Taking a Boring Route to Successful Investment

Most of us have a primary source of income, out of which we save some portion for emergencies as well as future needs. A part of that savings meant for future use is successfully invested in various instruments to make money grow to meet medium to long term needs.

Future growth can come in the form of earnings through interest or though capital appreciation. Equities or stocks provide income in the form of dividends or price appreciation. However, equities are generally high-risk instruments where returns are unpredictable and can lead to loss of returns or loss of principal or both.

How can one maintain a balance between risk and return? How can one build wealth or earn consistently and keep a control over risks or losses? These are the challenges that we will try to discuss here.

The Mirage Effect

Risk and return go hand in hand in most cases, which even the layman on the street today knows. But when you find that some asset is giving very high returns and looks too attractive, we try to choose it over others.

For example: Many people in the recent past (September 2011) bought gold when it was hovering above Rs.28,000 per 10 grams. They invested either in coins, bars or ETFs (Exchange Traded Funds). This was driven by the fact that Gold surpassed Rs.24,000 mark in the recent past and in a couple of months or so it has been moving up by a few thousand rupees.

Since festival season was emerging in September a lot of people bought gold for two reasons – some felt that it will touch Rs.30,000 more when profits can be booked. A few people who needed physical gold bought early so that they need not worry about purchasing at higher prices if gold prices go up in future.

One must remember the typical disclaimer that all successful  investment companies quote – “Past performance is not an indicator of future performance”. Remember that no asset class can be immune from economic and business cycles – so any asset (a stock, commodity, index, etc), which appreciates continuously for several months will definitely reverse its trend at some point.

Deciding to invest in something that performed very well in the recent past can be dangerous unless you have seen some correction or reversal. The above story of gold clearly shows this trend. However, when gold dipped to slightly over Rs.25,000 levels recently it looks like a good price point to initiate some buying.

Passive Long Term Investing Philosophy

There are two ways of investing active and passive. Active investing involves a strategy where an investor tries to pick stocks or sector that will outperform the market or benchmark. On the other hand passive investor tries to use an index strategy by investing in index funds or ETFs to replicate the returns of the index.

So the strategies that I would recommend for investing in equities in the current market include:-

1. Passive Index Investing Strategy
2. Passive Portfolio Holding

In both cases above we are talking about equities only. In addition to the above Gold ETF can be used to provide a hedge and safe haven touch to the portfolio.

Passive Index Investing Strategy

The index investing strategy I would recommend is a simple Nifty investing strategy. There are two ways to do this – one is via index funds and the other is via index ETFs. My vote goes for index ETFs which are easier to buy and sell in smaller units, have low expense ratios and come with lower transaction charges.

The concept is very simple. For example lets us say the Nifty index is around 4,700 level. Lets say the most popular Nifty ETF, which is Nifty Bees (now called Goldman Sachs Bees) trades around Rs.478 per unit.

Assume Mr.Chintamani, a small investor who lost money in 2008 market crash has been very nervous about markets, but at the same time he tempted to try because he has seen growth and profits in Indian markets in the last 3 years.

He does not have a huge income to build a portfolio of stocks or funds, so where does he start ? The simplest way to start is to buy a Nifty ETF (say GS Nifty Bees) by investing Rs.478 per unit.

What ‘s the benefit? By investing less than Rs.500 Mr. Chintamani is able to have a portfolio of Nifty 50 stocks, which even the top wealth managers cannot offer.

Even a customized portfolio cannot match the safety , returns, liquidity and performance of Nifty 50. Past statistics show that very few mutual funds outperformed the Nifty/Sensex, so why not invest in the index itself, which provides reasonable returns?

For this strategy you need to invest in the following

• One Nifty ETF (Equity) &
• One Gold ETF (Gold)

The only additional effort involved is to allocate your investment across equity and gold. The gold portion can go up to 30% depending on the requirement of the investor and his financial goals.

Strategy

When markets are in bullish phase, the investor can gradually book profits. A good example can be seen in the index level of 6,100 in early part of January 2011. Some profits could have been booked at 6,000 or 6,100 levels. This will make sure that some part of profits are realized and remain intact.

Similarly, when Gold prices are over heated some profits can be booked partially. The amount realized on sale of equity can be put in gold if gold is available at attractive prices else one can wait for further correction to re-enter equities. This strategy of sell on tops and buying at attractive levels can be executed gradually over a long period of time.

Investing in ETF can be pretty boring and mundane. But it’s the smartest move because you don’t have to worry about stock selection, allocation of investments in stocks, sectors, etc. Dealing with non-performing stocks or laggards and picking new stocks is also time consuming affair and can add up your transaction costs.

Instead picking up a couple of ETFs (one Nifty and one Gold ETF) would give you a single asset which grows overtime giving you peace of mind.

Passive Portfolio Holding Strategy

This strategy involves choosing a good mix of index stocks to form a solid, robust and safe portfolio which will also provide sizable returns over a medium to long term.

Although this strategy involves sizable investment, the current market offers lot of opportunities for picking up blue chip companies at attractive prices, which may not last forever. Its like a limited seasonal discount offer which may not last long.

However, this strategy requires one to pick stocks intelligently and to have a lot of patience to wait for atleast one year for significant results.

A stock selected should meet the following criteria

• It should be a part of a large group with solid reputation and valuable brands which have the potential to boost future earnings.
• Debt/Equity must be low. Companies in high debt are now facing a tough time, but those with reasonable or low leverage will come out of this tough phase to emerge as winners
• Cash rich firms which have their own treasury chest to deploy would be able to invest in new projects, acquire companies or expand to new markets, launch products, etc. Although the markets are in a bad mood doing these in bad times will also mean lower costs and opportunity to get cheaper deals at bargain values
• Cash rich firms will also pay dividends during tough years
• Where promoter holding is 25% or less. In other words the company should be widely held by public and institutions and have professional management in place.

The world’s most admired investor Warren Buffet recommends that one has to invest in a stock for perpetuity or forever. So the criteria above would mean choosing stocks which you like to own life long and which have the potential to provide consistent over long periods.

However, unlike the market gurus we are not adept at identifying bargain stocks which will become tomorrow’s multibaggers. Instead we should try to choose large well known names that will survive the test of time and provide consistent earnings as well as capital appreciation.

Some of the metrics you can evaluate would include EPS growth, Return on Capital Employed, Return on Net Worth, Debt-Equity and others. A consistent dividend track record would be another positive factor to look out for.

People who find the ETF route too boring can use the Passive Portfolio Holding route, but this may not give you kicker returns. Why? Because most of the stocks are safe large cap names with high safety factor. However, a year later you may not be able to buy the same stock at the same price because it might turn more expensive.

Also unlike penny stocks, mid caps, etc these are never cheap. Though they are expensive they bring in a lot of safety, and current market downtrend and bearish sentiment is providing a golden opportunity to pick up some of the best names at attractive levels.

Most analysts would argue that these are not attractive since more downside is yet to come, however one can gradually pick a few instead of waiting for an absolute bottom.

Conclusion – Successful Investment

No strategy is 100% fool-proof, so investing some portion in Gold or fixed income instruments can provide you some insulation in case the market conditions turn unfavorable. A mirage is known to be misleading. In hindsight the recent market turmoil is also a kind of mirage which will not last forever.

But if problems persist one can also take exposure to Gold or fixed income for safety. If history were to repeat itself (as in case of 2008 crisis) it will not be surprising to see 2012 becoming a good year for most markets across the world. Start investing today to reap good returns in 2012.