THE CATS AND THE MONKEY STORY

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Few days ago, some of my friends were arguing that stock is a zero sum game stating that you might make money on an occassion but you will also loose money on another occassion and as such people don't make money from the market. Recently, I also came across a topic in one of the orkut communites. The originator of the topic claimed that the retail players in the stock market basically end up with a loss. Few people admitted that their stock market endeavour was a failure while few said that they made good money in the market. I started my enquiry into the subject to ascertain why a lot of retail investors end up with a loss.

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Let me analyse it from the Indian context. Well, we all know that the market has performed really well in the last few years. However, let us take a realistic view of the market returns. Let us consider the ten year period between April 1,1996 and March 31, 2007. The performance of the nifty during the decade is shown below

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I don't know if there was some other time period that was as exciting as the last decade. As you can see in the chart, the first few years of the decade witnessed a relatively flat market. However, middle of the decade witnessed two major stock market bubbles. One was the Ketan Parekh scam and the other one being the dot com bust. The latter part of the decade saw sharp upturns followed by some correction at the fag end of the decade. I am fairly convinced that this decade fairly represents the general movements of a stock market and hence it is suitable to be used as a proxy for calculation of long term metrics.

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The decade started of at 968.30 and ended at 3821.55 resulting in a Compounded Annual Growth Rate (CAGR) of roughly around 15%. This CAGR of 15% is basically the geometric mean of the return on the Nifty. I don't have details about the dividend yield of the index during the period but I am sure that it can't be too significant. Taking cue from this past data and assuming an optimistic dividend yield of roughly 1%, the total return that could be expected from the market is around 16%.

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I don't have adequate data in hand. However, in general, organised fund houses tend to outperform the market and which means that the return that is available to a retail investor is even below this 16% mark.

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Let me now, introduce to you the biggest villain of the Indian stock market - 'Transaction Costs'. Well, transaction costs are highly inevitable in the world of business. There is always a gap between the seller and the buyer and you need a middleman and a vehicle to fill up this gap. The more underdeveloped the market is the higher is the transaction cost. In the Indian scenario, the transaction cost comprises basically of Brokerage, Security transaction tax and Other taxes such as service tax etc. You will soon realise why I called 'Transaction cost' a villain.

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Typically, large players like mutual funds or high networth individuals are subject to a very low level of brokerages. However, a typical retail investor in the Indian market pays not less than 0.35% (per leg) as brokerage for a transaction. Then you have a security transaction tax of 0.125% (per leg) besides a service tax on the brokerage fee. All this roughly converts to something around 0.5% of the value of a transaction. So, in case, if you are going to buy and sell a stock then you would eventually be shedding out roughly 1% of the entire transaction cycle. So, your return further gets eroded by 1% per transaction.

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Perhaps people wouldn't mind too much about incurring a flat 1% since the potential returns from the market far exceeds that of any other investment avenue. However, this is where a normal retail player committs blunder. Quite a lot of the retail players (atleast those who I know and including me) try to outsmart the rest of the crowd. In an endeavour to outsmart the market they keep switching stocks and every time one switches stocks he incurs the 1% transaction cost. Roughly 15 switches a year or roughly 5 switches every 4 months, by an investor erodes his share of the return from the market. If you are wondering whether people switch stocks so frequently, then perhaps you would be even more surprised to know that quite a lot of retail guys switch stocks even more frequently.

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Day trading is again another game where you probably have several loosers for every single winner. A typical day trader incurs atleast 0.2% (both the legs put together) of his trade value every day. So, in total a day trader incurs more than 50% (assuming 250 session per year) of his average investment as brokerage. This 50% is perhaps the total return of three guys. So, if he is going to make money beyond this 50% then definitely for every such winner there will be atleast four loosers.

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Besides you also have a crowd that tries to make money by using instruments such as the futures and options. While these derivative instruments represent one another exciting stock market instrument, it should be understood that they derive their value only based on the actual stocks that are traded. Hence the sum of the returns for the stock market and the equity derivatives market of all the players put together cannot exceed the total return of the stock market. However, derivative instrument also incur transaction cost.

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This is no different from the typical cat and monkey story that we read in our childhood - but perhaps a little modern. While the cats - the investors, fight between themselves to grab the bigger pie, the monkeys - the brokers (and the Government too), are calmly eating the cakes.

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Well, perhaps my intention was not to negatively portray the brokers. They play a very vital role in bringing the buyer and the seller together. But investors, out of their greed to outsmart their counterparts basically end up loosing all their profits to the brokers.

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I think perhaps, you would've realised by now as to why most of the retail investors end up loosing their money even in a market that is rewarding well. No doubt, there are people who make huge money despite switching stocks continuously. However for you to be that successful, you definitely need to be damn smart and have enough financial resources to drive the prices or the lady luck should be sitting on your lap. Again, as I mentioned above, for every such winner you are going to have several loosers.

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Before, I conclude, let me clarify one more thing. I am not saying that stock market doesn't reward. Neither I am saying that one shouldn't try to outsmart the market. But timing and continuous switching of stock is the not the best way to do that. If you want to outperform the market, then put your effort to see what others cannot see and identify that long term bet which will take you to the road of richness.

PURCHASE PRICE AND THE SELLING DECISION

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Are you an investor in stock? Did the loss or profit that was made on a stock influence your decision to sell or hold that stock? If yes, then you will definitely need to go through the rest of this page.

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Those who succeed in the stock market say that shares are a great investment. On the other hand those who fail quite often mention that share market is more of gambling. Shares are definitely one of the best investment avenues. However investing in stock requires understanding of business fundementals and common sense. I have a strong conviction that understanding of business is not too important if you are sure that your money is going to be with a strong management team. However, there is no substitute for common sense and unless someone has that, it is indeed difficult to make money in the market.

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One of the most commonest mistake that people do is to take their selling decision based on their purcahse price. Let us take two categories of investors who decide their selling decision based on the purchase price. The first case are investors who want to hold on to their stock because the stock price has gone below the purchase price. The second case are those who want to sell their stock because they have suffered considerable loss on the stock already.

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Among those two, who do you think are the most rationale group? If you answered that it is the first group then you are wrong. But if you think that second group is more rationale then again you are wrong. Neither of them are rationale investors. The loss that one has suffered on a stock is a past event and your selling or holding decision cannot undo such losses. In short, those are sunk costs and your subsequent actions will have no impact on them.

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Once you purchase a stock, the purchase price should cease to be a factor driving your sell or hold decision. What should drive your decision is the return that you could expect on stock at its prevailing market price.

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Let me illustrate it with this example. Suppose, you bought a stock for Rs.300 three years earlier and the stock now trades only at around Rs.150. At the same point in time you see another stock that has been doing so well and has got a potential to earn 20% return based on its prevailing price. Investors might generally get tempted to switch stock at this point in time. However, just imagine that if on the other hand the stock that is trading at Rs.150 is undervalued and can has the potential to yield a 30% return. If you decide to sell the stock at Rs.150 and switch to the other stock you would end up loosing 1/3rd of your total returns in addition to the transaction charges.

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On the other hand if the stock that you hold is not a good bet and has a dull future, then holding on to it for the reason that you suffered losses would only mean that your loss is going to increase further.

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However, the principle of 'Stop loss' (squaring of the position to protect against further loss) is not always a bad one. Especially if you are a trader or an investor with a very short terms perspective. Stock prices move in a very random fashion in the short run and therefore traders or short term investors necessarily need to inculcate the habit of stop loss.

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To conclude, a short term investor or a trader definitely needs to follow the principle of 'Stop loss' as a regular discipline. However, a long term investor should never decide on a sell vs hold decision based on the loss that has already been suffered since such losses are a sunk cost and cannot be recovered.

INVESTING IN REAL ESTATE

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The real estate market in India is booming like never before. Such a phenomenon is suppose to attract too much of attention and the real estate sector is no exception to it. In fact, I would say that it has got a little too much of attention that today every single individual has got his own opinions on it.

In an endeavour to enable the investing community to smartly invest their money I am bringing you this piece of writing on real estate - the market, the players, the forces, the fundamentals and valuation. In all the subsequent lines I address the topic only from an individual's perspective rather than from the perspective of a commercial player.

Let us first start off understanding the unique features of real estate compared to other investment avenues.

UNIQUE FEATURES

• Real estates are real assets that have physical existence.
• They have real value as compared to other real assets like gold or art which only have a perceived value.
• They have alternate uses. For eg. a piece of land can be used for agriculture, industry or for domestic residential purpose
• They are immovable.

THE PLAYERS

I would classify the players in the market into three.

• Firstly, the property developers.
• Secondly, the citizens who want to buy their dream houses and
• Finally, those who see it as an investment option.

The market also has got several organised and indegenous middlemen. However, the rest of this post will adress the issue only from the point of view of an individual who sees real estate as an investment option.

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THE FORCES

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Real estate is also subject to the market forces i.e. the demand and supply factors. Population growth is a very obvious factor which will increase the demand for real estate on a overall basis. However, I believe that increase in industrialisation is the most important factor that would influence the demand for real estate in a particular geographical area. Increasing industrialisation provides more employment opportunities and increases the concentration of people around a particular geographical location. Further, it also increases the standard of living thus prompting people to expect more space around them. Industries themselves would also need real estate spaces to carry their operations.

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The supply side of the real estates is theoretically limited. However, practically, multi storied building and apartments expands the scope for realty space and reduces the limitations to a good extent.

The real estate market certainly has a relatively elastic demand at this juncture notwithstanding the fact that shelter is one of the basic necessities. Hence it is impossible for any one to be an absolute price maker. On the other hand, the lower amount of liquidity enables all the players to influence the prices upto a certain degree away from the equilibrium price.

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THE FUNDAMENTALS IN INDIAN CONTEXT

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Any investment, derives its value based on the return that it generates. So, the fundamental factor that needs to be analysed first is the return or more precisely the rent that a real estate would generate. The tenth five year plan in India estimated a shortage of 22.4 million dwelling units. I believe that the severity of such a shortage in the urban area would be much higher compared to other parts of the nation. I further believe that India is still an under industrialised nation and see a huge potential for further industrialisation which would fuel the demand further. On the other hand the population density in the major cities in the nation is already at an alarming level (see table 1) and could be a major constraint, in the short term, to increase the supply. Therefore, as far as, the major cities like Bombay, Delhi, Chennai, Pune, Banglore etc. are concerned, I believe that the rentals might see an uprecedented growth levels in the short term. However, I believe that in the long run, the industrialisation would get widespread in terms of the level of concentration which could reduce the pressure on rentals in such locations. On the other hand, I believe that the rentals in the 'not so hot' regions of the nation would be fairly stable now. However as the industrialisation gets widespread the rentals in such regions will also see the same phenomenon that the major cities are witnessing today.

Source: Wikipedia

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According to Wikipedia the population density of India is at around 312 persons per k.m. While this is quite high compared to several other countries, I believe that this figure is much nominal considering the fact that most part of India is habitable. With a population growth estimated at just around 1.50% per annum I believe that population growth wouldn't be such a huge factor affecting the real estate prices atleast in the medium term.

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The next fundamental factor that needs to be analysed is the required rate of return. The required rate of return on a particular investment depends on the returns that are available in alternate avenues adjusted for the specific risk charteristic of the investment. So, in order to determine the required rate of return on real estate, the starting point perhaps from an individual's point of view must be the return that is available on a bank deposit. I would be stretching myself a little too much if I try to project the interest rate over the next 15-20 years. So, I am proceeding based on today's scenario. Today, a fixed deposit for a decent duration would provide a pre-tax return of 9%. However, the interest rate is driven by an inflation that is above 6%. I believe that economy would turn more stable and the normalised inflation rate would be at somewhere around 4% to 4.5%. Thus the normalised return that could be expected out of a bank deposit would be around 7%. Considering the fact that rental incomes are subject to the risk of default and under realisation due to vacancy, I expect a slightly higher premium over the bank deposit rate. In my opinion a return of close to 9.5% on a pre-tax basis would really be a decent return to be expected out of a real estate investment.

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The input cost wouldn't affect the valuation of the super structure since the asset is valued based on its return generating capacity. However an increase in costs of inputs like cements, steels and sand, in an ideal scenario, would push the land price downward. This is because the value of the the entire asset as a whole on cetris peribus basis, has to remain same. Therfore an increase in the cost of construction will bring down the land price to compensate for the escalation.

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VALUATION

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The rentals and the fundamentals are too different for different geographical locations. Rentals also vary too much within a particular city. Therefore, I am not going to ascertain the fair value in a particular location. Instead, in this section I shall explain on how should one try to find out the fair value of a residential property and I will be illustrating it with an example of an hypothetical city that is growing as well as the cities like Pune, Banglore or Chennai.

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Before proceeding to discuss further, it is necessary that I introduce the concept of present value. Today the bank interest rate is around 9%. Rs.100 invested in a bank deposit would increase the value of your wealth to Rs.109 one year down the line. Looking at it from another point of view, Rs.109 to be received one year down the line is worth Rs.100 today.

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Essentially the value of the real estate should be the present value of the rental income that will be realised in the future. Rental income and interest income are subject to differential tax system. Hence, the analysis of valuation would be more accurate if it is on a post-tax basis. Therefore both the income as well as the opportunity cost of capital should be adjusted for tax. As mentioned above, an individual should realise atleast a pre-tax return of 9.5%. Assuming that he is subject to a 30% tax, the post tax return should be at around 6.65%. Similarly the rental income is also subject to tax. However, as per the current tax structure, in India, only 70% of the rental income is taxed and as such the effective tax rate will be at around 21%. Table 2 provides a sample valuation sheet for a hypothetical city mentioned above.

The assumptions in the table about annual growth rate, taxes etc. are purely for illustration purpose and shouldn't be considered as my estimate or opinion about how much future rentals could go up in any part of the nation. Considering such assumption the value of the property in the hypothetical city is only worth 79 times the annual pre-tax rentals that the property could fetch today.

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VALUATION OF VACANT LAND

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A prudent reader might be wondering now as to how could these principles be employed to value a real estate property like a vacant land that does not earn any rentals. In an ideal situation the market would never reward an asset that is kept idle. Therefore the valuation of such a land should be based upon how much rental could it fetch if a proper super structure is constructed on it. The cost of constructing the super structure should be reduced from the present value thus computed to arrive at the value of the vacant land.

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The above principles are easier said than used. Most importantly, it is very difficult to identify the future rentals of a property as real estate has got alternate uses and the returns that could be generated varies based on the purpose to which it is put. It is neither correct to assume that all the investor would use it for the purpose the produces maximum return. For instance, a commercial property might yield more returns than a domestic property but there cannot be too many commercial properties. It is also really difficult to predict the growth rate of rentals. A different growth rate than what is projected could affect the valuations both favourably (if actual growth rate is higher) as well as adversly (if the actual growth rate is lower).