Monday, February 20, 2006

Go short on Nifty and Sensex a week prior to the Budget, says history.

It's Budget time yet again. The next few days are going to be marked with large amounts of volatility as the tussle between "What I need" (Corporate India) and "What I can" (Finance Minister) comes closer to the climax on 28th February. The increase in volatility can also be seen in the way options are priced for the March expiry. They are usually significantly higher that what the dear old Black-Scholes method would otherwise indicate.

So how does one play this sharp rise in volatility ? I'm no expert in the derivatives (still learning the ropes there). But nevertheless, here is my half-bit. One should look to sell (write) out_of_the_money call options as this point in time.
This is purely based on my view that the markets may decline post the Budget. I've history on my side too. The chart given below indicates the same. A month after the announcement of the Union Budget, the benchmark indices (BSE Sensex and NSE Nifty) closed below the pre-Budget levels on eight of the last ten occasions. Will the same happen this year too, who knows ?

But, given the upcoming elections in the Left-dominated states (which may restrict GoI to undertake broader economic reforms during UB '06-07), the onset of the bird-flu disease in India, increased volatility in most of the emerging markets, a sharp slowdown in the growth of the Index of Industrial Production and a muted growth in exports, I feel a little wary of engaging fresh investments in the market. Writing out-of-the-money calls and increasing the share of cash in one's overall portfolio seems to be a safer bet at this point in time.


Monday, February 13, 2006

More reasons why active mutual funds are not required....

(...continuation of my previous article)

A nice article on index funds was featured on . The article can be accessed here. Index funds remain under-owned and I think common investors in India need to come out and put some of their savings in index funds or ETFs and gain from the economic growth of this nation.

Saturday, February 11, 2006

Do we need active mutual funds ?

Recently I came across a host of articles on how active mutual funds charge exorbitant fees to the 'gullible' investor. Dr.Shah has a nice article on this. One can read the same here. Couldn't agree more than what Dr. Shah had to say. But, obviously most of them go un-noticed so long as markets are headed north. While reading the article by Dr.Shah and what other commenters had to say about the same - it just struck me and I was asking myself a question - Who and why should one invest in active mutual funds ?

Who should invest -

a). Lay investor who has no understanding of equity markets and about companies. This list will include all those professionals (outside of the money mgmt biz), house wives, retirees, etc.

Now, the next question is - Why should they invest in mutual funds ?

To earn returns better than those doled out by fixed deposits, the NSCs, the GoI bonds. So far it's all fine. There is a need to get returns better than those offered by the aforesaid instruments. But, invest in active mutual funds ?

Hmm, here is where i've a little different view - I think there is no need for active mutual funds. A lay investor will be better off investing in index funds or exchange traded funds (ETFs). The reason I say this is because investing in mutual funds for a lay investor is analogous to investing in stocks, you still gotto identify the better of the lot fund. This is because not all funds outperform the benchmark indices in the long run. A lot of research has gone into this study and is best summed up in the book - A Random Walk Down Wall Street by Burton Malkiel.

How many of us have heard of mutual fund schemes that have consistently beaten the indices for a period of over 5-10 years. Not many, I guess. A few names that come to mind are - Morgan Stanley Growth Fund, Reliance Vision Fund and maybe a few others. Yet, we have whole host of funds floating in the market. Who makes by investing in those - surprise, surprise - the fund house.

What this means is that the onus of selecting the right fund scheme still stays with the individual investor, isn't the process same for investing in stocks ? And, if that is indeed the case, and the fact the lay investor does not know much about which scheme/stock to pick, isnt he/she better off investing in index funds/ETFs (passive funds). The other major advantage of investing in passive funds is lower fees. The only problem that the investor is likely to face is tracking error. I think it is still fairly high in case of Indian funds (Dr. Shah has written some very informative papers on this topic. I think the pdfs are available on his site). But, i think over time this is likely to come down.

The individual investor should always look at investing in better avenues than the archaic bank deposit. Yes, i know one can sleep well if the money is lying in the bank or that the value of the capital lying in the bank deposit does not fall (in the real sense, ofcourse). But, then I think it will be great for individuals to get some exposure to capital markets (by way of passive funds, ONLY). For those who strictly put their money into fixed deposits, or other GoI bonds, here is something to ponder -

a). A sum of Rs.10,000 invested in a fixed deposit in 1991 @ an average interest rate of say, 12 per cent, would have compounded into Rs.54,736. Such deposit rates will obviously be not available in the next, good god knows till how many years !

b). A similar amount in an index fund that tracked returns on the BSE Sensex would have compounded the initial investment into Rs.100,185. This is assuming a 'zero' tracking error. But, even if i assume a tracking error of '1%', the amount invested would still be significantly higher than Rs.55,000, much higher.

Ponder over this - If a GDP growth that averaged around 5-6 per cent (between 1991-2006) can produce such returns what should stop it from doing it again in the next 15 years ? Nothing can, If you ask me.

I think the numbers say it all. Those who cannot live with volatility and the gyrations of the stock market can, therefore, invest 30-40 per cent of their savings in index funds or ETFs. The rest can be put into fixed deposits/PPFs/NSCs..etc. But, invest in equity markets, one must. As even by allocating a 30-40 per cent of total savings into index funds, one can enchance returns substantially over the long run.

Thus, it is quite clear that active mutual funds are not the best options for the lay investor, so who is left ?

b). Companies/corporates.

This is one area where I strongly feel that companies that make large investments in funds (out of reserves, ofcourse) are doing a great disservice to the investors. Companies like Infosys, Bajaj Auto, Wipro, etc. are sitting on billions of rupees of cash in their balance sheets. And, all of it is invested in active mutual fund schemes. Conservatively many of them invest the same in income (debt schemes) or balanced funds (equity + debt schemes). Returns from these would be a paltry - 10-15%, at best. Whereas the RoCE for most of these large companies is in excess of 20-25%. Aren't these companies and therefore their shareholders better off investing in their own businesses (where the returns are higher) and if not give the money back to the shareholder. Why keep'em with the mutual funds, who charge nice fat fees for a mediocre performance.

Thus, I think the companies should not invest in active mutual funds.

These two groups are the largest investors in active mutual fund schemes. People like me who -

a). Do not believe that the markets are efficient (as the efficient market theory suggests),
b). Think that markets can be outperformed in every run (short or long), provided one trades/invests/speculates with discipline and some intelligencia.

will never look at investing in active mutual funds. I think only the RBI should invest in actively managed mutual funds (not in India but in the US, instead of buying their treasuary notes which yield a paltry 4-5%).

So, does one still think that there is a need for active mutual funds ?

Thursday, February 09, 2006

Together we rise, together we fall

How closely are global markets correlated ? Take a look at today's closing -

Sunday, February 05, 2006

Does one gain by investing in stocks to be included in the Sensex ?

Earlier in the week Kaushik had tested the hypothesis -

whether it is profitable to invest in stocks that are included in the Sensex or the Nifty ?

Taking his idea a step further, I tested another hypothesis (ofcourse, not in the real statistical sense) -

Is it profitable to invest in stocks that are to be included in the Sensex ? The difference in this was that I computed returns between the period of announcement, of the inclusion of a new scrip in the index, and the actual inclusion.

Of the 16 scrips studied, 11 outperformed the Sensex while five underperformed. On more than five instances, the outperformance was over 10 per cent whereas on two instances the underperformance was as high as 39 per cent. The two extreme cases in this study - Satyam Computers (underperformance - 38.9%) and Zee Telefilms (-25.8%) were largely a result of the dotcom bust that took place in 2000.


Note: These are not annualised returns and they do not include effect of dividends, if any.

If one keeps these two cases aside, the study does indicate an overall outperformance by scrips to be included in the Sensex between the period of announcement and the actual inclusion.

Thus taking a leaf out of Kaushik's book - the trading strategy would be to buy scrips that are to be included in any of the benchmark indices on the day of announcement and sell it on the day the same is included in the index.

Saturday, February 04, 2006

Even your house has a p/e ratio !!

Your house has a p/e ratio too. Shocked, well not if you know your finance well. A p/e ratio or price (you pay)-to-earnings (net profit per year) ratio simply put is -

  • a ratio that tells you that the number of years it will take for the asset in question to earn you back your initial investment.
A more simpler explanation can be given by looking at a fixed deposit at a bank. Lets say Mr.X deposits Rs.100,000 with the State Bank of India at an annual interest rate of 10% (or in this case it would be Rs.10,000 per annum). The p/e ratio of this bank deposit will thus be 100,000/10,000 = 10 times. A simple math would also tell you that given the rate at which you earn your net income (assuming no re-investment), the deposit should earn you the initial investment (Rs.100,000) in 10 years.

Thus, any asset that has an earning stream can be valued by its p/e ratio. Lower the p/e ratio, quicker will you earn your investment back. Value stocks are usually defined as the ones with lower p/e ratios. One of the important principles of Benjamin Graham was investing in stocks with low p/e ratios.

Coming back to the example of a house that has a capability of earning a rent. So for example, a house that costs - Rs.10,000,000 and can earn an annual rent of Rs.500,000 then it is said to be quoting at a p/e ratio of 20 times.

I read an interesting paper on valuation of investments in homes. Here is a small extract from the paper -

You may not think about it when you buy a house, but it’s the same thing. The price you pay should reflect the present value of future rent. You should go through the same mental calculation in purchasing a home as in purchasing a stock. Ask yourself how much the house could currently be rented for on an annual basis. Divide the seller’s asking price by this rental number. That’s the p/e ratio, the ratio of price to earnings. If a $500,000 house could generate $25,000 in annual rental earnings net of maintenance and management, then the p/e ratio is 20.

I know it’s hard to think this way. Unlike stocks, investments in homes do not come with quarterly earnings statements. Unlike stocks, the price of your home is not listed in the Wall Street Journal every day, which allows you to keep it on your books at whatever price suits your current mood.

You can download this paper from here. I had prepared a small presentation on p/e ratios and how growth in earnings affect p/e ratios. You may find it useful.

Friday, February 03, 2006

What is driving economic growth - domestic consumption or plain liquidity ?

There was an interesting article in this week's Business World on what is driving the current economic growth in India by Ashok Desai (the consultant editor of the Telegraph). Mr. Desai argues that the current growth in economy has more to do with liquidity than anything else.

This is what he has to say on the current state of Indian economy -

The widespread belief that the current boom is driven by Indian companies that became efficient and globally competitive in the downturn of 1997-2002 is mistaken. It was started by the rise in liquidity and fall in interest rates that resulted from the rise in reserves. Reserves rise because people who have foreign exchange - exporters, foreign investors, NRIs abroad - sell it to Reserve Bank. In return they get Rupees. So a rise in reserves increases money supply pari passu.

If people get more money in their bank accounts, they will repay old debts and borrow less. That reduces demand for loans, and leads banks to reduce interest rates. Both lower interest rates and lower debt increase profits. That cheers up businessmen and they start investing. And more cash cheers people up and they begin to splurge on consumer goods. That is the kind of boom we are having, not the kind in which the higher profits come through a reduction in real inputs into production. The latter also happened, but it was not the cause - it happened too long ago to have been the cause.

This stimulus would go into reverse if reserves begin to fall. Money supply would fall, liquidity would decline, discretionary expenditures such as investment and expenditure on consumer durables would fall, and that would pull the economy into a downturn. The rise in reserves has virtually come to a halt; we should ask ourselves whether this is accidental and temporary or denotes a change in trend. To me, it is clearly a trend - it is driven by the rapid deterioration of the balance of trade. It is worsening at such a rate that the current account deficit must outrun capital inflows before many months pass, let alone years; then reserves will begin to fall.

Read the full article here. (one has to register to read the full article).