There are questions that a lot of investors ask without thinking, but the answers are still worth a lot of careful thought
01-Jun-2020 •Dhirendra Kumar
I'm beginning to become a little allergic to the word 'sector'. Over the last three weeks, I have participated in four long online Q&As about investing. In three of these, I was the person answering the questions and in one I was in the audience. In the last one, which I wrote about a week ago, the questions were being answered by the redoubtable Nassim Nicholas Taleb.
In all four interactions, someone asked the standard Indian equity investment question about sectors, "Which sectors will do well now?" The problem with this question is not that it can't be answered but that it should not be asked. Imagine someone who could see into the future perfectly and actually provided you with the correct answer. How would that help you in actually making a sensible investment over the coming months and years and then actually generating good returns from it?
It wouldn't, because you have to invest in companies and not in sectors. As long-time investors have all experienced, there are great companies in all but the worst of sectors and awful companies in sectors that are doing great. In fact, these exceptions are often true outliers by their very nature. That is to say, companies that are doing well in a sector that is down in the dumps are likely to be great wealth-generators while the opposite, badly run companies in good sectors will be great wealth destroyers. The deviation from the norm of the sector will prove to enhance the effect.
I'm not making any predictions here (that would be absolutely contrary to the spirit of this article) but do not be surprised if you see this being played out in sectors like travel and banking, where everyone thinks that the future is much more clearly mapped out than in many other sectors.
At the end of the day, equity investing is a bottom-up activity and not a top-down one. Mutual funds are the opposite but that's a discussion for another day, perhaps next week. You make money by being right about companies and their stocks. In sharp contrast, being right about industries, sectors, national economies and even the global economy is of only negligible advantage, if any. This makes almost the entire conversation about economies that is currently going on of questionable value from an investment perspective. I do not mean even for a moment that the question of economic revival is not important - it is of the greatest importance to our lives and jobs and businesses. However, asking that question does not help you as an investor.
In my last week's Q&A with investors on the Value Research YouTube channel, there was another question that looks facile but is worth a little bit of a dig. One person asked what would be the returns of large-cap, mid-cap and small-cap stocks over the next 25 to 30 years. At first sight, it's easy to dismiss such a question. I too started my answer by pointing out that I was not an astrologer. However, even though the returns are not predictable, there is a framework within which one can think of such a question. The starting point would obviously be the previous 30 years. During this time, the BSE Sensex is 37X of what it used to be, up from 800 points on June 1, 1990. Is there any basis of thinking that such a performance could be repeated?
I don't know and it doesn't matter actually. What does matter is how well equity does when compared to the inflation rate and to fixed income returns. During the quarter century past, there was a period when fixed income returns were enormously high - I remember a time when Government of India tax-free bonds had an interest rate of 11 per cent. We were a high-inflation, capital-starved economy where the numbers just kept ballooning anyway. This inflation rate and the fixed income return was a cushion under equity returns which made the numbers look large without that much real value being added.
In the quarter century to come I would be happy if we had an inflation rate of 2-3 percent and equity returns of 6-8 percent upwards. That may look niggardly in comparison to the past but would be quite a bonanza.