What the Prudent Stock Speculator is Doing

Lord Keynes once famously said, “A speculator is someone who takes risks of which he is aware, and an investor is someone who takes risks of which he is unaware.” By this definition speculating is far more sensible than investing! To the prudent speculator all that matters is the relationship between price (what you pay) and value (what you get). Experience has confirmed the hypothesis that the simplest route to prosperity is to buy from panic-stricken sellers and sell to euphoric buyers. Simple as it may sound, most individuals find it extremely difficult to buy little known, neglected companies that inevitably result in superior risk-adjusted returns.

Most investors take comfort in owning “great companies” based on a cheery consensus among experts who opine that these wonderful entities “have virtually no risk.” For those who recollect the dominance of India’s largest consumer products behemoth and its legendary management team, it’s worth pointing out that compounded total returns including dividends from 31 December 1999 till date are under 6 percent. Contrast that with what relative midgets like Blue Star (34 percent), Marico (30 percent) and Container Corporation (26 percent) offered investors during the same period. So that brings us to the question of where do we currently stand?

Many “investors” seem intent on guessing what future FII money flows are likely to be. It appears that they are scared of being “left out”. Leading brokerages expect the BSE Sensex to come up with earnings of 1,200-1,240 for the current financial year. That being the case, the market seems fairly valued at 19,300. Based on a number of other yardsticks such as the relationship between dividend yields (1.5 percent) and the return on “riskless” assets (8 percent)  or the equation linking ROE (18 percent+), trailing PE (19+) and price-book (3.5), prices appear expensive. However, it is virtually impossible to conclude that equities should be the asset class of choice over the next 12 months since the potential exists for high and relatively stable returns from here. With corporate profits slated to grow at between 16-20 percent this year and interest rates hovering at just below 10 percent for top-tier companies, there is no way to believe that any margin of safety exists at current valuations.

Is this a call for the grizzly to show up soon? Absolutely not. Sheer longevity has taught me the folly of timing market turning points. The easy money has been made during the last couple of years and while the good news on the US recovery is important, inflation, geo-political upheavals and feckless fiscal and monetary policy measures in the developed markets pose a serious threat to prudent speculators.

Large companies have trounced their smaller brethren by laughably wide margins in the last six months. Given the inevitability of mean reversion, this suggests small companies may do relatively better in the next few months. Scepticism about investing in equities at the present juncture that rational analysis suggests is not in evidence. This is perhaps the most important reason to remain disciplined and selective today and postpone our enthusiasm for the bargains that are likely to crop up in the months ahead.

Disclosure: This column is neither an offer to sell nor solicitation to buy any of the securities mentioned herein. The author, a partner at Fortuna Capital, frequently invests in the shares discussed by him.