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.