I receive several comments and emails with questions which require a detailed response. Instead of replying through an email or a comment, I am posting my reply as I thought others may find the discussion useful
Question : Does the increase in inflation and interest rates, impact the intrinsic value calculation ? Would you not increase the discount rate and reduce the instrinsic value as the long term government bonds rates have increased?
My response : You can find my approach to calculating intrinsic value here. In addition my valuation template also has the format for calculating intrinsic value. You can download it from here.
As some of you would have noticed, the discount rate I use is around 12%. This is strictly not as per finance theory. The typical textbook way to calculate discount rates, is to use the CAPM model (use the cost of equity and debt to calculate the discount rate). I am however more influenced by buffett and munger and their way of looking at stocks. For me, the discount rate or hurdle rate is my opportunity cost.
What is opportunity cost ? It is the return I can normally get from other investment options (debt and equity included). So if I have to invest in a stock, the expected return should be more than my opportunity cost (with a margin of safety to compensate for the risk).
When the long term rates were around 10-12 % in early 2000, I had a hurdle rate of around 13-14%. However when the rates dropped to around 8-9%, I dropped the hurdle rate to 11-12%. If you believe that the long term rates are likely to stay around 10% or higher for quite some time, then it would make sense to increase the discount rate you are using. However in my case, I plan to hold the discount rate at 11-12% till I get a strong feel that the long term rates in india would be above 10% for quite some time to come. Even in that case I may bump up the discount rate by 1-2% at best.
The market is ofcourse adjusting the valuation due to rise in the inflation and interest rates by dropping the prices. However we cannot be sure if this rise in inflation is temporary (6-12 months) or we are in for long term inflation
Wondering what you did with your mutual fund investment(I guess you hold diversified equity funds) during Dec 07 / Jan 08 when valuations were sky high? A friend of mine informed me in Dec, 07 that he is swapping all equity funds to debt / balance funds. I ignored the info and thought SIP would take care of any correction. At the peak, gains were around 60% on the total money invested (during SIP of 1-1/2 years - infact I invested extra money in MF during all corrections) and now around -8%.
Actually I was not tracking the market and was taking care of monthly SIP money only. Now looking at current situation, I think I missed the opportunity. I should have done the same as my friend did. Lesson Learned – at a very high cost!!!
My response :
I have done this swapping in and out, jumping up and down and sideways and all around in the past. So after all the jumping and hopping, I decided to do some analysis in 2007 to see how I would have done in the last 8-9 years if I had just done an SIP. Well to my utter surprise, my returns were only 1% better than what I would have got through a dumb SIP plan in a decent mutual fund. With expense loads factored in, I have fared worse than an SIP plan.
I have seen from my past experience when I tried to time mutual funds, I ended up second guessing myself. When the market tanked, I was out and still waiting to get in.Then finally the market resumed its upwards course, but I was still twidling my thumbs. So this jumping in and out over the last decade has costed me a lot.
So this is what I decided – find 4-5 decent mutual funds. I don’t mean the top 5 or top 3 funds which is diffcult to find in terms of future performance. You can find the top 5 funds for the last X years, but that is no assurance that those funds will do equally well in the next X years. So I look at the funds with long histories (more the better) and if they have beaten the market by 3-5%, I set an SIP in them.
Will this give me the highest possible returns ? No it would not. Will I have bragging rights that I was smart to recognize the market top and jump out at the right time ? No, I will not. But I think I will end up following a fairly intelligent investment policy and make good returns. In addition this frees up my time and energy to pursue other activities.