Fall Together, Rise Alone!

This is a strange pair of two markets, Saudi Arabia and India. One is a rich oil producer sitting on huge amount of wealth and is 7 times richer than India on a per capita basis. Another is a growing emerging market three times the size of Saudi Arabia.

On the 31^st of January 2005 the TASI index was at a modest 8,231 points while the SENSEX was at its modest 6,555 points. Since that date the TASI index peaked at 20,643 points on 28/02/2006 while the SENSEX peaked to 20,286 points on 31/12/2007. The global credit crisis in 2008 brought them down together (as they did to all the markets in the world) with their bottoms reaching during February 2009 shedding 79% and 56% respectively (from peak) of their values. However since that date SENSEX bounced back to post a return of over 100% while Saudi Arabia totters. This has created a chasm between the two markets in terms of long term returns. During the last 5 years, Sensex produced a negative annualized return of 2% against negative annualized return of 5% for Saudi Arabia. Strangely enough oil prices seem to correlate more to Sensex than to Saudi index TASI (may be spurious correlation!).

Obviously this bounce back for India has produced some valuation excesses compared to Saudi Arabia. India currently trades at a p/e level of 15 (median is 16.5) while Saudi Arabia trades at 12 (median 14). Due to low valuation, Saudi offers better dividend yield (4.1%) compared to India’s 1.4%.

For the future, the following scenarios emerge:

1. The differential gap narrows with Saudi rising and India staying put or falling

2. The differential gap widens with India keeping up the bull momentum and Saudi straying sideways as has been the trend of late

3. The differential gap stays put with either both markets witnessing upward moment or both markets witnessing side way movement.

We would go with 1 above since valuation for Saudi Arabia borders on reasonable, government spending remaining strong, and oil price continuing to maintain strength. Time for pair trading among uncorrelated markets!

Comparison	KSA	India
GDP Constant USD Bn	657.049	1,946.77
GDP Per Capita PPP (USD)	25,722.00	3,851
Market Cap (USD Bn) (22/Nov/2012)	365	550
Mcap/GDP	56%	28%
Exchange	Tadawul	Bombay Stock Exchange
Index	TASI Al Share Index	Sensex
Performance (CAGR)
5 years	-10%	-2%
3 years	2%	2%
YTD 11/12	1%	20%
Standard Deviation (2007-2012)	37%	45%
Correlation	38%
total number of Stocks Listed IN Exchange	177	11,132
No of stock in the Index	ALL	30
Top 5 companies in index and their weight	SABIC: 20%	ITC 10%
	Al Rajhi Bank: 8%	Reliance 8.75%
	Saudi Telecom: 6%	HDFC Bank 8.05%
	Saudi Electricity 4.1%	HDFC 7.61%
	SAMBA Financial Group 3%	ICIC Bank 7.52
Current Index Level (27/11/12)	6,462	18,537
Historical peak (2005-12)	20,643 (Feb.2006)	20,232 (Dec.2007)
Historical Trough (2005-2012)	4384 (Feb.2009)	8891 (Feb. 2009)
Peak to trough (2005-2012)	-79%	-56%
Trough to current (2005-2012)	47%	108%
current P/E	12	15
Median P/E	14.1	16.4
Max P/E (2005-2012)	18.8	26.3
Min P/E (2005-2012)	7.8	9.0
Div Yield	4.1	1.4

 

Risk-based Asset Allocation

This article was published in The Global Analyst

Any investment advice starts with asset allocation, which simply means spreading our investments across various asset classes with a view to diversifying our risks. Sounds complicated isn’t?

It is frequently suggested that as investors we should invest across various asset classes i.e., equities, bonds, real estate, hedge funds, etc. I am not so sure if investors with non-investment background can really understand and appreciate the nuances and differences between various categories of asset classes. Even if they understand the difference between say equities and bonds, how frequently can they make an intelligent choice of these investments and how well they can view their overall investments in terms of asset allocation is still a question, at least to me.

I am proposing something that may be different from the classical asset allocation theories.

Before I recommend the idea, let us aim to draft the purpose of investing our surplus. To me, investments should

·         be age agnostic

·         be treated as a flow than a stock

·         let you sleep well at night

·         never result in capital erosion and

·         take care of us in old age

Two of the above 5 points need a little elaboration while the other 3 is self-explanatory.

Age Agnostic

Many a times, we are advised that we should be aggressive in our investment during our young age and should be conservative during our middle and old age. In other words, we should be risk seeking during our young age and risk averse during our old age. While this has its merits, it normally does not happen that way. The concept of ability to understand risk is ignored here. At young age, we may not have sufficient knowledge and experience to understand the risk inherent in an investment. Alternatively, as we age with experience we are more capable of appreciating what a true risk is. Also, we normally tend to invest our surplus. Surplus generation happens all through our life span and hence investment decisions have to be made even at old age as much as young age. In fact, the surplus tends to be less during young age as we are busy buying capital goods and incurring set-up costs.

Flow than a Stock

Since surplus flows every month (at least for salaried people), investments should be viewed as a flow. In other words, occasional decisions on where to invest should not be the case since surplus keeps accruing. However, traditional asset allocation assumes that our wealth is a stock rather than a flow.

Given this understanding and background of what should be the purpose, the question now shifts to how to deploy this surplus. When we encounter an investment opportunity, we have three scenarios i.e.,

·         We are familiar with it and we fully understand what it is (say fixed deposit)

·         We are partly familiar with it and we have difficulty in understanding what it is (say midcaps!)

·         We are totally unfamiliar with it and have no clue what it is (say managed futures!)

Let me call the first category as “Easy Bets”, the second as “Tough Bets” and the third category as “Wild bets”. The irony is that we do not end up always investing only in easy bets. Many a times we do investment in tough bets and wild bets based on advice tendered by friends/relatives and other associates only to rue such decisions later in life. Here is a list of many investment opportunities classified as per the methodology:

 

How do we make this classification? Whenever, we receive/view an opportunity we should put them in the following frame of simple analysis:

1.       Probability of loss: In my view, this is the true definition of risk. Easy bets are those where probability of loss is close to zero.

2.       Liquidity: Investments should be reasonably liquid, if not they only have paper value and not realizable value. Easy bet investments are normally highly liquid.

3.       Transparency: The opportunity should be easy and simple to understand even to a layman. Avoid structured products as even professionals do not understand them!

4.       Familiarity: The investments should be familiar and hence reduces your anxiety of investments. A Brazilian stock may be familiar to Brazilians but not to an Indian! Risk is a perception purely based on familiarity. For eg., if you are a currency trader, then exotic currency investments will become easy bet rather than wild bet!

The Strategy

The idea of this paper is not to suggest that you invest all your money only in safe bets. Predominantly you should be investing in safe bets (say 60% of your investible surplus). However, in search of higher returns, you should allocate some money towards tough bets (say 30%) and a small amount to wild bets (say 10%). The rationale behind wild bets can best be explained through an analogy that says “pulling the mountain through a hair. If lucky you get the mountain, if not the loss is just the hair!”. Take exotic currencies as an example. Iraqi Dinar is a good example. In the 1980’s, one Iraqi dinar bought 3 US dollars. Today one USD fetches 1,165 Iraqi dinars! Can you imagine? Iraq still possess huge oil reserves and can turn around like how South Korea and Italy did. If that happens in the next 20 years, imagine the payoffs. No wonder Americans are busy buying millions of Iraqi dinars and storing them in  their lockers and pillows. Wild bets have this characteristics. If they pay off, they pay off big-time. If not, you will lose all your money. Hence, such investments should never be more than 10% of your investible wealth.

 

GCC Liquidity: The Main Casualty of the Global Financial Crisis

This Article was originally published in several Arabic and English newspapers including Arabnews.

The Global Financial Crisis (GFC) has impacted world economies including the GCC. However the biggest issue has been the loss of liquidity in stock markets (as measured by value traded). Stock market investing and real estate are two essential pillars that provided occupational engagement to many GCC nationals. The collapse of both of these asset classes means significant contraction in many respects. This article dwells specifically on the issue of stock market liquidity, reviewing measures that can bring back liquidity at least to some extent if not all.

 

From a peak value, traded at over USD 1.6 trillion in 2006, liquidity experienced annual declines of 40% in 2007, 2009 and 2010 each and reached a low of USD 296bn in 2010 only to recover slightly to USD 354 bn in 2011, the first annual increase since 2006. The 2011 value traded is just one-fifth of the all-time peak experienced in 2006. Such a drastic fall led to many brokerage houses closing shop. So far, during the first half of 2012, the value traded has already exceeded that of the full year numbers for 2011 which is somewhat reassuring.

 The relative halting of lending across the region has played a large part in the declining liquidity on the exchanges. According to the Institute of International Finance, around 10% of bank lending goes towards the purchasing of securities while 26% and 10% goes towards real estate and investment companies, which are currently in a state of distress or low growth potential. Consequently, loan growth across the GCC has decelerated sharply since 2009. The average annual growth in loans between 2004 and 2008 was 29%, reaching a high of 38% in 2007. This rate has fallen to low single digits during the periods 2009-2011.

There are several factors which could aid in bringing liquidity back to regional stock markets. Many of these factors deal with creating an environment which is attractive and conducive to investing, both by retail and institutional investors.

There are not many options when it comes to investing in the GCC region; most funds and portfolios deal with plain “vanilla” products like mutual and sector-specific funds. Fixed Income is only now gaining popularity as an investment opportunity, but even then, most investments are held to maturity and little-to-no secondary trading is available on these products.

 A few derivative instruments have been brought to market; Kuwait Financial Centre “Markaz” has operated the Forsa Fund since 2004, which issues Call Options on Kuwaiti listed stocks. Abu Dhabi and Saudi Arabia both started ETF trading on their exchanges in early 2010, though these had little liquidity. Encouraging the development of a regional derivatives market would help support and raise liquidity levels by providing with additional options and instruments, which in turn would allow for more diverse and sophisticated product offerings.

 Given that the majority of investors in the region are retail investors, who are currently in an illiquid or deleveraging state, an increase in institutional investor support would help increase liquidity. This support has generally been provided by Sovereign Wealth Funds like Kuwait Investment Authority, Abu Dhabi Investment Authority and Qatar Investment Authority, in addition to other Government-owned entities (GOEs). According to Markaz, there are around 60 GOEs in the GCC that hold roughly 30% of market cap spread over nearly 180 companies. Saudi Arabia has the highest penetration in its local market, holding 35%, while Kuwait had the least at 13%.

There have been many regulatory developments in the region over the last few years, some as part of a natural maturing of markets while others have been in response to events brought on by the crisis. Regulatory progress and development is seen as a vital component to the restoration of the GCC markets, bringing with it credibility and the attracting of foreign investor interest. The UAE has pushed through a robust Bankruptcy Law which would provide a legal framework for distressed corporates to operate within. Qatar has been actively attempting to raise its Foreign Investor Limits, mainly to satisfy MSCI requirements for upgrading to Emerging Market status, but the move will make the market more attractive to foreigners in general. Furthermore, the Kuwait Capital Market Authority was established with its regulations and bylaws governing the exchange and investment companies.

Ultimately, a return of confidence is what is needed for liquidity to come back. ‘When that will happen?’ is anybody’s guess.

Risk-Based Investment Planning

This article was published in Indiansinkuwait.com on the eve of independence day on 15th August, 2012.

As investors, we are often faced with the situation to deal with our investment options almost on a monthly basis. As a group, we are so varied in terms of age, qualification, salary, and geographical lineage (south India/north India) and this can be seen in our investment habits as well. Regardless of this diversity, frequently all of us approach the question of investment options through the frame of returns. “Can this investment fetch me good returns?” is the question that we ask before we commit money. In many cases, we base our decision based on information gleaned from friends in social meetings. Our investments are also based on our current liquidity position. We invest when we have money and based on what options available at that point in time.

Predominantly our investments shall typically include fixed deposits, gold, real estate and equities (stock market). Sometimes we may loan money to our relatives and friends to help them in their studies or business. Over time, we accumulate a variety of investments. I see two problems in this approach:

1.       Organizing all our investments and regularly following up on how they are performing

2.       Ignoring risk while taking investment decisions

The first point may sound simple but it is not easy and most of us do a poor job of doing it. It is extremely important to organize all your investments in an excel file apart from physically maintaining all important copies. The job does not end with creating an excel file, the key is to update it periodically (at least once in a quarter if not monthly) and finding out the current value of our investments. These investments are made out of our hard earned income and hence it deserves follow up in order to take quick action on those that are losing in value.  A weekend spent on this is worth the time. Like cancer, most of the investment losses can be avoided by spotting it early.

The second problem is more fundamental. All investment opportunities should be categorized based on their risk i.e., High risk, medium risk and low risk. By high risk what I mean here is that the probability of losing all your investment is very high. Medium risk investments may result in loss but not entirely and low risk investments will not result in capital loss at all. However, high risk may also result in high returns while low risk will result in nominal returns and in most cases do not beat the inflation. Typical examples of investments categorized based on risk could be the following:

Low Risk	Gold, Fixed Deposits, Tax-free Government Bonds and Post office savings schemes
Medium Risk	Real Estate, Balanced funds, Corporate Bonds
High Risk	Stocks, Equity funds, Commodities

Opinions may defer on the classification marginally but not so much that a high risk investment can be felt to be a low risk investments. As you can see, in the low risk segment you may not run the risk of losing your investments while in the high risk investments the risk of losing your investments is very high.

Once you have an understanding of this categorization, then comes the key question: How much of my money should I commit to each of the three categories of risk? The answer depends on your age and liquidity requirements. When you are young, you have more time and hence you can afford to take more risk. The reasoning behind this is that even if you lose in value, you have time to ride it out and hope for the recovery. As you approach your retirement, your ability to take risk is reduced and need for liquidity increases. In this stage, you don’t have the luxury of time. Hence, you should initially focus your investments in high risk and gradually reduce it in favor of low risk as you get old. The following chart can illustrate this transition:

For eg., when you are in the age bracket of say 20 to 30 years, your income may be low but your liquidity needs are also low. The amount that you can save every month (after meeting your regular expenses) can be oriented more towards high risk investments like equities. When you move to the next age bracket i.e., 30-40 that is when you need to reduce your allocation towards high risk in favor of low risk. This can happen either by selling your high risk investments (and hopefully you would have made good profits!) and investing them in low risk or by committing your new money more towards low risk than high risk. As you can see from the chart, when you approach your retirement age (typically between 60 and 70) you can see that most of your investments are in low risk income yielding investments since that is the time when you need income to support your retirement. A key opportunity in the medium risk is the real estate. For most people, real estate make up a large part of their total wealth. Buying the first home has sentimental value . Also, one may argue that real estate has no risk since it does not generally depreciate in value. This may be true but most of us buy real estate through mortgage loan running into several years. During this time, interest rate may fluctuate and cause hardships. Also, sometimes if you make a decision to buy a real estate at the peak of the bubble then the price may start stagnating and sometimes fall as well. Hence, it is prudent to consider this as medium risk than low risk. The increased allocation towards low risk as we enter 40’s and 50’s is to make sure that we have enough liquidity to fund the higher education expenses or marriage expenses of our children.

As the saying goes, “Trust in God but lock your car!”, prudent planning and follow up of our savings is key to financial prosperity. It is not enough that we work hard and earn money, it is equally important to save them in an intelligent and organized manner fully realizing the risk behind those investments.

Buy Low, Sell High, But How?

This article was published in The Global Analyst

The greatest investment challenge for any investor is to buy low and sell high. However,. many a times we end up buying high and selling low!

While historical returns can look appealing, the exact timing of your investment can create huge divergence between your returns and historical returns. If your timing is wrong, then a Buy and Hold Strategy can backfire heavily. This is best explained through this chart that shows annual performance of Sensex since 2004. In these 8 years, we had 6 positive years and 2 negative years. If you would have invested Rs.100 at the beginning of 2005, it would be worth Rs. 234 at the end of 2011. On the other hand, if you would have invested Rs.100 at the beginning of 2008, your investment would be worth only Rs.76 now. So, a passive investment approach (what is called Buy and Hold) may yield results based on your market timing.

On the other hand, if you are an active investor trading in the market day in and day out (what is called as high frequency trading), it mostly will be a negative sum game that benefits only the brokers to earn their commissions. Also, it involves heighted level of tension on a daily basis leading to acidity and associated habits.

This article is to present a strategy that can time the market without emotions but based on carefully evaluated rules (through an intense study of the past). I believe such a strategy can generate ‘above ordinary” returns and can live up to our initial expectation of “Buy Low Sell High” ambition. However, it should be noted that there is NO investment strategy that beats a Buy and Hold strategy 100% of the time. It depends on the level of entry and further market movement.

 Before we aspire to “Buy Low, Sell High”, there are some insights from the market that are worth exploring.

1.       All markets frequently go “underwater” and stay there for longer than what you can anticipate.  For eg., if you invested at 100, and your investment value goes down to say 90, technically your investments are termed “under the water”. The problem is, both the depth and the period of time of your investments being under the water cannot be predicted. The Japanese stock market is a great example. The Nikkei Index reached its highest level of 38,915 on 29^th December 1989. The current level is 8,724 (15^th July 2012), after 23 years!

2.       Do we have such episodes in the Indian market? For eg., if you would have invested on 14^th January 2004 when Sensex was at 6,194, you would have gone under the water immediately and you had to wait till 30^th November 2004 before you could level your original investment[1]. You had to wait for 10 agonizing months during which your investments could have dropped by 24% when Sensex reached 4,708 (24^th June 2004). Any investment made around November 2010 is technically still “under the water”. The probability of something going under the water is high during the peak of  bull markets. Once our investments are “under the water”, we take time to accept the fact during which time it goes even deep under the water. For eg., , if you would have invested on Jan-08 when Sensex was at 20,873, you would be under the water till 4^th November 2010 to reach the same level, a staggering period of 34 months(nearly 3 years) during which time your investment value could have gone down by 60% before it recovered. Simply put, you would be staring at a loss of 60% which can be psychologically nerve wrecking. The lowest point during this period was 9^th March 2009, when Sensex hit 8,160. Like how Sensex can zoom from 8,000 levels to 20,000 levels, it can also crash from 20,000 levels to 8,000 levels.

3.       When markets go under the water, we often ride it down fully rather than limit our loss by cashing out at some stage.

4.       Once our investments are “above the water”, our expectation about future profits is unlimited!

5.       Most of our buy/sell points are either determined emotionally or arbitrarily than a careful evaluation of our investment environment. Psychology plays a major role in our market timing. After we make an investment, and if we move into profit zone, we attribute that to our “skill” and not “luck”. However, when we move into loss, first we are in “denial” mode (how can I make a bad investment decision?) and then when we are deep in the red, we “resign” to our fate and do nothing. Again psychology!

The Strategy

This strategy aims to Buy low and Sell High. The strategy is explained through a series of questions:

When to Buy?

The basic idea is to invest only when market is in a “new low” as determined by a reference to a previous high. For eg.,

---

[1] For the sake of simplicity, I am assuming that you invest in a ETF like structure that replicates the broad market.

On 15^th April 2009, Sensex reached 11,284 a new high. You should index this as 100 and keep referencing further moves to this 100. Subsequent to this, the index offered a “new low” on 16^th April at 10,947. Then offered another “new low” on 21^st April when Sensex reached 10,898 and offered another “new low” on 22^nd April when Sensex reached 10,817.  As per the strategy, we will invest at all such points of “new lows”.

Remember, markets can keep going down for a considerable period of time which means that it will offer you many “new lows”. You should then be prepared to invest in every such “new lows”.

How much to invest?

We should start with a defined instalment amount of say Rs.10,000 and increase the investment amount as we encounter further “new lows” tracked by the indexing explained above. The following rules can help:

As you may see, the amount to be invested is based on spotting a new low and also the level where it is spotted. Hence, it is variable and cannot be determined upfront. All you can do is to have some amount locked up in a money market fund to be utilized as and when the model screams a “buy”. As the table indicates, you may end up investing Rs.15 lakhs during the last 3 years, Rs. 24 lakhs during the last 5 year or Rs. 44 lakhs during the last 8.5 years. But there is no way you will know that in advance since you cannot predict how long the markets will fall.

What is the frequency?

By virtue of the strategy, even this cannot be determined upfront. You may have a situation where you will find the need to invest almost on a daily basis or there may be periods where you will not invest for years.

When to Sell?

You will sell when the market reaches back a high from where you started (i.e., 100).  Continuing on our earlier example, while we would have bought on 16^th, 21^st and 22^nd April because it reached “new lows” on these days, we will sell our position on 24^th April when the index reached 11,329 and surpassed earlier new high of 11,284 and reached a “new high”.

How much to sell?

We will sell all the investments that happened during this period at that day’s value.

How intensive is the strategy in terms of implementation?

The strategy involves buying and selling whenever the model screams so. However, we will not know in advance when it will scream. Going by the number of buy and sell activities, we can classify the findings as follows:

The % number of days on which the strategy will force you to act is at the peak 18.5%. In other words, we will have some trading action only on 18.5% of the time while it is 100% if you are a day trader. Hence, it is not too much of a call to act.

How did the Strategy do?

I have tested the concept for several time periods (last 3 years, 5 years, 8 years) and find that the strategy outperforms the buy and hold strategy in the 5 years and 8 years period significantly while it slightly under performs the buy and hold in the 3 years category. Hence, it is worth the time and effort. However, it should be noted that this strategy  might underperform a Buy and Hold strategy in an upward trending bull market.

When does the strategy perform the best?

When the market goes one full cycle i.e., it comes back to a point where it was before. Technically it is called “Peak-Trough-Peak” (PTP). For eg., as stated before the Sensex reached a peak on 9^th Jan 2008 at 20,869 and thereafter fell continuously till 9^th March 2009 to reach 8,160 after which it started climbing back slowly and reached its earlier peak of 20,869 on 4^th November 2010. In other words, if you would have invested in Sensex on 9^th Jan 2008 and exited on 4^th November 2010 (after app 3 years) you would have just got back your money implying nil returns. However, our strategy would have screamed a buy 35 times all through the fall from Jan 2008 to March 2009. As per the investment band, you would have invested a total of Rs. 13.46 lakhs in this period through 35 buy actions with the last buy of Rs.60,000 on 9^th March 2009 when the Sensex was at 8,160. Remember, as per the band, you start off modestly at Rs.10,000 investment and increase your investment value as the market braces new lows. Since after 9^th March 2009, the Sensex did not encounter any new low, there was no buy call till 4^th November 2010 when Sensex touched a new high and the model told you to sell. The sale value would have fetched Rs. 24.4 lakhs implying an IRR of 30.6% against a 0% return on the buy and hold.  Look how active the strategy becomes when the market falls and how inactive the strategy is when the market is rising!

So, what is the difference in terms of investment style?

Concluding Thoughts

As Warren Buffet said (which most of us do not follow), be adventurous when others are fearful and be fearful when others are adventurous. When you follow that advice, you can buy low and sell high. The idea of investing a pre-defined amount at a pre-defined time will expose your investment to market timing risk. On the other hand, the idea of investing when markets are in a free fall and cashing out when markets are in a free rise will make sure that you don’t encounter capital loss. The idea espoused above is just that. Given our limited ability to deal with losses psychologically, I feel such a strategy can be of great help. All it needs is some basic excel skills which all of us possess these days thanks to Microsoft!

Best of luck!

PS: The Author thanks Mr. Madhusoodhanan for data analysis