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Build your Own Pension Plan

You can stop working for money when your money works for you. Build wealth by trading systematically...

Warren Buffet said "buy the business, not the stock", to which Charlie Munger added the tailpiece "the best time to sell a stock is never". For ordinary savers and investors, it raised a dilemma: how do I know that I have taken the right decision, and that the stock or business I have bought is going to create enough wealth for me to retire on?

The answer to this question has set off many other trains of thought: some people advise diversification, but that sometimes adds to the risk of failure. What if you put Reliance Industries and Reliance Communications in the same portfolio; or Hindustan Lever with Hindustan Machine Tools?

Another piece of advice that pundits give you is, "systematic investing", i.e. the steady, continuous investing of fixed sums of money into a good, long-term performer through good markets and bad. This helps you buy low(er) than you would, if you just suddenly sat up and decided that you would plump all your money into the markets. This would normally happen in the middle of a bull market, leaving you stranded in (maybe) a good company at high valuations. This is the reason why most of us do not get our pensions from our equity portfolios.

Volatility is an asset
If you combine stock picking with systematic investing, you would need to understand fundamental analysis and add a bucketful of patience to add to that. In the previous generation, you might have bought HUL or Colgate without much research and done ok for your old age.

That kind of "fundamental analysis" won't get you very far in the 21st century. Even a Reliance Industries can go down 40 per cent, a Tata Steel 50 per cent and Reliance Communication 85 per cent over the last 5 years, spanning a bull market and 2 bear markets.

You would have to add a new skill to your arsenal, an understanding of Volatility and its math. Companies who cross their previous tops in the next bull market are now few and far between, and they always look horribly expensive (look at Nestle or Asian Paints). Sometimes when these blue chips go down, they can wipe out quite a lot of savings, and the earnings, if you have them, of quite a few good guesses in the equity market. Look at Aban Lloyd or Ranbaxy…

It becomes very important, therefore, to 'time' your average holding cost of a stock into the lower quartile of its long-term movement, and 'extract' a steady 25 per cent return thereafter. That would mean getting into a Reliance at 800, not 1600 and then getting Rs 200 per annum in the form of a yield.

And yet, it is not impossible to achieve such returns with a little bit of application and intelligence. Oh yes, the pundits will tell you that only the broker makes money if you trade; that is NOT true if you follow systematic trading:
* Pick up a stock which has been largely ignored by the market. This will be characterised by lower-than-average volumes, negative news coverage and a graph which looks a bouncing ball losing momentum.
To get an idea of what I am talking about, look at the charts of JP Associates, DLF, Aban Lloyd (P.S. I am NOT recommending these stocks, just pointing out what kind of charts to look for)
* Calculate the "intrinsic value" being imputed by the market, by looking at the most visited point in the chart. How you choose the period over which to view that chart, takes some intelligence and experience, but choose a period over which the company has largely "gone nowhere". For Tata Steel, this would be 2008-12 (after the Corus acquisition), for example
* Look at where the stock is, with reference to such an "intrinsic value". The reason why I am misusing this term from Classical Finance, is because I believe that over a long period of time, the market has absorbed and understood all information having a long-term implication on the valuation of the company
In case of Tata Steel and Tata Motors, you will see 2 diametrically opposite reactions to their acquisitions, with the market reaching different levels of "intrinsic value" for the respective companies
At this price point, you can calculate the discount to "intrinsic value". Ignore the stock for the time being, if it is quoting at a premium. Tata Steel, for example, is quoting at a 30 per cent discount to its historic book value, while it has traditionally quoted at a 30 per cent premium to book value. Even if we assume that the stock will take a long time to sort out its European operations, we can take its book value as "intrinsic value".
* Now look at the historic bottom (usually October 2008 or December 2011 on most charts of leading companies) and calculate the distance from the current price. For example, in case of Tata Steel, that would be 20 per cent (a recent historic bottom of Rs 320 against a current price of Rs 400). You have an Inventory Holding target price of Rs 320 now
* From here starts the math. You have your risk: reward equation now, a risk of Rs 80 and a target reward per annum of Rs 100 (25 per cent of Rs 400). Break up your investment into about 30-50 lots and try to capture the "average volatility" in the stock. A good rule of thumb is to try and churn (i.e. buy and sell, at a mildly varying profit) the same stock every day

Different stocks have different average (daily) volatility, but they all fluctuate around the Nifty's (long-term) average of 1.2 per cent. You have to try and maximise the number of turns every year; out of about 260 days, you would be doing well if you get about 210 churns every year. If your average inventory is, say, 30 such lost outstanding, you will get 0.3 per cent return on your portfolio every trading day.

This is where the power of compounding kicks in. 1 per cent compounded daily is not 365 per cent per annum, but 37 times your money by the time you are hitting the 365th trade. The smaller the compounding period, the larger is the impact.

But to get back to the logic of our Pension Plan. Let alone 0.3 per cent per day, if you get even 0.1 per cent per day over 240 trading days (both conservative assumptions), you are sitting on a 24 per cent annualised return, not counting the power of compounding. That is a very big cushion to your returns. The actual return, if you compound slowly, may come in at a multiple of the base 24 per cent...

What can go right for you? One, you might have picked up the stock in the lowest 20 per cent of its (long-term) range. That would mean that you can increase your lot sizes to 20, and trade them one at a time. Using the principles of Systematic Investing, your Average Holding Cost would anyway be in the bottom 10 per cent of the range. Two, you might have higher volatility than my prediction (which is anyway conservative). If you get in closer to the bottom, and have built up enough inventory over time, you will get much higher volatility as the stock rises in value. Three, there is a fixed risk: reward formula, that measures the amount of TIME it takes to bring down the risk to zero, provided you have stuck to the above mathematical constraints. A 20 per cent downside risk is neutralised with about 1 year of trading, while 30 per cent downside takes about 18 months. At this point, your entire holding has been traded down to an average cost which is at the bottom of the long-term chart, i.e. Tata Steel at 320 and Bharti at 250. Keep building up new positions and trading down in a disciplined manner, till the stock reaches a premium to its "intrinsic value" in the upper half of the chart. Then start "distributing' your holdings, using the proceeds to enter a stock which is going into discount territory. To understand this, see my previous column…Reversion to the Mean (March 31, 2012).

To the uninitiated, the math might be a little complex, but it is simple arithmetic after all. Cassandras might argue that a stock might have no bottom, and they are (theoretically) right. But this is not theory, just a very practical plan to get a market-beating return through simple, disciplined trading and regular, algorithmic closing of trades. If you get the major Operating parameters right, this is a 'riskless' strategy. Oh yes, Tata Steel or Infosys might go to zero, like Satyam at one time or Sterling Biotech recently; but the world almost ended on December 21...you still need plans if it didn't live up to its promise.