EQUITY / STOCK MARKET INVESTMENT:
Mr. Gerard Colaco: The world’s best experts on investment are unanimous in their opinion that equity is the best avenue of investment ever invented for long-term growth. The problem is equity can also be used for speculation. When you see or hear of your friends, co-workers or acquaintances strenuously doing day trading, margin trading, etc., understand that these people are speculating and perverting this magnificent avenue of investment into an avenue of gambling.
You can invest in the stock market in two ways.
DIRECT EQUITY / EQUITY INVESTMENT MODEL.
To invest in direct equity, you need to open a trading and demat account with a stock broker. The second way of investing in equity is through mutual funds.
Our paper entitled “A Guide to Equity Investment“ describes how a normal investor can invest effectively in the stock market by buying and holding a diversified portfolio of blue chip stocks over a minimum period of 5 years. If you have not done so already, it would be advisable to read these two papers before continuing.
In 1988, we came out with a simple model for equity investment that any common investor could follow. It was based mainly on the classic “The Intelligent Investor” by Benjamin Graham, which is the only book on the stock market worth reading. Benjamin Graham was the teacher of Warren Buffett, who went on to become the world’s most famous and successful stock market investor.
We attempt to give you a few other insights. These insights are worth having even if you do not immediately invest in either the stock market or equity mutual funds. Our model consists of six simple rules and one recommendation. Let us take the rules one by one.
The first two rules speak about the most important investment technique ever invented, and that is diversification. We have tried to improve the quality of diversification by looking at it both from the point of view of industry sectors as well as companies. The stock market is not some magical place where stock prices keep fluctuating, often violently, of their own accord. The stock market is nothing but a reflection of the economy of a country. It factors in both current economic performance as well as future expectations of what is going to happen in the economy.
That is why no one can call himself a stock market investor unless he invests in the economy of the country. That is why, the world’s best investment advisers always recommend that you “buy the market.” This is another way of saying “buy the economy,” as the entire market consists of companies from almost all worthwhile sectors of the economy.
In the US, there are total stock market index mutual funds which buy and hold all the stocks listed and traded on the stock market, in the ratio of their market capitalization. A low-cost, total stock market index fund would be the best way for a normal investor to invest in the stock market. In India however, such broad-based index funds do not exist. Therefore, we looked at the Indian economy and found that productive activity in the economy is generated by 3 major segments: agriculture, manufacturing industry and services. Today, services contribute approximately 55% to the GDP. Manufacturing contributes approximately 27%. Agriculture contributes approximately 18%.
Translating this to stock market investment would mean that care should be taken to select stocks of companies present in all these 3 major segments. What we have attempted to do, is to take a sample of major companies from major sectors and build a portfolio spread across something like 60 to 70 companies and 20 to 25 sectors drawn from agriculture, manufacturing and services. We are also great believers in the concept of “economic impact”. We will explain this concept with 3 examples.
Example 1: Around the year 2000, there was an all-India craze for shrimp farming, which was also called aquaculture. A number of farmers converted their paddy fields into shallow lakes where they did prawn farming. The Supreme Court then passed a judgment that such farms had an adverse impact on the environment and should therefore be shut down. Overnight, the farms had to shut down. Thousands of entrepreneurs lost their money. Tens of thousands of workers lost their employment. There were hardly any protests, and aquaculture disappeared almost without a trace.
Example 2: In 2001-2002, there were numerous leather tanning industries in and around Calcutta in West Bengal. In another judgment, the Supreme Court laid down that the chemicals from these leather tanneries were polluting certain rivers. The tanneries closed down, thousands of entrepreneurs lost their money, and tens of thousands of workers lost their jobs. Despite all this taking place in the Communist ruled state of West Bengal, this industry disappeared without a whimper.
Example 3: At more or less the same time, the same Supreme Court of India passed another judgment sharply raising the vehicle emission control standards in India and giving manufacturers very little time to comply with the new requirements. The profits of all vehicle manufacturers were hit badly. The automobile companies could convince the finance minister just how much revenue in terms of excise duties, sales tax and corporate income-tax the government would lose, if major auto companies like Tata Motors, Mahindra & Mahindra, Maruti Udyog, Bajaj Auto and Hero Honda, ran into serious trouble.
When the failure of a major company or industrial group can have an impact on the revenue generation by the government and when this impact will be felt in the GDP growth of the country, it is called economic impact. The auto sector had economic impact. The prawn farmers and leather tanners did not have it. The government immediately amended certain laws, and gave more time for the Indian automobile sector to introduce emission controls in a phased manner, thereby circumventing the judgment of the Supreme Court. Once you have chosen the top sectors and the top companies, then as per the third rule of our model, spread your investments equally across companies arranged in these sectors, without attempting to predict which sectors and companies will do well and which won’t, in the future. Such predictions have repeatedly proved themselves to be thoroughly useless.
The fourth and fifth rules of our equity investment model do not need much explanation since they are very simple to understand. It is good to reinvest dividends. It is also good to review your investments once in a way. However, additional purchases need to be done only if there is a drop of 25% or more in the index from the day you started your initial investment, or from the last market peak. The portfolio need not be churned frequently and repeatedly.
The sixth rule is extremely important. It speaks of the time horizon. A time horizon is a time element attached to each avenue of investment, which if adhered to, eliminates risks and delivers optimum returns. Time horizons are not dreamed up by us. They are based on the average time it takes for a boom and recession cycle to be completed in the stock market. Thus, time horizons are arrived at, by studying the time taken for boom-recession cycles throughout stock market history.
The stock markets are slightly over 400 years old, having started in Amsterdam, Holland, in the very early 1600s. The remarkable thing is that across countries and centuries, the average time taken for a boom and recession in the stock market has been 5 years. True, there have been times when either a boom or recession may have lasted longer than the average of five years, but the average works most of the time.
The concept of time horizons is not confined only to investments. To give you an example from agriculture, a farmer growing paddy can expect to harvest his crop after 6 to 7 months of sowing. However, if the same farmer plants mango saplings, he cannot argue that now also he must get yield in 6 to 7 months, just because paddy gave him yield in that period! Even the best varieties of mango saplings will give meaningful yields only after five years or so.
Similarly, the best variety of coconut trees will give meaningful yield only in 8 to 10 years. In real estate investments in India, the time horizon is 10 years. For equity, worldwide, the time horizon is 5 years. What this means is, money that I put into equity should be money I can afford to block for a minimum of 5 years. Similarly, money that I put into real estate should be money I can afford to block for at least 10 years. If not, I may be forced to sell in distress.
A time horizon is however, not a jail sentence. If by some chance you make a lot of money in the stock market, in 2 or 3 years, and you are satisfied with the results, nothing prevents you from booking profits. If however, things go wrong, you can expect safety and returns over the time horizon.
Finally, let us come to the one recommendation we always make for equity as well as equity mutual funds. That is, systematic investment. This simply consists of deciding about a fixed amount you are going to invest in the stock market every month and then sticking to your monthly investment programme, for a period of at least five years. The concept of systematic investment is very closely related to the risk management tool of diversification. Systematic or recurring investment is nothing but diversification across time.