The Intelligent Investor – 4 – General Portfolio Policy: The Defensive Investor

Posted on August 18, 2019 by Jimit Zaveri under Bibliophile: The Intelligent Investor

It is prevailing to the market that if we take a low risk then our return will be comparatively lower and we get a higher return with higher the risk. But actually, it is not always true. When we acquire a bargain situation with the proper margin of safety then we have a higher probability to get a higher return with the lower or controlled risk.

Mr. Graham has explained “Active” or “Enterprising” investor and “Passive” or “Defensive” investor –

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When we have time to spare, competitive thinking then we need to select the active investment strategy and when we cannot spare time on investment, do not keep on thinking about money then passive investment strategy is suitable for us. So that we have to select what works for us, which strategy is suitable to us rather what has worked in the market. If we cannot spend time researching the companies, what was going on to the business, etc then we should select a passive style of investing.

As we have seen in the review of the second chapter that defensive investors have an allocation to the bond as well as common stocks. And they makeshift from common stocks to the bond when they found a higher valuation of common stocks. As per Mr. Graham, If we have chosen to have a 50-50% allocation to the bond and the common stocks. So, at that time, if our stock allocation goes to 55% then sell off of additional 5% and transfer it to the bond and if common stocks allocation goes to 45% then bring 5% by selling off of bonds. This is one of the simple formulae for the defensive investor. Defensive investors have a strategy to fall less than the market during the worst time. And such a strategy can be helpful to them.

One of the other strategies is recommended by Mr. Graham –

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Example

If we have a dividend of Rs.720, SENSEX at 36000 and bond yield is 7% then we need to allocate 75% to the bond and 25% to the common stocks because 2/3^rd of the 7% is 4.67% and we are currently getting a dividend yield of 2% on the SENSEX. Now, we need to wait for fall into the bond yield or reduction to the level of the SENSEX for increasing the allocation to the common stocks. It’s just a hypothetical example. The dividend yield in India has not reached at such a higher level, especially into the Index so that we can go for the earning yield.

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*Red indicates exit and green indicate entry

As we see that Mr. Graham indicator suggesting overvaluation in the SENSEX. And for getting it fair value -1) Risk-free rate has to fall, or 2) Earning has to increase (At least by 10%) or 3) SENSEX has to fall (At least by 10%). Rate cuts have given a positive boost to the market but if earning will not pick up then the market has to fall. If anyone has invested 100% into debt fund in the red zone and invested 100% into the green zone then the person has earned ~15% CAGR compared to ~11% CAGR of SENSEX.

When investors select the lower quality of the bond then return on it will get increase compared to the high-grade bond. We need to focus on to the buying a bond at the discount for getting a higher yield on it but with the same level of quality.

Defensive investors also can deploy fund to the FD, liquid fund, bond, preference shares, convertibles, etc.

For the allocation to the bond and stocks by defensive investors, an old theory which was prevailing to the market was deducting age from 100 and remaining amount consider as a % to invest in the stocks. That is if age is 28 years then 72% (100-28) of the net-worth will be into the stocks. But age should not be a factor in considering the risk-taking ability of any person. If someone at the age of 80 also well settled and having a good fund for spending his life then he can take more allocation stock also and does not just have to deploy 20% (100-80) to the stocks.

It is also possible that 20 years old person saving money for his further education, marriage in future, house, etc. So, he may not be able to deploy 80% (100-20) to the stocks. Allocation to the common stock or the bond depends on everyone’s risk-taking ability. We should not generalize certain allocation percentage for everyone.

This is what happens to the market and keeps on repeating in the future also.

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For allocating to the stocks and bond, we need to look at our life and situations where we require cash. We can ask a few questions to ourselves before making an allocation.

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We need to allocate to the bond and stocks, after considering all the above point. But as Mr. Graham mentioned that we need to make a minimum allocation of 25% to the maximum 75% the bond. When we make an allocation decision, then we need to change that allocation only while our situation at life changes. Not when the market starts moving upward. If we need a constant fixed amount of cash-flow to spend for the household expenses, covering the cost of living then bond only provides those cash flow rather to common stocks. We only can put 100% to the stocks if we have enough money to support our spending, survived during a bear market, we can able to buy more stocks to the bear market, we do not need to sell stocks for survival, we can invest for at least 20 years.

Disclosure – Companies mentioned in the article is just for an example & educational purpose. It is not a buy/sell/ hold recommendation.

Read for more detail: The Intelligent Investor by Benjamin Graham, Jason Zweig

The Intelligent Investor – 3 – A Century of Stock-Market History

Posted on August 4, 2019 by Jimit Zaveri under Bibliophile: The Intelligent Investor

We do not have data available for a century in the Indian stock market so that I have done a calculation with available data. All data are taken from BSE India and RBI site.

When we have seen a huge return into the past from the equities then it is not necessary to consider a similar kind of return into the future. Reality is that common stock prices related to the earnings and dividend from the particular companies or basket of companies. If the company fails to deliver earnings and dividend then it is obvious that the company will not deliver a similar return in the future.

This example shows that growth in earnings and dividend has an impact on the price of the companies and basket of companies (Indices). If earning/dividend growth contentiously falling or depressed during a time then prices of the securities also have an adverse impact. So that we can see that during the year range 2011-2019 or 2016-2019, SENSEX has increased more rapidly compared to the EPS growth. Now, either EPS to grow much rapidly or SENSEX has to fall. Or it can also happen that SENSEX can remain in the range till EPS growth does not match to the average return. For matching the average return, either EPS has to grow by 20-22% or SENSEX has to fall 22-25%. This study can provide a similar result with particular stocks.

When the difference between earning yield to bond yield and dividend yield to bond yield start getting lower than we can think that particular stock or basket of the stocks becoming overvalued. This is one of the effective indicators where we can see that when Earning yield / Bond yield has cross 0.67-0.70x then SENSEX has provided us an attractive investment opportunity and when Earning yield / Bond yield has gone below 0.67-0.70x then we need to decide to liquidate our position to the SENSEX in a phased manner.

The stock market does not become less risky just due to advancement to the prices of it. I have seen many people enter into the market or the particular stocks when the price of it starts increasing.

We have seen during the series of Mr. Howard Marks, The Most Important Things that if everyone thinks in the same way then that thinking getting discounted to the price and will not able to get similar kind of returns for the future.

Above mentioned parameter, we can check into the current scenario where real growth of the corporate earnings was not much and the stock market has performed due to the speculative growth. Everyone starts preferring equity as an asset class to invest due to the recent past return. Now, such a scenario is unfavorable for investors. Absent of earning growth does not attract higher valuation for a longer period.

Disclosure – Companies mentioned in the article is just for an example & educational purpose. It is not a buy/sell/ hold recommendation.

Read for more detail: The Intelligent Investor by Benjamin Graham, Jason Zweig

The Investor and Inflation

Posted on July 14, 2019 by Jimit Zaveri under Bibliophile: The Intelligent Investor

We all have some needs, some desire in life and we work for fulfilling those. But due to Inflation, our purchasing power get reduce which has always remained a serious question for all of us. We all working hard to beat inflation and enhance our purchasing power. We save, we invest money for our future life. The very popular story everywhere at the market prevailing is a common stock investment is a better tool to beat inflation compared to the bond investment. But is it true in all the situations? We know that every-time it is not true; many a time, good stocks do not give a good return compared to the bond. We need to focus on the valuation of the stock and yield available on the bond. It is very much possible that good stocks can be traded a valuation of the great stocks which can be harmful to us to beat the inflation by investing in it at such a valuation. And at such a valuation, investing into the bond becomes a better choice. Good business is not always a good investment.

Common stocks do not have an inheritance feature to always beat inflation. Yes, it is acceptable that stocks have delivered a good return compared to the bond in the past. But for the future, we need to look at the future of the growth of the economy, growth of the corporate earnings, etc.

If we see the growth of Japan then GDP grows at ~3% CAGR since the year 1981 and similarly their stock market also has given a return of 3% CAGR since the year 1981. Nikkei still is not able to break the higher level of the year 1989. So for growth of the investment return, underlying companies/economy also has to grow otherwise we are not able to earn by making an investment.

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When inflation keeps on rising then companies need to bring more capital for growing sales (as the purchasing power of the company reduces) at similar peace. Such a scenario creates difficulties for businesses to survive and grow further. When companies need additional capital to grow similar sales level, then return on incremental capital will reduce, also companies cannot able to put capital to the new projects as old projects require additional capital. This also can enhance a debt level or the external funding to run a business and that can hamper the profitability.

One of the communication company

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We can see that the capital employed of the company is growing at 16% CAGR and sales growing at 8% CAGR. This means for growing a similar business, the company need to make a twice of capital employed. So that company keeps on requiring external funding to grow the business. Here, we can see that company having a negative working capital cycle though the company needs to bring external funding to grow or maintain the business. There is much business which having such problems and those businesses require to have a huge capital to grow and to even maintain the business.

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Hyperinflation stop consumer to buy more and more goods as their purchasing power starts getting reduced. During such time, businesses do not rise a price to overcome the impact of the rising cost of raw material and other utilities. So that hyperinflation can hamper the earning, growth of the companies and which having an adverse impact on the annual investment return during those time period.

Many people make an investment to the gold, real estate, old paintings, old currencies, etc. for beating inflation but such a scenario does not seem to be practical even. Real estate is a hot investment for getting protection against inflation. But if we missed with a location, the price needs to pay, etc then we also do not protect ourselves against inflation by investing in the real estate.

We should not focus on the one and only basket by seeing the huge return in the past. We should focus on the different basket for making an investment. As we have experience in the near past that due to good return from the equities, people have started making an investment into the equities and market got a huge liquidity flow which has bring the market to the record high level. Similarly in the past for the real estate market.

Our investment success does not count by how much % of return, we have made through investment but how much we left after adjusting inflation is considerable. That means if we have earned 20% return on our investment and inflation is 8% then we need to consider our return is 12% after adjusting inflation. And if our investment is not able to generate a positive return after adjusting for the inflation at a longer period of time then that is of no use for us.

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Similar thing with the Indian economy, we also experienced a Current Account Deficit and we have to borrow money for supporting the economy. If the hyperinflationary situation starts prevailing to an economy then it will become difficult for the economy to grow further. We need to bring more fund to just maintain the existing state of living.

Disclosure – Companies mentioned in the article is just for an example & educational purpose. It is not a buy/sell/ hold recommendation.

Read for more detail: The Intelligent Investor by Benjamin Graham, Jason Zweig

Investment versus Speculation: Results to Be Expected by the Intelligent Investor

Posted on June 29, 2019 by Jimit Zaveri under Bibliophile: The Intelligent Investor

From today, I am going to start a series on Book “The Intelligent Investor” under the Bibliophile category. Mr.Buffett has always mentioned that he keeps on reading this book every year. This book helps us with the developing an investment philosophy and also, help us to recognize ourselves as an investor or a speculator. I am grateful to the readers by which I am getting motivated to keep writing more and sharing more pearls of wisdom.

Mr.Graham has started the book with the definition of an investor which is very essential for us to understand to becoming a wise investor.

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Many of the people call themselves as an investor but they are not meeting criterion mentioned by Mr. Graham. If a person does not meet any of the criterion mentioned above then we need to consider him as a speculator rather consider as an investor. We have to check to introspect and need to check whether we are meeting above criterion or not. If not then we are doing speculation though we called ourselves as an investor. I have seen many of the people focuses on the adequate return but not meet up other two criteria, or they meet safety and return but not meet up with thorough analysis so that we need to consider those as a speculator, not an investor. People get more involves speculation because they get excitement into it and investing is a boring & lonely game. But over a longer period of time, excitement does not reward us. The stock market is not a place for getting excitement or thrill but it is a place where we need to stay calm, cool with a balance of emotion and balance of activities with hyper activities. When we do speculation, we get an immediate result but not happens the same with the investment. We can earn through making an investment in the long term only if we play this game with the rules.

People call themselves as an investor though they are just buying and selling shares at the stock exchange. They do meet the criteria of being an investor or not. Investor word commands a good reputation among the people so we feel the pride to call ourselves as an investor but rather to just get feeling, we need to work on logic and accept the reality. Though we perform a thorough analysis of investment opportunities or not, we consider ourselves as an investor but we need to understand that it is easy to call ourselves as an investor but it is difficult to act as an investor.

A thorough analysis of companies means we need to analyze the soundness of the company, long term survival of the business, pricing power with the company, etc.
Our major focus should be on capital protection. When we work on capital protection, we have already won half of the battle. I always emphasis on my philosophy which is “Return of Capital” is more important rather than “Return on Capital”.
We need to focus on adequate return rather than earning an extraordinary return. We run behind getting rich within a short period of time so that we desire to earn an extraordinary return.

People can do speculation also but many a time, speculation becomes dangerous –

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If we cannot stop ourselves from doing speculation then put some fund aside for making speculation and we never put the fund into the same account for making speculation and for making an investment. Also, we should not increase a fund to the speculation account just because the market has gone up or we have a good profit into it, but we should bring out the fund from it and transfer it to the investment account. 10% limit of our overall wealth is permissible for the speculative bets and we should not violate this rule. When our speculative account goes above 10% then those amounts need to shift to the investment account and if it goes below 10% then we should not transfer fund from investment account to speculative account.

Mr.Graham has advised to the defensive investors to keep their portfolio into the high-grade bond and into the common stocks. We should have a range of bond should be into the 25-75%, not less than 25%, and not more than 75%. Similar to the common stock also.

We need to make a selection of stocks and bond on the basis of inflation, interest rate, the future expected return from stocks, etc. Which can help us to earn above inflation return. As a defensive investor, we should make an investment to the company which has a good business with a strong track record of financial. We should avoid buying hot stocks which can be harmful to our wealth during the long term. Mr.Graham also has mentioned the concept of Systematic Investment Plan (SIP) for the defensive investors.

Mr.Graham has explained methods for aggressive investors such as 1) buying a security which is doing better than market average, and those not doing better which are candidate for short selling a security 2) Buying a companies which are expected to post a good earning or other favorable development expected 3) Buying a companies which have given a good earnings growth in the past and expected to deliver similar to the future or companies does not have a good past earning but expected to post a good earning to the future.

Here, uncertainty associated with the investment is human error and wrongly estimation of future or estimated future is already into the current market price. When we buy stocks on the basis of current year good result with the similar will happens to the next year then it is highly possible that other participants also think in the same manner.

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If we buy popular stocks on the street then we end up with the result what everyone else is expecting. We are not able to get above average return. We have other ways to make a return without taking a huge risk is a special situation such as a merger, demerger, buyback, liquidation, delisting, etc.

One of the bargains is given by Mr.Graham was Net of Current Asset (I.e. Working Capital) after adjusting all the liabilities. That means the stock price is well below working capital – all the liabilities. Here, we are not taking a plant and other fixed assets into consideration. Such issues consider as a bargain to its value.

One of the Indian air cooler company was available below the net of current asset

Company has a current asset of Rs.74.24 crore and total borrowing was Rs.29 crore so that the net of the current asset was Rs.46 crore, whereas Market Capitalization of the company was Rs.35 crore at the end of FY2009.

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Many of the investors do not take rest when odds are not in our favors. They keep on doing something though things are not into their favor. Such hyperactivity is also dangerous to the long term return of investors.

We have seen that many strategies and stories for the stock is getting popularized over a period of time and also erased as time get passes. We always need to focus that stocks only will perform well or poorly in the long run when business behind that stocks will do well or poorly. So that we need to focus on the performance of the business rather than focus on the different kind of strategy to becoming wealthy in the long run.

Disclosure – Companies mentioned in the article is just for an example purpose. It is not a buy/sell/ hold recommendation.

Read for more detail: The Intelligent Investor by Benjamin Graham, Jason Zweig