“THE BIG MONEY IS MADE BY RIDING TRENDS”

Traditionally, the stock market has been looked upon as a gambling den or a casino; where fortunes are made (and mostly lost) at the roll of a dice. The stories about people having lost money in stocks and shares outnumber those of having made money by a factor of 10:1 because of which ‘stocks and shares’ are considered exact synonyms of ‘shocks and stares’. A majority of the newcomers and plenty of the old ones approach the market as a ‘get rich quick’ scheme and are often unable to figure out ‘ki paisa jaldi banana hai ki jyada’.

Most of the above misery originates from the fact that gains from investing are non-linear. Many first time participants consider the stock market as an avenue of making regular income not realising that markets do not care if there is an immediate bill to be paid or a debt to be relinquished. The stock market is not a game which promises to pay an investor’s monthly expense by generating periodic returns. One needs to understand that the gains are non-linear and come in bunches while expenses are linear and have to be paid off periodically. There remains a permanent mismatch in paying off the expenses from stock market gains. However, as the size of the portfolio increases, investors can choose to pay their expenses through their dividend income, which in spite of being received once or twice a year is broadly definite in character.

Portfolio creation is both simple and complex depending on how an investor approaches it. The first time investor, with limited knowledge and restricted experience, should spread his bets across 10-15 stocks. In doing so, he should avoid sectors whose fortunes are beyond his control. As such, he might want to stay away from investing in cyclical stocks like cement, steel, shipping, sugar, etc. These sectors move on their own and an investor has to get both the entry and exit decisions correct unlike the secular growth stocks where one has to just buy a stock and ride it through.

Furthermore, a new investor would do well to avoid companies whose profits are regulated by government action. Companies like Coal India, ONGC, BPCL and GAIL fall in this category. There are several examples which indicate that anything related to government generally faces an uneven path to prosperity.

There could be counter arguments to this theory as these stocks might do well if the restrictions are removed. But in a democratic set-up the government is expected to work with both a profit and welfare motive. Additionally, an investor need not make money from all the 7,000 listed companies on BSE to get rich. All he has to do is stick to the winners and avoid the losers. On the portfolio side when it comes to computing gains very few investors think in terms of compounded annual growth rates (CAGR). Even if they do, the assumption of returns does not extend to the entire portfolio but remain restricted to a stock or a set of stocks. With an inflation rate of 8 per cent generating a CAGR of 20 per cent for 10 years isn’t too tough in India as it seems at first sight.

Allocating capital to a stock as part of the portfolio comes next. A stock which has a 2 per cent allocation and moves up 10 times takes the portfolio up by only 20 per cent. And such stocks don’t come too often in the lifetime of an investor, and if they do the occasion calls for a higher allocation to maximise returns.

Avoiding permanent losses to capital is important. A simple way to avoiding large losses is to stick to sector leaders which are in most cases run by an honest and effective management. Investors who held on to Infosys recovered their capital back even from the top of March 2000 but those who bought Mastek and Silverline suffered a permanent loss of capital. Investors recovered their money in ACC from the top of 1992 but the same cannot be said about the owners of Kalyanpur Cement. Post the 2003-08 infrastructure boom L&T is still nearer to its all time high but the likes of Nagarjuna Construction, IVRCL and HDIL are still struggling at their lows. Notwithstanding the recent frenzy, these stocks that have doubled up in price after falling 95 per cent are still 90 per cent below their all time highs.

Sector leaders however, will always be expensive. Hence, most investors would not be able to justify it while computing the margin of safety. But a number-based approach to investing is faultier than it looks. Investing is as much a formula-driven excercise as it is a feel-based endeavour. One has to feel for the product, business and the management - most of which cannot be captured by pure numbers. One of the essential ingredients of an outstanding investment strategy is to make less and retain more rather than make more and retain less. A sector leader is thus the best way to retain most of what an investor makes.

In a sector-driven bull market, the leader generally underperforms the Tier-2 and Tier-3 companies. But the minute the bull market ends, the outperformance of the inferior stocks disappears. As the bear market starts, these second and third line players fall 60-70 per cent while the leaders still retain most of the gains. In 2008, L&T never fell 90 per cent but Nagarjuna Construction and HDIL fell 90 per cent each.

My theory is to make a lot of money, lose a little bit of it and retain most of it. In this connection one has to let the profits run on a company that is showing the right kind of earnings growth. Look at it this way; how much can you lose by buying a stock? Only 100 per cent. But how much can you gain? 100 per cent, 200 per cent, 500 per cent; theoretically infinity. Still people lose money in investing because they cap their gains and let the losses run even if the company isn’t behaving the way they thought it to. A logical reason for this is that most people get insecure as their stock starts to make profits and cash out either in part or whole in the fear of giving it all back. On the other hand, if a person buys an apartment in Chennai does he sell the verandah to lower the cost of his kitchen or sell both his kitchen and verandah to lower the cost of his bedroom? He doesn’t, because he is used to making money in real estate.

The big money is made by riding trends. A trend that is right now in vogue and where I have a vested interest is the low income rural mortgage financiers. Some companies in this space will go up 50 times in 20 years and some can even move up 100 times in that period. If it is 50 times, an investor makes 21.6 per cent CAGR. If it goes up 100 times he will generate around 26 per cent CAGR. Companies like Repco Home Finance and Gruh Finance fall in this bracket and can give outsized returns for someone who a) has patience and b) can follow the company well. These stocks are expensive and will remain so but in the stock market you cannot buy mangoes at the price of bananas.

An important point to consider is that you cannot buy or sell today’s stock at yesterday’s price. The price that is on the screen today is the price you need to buy it at. Secondly, if the price has gone up in the backdrop of rising earnings or if something better has happened to the company like increase in sales or a launch of a new product or if it has taken market share from its competitors then you can buy more of it at a higher price also. My strategy is similar to this; if a stock goes up and the company is doing the right things I will continue buying. Just to vindicate my stance, my first purchase of Page Industries was at Rs 350 and the last purchase was at Rs 7,200.

However, the important part is that in case of a cyclical you have to behave like an amateur investor and think of taking profits if the price goes up. But if it is a secular growth stock you can add more to the original position if the stock behaves the way you originally thought it to. So a third grade cyclical will rise eight times from bottom and other cyclicals like Tata Steel will rise about 2-4 times. If you are investing in cyclical stocks then beyond a point you should keep selling as the stock price increases. This is because the balance-sheet of the cyclical will look best at the top and worst at the bottom. So a loss-making or a 100 P/E Tata Steel will always be a good buy but at a P/E of 10 it might well be time to say ‘goodbye’. This is because when the P/E is 10, steel prices would be at the top. So if the steel prices come down, this 10 P/E stock will again become 100 P/E and the company will make losses.

Value creation and wealth creation are two important points to note. The former comes from a company which generates a high RoE while the latter originates from the investor level. Value creation doesn’t always lead to wealth creation and vice versa. Just because a company isn’t creating value doesn’t mean that it won’t create wealth for its shareholders – at least in the short-term. For instance, Pantaloon Retail wasn’t a value creator but it created wealth for its original investors, including me. Another example is Nestlé. From 2003 to 2008 it was big value creator with a RoE of 60 per cent but there was little wealth creation on a relative basis. In theory, value creation matters, but when you come to the market it is the wealth creation that rules because ultimately money has no colour.

To sum it up, the investor should invest in the markets to become a dollar millionaire which at current levels would be more than Rs 6 crore. Stock market investing should not be a means of making money but of creating wealth instead. An annualised return of 20 to 25 per cent on a decent upfront capital will be enough to ensure that the investor reaches financial freedom which is a surplus capital of 50 times his annual expense.