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Sunday, December 24, 2006

Diversifying, key to success

With an eye on inflation, it would be prudent to start planning one's investment strategy young as it offers the advantage of compounding. The basic principle is to save regularly, says Mr Manoj Shenoy, Regional Director, Anand Rathi Securities Ltd.

In the long term, equity is the best bet against inflation; in the last 25 years, it has given an average return rate of 17 per cent. But the key to success is to diversify, be realistic in expectation of returns and invest for the long term. But here is a warning: "Put a structural framework in place that allows you to remain emotionally detached from your investment — a detachment that is vital if you have to make intelligent decisions based on rational analysis of a business rather than emotional reactions to changes in market prices."

A business is only worth the cash flows that it will generate from today until doomsday, discounted back to the present value at an appropriate rate. "Without the ability to arrive at an independent, reasonable, valuation, you'll be vulnerable to unethical promoters who simply push seemingly attractive (often high-priced) initial public offerings or the like," he says.

Aggressive techniques

Mr Shenoy advises investors to spot the aggressive accounting techniques of the company they invest in. Many new investors do not realise that the reported net income and earnings per share in a company's annual report are, at best, a rough estimate. That is because even the simplest business with the cleanest balance-sheet has numerous estimations and assumptions that the management must make — the percentage of customers who are not likely to pay their bills, the appropriate rate of depreciation on buildings and machinery, the estimated level of product returns, and that is just a few of the most obvious examples, he asserts. So "Unscrupulous managements can game the numbers to appear better than they are by utilising aggressive accounting techniques. Knowing how to spot these is vital to protecting yourself."

Mr Shenoy says it is surprising how few people actually know how their company makes money. Coca-Cola, for example, does not generate most of its profits from selling the drink you pick up at the grocery store. It does so by selling concentrated syrups to bottlers throughout the world who then create the finished beverages for retailers.

A diversified portfolio

Which portfolio, for example, would one would consider more diversified? Portfolio A that has ten stocks, comprising three banks, two insurance companies, and five real-estate companies; or Portfolio B with five asset classes, comprising a real-estate player, an industrial giant, an oil company, a bank, and an international mutual fund?

In this case, the surprising answer is that, one would probably be more diversified owning five non-correlated stocks as in Portfolio B than twice as many equities in similar industries. That is because when troubles come, they often affect entire sectors of the market; witness the banking crisis of the late 1980s or the real-estate collapse around the same time, Mr Shenoy says. Warren Buffett has often mused that stocks are what people want in less number as they get cheaper.

In every other areaof our life, we typically rejoice at a sale, whether it is on hamburgers, silk ties or automobiles. As equities get less expensive, however, people typically flee from them, often saying, "I'll wait till the price stabilises and starts to rise again." This makes no sense, he says.

Finally, a rider from Mr Shenoy: "If you are unable to watch your holdings fall by 50 per cent or more without panicking or liquidating your positions, you should not be managing your own investments."

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