Equity Dilution : The unseen enemy….

The startling observation that the BSE 100 Index’s “real” EPS growth lagged India’s “real” GDP growth over a three and five year horizon. Over the three year period, FY07-09, the BSE 100 real EPS CAGR at 4.7%, was much lower than the 8.5% real GDP growth. Over the five year horizon, FY05-09, real EPS growth at 8.4% was marginally below the 8.5%. The primary reason behind this was equity dilution.

There have been tomes written about how India will be the one of the key global growth engines for the next decade (at least) and how as investors we should hop on to the bandwagon by investing in equities. No doubt this appears to be compelling logic since “net profit” growth has often outpaced GDP growth rates. However, “real” EPS growth has not kept pace mainly because capital intensive companies have diluted their equity at regular intervals. Although there are some sectors/companies which are cash rich (frontline FMCG and IT companies are prime examples) most other sectors require dollops of capital in order to attain the next level.

While the overall financial leverage in our corporate sector has reduced over the past two years, this has often been achieved not through retained earnings but by refinancing high-cost debt through fresh equity issuances. Buoyant equity markets provide a temptation that few promoters can resist. There have been some promoters who have even candidly admitted that they are raising money while the going is good even though they do not have any concrete idea as to how to deploy it profitably.

The James Montier of GMO stating that between 1970-2001, US, UK and Germany too experienced the same problem.

As investors, this could hurt us in two ways :

1. Money which may have deployed more profitably ourselves, could be transferred into the hands of promoters with vague notions and intentions.

2. Other than EPS growth, constant dilution also affects the Return On Equity (RoE) adversely since most dilutions take place close to the current market price and RoE takes the premium component into account too. This is especially true in case of projects being commissioned over the next few years instead of the near-term (Eg. Metals, mining and oil & gas companies).

While, it may be difficult to avoid such companies entirely we can take some precautions in order to ensure that only a small portion of our portfolio is in companies prone to regular dilutions. Of course, often cash-rich companies with predictable earnings command a stiff valuation premium. However, there are bouts when the premium reduces. This especially happens during frothy times when risk aversion is very low and the companies’ conservative nature and the cash on their books is actually seen as a liability. Patiently waiting for such times may serve us well……

Timing really is crucial

There are enough investing philosophies out there to make your head spin. Buy and hold. Ride the commodity wave. Value investing. Technical analysis.

Each has its own merits, but sometimes you just need to look at the numbers to make sense of it all.

Ed Easterling, who runs an investment management and research firm in Corvallis, Ore., did just that, and he illustrated his findings in a graphic that The New York Times has published.

As the Times describes it, in 2001 a client asked Mr. Easterling what kind of return investors should expect over the long term. Instead of rushing his response, Mr. Easterling did some research and found that the answer, as it is with so many things related to finance, is that it depends. What exactly does it depend on? Timing.

Mr. Easterling tracked the S&P 500 average real return -- that is, the return that accounts for dividends, average taxes, fees and is adjusted for inflation -- from 1920 on. His analysis determined an investor's average annual return depending on what year he or she entered and exited the market.

For instance, if money was invested in 1994 and held to 1996, the average annual real return was about 7 per cent. But if the investor got greedy and kept the money in there until 2002, the annual return over that period fell sharply.

The analysis also determined that the best 20-year period to invest in ran from 1948 to 1968, when the average annual real return hit 8.4 per cent. The worst 20 years ran from 1961 to 1981, when the average annual real return was negative 2 per cent a year.

The graphic might take few minutes to figure out, but it’s worth the time.

The secret to investment success: Self Awareness?

The secret to investment success: Self Awareness?

I know that there are many who claim to have found the secret ingredient to investment success, though few actually deliver. However, I want to present an unconventional ingredient that I think most academics and practitioners miss when they talk about investment strategies: your personal make-up as an individual.

There are many different investment philosophies out there and they range the spectrum both in the tools they use (charts for some, fundamental analysis for others..) and their views on markets (markets learn too slowly, markets over react). In fact, some of these philosophies directly contradict others. But there are two puzzles. The first is that there are a few investors within each philosophy who have succeeded in using that philosophy to great effect over their lifetimes: there have been successful technical analysis, value investors, growth investors and market timers over the last few decades. The second is that within each philosophy, success seems to be elusive for most of those who try to imitate the Warren Buffets and Peter Lynchs of the world.

. Every investment philosophy works but only for some investors and not all of the time, even for them. Each investment philosophy requires a perfect storm to succeed: not only do the times and circumstances have to be right for the philosophy but the investors using it have to be psychologically attuned to the philosophy.

Consider, for instance, the investment philosophy that many argue is the best (or at least the most virtuous) investment philosophy for all investors. Good investors, they claim, invest long term in companies that are fundamentally under valued, usually in the face of market selling. Here is the problem. The strategy sounds good and makes money on paper but requires three ingredients from investors for success: a long time horizon, a strong stomach and a willingness to go against the grain. If you are an impatient investor, who has a worry gene and care about peer pressure, adopting this strategy will be a recipe for disaster. Not only will you end up abandon your investments well before they pay off, you will make yourself miserable (and physically sick) in the meantime. For this investor, a short term momentum strategy makes a lot more sense.

As you think about what investment philosophy is right for you, here are some things about yourself that you may want to think about:
1. Are you a patient or impatient person?
2. How do you respond to peer pressure?
3. Are you a "worrier"?
4. Are you a details person or a big picture person?
A little self introspection will pay off much more than investing your money in another "get rich quickly" book or investnebt idek,

Ultimately, what I am arguing is that there is no one best investment philosophy that works for all investors. The right investment philosophy for you will depend upon your time horizon as an individual and what you believe about how markets make mistakes.

on value investing

On Value Investing

-Under 5% of all assets are run under value investors, a real minority in the investment world.
-The stock market is created for the other 95% of people, that is where your opportunity and challenge is.
-Biggest challenge: understand whether you are the 5% or the 95%
-It is tempting to do what the other 95% of people do. Emotionally very difficult to be in the 5%, but value investors typically have better returns. The money is really for traders and they tend to amass more assets.
-5% have a spectacular return, but 95% of money probably always resides to somewhere else.
-Understand who you are. You will be tested. You will have to ask yourself whether you are or aren’t a value investor.
-If you are a value investor, you are probably genetically mutated and comfortable being in the minority. This is unnatural to human beings. You have to be comfortable being by yourself. You have to adopt the idea that you are right because your reason and evidence, not because others agree with you.
-You will probably spend most of your time being an academic researcher rather than a professional. You are a researcher or journalist, with insatiable curiosity. You are trying to figure out how everything works.
-The more you know, the better you are as an investor.
-Politics, science, technology, literature, poetry, everything can affect businesses and help you.
-Occasionally you can find insights that will give you tremendous insights that other people don’t have.
-Then you find if the business is cheap. Is the management good? What else? Why is the opportunity there?