How changes in Index Constituents impact Index PE Ratios and PE Based Investing?

I was working on a more comprehensive P/E Ratio analysis of Nifty and Sensex when I thought about bringing this important point to everyone’s notice.

In December 2015, Sensex underwent few small changes. Two companies in the 30-share index were replaced. Adani Ports & SEZ and Asian Paints were added to the index and Hindalco and Vedanta were removed (source). I am sure that weak performance of the two outgoing companies combined with a bleak outlook for the metals sector in general, must have necessitated this change.

Now this is not unusual. The index management committee regularly reconstitutes indices to (and I guess) take index to newer heights by only allowing companies with better incremental earning potentials. 🙂

So what will happen when two low profit (or loss-making) companies are removed from the index?

By replacing these companies with profits-making ones, the total earnings of Sensex will increase. This would mean a lower PE ratio, which is calculated by dividing the total market cap of the constituent companies in the index by their total net profits.

And as we can see from table below, the immediate impact of this change was that PE came down on the day of change, inspite of index going up.

Sensex PE Ratio 2016

So this particular fall is PE is not because of fall in share prices. It is purely because the index constituents have changed and consequently, earnings have increased. For those who thought that markets have come down suddenly in valuations, this is something to make note of.

This change will also have an impact on Sensex valuations based on future earnings estimates. That is another matter the estimates are at best, estimates. 🙂

I wanted to highlight this because I regularly make references to link between returns and market PEs and how one can use this indicator to broadly assess market valuations.

Extend this concept of change in index constituents and you will realize that when comparison of index’s PE in 2016 is made with say of year 2001, then essentially, two very different indices might be getting compared.

To put it simply, the index of 2016 would be quite different from that of 2001. Sensex of yesteryears might be giving more weightage to metal and cement companies. In comparison, index of today might be more biased towards sectors like FMCG and IT. So when we compare historical PE ratios with current ones, then we need to acknowledge that we are not exactly comparing apples to apples. Due to law of averages, its also not like apple-to-orange comparison but its still not the same apples we are talking about. 🙂

Another thing that worries me is management framework of the index. I am sure that the index management committee would be doing their jobs honestly and carrying out required due diligences, when including and excluding companies in indices. But I am not sure whether there are any SEBI norms governing them or index changes.The indices traded on stock exchanges are owned (not sure) and managed by separate legal entities that do not come under the direct supervision of SEBI. I think there is a scope of increasing regulatory oversight here.

Mutual Funds Vs ETFs in India – Which one to choose Today, And Which one in Future?

Note – This is a guest post by Girish Sidana, a reader and an accomplished professional working for a well-known name in Indian automobile industry. You can connect with him professional here.
 
So over to Girish… 
 
Most people reading Stable Investor would be fully convinced (even I am) that investing in well diversified Mutual Funds for a reasonably long period fetches the best possible returns. But what if I tell you that this may not remain true in future?
Yes. It may sound surprising.
 
But before I go into the details and tell you the reason for the above statement, let me try and explain the concept of another product, which is bound to play a big role in future. I am talking about Exchange Traded Funds or ETFs.
 
 
What are ETFs?
 
An ETF is very similar to mutual funds (MF) in a way, that it is also a fund of various stocks. It helps investors diversify their investment portfolio. But unlike actively managed mutual funds which charge around 2% as fund management fees, ETFs comes at a very low cost of about 0.5%
 
So how are ETFs able to charge so less?
 
Its because ETFs are not actively managed by fund managers. Rather these mimic the composition and returns provided by various indices. So you can invest in Nifty ETF which will track Nifty and will give returns commensurate to Nifty.
 
ETFs are also traded live on the exchanges. This is quite unlike MFs, which have a declared NAV for each day. Although ETFs have their own set of problems like tracking error, commission on each purchase or sale, liquidity etc., lets keep that discussion for some other day.
 
Here is what National Stock Exchange had to say about ETFs:
 
“In essence, ETFs trade like stocks and therefore offer a degree of flexibility unavailable with traditional mutual funds. Specifically, investors can trade ETFs throughout the trading day as in stocks. In comparison, in a traditional mutual fund, investors can purchase units only at the fund’s NAV, which is published at the end of each trading day. In fact, investors cannot purchase ETFs at the closing NAV. This difference gives rise to an important advantage of ETFs over traditional funds: ETFs are immediately tradable and consequently, the risk of price differential between the time of investment and time of trade is substantially less in the case of ETFs.
 
ETFs are cheaper than traditional mutual funds and index funds in terms of fees. However, while investing in an ETF, an investor pays a commission to the broker. The tracking error of ETFs is generally lower than traditional index funds due to the “in-kind” creation / redemption facility and the low expense ratio. This “in-kind” creation / redemption facility ensures that long-term investors do not suffer at the cost of short-term investor activity.”
 
Note – To know more about ETFs and how they are structured, you can read comprehensive writeups available on NSE’s website (link).
 
Philosophy of Index Formation
 
It is also important to understand how an index is formed. Let us take the example of Nifty 50. It is made of top 50 companies of India. It is a dynamic index and keeps adding and dropping companies based on their market caps and various other factors. So, essentially, Nifty 50 is a good-enough barometer of the top Indian companies.
 
Thus an ETF taming Nifty 50 will give returns of these top 50 companies of India. Logically, this should be the best possible return one can think of. What better than top performing companies and that too tracking them almost on a real time basis?
 
But historical data shows otherwise. We all know (if not all then at least readers of this website) that lots of actively managed Mutual funds in our country have been giving better returns than Nifty (or Sensex for that matter).
 
And since actively managed funds are costlier than ETFs (or index funds), the higher expense will be justified as long as active funds, after accounting for expenses are able to beat the ETFs (and index funds) by a decent margin.
 
 
What Happens in Mature Markets like US?
 
The story in markets like US is very different from that of India. In those markets, most actively managed funds are not able to beat their benchmark indices. So purely from the returns perspective, ETFs make more sense there. 
 
An actively managed fund needs to return at least 2% more than the benchmark index to come at par with ETF. Now for all of you who have understood the power of compounding, appreciating a 2% increase per annum will be lot easier.
 
The reason which I have understood (by reading expert articles on this topic), and even though I don’t agree completely, is that Indian Mutual Fund managers are able to identify hidden stocks which may not be part of an index but are value stocks. Or, to put it differently, Indian stock markets still have nuggets of Gold hidden here and there – and that is because our markets have still not matured enough. And because of this, quite a few Indian mutual funds are able to give better returns than ETFs.
 
The Question / Deduction
 
Now the big question is that as the Indian economy grows and stock markets mature, the hidden value stocks may not remain as hidden as they are now. Also, there may be very few value stocks available over a period of time. This will make the task of Mutual Fund managers a lot more difficult.
 
Based on this logic, my understanding is that in times to come, the gap between returns from an ETF and return from a MF will reduce. And once this starts happening, it will be prudent to invest in ETFs rather than MFs. Or at least it will make sense to start allocating a decent part of your portfolio to a broader ETF like Nifty ETF.
 
Again, to take the example of developed market like USA, the debate of MF vs ETF is pretty hot. The data is very much in favour of ETF but there are equal proponents of both schemes. I remember reading one of the articles which compared this debate to vegetarian vs non vegetarian. Both advocate the merits of their school of thought.
 
Although history tells us that diversified MF are best investment vehicles, the future may be very different. So it might be wise to stay on the lookout for this development and remain cautious. 
 
MF may not be the cure-for-all as it is being told to all of us.
 
Personally, I have started allocating a part of my portfolio to ETFs (apart from the regular SIPs I do in MF). Whenever I see Nifty P/E going below 22, I invest some amount in Nifty ETF. I have started doing this very recently so have not got too many opportunities. My plan is to keep doing this regularly and may also reduce my SIP amount for a given month if I see Nifty P/E going below 20 and put this money in ETF. Or even skip my MF SIP in favour of ETF if it goes below 18.
 
What do you think? Do you think it makes sense to start looking at ETFs a little more seriously in near future?
 

A Short Story to tell why You shouldn’t Compare Your Portfolio Returns with Index Returns

There is a general trend to compare your portfolio returns with returns of popular indices like Sensex and Nifty. And this is not a recent phenomenon. It has been going on since years. Ask anyone and they will tell you that their portfolios have beaten Sensex by 5% or 10% year on year.

Here is a short but interesting story about why it doesn’t make much sense to do it:

Years back, there was a man searching for something under a streetlight. A policeman comes by and asks what he’s lost. The man replies that his keys are missing and he can’t get back into his house.

After a few minutes searching together, the policeman inquires whether the man is sure he lost his keys under the lamp.

No, the man replies, he lost them in the park.

“Then why are we searching here?” exclaims the officer.

“This is where the light is,” replies the man, continuing to search.

Story Investing Street Lights

That is the end of the story. Can’t get it?

Don’t worry. Read further…

The problem with evaluating relative performances is that you can’t get much out of relativity, i.e. you can’t eat relative performance. And the biggest problem with relative performances is that it ignores what an investor actually needs? Some investors invest for growth. Others might invest for generating dividend income. And many like me invest for a combination of the two. 

And comparing short term relative performances when you are investing for longer time horizons like 5 or more years does not make much sense.

And an index is not designed keeping in mind an individual investor’s needs. Remember that. So if you are comparing your portfolio performance with that of an index, then remember that index does not know that you use it (and not your actual needs) to judge your portfolio performance.

So if you really want to find your lost keys, you need to look where you’ve lost them, not where the light is (index performance). And if you want to know how your portfolio is doing, compare it to your actual needs and not any arbitrary index.

Note 1 – The idea for this post is sourced from here.

Note 2 – If you want  to read another interesting story about monkeys & goats and what they tell about stock markets, then you can read it here.

Proof (Using 24+ Years Data) that Market Timing May Not Be Worth the Effort…Atleast for Us

I know people who have an uncanny knack of making correct calls (with almost perfect timings) in markets. And surprisingly, they are right more often than they are wrong. This surprises me as almost all wise investors are of view that average investors should not try to time the markets. Maybe I am wrong in putting these people in category of average investors. 🙂

Jokes apart, I feel that making correct calls and making money in markets are two very different things. And as far as timing is concerned, I think that timing the markets is very tough, if not impossible. And as an extension to this thought, I feel that accepting one’s inability to time the markets can eventually help amass quite a lot of money in markets.

I keep looking for data which proves the futility of market timing, atleast for average investors. This post evaluates data set for last few decades to see whether it makes sense to try to time the markets or not.

Now someone has rightly said:

“The market timer’s Hall of Fame is an empty room.”

Even Peter Lynch, one of the greatest investors of his generation, who also popularized the concept of PEG Ratio once remarked:

 “I can’t recall ever once having seen the name a market timer on Forbes’ Annual List of Richest People.”

Now to evaluate the usefulness (or uselessness) of market timing, lets pick 3 long term investors named A, B and C.

Investor Types

All three investors invest Rs 5,000 every month. Only difference is the timing of their investments.

Investor A invests on Monthly Highs (Perfect Mistiming)
Investor B invests on Monthly Lows (Perfect Timing)
Investor C invests on any one of the trading days of the month (Average Timing)
Now performance of these three investors has been evaluated over 5 different time periods (with amounts invested in brackets):

Starting 1990 – 24 Years Till Now (Rs 14.8 Lacs)
Starting 1995 – 19 Years Till Now (Rs 11.8 Lacs)
Starting 2000 – 14 Years till Now (Rs 8.8 Lacs)
Starting 2005 – 9 Years till Now (Rs 5.8 Lacs)
Starting 2010 – 4 Years Till Now (Rs 2.8 Lacs)

Results obtained by them over various time periods (upto 01 August 2014 – assuming complete month) are given in table below:
Market Timing Investor

Remember that Investor A is a Perfect Mis-timer and Investor B is a Perfect Timer. The calculations are based on actual Sensex figures between 1990 and 2014.

As you can see, the difference between a Perfect Timer (Investor B) and a Perfect Mis-timer (Investor A) is not as big as expected. For example, if both started out in 1995, their total investment of Rs 11.8 Lacs would have become Rs 54 Lacs and Rs 49 Lacs respectively.

A figure of Rs 49 Lacs is not bad for someone who got it wrong each month of the year since 1995!! He invested when index was at its highest point of the month. And he still fares decently when compared with Rs 54 Lacs achieved by a perfect timer (Investor B).

As an investor, I know I cannot time the markets perfectly, i.e. I am not Investor B. But since I invest regularly, I also know that by principle of averages, I cannot be Investor A, i.e. I cannot possibly pick the highest point every month to invest. This leaves me with just one option…that of being Investor C.

And I will be glad to be like Investor C.

Reason?

Without the effort (like that required by perfect timer), I am able to earn returns which are respectable when compared to those earned by a perfect timer. And this is clearly visible in table below:

Market Timing Outperformance

There is no big outperformance achieved by the investor who times the market perfectly (atleast monthly). As an investor who strongly believes in Power of Doing Nothing in Stock Markets, this result should be acceptable to all average investors.

And this clearly (if not convincingly) shows that if someone is ready to invest periodically with discipline, then timing the markets may not be essential at all. I agree that I have made few assumptions in these calculations. And that these may not be a technically correct ones when trying to prove the uselessness of market timing. But for average investors like us, this analysis is a clear indicator that if one is not interested questions like how and which stocks to pick, then trying to time the markets may not only be futile but also a worthless exercise. 

Just keep investing regularly in well diversified equity funds or index funds. You will be better off than 99% of the investors.

Caution: The data used in above tables is only for one index (Sensex) and hence representative of performance of a weighted-combination of only 30 companies which constitute the index. And since index constituents change over time (existing companies are regularly replaced by other ones), its possible that numbers might differ if any other index is chosen. Also, as a reader has rightly pointed out in comments below,  if the same logic is used for a combination of companies which are not part of the index, chances are that you might lose some money! But this also does not mean that if you follow passive investing, then you will not lose money. In markets, no matter how careful we are, we can never eliminate the risk of being wrong. 

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One of the Biggest Reasons You should be Investing. Even if you can’t beat the Markets.

Surprised?

I am asking you to invest, knowing very well that most of you may not be capable of beating the markets regularly.

Let’s be honest here. Most investors haven’t been able to beat markets consistently over long periods. I am not talking about greats like Buffett. I am talking about common people like You and me. People who have an intention of making a killing in markets, but somehow or the other, end being killed by the markets.

But if you know that you cannot beat the market, then does it make any sense to be in market?

Yes it does.

But first and foremost, please understand that accepting and embracing the fact that you are incapable of beating markets is an achievement in itself. 95 out 100 people in markets do not know this or don’t want to accept this. But it is the hard truth and tough to swallow.

But…if you are ready to accept this uncomfortable truth, then it can be one of your biggest strengths in stock markets. 

Market has an unbelievable potential of creating wealth. On an average, markets deliver annual returns of 12% to 15% over long term.

For someone who is capable of beating these numbers, returns would be in excess of 15%. But for those who are not in markets, all they can possibly earn is 7% to 9% depending on taxes applicable on the chosen asset class like banks deposits, etc. By not investing in markets, these people are missing out on extra 3% to 5% which can be earned by staying in markets.

Now these might look like small single-digit numbers. But you will be shocked to see the effect these numbers have on your wealth over a period of 10-20 years.

And the graph below clearly shows this. It’s a very simple depiction of what happens when an annual investment of Rs 60,000 (5K Per month) grows at 12%-15% (Equities); and what happens when the same money is parked in safer options at 7%-9% (FDs, PFs, etc).
Monthly Investment 20 Years
Returns on Rs 5000 per month investment in 20 years (At 7%, 9%, 12% and 15%)
Over a period of 20 years, you would have put in Rs 12 Lacs, i.e. Rs 5000 every month. Now this can either grow into Rs 26 to 34 Lacs if invested at 7% to 9% class of assets. Or into a much bigger amount of Rs 48 to 71 Lacs if invested at 12%-15% in stock markets.

Now wait…if you think that markets guarantee 12%-15% every year, then that is not the case. Returns in market are volatile. It can be 50% in one year and (-)30% in another. But over long periods spanning decades, the average returns are in line with these numbers.

And this clearly means one thing…

Even if you cannot beat the market, you should still not avoid investing in it.

Avoiding markets would prevent you from achieving higher long-term returns when compared with other options like bank deposits, PF, etc.

So is there a way to invest in markets, which is…

1) Simple
2) Sensible
3) In line with the thought that it is not easy to beat markets?

The answer is yes.

And the way to do it is Index Funds.

What is an Index Fund?

According to Investopedia, Index Fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index (such as Sensex or Nifty 50). An index fund is said to provide broad market exposure, low operating expenses and low portfolio turnover.

You might not know which individual stock or sector will outperform. But on an average, a carefully selected group of companies across sectors can do a decent job of maximizing diversification and minimizing exposure to few individual companies or sectors.

I am not saying that you should invest all your money in index funds. But if you think you want to save (invest) for long term, then atleast a part of your money should be parked in instruments linked to stock markets. And your safest bet can be Index funds. You can also choose well diversified large-cap or multi-cap funds which have proven track records. But that would mean that returns achieved by such funds would depend on fund manager’s ability to pick stocks. On the other hand, there is no active selection of stocks in index funds. Such funds simply replicate the composition of an index.

So if you feel that you have a knack of picking stocks which give market beating returns, then there is nothing like it and you should surely invest in stock markets directly.

But if not, then may be its time to think a little more seriously about Index Funds. And that is because if you are not in markets, then over long periods, you are missing out on some seriously big wealth creation opportunity.

Interesting Story:

When Google was about to launch it IPO in 2004, the company realized that this would create quite a few millionaires among its employees. The company therefore brought in a series of financial experts to teach them to make smart investment choices. A 1990 Economics Nobel Prize winner was also brought in. Even he advised Google employees “[not to] try to beat the markets” and to park their money in index funds.

Seems like Someone has rightly said – If you can’t beat them, join them. 🙂

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P/E Ratio of Indian Markets in July 2014 – Is It Telling Us Something?

I regularly monitor index ratios like price-to-earnings, price-to-book values to gauge overall market sentiments. I know it’s a very crude way of doing it. But still it provides a decent picture of what is happening in markets.

Now here is something interesting what happened on July 7th, 2014.

Nifty 50’s P/E multiple crossed 21 after almost 3 years. Surprisingly, last it stood past 21 was also on July 7th (2011). That’s exactly 3 years back!

Long term analysis (starting end of 1998) of Nifty’s P/E ratio tells the following story…
PE Ratio India 2014
We all know its common sense to buy low (Low PEs) and sell high (High PEs). And we also know that its difficult to do it. So if you go out and buy the index as whole when P/E multiples are less than 12 (quite low), then on an average, your probable 3 year and 5 year returns will be 39.5% and 29% respectively.

Similarly for index-buying during P/E multiples being in between 12 and 16, the 3 and 5 year returns are 28% and 25% respectively.

But we are currently in the band of 20-24. And this is not a cheap market at all. As per past data, your 3 year returns and 5 years returns look bleak at 4% and 7%. 

So does it mean that we sell all our stocks and put money in bank deposits?

The answer is I don’t know.

The above numbers are based on data of past 15 years. And there is no guarantee that past performance may be repeated. Or whether this time it might be different.

The last instance of PE21, for which 3 year returns data is available (May 02, 2011), the market gave a return of 5.3%.

Similarly for last instance of PE21, for which 5 year returns data is available (June 11, 2009), the returns were 10.3%. Not bad considering the superiority over returns given by safer ones, but also not eye-popping considering the optimism we have for next 5 years.
Now we are all quite hopeful that the new Indian government, if permitted by external uncontrollable like oil-shocks, natural-disasters, wars, etc… would be able to provide a conducive environment for India’s return to high growth days.

But having said that, I also beg to differ with those who believe that this would be achieved overnight and Sensex will hit 40000 by end of 2015.


As for the current markets which are rising everyday, it seems that they are now running ahead of the actual ground realities. But it is this over-optimism that gives us, the long term investors a chance. Isn’t it? 🙂

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Nifty & Sensex Index Mutual Funds

After writing the last post on importance of index funds, we decided to compile a list of all index funds tracking Nifty & Sensex.


All data has been sourced from Moneycontroland it is found that GS Nifty Index Fund is by far the largest index fund, with an AUM of Rs 552+ crores.

Top 10 Index Funds (AUM) – Jun 2012
Generally, all index funds trail the index because they incur costs and keep some cash for redemptions.

Below is a list of all index funds tracking Nifty or Sensex. The list is sorted in descending order of AUM. It also includes funds which track other important indices like Nifty Junior etc. Such funds have been italicized in the list.

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