Equities - Implementation Pointers, Part I

While implementing a portfolio, an investor is faced with a variety of choices, whether to invest actively or passively and whether to go solo or delegate the task to a financial advisor. Lets discuss these choices in more detail:

Active vs Passive: Active investing refers to forming an opinion about the fair value of a stock and taking decision accordingly i.e. buy the undervalued & sell (often sell-short) the overvalued stock in anticipation of an increase/decrease in its market value. Passive investing is the by-product of the academic school of thought (a.k.a. The efficient market hypothesis, EMH) which belives the marketplace is full of smart players who quickly react to any new information about a security and their actions (i.e. buy/sell activities) gets reflected in its price. e.g. If too many people are bullish about the prospects of Google their buying would drive its price higher. Also if too many investors are bearish about GM or AIG, their selling (or lack of buying them) would get reflected in its lower price. So at any given time the market value will most likely reflect the fair price of a security and investors should just buy the overall market (as represented by an index fund) to accrue the core benefits (inflation protection & real growth in savings) of equities investing.

In some ways the debate between active & passive investing routinely takes the form of the political debate between democrat & republican supporters in USA. It is easy to understand the advantages & disadvantages of both approaches in their raw form but most investors end up taking sides much to their own peril. The active side routinely trashes EMH as non-sense citing wild fluctuations in market-price as a proof that stocks hardly trade at fair-value as suggested by the EMH. They also offer the specious but easily acceptable argument that owning a passive index fund would only fetch average returns as the investor would end up owning both the good as well as the bad securities. The passive side which rose to prominence by correctly pointing that only a handful of professional investors have managed to successfully beat an index fund over a long period of time but then go on to equate even truely successful investors like Mr. Buffett & Mr. Lynch to Oragutans (type of apes) and attribute their success mostly to luck. I think a good way for readers to get an understanding of this Active vs. Passive debate is to read a little known book named 'Investment Gurus' by Peter Tanous. This 1996 book features detailed interviews with top active proponents (those who generated exceptional returns over the 10 year interval from 1985-95. These include the likes of Peter Lynch, Michael Price, Mario Gabelli, etc.), the top passive investing proponents (Eugene Fama, William Sharpe, Rex Sinquefield, Merton Miller, etc.) as well as the ones in the middle like the hedge fund manager D. E. Shaw who acknowledges that the markets are largely efficient but there are some small cracks which can be taken advantage off. A good thing about reading a slightly dated book is the ability to see how things turned out afterwards. Most of the hot-shot active managers featured in the book are no longer considered superstars (baring Mr. Lynch & Price both of whom have long been retired and their funds haven't performed admirably thereafter). One fellow John Ballen was even barred from the industry for the mutual fund market timing scandal and the funds run by few others are no longer in existence because of poor performance! As for the passive investing folks, we all know of the two epic US stock market booms & busts that have followed since 1997 so anyone who invested with the blind faith that markets are always priced efficiently paid dearly. Even the ones in the middle like D. E. Shaw whose firm prided itself in hiring only the very best Phd candidates & using sophisticated computing resources to find those tiny cracks in the efficient market encountered some lean years. So what are the key takeways for a Sensible Investor from this Active Vs. Passive debate? One can really hit a jackpot by investing alongside a highly successful active manager (e.g. Warren Buffett, Peter Lynch, Michael Price, Seth Klarman, etc.) or by picking a winning stock (Abbott Laboratories, Walmart, Reliance Industries, Infosys, etc.) over a long term. Even a mere 2% point difference (10% vs. 8% annual return) over a 20 year period will translate into 44% higher wealth. However for an average investor the problem lies in successfully picking the active manager or a group of winning stocks that will generate such an outperformance over the next 20 years. The probability is so low that it is equivalent to finding a needle in a haystack. So primarily from this perspective, it makes sense to bet on a group of index funds (spanning across different market capitalizations and geographies) to come out ahead of a vast majority of accomplished active investors and generate higher returns (or less risk for the same level of returns) through other means (diversification, rebalancing, dollar cost averaging, etc.) which we will discuss later. If you still end up choosing an active manager or an active investing approach (because of limited fund options in your retirement plan or picking stocks gives you that warm & fuzzy feeling) then try to limit this exposure to a maximum of 20-30% of your portfolio. As far as picking a winning fund goes, I don't have a fool-proof receipe but picking a fund with following characteristics in the order mentioned might help: low portfolio turnover (< 25% per year), longer portfolio manager tenure (5+ years), reasonable size (not too big depending on market cap), reputation of mutual fund house and your liking of manager's portfolio/investment philosophy. Picking a winning stock is a vastly different ballgame which I will address once we are done discussing the concepts of all asset classess & portfolio management topics. In the next post I will address the other implementation issues pertaining to equities.

Equities - Digging Deeper

Having made the case for the attractiveness of equities, let us now discuss the various ways professional investors slice & dice the equities asset class.

Size: Based on the market capitalization (no. of shares outstanding * share price) of a company, its stock can be classfied as large cap, medium cap or small cap. See the links for the size threshold for the various market cap categories in US & India. As mentioned in a previous post, the long-term returns of US small cap stocks are approx. 2% higher than the large-cap stocks. However small-cap stocks don't outperform large-cap stocks at all intervals. Markets tend to go through alternate cycles of several years where one category outperforms the other. Large cap stocks are generally perceived to less risky & are more liquid but the underlying companies are slow growing due to their massive size. On the other hand small cap stocks are considered more risky & illiquid but offers higher potential for growth.

A sensible investor can generally divide his equity allocation among these capitalization categories based on the percentage of total market capitalization they represent (sample distribution: large -> 75%, mid -> 15% & small -> 10%) and modify it tactically (by 1 - 10% points) based on ones risk preferences & judgement about their relative attractiveness at a given point in time.

Geography: Based on the domicile of listed companies, equities can be classified as developed or developing (also known as emerging) market equities. The developed market equities can be further classified into US (or North America) & EAFE (Europe, Australasia & Far East) because the dynamics of these two regions differ considerably (in technical speak they are not perfectly correlated) and their overall size (market cap) is approximately the same, i.e. about $14 trillion. Offcourse there are funds available for practically any country (of investing significance) but for the sensible investor the granularity to the level of four regions is sufficient; US (+ Canada), Europe, Pacific (Japan, Australia, Hong Kong, Singapore) & Emerging Markets. As per conventional wisdom, international investing (especially of emerging variety) is perceived to be more risky but also more rewarding because of better growth prospects.

Most asset allocation models I have come across prescribe a max. of 15-25% for EAFE & 5-15% for Emerging markets. While these recommendations makes sense in light of higher correlation among equity markets, inferior rights of the foreign investors in the unforseen event of a conflict between countries, poor corporate governance & the fact that US investors liabilities are mostly tied to the dollar. The downside of such conservatism is that it may also cause an investor to miss out significantly on positive developments in the international market like the rise of emerging markets (beware: the opposite also holds true).

Although currency diversification through international equities investing is often perceived as a risk, it can prove to be advantageous over the next few dacades. While the exchange rate between developed market currencies (US$, Euro & Yen) tend to mean revert every 10-15 years, one can take advantage of the divergence through periodic rebalancing (an important topic to be covered later). As far as emerging markets are concerned, these countries have over the last few decades excessively diluted their currencies to boost exports to the developed world but as the domestic markets in these countries mature and their politicians realize currency appreciation to be an effective way to tackle inflation & boost the purchasing power of its population, the phenomenon can serve as a return booster for foreign investors in these equities.

So in my personal view an asset allocation strategy based on the Gross Domestic Product (GDP) of various regions may be more rewarding considering the predominant home country bias. So a sample distribution can be: US (+ Canada) -> 35%, Europe -> 23.5%, Pacific -> 11.5% & Emerging Markets -> 30%. As before, investors can tactically adjust each category by (1 - 10% points) based on their risk preference & judgement about relative attractiveness of these markets.

Style: Equities can be classified into Growth & Value based on certain characteristics of a stock. While there is no standard definition, stocks trading at a high P/B, P/E or P/CF multiple are termed as growth stocks. They usually represent solid flourishing companies like Infosys, Dabur, Google, L&T, etc. A typical growth investor likes to see the sales/earnings grow faster than the bacterical multiplication rate or a strong brand equity and they don't mind paying extra for such companies. On the other hand value stocks represent stocks trading at low P/B, P/E or P/CF multiple. These companies are usually sick puppies or slow growing companies with poor management, negative earnings outlook or a crushing debt burden like Indo Rama Synthetics, India Nippon Electricals, Tanfac, Ceat, etc. A typical value investor has the mentality of a bean-counter and he is more concerned about not overpaying for a company's stock. There are also in-between categories like GARP (Growth at Reasonable Price) which are a concoction of these two styles in different proportions.

As far as returns are concerned, value stocks have offered higher returns than growth stocks over the long-term. Academics attribute the higher long-term returns of value stocks to their risky nature resulting in their price being overly depressed during bad times. Eventually the companies figure out a way to grow again or get acquired by a savvy competitor which brings their price back to normal. The growth stocks as a company do perform well but are generally priced so high that investors don't get enough bang for their buck. However similar to size, this outperformance of value stocks does not happen in all time-periods and market goes through alternate cycles of several years where one category outperforms the other (e.g. In US growth stocks were the cynosure of all eyes in 1980s & especially the 1990s but value stocks ruled the roost in 2000s). Today the conventional wisdom seems to be so much tilted towards value in US (the story is a bit different in India though) that it is hard to find a well-known courageous soul who identifies himself/herself as a growth investor.

I think a sensible investor under normal circumstances (prevails at most times except when growth stock gets priced disproportionately high, e.g. Nifty-Fifty craze in early 1970s & Tech mania in late 1990s) can just take a pass in this growth vs. value contest and own the overall market (which essentially includes both growth & value) for their core portfolio.

Equities - Advantages Reinforced

From the previous two posts on equities, I hope I have impressed upon the readers the following key characteristics of the equity asset class:

• Over long term (10+ years), equities offer a chance to beat inflation handily (unless purchased near the peak of unprecedented market bubbles like Japanese stocks in 1989 or US stocks in early 2000)
  
• Over long term, equities offer a chance to profit from a company's earnings growth (as before exceptions apply) and if purchased as a broad index they offer a chance to ride the GDP growth of a country

The is one more advantage of equities worth discussing:

Tax Advantage: For equities taxes can arise from tax on dividends or capital gains tax (incurred only at the time of selling the equities at a higher price). Most countries tax dividends at a lower rate. In US its either 5% or 15% depending on ones tax bracket. In India investors pay no taxes on dividends. Even capital gains are taxed favorably. Capital gains can be either short-term (when sold within 1 year) or long-term (if sold after 1 year). Short term capital gains are treated as ordinary income in US & are charged at 10% in India. Long term capital gains are either 5% or 15% in US & none in India. So while an investor is riding the companies earnings growth he/she pays very little taxes if the stocks are held for a long time in a taxable account. This can boost the returns significantly over long periods of time due to the effect of compounding.

Equities - Return Drivers

Before commiting funds to the equities asset class, a sensible investor should first enquire about the historical returns provided by equities & the source of these returns. Here are the historical returns (annualized compounded total returns) of the US Large Company Stocks:

• January 1885 - December 1925 -------------> 7.3%
• January 1926 - June 2009 -------------------> 9.6%
• January 1885 - December 2008 -------------> 8.3%

I don't have access to small company equity returns but they are generally 2% higher than those of large company stocks over the long run. In US, one can find uptodate equity returns free of cost in the Stocks, Bonds, Bills & Inflation (SBBI) Yearbook published by Morningstar's Ibbotson unit at a reasonably big public library. Per my understanding the equity returns of developed international markets (usually referenced by the acronym EAFE -> Europe, Australasia and Far East) are comparable to US equity markets. There is not much data available on the internet for the Indian equity markets but over the last 30 years the returns have been around 20% (although it appears phenomenal at first glance, please account for factors like the relatively short time period, very high inflation and the commensurate currency devaluation, large P/E multiple expansion before you write off the other equity markets in the world).

To assess the attractiveness of equity returns in relative terms, one should compare the US equity returns above with the US government bond returns of 5.7% & US inflation of 3% during the 1926-2008 timeframe. Clearly the equity markets have beaten bonds & inflation by a wide margin. But before euphoria grabs you and you decide to put all your savings into equities do remember that equity markets have a tendency to choke for prolong periods of times as indicated in one of my previous posts.

To get a better perspective on future equity returns lets first analyze the components of equity returns. As per investment theory equity returns can be decomposed into following components:

Expected Equity Returns = Dividend Yield + Earnings Growth + P/E changes

Earnings Growth can be further decomposed into Inflation + Real Earnings Growth (i.e. excluding the effect of inflation from absolute earnings growth number). For a detailed treatment one can also refer to the Grinold & Kroner model. As per this model:

Expected Returns = Dividend Yield + Inflation + Real earnings growth - Change in number of shares outstanding + Change is P/E

In one of the previous posts, I took potshots at Mr. Ajit Dayal for suggesting a 20% annual return for the India stock markets but did not offer any return expectation to counter that. I think we now have the necessary building blocks to calculate the anticipated future returns of the Indian stock market. Using the broad index S&P CNX 500 as a proxy for indian stocks here are the values for the various components of the Grinold & Kroner model as of January 19, 2010:

Dividend Yield: The current dividend yield of CNX 500 is about 1%

Absolute Earnings Growth (Inflation + Real Earnings Growth): As per a recent RBI quarterly survey of professional forecasters, the maximum value of corporate earnings growth for a relatively decent year like 2009 was quoted as 15%. Lets assume this value will hold true for the next 10-15 years.

Change is shares outstanding: Lets assume a number of 3% per year considering the plethora of mega IPOs (by both government & private companies) & QIPs in the recent past. One can expect such trend to continue over next 10-15 years in view of the widespread optimism among the Indian investors & the insatiable desire of big corporate houses to acquire large global companies (LyondellBassel, Jaguar, Corus Steel, Novelis, etc.)

P/E Changes: The current P/E of the market is 21.47. Per this CNX 500 P/E graph a more realistic P/E after a decent earnings growth of 15% p.a. for 10-15 years would be 17. This would result in a P/E multiple contraction of 2.31%.

After putting all these values in the Grinold & Kroner equation, the expected return over the next 10-15 years for the Indian stock market turns out to be: 10.7% (1+15-3-2.3). I know this would come as a rude shock to all the optimists reading this article. Well the actual returns can turn out to be higher but expecting 20% as suggested by some experts is clearly a stretch as far as market fundamentals are concerned.

Equities - Overview

Equities are perhaps the most liquid (can be easily traded) of all asset classes. They are the common stock of publicly listed companies. In essence they represent an ownership stake in a publicly listed company proportionate to the amout of shares held. Baring notable exceptions (IKEA, Mars Candies, Bechtel, Fidelity Investments, etc.) an overwhelming majority of world's top companies are public. The common stock (i.e. shares) of these companies are traded on various stock exchanges around the world. Although a primer on equities is too basic a topic for this blog, I think discussing it might still help some readers.

How does the shares come into existence? In a typical example, an entrepreneur (say Dhirubhai Ambani) comes up with a business idea and initially grows the business (Reliance Industries) with his own capital. After reaching a certain size most of these companies need a sizeable amount of capital to grow further. So the entrepreneurs (i.e. promoters) comes out with an IPO (public issue) allowing the general public to own a piece of the company and benefit from its future growth. During the initial stages, most public companies reinvest their profits back into the business for expansion purposes and after few years when they start generating excess profits the money is distributed back to the shareholders in the form of dividends.

At what prices do the shares trade on exchanges? Ideally the value of a company (also known as its intrinsic value) is equal to the present value of the future cash flows the company is expected to generate during its lifetime or alternatively it is the replacement cost of building an equivalent company. The problem is that it is very difficult to know these values with a high degree of accuracy because they depend on several factors (future demand of company's products, competition, interest rates, inflation, exchange rates, government policies, management smarts & honesty, etc.). So invariably the shares of a company trade at wide divergence to its instrinsic value based on investors perception of the value of these factors and the degree to which each factor affects the intrinsic value. Additionally the value of these factors keeps changing with time. Due to so many moving parts in the valuation equation, the share price of a company becomes quite volatile (atleast in the short-run). With prices being so volatile any wrong judgement call by an investor can lead to huge losses thus giving stock investing a connotation of gambling.

So how does one come out ahead in the stock investing game? Most people think the obvious answer is to form better insights on the plethora of variables that impact stock prices. Naturally they turn to watching CNBC as much as possible, devouring the business journals like WSJ (or Economic Times in India), reading a ton of stock posts at Yahoo Finance (or Moneycontrol) and forming an opinion about the numerous economic & financial indicators that the media throws at them. Over long term (i.e. 10+ years) the unfortunate ones drop out after suffering early losses, the reasonably smart ones (which includes a majority of investors) end up earning a return which equates to the growth rate of underlying companies profit they invest in minus the cost of playing the stock market game (i.e. brokerage & custodian charges, taxes, penalty for improperly timing their investments & investing disproportionately large sums to fiascos like Enron, Satyam & AOL-Time Warner at their peak prices). Only the incredibly LUCKY and very smart ones (< 1% of the investing population) end up multiplying their wealth several times more than reasonably smart ones (i.e. the majority). The media zealously portrays eloquent stories of these elite investors to sell more news which again breeds a new wave of aspirants for the brutal game I just explained.

I know I am again sounding like a broken record and I need to quickly tell you how a sensible investor can use the equities asset class to his/her advantage without expending a lot of effort. For that you will have to wait for the next post as we are out of time.

Asset Classes - The building blocks

Before we delve into the topic of Portfolio Management lets talk a bit about asset classes. They form the building blocks of a Portfolio. Examples of asset classes are equities, bonds, real estate (direct & indirect), commodities, precious metals (gold), private equity & venture capital. For an average (but sensible!) investor only three asset classes matter: equities, bonds & real estate (primarily indirect & direct only to the extent of personal home). I will state the reasons for this while discussing the characteristics of each of these asset classes in the next few posts.

Determining the right mix of asset classes in ones portfolio is called Asset Allocation. It is a very important part of Portfolio Management. If one were to define the essence of Portfolio Management then it would be all about Asset Allocation. According to some widely accepted academic research, sources of investment returns can be decomposed into 3 things:

• Asset Allocation: the mix of asset classes in a portfolio (e.g. 60% Stocks, 20% Real Estate & 20% Bonds or 20% US Stocks, 20% International Developed Stocks, 20% Emerging Market Stocks, 20% US REIT & 20% US Treasury Bonds)
• Market Timing: jumping into & out of an asset class with the anticipation of rise/fall in its value (e.g. trying to time the stock market)
• Securities Selection: cherry picking only a few securities within an asset class based on their attractiveness (e.g. picking winners like Infosys instead of going with large cap Indian IT stocks as a whole)

As per a famous empirical study by Gary Brinson (one of the most influential investment managers in the institutional investing landscape) & others, over 90% of the variance in returns between two portfolios can be explained by the difference in their asset allocation (e.g. if fund A generated higher returns than fund B, over 90% of that higher return can be attributed to fund A's investment in better performing asset classes). For a more detailed discussion on the importance of asset allocation please refer to two of my favorite books 'Unconventional Success' & 'The Intelligent Asset Allocator'. If you are on a time crunch, here is an hour long lecture by David Swensen on the topic.

Rule of 72

While reading the book 'The Intelligent Asset Allocator' by Dr. William Bernstein, I came across a useful rule of thumb related to compounding. As per the rule, the number 72 divided by the annual compounding rate gives the approximate number of years it takes for an investment to double. e.g. 72 divided by annual compounding rate of 9% equates to 8 years. The equation can also be used to estimate the annual compounding rate required to double the money in a certain timeframe. e.g. 72 divided by 6 years equates to 12% annual compounding rate.

The Rule of 72 can also be used to compare the relative multiple of a stock to another stock or to the market. e.g. suppose a hot stock like Asian Paints India Ltd which already has about 70% market share in the paint industry is trading at twice the P/E multiple of the paint industry in general. In order to justify the valuation solely on the basis of P/E, its earnings would have to grow at 5% rate relative to the industry for the next 14 years! Offcourse the valuation of a company hinges on many other factors and Asian Paints has exhibited higher profitability & growth which may justify its higher P/E but the Rule of 72 provides a quick & easy way to compare valuations in terms of growth rates. Disclaimer: I own Kansai Nerolac Paints and that is probably the reason I despise the higher valuations commanded by Asian Paints.

As per the Wikipedia entry on Rule of 72, one can use the numerator 69 or 70 for more accurate results when dealing with shorter compounding periods like continuous/daily compounding.