The Intelligent Investor – 5 – The Defensive Investor and Common Stocks

As we have seen to the previous articles of the same series that common stocks have the advantage to beat the inflation and given an income in the form of dividend and price appreciation. But we also have to keep in mind that common stocks become riskier if we bought it at a higher price. If we consider the period of the year 1929 then it has taken 25 years to break the market level of the year 1929. and we need to keep such a scenario in mind while making an investment decision. Such a scenario is more difficult and riskier compared to the bond investment. This scenario becomes difficult to survive if the focus does not have on the risk control.

The criterion for the selection of the stocks for the defensive investors are suggested by Mr. Graham

• Investors have made a diversification between 10-30 stocks of the portfolio
• Selected companies should be large, prominent, and conservatively financed.
• Long track record of dividend payment.
• Price multiple limits – multiple should not be higher than 25x of average earning of past seven years and multiple should not be higher than 20x of TTM earning. Such criterion removed growth stocks, popular stocks, etc.

Growth stocks to consider which has given a decent earning growth during the past period and also a similar growth will be sustained to the future also. As growth stocks have a long track record of the decent growth which will attract a speculative nature and increases a higher multiple. Such higher multiple can drop as earning growth fall, earning falls, etc. and that proves dangerous for the defensive investors.

One of the Air Cooler company of India

As we can see that the company has posted the lowest growth in March-18 since the year 2010 and due to the lowest growth, P/E multiple of the company has fallen from around 89x to 32x.

After the selection of the common stocks to our portfolio, we need to keep track of the particular common stocks for checking whether the improvement of the business, financial or not.

Mr. Graham has also appreciated the systematic investment plan for the index fund which can be helpful to investors for the 20+ years.

We have seen to the last article of the same series that allocation of the capital between common stocks and bond depends on the individual situations. When a person needs money to run his family with no further income sources then he must deploy 75% fund to the bond. Also, investors should allocate fund as per their knowledge, experience, and temperament which is a fortune creator to the investment field.

People get confused for the risk with the fluctuation in the price of the particular common stocks. But we should take value rather than consider a market price of the particular common stock. If value, quality of value is getting deteriorate then it is a real risk for us. And also, if we have paid an excessive price for the common stock, then that invite a loss to our wealth. We need to buy common stock at a price which provides further growth to the future.

If we make a thorough analysis and keep the focus on the safety of capital then deploying money to the common stocks becomes as easy as we put money to the bonds. But when people have lost their money during the crisis, they do not believe that common stock investment also can be safe & help us to create wealth.

Mr. Lynch has mentioned that we should buy common stock of those companies of which we are using a product or we understand the business. Also, he mentioned that though products of the company are successful and we all are using it, we need to study the financial statement of the company and estimating the value of the particular company. Majority of the people forget to do a later part and just put the focus on to the first part of the saying of Mr. Lynch.

One of the specialty foods with branded rice manufacturing company of India

A company having a good brand for its products but its major fund gets stuck into the inventories and for that company requires to bring a borrowing. There are many examples where good products do not have rewarded as a good investment. So, there will be no alternative for hard work and analyzing financial statements.

Disclosure – Companies mentioned in the article is just for an example & educational purpose. It is not a buy/sell/ hold recommendation. 

Read for more detail: The Intelligent Investor by Benjamin Graham, Jason Zweig

The Intelligent Investor – 4 – General Portfolio Policy: The Defensive Investor

It is prevailing to the market that if we take a low risk then our return will be comparatively lower and we get a higher return with higher the risk. But actually, it is not always true. When we acquire a bargain situation with the proper margin of safety then we have a higher probability to get a higher return with the lower or controlled risk.

Mr. Graham has explained “Active” or “Enterprising” investor and “Passive” or “Defensive” investor –

When we have time to spare, competitive thinking then we need to select the active investment strategy and when we cannot spare time on investment, do not keep on thinking about money then passive investment strategy is suitable for us. So that we have to select what works for us, which strategy is suitable to us rather what has worked in the market. If we cannot spend time researching the companies, what was going on to the business, etc then we should select a passive style of investing.

As we have seen in the review of the second chapter that defensive investors have an allocation to the bond as well as common stocks. And they makeshift from common stocks to the bond when they found a higher valuation of common stocks. As per Mr. Graham, If we have chosen to have a 50-50% allocation to the bond and the common stocks. So, at that time, if our stock allocation goes to 55% then sell off of additional 5% and transfer it to the bond and if common stocks allocation goes to 45% then bring 5% by selling off of bonds. This is one of the simple formulae for the defensive investor. Defensive investors have a strategy to fall less than the market during the worst time. And such a strategy can be helpful to them.

One of the other strategies is recommended by Mr. Graham –

Example

If we have a dividend of Rs.720, SENSEX at 36000 and bond yield is 7% then we need to allocate 75% to the bond and 25% to the common stocks because 2/3^rd of the 7% is 4.67% and we are currently getting a dividend yield of 2% on the SENSEX. Now, we need to wait for fall into the bond yield or reduction to the level of the SENSEX for increasing the allocation to the common stocks. It’s just a hypothetical example. The dividend yield in India has not reached at such a higher level, especially into the Index so that we can go for the earning yield.

*Red indicates exit and green indicate entry

As we see that Mr. Graham indicator suggesting overvaluation in the SENSEX. And for getting it fair value -1) Risk-free rate has to fall, or 2) Earning has to increase (At least by 10%) or 3) SENSEX has to fall (At least by 10%). Rate cuts have given a positive boost to the market but if earning will not pick up then the market has to fall. If anyone has invested 100% into debt fund in the red zone and invested 100% into the green zone then the person has earned ~15% CAGR compared to ~11% CAGR of SENSEX.

When investors select the lower quality of the bond then return on it will get increase compared to the high-grade bond. We need to focus on to the buying a bond at the discount for getting a higher yield on it but with the same level of quality.

Defensive investors also can deploy fund to the FD, liquid fund, bond, preference shares, convertibles, etc.

For the allocation to the bond and stocks by defensive investors, an old theory which was prevailing to the market was deducting age from 100 and remaining amount consider as a % to invest in the stocks. That is if age is 28 years then 72% (100-28) of the net-worth will be into the stocks. But age should not be a factor in considering the risk-taking ability of any person. If someone at the age of 80 also well settled and having a good fund for spending his life then he can take more allocation stock also and does not just have to deploy 20% (100-80) to the stocks.

It is also possible that 20 years old person saving money for his further education, marriage in future, house, etc. So, he may not be able to deploy 80% (100-20) to the stocks. Allocation to the common stock or the bond depends on everyone’s risk-taking ability. We should not generalize certain allocation percentage for everyone.

This is what happens to the market and keeps on repeating in the future also.

For allocating to the stocks and bond, we need to look at our life and situations where we require cash. We can ask a few questions to ourselves before making an allocation.

We need to allocate to the bond and stocks, after considering all the above point. But as Mr. Graham mentioned that we need to make a minimum allocation of 25% to the maximum 75% the bond. When we make an allocation decision, then we need to change that allocation only while our situation at life changes. Not when the market starts moving upward. If we need a constant fixed amount of cash-flow to spend for the household expenses, covering the cost of living then bond only provides those cash flow rather to common stocks. We only can put 100% to the stocks if we have enough money to support our spending, survived during a bear market, we can able to buy more stocks to the bear market, we do not need to sell stocks for survival, we can invest for at least 20 years.

Disclosure – Companies mentioned in the article is just for an example & educational purpose. It is not a buy/sell/ hold recommendation. 

Read for more detail: The Intelligent Investor by Benjamin Graham, Jason Zweig

Interest rate cuts: Does it provide long-term benefits?

When rate cuts happen, people think that the economy is weak so that it required a rate cut. The reduced rate provides stimulus to the economy which resulted in the stronger GDP, higher corporate profits and higher stock prices. This is the first-level thinking.

Rather second-level thinker thinks that –

• Why do rate cuts happen?
• The economy is weak or weakening?
• What damage can occur if rate cuts not happen?
• How much worse it is?
• Does this rate cut help to revive things?
• Shouldn’t we need to take rate cut as a worrisome scenario?

A very nice example quoted by Mr. Marks that when we visit a doctor for our weak health and then he works on healing us through higher treatment, should not this worrisome for us?

First level thinker takes it as this treatment heal us and we will get all right soon

Whereas second-level thinker take it as –

• how much worse it is that such high treatment is required? Or the situation is worsening highly?
• Does it resolve the issue?
• Is this treatment sufficient?

We need to think that the doctor has to bring a higher treatment that means simple treatment does not go to work for healing us. This means either issue is big enough or it is on the way to becoming bigger. So that when we have a bypass that means chest pain is not because of a gas problem but actually, we have a heart attack.

What can lead to growth at a lower interest rate?

• Lower cost of borrowing – lower interest on EMI – more savings leads to more spending on the consumer front and that resulted in the GDP growth
• Lower cost of borrowing – encourage businesses to make an investment – lower cost leads to more cash left with businesses to make further Capex – earning starts growing – more dividends or stock buyback enhance cash inflow to the investors – more spending – that increases GDP
• Consumer spending increases – demand increases – encourage businesses to invest – more employment opportunities – more wages – increase consumers spending – GDP increases

The most important thing is that when interest rates go down then we reduce discount rates also. So that lower discount rates resulted in the higher assets prices. And lower rates encourage investors to take more risk to earn more return in the low return world.

Rate cuts provide hints for future rate cuts. And the above cycle keeps repeating.

There are many situations where lower rates are undesirable –

Low rates increase the inflation (some inflation is required for the growth but excessive can kill) – too much inflation increases cost of living – it makes hard for people to spend more money – lower rates reduces the return on the cash, money market investments, high-grade bonds so that people make an investment into the risky products to earn more return – people take more leverage to make an investment – this creates an assets bubble & some point of time it will burst.

Due to the lower interest rates, we provide lower discount rates to the assets which have increased the price of the assets and when the bubble burst interest rate increases which creates huge damage to the prices of the assets.

This is like painkillers which cure pain for now but harmful to health over a longer period if we continue with taking painkillers frequently for immediate relief then it can destroy our health in the future. So, we need to be careful while taking a painkiller for curing pain at the time.

We need to focus that whether growth is natural or artificial stimulating growth. If growth is not natural then central bank and government have to take measures to boost growth. Such kind of growth does not survive for long without stimulation.

As current slowdown is not only cured through rate cuts but the government need to bring further measures which can provide long-term domestic growth without any temporary stimulation. Temporary stimulation brings future demand in the current period or till the stimulation remains in the force. After that demand starts getting dry up. Such a stimulus can be more harmful and lead to huge damage to the economy at whole.

Inspired from Howard Marks memo – “On the other hand”

 

The Intelligent Investor – 3 – A Century of Stock-Market History

We do not have data available for a century in the Indian stock market so that I have done a calculation with available data. All data are taken from BSE India and RBI site.

When we have seen a huge return into the past from the equities then it is not necessary to consider a similar kind of return into the future. Reality is that common stock prices related to the earnings and dividend from the particular companies or basket of companies. If the company fails to deliver earnings and dividend then it is obvious that the company will not deliver a similar return in the future.

This example shows that growth in earnings and dividend has an impact on the price of the companies and basket of companies (Indices). If earning/dividend growth contentiously falling or depressed during a time then prices of the securities also have an adverse impact. So that we can see that during the year range 2011-2019 or 2016-2019, SENSEX has increased more rapidly compared to the EPS growth. Now, either EPS to grow much rapidly or SENSEX has to fall. Or it can also happen that SENSEX can remain in the range till EPS growth does not match to the average return. For matching the average return, either EPS has to grow by 20-22% or SENSEX has to fall 22-25%. This study can provide a similar result with particular stocks.

When the difference between earning yield to bond yield and dividend yield to bond yield start getting lower than we can think that particular stock or basket of the stocks becoming overvalued. This is one of the effective indicators where we can see that when Earning yield / Bond yield has cross 0.67-0.70x then SENSEX has provided us an attractive investment opportunity and when Earning yield / Bond yield has gone below 0.67-0.70x then we need to decide to liquidate our position to the SENSEX in a phased manner.

The stock market does not become less risky just due to advancement to the prices of it. I have seen many people enter into the market or the particular stocks when the price of it starts increasing.

We have seen during the series of Mr. Howard Marks, The Most Important Things that if everyone thinks in the same way then that thinking getting discounted to the price and will not able to get similar kind of returns for the future.

Above mentioned parameter, we can check into the current scenario where real growth of the corporate earnings was not much and the stock market has performed due to the speculative growth. Everyone starts preferring equity as an asset class to invest due to the recent past return. Now, such a scenario is unfavorable for investors. Absent of earning growth does not attract higher valuation for a longer period.

Disclosure – Companies mentioned in the article is just for an example & educational purpose. It is not a buy/sell/ hold recommendation. 

Read for more detail: The Intelligent Investor by Benjamin Graham, Jason Zweig