Sunday, November 13, 2011

Making out Uncertainity from Risk

I recently met with the Vice President of a retail broking firm. A clan I dislike as I have no interest in the subject. My impression of a retail broker is about nosey dealers wanting to ever increase their brokerages and conning people into trading. I probed to see if there are any new ideas for an investor. I was impressed by his discipline ‘program of investing’. He is someone who has built a portfolio by adhering to a simple ‘2 step method’.

Step 1: He only buys when a Good company is sighted with bad news. State Bank of India has suffered in stock declines due to the bad news of higher provisions, 99% drop of profits, high interest rates slowing growth & expectation of high nonperforming assets, deregulation of savings account interests which will increase cost of capital . The negative news caused SBI share prices severe decline of 45% in a year. Or take the example of Maruti which has corrected by 25% in the wake of bad news: strike at Manesar plant, higher raw material costs and lower profits. The bad news never last long. And things eventually get better for great companies with
sound management and economy.

Step 2: Do Not Buy, if you still linger doubts, after having spotted a sound business with bad news and depressed prices. On the contrary when you want to sell after the prices have risen
sharply and your greed stops you from selling, sell at-least half. This step helps control our emotions of greed or fear for better investing success.

Bad news creates an environment of uncertainty. Most of the times, there is no risk. Like with SBI, the question to ask then is what has changed in the business other than the price? We must be able to differentiate between uncertainty and risk. Markets hate uncertainty and the typical reaction is by beating down the prices. Remember how Satyam was battered within days from Rs 400 to Rs 30. That would go down in history as one of the highest uncertainty caused due to corporate fraud. But what we forgot is that this is a business with customers and services delivered in real economy terms. The response to such uncertainty is normally much more magnified than the uncertainty itself.

Risk is even more difficult to see or know. The entire industry of Travel Agency disappeared with the advent of Information Technology,. It was slow but brutal and not recognizable. Remember Encyclopedia Britannica ? Some companies disappear because they do not either stay relevant or do not leverage new generation methods of conducting business.

Investors like predictability that blue chips offer. This explains why Bluechips quote at a premium over midcaps and why investors pay higher premium for them. Investors pay less for small stocks due to unpredictable earnings and create bargains in the process for value investors. Although these mid caps underperform in the short run, they go on to earn better returns in the long-term.

Discipline of a ‘method’ to invest or sell helps inhibit emotional reactions stung by panic or greed. Keeping a time frame of say 5 or 10 years while investing in a MutualFund, or having an objective for pension or children’s higher education allows you to mentally align with the time horizon. When the sensex tanks, if Iran gets bombed or Greece defaults, you will then consider it an opportunity to buy more units at lesser cost. Because you have a lot of time left for your goal redemption. The discipline will make you look at it as if the discount sale has begun. As opposed, if you were to invest in SIP MF for the sake of making returns, you will see yourself selling investments at a loss when crisis strikes and panic sets off.

Kingfisher Airlines is in big trouble. The stock of the Company which was once near 400 mark is now at 17. The Auditors of the company recently wondered if it would go bankrupt. Now would you call this Risk or Uncertainty? I will be delighted to hear your views on this.
Wishing you the very best.