Thoughts

"Happiness is a choice that requires effort at times."

Driven by ‘hot state’

B. Venkatesh

Last week, I was down with severe stomach infection. When I was lying on the bed in pain, I decided that I will henceforth stop eating the greasy potato chips, the creamy cakes and the like. Two days later, when I got better and walked into the kitchen, I unconsciously (or so I think) grabbed the jar of chips not to mention the desperate search for some cake in the refrigerator. It was personally upsetting to know that I did not learn much from the pain that I suffered just two days earlier. But it seems we all behave that way.

Why?In a cold state

Behavioural economists call this the hot-cold empathy gap. When I was in pain, I swore to myself that I will no longer eat junk food. Or stuff my stomach with lot more than it can bear. I was then in a cold state — a state when there is literally no craving for such food. But after I got better, I occasionally switched to the “hot state” and started demanding sinful food. In that state, I did not really care about the consequences of eating such food.

My inability to realise when I was in a “cold state” as to how I will behave in a “hot state” is what is called as the hot-cold empathy gap. George Loewenstein, a behavioural economist, coined the term after conducted several experiments in this area.

The empathy gap

The hot-cold empathy gap exists because we tend to exaggerate our willpower. Suppose you and your friend decide to visit a closing sale at a mall. In her “cold state”, your friend tells you that she does not intend buying any clothes. She, however, splurges as her “hot state” arouses her desire after she enters the shop.

Her behaviour may seem irrational to you. But remember, it could have well been you in a “hot state”, indulging on clothes instead of your friend. We all succumb to some vices — buying clothes, eating junk food or smoking, for instance.

(The author is a self-styled investment psychologist. He can be reached at enhancek@gmail.com)

Sourced from : http://www.thehindubusinessline.com/

Thoughts

"If you fill your heart with regrets of yesterday and the worries of tomorrow,
you have no today to be thankful for."

Choice irrationality

B. Venkatesh

Consider this. My friend earns Rs 1.5 lakh per month with a total annual income of Rs 20 lakh including other benefits. One of his company’s clients wants him to work at their office in Europe for four months. He has been promised an income of Rs 10 lakh in lieu of his existing salary. Should he grab the offer? My friend passed it off. Why? Based on his current salary, he will earn Rs 6 lakh in four months. He has been offered Rs 10 lakh, two-thirds more than his current earnings. Classical economics tells us that he should accept the offer, as it increases his total wealth.

So, why then did he reject the offer? Classical economics assumes that all human beings are rational. That is, given a chance, all of us will strive to maximise our well-being. But that is not true in the behavioural world.

Against principle of fairness

Here is how my friend evaluated the proposal. A person of his skill-set can earn Rs 15 lakh for a four-month period in that country. The company offered him 50 per cent less. That went against the principle of fairness. So, he rejected the offer. Classical economists may scoff at his decision. Behavioural psychologists term this behaviour “choice irrationality”.

The same principle works elsewhere too — in factory strikes and job appraisals. Suppose your annual appraisal has just finished and you expect an increment of Rs 25,000. Your boss in a surprisingly generous mood gives you Rs 40,000. You are obviously ecstatic, till you find out that your colleague received Rs 60,000! How will you react? At the extreme, you may quit your job and join another company, perhaps, for a lower salary. Why? You feel that your boss was unfair in paying you less. Your “irrational” choice leaves you worse off. But that is a price you pay to deal with the unfair treatment.

“Choice irrationality” then shows that my friend’s reaction was normal indeed. Would you have reacted the same way?

(The author is a self-styled investment psychologist. He can be reached at enhancek@gmail.com)

Sourced from: http://www.thehindubusinessline.com/

Thoughts

"Silent gratitude isn't much use to anyone."

Why higher equity allocation is optimal for long-term investors?

B. Venkatesh

Many investors have carried their exposure to stocks through 2008 in the hope that these stocks would generate positive returns if they hold on longer.

If their hopes have indeed come true, there is a lesson for long-term investors: construct portfolios with higher equity allocation.

But are stocks less risky over the long term?

This article explains time diversification — the notion that the risk of stocks declines as time horizon increases.

It discusses why experts are still divided on the subject. It then suggests why it is optimal for investors to carry higher equity allocation without engaging in time diversification.

Long-term investment is typically an after-thought. Or to be precise, it is usually a short-term investment that has turned wrong!

But does extending the time horizon help? Jeremy Siegel in his book “Stocks for the long run” states that stocks produced positive real returns in excess of both bonds and Treasury bills over longer time horizons.

Intuitively then, extending time horizon makes sense. Suppose a portfolio was set-up in October 2003 with the objective of doubling capital in five years. The portfolio would have fallen short by seven percentage points in October 2008. Extending the investment horizon by a year would have served the objective.

Suppose the portfolio was instead set-up with a strict five-year time horizon. Some experts argue that the terminal wealth then becomes important. That is, an investor should not be bothered about yearly volatility in asset prices as much as the holding-period volatility.

But that may not be true. Suppose the average yearly volatility over five years is 20 per cent while the five-year holding-period volatility is only 7.5 per cent. An investor has to first endure five one-year periods to realise the five-year holding period.

And that could be painful for many. This is one of the reasons critics argue that extending time horizon does not reduce risk.

So, the question remains: Should investors with longer time horizon have higher equity allocations?

Behavioural investing

Suppose an investor wanting to buy a house in five years time constructs a portfolio today with a higher equity allocation.

The investor will regret the decision if equity prices decline at the horizon. Importantly, the investor has to then settle for a smaller house if the portfolio does not generate enough to buy the desired real estate. Extending time horizon in this case moderates the regret.

If equity prices, however, climb up sharply within five years, the investor experiences pride of making gainful allocation, not to mention the joy of buying a larger real estate.

A discerning investor, therefore, wants to balance pride and regret. Making higher equity allocation, hence, assumes importance.

But can investors take higher equity exposure without engaging in time diversification?
The answer lies in constructing the portfolio within a core-satellite framework. It is clear that a strict buy-and-hold strategy will not be optimal in a volatile world.

The investor, therefore, needs to construct a passive core at various price points using the concept of rupee cost averaging. This portfolio will be held for five years, subject to periodic risk rebalancing.

The pain of regret associated with this portfolio could be high, if equity returns trail bond returns.

This pain could be offset with the satellite portfolio, which will be actively traded to take advantage of the high intermediate volatility.

Note that the actual asset allocation policy would be drawn up based on the time horizon and the risk appetite of the investor, a factor dependent on a person’s human capital.

Conclusion

Extending time horizon may not always make stocks less risky. It is true that a portfolio can generate higher returns in 10 years compared with five years.

But risk may also increase with horizon due to high intermediate volatility. Nevertheless, higher equity allocation may be optimal for long-term investors based on pride-regret behaviour.


(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at enhancek@gmail.com)

Sourced from : http://www.thehindubusinessline.com/

How to analyse an IPO

Bhavana Acharya

The year 2008 was one of drought as far as Initial Public Offers (IPO) goes. But with a revival of sorts in the markets, quite a few of these are lined up, with one — that of Mahindra Holiday and Resorts — already through. Investing in an IPO is a shade trickier than an existing company since not much information about it — financial or otherwise — will be publicly available. This is where, as a rule, the prospectus comes in as the best possible source of comprehensive information on the company.

Since the bulky document may appear a tad intimidating to the new investor, here are a few guidelines on how to pick relevant information, and what to base your investment decision on.

Any issue prospectus will be divided into seven sections — risk factors, an introduction to and detailed information about the company, financial information, details on the issue, legal and other regulatory information. Of these, the company background and business model, the industry it operates in, purpose of the issue, financial performance and risk factors are areas you should concentrate on.

Business

The section ‘About the Company’ gives a detailed description of the nature of the company and its business models; understand how and where the company accrues revenue, and if it is sustainable.

This includes going back to the history of the company, since it explains how the company has developed over the years, acquisitions made, milestones crossed, subsidiary activity, all of which are indicators of the consistency of performance and sustainability.

If possible, compare revenue models with those of existing peer companies to identify if, and where, the company has an advantage. If any competitor is already listed, use it as a comparison for performance, valuations, financials, and strategies.

Also included in the business section is an overview of the industry. Scrutinise it thoroughly to get a grip on the future of the industry and the company’s own prospects within it. As far as financials go, analyse these as you would for any other company.

Strengths

The company will list its ‘strengths’ — what it considers as an edge over peers — again in the business section. Give these a once-over, paying attention to the details only if the said strength stands out — for example, Gitanjali Gems has a diamond sourcing agreement with Diamond Trading Corp, a key strength since the company is ensured of access to good quality rough diamonds which most peers do not enjoy. Sizeable market share (check source of data here), backward integration, and so on, are other factors favouring the company.

Take the strengths with a pinch of salt, since companies sometimes tend to paint a brighter picture than what they actually are. Conclude yourself if the point given in reality works in the company’s favour significantly.

Risks

Risks detailed are wide-ranging, from an economic scenario to company-specific, which must be noted to understand potential downside to your investment. Risks are explained at the start of the prospectus.

Some risks given are general in nature and can be ignored, such as political instability, natural calamities, competition from peers and such, which are usually applicable to all companies, regardless of industry.

Legal issues that have a significant bearing on the functioning of the company, are also given here — for example, Mahindra Holidays has a resort in Munnar, where the land is under legal proceedings since it was said to be agricultural.

Now if the case goes against Mahindra, it will mean closure of a flagship resort and loss of revenue from it.

Understanding such material legal proceedings allows you to skip most of the section on legal issues that appears later in the prospectus. For example, legal issues regarding taxes, labour and such need not be combed through.

Objects

The purpose of the issue is explained in depth, and companies are required to explain the utilisation of funds raised in subsequent annual reports.

Proceeds from the issue can go towards any number of purposes, from repayment of debt to working capital, from capacity expansion to company acquisitions besides covering issue expenses.

Fund utilisation should, as far as possible, contribute to revenue generation and earnings expansion.

For example, companies may raise funds to either ramp up production capacity which may lead to increased sales, or to pay back high-cost debt resulting in lower interest costs and more leveraging capability; or for acquisitions that may add to revenues. However, the time taken to accomplish the stated objectives needs to be gauged.

Check the amount of funds set aside for issue expenses, which include advertising and promotion, printing of the prospectus and so on. Check also whether the proceeds of the IPO go entirely to the company; some IPOs involve a stake sale by the promoters in which case funds raised would not accrue to the company.

Other sections you can glance through are the regulations and policies the company is subject to, the management team and the relevant experience they hold and the instructions to bidders in the section detailing the issue — just to make sure you don’t inadvertently mess up your application.

Sourced from: http://www.thehindubusinessline.com/

Thoughts

"Make the most of yourself, for that is all there is of you." ~ Ralph Waldo Emerson

Value or growth

Adarsh Gopalakrishnan

Watching business channels during a bull market is quite a scintillating experience. The investment community quickly put on their smiley faces and go about explaining the rationale for the current market run. Words that get thrown about include contrarian, growth, value among others. Value investing, a style pioneered by Benjamin Graham in the 1930s, involves picking up shares when they are trading below what they are supposed to be worth.

Graham also popularised the idea of stock being represented by a company. What a company is worth can be estimated by parameters such as its book value, replacement cost, and cash per share and so on. Growth investing, the diametrically opposite, involved paying a premium price for a business, perceived as having great growth potential.

Blending styles

Value investing involves buying assets worth a rupee at 50 paisa and selling them when the market acknowledges the underlying asset value. The possibility for such arbitrage exists only for active and informed investors who scour through balance-sheets looking for such stocks, which Warren Buffett referred to as the cigar butt approach to investing — stocks which akin to a used cigar which have a puff or two left in them (indicative that a stock may yet have value left in it).

Such an approach does pay off in a dull market; such opportunities diminish in a bull market or in a market where a large number of investors actively seek such opportunities. With too many people chasing these opportunities, it gets more difficult to find them.

Value investing in its modern avatar has been associated with picking up businesses at low price-earnings (P/E) multiples, price-to-sales (P/S), price-to-book (P/B) or other such ratios. Value investors have traditionally taken a strongly quantitative view of a company. Metrics such as P/E, P/S, P/B values are indicative of cash flows and financial information at a specific point. These values, ‘high’ or ‘low’, are merely a starting point to investigate a prospective investment.

Growth investing has been taken to the illogical extreme of disregard for the price paid, if the prospect for growth looks promising. But if you want to invest effectively, blending these two ‘styles’ may be the right thing to do.

If you pay a ridiculously high price for growth, even stellar growth may not recoup the price you paid. Conversely a low price is no guarantee for success, if the business you invested in goes bust or does not have enough puff left.

In growth investing, success would entail buying part of business which is capable of growing at a minimum cost to investors. The latter is an oft-ignored component. Buffett in his 2007 annual letter highlighted three types of companies:

The company which grows its earnings with minimum capital expenditure;

The company which grows its earnings with capital expenditure, but the pace of earnings growth outpaces capital expenditure;

The company whose earnings growth lags the pace of its capital expenditure.

No prizes for guessing which one of the above makes for the most desirable investment.

Cost of growth

Investors should not confuse increased earnings from increased capital expenditure, with increased earnings from increased efficiency.

The cost of growth is the vital figure. If a company spends a rupee generating a rupee of growth, growth may have no impact on the stock price!

Growth and value may, therefore, have to be put together for effective investing. The environment, economics and management of the business are other components. None of these are independent of the others.

Investing is essentially an act of buying a share of a business and its future cash flows. It involves taking a view of the future cash flows, their sustainability and the cost of generating those flows.

Your call on the sustainability of a business comes from understanding ‘intangible’ aspects such as brand, demand elasticity and institutional culture. The only way to derive value from investing is in understanding how growth happens; this is the point where growth and value cease to be standalone elements.

Sourced from: http://www.thehindubusinessline.com/