The ability of Mr. Market to contradict perception held by market participants, who themselves constitute it, continues to be a great mystery. Ever since the emergence of financial markets, this elusive trait of Mr. Market has continuously caught investors on the wrong foot and, in the process, cost them billions.

This has been made possible by the fact that crowd, which is much influenced by fear and greed, continues to make the same mistake again and again. Also, the fact that the brunt dealt by such blows to one generation is lost on the younger generation, does not help the cause.

As an investor, our goal is to try to ensure that we do not end up committing the same mistake. Following the advice of Santayana, who observed, ‘those who do not learn history are condemned to repeat it,’ let us reflect on what successful investors have done to deal with this problem.

Benjamin Graham answered it best when he said, ‘in the short run, stock market is a voting machines and in the long run, it is a weighing machine.’ There is much wisdom in this one stanza than in many a book on the subject of investing.

It is like you concede defeat to Mr. Market in the short run, yet emerge as a surprise winner in the long run. It requires a sound temperament to accomplish this task but it is well rewarded.

A natural consequence of this lesson is to not succumb to ‘timing the market’ syndrome and follow the ‘time in the market’ rule towards investing.

In a nutshell, ‘time in the market’ rule says that if you appreciate the fact that predicting market movements is not a rational course of action then it becomes much easier to stay invested for longer periods of time, which is the cornerstone on which wealth is created in the stock markets.

Any investor following this rule would have reaped the benefits of this rule immensely during the last few months as Mr. Market caught the investor community on the wrong foot once again. It will happen again but you need not worry much, if you can remain equanimous.

Let me end the write-up with Rothschild’s Law. The legend goes like this:

‘When asked if there was a technique for making money in the stock exchange, Nathan Rothschild said, ‘there certainly is. I never try to buy at the bottom and sell at the top.’

Children like stories and so do investors. The latest story, which has captured the imagination of investor community, is, ‘a stable government will unlock the growth potential of India.’

This story has, in part, restored investors’ faith, which was thrashed, when the ‘decoupled from developed nations’ story failed to stand up to their expectations.

What investor community doesn’t realize, however, is that just as children stories are fictitious; these stories can be fictitious, inspite of them sounding realistic. And, as a famous philosopher, once observed, ‘“we’re never so vulnerable than when we trust someone,’ investors’ end up being a vulnerable lot.

The behavior of investors, at large, can be likened to a balloon. The more inflated it is with optimism, the more vulnerable it is to blow up in the face of slightest trouble.

The historic rally, which we have witnessed during this week, highlights the tendency of investors to take a good story too far. Of course, it is a relief, more than anything else that we have a stable government after numerous elections resulting in hung parliament halting economic reforms.

But, as Benjamin Franklin observed, ‘he who pays in advance gets a penny worth for a nickel paid,’ investors, in their optimism, always seem to end up paying in advance (think, forward earnings estimate to justify the high valuations of stocks) and end up disappointed (as earnings fail to catch up with expectations and PE multiples collapse).

The SENSEX closed at 13,887 on May 22^nd, 2009. This discounts the earnings at19x. Given the cloud of uncertainty prevailing world over and dipping industrial production levels, such an earnings multiple seem to contain elements of irrational exuberance.

At PPFAS, we are not in the business of making market predictions and neither is this a prediction that markets are ripe for correction or over-valued. After all, there is a lot of wisdom in John Maynard Keynes’ advice, ‘markets can remain irrational for longer than you can remain solvent.’

The purpose of this article is to highlight the manic depressive behavior that market displays every now and then and how susceptible, in the process, it becomes to disappointment. And in markets, disappointments mean losing not only one’s hard-earned savings but also losing one’s sleep.

Let me end the article with an excellent quote from Benjamin Graham, which sums up the essence of the whole article succinctly and is, to some extent a reply to the ‘unlocking of growth potential of India’ story,

‘Obvious prospects for physical growth in a business do not translate into obvious profits for investors.’

Goldman Sachs posted better than expected results and the share price closed at $ 130.15. The warrants which Buffett purchased for Berkshire are again in the money and the 10% yield on the preferred stock looks heavenly.

Currently Goldman is clamouring to repay the TARP funds received from the US government in the past. Who wants to work under compensation restrictions after all? $ 500,000 (half a million) is hardly anything after all! However there seems to be a catch. The US government may not accept back the funds under the assumption that banks not paying back would be seen as weak.

Will Goldman pay off Berkshire instead? If it were to, Berkshire would make 15% on the preferred for around 6 month holding (including the 10% redemption premium). This would translate to a 30% annualised return. Plus Berkshire would have a free ride on $ 5 billion worth of Goldman stock at a price of $ 115 per share.

The rating agencies have got to be nuts to downgrade Berkshire.

There has been some noise lately about regulating hedge funds in the developed markets. Most hedge funds are structured as Limited Liability Partnerships (LLPs). People say that oversight of the central bank (Federal Reserve) and the securities regulator (SEC) is required as some of these hedge funds can cause “systemic risks”. 

By “systemic risks” I presume we are talking about

a) Banks and other institutions (like insurance companies) which raise money from retail depositors suffering losses, or

b) The securities market having large disruptions on account of the large volumes controlled by these hedge funds.

In India these issues have not arisen yet. We have recently passed an act allowing formation of limited liability partnership firms. It is possibly a few months before we start to see the formation of LLPs in India on account of registration and taxation issues.

Just because a few “enterprising” ex-fund managers / investment bankers get a few rich individuals to partner with them in a LLP Hedge Fund to play the markets does not mean that these will become systemic risks to the banking system in India. 

The necessary condition for sytemic risks is the lending of money by banks and financial institutions to these entities for making leveraged bets. In India, hedge funds (or individuals for that matter) have severe restrictions in accessing bank funds (against securities as collateral) or in accessing OTC foreign exchange derivative markets (run by banks) or accessing the repo market. In fact, any entity which is not a bank has very limited access to any market governed by RBI. Anybody having anything to do with the stock markets is a financial pariah for RBI. I do not think RBI will have too much problem with LLPs coming in.

My feeling is that SEBI and Forwards Markets Commission (FMC) however will have a tough time. In the race to increase volumes and profitability, stock exchanges have included all sorts of stocks in the Futures and Options segment of the equity markets. Margins are adequate on most days in a year but are found short on days of high volatility. “Black Swan” events are not considered and “Six Sigma” events occur pretty regularly . Currency futures are here and so are commodity futures. FMC currently prohibits “portfolio management” kind of services in the commodities segment. A LLP however would be dealing on its own account and hence technically would not be managing trades for anybody.

Hedge funds starved for funds from banking sources could go amok in the exchange traded markets on the derivatives side. Mutual Funds and Portfolio Managers have strict guidelines on what they can do and cannot do in derivatives. Leverage is prohibited. Hedge Funds would not have such restrictions.

What should be done is that unreasonable restrictions on market access (especially from RBI’s side) should be removed on portfolio managers and mutual funds and hedge funds should bear some restrictions in exchange traded markets. 

Do Mr. D. Subbarao, Mr. C.B. Bhave and Mr. B. C. Khatua need to look at this?

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I have been harassed by market timing clients lately. All of them want to invest in equities but they want to do it at the market bottom when the economy starts to revive. One of the clients was incredulous (20 to 25 days back) when I said that I was fully invested. He said “Come on don’t be ridiculous, everyone knows that the economy will be in a bad shape for some time to come and markets will come down”. Now he is in a dilemma. Markets have run up 25% and he has been selling all this while. His question now is should he sell more or should he buy so as to not miss out. I wish I had an answer.

Warren Buffett wrote the following in his 2008 letter to Berkshire shareholders.

“Neither Charlie Munger, my partner in running Berkshire, nor I can predict the winning and losing years in advance. (In our usual opinionated view, we don’t think anyone else can either.) We’re certain, for example, that the economy will be in shambles throughout 2009 – and, for that matter, probably well beyond – but that conclusion does not tell us whether the stock market will rise or fall.”

That got me to look at some past recessions (as usual, the US data is more readily available than Indian data). Here is a link to an excellent post on how long recessions have lasted and how markets have done in those recessions. 

http://seekingalpha.com/article/108810-how-long-will-the-recession-last-and-how-will-the-market-perform

In 8 out of the 14 recessions in the US a new bull market started well before the recession ended. 

Let us look at India and a financial crisis that India was facing in 1991. India had to sell 20 tonnes of gold in May 1991 and to pledge another 47 tonnes in July 1991 to raise foreign exchange to meet its import needs. (Please bear in mind that Dr. Manmohan Singh had not yet achieved the rock star status. There were questions regarding the survival of the government and of the country itself). So what did the stock markets do during this time? Crash? Hardly. The BSE Sensex rose from just under 1,000 on January 1, 1991 (999.26 to be precise) to 1275.23 on July 1, 1991, a gain of 27.5% !!!

This is not to say that we are definitely in a bull market or that share prices can only go up. If I could predict the weekly and monthly market movements, why would I work at all? I would be owning an island somewhere and chilling out, just buying when an upmove was about to begin and selling out when the downward trend was about to start.

As individual investors and as investment managers all that we can do is to select good businesses at attractive valuations to invest in and then let the businesses prosper over the long run. In the interim if Mr. Market overvalues those businesses significantly, we use the opportunity to sell. There is no exercise as futile as trying to predict the markets, economy or election outcomes.

(PS - BSE Sensex was at 1957.33 on January 1, 1992, an increase of more than 95% over the level of January 1, 1991. So much for predictability)

The financial year 2008-09 has come to a close. It is gratifying to see that sensible investing (that is sensible in our opinion) has come back into fashion. Investments in our Cognito PMS (Equity) declined in market price by 11% versus a more than 35% decline in BSE Sensex. This big outperformance in 2008-09 has come after a big underperformance in the go go days of 2007-08 where all sorts of thrashy stocks (thrashy in our opinion) were doing well. Net net, after giving the boom in thrash a miss and thus avoiding the brunt of the crash, we have been better off.

The only difficulty is that clients who left us in the go-go days, now have a very depleted asset base when they are starting to come back having lost a bulk of their savings elsewhere. Some clients came with statements of portfolio investments run by a reputed foreign bank where depletion was around 75%. These clients are now affected by a bout of what Hersh Shefrin calls Get-Evenitis. They want their portfolios to recover before they withdraw the funds and switch portfolio managers. Or as Peter Lynch puts it, cutting out the flowers and watering the weeds. Such is life.

From our point of view, we prefer to abide by the rule “I would rater lose half my clients than lose half of my client’s money”. Amen

Renewing my car insurance has been an amazing experience. Almost two months before the insurance was to expire, i got a renewal notice from my insurance company. There was a prompt follow up call saying that this was a special rate for early renewal. I smelt a rat as I had fallen for a similar trap at the time of the last renewal. I waited it out this time.

Soon other insurance companies started calling me up (how they got my number and the fact that my insurance was expiring is a mystery to me). The standard lure was lower premiums. When the lower quotes of other insurance companies were shown to the company which had issued the current policy, they promptly promised to match the lowest quote. When I finally paid the premium through an agent, I got a call from someone who claimed to be directly with the insurance company. He indicated that if the policy was renewed with him, even the insurance agents commission would be reduced from my renewal premium.

After all the negotiations and haggling, I still do not know whether I overpaid (meaning I could have got an even better deal). May be I should have left the haggling and negotiations to my mother………

Pricing apart, there are other factors at play here. Questions I have are:

1. Will the least expensive insurance companies pay claims honestly or will they try to wriggle out of commitments?
2. All the competition for my business (under the free pricing regime) was because I have had no claims experience for some time. How high will my premiums go if I have a claims experience?

The good thing about the new pricing regime is that private car owners are not subsidising cab drivers and truck owners in auto insurance.

On a similar note, the premiums charged by Life Insurance companies vary quite significantly across insurance companies. Being a fearful and conservative type of a guy, I would however stick with LIC or at best something like SBI Life where one can be sure of government backing. Life Insurance after all is a multi year contract unlike General Insurance which is a one year contract. One would not want to depend upon the US government capitalising AIG over many years for sure!!!