Do Equity returns compound? No !!

In my last post I had written about the frequent wrong usage of Maths to create misconceptions in investing which are not factually true. One such glaring misconception is for investors to feel that there will be compounding returns on equity investments, at least over the long term. This is simply not true and I would have thought that most investors would be able to understand this. However, as I have got quite a few queries and requests for clarification, let me do so here.

To start with let us fundamentally understand what Compounding is. I have used the following definition from Investopedia:-

DEFINITION of ‘Compounding’

The ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.

Essentially compounding involves some positive return on your asset, irrespective of what the return might be. Due to this the absolute value of your investment will always be increasing. Note here that we are not talking of inflation and Real returns here. For example, if I have a FD of 1 lac Rs and it pays me an interest of 8 % today then at the end of 1 year I will have an amount of 1.08 Lacs. Now if inflation is also at 8 %, my real return ( interest rate – inflation rate) is 0 and I have not really gained anything in terms of my purchasing power through this investment. At the same time, the absolute value of my investment has definitely grown by 8000 Rs in the one year period. This 1.08 lacs becomes my principal amount in the next year and I earn interest on this new amount. So in effect, compounding entails my earning interest not only on the principal amount but also on the interest amount.

The usage of compounding logic works great with debt products where the interest rates are relatively stable. Take an FD as an example again. At 8 % interest rate your money will double in approximately 9 years, at 12 % rate it will double in approximately 6 years and so on. Your money always grows in absolute terms, ignore the real growth for this discussion.

Now let us look at equities and see if this logic can be sustained in the light of our knowledge of it. If you look at stock prices over a period of time, you will see that it is clearly not so. Let me give you some examples from well known companies and their share prices from fairly recent memory:-

  • ITC reached 400 Rs and is now down to 300 odd levels.
  • HUL went to 1000 and then declined to levels of 800.
  • Reliance has had negative growth over years, so has Tata Steel.
  • Some company shares like Kingfisher Airlines have become penny stocks today.

There are also many examples of company shares having done extremely well and generate spectacular returns. My point here is simple – equities can give great growth but the way to understand that is not through the compounding principle. The growth in equity is non-linear and carries serious risk with it. Now at this point, people may tell you that over the long term of 15-20 years the compounding logic will hold true for equities. Sorry, it does not – if you bought the shares of Deccan Aviation at 146 Rs in the IPO , you have lost this money pretty much forever, never mind how long you are going to wait.

When I think about why there is such a great misconception about something really straightforward, I could come up with the following reasoning in my mind:-

  1. Most people invest in equity through Mutual Funds. As a MF scheme maintains a portfolio of stocks, the overall NAV of the scheme would normally increase in a reasonably good market, which we have had in recent years.
  2. Of course, the above can change in a prolonged poor market, but not many of today’s investors have had this experience. 2008 through 2010 was such a phase but has been mostly forgotten now.
  3. The usage of CAGR term, somehow makes one think that equity investments compound. This, of course, is complete nonsense but I have seen many sensible people believe this. CAGR is an artificial construct to understand annual returns, it in no way says that such returns are stable and not even that they are positive. In fact you can have negative CAGR and negative IRR / XIRR quite easily.

So, if it is clear by now that compounding logic is irrelevant to equities then how do we go about financial planning with equities as an investment asset class? I will answer that in a future post. For now, do understand that you cannot just hope that you will invest in stocks and it will give you an XIRR of 15-20 % because that has been the historical returns in the index. I really wish life were that simple for me and you, but it does not work like that.

Take heart though – we can make great returns from equity, by understanding the correct ways of investing in it.

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How will the Nifty perform now and in 2017?

As expected the Nifty levels hit a fresh high as a result of the positive sentiments emanating from the election results. The market players like stability and after the results there was renewed FII buying. However, it was not a runaway rally as many had predicted for 2 reasons. Firstly, a lot of the possible BJP victory in UP had already been factored in. Secondly, there are some serious factors which will come into play in the medium term.

So to address the first issue, where does one see the Nifty in the next week or so? Given that the March expiry is next week both transactions and medium term fundamentals will be pertinent. From all technical analysis the Nifty has serious resistance levels at both 9180 and 9220. If it is able to cross both these points then it is likely to rally for a couple of hundred points more. However, in terms of probability that is rather unlikely and like this week, the markets will probably be range bound. On the down side Nifty has strong support at 9050 and again at 8975 levels. In case both of these break there is every possibility of a deeper correction in April. Again, in probabilistic terms this scenario is also not very likely and therefore, we will probably be in a range of 9050 through 9200 for most part in the week.

What about 2017 then? Well, many analysts believe that an overall growth of Nifty by 15-25 % in the year is possible. So, given that we started 2017 at levels of 8000, we should be able to get close to the 10000 mark. As usual, there are many factors that can make this happen or prevent it from happening. Here are some of the key ones.

  • GST implementation from July 1st
  • Monsoon performance and whether the EL Nino effect is a serious one
  • US Fed rate hikes and impact of it on FII buying in our markets
  • Earning growth showing positive signs finally in this FY
  • Infrastructure spending by government to increase in the next 2 years or so

What is my call on the Nifty? Well, I think we may well get close to 10000 by the end of this FY but the path will obviously not be a linear one. There is a possibility of a sharp correction of about 10 % and that may well happen in the months of May and June, especially if the monsoon predictions turn negative and the GDP and IIP numbers show an unexpected decline. The route Nifty will take from 9100 now can well be as follows, though predictions are hazardous : 9100-9250-8700-8500-9000-9400-9200-9500-9700-10000. Each of the ranges may last for several weeks or months. While the route is tough to predict with any real degree of accuracy, I do think Nifty will end with 9700 plus by the end of this FY and may very likely get to 10000.

What does this mean for your investments this year and how should you plan them. Let me get back to this in another post.

My stock portfolio -5 top holdings

While most investors may be going through the MF route to buy equity as an asset class, there is a lot of interest in the stock portfolios of seemingly successful investors. This is amply demonstrated by the numerous requests I get for stock tips and readers wanting to know about my portfolio. I had written on this earlier but with the passage of time a few things have changed. So here is a list of my top 5 holdings.

The first in the list is Tata Motors and some observations are below.

  • My motivation for buying the stock was it’s prominent place in the Auto sector along with Maruti as Indian auto companies.
  • My first purchase was in 2007 February and the last in January 2009.
  • The stock has seen a lot of corporate action in terms of bonus earlier but I only witnessed a split in 2011.
  • It has normally been a good dividend paying company at 100 % but in the past 2 years this has come down considerably.
  • In terms of potential, this is clearly one of the best examples of an Indian company which has gone global successfully. I think it is quite possible for the stock to double over the next 2-3 years.
  • My investment in the stock is now at an average price of 109 Rs and it is about 8 % of my portfolio value at CMP.
  • I do not have any real plans to sell the stock, now or in the near future.

The second in the list is Palred Technologies and some observations are below.

  • My motivation for buying the stock was really the options I got as the CEO of Four Soft between 2007 and 2012.
  • These were mostly through allotments over these years.
  • The stock has seen a lot of corporate action in terms of capital reduction and split. Four Soft was also sold off to Kewill and the current business of Palred Technologies is completely different.
  • It has normally never paid dividends but on the selling of the company the shareholders got a special dividend, which for me amounted to more than 10 lacs.
  • In terms of potential, the company is one of the few listed Indian companies in the E-commerce portal area. However, it deals in relatively cheap electronic accessories and is in a low margin business.
  • My investment in the stock is now at an average price of 30 Rs and it is about 7 % of my portfolio value at CMP.
  • I do not see this as a long term success and may sell it whenever I need money.

The third in the list is Maruti Suzuki and some observations are below.

  • My motivation for buying the stock was it’s prominent place in the Auto sector along with Tata Motors as Indian auto companies.
  • My first purchase was in 2007 June and the last in October 2009.
  • The stock has not seen corporate action in terms of bonus or splits.
  • It has normally been a good dividend paying company and in the last 2 years the dividends have been 500 % and 700 %
  • In terms of potential, this is clearly one of the best examples of an Indian company which has dominated locally and started it’s global journey now. I think it is quite possible for the stock to double over the next 4-5 years.
  • My investment in the stock is now at an average price of 678 Rs and it is about 7 % of my portfolio value at CMP.
  • I do not have any real plans to sell the stock, now or in the near future.

The fourth in the list is Infosys and some observations are below.

  • My motivation for buying the stock was it’s prominent place in the IT sector as a major global player.
  • All my purchases of this stock was between June and November 2007.
  • The stock has seen a lot of corporate action in terms of two 1:1 bonuses in the years 2014 and 2015.
  • It has normally been a good dividend paying company and mostly pays dividends at 500 % and beyond.
  • In terms of potential, this is clearly one of the best examples of an Indian company which has gone global successfully. I think it is quite possible for the stock to double over the next 3-4 years, despite the obvious challenges.
  • My investment in the stock is now at an average price of 454 Rs and it is about 7 % of my portfolio value at CMP.
  • I do not have any real plans to sell the stock, now or in the near future.

The final one in the top 5 list is M & M and some observations are below.

  • My motivation for buying the stock was it’s prominent place in the commercial vehicles sector, which is an important one for our economy.
  • My first purchase was in 2007 March and the last in January 2009.
  • The stock has seen a split in 2010 when the face value was reduced to 5 from 10.
  • It has normally been a good dividend paying company at around 200 % and more.
  • In terms of potential, this is clearly one of the best examples of an Indian company catering to a growing local demand. I think it is quite possible for the stock to double over the next 4-5 years.
  • My investment in the stock is now at an average price of 285 Rs and it is about 7 % of my portfolio value at CMP.
  • I do not have any real plans to sell the stock, now or in the near future.

As you will see from here, investing in good companies and holding them for a long period of time has really worked for me here. There are some other holdings I have that may be of interest to my readers. I will share it in a future post.

Equity MF buying in 2017 – which ones to buy?

As I discussed in an earlier post, equity is an asset class which will probably perform the best in 2017. While I think it is a good idea to have both an MF and stocks portfolio, for most investors an MF portfolio will be a good place to start. In any case, I think most of my readers are having an MF portfolio and will definitely like to continue the same in 2017.

In this post, let me share the names of a few top funds in different categories which will make a great deal of investment sense in 2017. There are two important things to note here. Firstly, do not get swayed into buying MF through all kinds of statistical analysis and tools. These methods are amateurish even though I daresay they are sincere. Like every industry, the MF industry has professionals who are knowledgeable and neutral. It is very logical to go with their recommendations, reinventing the wheel has always been a rather poor idea. The funds suggested in this post are taken from the TV program “Investors Guide”. Secondly do not change your portfolio just because these funds are not there in it. There are several good MF schemes from different fund houses and changes should only be done when your annual review has shown some funds in your portfolio to be performing poorly. For new MF investors, I think it will make a lot of sense to pick some funds out of the ones mentioned in this post.

Coming to the fund categories, let us start with the multi-cap category. You must have this in your portfolio even if you are having only one category. Based on performance and potential, the following funds are recommended ones :-

  • ICICI Value Discovery fund
  • Franklin India High Growth companies fund
  • Birla Sun Life Equity fund
  • SBI Magnum Multi-cap fund

It will be important to have the mid-cap category fund in your portfolio too as these are the potential large caps of the future. Recommended funds in this category are :-

  • Mirae Asset Emerging Blue chip fund
  • Principal Emerging Blue Chip fund
  • UTI Mid-cap fund
  • Franklin India Prima fund

You also need to have the small cap category fund in your portfolio as, despite the risks, these are likely to reward you substantially in the future. Recommended funds are :-

  • DSP BR Micro cap fund
  • Franklin India Smaller Companies fund
  • Reliance Small cap fund
  • SBI Mid and Small cap fund

Finally the large cap category is important as it is likely to do well in 2017 and it provides some stability to your portfolio. Recommended funds in this category are :-

  • Mirae Asset India Opportunities fund
  • SBI Blue Chip fund
  • Birla Sun Life top 100 fund
  • Quantum Long Term Equity fund

For a good long term MF portfolio you just need to pick a fund from each category and invest in them regularly. You can decide on your allocation based on your risk taking ability, but even if you allocate 25 % of your money to each category, you will be fine.

Should you do SIP – not in general and in 2017 it will be a particularly bad idea. I will explain how you can invest in your portfolio in the next post.

How will I buy MF in 2017?

Even though I have explained my perspective on buying MF in several of my blog posts, I keep getting requests from readers to share how I plan to buy MF. As we are starting a new year soon let me state my plans to buy MF in 2017.

First things first Рis it a good idea to invest in MF this year? I would say yes to that. Most investors are not equipped properly to invest only in stocks and even the ones who have that knowledge, should invest in MF for greater coverage of the market. My 3 portfolio strategy of Debt, MF and stocks remain the same in 2017. Avoid stocks if you are not comfortable with it right now, though you must have a stock portfolio eventually. As far as MF goes you must invest in it consistently and increase your investments with time. 

Now will it be a good idea to invest in MF even though the indices may not see any great upswing this year? Again the answer will be a yes, if you are investing for the long term then current levels do not matter much. Of course, your buying levels matter and as such doing SIP blindly will really be a bad idea. There will be serious fluctuations in the indices this year and you need to take advantage of this. I think we will see levels of sub 8000 on the NIFTY with a possibility of going down all the way to 7000. At the same time there will be a possibility of crossing 9000 levels and potentially reaching 9500.

Based on this, my plans to buy MF in 2017 is as follows:-

  • I will have an overall investment allocation to MF of 4.8 lacs, in the 4 funds that I invest in. You can read about this in my other posts.
  • My assumption is there will be at least 4-5 opportunities this year where Nifty will go below 8000. I do not plan to try and catch the bottom which is an impossibility.
  • I estimate the first opportunity to come around budget time and the next one to come after results of the assembly elections.
  • At these 2 times, I want to invest about 3 lacs. This money will be available from my active income and also from my FMP redemption as needed.
  • Of course, these are estimates based on two assumptions. First, the budget will come at a time when the Q3 results are out and have suffered due to the demonetization issue. Second, BJP will lose in the UP elections as their traditional support base has been rather badly affected by the same token.
  • Regardless of whether this happens or not, there will be 4-5 opportunities that you need to wait for.
  • Last year such a strategy allowed me to buy DSP BR Micro cap fund at an average NAV of 38 Rs, which was great.

What happens in the unlikely case that the market just starts going up and Nifty scales 10000 and more in 2017? Well, firstly in a rising market it makes no sense to invest through SIP. Secondly, the markets will definitely have a serious correction at times. I will just wait for it and invest most of my money when that happens.

When the market is falling how do you know at what point to buy? Look at the DMA figures for the appropriate index. For example, if the 200 DMA is falling and so is the 50 DMA then you can wait for some time. The moment there is a turnaround in this and the trend reversal sustains for 2-3 days go ahead and buy your MF units. Yes, there is no guarantee that the indices will not fall further but always remember that you are not trying to catch the bottom of the market, only attempting to buy at a sensible price.

What are the chances of this strategy not working out ? Fortunately, none !!!

 

 

How will Nifty behave in the next year and why

It is rightly said that predicting the market levels in the short to medium term is fraught with the hazard of you looking really silly. However, the trends in the market are easier to predict and, with some knowledge and experience in the markets, you  will probably get it right more times than you get it wrong. Let me therefore attempt to try and give some overall predictions of the NIFTY trends between now and March 2018. I have tried to keep all explanations in simplest of languages and devoid of any jargon.

To begin with one will need to understand the key factors behind market performance in our situation. The determining factor in the markets is the amount of money pumped in and out by the FII’s. Most people do not understand this and keep looking at other reasons which are not quite so important. Now, the FII money will come in when they feel putting money in Indian markets is going to be better for them as opposed to other developing or developed markets. However, it can also go out when it becomes apparent to them that some other markets are relatively more attractive.The other important factor for the markets is of course the growth in corporate earning. As we all know real growth or the potential of it will help market up move and vice versa. The third important factor is some structural issues in particular industries, for example Metals, IT , Pharma etc. This may not effect all companies but if the sector has a good representation in the Index then the impact on the market levels can be serious. The final factor is sentiment based which is normally news driven – again either real or perceived facts.

So what is the environment really telling us right now. While there are many issues the most important ones are as follows:-

  • The US elections are expected to result in a win for Hillary Clinton. If Donald Trump manages to pull off an upset that will be a shock for the markets. This will be a bad news for Emerging markets as more money may flow into US at our cost.
  • The Fed rate hike is a given and this is again a negative trigger for the FII money to see a sell off.
  • Our own interest rate cycle is probably bottomed out or there is at most one more cut amounting to 25 bps. The bad news is that the stock price movement in the rate sensitive stocks we have seen lately will now come to an end.
  • Sectors such as IT, Banking, Pharma which are vital to the NIFTY are having serious structural issues now and are likely to see serious declines.
  • In general corporate earning growth has again disappointed this quarter and now the whole pressure will be in the next 2 quarters to deliver this FY. Given the indicators in most sectors this does not look very likely.
  • Auto sector, Consumer durable and the FMCG sector are likely to do well based on the good monsoons and 7th Pay commission outcomes.

As you can see from here, there are very few factors which are positive for our markets. I think the trend is clearly going to be negative and a 5 % correction on the Nifty is quite imminent. In case there is a major FII sell off then the correction will be way deeper and it can easily be 10 % or more. Over the next six months local factors such as the budget, assembly elections, GST implementation etc will hold sway and the outcome of most of these are again likely to be negative for our markets. I therefore anticipate further weakening of the Nifty till March of 2017 or so. Thereafter, assuming that there are no real shocks for the rest of the year in the global economy and markets, money is likely to flow into the Indian markets and we should end 2017, probably at the highest point of the year.

What are the Nifty levels we are talking about? Probably a low level between 7000 and 7500 by March 2017 and a high level between 9000 and 9500 towards end 2017. While the level of 7000 can be breached I do not feel this will happen for the 9500 level. Do remember that levels are far harder to predict and all numbers here should be taken as indicative and not absolute by any means.

Assuming that this is a reasonably accurate projection of the next 15 months, how will it be affecting your existing investments ? How will it make sense to invest in this period? Let me address it in another post.

Nifty call and investment rationale for rest of FY

Any prediction of the markets is always a hazardous job but in order to benefit from the markets one must attempt it nevertheless. For the last few months the Nifty has ranged between 8400 and 8900. It has threatened both these levels several times but have not been able to break out in a decisive manner. The Indian situation in terms of the economy has been improving but the overall global economic environment and therefore the market sentiments have really not been positive.

This has resulted in the Nifty finding good support at 8400 and even 8600 recently, mainly due to the high availability of cash being brought in by FII players. At the same time, it has faced resistance at 8900 as at that level the valuations become rather unattractive. As we wait for the Q2 results, we are observing a strange situation. At long last corporate earning growth for several sectors in the Indian economy, most notably Auto/Cement are looking up. With a supportive global environment. one would expect the Nifty to decisively cross the 9000 levels and make new lifetime highs by the end of 2016. Unfortunately the serious headwinds in terms of the US Fed hike, US presidential elections, situation in Europe/Japan, now rising crude prices and the fallout of the BREXIT impact will not enable us to see these Nifty levels.

So what will be a call on the Nifty then? I think the following scenario will play out:-

  • There may be fluctuations of the Nifty on both sides of 8500 levels in October, to the extent of 300 points. I think we are more likely to find support at 8500.
  • In November and December the US news will dominate and any event there will probably have a negative fallout for our markets. If the Fed rate hike takes place as planned, we will easily see 8000 levels being breached on the Nifty.
  • Between January and March 2017, local factors such as the budget and state election forecasts will dominate the news and sentiments. This will result in the Nifty being in the overall range of 8300 to 8700, depending on how things pan out.
  • By the end of 2017 a pessimistic Nifty projection will be 9000 and an optimistic one will probably be about 9500. It is very unlikely to be either lower or higher by much more (say another 200 points).

Based on this, how should you plan your investments?

  • If you want to rejig your MF portfolio, get out of your unwanted funds when the Nifty hits 8800 or so in the next rise. You can then wait till 8300 or lower to invest in the funds of your choice. I have about 7-8 funds which I plan to deal with in this way.
  • Over the next 6 months or so, SIP will actually be a good way to invest. You can put most of your annual money in the next 6-8 months and then stop your SIP for the remaining part of 2017. For my part I plan to invest the remaining 40 % of my MF investments when the Nifty gets close to 8000. It is likely to be in December.
  • As far as stocks go, keep your shopping list ready and add to your portfolio by seeing the right prices. Keep a watch on the DMA figures closely between now and the next 3-4 months. There will be serious buying opportunities.
  • Pure debt instruments will give lower returns over the next 2 years or so. Even then keep investing in PF/PPF/SSY as per your regular plan. Duration funds may be a risky bet as there is a possibility of the interest cycle turning.
  • Arbitrage funds will not make much sense going forward, unless you are purely using these for short term goals. Gilt funds again will give higher returns but are fraught with risks.
  • I will focus on MIP, Equity Savings Funds and some hybrid FMP in the debt space. Returns from pure debt FMP will be low, so not much point in being locked into such schemes for 3 years.

Overall between now and 2017 end will be a rather interesting period and I do think thart my call on the Nifty figures will largely hold good.