## July 16, 2008

### Responding to comments and emails

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

From prashant

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.

Anonymous said...

Hi Rohit,

Thanks for sharing your thoughts / experience. I would have switched in the same fund house to avoid paying extra in/out load. Still think SIP would take care of this correction too (in long term).

Regards
Prashant

VISHNU said...

Hi Rohit,

Sorry to write one comment for your multiple articles..I was not really looking at any site nowadays due to my viral fever..and my calculation below is very rudimentry but works fine for me...

COMMENT for inflation and interest rates

I always look at general market from real returns(as per the Buffet Fourtune article) + Earning Yield Bargain from Security Analysis (Twice that of AAA Bond)

Lets say that Interest rate is 10 % ..and the Inflation is 12 %..I feel it is ridiculous to say my hurdle rate is 10 %..because you are looking at -2% real returns..So based on Interest Rate + Inflation I try to increase my required margin of safety..

Lets play an example..
Interest Rate now is 8-9 %..and the inflation is 12 %..Now where do I invest ?
Now I am seeing Rane Madras (just for an example) is 2 PE. and Earning Yield is 50%. Looks like i found perfoect solution for the real returns and my margin of safety coming from Earning Yield is more than that of Interest Rate , Inflation , AAA Bond , Real Estate

(This is again from general market perspective..buying a dollar for 50 cents works beautifully in any market..)

Returns by buying a dollar for 50 cents
1 Year = 50 % (assume market corrects in 1 Year)
2 Year = 25 % (assume market corrects in 2 Year)
3 Year = 16 % (assume market acorrects in 3 Year)
4 Year = 12.5 % (assume market corrects in 3 Year)

I generally come and see if the market is offering any mispriced assets for me..thats it..be it real estate , bonds , Real Estate..If I find a one I understand, then I buy it...

I dont see whether Voltas / Amararaja Batteries are good companies..(Because price changes everything)

Some example from the master..(Warren Buffet)

About 7 or 8 weeks ago you may have read about how in auction rate securities the weekly auctions were fake. In other words, these were instruments backing up money market funds (\$330 billion of tax exempt funds). People had their money in what they believed were demand deposits and the way they could get out was that every week there was an auction of underlying securities where anyone could get out and somebody else get in. They had limits on the interest rates they would pay. Nobody ever thought they would hit those limits. They were past those limits. If the limit was 4% then the issuer would pay 4% and nobody was willing to buy at 4%. So the people were stuck in it. The underlying credits, in 99% of the cases, there were no problems with the issuer. The problem was the whole financial system was under strain and nobody wanted to come in. Incidentally, many of you are from Canada and this is similar to the commercial paper that was frozen. People thought they had something that they could get out of tomorrow morning and couldn’t. Here in the US we had hundreds of billions of dollars that people were locked into these auction rate securities. So what happened? 6 or 7 weeks ago we started bidding on these things.That caused me to start thinking about it. This doesn’t add up to lots of money, but we started buying these issues and today we have something like 4 billion in things that 7 weeks ago were paying 2% and now are paying 8%. This is when short term treasury bills are 1%. So this is crazy, but the really crazy part is that every day we get these bid lists from Citi, Merrill Lynch, JP Morgan of all these different options. Sometimes we see that on different pages there will be the same issuer, lets say the New York Port Authority, because, in fact, they are different issues. Sometimes we put in bids at an 8% basis and someone else, just because they are on another page, gets them on a 5% basis; now that is huge. That can’t happen if markets are efficient. This is not some little market anomaly, this is a \$300 billion market, with a 300 basis point spread on the same security. 8 weeks ago I would not have dreamt that this would happen - and then it happened. And it is lasting longer than I thought it would.

Regards
Vishnu

Rohit Chauhan said...

Hi prashant
with SIP you will have to be patient. It may not work for long stretches. jumping may seem to work in the short term and also gives a feel of control and action

vishnu
i would agree with calculation only if i assume that long term inflation is going to be around 10%. i am not quite sure about that ..
12% is the hurdle rate. however there is always a margin of safety too. so if your analysis is correct and company does well, then the reduction of this gap and growth in intrinsic value will give returns more than 12%.
the hurdle rate is what you will get if the intrinsic value remains where it is and there is no reduction in the gap.

i will increase my discount rate only if i believe the long term rates will be higher. if you increase discount rate based on a 2-3 month high inflation, then you may be jumping the gun. ofcourse if the long term rates for the next 3-5 years remain around 10%, then you are right

finally, i agree valuation is important. but i would look at fundamentals before going on to valuation, which is what i have done for volats. I am not sure about amarraja's fundamentals and hence not even looking at valuations now

regards
rohit

Mahendra Naik said...

Your SIP theory makes perfect sense. It's time small investors stopped timing markets and adopted some discipline.

Rohit Chauhan said...

Hi mahendra
dont see that happening anytime soon. most of the people want to get rich quick ..SIP is like watching grass grow.
timing the market is seductive and you getting bragging right. SIP is boring even if it makes you money in the long run
regards
rohit