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’80% of stocks don’t beat expected return required from equities’

Author: Kumar Shankar Roy/Wednesday, October 9, 2019/Categories: The Finapolis Conversation

’80% of stocks don’t beat expected return required from equities’

The average retail investor does not make money in markets as much as he/she would like. In most cases, they end up selling their best-performing stocks and put that money into cost-averaging their worst stocks. As a result, their stock portfolio looks bad. When markets slump, this gets magnified and disappointed retail investors leave the equity market forever. The two most important things in stock markets is what you buy and at what price. However, most retail investors often lack the know-how. Less than 1 out of 5 stocks actually generate the returns to justify the risk of equity. Stock selection is a tricky art, says Jimeet Modi, Founder, and CEO, Samco Securities. Therefore, retail investors must pick good quality businesses and hold them long enough to see the magic of compounding, Jimeet Modi tells Kumar Shankar Roy.

Why do many retail investors complain they are not making money in stocks?

Pareto principle applies to equity investing. The Pareto principle (also known as the 80/20 rule) states that, for many events, roughly 80% of the effects come from 20% of the causes. We have found 80% of stocks don’t beat expected returns required from equities i.e. 15%. Less than 20% of stocks actually beat expected returns required from equities.

What does your research show?

We found that more than 55% of companies make negative returns. We found that over 70% of companies never beat FD returns. Also, only 17% of companies beat the 15% required equity return threshold. Less than 1 out of 5 stocks actually generate the returns to justify the risk of equities.

Do retail investors buy more wealth destructors versus wealth creators?

There is a wide variance in the number of retail investors holding wealth destructors versus wealth creators. There are examples to illustrate. HUL products are consumed by most Indians. It is owned by only 3,81,651 shareholders. Colgate product is consumed by at least half of India, but it is owned by only 1,83,63 shareholders. Dabur is owned by only 1,92,475 shareholders. Now, take a look at Reliance Power where wealth destroyed was for a massive 31,07,205 shareholders. In Suzlon, wealth was destroyed for 10,06,300 shareholders.

Do retail investors lose more because they lack patience?

The churn of retail investors is very high. Retail investors don’t own stocks for long term. We found that the average period of holding for most companies is below 2 years! Additionally, retail investors are at a serious disadvantage because the stock selection is a tricky art with less than 20% chance of success.

How can investors be wary about potential wealth-destroying stocks? Are there any indicators?

Yes, there are. Biggest contributors of wealth destruction are businesses with low Return on Equity (RoE), businesses with moderate Return on Equity but poor free cash flows, businesses with lumpy and unpredictable cash flows and large discretionary products, commodity nature of businesses. Wealth destruction can happen if you overpay for quality businesses.

Charlie Munger once said that the winner has to bet selectively. As opposed to direct equity investment by retail investors, do mutual funds bet selectively?

Unfortunately even mutual funds don’t follow this simple principle of elimination. For instance, Reliance Nippon Mutual Fund holds 318 stocks. ICICI Prudential Mutual Fund holds 289 stocks. SBI Mutual Fund holds 254 stocks. HDFC Mutual Fund holds 238 stocks.

Is the selection of poor stocks to blame for poor stock market penetration in India?

Financial inclusion and penetration of equity investing in India have not taken off since most of the retail investors actually end up losing money. More than 95% of the retail investors lose money in the stock market and two of the biggest reasons for these are that they do not pick good quality businesses. When they do, they do not hold it long enough to see the magic of compounding. Usually, retail investors end up investing in poor quality companies in speculative hope of earning multi-bagger returns and end up losing a lot of money and never return to investing in equities.

You have launched StockBasket, which is a buy and hold research and investment platform. How does it solve the problems for retail investors?

Each StockBasket is a one-click investment product and is a carefully selected basket of India’s top companies that can help investors create and compound their wealth over a minimum 5-year period. Each StockBasket comprises of 6-25 stocks that are selected by our research team and are filtered based on our proprietary stock rating framework and are constantly monitored by our research experts. Out of a total of 26 baskets currently available on the platform, ‘International Vacation Basket’, ‘Leaders of Tomorrow’, ‘India’s Biggest Brands’, ‘Retire in 2040’, ‘4x target in 10 years’ are some of the unique baskets that investors can pick from.

You said mutual fund houses invest a big number of stocks. Will you be doing any different? How many stocks will form your universe?

Our stock baskets are carefully selected to avoid wealth destructors. This means no infrastructure, airlines, industrials, real estate. There will be no businesses with high debt, poor returns and free cash flows. We will have a selective universe of only 60 stocks. The stock baskets will not be designed to follow any short term trends.

All brokers claim their stock research is great. But once an investor buys stocks, the relationship is over. The entity recommending the stock never faces any fall-out. How are you being different?

Each StockBasket is designed and built to pass the bond test that focusses on the return of capital and generating a return on capital. A flat research subscription fee will be charged to the customers. In case a StockBasket fails to generate any return over a 5-year period, SAMCO promises to refund the entire research subscription fee collected over a 5-year period. Since each basket is designed to pass a bond test i.e. pass the test of return of capital, if an investor earns absolute return of less than 0% after holding a StockBasket for a period of five years from the date of investing, then SAMCO makes a commitment that they will refund the entire research subscription fees collected from customer during this period.

You said many retail investors don't hold stocks for the long-term. How will StockBasket change this?

We have features to align investors to long term thinking. One, all baskets aligned with 5-year price targets. Two, basket constituents are selected to ensure little to no rebalance over 5 year period to ensure compounding benefits over a long period. Three, there will be lower costs due to little to no churning and Long Term Capital Gains. Four, there is a disincentive to exit early – double fees if exited before 5 years. Five, subscription fees will be refunded after 5 years if the absolute return is less than 0%.

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