In Praise of Idleness

Human beings, in general, and investors in particular, suffer from an innate desire to justify what they did in the past. Harmful as it may be, it helps reduce the guilt and keeps intact our mistaken beliefs about out own competence.

Given this background, it may not seem odd to you that last night, instead of completing the Feb issue of Unfair Value, already behind schedule, I was reading an essay called “In praise of idleness”[1] by Bertrand Russell. He recounts a story of the traveler in Naples who saw 12 beggars lying in the sun, and offered a lira to the laziest of them. Eleven of them jumped up to claim it, so he gave it to the twelfth.

It occurred to me that Mr. Market also gives the best returns to the laziest of investors. A hyperactive investor produces best results for his broker, his advisors and the revenue department of his country’s government, but not for himself. But I’ve evidence to suggest that an average investor is hyperactive. Half the time he is jumping from one stock to another and in the remaining half he is cursing himself for not having swapped his defensive stock with a commodity stock that just doubled in a month.

For such investors, I have a message. If someone who became the world’s richest claims that “lethargy bordering on sloth should remain the cornerstone of an investment style”; you better listen. If you can’t, for god’s sake, stop fretting about missing a golden opportunity to make a quick buck in the market.

And now the evidence of hyperactivity! Here is the data of the annual turnover of India’s stock exchanges[2]

NSE equity turnover in 20083,188,510.30
BSE equity turnover in 20081,323,368.41
Total turnover in 20084,511,878.71
Total Market cap average in 20084,588,210.64
Turnover/average market cap98.34%

# All figures in Crore Rs

To understand this let’s merge all listed Indian companies in a company called India Inc. Now, India Inc. has only one share and distributed all its profits as dividends. The turnover percentage suggests that the lone share of India Inc. would have changed hands every year. Based on average market capitalization of the year 2008, the earnings yield of India Inc. was 4.95%. After 14% dividend distribution tax is paid by the company, the investor receives 4.257% as return on his capital. He pays 0.5% to 0.8% of his capital in brokerage, 0.125% in securities transaction tax. I’m not counting the transaction costs on derivative, which will make the equation worse. Last Friday, Feb 20th, the derivative segment turnover was 43,149.65 crores compared to 6,459 crores turnover of the spot market.

You see that the investors fritter away a significant percentage of the returns that their company earns for them, as trading costs. If you add the spreads, fund management fees and fees charged by advisory services, we, as investors, are squandering somewhere between 20% to 33% of our profits to these frictional costs. Warren Buffett, in his article in Fortune Magazine in 1999, had reached the same conclusion and estimated the frictional costs to be around 33% of profits from Fortune 500 companies[3].

In India, the short term capital gains are taxed at 15% but there is no tax on long term capital gains. This means an investor who holds his stocks for less than a year has to generate an internal rate of returns 1.18 times higher than the long term investor, to reach the same after tax returns as the long term investor. In the long run, this small advantage helps the tortoises of the investing world to beat the hares.

Let’s try to understand the reasons behind the tendency to churn the portfolio. The little speculator lurking within the investors makes them susceptible to follow-the-herd mentality. Every boom is characterized by irrational expectations from few sunshine sectors. In the last boom, people went to crazy heights of stupidity while evaluating sectors like retail, power and real estate. These have always been capital intensive, low margin businesses and will always remain so. In Jan 2008, there was no reason for any investor to buy Pantaloon Retail at 100 times its profits, or Reliance Power at more than one lakh crore Rupees, or DLF at more than 2 lakh crores. However, the investors stood in queues to get a chance to participate in the ‘boom’. Reliance Power was oversubscribed 69 times and DLF 4 times. People in resource starved countries like India love standing in queues. A queue is their ticket to get something that is in demand. One of my friends once told me about a similar incident. After an entertaining evening at a rock show, he was standing in a long queue in front of a mobile toilet. Two guys saw the queue and promptly joined it. After sometime, when they couldn’t figure it out themselves, they asked my friend, “What is this queue for?” The queue of IPO investors is made up of many such people.

When the fascination for a specific sector ends in a disaster, the investors rush to the next hottest sector. The stock portfolios that change like the wardrobe of a fashion model, always burn a hole in the pocket.

The misguided self belief of investors, in their ability to time their purchases and sales, adds to the churn. Suppose you hold an auto stock that you like but at the same time you believe that in the short term, the auto industry can throw only negative surprises. You would think you can sell the stock now and buy it back later at lower prices. Similarly there are people who know that the real estate stocks don’t make a good investment, will buy them because they have fallen 90% and the government has announced a package for cheap housing loans. They hope to be able to sell for a quick profit. You may get it right once a while but there is enough empirical evidence to suggest that it does not work. In 1975 article, Nobel laureate William Sharpe, demonstrated statistically that in order to benefit from a market timing strategy you had to guess it right 74% of the time.[4]

We all have a desire to profit from every opportunity that comes our way. It is not uncommon to find the buyers who, having waited patiently for years, jump as soon as the prices fall. If you ask them the rationale behind buying, they will quote the fall in prices. Let’s say you wanted to buy a house and it was quoting at a million dollars and you find the valuation insane. Then the subprime crash comes and you see the same house selling 20% below that price. Now answer this question. If you did not buy that house at 1 million dollars (or Rupees 5 crores) because you thought it was overpriced, why are you using that million dollar price as a base to say the prices have fallen by 20%? Fallen from where? The calculation must always be based on the worth of the house. A similar fascination among stocks investors, with the 52 week highs, is main cause of their troubles all 52 weeks in a year.

There are more ways to make money in equities than you can imagine but most of them are not exciting. It’s no fun waiting in the sidelines for years for a stock and then buying when people around you are losing their job, their home and peace of mind. But one thing is very clear – you are better off with a boring strategy that yields good returns than an exciting, doomed to be short-lived, stint with exotic trading strategies. Once you have the money there are countless ways to buy excitement.

It’s a once in a lifetime experience to watch a cheetah cross the speed of 100 km per hour in a mere 3 seconds while chasing a prey. But it could be even more fun to watch the puzzling phenomenon of how animals like the sloth (typical speed 15-30 cm per minute) manage to survive and thrive in the fiercely competitive natural world”.

Sloths survive on a diet of leaves which give very little energy or nutrition and do not digest easily. Their digestive process takes almost a month and naturally their undigested food accounts for two thirds of their body weight. They sleep 15 hours a day and their metabolism rate is less than half of that expected for a creature of their size. With the help of their long, curved claws they effortlessly hang upside-down from branches, sometimes even after death.

What have sloths done to earn the badge of honour, going by Darwin’s theory of survival of the fittest? Sloths have taken energy conservation to its extreme and turned it into their advantage.

The DNA of value investors should match more closely to the DNA of sloths than to cheetahs. They should be omnivorous like sloths (bonds are as good as stocks if they give better returns at lesser risk…Gold? Why not!). They should preserve their capital as scrupulously as sloths preserve their energy. They should chew their thoughts for months and they should remain hanging to their good stocks for life….sometimes even after death.

P.S.: Having extolled the virtue of laziness, let me state that I’m not proud of my laziness in spheres other than investing because – in Ben Franklin’s words – to be proud of virtue, is to poison yourself with the antidote.

1. In Praise of Idleness
by Bertrand Russell

2. Transaction Volumes

3. Warren Buffett On The Stock Market
December 10, 2001

4. Does Market Timing Work?
Gary Lucido, July 2007

0 comments: Blog Search Engine blog catalog EatonWeb Blog Directory Bloggapedia, Blog Directory - Find It! Blog Directory Directory of Investing Blogs Blog Listings Superblog Directory