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Opinion | Portfolio Yoga - Part 7

Category: Opinion

The Impact of Fees on long term Returns

In the days of the old when Stock Broking was carried out in a ring with people shouting at one another, brokerage as a percentage made eminent sense. Buying 100 shares was far easier than buying 10,000 shares for example. A percentage fee made sense since a higher effort was required to buy such huge quantities while at the same time trying to get it for the best possible price for the client.

Once we moved to computerized mode and we did that once NSE came into existence, this should have gone out of favor but it did not. In fact, one of the reasons I became a broker was the attractiveness of the fees. Placing an order for say 100 shares in the new environment took me as much effort as it was for placing an order for 1000 shares but the magnitude to the income was 10x, 100x if you consider a client who wanted to buy 10,000 shares.

Once online brokerages came into being, this should have vanished since now the client himself did all the work and the broker had nothing to contribute regardless of the size of the order and yet it did not. It took Zerodha to shake things up starting in 2010 but even today, that is not the norm.

In the world of investing though, it’s been a percentage fee all the time even though the effort to manage your money of say 10,000 isn’t very different from the effort to manage another person’s investment of 1,00,000. Higher the investment, the more the fee you end up paying in absolute terms even though there is no real difference in the way you are handled vs the smaller guy. 

While we have order based brokerage and flat fee advisory, we are yet to come across any fund that charges a fixed fee and why should they anyway. The barrier to entry is high and one that ensures not every Jill can become a fund manager and even if he does, unless he can showcase good performance over a long time, money ain’t going to flow and the high cost structure makes it a non-feasible venture right at the start.

When the mobile revolution started in India, one needed to pay approximately 24 rupees per minute for every incoming and outgoing call. This fell as competition rose and the number of subscribers grew. Today, we are accustomed to pretty much free outgoing and incoming once you have paid a fixed fee.

What the Cable guys used to charge and continue to charge as is the case with say a DTH operator or OTT networks like Amazon Prime or Netflix charge is based not upon how much you use or not use but based simply upon a fixed fee. I may watch them on a 21 inch television or project them on a large screen, watch them for an hour once in a way or watch them continuously for days – the fee is the same.

A few Portfolio Management Service companies offer a zero management fee but charge a percentage on performance. On the face of it, this seems ideal – I make money only if you make money. His fee structure was simple – Zero Management Fee, a 6% hurdle rate and 25% of the profits above it. 

This has been copied by many others though with one unique distinction. Most of them aren’t Warren Buffett. In the years he managed the partnership’s, he had not one negative year. This even in years when the S&P 500 had a negative year. In 1966 for example, the Dow closed with a loss of 15.6% while Buffett generated a positive return of 20.4% for his clients. How many such fund managers are around these days anyway.

To encourage equity investing, talking heads regularly talk about how the long term returns for the Indian market is 15% never mind the fact that Sensex was not even there let alone investable during the star period. But overall, the assumption is that you should get around 12% for the investments you make in equity.

The question is not whether you need to pay a fee and given that we don’t really have a choice in terms of Fee only Investment Products vs % fee based Investment Product, such a question adds no value either. But it’s about whether you are getting value for the fee you pay. If a fund performed in line with the markets, should you pay 0.05% or 2%. Depending on your investment capital, this can run into lakhs of Rupees – not something that should be taken lightly or ignored. 

A very well known fund manager recently posted his long term track record of 15 years and it’s impressive. If you had invested say a Crore of Rupees with him when he started, the value of the said investment today would have been before fees worth nearly 14.40 Crore. Post a small 2.5% fee levied year after year, this drops to just below 10 Crores. A 30% cut in the profits.

The returns are still better than if you had invested in Nifty 50 (Total Returns) , so maybe this is okay or is it. As an investor today, you have no clue as does the manager whether he will provide you with an Alpha say 10 or 20 years away while the only guarantee is the fee you pay.

Much of the personal finance space about savings is dedicated to saving on small things that bring joy to our lives but would barely make a dent when it comes to the long term. There are plenty of stories of how instead of buying a Royal Enfield bike you had invested the same in the stock, you could have afforded a Merc maybe. Of course, most of them don’t use LML Vespa (a fairly nice scooter back in the days as an example) since if you had invested in the shares of LML instead of buying that scooter, your value of the investment today would have been Zero.

From a personal point of view, I think it’s important to save where we can and spend where we must. 

So, why do we pay. Are investors really that ignorant about the impact of fees on their final returns?

The reason we pay is not because we are generous but because we expect better returns than the market. In a world or market where data cannot be gathered, this could hold true – we don’t know what we don’t know.

But we are in an interconnected world and data to back the fact that not only does fees eat deeply into long term returns is out there but we have sufficient data to show that very few fund managers after accounting for survival bias are even able to beat their benchmarks.

So, why do we pay? Is it Greed or is there something else. Why do funds that have massively under-performed their benchmarks continue to get new investors to bet that the “Worst may finally be over”. Is it Behavioral?

Our Goals are 20 / 30 years out and fees we pay can have an extra ordinary impact on the final capital we aim to reach but one that is less discussed and even lesser talked about.

One reason passive indexing is picking up so much is not only because they are cheap but also because most funds don’t really provide a differentiation that makes the fee worth paying. A fund that is a closet index has no reason to charge anything more than what a passive fund should and yet most closet funds (and the number of such funds will only go up in time) are happy to charge for the Beta while ignoring the impact it has on the Alpha.

As I finished writing this, I stumbled upon this 

https://www.bloomberg.com/opinion/articles/2015-04-30/how-fund-managers-take-a-yearly-cut-of-your-savings

and a even better counter opinion

Why do Investment Firms Charge AUM Fees?

Final Thoughts

Writing for me is a way to clear my own thoughts and if it can help someone else, so much the better. As a trader, we once upon a time used to complain that if not for the brokerage we would have been profitable. I should have become profitable once I became a broker myself for there was no brokerage and yet, magic did not happen. It took me a long time to realize the mistakes and rectify the errors so as to speak. So, apologies if this post comes up as a confused one this is not about providing the right answers but trying to ask the right questions.

The Path and Reason to become a Fund Manager

The other day I received an email from someone who is currently a student but wishes to pursue a line of work that one day will lead to him becoming a fund manager. While everyone of us have their own reasons as to why to become a fund manager and take the trouble of not only having to manage our own emotions that come tied with the funds but the emotions of others, one uniform reason many choose that route is the leverage, something I touched upon in a short Twitter thread a few days back.

When we talk about Leverage, we always think of Derivatives for that is how the majority of investors perceive and are able to access. A secondary way is margin trading and finally leverage by way of personal loans and commitments. 

Most traders go bust – the odds of long term success is incredibly hard. This is more with traders whose capital is too small to start with and hence are forced to take higher leverage to make it work. A single losing streak of trades is enough to destroy them even if the strategy they are following has a long term positive expectancy.

A few, just about go on making money and losing money with little to show overall for the efforts and time spent. Success is always so close and yet so far for these folks – it’s like the Carrot and Donkey. Always visible just across the horizon, but unable to reach. Yours truly belonged in this camp for a really long time.

Then there are the Unicorn’s, the true blue real deals (and not just Twitter Screenshots). They are incredibly successful (the money of the losers have to go somewhere) and barely wish to be seen. Even with these folks, it’s normal to see some of them just burn out from the day to day pressure that trading forces upon oneself.

How rare are these folks? Well, Nitin Kamath of Zerodha had this to say about Successful Option Traders. 

Which reminds me of this scene from the movie, The Mask

While it’s not Luck that takes you from being no one to being someone, Luck is a very important catalyst that you cannot do with. For starters, assume you are both lucky and not lucky. Even the most successful traders have seen very hard times including bankruptcies but have been able to overcome them all.

Leverage as implemented using Derivatives is a double edged sword. You make it good when things are going your way but can end up losing a substantial part of your capital. With the odds of success being as it is, it’s not surprising to see thousands of books, hundreds of seminars and talks and a variety of tools that promise that you can become a better trader. But the truth is that it’s more profitable to sell dreams aka shovels to enterprising traders than become a trader oneself.

So, how to get leverage without running the risk of personal bankruptcy if things go south? One way is to become a fund manager. Of course, becoming a fund manager is neither a simple process or a cheap one these days, but who said it’s easy. 

Let’s take the case of one Mr. Warren Buffett. We all know his story of how he started earning money delivering newspapers and invested the same. As much a success he was in other ventures such as PinBall machine operator, his big bet on Geico where he invested 65% of his wealth in 1951 among others. He was incredibly talented as well as lucky in many ways. But that was not what provided him the foundation that led him to become one of the richest men in the world.

Between 1949 to 1956, his net worth (Income from Salary / Business) grew at a phenomenal rate of 70% per Annum.  But what transformed a substantial (for those times) sum of money to being a Millionaire and later a Billionaire was his partnerships.

In 1956, Buffett started his first of the many partnerships he would have over the coming years. He himself invested $100 while raising 1,05,000 from family and friends (as he has said himself, he had won the Ovarian lottery). To give a context, in 1956 the average income of all families was estimated at $4,800. 

Forget for a moment that he had another 100,000 of his own money (but not invested in the partnership). The partnership had no Management Fee but charged a Performance Fee of 25% of the returns above 6%.

Before we get any further, the most important factor to note is that he out-performed the markets massively. Today such out-performance is as rare as an Oasis in the Sahara Desert. Just look at the table below. Literally zero years of negative performance and only in the last year was performance in single digits. 

Want to learn more about his Partnership Days? Do check out this book (Link)

From 1957 when he started with his first partnership and later added more on the way to 1969 when he liquidated the same, he grew his Networth from a mere 100 thousand Dollars to 25 Million Dollars. 

Would he have been able to grow his wealth and one that was later invested into Berkshire Hathaway if not for his managing other funds? Assuming the same 100,000 was invested in the same way he did for the Partnerships and recorded the same returns, in 1969, he would have been worth nearly 2.9 Million. That is huge but is 90% below where he eventually ended up with.

Okay, so we know that the path to Riches lies in being a Fund Manager, what is the path?

First – A strong Education. Today, nothing less than an MBA with a CFA. The foundation this gives can shave away years of learning on the ground. 

Second: Okay, you are done with the Education – what next. Can I become a Fund Manager now?

Well, not so fast. As Yogi Berra says

In theory, theory and practice are the same.

 In practice, they are not.

In the MBA class you may for instance learn about the fact that markets are efficient only to come to the real world and see that it’s really not so efficient after all. But the theory from ability to learn about businesses to knowledge about how to read and decipher the complex financial statements will come in handy for the rest of your life.

The common path for many is to join a fund house as a Research Analyst and work one’s way upwards till either he or she becomes a fund manager. While this takes more time that what you may be prepared for, it’s important to have lived through one complete cycle before you get the confidence of managing others people’s money in bad times you may encounter later since you have already passed through the Agni Pareeksha. 

Research is categorized as Buy Side Research and Sell Side Research. If you were to join a PMS firm or a Mutual Fund house as a Research Analyst, you are basically a Buy Side Research and one that is the more coveted of the two. 

Joining a Brokerage house on the other hand would make you a Sell Side Research. Basically, your Research is not for the firm to buy stocks on its own books but to sell to their clients. 

A Sell Side Research report is for instance never complete without a price target. After all, when you ask someone else to buy a stock, they also wish to know at what price to sell. In the buy side, while it’s nice to have a broad target, that is never the focus.  

While today we have PMS / Advisory firms from all over the country, I believe that if you really wish to grow in this field a stint in Mumbai will give an impetus to your career that is not possible in most other cities. It’s similar to the fact that if you want to grow in the technology sector, especially in the product side, you are better off in Bangalore than anywhere else even though today we have a lot of product firms outside Bangalore. Once again, the advantages the ecosystem offers can cut down the learning curve substantially. 

Most Analysts do not rise to become a fund manager for various reasons. One reason that you can avoid is to become an expert on one particular industry or segment. As much as it’s nice to have a very deep insight into a single industry, do note that most successful fund managers tend to be multidisciplinary. 

Finally, keep a public time stamped track record of your investments. Unless you have become a very famous Analyst, when the time comes to ask for money from others, this can help convince them that you are not just one of theory but also have practiced what you preach for years.

The biggest thing I have liked about the Industry is that even if you are not extremely successful or even as successful as some of your peers, the learning this industry provides is unmatched elsewhere. Make your goal one to constantly learn and evolve and who knows what doors open when.

End Note:

Sometime back, I started a Free Slack Group to discuss markets and strategies with like minded investors. If you are interested, Join here

Of Stories, Trends and Megatrends

I grew up on a diet of reading about Successful Entrepreneurs. I was young and naive at that time (and old and naive these days) and the one common thing I saw among these successful Entrepreneurs was that they all started off from a Garage. I always wanted to be my own boss and would you believe, my Grandmother even had a Garage. All I required was to start a business and voila

30 years later, having floundered in 3 businesses I started or co-started off with and with a bit more understanding than I had in my youth, I now know that the secret ingredient behind those successful fellows was not having a Garage. 

Yet, in the world of investing, we read about the traits of Successful Investors, try to distill it to a few common pieces of wisdom and believe that if we copy that, we shall be Successful too. 

Success has many fathers, Failure is an orphan is a wonderful saying and one that has had profound impact on people and nations. Who doesn’t love a Success story – be it in the Movies or in life. Our optimism is boosted by reading about other’s success and one we hope we can enumerate in our own life as well. But if only life was that simple.

One of the most successful investors of all time is Warren Buffett. While he himself has not authored a single book, on Amazon you can find over a 1000 books where the authors have tried to dig deeper into his philosophy and what it would take for a small investor to be able to be as successful, I doubt how many books talk about the fact that he had advantages a present day investor doesn’t possess.

For a long time, common stocks were perceived to be much riskier than bonds, the investors required that the income from common stocks must be greater than that from bonds. The guy who challenged that thesis was Graham. But old beliefs don’t go away easily and for a long time, investors like Buffett had an advantage that most others lacked. 

Today, there is little of any informational advantage you can have over your peers. Today, everyone wants to buy good quality companies, having strong cash flows, a business that is easy to understand and one that is available with Margin of Safety. Basically, everyone wants to live in Lake Wobegon.

In 2016, Saurabh Mukhejea came out with his book – The Unusual Billionaires which provided a good hypothesis and back-test of the Coffee Can strategy. I was impressed enough to invest a portion of my brother’s funds into one such portfolio. The key here is to wait for 10 years – some have been good winners, some haven’t, but the portfolio as a whole has done better than the benchmark I could have invested.

The table below lists the Stocks I purchased, their Price to Earnings at that time and the same today plus the Change in Stock Value.

What is immediately evident is that most of my wins have been massively helped by positive price to earnings ratio revaluation while the losers were because of contraction of PE. While the portfolio has been better than the benchmark, that was because of differential weighting. An equal weight would have underperformed.

Today, the stocks that qualify for Coffee Can have an even higher Price to Earnings Ratio. What if Price to Earnings decrease even as the companies continue growing. Would the strategy still hold water?

What I am trying to suggest here is that there is a huge tailwind if you are able to pick up stocks or a strategy before they become famous. Once a strategy becomes famous, the money that chases it more or less dampens future returns.

A new theme I keep hearing about how Investors can do better is by catching “Megatrends”. It’s not a new word or theme though – John Naisbitt in 1982 first wrote a book titled Megatrends where he tried to outline how to “identify and ride a large trend”.

How nice it would be to know the sector or industry that shall flourish over the next decade or decades and benefit by betting on the same. But is identifying a Megatrend the same as being able to profit from it?

The Internet has changed the lives of Billions and heralded a new way of life for most of us. But identifying this trend was one thing and being able to bet on it quite another. The other day, Devesh asked me if I could recollect some of the stocks that were listed during the heydays of the Dot com bull market. While Bangalore Stock Exchange alone had 50+ stocks listed, so much time has passed that it is not easy to recall. But those I could find, it’s amazing how few of them have even survived to this day, lets not even talk about returns.

https://twitter.com/Prashanth_Krish/status/1319195735393382401

It’s nice if you can spot a megatrend before others do, but it’s not really necessary to be a better investor. In fact, it may actually be harmful. In 2013 – 14, one theme that made all the news was Logistics. With a new BJP government in play, focus on GST and growing eCommerce was supposed to change the companies. Stocks did play it out for a bit. But even if you had identified them early and held till date, your returns would be inferior to someone who identified no such trend but invested in Nifty 50.

We love stories and while they can make for a good movie, stories have a huge appeal as investors for we are not just investing our money but also investing emotions. This makes it a double edged sword, something Investors need to aware of.

Vedanta – Valuations and more…

Unless you have been sleeping under a rock, you know the story of Vendanta that has been splashed all over in recent days. Promoter wishes to buy the company back from its public shareholders. He proposes a price he thinks is a fair price to start discussions with, the biggest shareholder baulks and says the price he is willing to part with is multiple times that, others bid at various prices including a few at 1000 times the offer price. Offer fails – end of story.

The biggest non promoter holder of the shares who had once stymied a similar offer from the promoters came out publicly with his Valuation that was 3.7 times the floor price offered by the Promoter and 2.5 times the current market price. By making this number public, he essentially made it clear what he thought about the company and where he shall part company at.

On Twitter, a controversy has erupted over Mutual Funds that tendered at lower prices than what the biggest Institution had placed. How dare they sell the jewels at a price lower than what the other guy felt it was worth at. Mutual Funds chor hai resonated.

Warren Buffett says that he Invests for the Long Term. But that doesn’t mean he won’t sell when he finds an opportunity good enough to warrant such a sell. Our guy on the other hand is the Baap of Warren Buffett when it comes to Long Term holding. He is willing to bear any amount of pain as he holds stocks for periods longer than anyone else – sometimes even outlasting the promoters.

The biggest advantage of his pool of money that he uses to buy these stocks and hold them forever is that he really doesn’t have to sell just because a client comes calling and asks for his money back. While the source of the monies are its clients, because it’s an Insurance company and not a Mutual Fund, the whole business model of investing is different. The profits and the losses of the investments don’t flow completely to the unit holders. 

Mutual Funds on the other hand buy stocks with money from their clients and all the profits and the losses are directly attributed to the hands of the investor. What this means is that the thought process of a fund manager who manages a fund dependent on the public continuing to remain invested differs from someone whose capital is more or less permanent. 

Warren Buffett can afford to do what he does because he manages no money for the public in the way Mutual Funds do. This means that he can afford to play the really long game since the only option for his investors who hold shares of his company is to either continue to be an investor or sell the stock to another public shareholder. The cash flows of Buffett is immune to this.

Mutual Funds on the other hand have to provide an exit for their unit holders and if a large portion of them wish to exit, the fund manager has no other option but to sell even good companies at whatever price the market thinks it’s worth even if the fund manager himself thinks the companies are worth a lot more.

Markets are efficient in the long run but inefficient in the short term. This is why active investment strategies work. We buy stocks when we feel they are available at a price which is lower than what we believe the company is worth and sell when we feel they are well above what we think it worth. Whether we make a profit or not though is dependent not on our calculation but if the market thinks similarly too. 

The other day, I calculated the weighted average price at which Vedanta exchanged hands since 2005. The number came to Rs.190 even though the range the stock has traversed in the said period is between a high of 495 and a low of 28. 

Let’s assume our Mutual Funds guys have acquired the shares at the same price. The current market price is 120 which means their investors are underwater and if an investor exits the fund – he is indirectly booking a loss in Vedanta. Assume all the unit holders of a fund want to exit – the Mutual Fund manager has no option other than selling the stock he owns at whatever price the market asks for it regardless of what he believes the company is really worth.

So, the fund has  a buy price of 190, current market price is 120 and the promoters wish to buy back at 90 and a guy with permanent capital who plays a way different game than yours says its worth 320. What price should the fund manager tender the shares?

From the fund manager’s perspective, any price higher than 120 which is where he can sell his current stock at is a “Profit”. The reason I say Profit is because for the fund manager, a 160 Rupee buyback (if it goes through) is worth more than a 320 he thinks the company is worth at but one that may never see the light of the day.

A friend of mine who tried to take advantage of the arbitrage he felt was on offer had an interesting view – the promoter was no different from a value investor –  he was just trying to exercise his ability to buy the stock cheap than what it was worth and he better than anyone knows what is worth since he has inside knowledge as also control of the company’s future path.

Vedanta may be worth even more than 320. A blog post sometime back speculated that it’s worth north of 500. The issue though is not what we think a company is worth but what the market thinks it’s worth. Remember, when the time comes to Sell, it doesn’t matter what you think it should be valued at, you shall sell at what the buyer thinks it worth.

Paying Advisor to Buy Blue Chip Shares

Twitter is a place where you meet Strangers. Some become friends for life, some acquaintances but most just some one whose tweet you once read and either agreed or disagreed. While Twitter is known for its Trolls and abusive behaviors thanks to the cover of Anonymity, there are people who are kind beyond what you feel you yourself deserve. For me, one such guy has been Muthukrishnan. I haven’t met him or even talked to him on the phone, barely retweet his tweets and have once in a while disagreed to. Yet, for some reason he showers more kindness than I receive from people I know better.

I don’t disagree on his overall philosophy though once in a way I do disagree. His view on buying stocks for dividend for instance. I have my reasons, he has his. A key question he is asking these days is – Should you pay a fund manager a % fee or worse a profit sharing fee to buy and hold Blue Chip Shares. He believes that fees eat into returns and hence one should not.

I agree with his view that fees eat into returns. But that is not the entire story and here is my view on why it may not be wrong to pay a good advisor to buy and hold great shares.

Vanguard US has a very nice graphic that shows that if you pay 2.0% per year over 25 years it would wipe out almost 40% of your final account value. If you have invested in a regular mutual fund, 2% is what you are charged. So, the number is not a huge assumption vs the reality.

The delicate question though is – Should you pay a manager to Buy and Hold Blue Chip shares. Now, this is not a strategy I know that is followed by most funds and here I mean PMS since Mutual Funds like it or not are measured against bluechip returns and hence forced to buy the very same bluechip stocks.

The flexibility SEBI allows PMS on the other hand is very huge when you compare versus a Mutual Fund Manage. From Large Cap to Micro Cap, he can invest anywhere. He can go to Cash for 100% of the portfolio value if he deems it necessary. Only thing he cannot do is take leverage – but an AIF fund manager can do even that.

Before we tackle PMS, let’s get the pesky Mutual Funds out of the way. Large Cap funds haven’t been able to beat the benchmark Indices for a long time now. With Reliance now being the biggest jockey, it can become even more pronounced as Mutual Funds are limited to holding not more than 10% of their Equity in one company while the weight of Reliance in the Index they track has moved well past that number.

Large Cap Mutual Funds are now called Closet Index Fund. From the web, a Closet Index Fund is defined as 

A closet index fund is an actively managed mutual fund whose portfolio includes many of the securities in its benchmark index but whose expense ratio is higher than that of a true index fund or exchange traded fund (ETF) tracking the same index.

A simple ETF is available at 0.10% fee or lower. So, why the hell are people paying 2% (or even more in some cases). Are these guys really stupid? And we are not talking about a few folks either – Almost 81% of investors, that is 4 out of 5 investors come through the Regular route and hence are paying upwards of 2% as fees for having their funds managed by the Mutual Fund Companies.

With Indian Economy and Industry going nowhere, returns are pathetic and yet, the surge in assets we saw in 2014 is not going to topple over easily. So, why are investors staying despite pathetic returns that could have been achieved by safer methods and more importantly paying a 2% fee for the pleasure.

To understand that, we need to take a look at the bigger picture. While the Mutual Fund Industry has grown tremendously, it’s still small when you look at the “ Composition of Household Financial Assets”. As of June 2020, RBI estimates it at around 7%. This is the percentage of financial assets which ignores assets such as Real Estate and Gold.

That is 7% financial savings of Individuals are getting routed to the markets. This is fairly low but not surprising owing to not only lack of knowledge but also lack of safety net in India which means Individuals prefer safety of capital over its growth.

Source: RBI

As someone who has been in the Industry for a long time, it’s not surprising that Industry veterans find it surprising that there are folks who are paying for non-performance so as to say. But what they are missing is the fact that most of the clients don’t have the financial knowledge required to handle their own monies. 

The Internet has democratized learning but you don’t self-medicate (other than maybe Crocin or body pain tablets) just because you have read on the Net and understood what is ailing you. While not exactly comparable, for many they feel better off with someone – even if that someone is not really an expert himself but paints as one rather than take the risk himself.

The fear for most is losing money. It’s that fear that drives most to trust someone who they think will handle the money better than they can handle themselves. This fear is not about being paranoid either – whenever markets crash, even non business papers write in big bold fonts the thousands of Crores that has been lost by investors in a single day. This is a meaningless number, but who is to inform them of this.

The alternative path that most of these investors will choose without the ability to invest through an advisor is to invest in a Fixed Deposit. In fact, I am pretty sure that a lot of Investors who go to the Bank – a private sector bank to be more specific would have had the idea of investing in a Fixed deposit but were shown a different way to save and invested (hopefully since Banks are notorious for selling ULIP) in a Mutual Fund.

Markets have had a crappy time for a long time and regardless of what the Experts say, it’s unlikely to change in the coming quarters either. Yes, the darkest before dawn but the light at the end of the tunnel could also be the headlights of the incoming railway engine and not the end of the tunnel itself. 

Either way, while investors seem to be getting a raw deal, the other options available to them aren’t any better either – invest in FD at a taxable rate of 5.5%?

Okay, I understand why small investors may be okay with high fees and pathetic performance, but what about HNI’s you may ask – Why are HNI’s willing to pay a fund (PMS generally) a fee for just buying and holding a set of high quality stocks.

While most PMS don’t buy and hold, I do know of a PMS that has a AUM of greater than 2000 Crores and buys and holds a portfolio of quality stocks. In the few years of data I could get access to, the client saw barely any change other than one stock being added after its Initial Public Offer.

The said fund charges no fixed fee but a performance fee over a hurdle that can be crossed even in these days by a liquid fund. Yet, the AUM keeps growing. What explains such incongruence. After all, here we are talking about sophisticated investors who can easily replicate what the fund is doing and save themselves a bundle. Why are they not doing it when it seems so easy?

In mid-2016, Saurabh Mukherjea came out with his book – “The Unusual Billionaires” where he showed how buying and holding a set of quality stocks over 10 years would have beaten most other funds not to mention the Indices. There was even a Interview where he listed out the stocks that currently matched the requirements (Link).

I used that list to create a portfolio (my own weighting method) and posted it on Twitter too. 

https://twitter.com/Prashanth_Krish/status/799997097923645440

I bought and have been holding the same. A few months from now, it will be 4 years since I did that exercise. The portfolio itself is up 60% vs 42% by Nifty 100 which I took as the benchmark. No trades, No Fees, None whatsoever over the last 4 years – not tough, ain’t it?

The reason I have been able to hold is not only because I understand better but also because today it comprises just 10% of the equity portfolio. What if this was 50%, would I have been able to stay on?

Identifying Blue Chip stocks of today is easy – the problem is what will you do once they are no longer a blue-chip. An Index automatically chews over a stock that has lost its game and adds a new entrant, same goes for a fund manager who will chuck out a stock and buy what he believes is better instead. Stocks once considered blue chips and even many which were part of the Index today lie in ruin. Buying and Holding them would have meant not just an opportunity cost but also a real cost in terms of loss of capital.

By paying an advisor to buy and hold, many clients are basically outsourcing the pain component that involves selling the bad apples and buying new apples that appear suspicious today but in the end may actually deliver the goods.

Can this fee be lower? Of course, it could be – but like the Brokerage industry of the past, until a challenger emerges, why cut your own income. So runs the gravy train.

Personally I believe that funds that buy and hold good quality stocks and churn very little are doing a great service for while they may not get interviewed on Television every other day, the clients are assured of safety of capital. 

Measuring returns based on what they could have achieved by buy and hold of the same is factitious since we can never be sure if they would have bought and held the same stocks or rather just used the money to buy a vacation apartment as an investment. 

On Dividend Paying Stocks

On Twitter, there is a raging debate on whether you should buy stocks for their dividends. On one side are those who argue that buying dividend paying stocks is the best way to ensure a cash flow without having to liquidate investments to generate a regular income and on the other side we have those who argue that is simply makes no sense to buy dividend paying stocks especially considering the low yields most of them provide one with. It’s akin to buying real estate for the rental income vs buying real estate for the growth opportunity if offered. So, what is true and what is not?

To better understand the truth, let’s start at the beginning of why dividends were paid to shareholders in the first place. Going back in history, you will notice that the first companies were not of the kind that exists today but were joint stock companies formed for pooling of risk capital for a certain venture. Because the ventures of those days meant a binary result – the venture either succeeded beyond imagination or failed miserably, the pooling of resources reduced risk for all players and when the rewards came – everyone wanted a cut and this cut is what today we shall call as Dividends.

Paying out large dividends in the past meant the stock was seen as a great investment – In the early years of Dutch East India Company’s existence, the company paid out as much as 75% of its income as dividends. By doing this, the company was able to make a case for higher stock prices and which in turn enabled it to draw upon higher risk capital. 

Today, companies pay out dividends for a host of reasons but more than the share price, its paid to shareholders to retain their loyalty towards the stock. In the United States for example, historically the small shareholder bought companies that provided them with a regular income in form of the dividend and this meant that companies that paid out a steady stream of dividends.

In fact such stocks even have a moniker – Widow-and-orphan stocks. These stocks are seen as stocks that often pay a high dividend and are generally considered low risk. The dividend paying attribute is not limited to stocks either – even today we have Equity funds that pay out dividends.

Dividends are not free money the company is distributing to its shareholders. Rather, it distributes a part of the income it has earned in the previous year after keeping aside what it believes is required for either future investments or just hoard it for a rainy day.

When a company pays out a hefty part of its income as dividend, what it suggests is that it has no avenues to invest and feels better off paying back a large part of the said income back to its shareholders. One high dividend distribution company (and not making waves on Twitter) is Castrol. It has paid on an average 80% of its net income in the last 12 years. The stock CAGR over the last 10 years (12 years currently would fall right at the bottom of the 2008 crash) is a piddly 0.50%. I am not saying that this could have been better if the company had used the money instead to grow, but am saying that a high dividend payout ratio has a cost.

Coal India, another great company with a high dividend payout (to please its principal shareholder – Government of India) has seen its shareholders lose a cumulative 11.25% per year for the last 9 years.

Not all companies are believers in paying dividends even when they have substantial cash profits / reserves either. The biggest name in the Industry – Warren Buffett loves getting paid dividends by the companies he owns but hates paying out dividends for the shareholders of Berkshire Hathaway. In his 2012 letter he laid out his rationale for not paying dividends and instead says that shareholders who want such income are better off by having a sell-off policy. I would urge you to go through it  (Link) 

This year, has seen a spate of companies announcing mega-dividends. The rationale for the same is the fact that the government has changed its policy when it comes to how dividends are taxed. Until 1997, dividends were taxed at the hands of the shareholder. But those were the days of physical shares and very few tax payers I would assume would maintain let alone pay a tax on the dividends received. To eliminate this, the government of that time shifted the burden of paying taxes on the dividend paid out to the company. Thus came out about the Dividend Distribution Tax.  In 2020, this has been reversed with dividends once again being taxed at the hands of the Individual taxpayer.

This change has meant that a shareholder who falls into the higher tax bracket is better off selling a part of the share equivalent to the dividend he would receive for he pays a lower tax vs getting paid the same by the company. But the change is also a bonanza for multinational companies who can now payout a higher dividend for the parent may own shares in a lower tax rate country and hence end up paying a much lower tax on its income than what would have been deducted via the dividend distribution tax.

Given the immense opportunities in the market, I feel that investors would be short changing themselves if they went after dividends rather than growth. If you want a regular income, you are any day better of with products like Post Office Monthly Scheme than buy stocks based on their past dividend activity for the risk is that you may end up with a gain on dividends (that are then taxed) while losing not just opportunity but taking a cut in the capital itself. 

Want to read more. Do check out – 

The Evolution of Dividend Policy in the Corporation and in Academic Theory.

Investing, Path Dependency and Mental Barriers

I spent the last few days at my Sister’s place and returned home today. On the way, I picked up a packet of milk. Between where I picked up my milk and my home, I seem to have inadvertently dropped my purse containing a couple of thousand bucks in addition to other Cards and miscellaneous items that keep my purse fatter.

Today is also the day when a stock I hold dropped 10% (Selling Circuit). The loss in that stock alone is greater than what I lost in money terms today but I basically forgot that I had a loss today in the markets while the loss of my purse still boggles my mind. Did I drop it or did it fall off – what if I had left later in which case I may not have had to stop for milk or better still taken my father’s advice and taken another route which would have meant I would have missed the milk booth altogether and maybe would still have my purse in hand or what if.. You know the drill.

In Investing and Trading, we look at the past and wonder, what if I had done this and not that. The difference in outcomes is so enormous that we keep wondering what if everytime we hit a speed bump.

Active fund investors are ridiculed for buying closet index funds that at max provide the same returns as Index before cost. Post cost, most of them under-perform to the extent of the cost (Fee). But given the fact that selling Mutual Funds is a push business vs say Fixed Deposit at Banks which is pull, one wonders whether one should even compare the investor with a Index fund or should one consider the alternative he would have invested into – Fixed Deposit at a Bank.

One of the biggest risks in back-testing is that you end up building a trading system that worked great in the past but the future has no bearing with the past other than the fact that sometimes it rhymes. Having done thousands of tests on data, I found this tweet to be on the dot

Buying Quantitatively Cheap stocks worked for a while and then it stopped working. Fund managers though keep hoping that the trend is about to reverse. Apna time Ayega is basically what fund managers seem to be writing to their clients as the fund keeps disappointing compared to other strategies the money could have been invested into. Very few seem to question why it worked historically versus trying to prove why it shall work in future (which basically is claiming mean reversion)

One reason for Do it yourself investors to start favoring Index funds is because they are unable to reason out which of the 400+ funds will take the route that provides them with returns greater than what they could achieve by investing in the Index. There are funds that will definitely beat the Index, but finding them before has become tougher given the odds of failure which keeps raising.

Sometime back, there was a running joke that if Anil Ambani had invested into Nifty 50 instead of investing into all those companies, he would have been far more richer today than facing the law of the land with regard to bankruptcy procedures. The same joke is not said with regard to Mukesh Ambani for he has been much more successful. In 2005, when the family decided to split, I doubt anyone could have seen this forthcoming, but thanks to how we think, today it seems natural that Anil – the once flamboyant superstar would fail. As Annie Duke – You can’t use outcome quality as a perfect signal of decision quality, not with a small sample size anyway. 

When it comes to biases, it’s amazing how many of them hold us back from achieving our true potential. Every decision we make in life can be reduced to a binary – Yes and No. Each decision in itself is like a split from the main stem and can take a life of its own. Some decisions go right, some go wrong and while in truth we always have a 50-50 chance, it’s amazing how much time is spent on trying to understand the wrongs than the rights. 

A right decision in my case was pursuing a job in 2017 vs launching my own business. This turned out to be right. But in 2005, I decided the other way – pursuing a career in my own business vs taking up a Job I was offered. That in hindsight I tend to feel turned out to be a wrong decision  – not because of anything else but because my business failed. Knowledge of biases and fallacies alone is not enough.

Should I pursue a Business or take up a Job, should I invest directly in stocks or buy a Mutual Fund, should I buy an Index Fund or an Active fund. Should I hold a concentrated position of stocks or a diversified portfolio, should I pursue a strategy of Value or one of Momentum. The questions that investors face is mind boggling in nature and its no surprise many are concerned about whether they are doing the right things.

Each of the decisions we make is based on both our own biases which can get exaggerated by the company we keep and our own beliefs formed by actions of the past. The biggest regret of many investors is not having been invested in the right stock when they first started investing. 

A good friend passed me this tweet for instance

I have had a similar thought before. Wouldn’t it be amazing to have the incredible foresight that one has achieved today years back when one was just starting. It’s a question that has bothered me too but I came to the conclusion that even if I were able to go back in time and tell my younger self the greatness of Momentum Investing, I may have still failed. Not because the strategy is faulty but because my beliefs in the style of investing I focus today has been borne through the combined experience of years. 

In Investing, we can read through hundreds of books / blogs. But ultimately the path you take is your own and one that will not be smooth either. The only way to stay sane and continue despite the hurdles is to get a better understanding of both our losses and our winners while understanding the limitations.


There’s a difference between knowing the path and walking the path..

Writing this post has been one way to overcome the disappointment of losing my purse. I do hope that it provided some food for thought. If it did not, hopefully I can do a better job next time around 🙂