Wise Wealth Advisors

D.Muthukrishnan (Muthu), Certified Financial Planner- Personal Financial Advisor

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Understanding matters

Posted by Muthu on September 30, 2013

I wrote the below piece two years ago and thought of publishing the same again.

It’s time to revisit the basics when the media and pundits all around confuse and make us nervous.

Big money is always made in the bear markets. We just don’t realise it then. Asset has to be purchased when it is cheap. It would never be cheap if the news around is good. Either you can have good news or cheap prices. This is the time of cheap prices.

Please read on:

Our investments can be classified broadly into two categories

 1)     Lending

 2)     Owning

If you go and deposit Rs.10 lakhs in SBI, from your perspective, it is a safe investment. You are right. What you consider as a ‘deposit’ is actually lending money to SBI. The bank in turn lends the money to many others; the difference in interest spread (what it pays you and what it receives from the borrower) being its income.

If you buy Rs.10 lakhs worth of shares of SBI, you become its (part) owner. You share the profits or loss of the bank in proportion to the shares owned.

As a lender, you are assured of fixed interest. As an owner, no such fixed interest exists; but you tend to make more money than the fixed interest if the bank performs well.

When you invest in small savings; you are actually lending to Government of India. Of course there is no option to own the government:-)

You may think what I’m saying above is very basic. You’re absolutely correct. The more I interact with people; I find that there is lot of confusion on basics.

We are comfortable in lending to businesses but not owning them. Isn’t it paradoxical? We would lend to someone only when we are confident about repaying capacity. Repaying capability comes from economic performance. When we are sure of the economic performance and lend, then why we hesitate to own?

If  Tata Steel comes with a debenture paying 11%p.a tomorrow, I’m sure it would be over subscribed and not everyone may get allotment. Look at this way. If Tata Steel is willing to borrow from you at 11%, then Tatas should be confident of earning much more than 11% from their business. Would we not be making more wealth by owning Tata Steel than lending to it?

As a nation, we are not only under owning equity but our ownership has been steadily declining.

In 1991, when India’s population was 846 million; there were around 20 million investors; 2.36% of the population.

In 2011, when our population is around 1250 million; there are around 10 million investors; 0.8% of the population.

Both in absolute terms and as a proportion of population, the investors have come down by more than 50%.

If you observe, during the above 20 year period (Jan’1991 to Jan’2011), Sensex has provided an annualized return of 16%.

Though we are an entrepreneurial nation (may be forced, because of lack of employment opportunities!), we are more comfortable in lending to a business than owning it.

When we understand equity investments as part ownership of businesses and not a mere stock ticker in the bottom of the TV screen, whose price changes every minute, that is the essential and most important thing in investing.

Also people ask as Sensex is 20,000 or 15,000 or 18,000- will it go further from here? The index was set at 100 in 1980 and has multiplied by around 180 times in last 30 years. So say what prevents it from multiplying another 5 times in next 10 years?!

There is another way of  looking at it. The earnings for Sensex a decade ago was Rs.200/-. This year earnings is pegged to be at Rs.1200/-+. Assuming a trading multiple of 15, Sensex level of 3000, 10 years ago is same as the level of  18,000 today. The valuations remain the same but the earnings (of the companies in Sensex) growth has resulted in 6 times growth in Sensex.

In favourable times, the multiples also expand. Let us do some crystal gazing. As interest rates soften, growth picks up; we may expect a Sensex earning of Rs.2400/- after 4 or 5 years. We are expected to be the fastest growing economy by then. So if our market commands a multiple of 20 times, then Sensex would be at  48,000 (2400*20).

To arrive at the earnings of Rs.2400/-, I’ve assumed 18% growth. If the nominal growth rate (real rate + inflation) of GDP is 15%, good companies growing @ 18%+ is very much possible.

Why I’ve assumed a multiple of 20 is our growth at some point may start commanding premium. This is because different investors have different risk profile and return expectations. A Japanese or American investor, whose capital can earn only say 1% to 2% in his home country, would be very happy to get a 8% return from an investment in India. While we may expect 15% returns from our markets and they being  fine with 8% returns would result in their willingness to pay a higher price.

This decade would be a golden decade for equity investing. The market capitalization (value of the companies in the listed space) tends to be equal to or more than GDP in a good economy. Since our GDP is expected to be $5 trillion+ by 2020, the market capitalization cannot be far behind. Our market capitalization now is roughly $1.2 trillion.

Most importantly during this decade, more and more people would start owning equity. Considering that we lack social security net, the only way for middle and upper middle class to build wealth is by investing in equity. Though there is a great amount of poverty on one side; on the other side, if a middle class person aspires for good education for his child, quality healthcare for his family, decent lifestyle after retirement; it is impossible to have money for all these just by saving a part of his income. It needs to be invested in something which beats inflation by significant margin.

Also if you observe, the inflation in healthcare, education etc. is far higher than the general inflation.

So I would assume that atleast 10% of the population would  become investors by end of this decade. 10% in a country like ours is more than 100 million even as per current population! When more people wants to own an under owned asset, the asset gets premium automatically as it’s availability remains the same.

When we get our long term perspective right, we wouldn’t be bothered by short term noises.

Given our economic growth, we are in for a long term structural growth story. Stock markets would continue to be cyclical. In the context of this long term growth, each cycle would find a fresh top and bottom.

If you look at our GDP growth; it was 3.5% in 1960’s, 4.1% in 1970’s, 4.4% in 1980’s, 5.7% in 1990’s, 7.2% in the last decade, optimistic projection of double digit growth this decade if we get the infrastructure story right or even otherwise a good growth rate of 8% or 9% (I’m still confident we would get back to good growth rate in next few years).

Going by both fundamentals and economics of demand and supply; owning equities makes lot of sense.

Also as market has been consolidating (another way of saying that it has gone nowhere:-) ) for last few years; in all likelihood there would be a strong bull market during next few years.

What would trigger this is very difficult to guess. There are many possibilities. But eventually every bull market would find its own trigger!

‘Asset Allocation’ is very important and it is not wiser to invest all the money in one asset class, however good it is.

However, to allocate asset, one need to have assets first:-)

After ensuring adequate risk coverage, emergency fund and setting aside money for near and medium term requirements, equities would be the best way to build one’s assets in our country. SIP is the best way to invest in equity.

If we also start thinking as an owner rather than just as a lender; it would have significant impact on our wealth.

This understanding would give emotional stability when market goes through ups and downs; especially downs.

One Response to “Understanding matters”

  1. Shankar said

    Thanks Muthu for the article. I have a doubt. Why US or Japanese common people OR their banks invest atleast in our banks? This way they can surely get say 8% FD rate … what prevents them from doing so?

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