ASSESSING FUND MANAGER: THE 4D APPROACH

This article was published in The June 2014 issue of the Global Analyst

Mutual fund investors generally prefer a fund due to its historical performance. In the context of an equity fund, the primary expectation is that the fund manager should outperform his stated benchmark. For eg., if his benchmark is that of Nifty 50 or Sensex, the fund’s performance should be better than the benchmark to justify investor confidence in the fund. The extent to which the manager outperforms the benchmark is the second important element of attraction.

In an attempt to beat the benchmark, the fund manager is always in pursuit of winners and tactful in avoiding losers while selecting stocks. Where the winners outnumber the losers and where the fund manager’s commitment to winners (in terms of allocation) is better than the losers, he or she will generate out performance or what is technically called as alpha (excess performance over the benchmark). In other words, where a fund manager generates superior performance through consistently beating the benchmark, he/she is good at picking winners and avoiding losers. While this assessment sounds simplistic and hence reasonable, more often than not this 2 dimensional approach to assessing fund manager performance may not be enough.

In my view, the issue of fund management in the context of equity revolves around the concept of bets. There are bets that the fund manager sticks with and there are bets that he avoids. Hence, we need to view the issue from a 4-D perspective:

Dimension 1: Persistent Bets: These are bets that the fund manager is sticking with resolutely and believes in them strongly. A simple way to figure this out is to see if a particular stock is present at the beginning as well as  end of an evaluation period. The reason why he persists with these stocks can be borne out of a thorough research and fund managers’ conviction about its future ability to perform. If the stock price of persistent bets move up, the manager gains and vice-versa.

Dimension 2: Discarded Bets: These are bets that the fund manager has lost faith in and therefore sold out. A way to find this out is to see if a particular stock figures in the beginning portfolio but not in the end period portfolio. In this scenario, if the stock price gains after the manager has discarded them, the manager tends to lose out on performance.

Dimension 3: Missed Bets: These are bets that the manager did not take or we can call it as “failed to buy” scenario. These bets will not figure either in the beginning portfolio or end portfolio. In such cases, where the stock price moves up, the manager loses out in terms of opportunity gain and vice-versa.

Dimension 4: New Bets: These are bets that the manager took recently. A simple way to figure them out is when such stocks are present in the end period portfolio and not in the beginning period portfolio. Like persistent bets, the manager gains when such stocks move up and vice-versa.

Case Study: HDFC Top 200 Fund

Let us run through this 4D concept through the evaluation of the performance of HDFC Top 200 fund, one of the most popular equity funds in India.

Fund Return-2013	4.05%
Benchmark, BSE 200 Return-2013	4.38%
Alpha	-0.33%

As we can see, the fund has underperformed the benchmark albeit slightly during 2013. However, dissecting this further, we can perform a 4-D analysis on this.

Dimension 1: Persistent Bets:

Persistent Bets-Top10	Performance-2013	Weights (Average)
ICICI Bank Ltd.	-3%	7%
Infosys Ltd.	50%	7%
State Bank of India	-26%	7%
ITC Ltd.	12%	5%
Tata Motors Ltd.	20%	4%
Larsen & Toubro Ltd.	0%	4%
Reliance Industries Ltd.	7%	4%
HDFC Bank Ltd.	-2%	3%
Tata Consultancy Services Ltd.	72%	3%
Bank of Baroda	-26%	3%

The manager persisted with 55 stocks in his portfolio that figured both in the beginning and end portfolios. The above table provides the list of top 10 arranged in terms of weight. As we can see, most of these persistent bets are large cap blue chip heavy weights and are reputable names in the Indian stock market. Excepting for a few like ICICI Bank, SBI, HDFC Bank and Bank of Baroda (all bank stocks incidentally!), all others have done well especially TCS and Infosys (IT stocks incidentally!). The weighted average performance of persistent bets is 6.71% which is commendable.

Dimension 2: Discarded Bets:

Discarded Bets	Performance-2013	Weights (Beginning)
Hindustan Unilever Ltd.	9%	1.7%
LIC Housing Finance Ltd.	-25%	1.2%
Sun Pharmaceuticals Industries Ltd.	54%	0.9%
Tata Power Co. Ltd.	-17%	0.8%
Titan Industries Ltd.	-19%	0.7%
Cairn India Ltd.	2%	0.6%
Mahindra & Mahindra Ltd.	1%	0.5%
CMC Ltd.	36%	0.5%
NHPC Ltd.	-23%	0.4%
Britannia Industries Ltd.	84%	0.3%

During the year, the fund manager sold out (or discarded) 19 stocks while the table presents the top 10 in terms of weights. In some cases, the fund manager was right as in the case of LIC Housing finance, Tata Power, Titan, etc. But in many cases the fund manager paid a penalty of discarding some stocks whose performance later turned out to be very good. Good examples include Hindustan Lever, Sun Pharma, CMC and Britannia. The weighted performance of discarded bets is 0.49%. In other words, had he not discarded them, he would have added 0.49% to the portfolio performance.

Dimension 3: Missed Bets:

Missed Bets	Performance 2013	Weights (Index)
HCL Tech	104%	2%
NTPC	-13%	1%
Kotak Mahindra	12%	1%
Ultratech	-11%	1%
Hindustan Zinc	-3%	1%
Asian Paints	11%	1%
Adani Enterprises	-3%	1%
Nestle	6%	1%
Bhel	-23%	1%
Hero Motors	9%	1%

Here is a list of stocks that the fund manager did not look at all and in this case it runs into 125 stocks. However, a perusal of the top 10 among them in terms of weights reveal some interesting stuff. The greatest miss has been HCL Tech that performed more than 100% during 2013. Given the names like TCS and Infosys in the persistent bets list, it is surprising to see HCL Tech missing. The list of missed bets is a mixed bag with many posting negative performance ( NTPC, Ultratech, BHEL, etc). The weighted performance of this list is 2.55% which is quite significant. In other words, had he pursued these bets, the portfolio performance would be better by 2.55%.

Dimension 4: New Bets:

New Bets	Performance-2013	Weights (End)
Sesa Sterlite Ltd.	3%	2%
Idea Cellular Ltd	61%	0.3%
Siemens Ltd.	0%	0.3%
Jaiprakash Power Ventures Ltd.	-50%	0.2%
Alstom T&D India Ltd.	-9%	0.2%
Jet Airways (India) Ltd.	-48%	0.1%

This list is the smallest comprising in all 6 stocks. The biggest new bet is that of Sesa Sterlite that performed just 3% while block buster performance of 61% of Idea Cellular did not benefit much due to low weight. Similarly disastrous performance of stocks like Jaiprakash Power and Jet Airways did not hurt much due to lower weights. The total weighted performance of new bets is 0.09%.

In summary, we can tabulate thus:

Category	Weighted Returns
Persistent bets	6.71%
Missed bets	2.55%
Discarded bets	0.49%
New bets	0.09%

While the portfolio benefited hugely through the persistent bets, it also suffered due to missed bets while the impact of discarded bets and new bets has not been pronounced.

Caveat: In hindsight things always look very clear. Secondly, this analysis was performed taking into account the portfolio composition at the beginning and end of the evaluation period (2013). The performance of a portfolio is also affected by several transactions that happens in the intervening period and hence may cloud the analysis.

Having highlighted the caveats, the idea of this research is to take the literature of fund manager performance one step higher by looking at the opportunity cost of missing something and also the opportunity cost of sticking with bad choices which can take a heavy toll on the portfolio performance. What makes a fund manager stick with a bet, discard a bet, miss a bet or take a new bet is a combination of several factors including his ability to pick stocks, ability not to get distracted by peer group pressure, ability to have sound advice and being vigilant. In the end, the aim of any active fund manager is to generate alpha which is the only reason why investors are ready to pay management fees. In the absence of such a proposition, an Exchange traded fund (ETF) can simply do the job. In an ETF scenario, there is only one bet i.e, Index composition!.

The author thanks Karthik Ramesh and Rajesh Dheenathayalan for their assistance

The Debilitating effect of Inflation on Investments

This article was published in The May 2014 issue of the Global Analyst

       ·      Rs. 1 lakh invested in Equities 25 years ago will now be worth Rs.47 lakhs before inflation and Rs. 7.6 lakhs after inflation!
·         Rs. 1 Lakh invested in Gold 15 years ago will now be worth Rs. 6.7 lakhs before inflation and Rs. 2.7 lakhs after inflation!
·         Rs. 1 Lakh invested in Fixed Deposits 10 years ago will now be worth Rs. 2 lakhs before inflation and Rs. 1 lakh after inflation!
·         What Rs. 6,700 could buy in 1980, you will now need Rs.1 lakh for the same!

    Almost always we make investment decisions based on absolute performance rather than inflation adjusted performance. In my humble opinion, this approach can have very costly consequences in terms of our wealth and overall financial well-being.

     Without considering the effect of inflation, the investment performance can look really dramatic. For eg., Rs. 1 lakh invested in 1979 in equities can now be worth Rs. 1.88 crores!. But when adjusted for inflation it is worth only Rs. 12.6 lakhs, still better than other investments like gold and fixed deposits. Also, inflation creates more havoc in the long run than in the short run as it is a steady and silent killer. For eg., if you have invested Rs. 1 lakh in a fixed deposit in 1979, it is now worth Rs. 15.5 lakhs. But when adjusted for inflation, it is worth only Rs. 1 lakh! In other words, for 34 long years your investment worth has remained unchanged.

Source: RBI, BSE, and other sources. All data for period ending 31^st March 2013. 

     The table above reflects the complete picture across time and investment category. Let us analyse by investment category. At this stage, it may be worthwhile to explain what is nominal and real. Nominal rate of return is the absolute rate before adjusting it for inflation. Real rate of return is the performance after adjusting for inflation. For eg., during the last five years fixed deposits have returned an annualized return of 8% while inflation was also running at more or less same speed causing the real rate of return to be nil.

      

      Fixed Deposits

     If you are a fan of fixed deposits, think again. Most of us, deal with bank fixed deposits without realizing the meagre return (after inflation) that it offers. It has failed to produce any reasonable real rate of return in any time period. While banks have benefitted by the fixed deposits as they make nice spreads (the difference between lending rates and deposit rates), the investors have not made any returns since inflation eats away all the returns leaving nothing on the table. Whenever inflation increases in the economy, the RBI uses interest rates as a tool to contain the inflation (though I am not sure how effective that strategy is so far). In other words, when inflation increases, interest rates also increase thereby technically protecting the real rate of return. However, as data shows, inflation seems to have had the upper hand resulting in the dismal performance of fixed deposit. Over the long-run, a 0% real rate of return can hurt seriously. 

     

      Gold

    Your wife’s obsession with gold after all is not a bad idea! Gold has always produced good real rate of return across all time periods unlike fixed deposits. Gold seems to be having a gala time of late (during the last 5 years) compared to say last 25 years or 34 years. Gold has generated nearly 25% nominal returns annualized (before inflation) and 15% real return (after inflation) during the last five years making it as the best performing investment. It also had a nice run when seen from a ten year context with inflation adjusted annualized returns at nearly 11%. However, in the long run (25 years and 34 years), its real return (inflation adjusted) seems to be moderate but still better than fixed deposits.

    The recent good performance of gold in the last five years could be more due to global financial crisis and its aftermath all across the world. So long as global uncertainty persists, we can expect gold run to continue.

      Equities

      Indian Equities by far has the best story to narrate, especially in the medium to the long-term. In the short-term, (last 5 years), the equity performance is negative after adjusting for inflation but this is only expected given the volatility with which this asset class evolves in the short term. As said before, the global financial crisis has a direct bearing on the performance of equities and hence it is no surprise that its performance has been lack lustre. However, if you can muster some patience, it is by far the best hedge against inflation. It produced a real return of 8.5% annualized in the last 25 years compared to 1.7% for gold and 0.9% for fixed deposits. The same trend can be observed for the last 34 years where it produced a real return of 7.7% compared to 2.7% for gold and 0.1% for fixed deposits.

     It is thus clear that if we can have a time frame of 10 years+ then we can expect equities to protect us from the inflation beast. In the absence of treasury inflation protected securities (TIPS) as it exists in US, the only place to hide against inflation seems to be equities. Though there is no statistic to back the claim, I also feel Real estate doing a good job of protecting value against inflation.

      Welcome to the world of Finance!

     On a side note, while inflation is certainly not benefitting investors, it is benefiting insurance companies in terms of launching products. Recently Aviva launched “Family Income Builder” scheme which states as under:

    “You would be surprised to know that the cost of living has doubled in the last 12 years, and this trend is expected to continue. Are you sure that your savings are also growing at a similar pace? Presenting Aviva Family Income Builder - a life insurance plan that doubles your money. Pay an annual Premium for 12 years and get double of what you have paid every year, for the next 12 years, guaranteed”

    Simply put, what they are saying is that they will double your money in 12 years! A back of the envelop calculation says that the annualized return of such a proposition is just 6%, far lower than the fixed deposit returns that you get in banks! The catch is not in doubling, it’s how soon you double. Welcome to the world of finance!

   

     Trends and Challenges:

     There are 3 trends that are worth noting from a lifestyle point of view:

     ·        You will live longer than you think-more importantly your wife will live longer than you (based on life expectancy)
·         Your investment will produce lower returns as you age yielding lower income &
·         Your cost of living will increase more than what you estimate

      The power of inflation probably comes in directly in the last trend i.e., cost of living and to an extent in the second trend where after inflation the net returns will be lower. The final outcome of these 3 important trends is that you will experience a lower standard of living in retirement.

     

      How to beat it?

        ·         Focus on health-don’t just be content with maintenance. Spend money on building a healthier body.
·         Develop an investment strategy that is inflation proof (and fixed deposit is certainly not one of them)
·         Work longer-move your retirement age from 65 to say 70 or even 75

      The author thanks Karthik Ramesh and Rajesh Dheenathayalan for assistance. 

Mutual Funds Should Do More

This article was published in The March 2014 issue of the Global Analyst

It is not my intention to criticize mutual funds for I was also an avid investor till recently. However, the normal claims about virtues of mutual fund investing amuses me sometimes. Recently I read an online article published in Times of India with a fancy title “Why should you invest in mutual funds?” Like a lay reader, I started browsing through the contents till I realized that if not all, many of the claims can be easily rubbished. Here is a run-down on the claims of the virtues of mutual fund investing and the truth explained alongside:

1.     Beat Inflation: 

The MYTH: “Mutual Funds help investors generate better inflation-adjusted returns, without spending a lot of time and energy on it”.

The TRUTH: This is true only if the mandate of the fund is to beat the inflation i.e, TIPS like product (Treasury inflation protected securities). The RBI has just introduced a un investor friendly product and is still dusting the finer elements. However, I suspect the claim was made more in the generic context of equity mutual funds. Equities as an asset class beat inflation not because it is structured as a mutual fund, but because of the inherent ability of the asset class to perform better than the inflation. Even if I buy some 10 good stocks and sleep on it for 20 years, my investment should beat inflation without the hassle of being structured as a mutual fund.

2.     Expert Managers:

The MYTH: “Backed by a dedicated research team, investors are provided with the services of an experienced fund manager who handles the financial decisions based on the performance and prospects available in the market to achieve the objectives of the mutual fund scheme.”

The TRUTH: Academic research has proven time and again that fund managers as a group do not beat the market. Also, those fund managers that beat the market do not do it consistently. In other words, if you invest in a fund that has performed well because you got charmed by the fund manager, in all likelihood, he will trail the performance since there is no consistency in the performance. In the whole of the investment history, there is only handful of examples where fund managers performed consistently and even here they have attributed that more to luck than skill. Obviously there will be some fund managers that will do better than others and the market but there is no scientific way of knowing that in advance. 

3.     Convenience:

The MYTH: “Mutual funds are an ideal investment option when you are looking at convenience and timesaving opportunity. With low investment amount alternatives, the ability to buy or sell them on any business day and a multitude of choices based on an individual's goal and investment need, investors are free to pursue their course of life while their investments earn for them”.

The TRUTH: If technology helps mutual funds to offer convenience, the same technology offers investors the option to directly buy and sell financial instruments including post office savings. Opening a trading account with any reputed institution is just a matter of signing in 37 places, and beyond this hassle everything else is just a click of button. You can buy 1 share of Infosys and sell 1 share of Hindustan Lever and for that level of volume all else including electronic demat, service tax, sms alert, etc is done by the technology.

4.     Low Cost:

The MYTH: “Probably the biggest advantage for any investor is the low cost of investment that mutual funds offer, as compared to investing directly in capital markets. The benefit of scale in brokerage and fees translates to lower costs for investors.”.

The TRUTH: By definition mutual funds have to add extra cost to a transaction due to management fee, custody, etc. While they can bargain for lower fees due to scale, since they are normally applied as a % to total assets, there is no economies of scale. Also mutual funds get research from brokers apparently free of cost and in return for this favour, they are encouraged to trade more (technically referred to as portfolio turnover). The tendency to trade higher due to this in fact increase the cost. Left to himself or herself, the investor can buy when needed and sell when due only sporadically in order to achieve the same result at a far lower cost. 

5.     Diversification:

The MYTH: “Going by the adage, 'Do not put all your eggs in one basket', mutual funds help mitigate risks to a large extent by distributing your investment across a diverse range of assets”

The TRUTH: Mutual funds certainly don’t diversify more than the index to which they are benchmarked. It is due to this reason, they sometimes over diversify! Most of the index have a skewed distribution with the top 10 or 20 stocks accounting for 70 to 80% of the total with the remaining 100 or 200 stocks accounting for the balance 30% or 20%. A typical mutual fund portfolio will have its top holding a share of say 5 to 8% while the last stock in the portfolio will have a share of say 0.2% or 0.1%. While technically the portfolio has more than 40 to 50 stocks (substantiating the claim of diversification), the puny allocation to most of the stocks do not technically contribute anything meaningful to the performance of the overall portfolio. Assuming the last stock with 0.2% weight increases dramatically in value say by 25% in a particular month, its impact on the overall portfolio is only 0.05%, hardly moving the needle! Also, academic research says that you need only 10-15 stocks to meaningfully diversify beyond which the diversification benefit tends to reduce exponentially. 

6.     Liquidity:

The MYTH: “Investors have the advantage of getting their money back promptly, in case of open-ended schemes based on the Net Asset Value (NAV) at that time. In case your investment is close-ended, it can be traded in the stock exchange, as offered by some schemes”

The TRUTH: While it is true that liquidity is provided by mutual funds, the same liquidity is available even for direct investments and hence mutual funds do not provide anything additional in value. The current regulations requiring pay out in T+1 and T+2 ensures that one receives liquidity well on time. 

7.     Higher Return Potential:

The MYTH: “Based on medium or long-term investment, mutual funds have the potential to generate a higher return, as you can invest on a diverse range of sectors and industries”

The TRUTH: The higher return potential does not accrue because it is structured as a mutual fund. The higher return potential probably accrues because of longer time frame and stock selection capabilities in case of equities. As said earlier, if we select 10 good stocks and invest in them for say 5 or 10 years, it should provide higher return potential regardless of the fact that it is not structured as a mutual fund. 

8.     Safety and Transparency:

The MYTH: “Fund managers provide regular information about the current value of the investment, along with their strategy and outlook, to give a clear picture of how your investments are doing. Moreover, since every mutual fund is regulated by SEBI, you can be assured that your investments are managed in a disciplined and regulated manner and are in safe hands”

The TRUTH: Stocks purchased directly and lying the demat account is as safe as mutual fund investment. There is no added safety because it is a mutual fund structure. In terms of transparency, thanks to technology the trading platform provide dissection of the portfolio without any additional cost. 

9.     Product Variety:

The MYTH: “Mutual funds offer variety of products across asset classes like equity, bonds, money market, real estate, etc” 

The TRUTH: While it is true that they offer variety, the problem is investors are perplexed by the swathe of offerings and choices. In fact, the process of choosing among funds today is far more complex than choosing stocks. In other words, investors who avoid picking stocks thinking that they are too complex actually play a far more complex game of choosing funds” 

Apart from these limitations, mutual fund manager also suffer other issues connected with liquidity and fund size. Even well regarded blue chip companies can suffer from poor liquidity leading to higher cost. Mutual funds should suffer this problem especially in mid and small cap stocks. Given their ticket size, their requirement will always exceed what the market trades on a typical day. Also, if the fund has grown big, it will have a tendency to hug the market in order to avoid the risk of underperformance. In other words, the propensity to take risk is reduced while the managers are paid management fee to take risk! 

In summary, a mutual fund is a convenient structure for the fund house that earns good management fees. It is lucrative for the fund managers who earn fat salaries, sexy bonuses and television attention. It is productive for regulators as it keeps them busy. It feeds a host of other related industries like broking, custody, HR, etc. After all this drama, it is still anybody’s guess as to which fund will outperform the benchmark and the peers. As a lay investor, you are better off investing in a Exchange Traded Fund (ETF) that enjoys the lowest cost. If you are slightly informed, you may want to try enhanced index strategies. If you are hands on in the market, you are better off identifying and investing directly in some 10 good stocks and sticking with it.

Happy investing!

PS: The author thanks Rajesh Dheenadhayalan for his assistance on this research.

SENSEX@2025

This article was published in the November edition of The Global Analyst.


It is a common question to probe as to where would the Sensex be say in 5, 10 or 20 years. Currently Sensex is trading around 20,000 levels and its historic peak was 21,206.77 achieved on January 10, 2008.

To cut a long story short, let me tell you first my findings and launch into explanation later. I expect Sensex to touch 51,000 by 2020 and circa 100,000 by 2025. 

Sensex had a modest beginning in 1978 when it was launched with a base value of 100. Granular level data is available only from 1991 in the Bombay Stock Exchange website. In the 90’s it crossed 1,000 and in the 2000’s it crossed 4,000. In its 35 year history, Sensex averaged an annualized return of 17.3% outclassing all other asset class performance. 

While the base case call for Sensex in 2025 is circa 100,000, the optimistic call could be 155,657 and pessimistic call could be 68,454. The situation such optimistic or pessimistic scenarios could unfold is explained later. The base case call of 100,000 implies an annualized performance of 13.4% between 2012 and 2025 compared to 14.14% achieved during the last 12 years.

The period between 1980 to 2000 can be classified as “lost decades” where average economic growth (measured in real GDP) was below 6% with high inflation. Even under such circumstances, Sensex performance was exemplary especially during the decade of 1981-90 where the annualized growth in Sensex was nearly 22%. The decade of 2001-2010 can be termed “golden” with economic growth averaging 7.5%, inflation benign at 6.4% and Sensex performance was nearly 18%p.a. Viewed in this context, the call of 100,000 for Sensex by 2025 implies an annualized performance of 13.4% where economic growth is expected to average 6.18% with inflation at close to 9%.

Period	CAGR of SENSEX returns	Avg Real GDP Growth (in %)	Average Inflation (consumer avg prices, %)
1981-1990	21.60%	5.59	8.88
1991-2000	14.25%	5.58	9.05
2001-2010	17.84%	7.39	6.37
2012-2025*	13.41%	6.18	8.98
*Average computed only till the year 2018 as IMF forecasts are available only till that year

The projection methodology

1.     Historical values (closing price, P/E, div yield, P/BV, earnings, book value and dividends) from 1991 to 2012 were taken from BSE website.

2.     Base case scenarios were considered based on historical averages.

3.     Ratios (P/E, P/B & dividend Yield) were projected based on their respective historical averages.

For example, P/E ratio in ensuing 4 years was considered to be average of past 4 years (2012-2009) P/E and so on.

4.     Earnings, Book Value and Dividend growth for the first 6 years were assumed to be a constant growth (average of past 6 years). Incremental projections included the subsequent historical year.

5.     In order to project future values an upside of 25% (optimistic) and downside of 25% (pessimistic) was considered for the parameters (ratios, earnings growth, div.& book value growth) under consideration.

6.     Based on the various scenarios (optimistic, base case & pessimistic) the future values were computed.

The Drivers

 There are two primary drivers and two ancillary drivers for Sensex. The main primary driver is the economic/business cycle. According to Pami Dua and Anirvan Banerji[1], the Indian business goes through peaks and troughs. Normally the duration from peak to trough is relatively much smaller compared to trough to peak. In the Indian context, the duration of peak to trough lasts for approximately one year while the duration of trough to peak lasts for 4.3 years yielding total cycle duration of 5.25 years. The path of peak to trough is marked by recession leading to curtailment of investments and therefore negatively impacts company earnings and stock price performance. The path of trough to peak is accompanied by growth leading to capital investment and will normally witness earnings expansion. Hence economic/business cycle tend to impact earnings either positively or negatively depending on the nature of the cycle.

The second most important driver for Sensex would be the earnings, through which we derive in what is most famously followed metric called P/E ratio. The P/E ratio can move higher either because of increase in market price (numerator) or because of decrease in earnings (denominator) and vice-versa. As we can decipher from the chart, the P/E for Sensex ranged from a high of 45 in 1994 to a low of 13 in 1998 with a mean of 21. Episodes of bull market will magnify the P/E and take it to over valuation levels while bear markets produces subdued P/E. The key driver to the P/E ratio is the earnings (the denominator) which has shown remarkable progress during the period since 1991. Sensex earnings have since grown from a modest 85 in 1991 to 1,133 in 2012 implying an annualized growth of 13%.

Another key stock market metric is the price to book ratio (P/B). The book value (denominator) is defined as the total net worth which includes both equity as well as accumulated reserves (the portion that is retained in the business and not distributed as dividends). Book value growth is concomitant on earnings growth. Historically the P/B ratio hit a high of 6.35 (1992) and a low of 2.3 (2002) with a mean of 3.72. The book value rose from a modest 533 in 1991 to 6,307 in 2012 implying an annualized growth of 12%.

And finally the dividend yield which is simply dividends divided by the market capitalization. Higher dividends or lower market capitalization can improve the yield and vice-versa. Business that are experience growth will be loath to increase dividends as they feel that money can be better served in the business than in the hands of investors. Mature companies tend to favor higher dividends as they find fewer opportunities to redeploy earnings. The dividend yield fluctuated from a low of 0.68 (1994) to a high of 2.14 (2002, 2003).

Factors that can influence the Scenarios

In my assessment, there are 4 key factors that will influence the performance of Sensex in the next 12 years i.e., global growth, foreign investment, inflation and credit rating. In a globalized and networked world, the performance of the global economy (especially the developed world) will have a great significance on the performance of emerging markets like India. The jury is still not out on whether global growth has stabilized. Thanks to the global financial crisis, leading multilateral agencies (like IMF and World Bank) have been continuously revising the global growth outlook on the downside. There is a predominant view that global growth has settled to a “new normal” low and high growth rates are a thing of past. India’s stock market performance is significantly dependent on whether global growth will stabilize and pick up (the optimistic case) or will falter and fail (pessimistic case).

The second factor is the foreign investment both on infrastructure investment (FDI) and portfolio investments (FII). India’s track record on this has been dismal so far especially when benchmarked with China. However, a change of guard in the government and unleashing of policies that are foreign investment friendly can produce the optimistic case. It is also possible that politics will dominate economics here and India may continue to pursue “unfriendly” foreign investment policies which will produce the pessimistic scenario.

The third factor is inflation, which is an enemy for stock market performance. The monetary policies of RBI has so far been a failure in containing inflation since the problem is understood to have emanated more from a  supply bottleneck rather than demand induced. However, persisting high inflation will be viewed very negatively by investors (read foreign) and may unleash the pessimistic scenario. However, if RBI and the government succeed in taming the inflation, then we may be in for a pleasant surprise in terms of stock market performance.

And finally, India’s sovereign credit rating is now in the last leg of investment grade. A notch below this will classify India into “junk” status and there are many reasons (high current account deficit, fiscal deficit, inflation, etc.) as to why this can happen. And if that happens, the pessimistic scenario will unfold. However, if government policies can produce credible improvement in the economic scorecard, we can even see India moving up the investment grade rating which will be music.

The final word

Equity as an asset class has always performed far better than other alternatives but with only one caveat i.e., volatility. What has been discussed and shown in this article is only the return side of the story. However, the risk that one has to take to achieve these returns is also equally significant. A simple tool to measure risk is the standard deviation but there are other equally important measures of risk as well. Equity is one asset class which will dissuade investors from holding on due to its inherent volatility. Investors that can stomach this volatility and hold on to the investment can certainly reap the benefit. However, studies have repeatedly shown that investors show scant tolerance to holding up their equity investments and make erroneous entry and exit decisions that are harmful to their performance. In other words, they time their investments mostly wrongly leading to underperformance. Technology has enabled investors to buy the market (read Sensex) through cost effective solutions in the form of exchange traded funds (ETF’s). All one has to do is to invest in the ETF and ride through the time without getting distracted. Difficult isn’t?

[1] Business Cycles in India (2006)

 The author thanks Rajesh Dheenathayalan for his assistance