Monday, August 20, 2007

Stock market volatility and the long term investor

I have always thought about writing on this topic. But now seems to be an even more appropriate time to do so. Last few days in the global stock markets have been depressing. Indian stock markets have also reacted with hi-fidelity and nosedived into lower values. Suddenly people are waking up to the risks of equity investing and all the talks of bubble have come back to haunt them.

How should a retail investor react to this melee of events and opinions? I classify retail investors as being distinct from institutional ones on account of the simple principle that the retail investors do not have equity investing (or any investing for that matter) as their day job. They invest to grow their wealth.

To start with, I would like you to ask yourself a question. Why have you invested in equity? Is it because everyone else is making so much money out of it? Is it because that seemed like the right thing to do last year? Is it because you are building a long term corpus and are trying to get higher returns? Is it because it is a good hobby to have and you get a kick out of the ups and downs?

I am addressing here the concerns of the investor who has invested in equity as an asset class to build his wealth over long term. This long term in my view is longer than 5 years at the very least. I am not trying to run away from answerability in the interim. All I am saying is that the arguments below make sense only for this horizon.

When you buy a stock, you essentially buy a piece of a company. Why would you do that? Because at the price at which the stock is quoting in the market, you believe that the company is worth as much or more. And how do you infer that the company is worth more or less? In traditional asset pricing models, you will discount all future dividends from the company and thus arrive at a fair price. You can add to that other valuation models and triangulate your findings regarding the right price for the company. In light of this, why should there be a price variation in the market price of a stock?

That is because individual investors have different opinions of the company’s value. To keep matters simple, if you assume that all investors are using similar valuation techniques and have similar values for risk free rate and risk premia, the primary difference of opinion would come from the degree of faith each investor has in the company’s future. In theory, all the investors have different price points for a given company they partially own or wish to own. This creates the demand curve and supply curve for a company’s stock. The prevalent price is one which matches the demand with the supply of the stock. The stock prices move on account of various factors. To start with, let us focus on just the company. This means the stock market has only one stock which investors buy and sell. If things do not change from one quarterly result to another, the stock price would not move at all. However, real life is never so still. So when there is any news that might have an impact on the company, investors alter their expectations and thus the price they are willing to pay for the company. This shifts the demand and supply curves. The demand curve is built by those who want to own the stock while the supply curve is built by those who do own the stock. A given investor can of course be on either side at different price points (assuming she owns the stock or shorting is allowed).

Now, the news shifts the demand supply graphs and the intersections leads to a new price discovery.

Now add to this the fact that there are a multitude of companies. These companies all trade on the stock market and are individually priced as per their investors’ expectations. At this stage, the other factor that enters the picture is the correlation of the stock price of different companies. Since the investor can hold different companies, she no longer needs to take as much risk as she took earlier with one stock. Without getting into the complexities of the arguments, it suffices to say that the presence of other companies and a broader market allows investors to reduce their risks from a single company. Hence they might be willing to pay higher for a given company all other conditions remaining the same. All it means is that the discount rates used for the valuing a company can become more lenient if the investor is diversified.

This hypothesis makes an even bolder claim. It goes further to say that not only the investors can reduce the risk and price assets better, they actually have to do so because those amongst them that hold the market portfolio can effectively price out those that don’t. Everyone is forced to either diversify and hold the asset at a given price or is left to live with uncompensated risk in a single company (since the agreed price in the market for that asset does not account for the individual company risk).

That apart, around this time, another element that enters the picture is the sheer complexity of the impact various pieces of information can have on the market prices. That would have been all right if it was not for the emergence of another group – namely speculators. The speculators are not betting on what the company is fundamentally worth. More often than not, their interest is primarily in benefiting from the impact a certain piece of information can have on the market price. If the central bank is likely to reduce rates, the speculator would take huge long positions in the stocks affected positively by the rate cut – housing, automotives etc. She is not keen on valuing the companies fundamentally and thus owing them as an asset. All that matters to her is how the fundamental investors are likely to recalibrate their expectations in light of the new information.

The speculator has been the centre of controversy for various reasons. I do not wish to pass a value judgment on the philosophy. All I wish to point to here is the fact that the presence of the speculators adds to the variations in the market prices. It is compounded by the fact that various groups of speculators play the expectations game from across the globe on a more real-time basis than the fundamental investors do. The speculators interest is in second guessing how price revision would take place in a given asset – it matters little what the specific price level is, the direction and amount of change is more relevant. Often enough, in the process, the fundamental buyers of assets are pushed aside and the stock market becomes predominantly a meeting place for speculators betting on the impact on various events. They become a self-sufficient ecosystem because there are enough of them to bet on either side.

All in all therefore the stock market is combination of the market for the assets and market for betting on the price variations of these assets. I do not wish to denounce the latter. I would like to point out however, that if you wish to use the stock markets for fundamentally investing in equity as an asset class for wealth building, you need to acknowledge the presence of the speculators and learn to live with it.

How does one do it? It is straightforward really. Consider investing in the broad market index for instance. You need to estimate the rate at which the corporate profits of listed companies are likely to grow. For today’s India, starting with 8% real GDP growth expectation in next five years, we can estimate the nominal GDP to grow at 12-13% (with 4-5% inflation.). If agricultural growth is 4%, manufacturing and services will have to grow at nearly 10-12% to make the overall GDP growth 8%. Hence the revenues of the manufacturing and services industries will grow by 14-17% in nominal terms. If I were to make two simplifying assumptions that these are a proxy for the listed companies and the productivity growth is nil (so revenue growth is same as profit growth). Considering the upper hand larger listed companies have in garnering the fruits of growth as also the sharper rise in profits than that in revenues, both of these assumptions are conservative at best. All in all, we can expect the listed company profits to grow at 14-17%. That would be your first guess for the growth in the value of your equity holdings if you are going to hold the index. Similar analysis will apply for individual companies.

Where does the speculator fit into this? Well, she is going to speculate that the sub-prime debacle in the west is going to unnerve the FIIs and hence lead to general meltdown in prices. She is also going to bet on the monsoon’s effectiveness and the prospects of the central government and mid-term polls. She might make a killing by getting some of these right as also lose her scarf (losing shirts might be rather embarrassing for women) in getting some others wrong. You on the other hand would keep going to work at 9AM and return home at 8PM and watch some reality TV show with your family and sleep in peace. Five years hence you will take stock (literally) and find out that you averaged 18% year on year (not bad!) or 9% year on year (could have been better!) or some such number.

The difference lies in the way you look at the investing process. Speculation is betting of the sort you will do in horse racing or cricket. Asset purchase is of the sort you will do in buying a house (for renting out). The assumption in asset purchase philosophy is that you do not mind holding the asset for eternity if you had to. The idea is that the asset will generate cash flows enough to justify your purchase price. In practice the presence of liquid stock markets ensures that should you get a better price or change your expectations of the cash flows from the asset or simply need cash, you can offer the asset to some other buyer at a mutually agreed on price. The difference between you and speculator is that the speculator would never purchase an asset with the understanding that she will hold it for eternity if required. Her hope is that the price of the asset will increase because changes in the expectations of the asset buyers or other speculators.

Wadala, 19 August 2007

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