Tuesday, December 1, 2009

Investing on the V Curve

This first blog is born of my own frustration at the disappearing investing opportunities in the post recession ‘V’ era. I have a large part of my net worth in cash right now and face a world with limited investment opportunities. With an ever increasing threat of inflation (see small note on inflation at the end), a day doesn’t go by where I am not thinking of ways to putting this cash pile to work.

In this blog I am going to examine various asset classes that are currently available to the Indian retail investor and argue the pros and cons of investing in each of them. I intend to focus on each of these asset classes separately at different points in time as each becomes more relevant or attractive. There are also some asset classes on this list that are going to get more attention than others (equities, real estate and bonds) primarily due to my own personal and professional experience of investing or having invested in them.

1. Equities – As I write this, the Sensex has crosses 17,000 - up almost 100% from its Mar 09 lows of 8,500. Almost every listed stock has doubled since the panic at the beginning of the year (some deservedly so while most rising just as part of the V euphoria). Now when I look at any stock, it seems overvalued on most parameters – EV / EBITDA, P/E, P/BV etc. In order to earn a 20% return on equity the Sensex would have to reach 20,400 in a year. I find that difficult to believe. I feel that the risk of Sensex falling is a lot higher than the 20% reward. Nobody wants to buy a stock for Rs. 100 and see it fall to Rs. 75 in 6 months.

The fundamental rule of making money in stocks – buy low sell high – works best when you get the first part right – buy low! Having said that, one should always keep a close eye on individual stocks that have the potential to become multi-baggers over a period of time. What I am trying to say is - don’t completely write off Equities as being overvalued. The case in point is Bharti Airtel. The stock has reached its 52 week low of Rs. 275 (last seen during Jan 09). Currently it trades at an EV/EBITDA of 7.2x and P/E of around 11.0x. I know there is a lot of talk about competition in the telecom industry and such but from a long term point of view (long term meaning forever!) this stock may be worth looking at. (I am currently going through the Bharti financials and hope to put a small piece on the stock in a few days)

2. Gold
– This is one asset class whose rise has astounded me. Rs. 100 invested in gold a year ago would have become Rs. 142 today – that’s a 42% return on investment! Of course, part of that rise can be attributed to the worst economic recession since 1929. Gold as an asset class tends to shine in times of uncertainty, chaos and fear. The reason this happens confounds me. Maybe people just perceive gold to be a stable and safe asset especially when other asset classes are in turmoil. Others consider it a safe inflation hedge. Whatever the reason, the fact is that gold has generated superior returns and continues to do so.

But, will gold produce the same kind of returns in the coming years? This is the question that the investor needs to answer. With the run-up that it has had, the current price of gold (Rs. 18,000 per 10 grams) looks expensive. Pundits point out that it could go up further. I myself would be very apprehensive to put my money in gold because the chances of it falling are higher than rising. I say this because a) it has already run up a lot b) economies around the world are slowly getting out of recession which would mean investors would divert monies to riskier asset classes like equity and c) the coming year(s) will be a lot less chaotic and fearful than the last. If you do want to invest in gold I would advise you to follow a disciplined SIP which over a long period of time effectively neutralizes the risk of ‘timing the market’ and averages out the cost.

3. Bonds / Government Securities
– As an Indian investor it is extremely difficult to purchase good quality corporate bonds. This is because we do not have a thriving secondary bond market like the West. The only way to purchase bonds is through an IPO most of which are so over subscribed that you end up getting a fraction of what you applied for. For e.g. if you had applied for Rs. 1 lakh worth L&T Finance 9.5% bonds you would have ended up receiving Rs. 6,000 worth of bonds. Thus there is no asset class between equity and risk free government bonds in India. You could invest in FMPs but then you do not get to pick and choose the issuers and after the FMP disaster last year it is best to avoid them.

So that leaves us with government securities. Right now, the 10 year government bond is trading at 7.3%. This used to be around 4.2% in Oct last year. Contrary to popular perception government bonds are not totally ‘risk-free’ – they carry interest rate risk (i.e. the risk that interest rates will increase or decrease). When interest rates fall, the values of the bonds go up. This is because if you hold a 10 year bond of face value 100 with a 7% coupon and interest rates fall to 6%, the bond in your hand will be worth Rs. 107.4 (since the new investor will have to pay Rs. 107.4 for the current market return of 6%) i.e. for every 100 bps (1%) fall in interest rate the bond value increase by 740 bps (7.4%). (for a 10 yr bond). However, interest rate risk is zero if you hold the bond till maturity. Interest rates fall when there is a ‘flight to safety’ i.e. investors are scared and want to retreat to the safe haven of government bonds. This happened last year in October when interest rates fell to 4.2% levels. If that were to happen again an investor in the 7.32% bond would make about ~23% returns.

Should one invest in government securities today? Let’s look at the pros and cons. Pros - a) it is the only asset class that is cheap right now – interest rates have moved up from 4.2% to 7.3% b) If markets and economies improve, interest rates will fall and monies will chase riskier asset classes c) It is a relatively safe asset (the government is not going to default on interest and principal payments) d) As the Indian government de-leverages its balance sheet the amount of supply of debt will reduce e) although your downside is protected (if you hold to maturity) there is a chance of an upside like the 23% above if interest rates fall. Cons a) Chances are high that interest rates will increase especially if there is high inflation and monetary tightening b) The government could continue to run a high fiscal deficit if the recovery takes longer. My own view is that this is an asset class worth investing through an SIP. What the SIP does is that it neutralizes the timing risk and to a certain extent interest rate risk because the purchases will be made in times of high and low interest rates. If the economy recovers fully in the next 3-5 years, interest rates should eventually go down increasing your returns on your g-sec portfolio. It’s also a great hedge against a market meltdown and worse comes to worse you will end up getting c. 7.3% on your investment.

4. Real Estate – We as Indians have always liked this particular asset class. All of us secretly harbor a desire for our very own apartment or a piece of land in which to build a house for retirement. The last decade has seen a huge shift in our attitude towards owning real estate. Affordability has increased greatly since the early nineties when our parents would not have dreamt of owning a house till they were way past 40. Today, 21 year olds are busy paying EMIs from their monthly BPO salaries to finance their dream apartment. The real estate boom fueled by excess liquidity and easy access to finance came to an abrupt end sometime in the middle of last year.

Developers were left with massive debt obligations supported only by high price land bought at the peak of the market and whose prices had fallen by half (effectively meaning equity value was zero since Equity=Asset-Debt). Even some of the biggest developers like DLF and Unitech came close to bankruptcy (except a few, most developers are still near bankruptcy). However, if newspapers are to be believed the demand for real estate among middle class Indian consumers is back (lower prices, affordable housing, latent demand etc) and the hey days of 2007 are close.

I myself, think this is all hogwash. Ground realities tell a different story. I was recently on a 4 day Goldman Sachs sponsored real estate tour in New Delhi, Gurgaon, Noida, Bangalore and Mumbai. What came out of the tour was that developers are still struggling to sell their apartments and debt and cash flows are hard to come by for this sector (RBI has increased the risk weightage for loans to the real estate sector and the IPO market has all but dried up). There’s still a long way to go before the Indian real estate sector comes back to its boom years. (Unitech’s market cap has tripled since Jan 2008 to Rs. 20,000 crores but its debt is still around 12,000 crores)

So should I put my hard earned money in real estate now that prices are low and developers have sobered up? Yes and No. Of the asset classes that are currently cheap or ‘out of favour’, real estate is definitely up there. Prices have fallen from their 2007 peaks quite a bit but so have rents and peoples confidences. I say a big NO to any hole-in-the-ground development and to any projects which are not at least 50% complete. Even for those that are, I would really try to understand how the developer plans to finish construction (i.e. where is the money going to come from). Chances are high that the upfront money you pay is going to pay the lender who already has a 1st mortgage on the property.

So be really careful of buying into development projects. However, there’s no harm in buying apartments in projects that are complete and ready to be let out. In fact this is a great opportunity to buy apartments in completed projects which are available at a below par price. It guarantees a continuous monthly rental stream and also provides a great hedge against inflation. The basket of goods that the rent you receive from the building will buy today will be the same 20 years from now, but the same cannot be said of other asset classes like fixed deposits. There is also the added upside of increase in value. Also, lets face it – this country is going to face an acute shortage of housing over the next decade and sitting on a nice 3 bedroom apartment in a good location is not a bad position to be in. The two drawbacks of real estate investment are that the yields on the rent are very low – about 2-4% depending on where you are in the country and they require huge upfront monetary commitments.

5. IPOs – This is not strictly an asset class but given the current market its worth analyzing its merits and demerits. My philosophy about IPOs (borrowed greatly from Benjamin Graham) is that It’s Probably Overpriced. I would never invest in IPOs simply because everything about the issue is decided by the seller – the price, the timing and the amount. I find the argument that sellers leave something on the table hard to believe. No one likes to not take what is readily available. Every IPO (other than maybe one) that took place post May 2009 is currently below its offer price. Don’t risk your hard earned money on punting in these issues.

6. Post Office Monthly Income Schemes
– This is another interesting option available to the retail investor. The MIS currently pay 8.0% interest rate per annum (i.e. Rs. 80 will be paid every month on a deposit of Rs. 12,000). However there is a limit of Rs. 4.5 lakhs per borrower and your capital is locked in for 6 years. These two conditions make investing in MIS schemes a bit depressing. Inflation can also play havoc with your investment. But it’s a good way to earn a decent monthly income to pay your household utility bills. Also, if you combine the MIS with the recurring deposit scheme where you transfer the monthly income to a recurring deposit, the yields increase to 10.5%. The other option for the more aggressive investor is to transfer the monthly incomes to an equity index fund to get an equity kicker. Worth thinking about.

7. Fixed Deposits – Currently fixed deposit rates in India range between 6.00% in HDFC to 7.50% in ICICI (3 years). This is the favorite and most traditional saving instrument used by Indians. Fixed deposits are considered to be safe but do nothing to counter the threat of inflation and interest rate risk. I would advise you to park only your short term ‘transitory’ income in these deposits while you look out for better opportunities.

(1) Small Note on Inflation

You might have noticed that the word inflation appears while analyzing almost all the above asset classes. So I thought it might be worth spending a couple of lines on the subject. Governments around the world have pumped in billions of dollars into the economy to stimulate demand and India is no different (low CRR, low SLR, low Repo rate, high government spending in agriculture, loan subsidies to farmers etc). Sooner or later this flood of money that is sitting quietly in banks and mutual funds is going to rear its ugly head in the form of inflation. To make matters worse we already have a low base from last year and the monsoons have not been adequate in many parts of the country. Consumer Inflation (which I think is the right metric to look at instead of WPI) is already at 12.0%. So what required Rs. 100 to buy last year now requires close to Rs. 112. Think about it – inflation is an investor’s worse enemy.