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Sunday, December 28, 2008

"Time in" vs. "Timing" the market

This is one of those investment debates that has been waged through the years, with no sign of a resolution in sight. With strong opinions on either side, it is quite likely that the controversy will endure for a long time.

The dilemma arises because of the way most experts and analysts define 'timing' - they mean selling out your equity portfolio completely at market tops, and buying the same portfolio back at market bottoms.

Common sense - which is not so common among the majority of investors - dictates that such a plan is doomed to failure. Why? Because consistently deciding when a market has reached a top or bottom over several economic and stock market cycles is pretty nigh impossible.

The stock market moves on its own logic, reflecting the collective sentiments of various market participants who have differing agenda. The hedge funds are in it for the short term (i.e. less than one year). Some of the Foreign Institutional Investors (FIIs) may invest for a longer term of 3-5 years. Pension funds tend to be real long term investors who stay in for 10 years or more.

As an individual investor it will be quite futile to try and outguess what these big boys are up to at any point of time. Chances are that they are better informed and have more research and financial resources. Therefore they can enter and leave the market in droves - driving up or smashing down prices before you can say 'Jack Robinson'.

Research has proven that those who stay invested for the long term perform much better than those who try to exit and enter the stock market frequently. No wonder most fund managers say that 'time in the market' is preferable to 'timing the market'.

While I can not disagree with such strong logic, backed by academic research, my investment experience has been otherwise. It arises from the basic definition of market timing.

For long term investment success it is imperative that you try and time the entry into and exit from individual stocks. But do not try to exit from your entire portfolio or try to buy the whole portfolio back.

If you've read my earlier post (Dec 1: Market cycles and Sectors), you will know that different sectors - and therefore, stocks from those sectors - get prominence depending on the state of the economic and market cycles.

Like now, when the Sensex is trying to find a bottom, FMCG stocks are hitting their 52 week highs whereas metal stocks are hitting their 52 week lows. So this is a good time to exit from FMCG stocks and enter metal stocks. (You don't have to sell your entire holding in a sector. Partial profit booking works pretty well.)

Now, experts and fund managers will tell you that FMCG is a good defensive sector to enter in a bear market and metals will face a lot of pain over the next couple of years. They will be quite correct from the short term view of the market. But a small investor with a long term outlook has to play contrarian. That is the only way to 'beat' the market.

While the 'time in' vs. 'timing' debate rages, my solution to the controversy is to replace the 'vs.' with 'and'; i.e. stay invested for the long term but time the entry into and exit from individual stocks.

In a future post, I will discuss about a technical indicator that helps lay investors to become master timers.

Sunday, December 21, 2008

Learn from my investment mistakes

When I look back on my track record of stock market investments over the past 20 plus years, I am amazed by the sheer number of downright idiotic mistakes that I have made.

Without trying to sound immodest, I consider myself of above-average intelligence. Most of my friends, and I dare say a few enemies, will probably corroborate that.

So how did I end up making so many mistakes in stock investing? And was I in a minority of one? Turns out that most amateur investors, and several professional and acknowledged experts, have made their share of similar mistakes.

Why do apparently intelligent and experienced people make ridiculous and stupid investing mistakes? The answer may lie in an area of study called 'behavioral finance', which studies the effect of human psychology on financial decision making.

Have you ever bought a share only to see its price going downwards? Or, decided not to buy a share (or bought only a small quantity) at a particular price, only to see the stock zoom up? This happens because the market has no idea - nor is it bothered - about your buy price. The market moves as per its own logic. But we tend to 'anchor' at a particular price.

If we buy at a higher price and the stock falls, our 'loss aversion' prevents us from selling it. Keeping a loss making stock in the portfolio does not seem like a real loss, whereas selling it would incur an actual cash loss. The way out is to have the discipline to stick to a 'stop loss' figure (it could be 5 or 10 or 25% below the buy price - depending on the stock's volatility and your risk tolerance), and sell as soon as the stop loss figure is hit.

What if the stock you buy starts zooming up, up and away (which usually happens in a bull market, but can also happen during sharp bear market rallies)? The smart investor's way is to keep moving the 'stop loss' figure upwards by the same percentage as the stock's price and ride the rally. During the next market dip, sell when the now much higher stop loss figure is reached.

One of the biggest mistake of all is to 'water the weeds and cut off the flowers'. This means selling off the good performing stocks too soon, and hanging on to the loss making stocks for long periods in the hope of a recovery.

This mistake is often compounded by another big mistake. That is over confidence in your stock picking skills. During bull markets, any stock that you touch seems to fly upwards and you start feeling that you are a genius at stock picking. When the market tanks, some of the high fliers - specially small and mid caps - lose as much as 80-90% of their peak value.

It is no wonder that Benjamin Graham in his 'The Intelligent Investor' has written: "The investor's chief problem - and even his worst enemy - is likely to be himself." (Haven't read Graham's book yet? Buy it tomorrow and then carefully read it, and then re-read it again and again.)

Sunday, December 14, 2008

Which sectors should you invest in?

In an earlier post ("Market Cycles and Sectors") on Dec 1, 2008 the sectors that receive prominence during different stages of the economic and stock market cycles were discussed.

Does that mean that you, as a small investor, should look at investing in all those sectors? Probably not.

Fund managers, who are under pressure to perform in the short term, have no alternative but to move in and out of sectors depending on the particular stage of the stock market. They also have access to company managements and better research resources and larger funds than small investors.

With considerably less funds and little or no research capabilities, small investors like you and me are better off choosing only a handful of sectors to invest in.

Some industries are in an environment that helps to create substantial competitive advantage. It is easier for the companies in such industries to make money.

Four sectors that I like - based on their competitive advantage and cash generation capabilities - are :-

1.  FMCG: Strong brands built up over the years create huge competitive advantage. Companies tend to be solidly profitable, debt free and generate a ton of cash (which is distributed to investors through generous dividends). The market leaders have been around for many years, so they are slow but steady performers.

This sector is practically recession proof and should form a significant part of a small investor's core portfolio. Companies to look at are HUL, ITC, Colgate, Nestle, Brittania, Dabur, Marico.

2.  Pharmaceuticals: Like FMCG, Pharma companies are recession proof, have strong brands, are hugely profitable and good dividend payers, and long term growth is assured because of the large population. MNC Pharma companies have access to better product pipeline from their overseas parents. Domestic Pharma companies profit from generics and contract research and manufacturing.

This sector should also receive pride of place in your portfolio. Companies to look at are Glaxo Pharma, Aventis, Sun Pharma, Lupin, Glenmark.

3.  Financial Services: Banks pay less interest to depositors and lend the money at higher interests. For current account holders, banks pay nothing at all. Many make more money by selling other financial products to their customer base - such as insurance, demat accounts, credit cards, mutual funds, home loans. Home loan companies tend to be highly profitable with long term growth assured.

Companies to look at are State Bank of India, Bank of India, HDFC Bank, Axis Bank, HDFC, LIC Housing Finance, Sundaram Finance.

4.  Media: Many companies have competitive advantage through regional language and regional market domination. This sector also tends to be recession proof.

The dynamics of the media business was covered in an earlier blog post on Sept. 8, 2008.

Are these the only sectors that an investor should look at? Obviously not. But this should be a good starting point in building a long term portfolio.

Future posts will cover other sectors and criteria for individual stock selection.

Monday, December 8, 2008

BeES in your bonnet?

After a steep fall and a short and sharp rally, the Sensex has been moving in a sideways consolidation phase for the past few weeks. At times like this, it becomes difficult for fundamental or technical analysis to provide clear indications of what is to follow next.

Reduction in the repo and reverse repo rates have probably been 'discounted' by the market already. The overhang of tensions following the Mumbai terror attack puts a spanner in the works of any quick recovery in the economy. And consolidation phases are notorious for doing exactly the opposite of what every one expects them to do.

Small investors have four choices.

For the adventurous who rely on their stock picking skills, this may be as good a time as any to start buying into frontline stocks at beaten down prices and build a good long term portfolio.

The less adventurous can select highly rated large cap diversified equity funds with good performance records over bull and bear cycles.

For conservative investors the above two choices may still seem risky because of the possibility of further downsides. Also, when the market does turn upwards (as it eventually will), there is no guarantee that the shares or funds selected will perform well.

Risk averse investors should then limit their choices to bank fixed deposits or index funds. Fixed deposits protect capital but are not tax efficient. At current interest rate of around 10%, the post-tax return at the highest tax bracket of 33% will provide a net return of 6.7% (which is lower than the current inflation rate).

Index mutual funds allow the investor to buy into a particular index - it could be the Sensex or Nifty. The underlying assets are the 30 Sensex or 50 Nifty stocks. There is no relying on a particular fund manager's skills or whims in stock selection. The returns will be almost the same as the Sensex or Nifty performance.

A good spin on an index fund is Benchmark Mutual Fund's Nifty BeES ETF (Exchange Traded Fund). An ETF is listed on a stock exchange and can be bought and sold at any time during the trading day through a broker by paying the Security Transactions Tax (STT). So for all intents and purposes, it is treated like a share. There are no separate entry/exit loads.

But while the underlying asset of a share is a single company, Nifty BeES' underlying asset is the entire Nifty 50 stock group. Which means that by buying a unit of Nifty BeES, whose NAV is 1/10th of the current Nifty level, you are effectively buying all 50 stocks that comprise the Nifty.

Why not just buy an index mutual fund? The major advantage of an ETF like Nifty BeES is being able to buy or sell any time during the day at the prevailing rate - whereas a mutual fund can only be bought or sold at the day's closing NAV value. During volatile trading days, this can be a real advantage.

The other unseen advantage, apart from there being no entry or exit loads, is that the fees charged by the fund is much less because an expert fund manager's stock picking skills are not required. So the disposable profits are higher.

If you are a risk averse investor with some spare cash, periodic investments in Nifty BeES can provide reasonable, if not spectacular, returns over the long term.

Monday, December 1, 2008

Market cycles and Sectors

The stock market rises and falls in a cyclical fashion that often 'leads' the economic cycle by several months. The signs of an economic down turn are quite visible now, but the stock market had started to 'discount' that fact back in Jan 08.

Now that we have been in a bear market phase for more than 10 months, many investors are struggling to understand what they should be looking for next.

Some who had purchased earlier when the market 'broke' Sensex levels of 12000 and 10000 are losing money and thinking about selling out at the next rise. Others may be resigned to the fact that they won't see any profits for several more months.

When all the fundamental and technical analysis still leaves common investors bewildered, a look at how different industry sectors have performed during previous market cycles may be enlightening.

The first signs of a stock market revival become visible when stocks from the financial sector like banks and NBFCs (Non-banking financial companies), retail and transportation sectors start to rise and consumer durables like home appliances, cars and trucks start showing improved sales. The economic story is nothing but bad news.

As the bull market begins to mature, and the economic cycle starts to improve, the sectors to watch will be technology, capital goods (like construction machinery) and construction materials (like cement and steel).

These will usually be followed by chemicals, paper, non-ferrous metals, petroleum - when the economy starts to gather momentum. Near the peak of the bull market, the real estate and energy sectors tend to dominate.

The FMCG and Healthcare sectors come to the forefront as the stock market begins its bear phase.  The economic cycle tends to be at or near its peak around this stage.

As the bear market matures, utilities and services sectors try to hold the fort. The economy is now well and truly in its downward cycle.

As the poet T. S. Eliot wrote in "Little Gidding":

What we call the beginning is often the end
And to make an end is to make a beginning.
The end is where we start from.