Use the SIP method instead of a 'wait-to-invest' policy.
Will next year dawn sunny with the recession easing off? It could happen - 12 months ago, few people thought 2008 would see a global recession. Similarly we could see a quick recovery in 2009.
But it isn't likely. The real economy will almost certainly get worse before it gets better. If there's an armed conflict between India and Pakistan and the odds on that are short, it could get much worse. There is domestic political uncertainty as well.
Capital is scarce both in India and abroad and that means delayed projects. Earnings are likely to be flat or negative through the next two quarters. Tight cash-flows through FY 2009-10 means debt servicing will be a struggle and there could be defaults hitting banks and other lenders.
How much of this gloomy scenario has been factored in by valuations? After all, the market has dropped over 50 per cent since January, presumably in anticipation of bad times. Do current valuations justify buying in a market with weak projections?
During the great Depression, Ben Graham's preferred style of valuation laid emphasis on break up value and ignored future profits. His argument was that if the chance of bankruptcy is high, he would like share prices to be below book value or at least, close to BV. That way, if the business delivered profits, there was a definite upside and if it went into bankruptcy, he got his capital back.
The Nifty is down to a PBV of below 2.5 from heights of 6. By historic Indian standards, that's a buying point since the market very rarely drops below those levels and is far more often traded above PBV 3. But by Graham's conservative methods, there's a still a large premium being placed on future profits and so, there's significant risk.
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Later thought processes on the same lines as Graham include Tobin's Q ratio. Q compares the cost of replacing a business with the current market value of the business. That is, if it will cost X to replace a running business and Y is the current market value of said business, Q equals Y:X. Q is usually calculated as (Market value+ Liabilities) divided by (Paid up capital+ free reserves+ Liabilities). In practice, Q is quite similar to the PBV.
Tobin theorised that during low Q periods, greenfield investment is low because it's cheaper to buy running businesses. Vice-versa if Q is high, fresh start-ups are common since start ups are cheaper than buying running businesses. Hence a low Q/PBV market attracts secondary market investment which gradually pulls Q up, while high Q markets create strong IPO interest.
Certainly IPO interest was very low in 2008 and it's likely to stay low in 2009 for there are no big issues on the anvil. Is the PBV low enough to attract secondary market interest yet? Maybe not. The danger of political turmoil and possible war will lead to a lot of fence-sitting from smart money. If that happens, prices won't go up till mid-2009.
A new-fangled approach could be based on option pricing to quantify a "wait to invest" decision for say, six months. Suppose you decide to conserve resources, put together a war chest and invest heavily in June 2009 and later, rather than now. You are acting upon the assumption that the index will be close to current levels (say below 3500) in June 2009.
The latest premium on a 4,000 Nifty Call in June 2009 was about 210 or 5 per cent - that annualises to around 10 per cent, which is well below the current cost of capital. So it seems to make sense to wait with a six month hedge thrown in.
The decision is weighted more heavily in favour of waiting by the fact that you can now generate positive returns in a market where interest rates are falling and must fall further. Debt funds are likely to see strong short-term gains in the next quarter.
One practical way to reconcile the wait versus invest decision is to look at Systematic Investment Plans. If the market drops, so do your average prices. But a classical SIP with equal monthly instalments would have to be staggered over the next two fiscals. Alternatively, you should look to increase the SIP exposures if prices fall.