Thoughts on starting a new portfolio – Part 1

In our post on changing Stable Investor’s approach, we mentioned that we plan abandoning our existing portfolio (Monk’s Portfolio). We also plan to start a new portfolio named Dead Monk’s Portfolio (DMP). Reason for choosing this name is given in next few lines.Why Dead?

We want our portfolio to be so easy to maintain that even a dead person is able to do it, i.e., without much thought and activity. 🙂

Why Monk?

For us, monks are ultimate symbols of calmness, serenity, stability and longevity. These are some of the terms which we want our portfolio to be associated with.

Note – The topic may seem a bit haywire as it documents a loud thinking session.

Here are some of our thoughts –

  • Dead Monk’s Portfolio (DMP) can follow a Core –Satellite approach in which core could account for 60-75% of portfolio and Satellite the rest 25-40%
  • Core can be made up of high dividend yield large cap stocks OR low PE, average to good dividend yield large & mid cap stocks OR low to average PE, good to average dividend yield large and mid cap stocks, trading below their book values OR any other combination of parameters and concepts like Magic Formula.
  • We prefer companies which pay regular & increasing dividends as the proceeds can be used to buy more stocks or as a source of passive income. Also these stocks are stable and less risky. But according to experts, this stability comes at the price of lower returns. And as stable long term investors, we are ready to accept non-astronomical returns.
  • Satellite can be made up of companies which offer long term above average growth and which may not be doling out dividends. Such companies generally prefer to invest profits back into the company which may be growing at rates higher than company’s cost of capital OR for novices like us, higher than overall market growth rates.
  • But how do we find stocks which offer stability as well as good dividends? There are many ways of finding such stocks. One is to check the indices that track dividends. Another is to check lists of highest dividend yielding stocks. But such lists throw up names which we are not comfortable investing in : so it would be a good idea to take such lists and add a filter or two like market cap, profitable in last 5 years, etc).
  • Another approach can be to use stock screeners with conditions like large and mid caps, dividend yield of more than 3%, consistent & increasing dividend payouts in last 5 years, trading close to 52 week lows, low PEs  etc. 
  • We are compiling a list of good stock screeners for this purpose and would share them shortly.
  • Another question which has been raised is that does it even make sense to bother about capital appreciation of the Core portion of such a portfolio?
These are just some of our preliminary thoughts and we are still not done with our analysis. We are also exploring other ideas which have not found mention in this post. Let’s wait till the time we finalize the first version of our new portfolio approach (with blessings of the Dead Monk in the grave). 🙂

Poker and Stock Markets

Regular readers would be surprised to see the word Poker (a game known for gambling), being used for title of a post on Stable Investor, which is all about stability and anti-speculation. But a further reading would be helpful in understanding a few obvious similarities between Poker and stable investing.

People may consider Poker to be a game of luck & gambling. But this is quite far from the real truth. Luck may play a part but rules, principles, odds and proper money management are the largest components of Poker, as well as investing.

A little introduction about poker would be helpful here.

Poker is a game of decisions based on having a sampling of the general information. It is all about having an ability to cut losses in risky situations by calculating odds, using a skilled memory and taking quick decisions under pressure. (Wikipedia offers all basic information about Poker and its variants).

Now the similarities between Poker and Stock markets are –

You can start small. But if you are sure, be ready to take bigger bets

Most poker players enter the game at ease. They place small bets until they have a fair idea about playing styles of other players & their own ‘luck’. Stock markets also allow one to start small. It helps in knowing whether one’s investment philosophy is profitable or not and whether same can be replicated with bigger bets or not. Poker allows one to raise bets if one is confident. Stock markets also allow one to increase their bets depending on confidence or overconfidence.

Controllable Vs Uncontrollable

Just like in Poker, there are only two factors in stock markets– Controllable and Uncontrollable. One must respect the fact that there are bound to be things that cannot be controlled. For example, in Poker one can neither control other player’s emotions nor the cards being dealt. Similarly in investing, one cannot control the overall markets or various events taking place which have an effect on stocks. But that does not mean that one should leave investments at market’s mercy. It means is that one needs to have a greater awareness about his environment.

In poker, a player knows that there are times when luck may not favor him. However, instead of playing blindly, he focuses on what can be controlled: his own reactions. For investors, it means knowing what is going on in the world and knowing how these things could affect one’s investments. So when a political, economic or social event occurs, you know how to react to save your investments.

Knowing when to Fold

In poker, the players who stay in the game the longest (& reap the biggest rewards) are those who know when to fold. One should understand that, not every bet may be favorable. It is better to cut losses and wait for a better opportunity. Same is the case with investments. Not every investment is going to have a high return. Some may fail. To avoid losing more money than usual, one should learn when to pull out of an investment.

There will be another opportunity

In both the games, there will always be another opportunity. So its better to wait for it to take a bigger bet. Its saner to live today and fight (play) tomorrow.

All-In can be the last decision you make

You put all your eggs in one basket and you risk losing everything. In investments too, a focused diversification is more advisable than single point focus.

Human Psychology

Poker requires skill in reading one’s opponents. A player must understand when other player has a really good hand or is merely bluffing. Otherwise he will always end up losing money. One must also be sensitive about how others perceive him. This in turn can be used to one’s advantage. Markets also bluff when some stocks go up in prices because of speculation or manipulations. Knowing the true value of a stock is based on knowing how humans think and rationalize.

Evening out the odds

Both poker and stock markets require a proper strategy, which is in synch with a player’s real self. Luck can only do so much in the way a game turns out. A poker player must know how to read the odds. He must know when to raise the bets and when to call a bluff. He must know which cards to keep and when to fold. Likewise, an investor has to know when to cut his losses and wait for another opportunity to score big. It in essence requires a long-term strategy based on solid facts rather than emotions. A stock market investor must always ask the question – What are the odds that a stock is going to rise? More importantly, one must ask the question -What are the odds that this stock would go down? And by how much? What is the worst case scenario?

In long-term poker play & long term stock market investing, somebody who has no strategy is as good as broke and one who merely goes with the flow is as good as busted.

Successful investors like Warren Buffett are regular Poker players. Just like in his investing, he is known to focus on players rather than the cards. He once remarked that –

 If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.

All in all, the number one goal in poker as well as stock market investing is to preserve capital (return of capital is more important than return on capital).  At the same time, the player must be willing to place big bets when the odds are favorable.

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.

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.

Market Timing Or Disciplined Investing – Which is More Sensible?

If you have read some of the older posts, you would have a fair idea about what Stable Investor is all about. And you will also understand that timing of stock markets is not what this website is interested in. And that is because for all practical purposes, it does not work!
A famous columnist once said,

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

And the great stock picker Peter Lynch once remarked,

“I can’t recall ever once having seen the name a market timer on Forbes’ Annual List of Richest People.”
This clearly shows how successful (or unsuccessful) market timers have been. In an ideal world, an investor would have all relevant information and would know when to invest and when to get out of markets.
To explain these concepts, lets take a scenario, in which there are 3 investors – A, B and C. All three are ready to invest Rs 5000 every month from January 2000 onwards. But timings of their investments are different. 

Investor A invests at lowest index level during the month (i.e. A has all the information);

Investor B invests at highest index level during the month (i.e. B mistimes the market every month!); 

Investor C is indifferent to news flow and invests at month-end closing prices. Each one them has invested a total of Rs 7,20,000 in 144 months.
So where do A (Perfect Timer), B (Perfect Mistimer) & C (Indifferent Investor) stand at the end of 12 years?
Market Timing Make Money
This analysis shows that the difference between a Perfect Timer (A person who has all the insider information) and an Indifferent Investor (Does not care about intra-month fluctuations and has automated his investment process to invest at month ends) is of just 6%. Just 6%.

That is, if you are ready to invest in a disciplined manner for long term, having information and timing does not matter much. Even an indifferent person can make money by investing dispassionately.
So what does this analysis point to?

  • It should be understood that there is no point in trying to time the market. Though it has been tried by millions of people and people have made money and have become millionaires, the fact remains that it is neither easy nor feasible for a average investors like us.

  • Timing is possible. But only for those who are part of the inner circle – people who have insider information.

  • There is a difference between information and wisdom. An investor should be vary of all information being bombarded at him and one needs to be wise enough to filter out the noise.

  • As a regular retail investor, it makes sense to keep on investing in a disciplined manner. The reason being that there is not much to lose (6% – Refer to above example) if an investor decides to ditch time-the-markets approach.

And wish you all a Merry Christmas to all the readers!
Stock Market & Christmas

PE Ratio of Indian Markets – A Long Term Analysis

Price to Earnings ratio (P/E ratio) is a measure of price paid for a share relative to the profit earned by that share; i.e.

You can read more about P/E Ratios here & here.

They say that it is best to invest when valuations are low.

Sensex is currently (December 2011) trading at a P/E of 16.5. So is this the right time to invest? Is this what experts call a low valuation? We at Stable Investor have decided to answer these questions.

Analysis of Sensex’s last 12 years data (from 1stJan 1999 onwards) reveals a few interesting points –
  • Over any rolling period of 5 years in last 12 years, Sensex has not given negative returns! So if you are ready to stay invested (in this case, in an Indian Index Fund) for a period of 5 years, you won’t lose money. 
  • Returns earned during last 12 years, when segregated on basis of P/E ratios are –
Returns (Over 3 & 5 years) & P/E Ratios

This clearly indicates that at current P/E of 16.5, we have a chance of earning more than 15% per annum for next 3-5 years!

(Caution – This statement is made on basis of historical data. Past performance is no guarantee of future performance.)

So after analyzing this interesting relationship between P/E Ratio and Returns, what does a Stable Investor do?
  • Stable Investor is now in a better position to respond to people’s view that it is better to invest in markets of lower multiples (P/E). Our analysis clearly shows that if investor invests in markets of lower multiples, probability of earning high returns is very high. 
  • P/E Ratios are still relevant for judging overall valuations of markets, if not individual stocks. 
  • It is advisable to invest when markets are trading in early teens (i.e. 13<P/E<16). It has also been seen that Indian markets tend to stay between P/E Multiples of 12 and 24 (Read Indian Markets PE 12 to 24 for details) 
  • P/E Ratio is a beautiful indicator of market’s overall valuation. But before making any buy or sell decisions, an investor should also look at a lot of other information/data.
Update – You can check the latest PE-Ratio Analysis of Indian Markets in 2013 or 2012. For constant updates about Indian Markets’ PE, P/BV Ratios, please check the State of Indian Markets.


Believe Us, You are not Warren Buffett!

Oracle of Omaha, Warren Buffett has been in news lately for tipping his son Howard Buffett to be the new chairman of Berkshire Hathaway (source). By profession, Howard is a farmer. Company’s investment strategy would still be governed by the CEO and Board of Directors. But Warren Buffett’s son would serve as a Custodian of Company values rather than take part in regular day to day affairs.

So what makes Warren Buffett so special? On very first page of his famous and revered Annual Letters to Shareholders (2011, 2012), it is mentioned that from 1965-2010 (a period of 45 years), Berkshire has had a CAGR of 20.2% i.e. your money doubles every 4 years!

Can average investors like you and me, who don’t know so many things beat that performance?

Can we earn 20% year on year for decades? I doubt that.

you are not warren buffett
You are not Warren Buffett. Period.

Such superlative performance can have have the effect that average investors try to become the next Warren Buffett. But in doing so, they would be making a grave mistake. That’s because-

  • Most profits made by Berkshire come from owning entire companies, which an average investor is incapable of doing.
  • Though Buffett gives independence to individual companies’ management, he always keeps a tab on them to see that they don’t deviate from Berkshire’s simple but sacred principles. As far as an average investor is concerned, he doesn’t even meet any member of the company’s management.
  • Buffett owns the perfect business of insurance. This is equivalent of having a constant source of interest-free loans given to buy shares of other companies. Now who among us can boast of ownership of such a business?
  • Inspite of being famous for having a holding period of forever, Buffett occasionally sells stocks. Unlike us, he doesn’t require money for his basic needs. He sells when he does not see value in his investments or wants to fund more lucrative investments.
  • Unlike average investors, he has access to loads of insider information and has an army of people who can do comprehensive number crunching for him. This augments his investment decision making process.
  • Buffett is a fast and voracious reader. We can’t imagine an average investor to read Forbes, Wall Street Journal, Financial Times, New York Times, USA Today and Omaha World-Herald every single day of the year, decade after decade. (For Indian Investors, replace above names with Indian financial newspapers and publications). Even if a person does read a few good publications, the question arises whether he will he be able to utilize and interpret this information to his advantage?
  • An average investor does not get deals which are skewed heavily in his favor. Buffett got one hell of a deal from Goldman Sachs, where he was earning $500 million every year for doing simply nothing!!! And when Goldman Sachs decided to redeem the preferred stocks, Warren was the unhappiest person in the world as any normal person would hate to lose a free cash flow of $500 Million an year. Very recently, he entered solar energy via Topaz. An interesting article shows once again that why and how he lands up such delicious deals.

Warren Buffett had once said – My wealth has come from a combination of living in America, some lucky genes, and compound interest”. Out of these three, only compound interest, is under our control.

Though compounding has a peculiar problem, it still works for those who are patient enough.

So an average investor should focus more on buying good stocks and allowing compounding to show its magic. But instead, what he does is that he is constatnly on a lookout for stock tips and is looking to find the next multibagger. As a sensible investor, one should be prepared for opportunities which markets throws up every now and then. And when that opportunity comes, be prepared to take advantage of them.

200 Day Moving Averages (200DMA) Based Investments – 5 Years CAGR

In the previous post, I analyzed returns on investments based on 200DMA and how such investments performed over 3 year periods. This post is an extension of the thought with only change being the increase in evaluation period from 3 years to 5 years.
Just to remind everyone, 200DMA is calculated by taking the arithmetic mean of all values in consideration (Stock prices, index levels) in last 200 trading sessions (40 weeks). Before going forward, I would recommend that you get a basic understanding of how to calculate 200 Day Moving Average & how to calculate CAGR
You can easily find data for last 20 years on NSE’s or BSE’s website. Similar to that in previous post, a comparison of 5 years compounded annual growth rate (5Y-CAGR) was made against the index’s distance from 200DMA.
200 Day Moving Average Returns 5 Year
Correlation | Investing based on 200DMA & 5 Year Returns (CAGR)
The blue portion indicates index’s level (+/-) from its 200DMA. For example, in region marked P, index was trading at levels 20% lower than its 200DMA.
The red portion indicates returns over a 5 year period on CAGR basis.
A few interesting results that can be seen from the graph are –
  • In regions marked P, Q, R, S, & T, the index was trading 20% lower than its 200DMA. And as red graph in these regions indicates, returns have always been in positive territory.
Possible Deduction: Chances of your investments earning a positive return are more if you invest at times when index is trading at a discount of 20% or more to its 200DMA.

  • Region A (i.e. Year 2000-2004) is a possible outlier in this analysis. During this period, India was in long term secular bull market and as evident from the graph, relation between 5Y-CAGR and distance of index from its 200DMA is not evident. Returns continue to be positive even though Distance from 200DMA continuously switches between positive and negative territories.
This 5-Year analysis and a similar 3 year analysis done previously reveal that if an investor is ready to invest in markets trading at large discounts to their 200DMAs, probability of earning positive returns over long terms is quite high.

Though 200DMA is generally considered as a tool to be used by traders, it can very well be a potent tool in the hands of a long term investor who wants to time his entries in the market.