The business of investing is all about predicting the future. When an investor endeavours to predict the unknown and when his thoughts and actions influence the outcome of events, it involves taking risk.
Most times, retail investors flit from being risk averse to being risk-seeking individuals. Conventional wisdom is that when the indices are constantly moving up in the midst of a raging bull market, an investment in stocks is considered least risky. When the markets face correction and move downwards, everyone panics and presses the ‘sell’ button. Stocks are then considered risky assets.
Sadly, as most serious, value investors are aware, the converse is true. Risk is at its lowest when markets are in free fall and is at its peak when markets defy gravity. We must understand that risk is being accumulated as the markets move up and come down when markets collapse.
Dealing with risk
One has to deal with risk explicitly. For that one has to first understand his or her tolerance to risk; second, one has to make a fair assessment of risk at current levels; and third, the realisation that we have no control over the outcome of investments but that we have complete control over the consequences, is key.
Value investment teaches us that one can achieve high returns with very low risk. This happens when we buy a stock for less than what it is actually worth. This is possible even in a raging bull market as the following example illustrates.
Manappuram Finance Ltd. is a company with a long profitable track record. The business of the company is similar to that of a gold pawn shop. It finances retail consumers who are willing to pledge their gold for a loan to meet their urgent requirements.
The net interest margin, which is nothing but the difference between the borrowing rate of the company and the lending rate to the consumer, is very high.
The biggest risks in finance companies are two fold: one, the value of the pledged assets drops and the customer defaults; and two, even if the price of the asset is high there must be a ready buyer for the asset at the quoted price. Assets which have a ready market are called liquid assets.
For some strange reason, the stock, in the midst of a raging bull market was available below its book value at ₹21.45 in September 2015. If you had bought the stock you would have gone against conventional wisdom. However, you would have been aware of two things: in rupee terms, the price of gold does not collapse and that there is a liquid market for gold.
You would have also known that most Indians do not have easy access to credit. The only way the masses can access immediate credit is to pledge their family jewellery.
Endowment effect
It is a known fact that most of us have an emotional connect with jewellery. Behavioural economists call it endowment effect. We try very hard not to default on jewellery loans. The company, in the subsequent five quarters, has declared a dividend of 50 paise per share every quarter. The stock recently traded at ₹100 on October 2016. In a recent correction, it declined to ₹61 in December and rebounded to ₹103.90 in February.
So, it was evident in 2014 that the stock was available at a discount to its intrinsic value at no risk and is today trading at close to three 3 times its intrinsic value.
(The writer is an author and consultant)
