Distress and time can be a value investor's best friends in the stock market
03-Jun-2010 •Research Desk
A colleague at the workplace once made a remark in passing that remains embedded in my mind after all these years because of its sheer acuity. "Every single accomplishment," she said, "calls for time and effort." When hunting for stocks, I am often reminded of this line.
At most times, the stocks of large-cap, well-known and thriving companies trade at high PEs. If you invest in them, the only way you can expect to make money is by hoping that momentum will drive their already-elevated valuations further up. If you have a "value" bent, you would be loath to go down that path. What's the alternative then? One way out is to make distress and time your allies in the stock market.
In times of distress, many otherwise highly valuable assets become available at large discounts. During the Second World War, a few bombs, fired by passing enemy ships, fell in Sydney. Alarmed, many Australians sold off their properties and moved further inland. Recent immigrants from Europe and England, who had lived through heavy bombing during the blitzkrieg, merrily bought these properties. This windfall laid the foundation of many of the big post-War fortunes in Australia.
How did steel magnate L. N. Mittal make his fortune? As Mohnish Pabrai, who runs the Pabrai Fund in the US points out in his book, The Dhandho Investor, Mittal used distress thrice over. He invested in steel mills that were in distress; in those times the entire steel industry was in distress; and often he made these investments in highly distressed geographies (the erstwhile Soviet republics, eastern Europe, and so on). After buying these mills at throwaway prices, he employed his considerable expertise to turn them around.
We may have come a way long way since our ancestors lived in caves, but many atavistic instincts remain alive within us. When the lion roars, i.e., a piece of misfortune befalls us, our instinctive response is to run. Pausing for a while to evaluate the seriousness of the threat doesn't come easily to most. Not surprisingly, those few who are able to keep their wits and review the situation calmly tend to have a better investment record than the majority.
Another approach that would serve us well in troubles situations would be to ask: will time remedy this problem?
Take a few examples from the current market. Today many cement stocks are trading at attractive valuations. The consensus view is: overcapacity in the sector will affect the pricing power, and hence the margins, of cement producers. Which then begs the question: in an economy where the government intends to double the outlay on infrastructure from around $500 billion (in the 11th five-year plan) to $1 trillion (in the 12th five-year plan), how long will this overcapacity last?
Stocks of many public-sector banks are also in the doghouse today. The reason: many have large holdings of government paper, and as interest rates rise, they will incur large mark-to-market losses on them. Again, the question to ask is: how long will the current upsurge in interest rates last? And what will happen when interest rates turn downward again?
Within the telecom industry, a bruising price war has driven valuations of even market leaders to low levels. But the price wars are likely to be followed by a phase of consolidation. And those left standing at the end of this battle will regain pricing power.
My hunch is that the majority of stock market participants have an investment horizon of one year or less. By adopting a longer investment horizon of, say, three to five years, you will greatly improve your odds of success in the markets.
Are you a Red or a Pink?
Should you follow a strict or only a mild form of asset allocation?
As Indian equity markets head into expensive territory, the glib advice you get everywhere is: sell equities and rebalance your portfolio. But when you speak to actual practitioners within the financial planning industry you find that not everyone is equally sold on the idea of asset allocation. For ease of reference, let us refer to the ardent believers in asset allocation as the Reds, and those who believe in only a mild form of asset allocation as the Pinks.
In support of their strong belief in the virtues of asset allocation, the Reds cite a 1986 study done in the US by Brinson, Hood and Beebower, which claimed that 90 per cent of returns from an investment portfolio can be attributed to asset allocation, and only 10 per cent to factors such as choice of right instruments, or right timing of entry and exit from investments. If your financial planner is a Red, he will readjust your portfolio frequently - every six, or perhaps every three, months.
The Pinks, as said earlier, practise only a mild version of asset allocation. They will not readjust the portfolio every three or six months, but (in some cases) after as long as three years. And in checking whether there has been a deviation from the original asset allocation, they do not use the current value of the portfolio but the average of the values of the portfolio at the end of the past 36 months. Only if the average value shows a significant deviation from the original allocation will they sell equities. And even when they rebalance their portfolio, they prefer to do so by putting new money into debt rather than by selling equities.
To bolster the case for strict adherence to asset allocation, the Reds argue: the whole purpose of asset allocation is to collect your gains from equities and salt them away in safe debt instruments where they cannot be lost again to the markets.
The Pinks view matters differently. Their counter-argument runs as follows: don't get carried away by the value of the portfolio that you see today. Much of what you see there is fluff: here today and lost tomorrow. Only if the long-term average value of your portfolio has moved up should you believe that you have made gains from the markets. And only then is there a need to readjust the portfolio. Further, they argue: significant gains from equities accrue only over the long term; and equities are the best-performing asset class over the long-term. If you get out of them, where do you put the money that has been set aside for long-term wealth building?
Not being dogmatic about either of these positions, our support is entirely with what serves the cause of pragmatism. We suggest that the approach you choose should be dictated entirely by your investment horizon. In a shorter-term portfolio, collect your gains from the equity markets and invest them in the safe haven of debt, as the Reds advocate. But if your goal is many years away (so you have the time to recoup your losses), giving a freer rein to the bulls, as the Pinks suggest, is likely to augment your long-term returns.
The author is the Managing Editor of Wealth Insight
