Election fever and deciding when to buy

In the fire hydrant post, I mentioned how every potential investor is inundated with a barrage of news / opinions / techniques to do his investing. It doesn’t help that financial news editors like using words like “surge” and “plunge” for routine market movements in their headlines. In addition, the investor has to contend with the enemy within – Mr. Market who exhorts him to jump in with both feet when markets rise and to dump everything when they drop.

The Calm Investor doesn’t let the noise or his own biases stampede him into thinking of the stock market as a casino in Las Vegas. Instead, she keeps the principles of calm investing at the back of her mind while making any decision.

And those decisions boil down to:

  • “When to buy?” (almost all the time)
  • “What to buy?” (quality companies at reasonable prices) and
  • “When to sell?” (almost never)

While the answers to those can be different for each individual depending on their own temperament and ability to handle uncertainty, having a clearly articulated approach is essential to any investor to develop and refine their investment methodology over time. We’ll look at parts of these questions in separate posts.

The first question “When to buy?” should set a few alarm bells ringing in the mind of some readers who’ve been alerted to the evils of trying “to time the market”. This would imply an ability to tell where markets are headed and that violates the very first principle of calm investing.

Markets have and always will be always unpredictable and often volatile in the short term. Anyone who says they know where the market will be a week / month / year from now is guessing (or has super powers). Accumulating wealth is therefore based on the realization of this inherent unpredictability

However, there have been instances in the stock market’s history where markets have climbed precipitously to slightly ridiculous levels where it would be impossible to buy quality companies at reasonable prices. An investor who decided to do a lumpsum investment in early 2008 would see his holdings lose half their value by the end of the year possibly causing him to never consider equity investing again.

And because the objective of the investing exercise is not to just identify great companies but to buy good companies at prices that will appreciate enough to offer good returns, its important to buy when enough people do not want to.

Excerpt from Phil Fisher’s book ‘Common Stocks and uncommon profits

[…Up to this point, our discussion of the financial community’s appraisal of a stock may have given the impression that this appraisal is nothing more than an evaluation of that particular equity, considered by itself. This is oversimplification.

Actually it always results from the blending of three separate appraisals:

  1. the current financial community appraisal of the attractiveness of common stocks as a whole
  2. of the industry of which, the particular company is a part
  3. and finally, of the company itself…]

This book, having been written several decades ago, refers to a time when tracking stocks was considered a specialized activity hence the emphasis on ‘the financial community’, but we can safely replace it with ‘the general investing community’

when to buy

 

With the election results around the corner, this is a good time to take stock of the “M” or where the Indian markets stand with respect to historical levels.

The first chart shows the NIFTY level from the beginning of 1999 to May 2014. It is also the least useful chart in this post.

As on 12th May 2014, it stood at 7,014 having started the year at 6,301, a gain of 11%, which is more than the gain for all of 2013. Zooming out shows a largely upward trend with some dips in 2000, 2008 and 2011. So what? Stock markets are supposed to rise with increasing company earnings and that’s what this chart shows. What it doesn’t shed any light on is whether they are at unsustainable levels and if the chances of a sharp drop are higher than usual. For that we’ll look at the next three charts.

Chart shows the NIFTY’s Price to Earnings (P/E) ratio since 1999

Price to Earnings ratio is the price of the stock or the index level divided by the cumulative earnings per share of all the companies that constitute the Nifty. A good way to think of this number is the number of years of current earnings that you would have to pay to buy 1 share.

As of 12th May 2014, Nifty is trading at 19.5 times earnings. Slightly above the median P/E of 18.3 over the last 15 years. A far cry from the 27.3 it hit in Feb 2000 and Jan 2008 before subsiding spectacularly and also from the low of 10.9 it hit in Oct 2008.

Chart shows the NIFTY’s Price to Book Value (P/B) ratio since 1999

Price to Book ratio is the price of the stock divided by the book value of assets of the firms that make up the Nifty. Since this number depends on how new or old the assets (plant and equipment) of a company are, it has limitations as a valuation metric. However, it offers a good comparison against times of irrational exuberance or pessimism.

On 12th May 2014, Nifty stands at 3.33 times book value. Lower than the median value of 3.5 but higher than the 2.15 it hit post the economic crisis post the Lehmann bankruptcy. Note the sharp correction from Jan 2008 to Oct 2008. Optimistic market observers liken the current scenario to what prevailed in late 2004 where the P/B started an upward climb from 2.9, but that’s anyone’s guess.

Chart shows dividend yield on the Nifty since 1999

Dividend Yield is the dividend per share as a percentage of the prevailing stock price. Given dividends paid out tend to be stable, higher the yield, lower the price.

Current dividend yield stands at 1.4 which is also the median for the Nifty. The yield hit lows coinciding with market highs like in May 2001 and Jan 2008.

The three valuation metrics (P/E, P/B, Dividend Yield) indicate that going into election results season, the broad index is neither significantly above or below median values. While this doesn’t, in any way, preclude the possibility of significant moves in either direction in the immediate term, it implies that markets are NOT terribly overpriced by historic standards. They aren’t cheap either.

Implication to The Calm Investor

While no amount of rearview mirror-gazing can ensure profitable investing all the time, tracking some of the key valuation metrics can help decide on how one should pace their investments. For instance, the closer the P/E and P/B charts are to the uppermost line (75th %), the more cautious the investor needs to be in deploying his funds.

Markets have run up over the last few months in anticipation of election results, the levels aren’t as dangerously high as in the past just before steep falls.

As of May 2014, an the Calm Investor should therefore

  • certainly not deploy a lumpsum amount into the market at this point simply because of the high probability of high volatility over the next few months
  • review the stocks she’s buying and examine them for steep run-ups that belie even the most optimistic expectations of corporate earnings
  • at the same time, not take rushed decisions based on the breathlessness of what’s happening all around. Not pull out of the market because sharp rises will exert  behavioral influence to jump in at even higher levels and impair returns
  • continue with any existing plan that buys regularly into the market on a monthly basis, using the SIP, Don’t Guzzle method

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