How to build a portfolio

Jayant Pai |

Before jumping to build a portfolio of stocks impacted by the recent reforms, choose the ones which will benefit the most.

This article was published in Business Standard on September 23, 2012.

Three Fridays and three sets of good news – ECB President Mario Draghi’s promise to buy unlimited bonds, Ben Bernanke’s commitment to purchase mortgage backed securities worth $ 80 billion a month, along with diesel price hike by the Indian government and Mulayam Singh Yadav’s commitment that the UPA will not be destabilised soon – has brought the smile back on stock investors’ faces.

While the exultation is, no doubt, justified, this may also be a good time to dwell on how the impending changes may affect our investments going ahead.

While the hike in diesel prices and a reduction in the number of subsidised LPG cylinders may have invited the ire of consumers, it is expected to help equity investors in two ways:

Other things being equal, an impending reduction in the fiscal deficit will accord greater flexibility to the Reserve bank of India, who have so far, been lamenting that yawning deficit is acting as a big barrier to any further interest rate cut.

A cut in rates, apart from helping borrowers, also results in the lowering of the hurdle rate for investors in equity markets, by reducing the attractiveness of fixed income instruments.

Currently, the earnings yield for FY13E (calculated as 100/PE ratio) is around 6.50 per cent while the yield on one year fixed deposits is around 8.50 per cent. As rates taper off, this yield differential will reduce and PE ratios should expand even if earnings remain constant.

Also, an improvement in the country’s fiscal will reduce the threat of a credit rating downgrade. This in turn, will help corporates keep their overseas borrowing costs in check, which could percolate down to healthier earnings. The positive effect on the Indian Rupee also cannot be understated. It has already perked up nicely over the past few days. All-in-all, if all goes according to script, equity investors should be awakening to a new dawn and the golden age of high fixed income returns may be ending.

While all this sounds enticing, it would not be remiss if investors asked “What next?”. In other words, while the entire market will benefit, which stocks should they pick? Well, here are a few pointers for avid stock-pickers who want to build a reforms-oriented portfolio.

Don’t judge a book by its cover 

While the changes announced in certain sectors will contribute to their overall growth, it does not mean that all the listed companies therein will benefit equally.

For instance, the entry of foreigners (albeit through joint ventures with an Indian partner) could actually increase the competitive intensity in a low-margin sector like retail. Also, incumbents may not be attractive enough to be bought out. Besides, if a listed Indian player enters into a joint venture with a foreign entity, their focus in the listed entity may get diluted. Even if that does not happen, future expansions may happen through the unlisted entity.

In the case of aviation, while most of the current crop of listed companies are in dire need of resuscitation, foreign investors will only be deem them attractive once clarity emerges on operational fronts such as aviation turbine fuel pricing, sharing of airport infrastructure etc.

Also, while liberalising the FDI regime in a complex sector like pharmaceuticals is welcome, foreign companies who have bought out Indian promoters have not had a very good experience so far, as various issues have cropped up after their purchase. Even today, issues like compulsory licensing dog the sector. Hence, here too it may not make sense to blindly chase Indian pharma companies these scrips in the hope that they will sell out soon.

Read between the lines

There are some other reforms that have still not happened and does sound ‘marquee’ but which can have far-reaching implications.

One of them is the restructuring of the State Electricity Boards and the other pertains to the Land Acquisition Bill.

The former should not only assist several banks who have lent to these companies, but also inspire greater investor confidence in the power sector. Clarity on the latter will certainly help most of the large Indian corporate houses who are involved in infrastructure and extractive industries.

Even property developers may benefit. However, once again, invest only after assessing the beneficiaries and the approximate extent by which they will benefit.

If all this sounds too daunting, participating in the stock market through mutual funds is a good option. If choosing a good scheme is too laborious, an index fund may suffice.

A few learnings revisited on Teachers’ Day

Jayant Pai |

It is a truism to say that we never stop learning….One way of doing so is to learn from the hard knocks that life sometimes give us. Another is to listen and learn from people whom you respect.

Today, on Teachers’ Day, I look back at a few things that I have learnt outside the classroom.

 My Chairman, Mr. Parag Parikh (Whom I consider a treasure trove of wisdom) has taught me several things over the years. A few of them are :

 In life, you may come across shades of grey but that does not mean you deviate from the path of black & white…

 It means that there may be several times when you may be tempted to stray from the path of the straight & narrow, and console yourself that that certain ‘grey situations’ compelled you to do so. However, true accountability demands that if one does deviate one must take full ownership of that decision rather than take the cowardly way out and blame everyone else but yourself.

 Everyone has the same 24 hours in a day :

Hence do not make the excuse that you did not find the time to do something. A time management lesson condensed into one sentence….

 Do not neglect any of your faculties :

 All faculties viz. the physical, mental, and spiritual are important, Hence do not shower attention on one to the detriment of the others.

 Be equanimous :

 Neither joyous times nor depressing times are permanent. Hence cultivate the art of being equanimous.

 Apart from Mr. Parikh, others have also influenced me in subtle ways, either through their words or actions….

1. My aversion to borrowing and focus on prudent spending & investing is the result of lessons instilled in me by my father and grandfather. This has certainly saved me in an environment where instant gratification is all-pervasive.

2. It may be competitive out there but there is always room at the top

Noted consumer activist, Mr. M.R. Pai said this to me over two decades ago. While I am the last person to be bothered about the rat race, I always aim at excelling in my chosen domain of ‘Personal Finance’. Today, there are several people purporting to offer advice but the number of credible advisors are few and far-in-between. For me credibility is paramount, in my dealings with the media and with consumers. It is the only way one can stand apart from the crowd.

3. My CEO, Rajeev Thakkar’s balanced approach and his penchant for meticulousness is something I am striving for.

There are also publications like ‘The Economist’ and ‘Mutual Fund Insight’ which have shaped my opinions and ideas.

Finally, there is one statement attributed to Warren Buffett which has influenced me deeply viz. “The chains of habit are too light to be felt until they are too heavy to be broken”.

I hope you do not consider this write-up as an article in self-indulgence. There are a few points here which could benefit everyone.

Also, while several of these may seem elementary, today seemed to be a good day to revisit and reinforce them. 

Information overload?

Jayant Pai |

Don’t get confused. Create a reading list of your favourite newspaper, website, research house to take informed decisions

This article was published in Business Standard newspaper dated September 2, 2012

Buy ‘X’ share, sell ‘Y’. Stay invested in mutual funds… exit some schemes. Outlook for gold is good…sell gold…

Different channels, newspapers, websites, blogs, research reports… sure, there isn’t dearth of information. While business channels and magazines were anyways into an overdrive, many general news channels have also jumped into the fray. The worry: Much of that viewership is only for the daily stock market related programmes and not for other personal finance programmes. And even among personal finance programmes, many question sonly pertain to stocks, with other aspects (such as insurance and mutual funds) taking the back seat.

It is, therefore, surprising that despite our seemingly avid interest in the stock market, every day we hear that retail investors are exiting the market or stopping systematic plans and so on. In fact, the quantum of wealth actually invested in stocks is barely 4 per cent. Even mutual fund distributors have actually come down, and not gone up. Though many blame it on the entry load ban, the jury is still out.

Obviously, this overload of information and the so-called keenness to know about stocks and their future has not translated into much real money coming into the markets or for that matter, mutual funds. Why is this so? Some of the reasons could be:

Too many advisors but no accountability

This is paradoxical but true. Rather than increasing the number of investors, the rate of rise in the advisors hasn’t really helped them. Though there is no data to back this up, one can clearly see it from the absence from retail participation in the market.

Many complain that they are confused by diverse views. The fact is that it does not take much to be a stock market pundit. Spout a few words of jargon, pop-up on a couple of business channels and voila… you have a fan following. Follow this up with a website dedicated to proffering “advice” for a subscription fee and you are ready to go. However, when it comes to accountability for the advice, these people turn coy, blaming everything (even acts of God), except themselves when stocks do not perform the way they say they will. There is also no rating system of how many ‘hits’ or ‘flops’, these so-called advisors have.

But if any retail investor has burnt his/her fingers by putting their money on their advice, the financial loss is good enough to put them, perhaps, even their near and dear ones off. In other words, the absence of accountability hurts the overall sentiment towards stock markets very badly, as many stop investing after being saddled with a few dud recommendations.

Too much data but little explanation

Till recently, research agencies would criticise companies but not give a ‘sell’ because the banking or broking or other arms of the group would lose business. While much of that has changed because of overall bad market conditions, investors are often confused that even after reams of data pointing against a company, why seldom there is a ‘sell’ recommendation.

In other words, there is a “Tyranny of Choice” when it comes to market information. The ticker rules our lives (thankfully, we are spared on weekends), we are bombarded with statistics of all hues, be it the cash segment, F&O segment, institutional activity, quarterly results, etc. Unfortunately, just as a glass can hold only so much water, our brain ceases to process information beyond a point.

Feeding it with more makes it freeze into inaction. Many are in that state nowadays, overawed and overwhelmed by the deluge of information, but there is seldom concrete solution or recommendations.

Few can stomach volatility

We are spoilt. In the good old US-64 days, we were promised 18-20 per cent without any labour. Despite the realisation that the scheme had to be stopped because it promised too much without the fundamentals supporting it, we still want to live in those good old days.

Often people inquire with me as to which stock is a good investment. While I do not have an idea a day, I do name a few good stocks once in a while. However, after a few days or weeks when I ask them whether they have invested, most of them say they have not done so, because the market is too volatile right now and they are waiting for it to stabilise. Well, I often joke that markets are stable only over the weekend and that too because they are closed. Volatility is part and parcel of any market. If you cannot stomach it, you should not be inquiring about stocks in the first place. Also, the media, instead of assuaging the viewers actually feeds on such volatility and makes mountains out of molehills making remarks like “Market crash reduces investor wealth by thousands of crores”. Extreme statements like these, scare off several potential investors who are sitting on the fence.

I think the best way to deal with this situation is to cut ourselves off from the clutter. Mentally, we can create our own list of favourites such as one favourite TV channel, one favourite website, one favourite magazine, etc. and stick only to those. They usually talk about the same developments anyway. With regard to self-styled advisors, zero may be a good number… After all, often their guess is as as good as ours.

Also, it would help if we changed our mental model of investing from one of action to one of inaction. Every source mentioned above (stockbrokers included) want you to do something. The shorter your horizon the better for them as they generate more income off you. Well, frustrate them by holding on to good investments for long periods of time. Stop being the sacrificial lamb at the altar of their greed.

Finally, treat volatility as a good friend who actually helps you buy good stocks at reasonable prices during panics.

Dealing with behavioral biases

Parag Parikh
Human thought processes are an amalgam of experience, intuition and rationality. Our actions are usually based on the belief that we know what is good for us. However, many times those actions are based on impulses which may actually be detrimental to us in the long run. Also, since the feedback mechanism is often not instantaneous, we bear the consequences of our actions much later. By that time it may be too late to remedy the situation. This behavioral tendency is visible in every aspect of our lives be it education, health, money, relationships etc.

While academics steadfastly cling to the ephemeral notion of “Rational Man”, there is an irrefutable and growing body of evidence contradicting this. If humans were truly rational, then all of them would have behaved in a very similar manner. For instance, the traditional regimented route to success is : Finish your schooling, go to a “reputed” college, pursue a “safe” degree and get a “good’ job, which until recently meant either a doctor, engineer or lawyer.

However, over the years, an increasing number of students have chosen to go on the road less travelled and guided by their heart, have chosen off-beat courses such as wild-life photography, linguistics, etc. At the outset, virtually no one knows whether they will be successful or not. However, that does not deter them from putting in their best effort. My point is, even in a relatively unadventurous field such as formal education, many a time, the heart rules the head.

Coming back to the core subject of this article, whenever clients visit advisors, they expect us to solve all their financial problems and want us to assist them in attaining all their financial aspirations. However, I have observed that they display several cognitive and emotional behavioral biases while interacting with us. Here are a few of them:

Optimism Bias:
Many a time, clients visit us after they have experienced some kind of financial trouble. It could be related to debt burden, the tendency to over-spend, a job loss etc. At that point they are overly optimistic about our ability to provide quick-fix solutions and immediately get them back on track. Often they fail to comprehend that it takes a joint effort on the part of both, client and advisor, to emerge out of the rut.

Representative Bias:

Many times clients compare us to their family doctor and expect that we will provide them with the equivalent of tablets which will help them recover in a few days. While, it is true that there are some parallels between the two professions, we are more adept at providing solutions which will help you in the long-term rather than the short-term. In other words, feedback mechanisms are often not instant, in our case. On a lighter note, I think it would be better if they compared us with to dieticians rather than cosmetic surgeons.

Sunk Cost Fallacy:

Clients persist with products which are unsuitable for them, simply because they have paid for them. Investment oriented insurance policies are good examples. The policies that they currently own may provide a low life cover and may be opaque & difficult to understand, Yet they are reluctant to surrender them, despite us pointing out better options. This is because they have already paid the premium for the past few years. Consequently, they are unwilling to bear any surrender-related losses, even if rationally they should be agreeing with our contention that in the long run it would be costlier to continue with the policy.

Confirmation Bias:

Often, certain long-standing beliefs have already ossified in clients’ minds when they approach us and it is difficult to suggest something which is contrary to these. For instance, if we suggest increasing equity exposure to an avowed debt investor, he may diligently point out all recent instances when the equity market has crashed. At the same time, he will not accord any weightage to the stellar cumulative performance of the stockmarket over the past two decades or so.

In other words, he will cling on to examples which fortify his belief that stocks are risky and conveniently ignore the ones which disprove this belief. To such people I cite several examples of companies reneging on their debt obligations.

Bandwagon Effect:

Everyone is more bothered about what the others are investing in rather than researching which product suits them the most. For instance, over the past one year, when Fixed Maturity Plans (FMPs) were in vogue, many of our clients were keen on opting for one year FMPs merely because some acquaintance or the other had done so.

This included clients who needed to utilise the same money within the next six months and for whom the illiquidity of the FMP was a big negative. It took a monumental effort to make them jettison this idea and convince them to park their capital in short term debt funds.

While there are many more such biases, the moot point is that while dealing with humans (and especially on a touchy subject like their finances), advisors must treat irrationality as “par-for-the-course” and not be surprised at anything that confronts them. This is more art than science. That is where experienced advisors score over the rookies who merely go by what their courseware states.