Markets

Why you should be happy crushing risk than chasing ephemeral high returns

By Saurabh Mukherjea

High flown theories of finance & investing dont work in India. What works in the Indian stock market is risk minimisation. We minimise risks associated with accounting fraud, with topline and bottomline volatility and with liquidity. In other words, we invest in clean monopolies selling essential products.

Sophisticated investment literature can be damaging for your wealth
There are many delusional theories in finance. One of these is the Efficient Markets Hypothesis (EMH), which contends that since stock prices efficiently discount all the information available in the market, it is impossible to beat the market.

Another is the Capital Asset Pricing Model (CAPM), which claims that returns from a stock will be directly proportional to the systematic risk (or beta) represented by the stock.

Whilst Warren Buffetts rubbishing of the EMH is well-known, thanks to the pseudo-science peddled by business schools, CAPM is still taught in classrooms across the world, including in India, a country where CAPM is even less applicable than it is in America.

CAPM says returns are proportional to risk, it follows therefore that the only way you can generate higher returns in the market is by taking more risk. Basis this elegant theory, wealth managers lead their clients down the garden path towards high-risk products while selling the delusion that higher risk will lead to higher returns.

Crushing risk is the key to generating higher returns
Our decade of working and investing in India has led us to conclude that you need to minimise four types of risks if you want to generate steady and healthy investment returns in the Indian stock market:

1. Accounting risk: Whilst we all now know how prominent public and private sector banks in India fudged their NPA figures for years on end until RBIs asset quality review forced them to come clean, the same problem exists with several housing finance companies (who dont come under RBIs purview).

The accounts of a leading cement manufacturer dont stack up. Neither does the annual report of high flying retailer make sense. Ditto with a prominent petchem company and a prominent pharma company. In fact, the majority of the companies in the BSE500 have annual reports, which dont pass scrutiny. Using 10 forensic accounting ratios and a financial model that contains time series data on 1,300 of Indias largest listed companies, we seek to identify that 20 per cent of the Indian stock market whose books are actually believable.

2. Topline risk: At $2000, Indias per capita income is still very low (less than half of Sri Lanka and a quarter of the level of Southeast Asian countries like Thailand and Malaysia). As a result, beyond the basic essentials of life – FMCG products, pharma products, basic apparel – most other products are luxury items for most Indians. As a result, even for small cars or entry-level two-wheelers, demand in India fluctuates wildly. For instance, Maruti Suzuki typically experiences 5-6 years of strong demand growth (growth well above 15 per cent per annum) followed by 3-4 years of famine (growth well below 5 per cent per annum).

Whilst its cross-cycle average growth tends to be around 12 per cent, the stock price volatility reflects the swings in Marutis topline growth. In contrast, a company selling essential products like Asian Paints or Marico tends to see steady

revenue growth – between 10-20 per cent per annum – pretty much every year. Investing in companies selling essential products in India therefore reduces risk.

3. Bottomline risk: As the cost of capital is still pretty high for India, it is rare to find Indian companies which spend heavily on genuine R&D. Understandably, therefore, the Indian economy is characterised by rapid imitation – one company spots a niche (say, gold loan finance) and within a decade it has a 100 imitators. This rapid new entry squeezes profitability of the first mover and thus creates risk for its shareholders. In order to reduce such risk we look for sectors where over extended periods of time, one or two companies cumulatively account for 80 per cent of the sectors profit pie. Such monopolies have lower volatility in their profit margin.

4. Liquidity risk: India is the least liquid of the worlds top ten stock markets, largely because promoters own more than half of the shares outstanding in the Indian market. As a result of this, beyond the top 30 or so stocks in India, liquidity – measured by average daily traded volume (ADV) – drops rapidly. By the time you are in the lower reaches of the BSE100, ADV is well below $5m per day. Such low liquidity creates stock price gyrations as investors go through their cycles of election-induced euphoria followed by accounting fraud-induced panic. Tilting the portfolio towards liquid stocks reduces this risk.

Investment implications
Over the past decade another corollary of CAPM – smart beta – has become fashionable. Smart beta practitioners (no pun intended) believe there are various types of systematic risk embedded in stock prices, for example, size (i.e. smallcaps should outperform largecaps), value (i.e. cheaper stocks should outperform more expensive stocks), momentum (i.e. stocks which are doing well should continue doing well), etc.

Basically, what smart beta Read More – Source
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