EPS has grown at 17.1%. Analysts predict that EPS for next 2 years is expected to grow at more than 20%. But considering present challenges of high inflation, high interest rates & global macro events, it seems to be a little too optimistic.

So how do we decide whether markets are fairly valuing future growth or not?

To answer this question, we use the PEG Ratio. It was popularized by Peter Lynch in his book One Up on Wall Street.

PEG Ratio is calculated as follows –

 

There is no hard and fast rule of which growth rate one should take. One can either take an estimate of future earnings growth or an average of the past earnings growth.

At present Sensex is trading at a multiple of 16.7 (Get latest P/E from here; For Nifty50, you can check this analysis too) and we take average EPS growth rate of 17.1% in our calculations. This gives us a PEG of 0.97 (=16.7/17.1).

So how do we interpret this number?

  • Normally, a PEG of greater than 1 indicates an overvalued company, and less than 1 indicates an undervalued company. So a PEG of 0.97 indicates that at present, Sensex is fairly valued.
  • Lower the PEG, the lesser one has to pay for each unit of future earnings growth. So, to put it simply, one should be interested in low PEG values.
  • Consider a situation where you have a stock with low P/E. Is it that the market does not like the stock? Or is it that the market has overlooked a fundamentally strong stock of good value? To figure this out, we look at the PEG ratio. Now, if the PEG ratio is big, we know that this is probably because the “earnings growth” is low & this is kind of stock that the market thinks is of not much value. Now consider another situation where the PEG ratio is small. It may be because the projected earnings must be high. We know that this is a fundamentally strong stock that market has overlooked.

But PEG is not a fool proof way valuing future growth and there are a few issues –

  • In strictest of sense, it is more of a rule of thumb rather than a formula. Reason being that the two sides of the formula have different units: you’re comparing a fraction with a percent.
  • It works well with normal values of growth rates only. For certain values, the results can be absurd. For example, it implies that a company with zero growth should sell for a P/E of 0.

An interesting but technical take on PEG Ratios can be found here. Drawbacks of PEG ratio can be found here.

Important note: You must understand that the PEG ratio relies on the projected % earnings. These earnings are not always accurate and so the PEG ratio is not always accurate. Also, being just a ratio it should be looked in conjunction with other ratios and numbers.