Creating a world of smarter investors

Do you remember the Indiabulls TVC? When the speaker at a company AGM is about to conclude, Mr. Kulwant Bhatia raises a query on the impact of raising long term debt in a potentially inflationary economy!

The TVC is funny. No one can be blamed for failing to notice the significance of the question. The contrasting visage of the speaker and the person asking the query with his ‘gotcha’ expression and accompanying glee, perhaps over rules all other thoughts.

This column is not a TVC aimed at making you laugh and help brand recall. This column is to make you think, so we will dissect the query highlighted in the opening para.

We live in times of high inflation. The impact of high inflation is felt when the value of a unit of currency goes down and leaves the owner of the currency ‘poorer’.

Let’s turn around this scenario a little. What happens if you own negative currency? In other words, if you are a net borrower, do you become ‘richer’ if inflation is high?

No one borrows to leave money idle in the bank. You put it in a business or in an investment where you can earn a rate of return which is better than the cost of your borrowing. Without this, you are worse-off borrowing money.

The return that you generate in the business or on your investment (an asset), if it is not fixed (which is likely to be the case) or if the market value of the asset is fluctuating, then there is a risk. The risk is of losing money. Either, the returns may fall below the cost of borrowing or the asset value may fall below the cost of the investment.

If you have an asset that has less chances of either risk coming true, and which is not difficult to sell (demand outstripping supply), then, it is safe to assume that an injection of borrowed capital for financing will enhance the return on own capital.

This is a simple principle of ‘leverage’ at work. The term is derived from physics where a lever is the simplest form of a machine at work, the output is magnified or multi-fold that of the input.

To further control the risk, try coupling the target asset with an asset that historically has a weak or negative correlation. Do you have a winner in your hands?

This does not mean you have a perpetual winner in your hand as any of the following things may happen - Rate of interest shoots up, inflation falls, return on asset and/or asset price falls.

The trick lies in balancing the risks and getting a return which is an adequate compensation for the risk. Timing the ‘exit’ from the strategy also becomes important. Reducing the leverage, if not wiping it completely is easier than exiting the asset. Do not wait for peak price, peak returns, and lowest rates of interest or highest rate of inflation.

Are you wondering what that dream asset could be? Well, how about your own business!

Ask not how the market is doing

By Vivek Reddy

"How's the market doing" or "what's happening in the market"! People ask these questions all the time, and expect short answers. The problem is whatever the answer, it usually leads to faulty understanding and wrong conclusions.

Let's take all three market scenarios — it has been rising, it has been flat or it has fallen. If the market has gone up, one has to answer, "the market is doing well". However, once these words register, the person hearing it usually becomes emboldened to put money into stocks. If the market has been flat or falling, the answer of the market not doing well is instantly interpreted as a signal to avoid investing. Clearly, such conclusions may be wrong and may not even have been intended by the person answering the question. If one were to analyze the causes of such miscommunications, they would be, one, an undue focus on the recent past and, two, a short attention span.

The way out is to communicate clearly that the past behavior of the stock market has little bearing on its future, and that a more reflective and studied approach should replace relying on sound bytes and one-liners on the market.

The more appropriate question, of course, would have been to ask, "what factors will influence the market" over whatever timeframe the investor is considering an investment/exit decision. And a sensible discussion will focus on the future and include:

expected future growth in corporate profits in relation to price-earnings multiples;

trends in liquidity and capital flows; and

impact of various economic and political events on corporate profitability. Thereafter, there has to be a view on how India's market compare on these factors to other developed and emerging markets. This analysis should give investors a basic idea on how much of their financial assets can be allocated to India's market.

It must be remembered that this broad understanding of the market will serve only those investors looking for a diversified equity portfolio or mutual fund. Those seeking to invest in individual stocks will need to study that company in depth before taking an exposure.

While deciding on an investment plan, there is always a multitude of expert opinions available in various forms. A sound approach is to ignore those analyses which dwell on the past and give a rear-mirror perspective on why the market behaved in a particular way. Also, distrust brokers who motivate you to transact often as they may be looking to profit at your expense.

So next time you feel like asking or have just been asked how the market is doing... pause, rephrase the question and take time to engage in a meaningful discussion. If there is a shortage of time, the best response is "only God knows".

(The author is former CEO, Kothari Pioneer Mutual Fund, which is now part of Franklin Templeton, this article appeared in 2006, however its relevance is timeless!)