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Jaimini Bhagwati: India - buy and hold

Source : BUSINESS_STANDARD
Last Updated: Thu, Nov 15, 2012 19:41 hrs
An employee arranges Indian currency notes at cash counter inside a bank in Agartala

Fund management could be through mutual funds investing in listed equities and debt instruments or through hedge funds, which have restrictions on who is eligible to enrol. Additionally, advisory services are offered for investments in private equity and venture capital. In all investment categories, fund managers claim they can achieve higher returns on capital on a sustained basis than if investors were to manage funds on their own.

It may be practical for those with large volumes of liquid assets and time constraints to use the services of fund managers. This is, of course, conditional on regulators overseeing fund managers effectively to ensure that the latter adhere to the risk-return preferences of their clients. However, equity investors will be disappointed if their expectation is that fund managers can consistently beat buy-and-hold strategies in well-diversified equity portfolios.

As we are well aware, investment preferences change with net worth and age. An older person would usually prefer risk-free income and hence choose government debt as the better option. All this is standard and conventional wisdom. This article reviews returns on listed equities in developed and emerging markets in the past 10 to 20 years and reflects on returns on longer-term equity investments in developed markets versus investing in India.

Table I lists gross returns in equity markets in developed countries and emerging markets over the past three, five and ten years, and since May 1994. The Morgan Stanley Capital Index (MSCI) "World" category reflects the performance of large- to mid-cap companies in 24 developed countries (country weight for the US is 54 per cent). The MSCI Emerging Markets category is adjusted for floating stock and represents the performance of equity indices in 21 developing countries including India, Brazil, China, Turkey, Mexico and Russia.

Although gross returns on equity are surprisingly comparable for the 18-year period from May 1994 to September 2012 for developed and developing countries, the standard deviation of monthly returns for emerging markets is higher, reflecting higher volatility in returns. However, during the last 10 years emerging markets and the four BRIC countries achieved much higher returns than developed countries, perhaps signalling a trend.

Many US consumer goods and services companies grew steadily for about 40 years from 1950 to 1990. The success of investment "gurus" such as Warren Buffett was driven by the long-term US growth story and by limiting leverage.

Going forward, given the uncertainty in the US and ageing populations in other G7 countries, the upside potential for developed market equities is likely to be limited over the next decade or more. The shift away from equities is reflected in the extremely low nominal interest rates for the better G7 credits namely, the US, Germany, Japan and the UK. Consequently, claims by fund managers that they can achieve high returns on equity investments in mature economies, unless these are linked to technology breakthroughs, imply high risk.

Analysts are currently using the expression risk-on or risk-off as indicative of whether investor appetite for risk is up or down. The rapidity with which risk-on changes to risk-off and vice-versa could lead observers to believe that the underlying economic and financial drivers are changing that frequently. Clearly, investors should be wary of making long-term investment decisions on such fickle understanding. Indian retail investors have learnt the hard way and tend to prefer fixed deposits in public sector banks to equity investments.

On November 9, 2012 the Smart Investor section of Business Standard reported that Indian mutual funds have lost equity assets every month from June to October 2012, with the total amounting to Rs 9,064 crore. Although the amount involved is comparatively small, there is pessimism about listed stocks as investors who bought at the highs of 2007-08 try to cut losses at every upturn.

Table I
Gross& annualised returns (in percentages)

Three-year Five-year Ten-year Since May 1994
World 8.07 -1.60 8.60 6.47
G7 6.86 -1.30 6.90

-

Emerging markets 3.86 -2.40 16.10 6.52
BRIC -2.70 -6.50 19.90

-

&Gross returns: Total dollar-denominated equity returns, including dividends but before taxes
Source: Morgan Stanley Capital Index
Table II
Annualised standard deviation (in percentages)#

Turnover (per cent) Three-year Five-year Ten-year Since May 1994
World 2.75 17.10 21.00 16.50 15.40
Emerging markets 4.44 21.80 29.60 24.30 24.10
#Based on monthly gross return data
Source: Morgan Stanley Capital Index

Looking to the future, global investors would be well advised to take into account region-specific GDP growth rates and focus on investing over longer horizons. This is particularly true for younger generations since defined benefits pensions schemes are being replaced or diluted by defined contribution plans. There are worrying signs about investment in Indian equities, too, due to distortions in policies and patchy regulation. More importantly, investors are weary of being told about India's long-term prospects. India sceptics should take a peek at a November 2012 report of the Organisation for Economic Co-operation and Development (OECD) titled "Looking to 2060: A Global Vision of Long-term Growth".

According to this report, in the next 50 years, among the countries surveyed, India should have the highest average GDP growth rate of 5.1 per cent. Even over a shorter period till 2030, India's average growth rate at 6.7 per cent should be higher than any other country. China is projected to grow at four per cent and 6.6 per cent, respectively, over these time periods. For purposes of comparison with the past, the report indicates that from 1995 to 2011 the GDP growth numbers for India and China were 7.5 per cent and 10 per cent, respectively. It is heroic or foolhardy of the OECD to make 20- and 50-year projections.

However, even if the absolute numbers in this OECD report prove to be incorrect, the relative magnitudes of GDP growth rates should be reasonably accurate. GDP growth rates are similar to growth in total sales for companies and may not necessarily be indicative of returns on capital. However, companies with consistently high rates of growth in sales should record high rates of return on equity.

To conclude, the chances of investing successfully in India's equity markets would be higher if investors were to follow Berkshire Hathaway-type buy-and-hold strategies in growth sectors. For example, given India's demographics and rapid urbanisation, products and services associated with just these two factors should record sustained growth. Therefore, it is reasonable to expect that the current clouds of negativism will lift, and returns on long-term investments in India will be relatively high.


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