When the tide goes out

‘Only when the tide goes out do you discover who's been swimming naked ‘– Warren Buffett.

It’s now clear to the entire world, that we as a country have been swimming naked. If you look at the last 50 years of our history, the 2003-2008 period looks more like an aberration or accident. We benefited from a wave of liquidity and enthusiasm for the BRIC countries (including India) and as a result were able to grow in excess of 8%, inspite of not having the institutional structure (such as a responsive bureaucracy) to support it.

Now the tide (liquidity and enthusiasm) has gone out and the visible symptom of years of mis-management is the crash of the rupee. I am extremely pessimistic about the macro picture and the ability of our political system to fix it.

….and yet my finger is itching to press the buy button !!!

No, I am not blind to the risks and as depressed about the country as any other Indian. Let me explain my reasoning behind this apparently contradictory stance.

What are the options?

Let’s define the problem – The main outcome of the currency crash and other macro problems on the common investor is a further rise in inflation. We are likely to see double digit inflation for some more time. This is likely to destroy the real value of our capital if we do not find means of protecting or growing it.

So if you have some capital (equity, real estate, cash  or FD) with you, what are the options for it ?

If you decide to hold cash or some form of an FD (which seems to be the safest bet), you have to keep in mind that the real return (after deducting the 10%+ inflation) is likely to be negative. For reference – do a search on East Asian crisis of the 90s and other such events in the past. You will realize that any form of fixed income investment did far worse than other alternatives.

The second option is real estate. I have been pessimistic about real estate for a long time and with low gross yields of 2-3%, think it is overvalued. However if one has the skill to find some undervalued property and can hold on to an illiquid investment for some time, then this could be a possible option. At the same time, if you are thinking of using a loan  to finance it – forget about it. If the currency rate continues to depreciate, we may see a further rise in interest rates (which has already started) and the loan which you are planning (or already have), may become even more expensive.

The next option is gold. This seems to be a good option as it is likely to hold value in real terms as the currency continues to depreciate. I think there is some truth in it – though I don’t think I understand how to value gold and hence I am not likely to go for it. In addition, gold at best is a defensive option (will protect principal, but unlikely to grow it in real terms over the long term)

I know that readers of this blog already know where I am going with this logic – equities. But before I get there, let me digress a bit.

I think the number one asset to invest at any point of time is you. If you invest (money and time) in developing your skills and become really good at whatever you do, then macro factors are unlikely to impact your earnings in the long run. If you are a talented, the market will pay you for what you are worth (and more of it in a depreciated currency).

The last option, which seems to be the most risky is equities. The reason it appears to be risky is due to the vividness of the risk. If you own a stock and inflation rises, the impact is visible immediately. On the other hand, options such as cash or real estate seem to be safe as we do not get a quote on it daily. However that is just a false sense of safety as the real value is eroding silently. A fixed deposit or debt instrument in the last five years has lost value due to inflation and so has real estate (if it has not appreciated by more than 12% per annum).

The case for equities

One can easily point out that equities are no better as the index has dropped in the last five years and hence the loss is even higher in real terms. That is true if you have been invested in the index for the last few years. At the same time, there are several companies such cera sanitaryware or crisil which have done quite well during the same period.

The key point is this – if you are an investor who can evaluate stocks (as quite a few readers of this blog are), then a carefully selected portfolio of above average companies (defined by high return on capital and good management) has done quite well in the last five years in spite of the extreme macro environment.

Let’s look at the same point mathematically – If you are able to buy a company, which is earning around 20% return on capital (and can do so for the next 3-4 years), one is likely to double his money in this period (unless the economy implodes completely) if the valuation remains the same. Finding such a company is not easy, but if the market keeps dropping, one is likely to find good companies at attractive prices

There are some caveats to the above suggestion –

- You have some amount of skill in finding good companies. Investing blindly worked only from 2003-2008.

- You have the patience and courage to hold onto stocks when the market is collapsing and everyone around you is heading for the exits

- You don’t need the money in the next five years. If you are retired or need money in the near term, please don’t think of putting it in the stock market.

My plans

I keep a wish list of stocks – these are companies which I would like to buy, but the price was never attractive in the past. One such company was crisil, which I bought in 2008 and have held on to it since then. There are a few other companies such as ITC , Marico (and more) in the list which I am watching. If the market keeps dropping, my wish may come true.

In summary, if you want to protect your capital from the impact of inflation, you need to find investments which have the capability to generate a 20%+ return on capital and are priced reasonably. If you look at the history of various asset classes across countries and time periods, equities come closest to it.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.