There is a psychological behaviour that humans, and especially investors fall prey to. This is referred to as the 'Conservatism bias'. Under the spell of this bias, once we make up our mind or take a view on the markets, we are unwilling to change our views. On most occassions, there is enough bullish and bearish data to hold a particular view on the markets. Once we make up our mind or take a view on market direction, we can see only data that supports our views and fail to observe contradictory evidence. We do not remain neutral and do not go with the flow of the markets. We seek information in the markets that supports our views. We stick with our views even as we keep losing money, convinced that we are right (and that the markets are wrong). After deep losses we may or may not get wiser, but we definately get poorer.
No investors would want to fall prey to this bias, I certainly dont. As investors, we want to keep an open mind and respect the market for what they are telling us. We do not want to be headstrong in the face of contradictory evidence.
In my previous blog (http://shashankcurrentissues.blogspot.com/2008/12/it-is-time-to-buy-stocks.html), I had argued that perhaps it was time to start buying stocks. Lest I should become a victim of the conservatism bias, let us examine if I could be wrong (and I certainly could be wrong) and what factors could potentially lead us to that eventuality.
PE derating and valuations:
I had argued that stocks are cheap; in fact they are as cheap as they ever were in the last 17 years. But 17 years does not constitute the history of stock markets. From the early 1980s, we had a large period of credit expansion and increasing leverage across the world, which probably ended this year in the form of the credit crunch. Now with deleveraging of the financial system, the era of cheap credit might be behind us, at least for a long long time. We might see stocks as an asset class being accorded much lower valuations in terms of PE ratios and other conventional valuation benchmarks. So what looks cheap on a historical basis could actually be normal under the new paradigm. I had written a post earlier (http://shashankcurrentissues.blogspot.com/2008/09/are-we-in-watershed-moment.html) arguing how we could be in an epoch making period which we are unable to recognise. Most market participants and advisors possess experience only from the period of financial leveraging. We have not seen financial deleveraging and what it could do to valuations. Money might not flow into emerging markets are it did earlier and this could lead to secular derating of stock markets across the world. If a PE ratio of 11 for the markets might have been cheap in the past, cheap in the new era could mean a PE of 8!
Corporate Profits:
The situation on corporate profits looks dismal, though we do not know whether the markets have fully discounted them in the price already. Corporate profits might be worse than widely anticipated. Earnings might fall going ahead making current valuations not as cheap as they optically look. In addition, costlier and scarcer money would dent demand and dent corporate profits, especially for leveraged players.
Globalisation:
Globalisation had a beneficial effect on prosperity across trading member countries over the past decades. Free trade has been widely hailed in its role towards wealth creation. But I am not sure we can take free trade for granted now. Under economic stress and compulsions to keep the citizens in better shape, we could see adhoc measures that could decrease globalisation based on free trade principles. USA differs with UK, which differs with France. Asia differs with USA and China want to keep its currency weak to stimulate exports. Such competitive devaluation of domestic currencies and protectionistic measures could get destructive for the world trade, and hence to prosperity. While world leaders are well aware of this, one can never be sure of how things might evolve on this front. Perhaps an year ago, this was unthinkable and globalisation was in full swing. Now we have to consider the possibility of globalisation slowing down as well.
Greater Regulation:
There is no doubt that the financial system will be subject to greater regulation post the current mayhem. In the developed world, the iron fist of the government might get a greater share in proceedings compared to the free hand of the markets. In developing countries, it could mean an attempt to prevent incidents similar to those that occured in the west. In either case, we could see greater regulation, less freedom, especially to finance. With fiscal simuli being thrown around like there is no tommorrow, it could lead eventually to higher taxes to make up those expenses and hence could lower earnings growth.
Terrorism:
We watched with horror, shock and dismay the events of terror in Mumbai last week. This has conflagrated into a big thing, and deservedly so. We might see the negative economic consequences to flow through over time. Decreased foreign investment could be the most obvious effect. Animal spirits of entrepreneurship could be also affected. More government money might get diverted towards preventing terror attacks in the future. Taxes could be raised to gather more money for this cause. Any conflict, either direct or indirect, reduces return on capital employed and hence reduces stock valuations.
Essentially, for whatever reasons, if earnings go down or if the PE ratio assigned to stocks by the markets goes down, stocks prices could go down. In addition, if there is a structural downward shift in the valuation metrics like the PE ratio, and if business environment remains tough, stocks could stay down for a long period.
All of us need to understand that supernormal returns are not possible across all time horizons in the real world. There always will be periods of above normal returns and periods of below normal returns. What causes these cycles could vary across such cycles. The bottomline is that over time, good and bad periods get evened out to result in normal returns. An example I always like to quote: If in the year 1000 A.D, any of our ancestors had invested Re.1 at 5% per annum, the value of that rupee would today be 45 quintillion US dollars!!! (One quintillion = a million trillion). This would be about 0.86 million (8.6 lakh) times the world's annual output! The interest at 5% per annum from this would be 42300 times the world's annual output! Over long (really long) time horizons, the return from most stock investments is zero! Capitalism ensures that. Even the East India Company eventually went bankrupt after practically ruling India for more than 100 years!
Now, no one in his right mind would look at returns over a 1000 years. Lets look at century returns. The Dow Jones Industrial average went up from a value of 71 in the year 1901 to 8500 currently. This is an annual return of only 4.5% (add another 3% for dividends). Anyone for the idea 'stocks for the long run'? Noteworthy is the period from 1982-1999 where the Dow went up from 875 to 11497 generating a CAGR of 15.3%. This period coincides with the begining of proliferation of financial leverage and massive credit expansion. That might explain the above-normal return compared to history. The greatest bull market in Japan from 1970 to 1989 saw the Nikkei go up from 2000 to 40000, a return of 16%; attractive but by no means spectacular! Maybe returns are mean reverting and revert back to normal long run values.
The short of this long story is that stocks today do look cheap when valued in the context of the existance of cheap money, high leverage and low taxes. The future might look very different from the past. Stocks might not be cheap in the context of more regulation, scarce and expensive money, less leverage and higher taxes.
How would the world evolve? Only time will tell.
Happy Investing!
Thursday, December 4, 2008
Monday, December 1, 2008
It is time to start buying stocks
“Be fearful when others are greedy, and be greedy when others are fearful” – Warren Buffet.
In reality, be greedy when others are fearful and only when there are valid reasons for being greedy.
The current environment can be best described as fearful. Investors are engulfed with fear, fear of losing money, in most case fear of losing more money. There are valid justifications of such fear. The world economy is slowing down. Many large developed nations are in recessions, people have lost so much money across asset classes. In India, there is an economic slowdown playing out. If all this was not enough, we witnessed the most terrible incidents of terrorist attacks in Mumbai that threatens to adversely impact economic prospects in the medium term. There are many valid reasons to be fearful and people are justified in being afraid of committing capital behind risky assets like stocks.
On the Indian stock markets front, they have corrected over 55-60% from their highs made earlier this year. Some stocks are down 70-90% and this includes many blue chip names as well. A spate of bad economic news has hit us and corporate results have not made us jump in excitement. We probably would continue to see more bad economic news come ahead. In the short run, stock prices are likely to go down further.
Yet, amidst all the gloom and doom, I think it is time to start buying stocks. Why? In this article, we shall look at the facts one by one and then look at the collective weight of the facts put together to try to figure out why investors should start buying stocks.
The markets have already corrected significantly. The market capitalisation:GDP ratio on the NSE now stands close to 0.6, down from its lofty value of 1.5 in Jan 2008. Prices however do not go down to zero, the productive enterprises of India are going to be valued and valuable as long as humanity exists. Yet, a large price correction is never a good enough reason alone to buy stocks. Stocks can fall and keep falling.
But at some point the fall stops as stocks get cheap and value investors step in to buy. Compounding returns by buying cheap assets is a very successful way of building wealth. Are stocks attractive now? I believe they are even as I acknowledge that what is attractive can get even more attractive.
The BSE Sensex quotes at a value of 9092 (28 Nov 2008 trading day end) implying a PE ratio of 11.62, a Price to Book Value of 2.43 and a dividend yield of 1.96% (Source: BSE Website). This compares favourably with previous lows. In fact, this is at the lower end of valuations for the Sensex since 1991. The same is the case with all other indices. The earnings yield of the Sensex stands at 8.6% which is higher than the 10 year Government of India security whose yield is around 7.2%. Stocks are yielding greater in return than government bonds. On a post tax basis, stocks are yielding more than most 1 year Fixed Deposits currently. Stock yields (earnings) rise over time but fixed deposit interests remain the same. Many stocks are currently quoting at ridiculously cheap valuations.
Over the past 17 years, there have only been 4 incidences when the Sensex got to such low valuations. This happened in Nov-Dec 1996, Aug-Oct 1998, October 2002 and April 2003. And what were the returns achieved in one years time post these periods? Here is the data:
Period________Return 1 Year hence
Nov-Dec 1996___25-30%
Aug-Oct 1998___50-75%
October 2002___70% +
April 2003_____100%
While 4 data points can hardly be a statistician’s delight to draw some inference, we have to do with whatever data we have. The data hence can only be indicative. The point to be noted however is that on every single occasion, the 1 year return has been positive, more often quite spectacular.
The PE ratios of stocks are way below their moving averages and trend lines suggesting oversold markets. Of course, you only have to look at the price to see how oversold these markets are.
India is slowing down, but the fears of an economic meltdown seem exaggerated. The last major bear market was the one between 2000 and 2003. Many blue chip stocks are currently quoting at 2003 bear market bottom valuations. And India’s GDP growth in 2002 had fallen to 3.8%. In the current turmoil, not even the most pessimistic analyst expects GDP growth to fall to those levels (although nothing can be ruled out). But stocks are already discounting an outcome as bad as that of 2002, perhaps worse. While that can still happen, it seems a trifle unlikely at this point. Yes, economic growth will be lower, but life still goes on. Good companies will not vanish. Their future profits will not go to zero; in fact they are likely to rise in the long run. We do not stop living because there is an economic slowdown. Life goes on, with some adjustments and some pain. Eventually, humans come out ahead of such circumstances. Since 1991, we have witnessed a Harshad Mehta scam in the equity markets in 1992, bomb blasts in the Bombay Stock Exchange in 1993, a boom bust cycle of 1994-97, the severe South East Asian crisis in 1997, economic sanctions on the country post Pokhran in 1998, a technology bubble meltdown in 2000, a war in Kargil, terrorist attacks on the Parliament in 2001, communal riots and plague epidemic in Gujarat, countless acts of terrorism in various cities in the country including cities like Mumbai and Delhi. And guess what? The markets still gave compounded returns of 15%+ (including dividends) over the last 17 years, even after the current crash! The Sensex still managed to move up from 999 in Jan 1991 to 9092 today! A boom follows a slowdown and at some point, things will again look up.
Let us also not forget that, generally speaking, the corporate sector is in far better shape than it was during all the previous downturns. It is perhaps better placed to endure this downturn. Be it Return on Equity or Return on Assets or other return figures, corporate India is more efficient today than it was in the past.
There are many positive macro economic factors that are going unnoticed, or perhaps being looked at with the glass half empty mindset. After the first crash in Jan 2008, the glass was half full. Now it seems half empty (or maybe almost empty). A few important macro economic variables are turning positive. First, inflation is no longer the enemy, at least for now. The central government and the RBI are trying to get more money into the financial system. This would most likely lead to lower interest rates and lower yields on debt, thereby making stocks even more attractive. A fall in interest rates boosts investments and boosts demand and also boost corporate profits by lowering their interest costs. All is positive for economic growth. Crude oil prices have come down to 2005 levels, down to 50+ USD per barrel. This is a huge boost to the India’s trade account and can perhaps counterbalance the loss in exports. Commodity prices have crashed, which though negative for commodity producers, is beneficial for commodity consumers.
So stocks look cheap on a historical basis; in fact almost as cheap as they ever were. History suggests that such occasions are infrequent but buying done at such levels rewards investors handsomely over time. In addition, today, many macro economic variables that were plaguing India since the beginning of the year have started turning benign.
Don’t get me wrong here. I am not in any way suggesting that the pain is over. More likely that we will see many more negative data points being thrown up. I do not know when good days will be back again. I suspect markets might see some more downside ahead. So would it be a wise idea to wait till all the downslide is over? If you are an investor, the likely answer is ‘no’. Investing is a game always played with incomplete information and uncertain external conditions. One has to make a reasoned judgment and take decisions decisively. One has to accept risk and accept the possibilities of making mistakes or being proven wrong. If you keep waiting for things to clear up or wait to feel comfortable again to invest, you are most likely to miss the boat altogether. Permanent bearishness or caution (or permanent bullishness) does not serve an investor well.
It is generally observed that stock markets lead economic development, what market observers call ‘discounting’, that news gets discounted into the price. We can never know whether the market has fully discounted all future bad news or not. We have to make an educated guess and a reasoned judgment and yet run the risk of being proven wrong. But we know that markets bottom out much before all bad news comes through. Bad news is an investor’s friend. At some point, it allows the investor to buy stocks cheap. If you are an investor, you welcome bad news. And you should buy when stocks are cheap. If you do not buy then, and if stocks run away, you not only look like an idiot. You are proven to be an idiot.
Having said this, bear markets do not end one fine day and then run away like a bullet train. They offer you ample time to spread your buying over time. How long is anyone’s guess, but in my judgment, you could start buying now and keep buying in equal amounts for the next 18 months. You should avoid companies that are highly leveraged or are in weak competitive positions in the marketplace. And then invest with some method of risk control, that if you are proven wrong, you don’t get hurt too much.
For most part of this calendar year till recently, I was advocating cash as king. Perhaps cash is no longer king.
Happy Investing!
In reality, be greedy when others are fearful and only when there are valid reasons for being greedy.
The current environment can be best described as fearful. Investors are engulfed with fear, fear of losing money, in most case fear of losing more money. There are valid justifications of such fear. The world economy is slowing down. Many large developed nations are in recessions, people have lost so much money across asset classes. In India, there is an economic slowdown playing out. If all this was not enough, we witnessed the most terrible incidents of terrorist attacks in Mumbai that threatens to adversely impact economic prospects in the medium term. There are many valid reasons to be fearful and people are justified in being afraid of committing capital behind risky assets like stocks.
On the Indian stock markets front, they have corrected over 55-60% from their highs made earlier this year. Some stocks are down 70-90% and this includes many blue chip names as well. A spate of bad economic news has hit us and corporate results have not made us jump in excitement. We probably would continue to see more bad economic news come ahead. In the short run, stock prices are likely to go down further.
Yet, amidst all the gloom and doom, I think it is time to start buying stocks. Why? In this article, we shall look at the facts one by one and then look at the collective weight of the facts put together to try to figure out why investors should start buying stocks.
The markets have already corrected significantly. The market capitalisation:GDP ratio on the NSE now stands close to 0.6, down from its lofty value of 1.5 in Jan 2008. Prices however do not go down to zero, the productive enterprises of India are going to be valued and valuable as long as humanity exists. Yet, a large price correction is never a good enough reason alone to buy stocks. Stocks can fall and keep falling.
But at some point the fall stops as stocks get cheap and value investors step in to buy. Compounding returns by buying cheap assets is a very successful way of building wealth. Are stocks attractive now? I believe they are even as I acknowledge that what is attractive can get even more attractive.
The BSE Sensex quotes at a value of 9092 (28 Nov 2008 trading day end) implying a PE ratio of 11.62, a Price to Book Value of 2.43 and a dividend yield of 1.96% (Source: BSE Website). This compares favourably with previous lows. In fact, this is at the lower end of valuations for the Sensex since 1991. The same is the case with all other indices. The earnings yield of the Sensex stands at 8.6% which is higher than the 10 year Government of India security whose yield is around 7.2%. Stocks are yielding greater in return than government bonds. On a post tax basis, stocks are yielding more than most 1 year Fixed Deposits currently. Stock yields (earnings) rise over time but fixed deposit interests remain the same. Many stocks are currently quoting at ridiculously cheap valuations.
Over the past 17 years, there have only been 4 incidences when the Sensex got to such low valuations. This happened in Nov-Dec 1996, Aug-Oct 1998, October 2002 and April 2003. And what were the returns achieved in one years time post these periods? Here is the data:
Period________Return 1 Year hence
Nov-Dec 1996___25-30%
Aug-Oct 1998___50-75%
October 2002___70% +
April 2003_____100%
While 4 data points can hardly be a statistician’s delight to draw some inference, we have to do with whatever data we have. The data hence can only be indicative. The point to be noted however is that on every single occasion, the 1 year return has been positive, more often quite spectacular.
The PE ratios of stocks are way below their moving averages and trend lines suggesting oversold markets. Of course, you only have to look at the price to see how oversold these markets are.
India is slowing down, but the fears of an economic meltdown seem exaggerated. The last major bear market was the one between 2000 and 2003. Many blue chip stocks are currently quoting at 2003 bear market bottom valuations. And India’s GDP growth in 2002 had fallen to 3.8%. In the current turmoil, not even the most pessimistic analyst expects GDP growth to fall to those levels (although nothing can be ruled out). But stocks are already discounting an outcome as bad as that of 2002, perhaps worse. While that can still happen, it seems a trifle unlikely at this point. Yes, economic growth will be lower, but life still goes on. Good companies will not vanish. Their future profits will not go to zero; in fact they are likely to rise in the long run. We do not stop living because there is an economic slowdown. Life goes on, with some adjustments and some pain. Eventually, humans come out ahead of such circumstances. Since 1991, we have witnessed a Harshad Mehta scam in the equity markets in 1992, bomb blasts in the Bombay Stock Exchange in 1993, a boom bust cycle of 1994-97, the severe South East Asian crisis in 1997, economic sanctions on the country post Pokhran in 1998, a technology bubble meltdown in 2000, a war in Kargil, terrorist attacks on the Parliament in 2001, communal riots and plague epidemic in Gujarat, countless acts of terrorism in various cities in the country including cities like Mumbai and Delhi. And guess what? The markets still gave compounded returns of 15%+ (including dividends) over the last 17 years, even after the current crash! The Sensex still managed to move up from 999 in Jan 1991 to 9092 today! A boom follows a slowdown and at some point, things will again look up.
Let us also not forget that, generally speaking, the corporate sector is in far better shape than it was during all the previous downturns. It is perhaps better placed to endure this downturn. Be it Return on Equity or Return on Assets or other return figures, corporate India is more efficient today than it was in the past.
There are many positive macro economic factors that are going unnoticed, or perhaps being looked at with the glass half empty mindset. After the first crash in Jan 2008, the glass was half full. Now it seems half empty (or maybe almost empty). A few important macro economic variables are turning positive. First, inflation is no longer the enemy, at least for now. The central government and the RBI are trying to get more money into the financial system. This would most likely lead to lower interest rates and lower yields on debt, thereby making stocks even more attractive. A fall in interest rates boosts investments and boosts demand and also boost corporate profits by lowering their interest costs. All is positive for economic growth. Crude oil prices have come down to 2005 levels, down to 50+ USD per barrel. This is a huge boost to the India’s trade account and can perhaps counterbalance the loss in exports. Commodity prices have crashed, which though negative for commodity producers, is beneficial for commodity consumers.
So stocks look cheap on a historical basis; in fact almost as cheap as they ever were. History suggests that such occasions are infrequent but buying done at such levels rewards investors handsomely over time. In addition, today, many macro economic variables that were plaguing India since the beginning of the year have started turning benign.
Don’t get me wrong here. I am not in any way suggesting that the pain is over. More likely that we will see many more negative data points being thrown up. I do not know when good days will be back again. I suspect markets might see some more downside ahead. So would it be a wise idea to wait till all the downslide is over? If you are an investor, the likely answer is ‘no’. Investing is a game always played with incomplete information and uncertain external conditions. One has to make a reasoned judgment and take decisions decisively. One has to accept risk and accept the possibilities of making mistakes or being proven wrong. If you keep waiting for things to clear up or wait to feel comfortable again to invest, you are most likely to miss the boat altogether. Permanent bearishness or caution (or permanent bullishness) does not serve an investor well.
It is generally observed that stock markets lead economic development, what market observers call ‘discounting’, that news gets discounted into the price. We can never know whether the market has fully discounted all future bad news or not. We have to make an educated guess and a reasoned judgment and yet run the risk of being proven wrong. But we know that markets bottom out much before all bad news comes through. Bad news is an investor’s friend. At some point, it allows the investor to buy stocks cheap. If you are an investor, you welcome bad news. And you should buy when stocks are cheap. If you do not buy then, and if stocks run away, you not only look like an idiot. You are proven to be an idiot.
Having said this, bear markets do not end one fine day and then run away like a bullet train. They offer you ample time to spread your buying over time. How long is anyone’s guess, but in my judgment, you could start buying now and keep buying in equal amounts for the next 18 months. You should avoid companies that are highly leveraged or are in weak competitive positions in the marketplace. And then invest with some method of risk control, that if you are proven wrong, you don’t get hurt too much.
For most part of this calendar year till recently, I was advocating cash as king. Perhaps cash is no longer king.
Happy Investing!
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