Sunday, May 13, 2012

Illusion of Analysis

A leading publication recently carried an article on Equity- returns versus fixed deposits that stirred a hornet’s nest. I got many calls asking if this was true, why I would recommend investing in equity. The story went like this: the author carried out a research of the last 20 years returns that Sensex had delivered. He concluded that the Sensex which was quoting 4285 on April 1992 is on 17,404 at April 2012. He calculated thereby that the Sensex had delivered an annualized return of a paltry 7.26% against an FD of 10.28%. Mathematically (=((17,404/4,285)^(1/20 years))-1), this made sense. However neither the choice of specific period nor the silence around elaboration really helped investors. I decided to do more research on this to extract any learning. I rewound by 3 months to 02, January 1992, the Sensex was then quoting at 1965, and recalculated the returns for the same period ending April 2012. The annualized return suddenly shot up to 11.52%. To further illustrate my point, if you consider another specific period between Jan 1992 and when the market peaked in Dec 2010, the annualized return works to 14%, although it becomes very biased. But that’s exactly the problem of statistics.

The famous anecdote of Malcolm Forbes illustrates this story. Forbes once drifted away during his -famous hot-air balloon pursuits and landed in a corn field far away from civilization. He fortunately found a passerby and asked him where he was. Pat came the reply, “Sir, you are inside a basket in a field of corn. “ To this, Forbes asked him if he was a statistician, and the person was astonished. “How did you know, sir?” Forbes said “Your information is concise, precise and absolutely useless.” Forbes’s reply cautions every investor not to get carried away completely by data slice and dice.

During my research on the same data-set, I calculated 10 yearly-returns for every month-ending between 2002 and 2012 , starting from 1992. I had a sample size of 136 ten yearly annualized returns. The 10 year returns varied from -2% to +19.47% , which means you could have waited for 10 years and made a negative return or a +19% depending on the period of 10 years you chose. A similar analysis of 5-year hold period showed an annualized return between -5% & +46%. Frankly, this data- set means little to investors as long as we can broadly take some lessons. You need to constantly keep tab of your investments; a half-yearly check on the stocks or mutual funds are absolutely necessary. The 7.26% paltry return the author referred to was from a sensex level of 4285 in April 1992, after the markets ran up from a sensex level of 1965 in January 1992, doubling in those 3 months with a peak valuation of about 55 times. It therefore goes that we always step aside or partially liquidate after the markets have run up to crazy valuations. It is difficult to value an asset but not that difficult to ascertain overvaluation or undervaluation of stocks. If you are in SIP, it means you can do a systematic transfer into a debt- fund and re-enter at favorable valuations. For instance, in the above example, the markets were available at fair valuations of 15 (P/E ratio) by December 1995. Normally, such rapid movements of stock- markets are followed by periods of stagnation or slow growth. We discussed this in details in a previous blog. We must fend ourselves from the belief it is possible to make easy money without commensurate efforts.

To understand these risks better, we need to have a handle on valuations. It is very difficult to price an asset precisely. But we can identify if the asset is overvalued or undervalued with relative ease. The P/E is one way of doing it, but that alone would lead to pitfalls. . In Japan, a few decades ago, investors were paying 40 times, hoping for great future earnings. However in the years that ensued, the confidence was rattled and investors were ready to pay less than 20 times. So while businesses continued to grow, the investors were willing to pay much less, leading to very low or negative returns for a period of 20 years. So we had a situation where businesses were doing not- so- bad, but the returns from equity stagnated for many, many years. The question of what price to pay is akin to asking how much are you willing to pay for the Taj Mahal? By and large we can expect that stocks with low P/E will out do those with higher multiples, other fundamentals remaining the same. Hence Great companies need not really make great investments.