## Case Study – When investing for 10 years pays more than investing for 30 years

I started earning when I was 23. Pretty late I guess. Nevertheless, not everything is under our control.

But benefits of starting early cannot be matched easily by other reasonable approaches (like even investing more in later years). And I did some calculations that once again prove that as far as saving and investing are concerned, best advice is to START EARLY.

Next piece of advice? Don’t doubt the two words of the advice above. 🙂

The calculations that follow are based on certain assumptions, which you might question. I have tried to address the concerns later in the post. But I suggest that you focus on the crux of the story here, which is – to start investing early.

Scenario 1:

Suppose a person who starts earning at 23, is able to save Rs 1.5 lacs every year for next 10 years. He then stops (at 33) and doesn’t invest anything till his retirement.

What will his corpus be at the age of 60 (i.e. retirement)?

I will bypass the discussion on expected returns and how resorting to better asset allocation strategy can increase expected returns. Instead, lets use a reasonable and constant return assumption of 8% per annum.

Calculations show that at 60, his corpus would be about Rs 2.02 crores.

Now remember that this person has contributed a total of Rs 15 lacs from age 23 to 32. And not a rupee more after that.

Scenario 2:

Lets take the case of another person who realizes the power of compounding a little late and starts at 31. He continues investing Rs 1.5 lac every year till his retirement.

In total, this person would have contributed Rs 45 lacs in 30 years.

And he will end up with a corpus of Rs 1.83 crores.

See the difference?

First person invests Rs 15 lacs in 10 years and gets Rs 2.02 crore.

Second person invests Rs 45 lacs in 30 years and gets Rs 1.83 crore.

Now we all know that its not possible to invest a very large amount at the start of our careers. The annual investments gradually increase with increase in income. And in reality, investments neither stop at 32 (like first scenario) nor they remain constant between ages 30 to 60 (like second scenario).

So this is indeed a theoretical exercise. But it serves the purpose of highlighting the importance of starting early.

Scenario 3:

Now lets take another scenario:

Suppose your parents decide to invest Rs 1.5 lacs for 2 years after you were born. Then from the age 2 to 60, neither you nor your parents contribute anything. Unreasonable assumption but lets stick to it.

Result?

Corpus of Rs 3.15 crore at the age of 60.

The reason for this astonishing outcome is that Rs 3 lac invested immediately after your birth had many decades to compound.

And by the time you turned 23 and were ready to earn your first rupee, your corpus was already in excess of Rs 18 lacs. That’s a good amount to start with. Isn’t it? A big snowball to start rolling for someone who is yet to earn anything. 🙂

Again the assumption of Rs 3 lacs can be questioned. An amount of Rs 3 lacs was huge 23 years ago. But again, this is a theoretical exercise. It only proves that starting early works. It just does.

But don’t get disheartened if you are unable to invest in line with either of the first two scenarios or if your parents did not do anything like the third one. 😉

When it comes to compounding, there is no amount too small to start investing.

And remember that in initial years, you will not notice the impact of compounding. Its only after years that compounding starts to show its magic.
Compounding is like the god. Your prayers will only be answered after years.

## Interview with John Huber – Part 2

You can read Part 1 of this interview here.

Dev: As a long-term investor, how should one control oneself to not to panic? Also, when should one panic (say, panic to buy more when markets falls a lot)?

John: This just comes from maintaining a discipline about your investment philosophy.
I think it’s helpful to keep in mind that stocks aren’t trading vehicles, but pieces of real businesses. And if you’re buying a business that produces x amount of cash flow, the lower the price, the better.
As Buffett says, whether it’s stocks or socks, we like buying merchandise when it’s marked down.

Dev: I am a conservative investor who focuses a lot more on Return of Capital than on just return on capital. Though every individual’s risk and investing profile is different, do you think that focusing on mistake-reduction is what investors should focus on? Or lets say that just like in the game of Tennis, its best to first work towards reducing unforced errors. Does it help in winning the game of investing too?
John: Absolutely. I think the vast majority of investment mistakes come from “stretching” too far for upside potential at the expense of downside risk.
The tennis analogy is a good one—amateur tennis players win matches not by making the most forehand winners, but by making the fewest mistakes. Just hit the ball over the net. In investing, it’s very difficult to make up for losses. So keeping a relentless focus on preventing losses has always been at the core of my investment approach.
To use one more sports analogy—focus on base hits, not home runs.

Dev: As an investor, hardest thing about investing is to find a balance between 1) riding out periods temporarily unfavorable to your views and 2) realizing your views are wrong and moving on. How should an investor maintain that balance?
John: This varies case by case, but certainly you have to be honest with yourself. If you’ve made a mistake (which all investors do, and will continue to do), you should be honest in your assessment, sell the stock, and move on.
Of course, the market is volatile so sometimes general market conditions take all stocks lower, and this volatility might have nothing to do with the intrinsic value of stocks in your portfolio.
So company specific situations should be differentiated from general market volatility.

Dev: In his book Thinking, Fast and Slow, Daniel Kahneman talks about two approaches to thinking. System-1 (which is fast, instinctive and emotional) and System-2 (which is slow, effortful and calculating). How can an investor make use of these two systems to invest? At the face of it, System-2 seems like a better choice. But are there any market situations, where thinking in System-1 mode can work wonders for long-term investors?
John: I’m not very familiar with Kahneman’s work, although I’m familiar with his ideas you referenced.
I think generally speaking, my style of investing falls very much in category #2. Thinking logically, rationally, and patiently has always been beneficial to me.

Dev: Do you think lack of preparedness is what causes most investors to miss out on wealth creation opportunities in stock markets? (Both mental as well as financial preparedness)
John: I think that has a lot to do with it. But I think the biggest reason investors probably fall short of what they hope to achieve is lack of discipline (selling during downturns, and buying when outlooks are more optimistic). Generally, investors need to do the opposite to do well over time.
For people with full-time jobs and excess earnings, building wealth is a very simple formula.

Spend less than you earn, and invest in a basket of good businesses (or a broad index fund) over long periods of time.

In America especially, earnings of S&P 500 companies will be much higher 10 and 20 years from now, dividends will be two or three times the levels they are now collectively, and stocks will be much higher.
Dollar cost averaging works – as long as you’re not buying into bubble-level valuations (like 2000). Try to buy stocks when they are down, save more than you earn, and you can’t help but become wealthy over a working lifetime.

Dev: How do you manage your own money? Funds? Direct Stocks? How do you go about it?
John: I invest in stocks. Saber’s strategy is to buy well-managed businesses with stable competitive positions, predictable cash flow, and high returns on capital. I try to invest in these high quality compounders when they are priced well below my estimate of their fair value (or the value a private owner would pay for the entire business).
Because of my standard of looking for both high quality and discounted price, I tend to only invest in a small group of stocks at any given time.
I feel that owning a few things that I understand very well is much less risky than owning a lot of things that I don’t know so well.

Dev: What is your advise for those who are just starting their investing journey?
John: Read about value investing – specially Warren Buffett. I think the simple logic of value investing makes intuitive sense, and it works over long periods of time.
I think investors who don’t have time to manage their own money should invest in index funds, or possibly with an investment manager who uses a straightforward value investing approach, but the best way to learn is through practice.
Those who want to learn to manage their own investments should get in the habit of reading a lot. Study Warren Buffett’s letters, and begin reading company annual reports. Knowledge is cumulative, and it’s possible to do well in investing with the right approach combined with the right temperament.

Dev: For most common investors, it’s suggested that they should Dollar-Cost Average through mutual funds. Not trade much in individual stocks. Buy some shares directly here and there. Tell me what is wrong about this that these people fail to understand?
John: I believe this is good advice generally, but I would say that instead of mutual funds, I would prefer most investors using simple, low-cost index funds (ETFs). These are similar to funds in that they are diversified with hundreds of stocks, but different in that they are passively managed (they are designed to match the performance of an index, such as the S&P 500 in the US).
The costs of these index funds are much lower than the cost of actively managed funds. Of course, a good investment manager can outperform the index over time, but these managers are rare and it’s often easier to focus on just putting money into one or two diversified passively managed index funds.
Dollar cost averaging simply means putting more money to work over time, and I think this is a good approach for working people because they are steadily getting more money each month from their paycheck. Some months will be making purchases at higher prices, but some months will be at lower prices.
This mechanical method is helpful because—if one sticks to it—can help you be disciplined when bear markets (and fear of stocks) come around again. That is the time to buy as much as possible.

Dev: As someone who spends his day in midst of financial data and news, how do you filter out what is good and what is not to get to your daily reading list? How to become a good consumer of financial content?
John: I generally stick to my routine. I get up each day at 5am, read the Wall Street Journal (and sometimes a few other papers), and then (after spending an hour helping my family/kids get ready for the day) I begin working on whatever research project I have going on at the current time.
I don’t pay much attention at all to mainstream media (CNBC, Bloomberg, etc…). I spend most of my time reading primary materials (company reports, industry reports, trade magazines, etc…). I also make phone calls to people to learn more about businesses, but most of my time is spent reading. So I pretty much stay away from mainstream business media.

John: Wall Street Journal, Economist are daily reads (Economist comes each week, but I read a few articles each day).
I also read NY Times, Financial Timesand a few other papers, but not necessarily daily.
But most of my time is spent reading about companies through books, annual reports, industry research, etc… this varies from day to day, but each day involves a lot of reading.

Dev: 5 quotes that should be framed and put on every investor’s desk?

John:
• There are two rules of investing: #1: Don’t lose money. #2: Don’t forget rule #1. – Warren Buffett
• I will tell you how to become rich: Be fearful when others are greedy, and be greedy when others are fearful. – Warren Buffett
• An investment in knowledge pays the best interest. – Ben Franklin
• Just practice diligently and you will do very well. – Johann Sebastian Bach
• And the one thing that all those winner bettors in the whole history of people who’ve beaten the pari-mutuel system have is quite simple. They bet very seldom. – Charlie Munger
• It’s not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it – who look and sift the world for a mispriced bet – that they can occasionally find one. – Charlie Munger (an extension from the previous quote).

Dev: 5 books that everyone looking to become better investor must read. Atleast one each from domains of building processes, psychology and financial analysis.

John:

Dev: Lastly, I know this might sound funny, but how to find a company like Google, Apple, Tesla, Berkshire, etc. early on. And more importantly, how to have the conviction to stay with them?
John: This one is tough. We should all be so fortunate to find one of these in a lifetime, but most of us won’t. The good news is, you don’t need to find the next Google or Microsoft to become a very good investor over time.
I’m not sure there is a specific way to describe how one could locate such an investment.
It’s part preparation, paying attention, working very hard, and learning about a variety of companies.
But to find an investment of the kind you mentioned, it’s also part luck – being in the right place at the right time.
If you find such a great business, it takes discipline and foresight to stick with it through periods of seemingly overvaluation and short-term underperformance.
It’s hard to specifically set out to find such an investment. I think focusing on working a specific investment process is a better approach. Look for base hits, and maybe one day you’ll come across a home run idea.

Ben Graham made 20% per year buying bargains, and then happened across GEICO, which made him very wealthy. He had many base hits, and one home run. But the home run wasn’t necessary to produce.

Dev: That’s all from my side John. I thank you for answering my questions. It was wonderful to have you share your insights.

John: Thanks Dev.

## Interview with John Huber – Part 1

John Huber is portfolio manager at Saber Capital Management and author of the popular investing blog Base Hit Investing. In his own words, his investment style (which is amazingly methodical) is influenced by Warren Buffett, Ben Graham, Walter Schloss and Joel Greenblatt.

I have become a big fan of his writing and thought process, ever since I came across his blog and strongly recommend it to anyone interested in following a structured approach towards investing and improving as a rational thinker.

I thank John for agreeing to get interviewed for Stable Investor.

So lets get straight to the interview now…

Dev: Hi John. Tell me something about your investment journey. How did you get to where you are?

John: I’ve always loved investing. My father was an engineer by trade, but was very active in the stock market (investing his savings) and by extension, I became interested in stocks.

But I came to the world of investment management unconventionally. I began my career in real estate, and I established a few small partnerships with family members and friends to begin buying undervalued income producing property. We bought residential properties as well as small multi-family properties.
About ten years ago, I began studying the work of Warren Buffett. Like many value investors, the simple logic of value investing really resonated with me right from the start.

I began studying Buffett’s letters, and reading various Buffett biographies. I set a goal early on to establish a partnership that was similar to the partnership Buffett set up in his early days.

After a number of years, I was fortunate to build up enough capital to support my living expenses while also seeding my investment firm. Saber Capital Management was established in 2013 as a way for outside investors to invest alongside me. Saber runs separate managed accounts, so clients get the transparency and liquidity of their own brokerage account. Our goal is to compound capital over the long run by making concentrated investments in well-managed, high quality businesses at attractive prices.

Dev: I know you focus a lot on having a process-oriented approach towards investing. How should one go about creating and refining one’s investment process?
John: It’s a great question. I think developing an investment philosophy is very important.

There are many different investment approaches out there — even within the value investing category. I think it’s important to first identify an investment program that will work (value investing — or buying stocks for less than what they are worth) works over time.

But I also think it’s important to understand your own personality, your own skill sets, and your own circle of competence.
Look at Benjamin Graham and Charlie Munger as an example. An approach that worked for Ben Graham was a completely different approach that ended up working for Charlie Munger, yet both were fantastically successful. But they both had different skill sets and preferences.
Graham loved numbers, he loved the mathematical aspect of investing. He thought of a portfolio like an underwriter would think of the insurance business—buying stocks for less than their net asset values worked collectively as a group over time, but any one individual situation was difficult to predict (just like insuring 1000 automobile policies with a given set of underwriting criteria would lead to very predictable results—although on a case by case basis it would be very difficult to predict which driver would end up making claims). So Graham’s preference for these investment tenets led him to manage a diversified portfolio of value stocks.
On the other hand, Charlie Munger became fascinated by great businesses. He wanted to own companies that could compound at high rates of return over long periods of time. He loved thinking about the intangible qualities of great businesses.

He once asked an associate to write up an investment thesis on Allergan, and when the associate came back with a list of Graham-esque metrics, Munger told him to forget the numbers and research why the company had such an advantage over its competition.

He was interested in brands, pricing power, predictability of earnings, high returns on capital — things that produced growth and compounding value over time.
Both Graham and Munger were enormously successful in their partnerships—both producing around 20% annually over the period they managed money, but both did so in very different ways.

Neither were right or wrong in their approach, but both managed money according to their personalities.
I think if you first identify what works in investing, and then you tailor it to what you like and what you understand, you’ll do well over time.
Along with value principles, discipline, and patience, perhaps Polonius has some good words of advice when it comes to setting up an investment process when he told his son Laertes in Hamlet: “To thine own self be true”.

Dev: How to generate new investment ideas and more importantly, how to filter those Ideas?
John: I used to do a lot of screens and other mechanical methods to generate ideas, but I find the best way to look for good investments is just to read as much as possible, build watchlists of good companies that you feel you can understand, and then patiently wait for opportunities to buy stocks on that watchlist. Inevitably, if you have a list of 50 or so businesses, there are almost always opportunities on at least a few of them to make an attractive purchase of an undervalued stock.
So most of my time is spent reading about companies and trying to always increase my understanding of the companies I follow, while also slowly expanding my circle of competence.

I read a lot of company annual reports, but I have also found a lot of value reading books about businesses, or books about general industries. I also read numerous newspapers, and the Economist.
Often, investment ideas come from situations that occur within companies on my watchlist that I already know well. Other times I read about a special situation or corporate event in the news that might offer an interesting investment idea.

So while my method isn’t scientific, my routine is quite replicable, and it basically involves a lot of reading and thinking. I would say that it is an approach that helps me always be tuned in to a variety of interesting situations where opportunities often pop up. But most importantly, it’s an approach that helps me continually learn, and I enjoy that aspect of investing.
Dev: Do you believe in importance of having an investment checklist?
John: I do think having a checklist can be a very valuable exercise. I’ve discussed checklist items before, but I’ve also adapted this point of view in recent years as well.

While I consider various checklist items when evaluating a business, I have found that because each investment situation is so different, that unlike flying an airplane that requires the same multi-point checklist before each flight, each investment is like a snowflake—it is unique and not exactly like any other investment.

So while I’m 100% sure that studying case studies is a valuable exercise (especially investment failures of great investors — something Mohnish Pabrai discusses which is a great idea), I’m not sure that a single checklist will be suitable for each investment idea.

Studying why Dexter Shoe was a bad investment is a very valuable exercise. But the lessons learned from that case study might not transfer directly to another investment situation with its own unique set of variables.
So I don’t have a practice of running a bullet point mechanical checklist, although I think that might work for other investors and it’s certainly not a bad idea.

Instead, I choose to try and locate investments with very few variables that are required for the investment to be a success. I try to identify those variables, and then evaluate them over time as the investment plays out.
I think studying case studies probably helps you build a mental database of checklist items, so maybe indirectly we all have checklists as investors, but I choose to focus on each individual investment as its own situation with its own set of variables, and I try to reduce risk as much as possible by locating ideas with very things that can go wrong. The lower the hurdle, the better I like it.

Note – John has agreed to share a checklist which he prepared few years back. Below is the snapshot of the checklist. Though he doesn’t strictly follow the checklist approach anymore (as discussed above too), it can still be a great starting point for those who are setting out to build their own checklists. You can read about it in detail here.

Dev: It’s very easy to say that investors should only invest when value on offer is blindingly more than the price that needs to be paid. But how does one implement that in reality? Being greedy when others are not, is actually quite difficult to do.
John: As I said before, each individual investment is different, so there isn’t necessarily an exact approach that can be implemented with each stock being evaluated.

But I think the first thing is to stick to businesses that you can understand. This is widely discussed, and highly touted, but I think it still might actually be under-appreciated.

Reducing unforced errors in investing goes a long way to producing great results over time. And reducing mistakes comes from sticking to what you know, and picking your spots.

I think patience is a real virtue in investing, and over the course of time, there will be a number of opportunities to buy good businesses at prices that are clearly well below their intrinsic value. The key is to have a list of companies you know very well, and then just wait for one of them to fall significantly below your range of estimated values. Easier said than done, but being patient is very key.

It is also a necessity in investing to have a calm demeanor and a contrarian attitude in general — the market is often correct, so being a contrarian for contrarian’s sake alone isn’t rational, but you must be able to be detached from the crowd so that in times of general market panic, you are willing to buy stocks even when the near term outlook is bleak. This is also easier said than done, but it helps if you have a long-term view of stocks, and stick to owning good businesses that you understand well.
One other thing to point out—I’ve read the average NYSE stock fluctuates by 80% annually (meaning the 52 week high is 80% above the 52 week low for the average NYSE stock). This holds true across every index, and every country (probably much more pronounced in many countries than it is in the US).

Note – Check out a similar analysis on Indian markets here.

So stock prices are very volatile. There is no way that the average company’s intrinsic value fluctuates this much on an annual basis.

So this of course means that stock prices fluctuate much more dramatically than true values do, giving investors an opportunity.
And since these statistics refer to annual levels, it means that there are a lot of opportunities each year in the stock market to buy undervalued merchandise.

Dev: Joel Greenblatt (of Magic Formula fame) once said, “My largest positions are not the ones I think I’m going to make the most money from. My largest positions are the ones I don’t think I’m going to lose money in.” What are your thoughts on this?
John: I completely agree with this. In fact, my largest position right now is Berkshire Hathaway, which became my largest position in February (I wrote a post recently outlining my thoughts on Berkshire).

The stock doesn’t have tremendous upside as its capital base is so large now, but it has—in my opinion—virtually no chance of any permanent downside.

These are my very favorite investment ideas because they allow you to put a lot of capital to work with no risk, and I’ve found that often the market “corrects” itself sooner, meaning that sometimes 2 or 3 year return potentials occur in a year or less, simply because of general market volatility.

1) Don’t lose money.

2) Don’t forget rule number 1.

Trying to stick to companies you understand and sticking to businesses that are growing value over time helps reduce risk.

I think keeping a relentless focus on capital preservation is the best way to produce great results over time.

Dev: Another of Greenblatt’s idea has been to focus on the Key Variables of an Investment. He mentioned once that he might be average when it comes to the valuation exercise. But was above average at putting the information in context, remembering the big picture, and being able to pinpoint what factors really matter to an investment. How does an investor focus on what really matters?
John: I agree with Joel on this point as well. I think many investors get lost in the weeds — they become too focused on their models, their excel spreadsheets, or trying to predict what margins will be in 2019, etc.

I think gaining an understanding of the big picture is usually the most important objective when looking at a stock.

The big picture often means identifying the most important drivers of value in a business.
These value drivers could be things like cost advantages (Wells Fargo gathers deposits cheaper than just about every other bank), network effects (the more people that use Visa’s network, the more valuable it becomes), supply chain management (Amazon), economies of scale (Walmart’s leverage over suppliers), sometimes brands are very valuable assets (Nike, or even Apple for example), and sometimes it could be the management team that is just executing a business model well or is very adept at allocating capital (Berkshire Hathaway is an obvious example, but there are many companies that owe large portions of their success to the management team).

Many of these things can’t be measured by simply looking at the financial statements, so it helps to identify these things and keep them in mind when analyzing businesses, because often these big picture items continue to be the reasons for the company’s success going forward.
To be continued…

## Interview With Mid-Cap Mogul Kenneth Andrade

Image Source: Livemint

I recently had the privilege of talking to Kenneth Andrade, who is widely acknowledged as one of the best fund managers in the mid-cap space in India.

Most people already know this legend and many refer to him as the ‘Mid-Cap Mogul’. Hence, an introduction is not necessary in Kenneth’s case. But for those who don’t know, he was the fund manager of IDFC Premier Equity Fund – one of the most popular and best performing mid-cap funds ever.

Ability to think out-of-the-box to identify the big theme, build investment hypothesis around it and most importantly, convert it into winning investments. This was and is his expertise. Now he has moved on from IDFC MF and turned into a private investor.

In this interview, he answers my questions about investor psychology, investing in stocks for the long term and mutual fund investing.

So here it is…

## Common Investor Psychology

Dev: One of the biggest problems of common investors is their inability to sit. So how does an investor stay put even if (say) markets have moved from 10,000 to 20,000 in just a couple of years and he/she wants to book profits?

Kenneth: Investors do stay put in investments; except in equities. This probably is associated with the volatility of the asset class and the lack of a fixed return or physical asset.

Also no one likes negative returns and the equity asset class can’t promise that every year.

The western world has found a way around this with their pension plans. India still needs to get there. As a discretionary investor they will always give into greed at the top of the markets and fear at the bottom of the cycle. Hence the only way out is to package products, which eliminate or smoothen out volatility. Manufacturers in India have been experimenting with hybrids. They tend to cushion the volatility of the markets. Maybe that’s one way to keep the investor interested. It may not be the most efficient way of equity investing but the yields across market cycles would still be higher than mere fixed income products.

Dev: It is said that in investing, it’s very important to avoid making big mistakes. Even someone like Charlie Munger believes, that not making big mistakes is a huge determinant of whether one will have financial success in life or not.

How does a common investor identify his limitations, create a simple mental framework and more importantly, implement this framework to avoid making big mistakes?

Kenneth: The way I would address this is to invest in what you know. I am very apprehensive in putting money to work either in a company or an investment, which I don’t understand. I guess the same would apply to any investor.

One way of avoiding mistakes is to understand what you do, that way you can identify and correct it when and if it does go wrong. If you don’t know the investment, you would never know if things are going wrong in the first place.

Dev: What according to you is the biggest reason most investors don’t succeed in stock markets?

Kenneth: I guess most serious investors do succeed in markets. The longer you stay invested, the better are the results. Investing needs to be passive and rather than focus on prices investors should concentrate on the underlying. This is a learning process. And being persistent is the key to long-term success. A lot of investors give up in the short term.

Dev: How important it is for investors to have reasonable expectations? Many investors start believing that markets will continue to perform well, just because they have done so in the past. How does one correct this perception?

Kenneth: In the beginning of 2013, 10-year index returns converged with liquid fund returns. There is no set rule that equity or any asset class will deliver an above average return in perpetuity. Sure if you play with statistics, we can prove otherwise.

In the long term, any manager or fund with a return over 5%-7% (post tax) over the risk free return is a job well done. If that is the benchmark, then it is fairly important to anchor investor expectation around this number. Of course at times this could be significantly higher if a couple of asset classes do extremely well.

Dev: Volatility is one of the most recognizable and hated aspects of equity markets. And because of volatility, most investors do the exact opposite of what needs to be done. They buy (on fear of missing out) when markets are high and sell (out of fear), when its low. This seems to be driven primarily by the perception of volatility and risk being same things.

But that is not correct as per my understanding. So how does one start believing and also, convince others about the fact that volatility is an aspect of risk and it is not 100% same as risk.

Kenneth: I guess the latter part of the question can only be experienced with time in the market. In one of my presentations lately I made a point that you need to use volatility to your advantage. Markets overshoot in both directions, and if you take advantage of this it could be extremely profitable. But one needs discipline to take advantage of these extremities.

## Mutual Funds

Dev: The best time to invest was yesterday. Next best is today. Though its easier said than done for most people (who invest for long term goals), how does one go about convincing people to stick with to long term mindset when it comes to investing?

Kenneth: It’s the discipline that’s very important for that. And more than convincing, it’s the investor experience in the product category that matters. If any consumer has had a good experience of a product or a service, chances are he will stick to that regime. So it’s important that a habit is cultivated.

A lot of investors like to see markets trend up so that their money is multiplied everyday. Logically if I had a steady income – I rather want to invest in a market that is sideways to down for even maybe 5-7 years. (Read I Pray for Bear Markets) That keeps my average holding of my investments low. Then if markets doubles or trends upwards, which they normally do once in 5 years, it’s a very profitable trade.

If you do the math investing in a market, which is trending upwards is very inefficient. You have a very high weighted average cost of holding and a relatively lower return than the former.

Dev: It is said that apart from returns, one should also consider many other factors while selecting a mutual fund for investing. Which factors according to you should form the key criterias for fund selection?

Kenneth: Investing in any portfolio should be a long-term commitment. Likewise the long term is also associated with durability. So if one needs to buy a MF scheme for the long term, the portfolio also needs to be in sync. There are a lot of funds out there, which promise long-term returns with the top stock undergoing tumultuous changes. Portfolio churn is never good for the long-term investor. If this were so with the underlying fund, at most the best return would be index linked. One needs to watch for this.

## Stocks

Dev: Inspite of MFs being the best option for common investors*, people do get attracted by the glamor of investing directly in stocks. As per my understanding, this is human nature and people will continue to do so.

But when they do it, it also makes sense to invest only in companies, which dominate their industries with no-to-moderate debts and positive cash flows (atleast for non-professional investors, these criterias should be good starting filters).

How can an investor go about finding such companies? Another problem with finding such stocks are the perennially high valuations, which they are assigned. How does one go about investing in such companies?

* neither has the time nor expertise to analyse individual stocks.

Kenneth: MFs reduce volatility and at the same time offer participation in the growth of the capital markets. Their models are largely disciplined with managers allocating money across a number of companies. Individuals can replicate this off course by buying stocks directly. The error that most investors commit is the discipline of diversification. If this were managed well the outcomes would not be very different from diversified mutual funds.

The second part of your question resonates around investment styles. And no one style fits all. But by sticking to what you understand best will give you more upsides than downs. Don’t diversify your style.

As an investor I have always shied way from levered companies (excessive debt). And I consistently look for stocks and business that are out of favour. That way you know you are getting in at the ground floor.

An example of an ideal investment case would be a loss making company with a shrinking balance sheet in an industry that is under stress. So go one step backward on what creates capital efficiency – higher profits and capital employed (RoE = Net Profit/ Shareholder Capital). The former is the function of the environment; the latter is the function of the management. Look out for the latter, this should not be bloating. Chances are these stocks will come extremely cheap because of the cycle they are in.

As investors we all consistently focused on return. On the contrary we should be risk managers. A bull market gives you the return because all stocks participate; a manager has a very little role in that. It is the downside that counts.

You have to have a framework that works in a market offering you negative returns and measure your successes by buying companies that survive an economic slide.

Dev: In one of your interviews, you said that it is very important to go for companies, which are in a space that is scalable and significant. But as Graham said in Intelligent Investor, “obvious prospects for physical growth in a business, do not translate into obvious profits for investors.”

How does one think on those lines, so as to avoid the pitfalls of investing in the wrong company in the right space? Is it that the predictability of understanding the environment that a company operates in, and the ability of the company’s management to actually execute in that environment is the most critical aspect of decision making?

If yes, how does one be sure about the management here?

Kenneth: A company profit is limited by the size of its industry. Hence my fetish for scale sets in. Off course once this scale is established, the execution has to be profitable market share growth.

In my framework any company that loses market share raises a red flag, the cost of building back market share gains is ridiculously expensive. It is an easy parameter for most investors to track. (This framework may not strictly apply to commoditized business, but it works in most cases).

Getting back to the scale question, I love excesses. I always am on the look out for the next stock market bubble and the reasons that would cause it, but I would rather preempt them. Else like every one else I end up being the follower. If this is the context, I would necessary need to find scalability in the business and in the mid term markets extrapolate these numbers creating these excesses.

Dev: Most people say that India will continue to grow for years to come. As investors we need to be optimistic about future prospects. But as I read in one of your interviews, you said that it is very important not to go into an expanding economy with the wrong portfolio.

Most people are looking at the same set of sectors, which have done, well in recent past. But to outperform over the long term, one needs to know what can drive the next bull market. Though its tough for common investors to do it, what would you advise a person who is willing to put in place a mental-framework to think on those lines?

Kenneth: That’s an easy one. Demand creates profitability, which creates market caps which in-turn creates the need for fresh capacity. So in this framework, companies, which were growing 15%-20% per annum, set up capacities to grow between 30%-50% using near term historical numbers to justify the capital investment. This creates excessive capacities. Which is why the same sectors get very capital intensive and never return to historic levels of capital efficiency and then valuations.

If the above is true, we would need to let go of the past and look at industries where supply constraints or competitive intensity is low. Chances are they hold on to their profits and efficient capital allocation. One way of tracking this is leverage. Banks usually are arbitragers of high capital efficient business and low interest rates. They usually fund excessive creation of capacity based again of near term historical numbers, which they extrapolate into the future. So look for what these institutions fund, it may be the beginning of the next economic bubble; and excessive lending may end up being the end of one.

Dev: I know that you like buying companies, which are efficient with their use of capital. How can one analyse companies to find efficient use of capital. And more importantly, how does one create a list of such (prospective) companies in the first place?

Kenneth: Go one step behind. In one of the question above I alluded to two components of the capital efficiency ratio – the numerator and the denominator (ROE = PAT/ Shareholder Capital; ROCE = PBIT/ Capital Employed). The numerator is profitability, which largely is the function of the economy; I don’t believe I can predict a complex subject of growth.

The denominator however is the function of the management and efficient capital allocation. A lower denominator is all I look for and you don’t need a model to predict that. This is already in public domain. Just look for the latter. If you buy a portfolio of 20 companies that meet this criterion, the probability of going wrong is well zero!

## Others

Dev: Few books which you would ask everyone to read, to get their thoughts about investing and money ‘corrected’ and streamlined.

And what will you suggest for someone who is interested in doing deeper analysis of the actual businesses behind the stocks?

Kenneth: I have always identified with the Peter Lynch style of investing, which is what makes his two books my all time favourites. i.e. 1) One Up on Wall Street and 2) Beating the Street

And nothing beats company annual reports if you want to deep dive into an analysis of a company.

Dev: How do you avoid noise and information overload, which are so prevalent these days? How does an investor focus just on what is important?

I feel that noise is generally made up of opinions people have. And I may be wrong, but most people don’t know what they are talking about when discussing about future. How does one stop oneself from becoming influenced by such noises?

Kenneth: As an investor I am always looking at a right price to buy a good business at. So noise is welcome if it gets me to that objective. Else, file all the information you get in some remote corner of your grey cells. Chances are you will need this sometime in your investing journey.

Dev: That’s all from my side Kenneth Sir. I thank you for taking time out of your busy schedule to answer my questions. It was wonderful to have you share your insights.

Kenneth: Thanks Dev.

## Do Indian Markets Bounce off PE levels of 12 & 24?

Sounds like a title of some Technical Analysis writeup? I don’t blame you. 🙂 But rest assured it is not. Infact, this will be an entertaining post for you if you are interested in giving some thought to PE-Based investing. In previous post, I did a detailed analysis of the PE Ratio of Nifty 50 in last 16+ years.

It does throw up some interesting insights. But what catches the eye is that there are levels, which the Nifty generally fails to breach on lower and upper sides.

There is no doubt that by investing (more) in markets trading at low PE multiples, chances of earning higher future returns increase. Similarly by investing in markets trading at higher PEs, chances of lower future returns increase. It is very simple.

But to say that one can time the market on basis of just Index PE will be an over-simplification.

As we saw in previous post, the mere fact that expected average returns are high does not mean that the returns you (in particular) get, will be guaranteedon lines of the high averages. It does not work like that.

If you are unable to understand this point, I recommend reading the post – especially the example of average depth of river part.

Now I did the following analysis in 2012too. There were clear indicators then, that broader indices had a dislike for staying above or below certain PE multiples. Not much has changed in last 4 years.

Without getting into the statistical accuracy of numbers, the analysis shows that these PE multiples are PE12 and PE24.

Have a look at graph below:

The blue line is actual Nifty level.

The red line is hypothetical Nifty level at PE24 at that time.

The green line is hypothetical Nifty level at PE12 at that time.

Clearly, Nifty seems to have trouble staying above PE24 (considered highly overvalued) and below PE12 (considered highly undervalued).

Whenever it reaches either of these two levels, it seems to bounce off in opposite direction!

Though the chart might look like a screen-grab from a trader’s terminal, it’s a clear display of how fundamental this concept is. 🙂

Buy low (PE). Sell high (PE).

If you think it’s timing, then you are right.

If you think it cannot be done, then you can try this instead:

More manageable. Right?

Now ofcourse you can say that I should have used PE25 or PE11 to make it more accurate. But the idea here is not to be as accurate as possible. Rather, the idea is to become cautious when markets start moving in irrational territories. Index PE depends a lot on what are the index constituents and other factors.

So broadly speaking and ofcourse basing my conclusions on past data, PE12 seems like a clear signal that investors are unreasonably pessimistic and at PE24, over optimistic. Both are unsustainable and hence, indicate near term reversion towards mean. Though nobody can guarantee that markets will behave on similar lines in future, chances of that happening are pretty high.

Those who think that, ‘this time its different’ – have not had much success when it comes to investing. 🙂

My analysis and conviction is based on the fundamental assumption that India is a growing economy (atleast for next decade and a half). And I believe that markets are highly undervalued around PE12 and highly overvalued as they approach PE24.

But ofcourse, you may choose to differ on this and invest accordingly.

So instead of getting into this debate, lets come back to the title of the post – Is it safe to say that index bounces off PE levels of 12 and 24?

It seems to be true. But note that markets don’t stay at such low/high levels for very long time.

So inspite of being sure to invest when PE12 is crossed on the downside, you might find yourself lacking enough firepower (cash) to take advantage of the situation.

Have a look at times the index has spent at various PE levels:

Now lets aggregate these PE bands into smaller groups:

Just 1% of the time – market has stayed below PE12. Can you catch it?

Chances are high that market will catch you unaware. And believe me, market is capable of doing that beautifully. 🙂

So what should one do?

Its simple, you cannot wait for markets to fall to PE12. But you can become (more) interested at it crosses PE15 on the downside. That is more manageable. By ‘becoming interested’, I mean that you should have a thought process like this:

“Market just came down to PE15. It looks attractive. But what if it falls lower? Do I have the money to buy more if it goes down to PE12-13? I guess I should be alert and start preparing myself.”

You might ask that why am I telling you all this when PE is neither near 12 nor 24 (Currently 19)? It is because you won’t listen to me when markets are booming (PE24) or when everybody else around you is selling and running away from markets (PE12). 🙂

So keep this in mind.

## A Small Guide I refer to when Investing in Stock Markets

Before I write anything about this guide, let me briefly define my approach towards money (and life in general).

I love investing in stocks. But its more because I like the process of investing, than for my desire to be rich. Though I would prefer to be rich than to be not-rich, money still does not mean everything* to me. I don’t loose my sleep over it. I don’t want to be the richest man in graveyard. I want to do things that I enjoy – Be with my family and friends, Travel, Read and Write (and maybe continue doing strange things).

*This reminds me of an interesting line by James Altucher – “Money is not everything. Its a side effect. Its a byproduct.”

Having said that, I also feel that if my approach in stock markets is not based on my above mentioned preferences, then it is bound to create a disconnect between my real personality and my investing personality – which will become a cause for sleepless nights (which I don’t want). So I created a small guide for myself. I shared this few months back on Twitter too. Since many readers here are not active on Twitter, I am sharing the guide here.

It is simple enough for everyone to understand. It is based on an easily available market valuation indicator – the P/E Ratio (which is available here).

You too can use this guide as it is or modify it to suit your own personality. So here it is…

Note – This is specifically for Nifty50 and not other indices, stocks or sector.

As many of you would have observed, the guide is more about avoiding mistakes than anything else.

It pushes me to keep investing when markets valuations are reasonable.

It pushes me to invest even more, when valuations fall further.

And it also pushes me to disconnect (and take a holiday) from markets, when valuations reach unreasonably high levels.

The guide also does not mention anything about selling. That is primarily because the decision to sell is driven more by change in original investment thesis, requirement of money, availability of better investment avenues, etc. and not just broader market valuations.

Caution: The above guide does not mean that reasonably priced good stocks are not available when markets are overvalued (say PE > 26). The ‘taking long holiday’ point simply means that chances of finding a good business, selling at a reasonable price are very low in an overvalued market.

So it is best to avoid such a market and take a holiday from it. And as Charlie Munger once said:

Tell Me Where I’m Going To Die, So I Won’t Go There.

It is as simple as this. If the cost of not venturing into a highly overvalued market is that I may miss out on a few future multibaggers, then so be it (known as FOMO – Fear Of Missing Out).

I prefer not making big mistakes.

I prefer return Of capital more than return On capital.

But that does not mean that I invest only in safe products like PPF, NSC, Fixed Deposits, etc. I have absolutely no doubt about equities and equity-linked products (MFs) being the best bets for long-term wealth creation.

Infact, it has already been proven. Want another proof? Here it is.

Another thing which I continue doing irrespective of market valuations, is to keep pumping money in my mutual fund SIPs. So you can take that as a confessional disclaimer from my side – that no matter what, I am always invested in markets. 🙂

Note – This guide is not a hard-and-fast rule book that I follow. It simply helps me stay on track with my investment philosophy and more importantly, helps me avoid making mistakes.

We all want to be rich. And if this ‘being rich’ comes from the stock markets, there is nothing like it. Its glamorous… Imagine being able to tell everyone that you are rich and you don’t need to go to office anymore. And its because you are rich (now) thanks to your great stock picks. Seductive…right?

But unless and until you are a superhuman trader who can pick the correct stock on a daily basis, its almost impossible to become rich enough, overnight. This is assuming you had to start from Zero. Then there is this risk of using leverage in stock markets.

But this post is more about a very simple, but difficult to answer question which was posted by Seth Godin in one of his recent short posts (link).

Though post is more general and not specific to money, it still is applicable to our world of investing.

And I quote what Godin writes…

A simple question with an answer that’s difficult to embrace.

What are you willing to give up today in exchange for something better tomorrow? Next week? In ten years?

I was quite impressed and more importantly, unsettled by this question. Read it a few times and you might experience what I did. Do let me know if you have any thoughts on this…

## Case Study – Do You Have Surplus Money To Put Aside for 5+ Years? Then You Should Read This

Note – This is a guest post by Ajay who sometime back, shared his experiences with Mutual Fund investing in the post titled second part.
Go and ask any financial advisor about the best available options for investing for average investors, and chances are that he will recommend using SIP (or Systematic Investment Plan) and rightly so (as proved here).
But while SIP may be the best tool for someone who wants to slowly and steadily build wealth using monthly investments…what should a person do if he has surplus money to invest?
Let us suppose you have Rs 10 Lacs to spare. Where will you put that money? Savings Account? Fixed Deposits? Or direct stocks? (But no matter what you do, please don’t do this with Your Rs 10 Lacs)
Or would you do a SIP or STP (Systematic Transfer Plan)?
But what if you somehow, decide to invest the entire amount in one go? And if invested in one go, what should be the time frame for that investment? And what are the risks involved in doing so?
This post is a case study to answer some of the above questions.
But before we go ahead with this case study, let us try to answer a few questions as honestly as possible:

1. Do you feel comfortable investing lump sum money in Equity Funds?
2. If yes, what is the time frame you are comfortable with for this investment? – 1 year / 3 years / 5 years / 7 years / 10 years.
3. Do you think a 5-Year Tax Free FD returns would be safer (and more) than a Mutual Fund for the same duration?

So now lets go ahead with our analysis…
For the purpose of this case study, I have chosen Franklin India Prima Plus Equity Fund (FIPPF). And returns of this fund have been compared with return of a 5-Year Tax Free Fixed Deposit. There is no specific reason for choosing this fund. It is more of a random choice. In fact this fund does not feature in the list of top funds regularly – but has been a steady performer in the long term. It is also a diversified large cap oriented fund and owns high quality stocks.
A period of 20 years (i.e. starting from 1995 and upto 2015) was considered for this study. This period has been full of economic booms and recessions and dull periods. As we are evaluating 5-Year period, in 20 years between 1995 and 2015, we have a total of 16 Five-Year periods.
5-Year annualized return of FIPPF was calculated as per the NAV of the fund – based on the investment start and end dates. Accordingly, value of Rs 1 Lac invested in FIPPF for each of these 16 Five-year periods was calculated.
For comparison, the above calculation was repeated for all these 16 Five Year Periods for 5-Year Tax Free Deposits. (The Interest rate for 5 year FD for each corresponding period was taken from RBI website.)
Note 1 – Sensex PE Ratio for all the periods was obtained from BSE website. The site does not have PE data for periods before 1995.
Note 2 – The start and end dates of the investment were considered as 1stJan of the corresponding years.
The results of the analysis are given in table below. And the observations follow the table:

Observations
• Out of the 16 Data points (for 5 Year periods), lumpsum investments in the FIPPF gave annual returns ranging from 3.56% to 54.89%. In comparison, returns of FD (Tax-Free) ranged from 5.5% to 13%.
• Out of 16 data points, FIPPF gave single digit returns twice i.e. 3.56% & 6.96%. Also, twice it gave abnormal returns of 54.89% & 47.30%. Both these excesses (great for those who got it), were because of the amazing bull run which ended in 2007-2008.
• If we were to remove these outliers on both up and down side, FIPPF returns ranged from 15.14% to 37.89%. Range of returns from FD remain same at 5.5% to 13%.
• There was not even a single period in these 16 data points, where FIPPF gave negative returns.
• 12 times out of 16, FIPPF gave returns between 15.14% and 37.89% annualized. This points to 75% chance of achieving similar results. And if we were to add the outliers on higher side, it will be 14 out of 16 times – which is more than 85% chance of making superior returns.
• In Rupee terms, Rs 100,000 invested in FIPPF could have grown anywhere between  Rs 119,193 to Rs 891,663 (in blocks of 5 years over 16 such periods). If the excesses removed on both up and downside (caused mainly because of 2007-08 bull market, followed by crash in 2008/2009), then Rs 100,000  invested in FIPP could have grown anywhere between  Rs 198,821 to Rs 498,596. Majority of the times, Rs 100,000 invested in FIPP would have grown to a value between Rs 200,000 to Rs 300,000.
• On the other hand, Rs 100,000 parked in a FD would have grown to a maximum of Rs 184,243 (at 13% peak FD interest rate). And most of the times, Rs 100,000 invested in FD would have grown to a value in between Rs 135,000 to 160,000.
• Did market’s P/E Ratio dependent entry points make a big difference to the 5 Year annualized returns? The answer is Yes. But there is no specific pattern. A lump sum investment made in 2009, at a low PE of 12.21 (supposedly a superior entry point) gave annualized returns of 18.5% over the next five years. But on the contrary, an investment made in 2010, at a relatively high PE of 22, gave an annualized return of 16.76%.
• Investment made in 2008 at very high PE of 25 gave the lowest return of 3.56% in the next five years. Therefore, entry at this and similar high PE points should be avoided. Except for this high PE point there is no much correlation between PE and returns. So as long as the PE is anywhere less than 21, even lump sum investing may work.
• Did PE exit points make a big difference to 5 Year annualized returns? Yes, but again there is no specific pattern. A 27% annualized returns was made even after exiting at 13.74PE in 2003. Again, 18% annualized returns were made, even after exiting at 12.21PE (near very low PE point) in 2009.
• One significant point to note from this analysis is that the fund NAV doubled (minimum) or tripled or more in most of the 16 data points. Though we are generalizing here, you can safely expect that in five years, chances of getting decent returns (better than FDs) are much more in equity mutual funds. And this is a very important observation.
Now after having gone through the above analysis, let us re-visit the questions we asked ourselves earlier…and see if we are in a better position to answer them now…
Do you feel comfortable investing lump sum money in Equity Funds?
Yes. But only when investing for more than 5 years.

If yes, what is the time frame you are comfortable with for this investment? – 1 year / 3 years / 5 years / 7 years / 10 years.
The minimum investment period should be 5 years. However, there is still a possibility of loss of capital if invested for anything below 5 years. Based on above analysis, an investment for 5 years in a decent mutual fund lowers the risk of loss of capital substantially.

Do you think a 5-Year Tax Free FD returns would be safer (and more) than a Mutual Fund for the same duration?
Based on above analysis, it is most likely that returns from MF will beat those of FD, significantly. But there will be inter-year volatilities.

What happens if the investment time frame is reduced to a period of less than 5 years for lumpsum investment?
There is a high possibility of loss of capital (and not only lower returns). You can easily see the NAV of the fund, which nearly doubles every five years, but falls significantly for some shorter periods (less than 5 years).

What happens if the investment time frame is increased for lump sum investment to something like 7 or 10 years?
On a 7-Year basis, the same fund shows a minimum annualized return of 9.92% and highest of 39%. If excesses are removed on both sides, the range of returns is between 15% and 36%. This is based on 14 data points.
For 10-Years, the results are extremely encouraging. The same fund shows a minimum of 18.29% and highest of 40.26%. If excesses are removed on both sides, the range of returns is between 20% and 28%. This is based on 11 data points.

Do you have the similar analysis for 7-Years and 10-Years data?

Do you think the high returns shown on this analysis are some what guaranteed?
No. Please don’t think so. There is no guarantee that what has happened in past will also happen in future. However, chances of such returns being delivered if one invests for long term are quite high. Although this analysis of 20 years has witnessed a lot of market action, I believe that the mega bull run of 2004-2008 distorts the figures and the analysis. We may or may not get similar bull runs in future and this fact, is likely to impact future returns. Therefore it is safe to assume the lower side of the returns, say about 15% – which I strongly believe is achievable.
If you didn’t get these kind of returns over a 5 year period (like Zero Returns of 2008 to 2013), then it is only a matter of time. And you should be ready to stay invested for longer periods like 7 and 10 years. In other words, even if you come to the market with a time frame of 5 years, be prepared to stay invested for longer…upto 10 years to achieve the desired result.

Did this analysis find something which no one has found in past?
Certainly not…In fact, Prashant Jain of HDFC once said that Indian Indices double approximately in every 5 years. This analysis actually proves that statement of his (atleast approximately). Also, this analysis endorses the fact that Time in Market is more important than Timing the Market.

So should you just go out there and invest in Equity Mutual Funds right away?
No. Please don’t do it. If you have surplus money to invest, do the following:
– Decide the amount you want to invest.
– Decide your time frame for this investment amount.
– If your time horizon is less than 5 Years, equities are a strict no-no. If its more than 5 years, check your asset allocation and then decide whether you can (and should) add money to equities or not. If you decide to go for equity MF, you should be prepared to remain invested for more than 5 years too…if the desired returns are not achieved. If you cannot wait for so long, then you are better off with debt and fixed deposits. And if your time frame is 7 to 10 years, then look no further. Simply invest in a diversified equity mutual fund in lump sum mode. But just make sure that PE of broader markets is not more 24 – which means highly overvalued. And if it is, then you should wait for the market to give a better entry point.

Do you mean Lumpsum investing is better than SIP investing?
No!! Not at all. If you have surplus lump sum money to invest…and you are well aware that you don’t need this money for next 5 or more years…and also that you are capable enough to wait a few years more if required…only then you should invest in lump sum.
For an investor who invests a small portion of his savings on a monthly basis, SIP is the best way to go about his investing. He should stay away from lump sum investing. And even for SIPs, the minimum investment period should be 7 years plus.

What is your final conclusion of the above analysis?
While 5 years is a decent time frame for investing, it is still a better option to invest for a 10 years time frame. As long as the market PE is less than 24, invest with 10 year time frame, only in very high quality, long term proven, large cap, well diversified equity mutual funds in lump sum mode. If the market PE is more than 25, better wait for a more sensible entry point below 24 (or even lower) and invest your surplus in lump sum mode.