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.

Sensex at 29,24,100!

While I don't intend to take potshots at individuals in this blog but sometimes the interest of the public at-large takes precedence over name-calling. Recently I read the following interview of Mr. Ajit Dayal in Hindu Business Line. In his interview, Mr. Dayal made a wager that over the next 30 years the BSE Sensex would probably grow 171 times (hence the number 29,24,100 = 17,100 x 171). Per my knowledge he is certainly not in the league of Indian super-investors like Rakesh Jhunjhunwala or Sunil Singhania but he does seem to have built a reputation for himself. He is the founder of Equitymaster & Quantam Asset Management which claims to advice Rs. 2500 crore of FII money. He was the country head/director of India operations for several well-known foreign investment firms. As per Equitymaster's website he has also been voted as best analyst for India by AsiaMoney in 1993 & 1994.


The BSE Sensex has indeed grown 171 times over the last 30 years. Without even considering the contribution from dividends this equates to a return of 18.7% which is truely amazing. Mr. Dayal expects similar returns over the next 30 years. I truely have no idea of what the future returns would be over the next 30 years but from my understanding no equity market in world has shown this kind of returns over a strech of 60 years (neither Japan, USA or West Germany during their spectacular growth phase). I think the main reason for the exceptionally high returns of the past 30 years in India are: valuation multiple expansion, inflation and dramatic devaluation in rupee from 1/8 per US$ to 1/48 per US$ because as per purchasing price parity which prevails over the long term more units of money would be needed to buy the same physical entity i.e. the companies in the Sensex. The prospects of all three of these factors expanding at the same rate over the next 30 years are not very high and the only other remaining factor (i.e. real earnings growth) in the return equation cannot grow fast enough to yield a 20% (18.7 % capital appreciation x 1.1% dividend yield) total return.

In such rosy forecasts lies the follies of excessive optimism by investors which is invariably fueled by self-serving investment advisers and market pundits. By assuming abnormally high returns on their savings, investors run the risk of running out of money just when they would need it the most (i.e. at old age when they cannot earn money through other means). Market returns everywhere have exhibited mean-reversion over a long period of time (e.g. after growing fast for 1-2 decades, US market have chocked for long periods of time: 1899-1920, 1964-1981; same is the case with Japan where the Nikkei at around 10,000 is way below its 1989 peak of 38957). The process also works in reverse i.e. investors should not be overly pessimistic when the markets are under stress (e.g. US in 1981, India in 2002 & perhaps in Oct. 2008 and possibly Japan today!!).

Still not convinced? Check out the following excerpts from a recent letter to Berkshire Hathaway's shareholders by the Oracle of Omaha. One might argue that Mr. Buffett is speaking in the context of US investors but please note that he is no stranger to emerging markets after having made a fortune by investing in South Korean companies & Petro China. In one of the future posts, I will also address the myth of higher economic growth = higher stock market returns when investing in emerging markets like India.

The Joys of Compounding

In the context of investing compounding can be considered an anti-dote to the problem of inflation discussed in previous post. Compounding is the exponential growth in the value of ones investments as a result of reinvesting the proceeds from the original investment. The reinvestment can be either explicit (e.g. reinvesting the stock dividends or coupon/interest payments on a bond) or it can be implicit (e.g. reinvestment of retained earnings by companies in case of stocks or a zero coupon bond). If the investments are compounded at a decent rate of return, its value can grow significantly over time. Let me give you a couple of examples to consolidate this point. These examples were quoted by one of the best known compounders of money (yes, its Warren Buffett!) to his investors in the 1960s. I am merely extrapolating the numbers to the present time.

1. In the year 1492 the Spanish queen Isabella underwrote Christoper Columbus' voyage which led to the discovery of the americas for a sum of $30,000. As we all know that was indeed a blockbuster finding and it brought incredible riches to the Spanish empire . Lets suppose the queen had followed a low key approach of investing that same money at the rate of 4% compounded annually. The money today would have grown to about $18.5 trillion (compare this to the current US GDP of $14 trillion, US Stock Market Cap of $12.5 trillion & Spain's GDP of $1.6 trillion)
2. In 1540, Francis I of France paid 4,000 ecus (equivalent to $20,000 at that time) for Leonardo da Vinci's painting Mona Lisa. We all know that even after 5 centuries it ranks among the most famous paintings of all time. Lets suppose Francis had invested the same amount at a conservative rate of 4% compounded annually. The money today would have grown to $1.87 trillion. While I not an expert at appraising artworks, I guess that money can easily buy you all the paintings of all the famous artists you may have ever heard off.

The key lesson to learn here is that with a decent rate of compounding one can grow their savings to an incredibly bigger amount over a sufficiently long period of time. A reasonably successful investor does not necessarily have to hit a jackpot like finding a new continent or have the foresight to buy a painting like Mona Lisa before it comes wildly popular.
I think there is another key take-away from this example, an average investor should not have an unreasonable expectation of earning a very high rate of return (> 15-20% per annum) over longer periods of time (i.e. 10+ years). I will address that issue in my next post 'Sensex at 29,24,100'.

The menace of Inflation

Once you get past the hurdle of saving, the next thing an investor needs to worry about is inflation. It is the erosion in purchasing power of (paper) money with the passage of time. As the purchasing power of the currency erodes, one would need more units of money to buy the same amount of a product/service in future. Let me give you an example to make it more clear:

When I was a child 25 years ago I was very fond of eating samosas (a fried indian pastry made of potatoes; no wonder I earned sourbiquets like 'mootu'). In those days samosas would cost about 50 paise (1 Indian Rupee = 100 paise). Suppose I received Rs. 20 from someone as a child and being an inspired saver I put it in my piggy bank. Today that same amount would buy me only 5 samosas instead of 40 at that time. So much rewards for the virtues of saving!!!

I am sure everyone would have their own story of how the value of money has diminshed over time. The key point for a saver is to realize that one would have to spend several times more for a good/service in future depending on their time horizon & expected inflation rate.

An inquisitive reader may inquire about the cause of inflation. While I am not an economist by training, my understanding is that inflation can occur due to various different reasons:

• Governments around the world spend more than what they earn (through taxes, etc.) to please the population and they make up for the short-fall by printing more money (given the option, who wouldn't!!). The end result is too much money chasing fewer quantity of goods and services and hence the inflation.
• We human beings always fancy the growth in value of our assets. This can happen through higher salary, high profits from a personal enterprise or through higher values of assets (especially during speculative bubbles) we own. Sometimes the money creation through such growth runs ahead of the supply of products/services we consume from that money, it again results in too much money chasing fewer quantity of goods & services and hence the inflation.
• Inflation can also occur due to supply side constraints of physical goods/human resources. Sometimes the scarcity can be due to natural causes (e.g. damage to mines due to earthquake) or it can be a contrived scarcity (e.g. restriction of oil supply by OPEC)

How can an investor/saver tackle the menace of inflation? It can be done by investing ones money in assets whose value grows faster than inflation (e.g. savings account deposit, bonds, stocks, real-estate, etc.) Based on historical results, over the long-term a savings account return will barely keep pace with inflation, bonds can provide slightly higher returns and other assets classes like stock & real-estate can provide even higher returns. Also an excellent hedge against inflation with a track record of several centuries has been gold. However I am not a big fan of investing in gold or commodities and would state the reasons when we talk about asset classes in detail.

Importance of Saving

One needs to save money for the following key reasons:

1. To support oneself during retirement when there is little/no income
2. To take care of big-ticket expense items like funding ones own or children's education
3. To take care of daily expenses of onself & dependends during unforseen events like job loss, death & disability

Investing provides for a way to grow the savings so one can take care of fairly large future expenses with a small amount of savings now. It is important to understand that this approach works mostly for items '1' & '2' above. For uncertain events like death & disability whose timing is never known in advance, a much better approach is to buy life & disability insurance. I have come across many smart people who underestimate the importance of a good insurance policy. One can buy a life insurance policy with daily premium less than the cost for a cup of coffee.

There are two more concepts: inflation & compounding that one needs to understand in the context of savings & investment. I will address these in the next post.

P.S. -> A cheap way to purchase life insurance policy in US is to buy it through your employer (if offered) or through online sites like quickquote.com or insure.com. I have found the brick & mortar insurance agents to be pushy & expensive plus they will also try to sell you other financial products. FYI, I don't receive any monetary incentives from these sites.

Blog Objective

My primary objective in creating this blog is to promote awareness of sound investing practices. Investing is a vast topic by itself and the plethora of easily available information (a.k.a. 'financial pornography') makes it even more difficult to navigate the trecherous investment landscape. This blog is mostly geared towards novice investors but intermediate level investors may also find it beneficial.

I would not be doling out stock tips or hyperventilating the overused quotations & investing methods preached by great investors like Warren Buffett, Benjamin Graham, Peter Lynch, etc. It is very easy for first-time investors to be allured by the stories of how these investing greats have managed to generate extra-ordinary returns by simply following common-sense investing practices. The subtext for most of these inspiring stories is that if you also follow these methods, your road to financial nirvana is assured. What these uplifting stories fail to emphasize are:

• It is incredibly hard to generate higher returns (i.e. > 1-2% than corresponding index returns) over a sufficiently long period of time (i.e. > 10+ years)


• The opportunity cost of generating market-beating returns: You may experience a much better payoff for your time by devoting more attention to your regular job, spending time with your family or pursuing some hobby


• Ironically even Mr. Buffett & Mr. Graham recommend Index funds for most investors but very few people talk about that

With this background, the primary focus of this blog would be to address the most pressing questions & concerns encountered by an average investor during his/her investing journey. So the emphasis would be on the proven & enduring concepts in the areas of Asset Allocation & Portfolio Management.

As in the case of eating, everyone knows that eating nutritious food is the right thing to do but very few people do it all the time so to satisfy that perennial desire of gambling & outsmarting other investors I will also discuss some active investing topics ocassionally to spice things up.