Book Review: Free Capital

“Free Capital” by Guy Thomas is a collection of biographical sketches of twelve individual investors who have made a living exclusively out of investing in the stock markets. The individuals have varying academic backgrounds and previous job profiles – usually unrelated to investing or fund management, and at some stage in their life have given up regular day jobs opting instead to focus exclusively on investing to make a living. All of them have exceptional track records and have built a fortune from modest beginnings.

The term “Free Capital” here refers to the corpus of savings the individuals have started with, essentially what is left over out of regular income such as salary after meeting day to day living expenses. Many of the individuals have chosen to remain anonymous in the book, with the author using dummy names instead.

Individuals who gave up day jobs to become full time investors

All of the investors have taken a different path to success. There are some who make broad macro calls such as on cyclical industries or commodity prices. Others use a bottom up approach, studying company fundamentals to exploit gaps between price and value. Some are day traders, investing for periods from just a few minutes to a few hours, while there are others who take upto 25 percent stakes in their target companies and put pressure on the managements to change course and create value. To each, his own. The book amply demonstrates that when it comes to investing, there is no One Way that is the Right Way to success. You have to choose what suits your style and temperament, and evolve over a period of time.

Despite these differences in investing styles, it is interesting to see some common patterns emerge from the profiles of these investors. There are similarities in personality traits and even personal backgrounds in many – though not all – cases.

This is not a typical investment book, though there surely are many nuggets of investing wisdom. The book does not seek to teach how to invest, or provide a roadmap for making successful investments.  The book narrates the personal stories of profiled individuals, as brought out from their own detailed interviews and the author’s external research on them. Free Capital is a small book that you can easily finish off in a few sittings.

If you are looking for an inspiration in your investing journey, this book will do the job.

The real truth behind long term investments

“Our favorite holding period is forever” – Warren Buffet

Financial advisors, fund managers, research analysts and other elites of the investing community always claim that ‘equities provide the highest return among all asset classes in the long run’. The pink press regularly dishes out data comparing long term returns from various assets classes, such as equities, gold, real estate, bank deposits and so on. Usually, stock market indices such as the BSE Sensex or NSE Nifty are used as proxies for returns from equities. Stories of successful “long term” investors such as Warren Buffet, serve as useful mascot to support these claims. The consensus currently, in the personal finance community, is that to create serious wealth, you need to invest in equities, and stay invested for the long term.

Rakesh Jhunjhunwala

Rakesh Jhunjhunwala is among India’s best known investors and needs no introduction to the investor community. Recently, I came across a study published by financial newspaper 'Mint'. The study analyzes 91 stock market investments of Mr. Jhunjhunwala in 84 companies (some companies were bought & sold more than once, hence the difference) over the last 10 years where he has held more than 1% stake at any point of time. Under extant regulations, investments above 1% of a company’s share capital are required to be disclosed to the stock exchanges, hence this is publicly available data.  Before we proceed, I urge you to read the full Mint article here.

The study finds that Mr. Jhunjhunwala’s “…average returns have been highest from stocks he held the longest”. The message for the lay investor, is that the longer you remain invested in a stock, higher your return. This argument is supported by a quote in the article, attributed to a professor from IIM, Kozhikode, “In the long run, stock markets in general have been seen to move in an upward direction. Therefore, the longer you hold on, the probability of superior returns is quite high” (emphasis mine).

However, this conclusion is not even half the story.

Behind every successful 'long term' investment are nine other not so long term investments

In fact, the Mint study finds that average holding period of Mr. Jhunjhunwala for these investments is just 3.44 years. In 26 out of the 91 investments (i.e. 29% of the time), Mr. Jhunjhunwala has exited the investment in less than one year. The article itself quotes a study of Warren Buffet’s investments, which found that “he held most of his stocks for approximately a year. He held his stake in only a fifth of his companies for at least two years.” Clearly, Buffet’s favorite holding period may be forever, but only 20% of his investments enter even the third year. This is quite at variance with the conventional image of these “long term” investors, who are thought to hold their investments for decades, not just years.

Even the market indices such as Sensex or Nifty that are used as proxy for the equity asset class are not static. Their composition changes frequently as some stocks are removed and others added. An article in The Hindu points out (click here) that between the period 2002 to 2012, the Sensex delivered a compounded annual return of 17%. Very attractive by all means, but during this period the index was reshuffled 18 times, with 26 of the 30 stocks replaced! I am sure if returns were calculated using the same stocks which existed at the start of the period, they would certainly not turn out to be as attractive.

Conclusion

The Mint article makes a reference to some of Mr. Jhunjhunwala’s best known investments (such as Titan, Lupin etc.) which he has held for decades. However, to state that these investments have provided best returns because they have been held the longest is to put the cart before the horse. The truth in fact, is the other way round.

These investments have been held the longest because they have provided the best returns.

The strategy of ruthlessly exiting mediocre investments quickly seems as much an integral part of Mr. Jhunjhunwala’s (or Warren Buffet’s) success as holding on to best for 10 years or longer. And the ability to differentiate between what to exit and what to hold on is what makes these investors stand apart from the rest. Not an easy act to follow. 

Returns or Inflation?

Between July 2008 and today, the Indian Rupee has lost 40 % of its value.

Talk about rising prices, and discussion in the media inevitably revolves around the Inflation Rate. The Finance Minister talks about the Inflation Rate, so does the RBI Governor, the experts on TV channels and journos from the print & electronic media – all you get to hear from them is the Inflation Rate. Further, more often than not, they refer to the WPI (Wholesale Price Index), while what matters to the people is the CPI (Consumer Price Index). A meaningful analysis of how rising prices are hitting the venerated (just for namesake!) 'aam aadmi' is therefore, conspicuous by its absence. To understand why I say so, you first need to know what the problem with the Inflation Rate is.

This is what they show you - falling inflation (click to enlarge)

The Inflation Rate shows the difference between price of a commodity (or price index) over a period of one year. It compares the current price of a commodity with its price at the same point of time a  year ago. So if the price of loaf of bread was Rs.20 exactly one year back, and it is Rs. 22 today, we say inflation rate is 10 %. (Rs.2 over Rs.20).

But the inflation rate completely ignores prices more than one year away. If your perspective is long term, as it should be, the current inflation rate will tell you nothing about how prices have risen over a longer period of time. If prices double in a year, and remain where they are for another year, you will get an inflation rate of zero, though over a two year period, prices would have gone up by almost 50 % per annum. Therefore, while inflation rate has its uses, it is also important to look at the actual price index itself, to get a proper perspective on prices. Unfortunately, the media, and their  so-called experts are rarely interested in such finer details.

This is what the truth is - ever rising prices (click to enlarge)

Take a look at the news items, such as this or this or this Rarely will you find a mention of the actual price index. So I thought it would be worthwhile to see what was has happened to prices actually, rather than the inflation rate since July 2008. I used the Consumer Price Index (CPI), and not the Wholesale Price Index (WPI), since that is what matters the most to the people. What I found out was what I told you in the first sentence of this article – the Rupee has lost 40 % of its value in the last three & half years. The CPI (IW) which was at 143 on  31^st July, 2008 stood at 199 on 29^th February, 2012, almost 40 % higher. What does this mean? In simple terms, what ever Rs.100 could buy in July 2008 costs Rs.140 today. 

Now, if you were to adjust any of the current prices to this, you will get the real picture of price increase / decrease during the period. Adjust Sensex or the Nifty to this, and the indices which apparently have given a return of 24 % during this period actually end up with a loss of 11% ! Even property price rise has been very modest (19 % in 3 & 1/2 years) while Gold has performed the best.

As on	31-Jul-08	29-Feb-12	29-Feb-12*	Real Returns
CPI (IW)	143	199	143	0%
Sensex	14356	17753	12757	-11%
Nifty	4333	5385	3870	-11%
Gold@	12530	28599	20551	64%
Property#	117	193	139	19%

(* Inflation adjusted level) (@ MCX Spot price per 10 gms) (# NHB's Residex for Mumbai) (All Returns are absolute, not annualised)

To assess the price performance of anything over the long term, you need to deflate it with the price level. That is when you will get the real picture.   

Note: In 2011, the Government issued a new series using 2010 as the base. As per the new series, the inflation rate is 9.45% and 10.30% for Urban India in February and March 2012 respectively, even higher than what the above figures indicate. For want of adequate history, I have used the old series of CPI in my calculations above. 

The Villagers and the Monkeys

Once upon a time, a man appeared in a village and announced to the villagers that he would buy monkeys for Rs.10/-. Since there were so many monkeys around, the villagers started catching them. The man bought hundreds of monkeys at Rs.10/- each, and kept them in a huge cage for all to see. As supply started to diminish, it became a bit difficult to get new monkeys and the villagers stopped their efforts.  The man now announced that he would buy monkeys at Rs.20/- per monkey. The villagers now renewed their efforts and started catching monkeys again. Soon, the supply diminished even further and people started going back to their farms. The offer rate now increased to Rs.25/- and the supply of monkeys reduced even further. The man now announced that he would buy monkeys at Rs.50/- ! However, he had to go to the city on some business, and would return after a couple of days. Till then, his assistant would look after the monkeys kept in that cage. When the man was gone, the assistant told the villagers – “Look at all these monkeys in the cage that the man has collected. I will sell them to you at Rs.35/- each and when the man returns from the city, you can sell it to him for Rs.50/-.” The villagers liked the idea, and squeezed up all their savings and bought the monkeys back. Then, then the assistant too left with all the money and never returned.  

Welcome to the Stock Market.