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The previous post stirred the pot quite a bit. I received several comments, which I will try to respond via this post. I wrote about my general thought process without getting into the details of the strategy. I will try to explore some thoughts around that in this post.

Strategy not executable in India
Let me clarify something at the outset, namely that the strategy of buying deep out of the money puts to hedge against extreme events (or black swans), works well with long term options. As far as I know, we only have 1-3 month options in India. I think these options are quite fairly priced and any chances of making money on these options due to mispricing are lower than winning a lottery.

I bought some options once (miniscule amount) to just experiment a bit and I think it is very unlikely I will ever buy short term options to hedge or insure my portfolio.

The strategy in my previous post would work well with long term options with durations greater than 9 months. These kind of options are available in the US market and called as LEAPS. I don’t think such options are available in india yet, so I think my strategy would continue to remain on paper till we have such options.

Justifying an approach
I received several comments and more emails which implied that I wanted to dabble in options and I was justifying it by wrapping it up with the logic of value investing. That may very well be the case, though I consciously don’t think so.

Let me give you an analogy. When we buy a car or a house, don’t we buy earthquake or accident insurance? We don’t hope for an earthquake so that we can collect money on the insurance. The purpose of buying insurance is to protect our asset against extreme events. In order to have this peace of mind we end up paying 0.2% or higher of the asset value as insurance.

Long dated, deep out of the money put options can sometimes serve the same purpose. The trick would be to buy when the premiums are low and the market does not expect the crisis. Ofcourse this is hardly do able in India.

Investing for the thrill
I don’t think I am in for the thrill. I have invested in options a few times and you cannot believe the agony I have gone through during the holding period. Options lose value with time, which is called as time decay or Theta. So if you have a 3 month option, you will lose 20-25% of the value in the first month (with everything else remaining the same). As a result, it has pained me to see my options position lose value everyday.

So with options one has to get the timing right too. I am almost 100% sure that I can never get the timing right. So it is unlikely I will buy options repeatedly to try my luck in the market.

Short term hedge
I would rarely want to hedge my portfolio for the short term via options. My approach is to sell overvalued positions or hold on to it through a market drop if I am convinced about the company. As some of you commented on the previous post, buying short term options would just be a waste of money.

Learning
All of the above discussion does not mean one should not learn about options. I think it is a topic one should explore and learn. There are quite a few interesting possibilities with long term options, especially during extreme market peaks or bottoms. That ofcourse is a separate topic in itself.

There is a Chinese proverb – ‘May you live in interesting times’ which may be a curse in disguise. The essence of the proverb is that if you want to condemn a person, you would wish that the person encounters ‘interesting’ times or in other words a lot of change and turbulence.

I don’t think anyone has cursed us, but we are definitely living in interesting times. I think the really interesting times started from 2008 and there has been no letup in the excitement.

The Greek tragedy
If you have been following the news, we have quite a situation in Greece. If one leaves aside the nitty gritty of the situation, it can be simply described as living beyond the means. Greece as a country has been spending (the government that is) way beyond its means (tax revenue) and covering up the deficit by borrowing from the market.

They were able to do it for sometime, till things finally came to a head a few days back. The market decided, enough was enough and started hammering the euro and European bonds of countries such as Greece, Spain, Portugal etc. It became quite scary by Thursday when the US and other markets started dropping by 3% or higher and volatility spiked by more than 50%.

The EU and ECB (European central bank) came together over the weekend and have put together a financial package of 600 billion dollars to aid the countries in trouble. This package has calmed the markets for the time being and would give time to countries like Greece, Spain etc to set their house in order. It remains to be seen if they will bite the bullet and fix their deficits. If they do not, then the markets will force them to in due course time.

My reaction
I typically ignore market fluctuations and macroeconomic situations. In this case however, there was a real risk of a market meltdown in Europe and US and a corresponding crash in India.

As I have already stated, I have started liquidating stocks which I would not buy if they dropped by 20% or more. I have already exited my positions in stocks such as VST, Denso, Ingersoll rand and started reducing my positions in IT stocks such as Infosys, Patni and NIIT tech (see my portfolio disclosure here)

My decision to sell is not a macro call. I have no clue how the macro picture will play out in Europe and how it will impact us in India. There are a lot of moving parts to be able to predict and all the opinions in the papers and on the TV are just that – opinions and guesses.

My decision to sell is based purely on valuations and my view of the future prospects of these companies. I am not too optimistic about IT companies at current valuations (key word is current valuations – the companies may still do well in terms of performance).

Exploring options
I am exploring the idea of ‘Deep out of the money’ puts to take advantage of a possible crash in the market due to the European debt issues. There are multiple issues associated with this thought process.

The first issue would be the possible corruption of my value investing philosophy. The general wisdom is that value investors should not dabble in options. Options are more suited for a trading or quantitative approach to investing. I would disagree with that. Value investing is not some religion, where you are either a part of the cult or out of it. Value investing at its core is buying something for less than its value. The ‘something’ can be a stock, option, bond or even a TV. So if I can find an undervalued option, and can evaluate the risk intelligently then it is as much a value buy as a stock.

Options are priced based on a Gaussian distribution (difficult to explain in detail in this post) and hence underprice extreme events. So if a company in question is likely to show great performance in the next one year or crash completely, the options may be underpriced for such a scenario. Similarly, put options may be underpriced if the market crashes due to some extreme event. The risk is ofcourse that the extreme event may not happen and you will be out of the premium you paid for the option.

I have been studying derivatives for sometime and have been analyzing them. Although I still look at them as a hedge or insurance against extreme events, I have been exploring the idea of combining value investing with options.

The main risk I personally face with options is not monetary risk as my positions are very small. If I lose money, it is likely to be a small amount. The bigger risk is that I will look like a complete fool in my own eyes (that I will look like a fool to others is a lesser issue). In order to avoid the regret and learn from my experience, I have started maintaining a daily dairy of my options work and have started recording my thoughts, feelings, actions etc.

As an aside, I bought puts on ICICI bank and some other companies in late 2008 to hedge my portfolio and deposits with these institutions in the extreme event that one of them failed and took my savings down with them.

If you think a value investor should never touch options and I am being foolish to do it, please leave me a comment with your reasoning behind it.

I was. If you are invested in midcaps or small caps, then it is likely that you would have seen some of your picks jump 5-10% in a day. I have seen some of my picks jump by that amount and some of the companies I was analyzing have gone up by the same amount and thus rise beyond my buy levels.

Feeling happy?
So how did you react to all this? happy?
I can bet that you must feeling good about it, unless you love self torture,. I was feeling good too, till I realized that the mid-cap and small cap index has risen by 100%+ in the last one year with several stocks going up by 200-300% percent in the same time.

When I saw this statistic, it poured cold water on my euphoria and reminded me of the following quote
‘A rising tide lifts all boats’

So there is nothing special in my boat or in other words, in my stock picks. I was lucky to be in the right place at the right time.

What does this mean?
If you are thinking – what makes this dude happy? A 100% rise in the midcaps and small caps and all he can do is whine about it!

Don’t get me wrong. I am happy that my picks and possibly yours have rise so rapidly in such a short time. If you had the courage to buy stocks a year back, then you have been justly rewarded.

The under pricing however got corrected some time back and now we may be entering a bit of a happy zone where everyone thinks that the future is going to be all bright and sunny and there will never be any problems.

The reality is that the future is never crystal clear. This risk we now face is that any negative news can cause the sentiment to sour and the midcaps or small caps to drop.

What to do?
As I said in my last post, I have started selling those stocks which I will not buy if they were to drop 20% from current levels. If I am not too optimistic of the fundamentals or think the stock is at fair value, I have started selling my holdings. I may be completely wrong about it and we may get another 50% rise.

So be it.

I think in my case greed is more difficult to manage than fear. I did not second guess myself to load up on stocks last year when the market tanked. The decision to start selling now is more difficult.

What am I selling?
I have started liquidating my smaller position like Denso, VST etc. I will however hold my long term holdings such asian paints, CRISIL etc. If the market tanks, I will load on them further.

Should you do what I do?
Think of it this way –
What incentive does Rohit have in mis-leading me? (Hint – none!). So you can listen to me.

What if I am wrong? Do I lose anything? No, I don’t. This is a personal blog, so I can write whatever I like. Hopefully I am not adding to the crap out there on stock markets 🙂

So please do your homework and think twice before taking free advice 🙂 (does not mean paid advice is any better)

I wrote a similar post on miscellaneous topics in Feb. I am able to use these posts to ramble on several disconnected topics which in themselves may not warrant a post.

Facor alloys
I recently analyzed this stock here. As luck would have it, Arcelor mittal – the LN mittal company seems to be in talks with the management to acquire a stake in a sister company – Ferro alloys corp (I received a comment on the same recently)

The management of the company controls three companies – Ferro alloys corp, Facor alloys and Facor steel. Ferro alloys corp owns and controls the Chrome mines. Facor alloys, also controlled by the same management has been able to access these mines and is in the business of manufacturing chrome alloys.

Chrome alloys are used in the manufacture of Steel and thus these talks on stake acquisition make sense as they would represent backward integration by acerlor mittal. These talks may or may not be successful, but the market has already responded by increasing the price by 10% for Facor alloys.

The stake accquistion seems plausible and could be a good trigger to exit the position. However I would not base my decision on this criteria alone. One should be convinced that the stock is undervalued and these kinds of events would only unlock the value

Sulzer india
I wrote about sulzer here. I have since then exited the position completely. I was able to get a 45% gain in 6 months. I am definitely pleased with the outcome. However this was sheer luck and nothing more. If I assume that I have the skill to make 90% returns per annum, then I can plan my retirement in the next 2-3 years.

Psychology of investing
I received two comments, which touched upon the issue of how can one manage emotions in the market ? If one has invested a sizable amount of savings in the market how does one handle the market swings ?

I personally think that the intellectual part of investing – learning the basics and the fundamentals of stock analysis etc is not too difficult. Any smart person should be able to cover a decent ground in 2-3 years. The most difficult part is handling the emotional roller coaster of the stock market. That takes a lifetime and sometimes even a lifetime is not enough.

I think some people assume that one is born with the temperament to handle these emotional swings . I do not agree with that. There is definitely some level of temperament involved, however one can train oneself to become better at it.

During my early days of investing, I would get happy and greedy when the market went up and anxious when my stocks dropped. I went through considerable self –doubt too. I was always asking myself – do I really know what I am doing?

However if one focuses on learnings from mistakes, then over time the self doubt reduces. I still feel good when my stocks do well or unhappy when they drop, but I do not base my decisions on how I feel. The only antidote to these emotional swings is to learn continuously and know what you are doing.

At the same time, if you feel anxious and are losing sleep when the market drops by a few percentage point, then it is a clear indication that you have taken on way more risk than you can bear. The reasonable course of action in such a situation is to reduce the amount of money in equities and increase the allocation in debt.

Ask yourself a question now – are you feeling bullish these days? if yes, then you are thinking like all others. The time to be bullish was Jan-Mar 2009. I am not bullish or pessimistic these days, but I am definitely cautious.

Responding to emails
I have been slow in responding to personal emails. If you have written to me and have not heard from me, my apologies. I read all the emails I receive, though my responses are delayed sometimes.
If however you have written to me asking for my opinion on a stock, I would prefer if you did some homework at your end and shared your analysis with me. I would then be able to provide a better response to you.

Overall portfolio plan
I am now adopting a slightly different approach in making sell v/s hold decision. I am now asking this question – If this stock drops by 20-30%, will I add to it or do nothing. If the answer is ‘do nothing, then the stock is a good candidate to sell.

I have exited my position in VST and would be doing so in case of some other stocks as the gap between the price and fair value reduces further. The issue is not if the stock is good or not, but whether there are better ideas in the market. Holding an average idea may not result in a direct loss, but there is always an opportunity loss if the stock does not rise as much.

I recently wrote a guest post on Jagoinvestor.com, a personal finance blog by Manish Chauhan. A few disclaimers : I am not related to Manish, he is not my evil twin and vice versa :). Just two guys with the same last name writing on investing and personal finance (what are the chances of that !!).

Jokes aside, manish writes well on personal finance and has written quite a few detailed posts on various topics such on mutual funds, fixed deposits, insurance etc.

If you are new to my blog, here are some of the salient posts you may want to read
My personal investment journey – part 1 and part 2
Index investing – SIP or opportunistic approach
Should you invest in the index funds or buy stocks directly? – here and here
Floating rate mutual funds
Fixed income investing
Planning for retirement – here, here and here
Why ULIPs are a bad idea
Analysing real estate
My experience with equity mutual funds
How I analyse stocks

If you have liked what you have read, you may want to subscribe to the blog.If you are a regular reader, the post is re-published below.

Investing sensibly in the stock market

The common view of the stock market is that it is a place for gamblers and risk takers. If you have the capital and the nerve to take the risk, only then should one put money in the stock market. Otherwise one is better off keeping away from the stock market and putting money in safe fixed deposits.

The truth is far removed from the myth, if one looks at the stock market with a different perspective and avoids the hype and hysteria associated with it.

Let start with the basics – What is the stock market?
The stock market is a place where buyers and sellers meet to buy and sell companies or rather small pieces of it. That’s all! It is nothing more, nothing less.
The small pieces of companies are called shares and they represent a very small ownership of the company. In exchange of owning a small piece of the company, the investor is entitled to his or her share of the profits which is given to the investor as a dividend. Of course the management does not give out all the profits to the investor, as they retain some portion of the profits to re-invest and grow the business.

So how should one invest?
If you agree with the above definition of the stock market, the idea of investing in the stock market boils down to investing your money in a selected group of companies.
If the purpose of an investor is to make a decent return on the money invested by him or her, then the investor should choose companies or businesses which are sound, consistently profitable for a long time and run by shareholder friendly management.

Finding a good company
Let’s explore the above statement a bit further. The long term return for a shareholder, where long term is 5 years or more, will be equal the underlying returns generated by the company.

The returns for a shareholder can fluctuate from year to year based on the market moods and sentiment, but over the long run the returns always track the returns of the company.
If the company can earn 20% on its capital, then the investor will make around the same returns over the long term. Thus we now arrive at the first criteria for successful long term investing, namely that to make above average returns one should invest in above average companies.

The above criteria is not a revelation to most of the people. However very few people want to follow the obvious as they think that there is some hidden magic in the stock market.

So how does one find the above average companies?
Look around you. Do you see products which have been around for quite some time and are used by a lot of people? find out the companies behind them and that would be a good place to start. I never said investing in the stock market does not require work.

Analyzing the company
Once you have identified a few names, the next step would be to get the annual report of the company and browse through it. The mention of reading an annual report either sounds boring or daunting to most people. However if you can bring yourself to it, it will place you ahead of 90% of the people in the stock market.

The idea of browsing through the annual report is not to become an expert at it, but to get a sense of the nature of the company. One can focus on some of the following sections to see if the company is worth putting your money in

Management discussion and analysis – This is the section where the management describes the business and lays out the plan for the company.

Profit and loss and balance sheet – This is the section which tells you if the company is making a profit or not, how much debt is held by the company, amount of dividend etc. If you come across a term you do not understand, search for it on the internet or talk to a friend or someone with a background in finance.

A few important factors should be checked when analyzing the annual report. A short list of these factors can be
– Is the company profitable and has it made profits consistently in the last 10 years?
– Has the company paid dividends consistently in the last 10 years and has the dividend increased over the same period?
– Has the company kept the debt equity ratio constant or better yet reduced the debt?
– Has the company been able to introduce new successful products in the market?

An example
Let’s look at an example – asian paints. This is one of most well known companies in India. This company has been the number one paint company for the last 20+ years. The company’s products like tractor distemper and emulsion, apcolite enamel, Apex exterior etc are well know and are widely available.

The company has been in business for over 30 years and hence we can be confident that the company has done something right consistently to be the no.1 paint company in India.
The annual report shows good performance over a long period of time. The ‘ten year review’ in the annual reports shows an increasing profits and dividend over the years. The company has used these profits to reduce the debt, pay out an increasing amount of dividend and re-invested the balance in the business to grow it over the years.

The above performance has been reflected in the share price too. An investment of Rs 1000 in 1998-1999 would now be worth around 19000 which translates to an annual return of around 31% !!! and this is without counting the annual dividend.

When to buy?
The immediate question which comes to mind is when should one buy the stock ? There is an army of people out there whose job is to advice investors the exact time to get in and out of stocks. I would personally say an investor would be far better off if he or she switched off the TV and ignored the advice of these so called experts.

If one is able to find a stock like the one above, the best approach is to invest in the company on a regular basis. If one can save Rs 2000 per month, then go ahead and invest 6000 Rs every quarter. A regular program of investing in good companies on a regular basis, while ignoring the noise and chatter of the stock market pundits, will give you very good returns and also good sleep at night.

Conclusion
So where is the catch ? The catch is within us. A lot of investors like to get excitement and thrill when investing in the market. They want to chase the hottest stock, so that they boast about it to their friends. At the same time they ignore the gems lying in front on them.
Investing is simple, but not easy. If one can find a few good and high quality companies and invest in them on a regular basis while ignoring the noise and chatter in the media, then that individual is likely to do well and have a good amount of money secured for his or her retirement.

The previous post on indexing generated a lot of comments and questions. I will list some of these questions and answer them from my perspective

Q1 – If you can beat the market, why do indexing?

This is one of the most common questions. The issue is not as black and white as it seems. Let me try to break my response into several points

Did you beat the market or were you lucky?

How do you know beforehand, that you ‘will beat’ the market? Let’s say you beat the market for 3 yrs. how do you know its luck or skill? Most of us think its skill!!

The only way to know that, is to keep doing it for 6-7 yrs and see how it plays out. One can be convinced then and put more eggs in the active investing basket, but till that happens what should one do?

Now if you follow this thought process, what is the best next best opportunity – i would say investing in mutual or index funds.

I have invested a part of my capital in the past in stocks directly as i did not want to risk the whole money. If you think that is being too chicken, I thought so too. I started by investing 100% directly, saw my portfolio go down by 20% and learnt my lesson. So unless one is sure that one has the skill to beat the market and has the data to back it up, one should be careful about going 100% in stocks.

Amount of time available
Do you have the time to learn and track all your stocks on a regular basis? It is amazing that so many investors, if you can call them that, think that beating the market is child’s play. One has to spend 1-2 hrs per week, watch CNBC and pick a stock tip here and there and that’s it.
Is there is any activity in life which will reward you with good monetary returns easy ? If it was so easy, why are there so few full time investors ?

So if you are working full time and do not have the time and interest in analyzing and researching stocks, the next best option is to invest via mutual funds and index funds

Q2 – Mutual funds are horrible, they charge 1-2% expense ratios. Even index funds are bad as they have high tracking errors

I have never understood this argument. I agree mutual funds in India are sneaky, bad and indulge in bad practices. So what is the alternative? Fixed deposits?.

The only way to participate in the equity markets is to buy stocks directly or via mutual funds. I would say 95% of investors should not invest directly. That may sound harsh, but it better than losing money and your shirt. The second best option is either mutual funds or index funds. There is no other option to invest in the equity market.

Real estate is a different story. But if you have Rs 20000 to invest, is real estate an option?

Please don’t even get me started on gold, oil etc. All this enthusiasm is due to the recent run up in gold price. Can you build a retirement plan around gold and other kinds of commodity investing?

Q3 – can you give some example of mutual funds ?

I have discussed some funds here. Some funds I like are HDFC equity fund, Reliance growth fund and Franklin Templeton blue chip fund. I have invested mine and my family’s money in it.

Are these the best funds out there? I think not. They are good enough and work for me.

For index fund, Nifty BEES (exchange traded funds) offer the lowest cost and tracking error. However they trade like stocks and so one cannot setup an SIP. As indexing is still not used widely, most index funds have high costs and hence a tracking error of 1% or more (tracking error is the difference between the index and the fund’s returns).

So if you want to do an SIP, pick either a decent mutual fund or one of the index funds with the lowest tracking error and set it up. It is better than having these intellectual arguments about the 1% difference and not do anything about it.

Sometimes it is better to go for a 90% solution than trying to achieve perfection.

Additional thoughts
I have seen a lot of different approaches to indexing. Buy when the PE falls below 12 or rises above 20 or when dividend yield is below this or that – wait I have written that myself 🙂

If you are generally interested about investing and like to play around or spend time on it like me, try all the gymnastics. However at the end, if you analyze the results you will realize that all you got out of it was a minor 1-2% annual advantage.

I think it is much smarter to pick a decent index fund or mutual fund, set an SIP and get on with it. Check the performance after every 1-2 yrs and you will find that you are doing fine.

Of course no one is likely to accept this suggestion as it does not feel smart. Where is the fun in it ?

First of all, my apologies to those of you subscribed to the blog feed, for the Test post. I realized that after I had put the test post and taken it off.

I have been wanting to re-design this blog for sometime and ofcourse do it on the cheap or even for free. I had asked for some help and quite a few of the readers offered to help, however for some reason or other the re-design did not work out.

Recently blogger introduced some new enhancement and so I decided to go for some changes. I have a preference for the minimalist design approach, which involves stripping down a website to its most fundamental features. I personally hate cluttered websites.

I spent hours tweaking and changing and revising and you see the final version which ….is the same as the old one :). I am just joking. I have kept the original design intact and tried to simplify it and will continue doing it further. I know most of you visit my blog for its great design 🙂

So please leave feedback in the comments section on what further changes you would like.