Mutual Funds, Moats and Markets
Personal finance, investment philosophies and fun facts - all without the jargon.
Welcome to the third edition of the Bodhi Newsletter! In today’s edition, we cover:
Types of Mutual Funds
Behavioural Finance: Loss Aversion and Financial Markets
Investor Spotlight: Vijay Kedia
Fundamental Analysis 101: Moats
Personal Finance
Types of Mutual Funds
By Subham Sen
In the previous edition, we covered the differences between mutual funds and stocks, net asset value, and the various ways to invest in mutual funds. With that foundation established, it is now important to learn about the major categories of mutual funds available so that we can make informed choices. We often come across names that contain confusing terms like 'Tata Digital India Fund-Direct-Growth' or 'Nippon India Nifty 50 Plan Growth’. In this edition, we'll make an attempt to break them down.
Equity Funds: Equity mutual funds invest in the publicly traded stocks of companies. In India, there are countless equity fund options available, with almost every mutual fund company offering these types of funds if nothing else. Equity funds can be further classified into:
Thematic Funds: These funds invest in stocks based on a specific theme or objective. Some focus on company market capitalization, like midcap, small cap, large cap, or multicap funds. Others target stocks in certain sectors, like technology or green energy. The fund manager selects stocks that fit the predefined theme of the mutual fund.
Index Funds: Index funds aim to match the performance of a market index like the Nifty 50. They hold the same stocks as the index they track. Index funds offer a broad market exposure as well as efficient risk management at low cost compared to other managed funds.
Based on the target of the fund, equity funds can be divided into Growth vs Dividend Funds.
Growth funds focus on investing in companies expected to have rapid earnings growth. The goal is capital appreciation over time. On the contrary, dividend funds invest in companies that pay out regular dividends to shareholders. The goal is generating income from dividends.
Growth funds aim for share price gains with little to nil dividend payout, whereas dividend funds aim for steady dividend payouts to investors.
Debt Funds: These funds put their money in fixed return bearing financial instruments, which are commonly known as debt instruments, as companies and government entities raise debt through these. They include bonds, debentures, corporate fixed deposits etc. Debt MFs are a popular choice when you are looking to mitigate risk by adding a fixed income component to your financial portfolio as they offer low risk, steady returns, higher than traditional FDs but lower than risky stocks.
Hybrid Funds: Hybrid mutual funds invest in a mix of equity and debt. They aim to provide moderate returns between high-risk pure equity funds and low-risk pure debt funds. Might be a great choice for beginners looking for a risk mitigated portfolio.
Based on the source where you will purchase a Fund from it can be divided into Regular vs Direct funds.
Regular MFs are sold through distributors who charge a commission. Like when you buy a mutual fund managed by TATA MF from a platform like Groww or Upstox or Motilal Oswal.
Direct MFs are sold directly by the asset management company without any intermediary. Like buying a TATA MF from directly their website or through their salesperson. There are no commissions charged, resulting in a lower expense ratio.
To understand mutual fund investing in more depth, a recommended read would be Common Sense on Mutual Funds by John C. Bogle, the founder and CEO of The Vanguard group.
Loss Aversion and Financial Markets: How Fear of Losses Shapes Investment Behavior and Market Volatility
By Rishika Jain
What is Loss Aversion?
Loss aversion is a psychological bias that causes individuals to feel the pain of losses more intensely than the joy of equivalent gains. This innate human tendency has far-reaching implications for financial markets as investors are often willing to go to great lengths to avoid losses, even if it means sacrificing potential gains.
Risk Aversion and Investment Choices
The fear of losses can drive individuals to make conservative choices in their investment portfolios. In investment terms, risk signifies the potential for a permanent reduction in your invested capital. As an investment's risk profile increases, so does the probability of enduring permanent financial losses.
Typically, individuals who are risk-averse tend to avoid investing in stocks and instead opt for what they perceive as ‘safer’ alternatives like bonds, certificates of deposit (CDs), and savings accounts. Now, consider the following chart. When you observe the short-term fluctuations in the stock market compared to the guaranteed returns provided by investments like US Treasury bonds, it's evident why some people lean towards risk-averse choices:
However, it's crucial to note that this chart doesn't inherently indicate that stocks are fundamentally riskier. It simply illustrates their higher level of price fluctuation or volatility.
Volatility and Risk
Certainly, stocks exhibit much greater price volatility compared to fixed-return assets like bonds, introducing an increased risk of potential capital loss. Nonetheless, it's important to emphasise that this risk is predominantly short-term in nature and can be significantly mitigated through diversification.
Loss aversion can make investors overreact to negative news and underreact to positive news, causing asset prices to deviate from their intrinsic values. This mispricing can lead to investment opportunities for astute investors. Thus, over a long time period, the historical volatility of stocks has translated into superior returns. This applies only to those investors who are willing to endure and remain invested throughout the temporary market downturns, maintaining a long-term investment horizon in their approach. To illustrate, a 30-year US savings bond purchased today might yield an annual return of approximately 3%, while the S&P 500 has historically delivered an annualized total rate of return closer to 10%.
Market Volatility and Investor Sentiment
In the stock market, loss aversion can result in erratic price movements. When investors perceive losses, they may panic and sell their stocks, contributing to market instability. This overreaction to losses can exacerbate market downturns and crashes after bubbles are often a manifestation of the same. As markets experience losses, negative sentiment can become self-reinforcing, leading to a cycle of selling and declining prices and contributes to an unfavourable environment for businesses.
The Disposition Effect
The disposition effect is a behavioural phenomenon closely tied to loss aversion. It's the tendency of investors to sell winning investments quickly to lock in gains while holding onto losing investments for too long, hoping they will rebound. These factors lead investors to sell their profitable investments too quickly, while concurrently maintaining their underperforming assets with the hope that they will eventually generate gains. This behaviour can lead to suboptimal portfolio management and underperformance.
It's imperative to acknowledge that the fear of losses often drives us to make decisions that may not be in our best financial interest. To mitigate the adverse effects of loss aversion, investors can employ several strategic approaches.
Firstly, diversification can play a pivotal role in minimising the impact of this bias. Spreading investments across a variety of assets and asset classes can help in cushioning against significant losses in any single area, thereby reducing the fear of catastrophic financial setbacks. Additionally, maintaining a long-term perspective is crucial. Recognizing that the financial markets will inevitably experience short-term fluctuations and downturns is key to overcoming the emotional impulse to react to these losses impulsively.
Moreover, staying informed about behavioural biases like loss aversion empowers investors to make informed and rational decisions. By recognising when this bias may be at play, individuals can work to counteract its impact with more objective decision-making.
Investor Spotlight
Vijay Kedia: Mastering Challenges and Opportunities in Finance
By Siddhant Goenka
In the dynamic world of finance, where uncertainty is constant and risks are inherent, the story of Vijay Kedia's investment in Atul Auto stands as a beacon of inspiration for aspiring young investors. Regardless of your background, whether you're a finance enthusiast or a college student embarking on your investment journey, there are invaluable lessons to be gleaned from Kedia's strategic acumen and unwavering belief in potential.
Seeing Beyond Challenges
Kedia's investment in Atul Auto occurred amidst the company's growing pains, a scenario familiar to any budding business. For college students venturing into financial markets, this underscores the importance of seeing the bigger picture. Every investment opportunity comes with challenges; recognizing the long-term potential amid these hurdles can redefine your investment game. Understanding that challenges are temporary, but vision is enduring, empowers you to navigate uncertainties with confidence.
Visualising Future Success
Kedia's investment was about envisioning Atul Auto's future trajectory, not just its present state. This underscores the significance of foresight for young investors. Understanding market trends, emerging technologies, and consumer behaviours empowers you to make informed predictions about a company's future. This proactive mindset is foundational for successful investing. By anticipating future market demands and technological shifts, you position yourself to seize opportunities before they become mainstream, giving you a competitive edge in the financial landscape.
Analysing Strong Fundamentals
Kedia's confidence in Atul Auto stemmed from the company's robust fundamentals. For college students immersing themselves in finance, mastering the art of analyzing a company's financial health, management team, and growth strategies is invaluable. These fundamentals are the bedrock of sound investment decisions, guiding you toward companies poised for sustainable growth. A deep understanding of financial statements and market dynamics equips you to identify undervalued assets and businesses with strong growth potential, enabling you to make well-informed investment choices.
Belief in Innovation and Customer Satisfaction
Atul Auto's commitment to innovation and customer satisfaction resonated deeply with Kedia. This highlights the importance of understanding a company's values. Businesses dedicated to innovation and customer-centric approaches often forge enduring relationships and resilient market positions. Aligning your investments with such ethical values enhances your portfolio's integrity. By investing in companies that prioritize customer needs and innovative solutions, you contribute to a sustainable and ethical market ecosystem while securing profitable opportunities for your portfolio.
The Bottomline
The Atul Auto success story encapsulates the essence of intelligent investing. As a college student passionate about finance, these principles of resilience, vision, and fundamental analysis serve as your compass. Every investment decision should be rooted in knowledge, driven by foresight, and aligned with your values. Let Vijay Kedia's strategic brilliance inspire and guide you on your journey toward financial success in the ever-changing landscape of the financial markets. Remember, in the face of challenges, your vision and understanding of fundamentals can transform obstacles into stepping stones toward investment excellence.
Fundamental Analysis 101: Moats
By Krishna Dixit
An economic moat functions as a sustained competitive edge that shields a company from market share erosion by competitors over the long term. Coined by renowned investor Warren Buffett, the concept draws an analogy from medieval castles surrounded by protective water moats. Similar to the strategic challenge faced by outsiders trying to breach a castle with a wider moat, a robust economic moat makes it more difficult for competitors to encroach upon a company's market dominance.
Till 2016, Buffett had used the word ‘moat’ in the Berkshire Hathaway shareholder letters more than 20 times since 1986.
Identifying businesses with strong moats is not an easy task. For an investor to identify essential moats, one must take into account three important questions:
Why does the business still exist?
What will ensure its profitable sustainability for the next 15-20 years?
What are the causal factors and how sustainable are they?
The last step is to assess the quality of its management. The rate of change of the boardroom, their skills and connections and how diligent they are in ensuring the sustainable earnings for the firm. Studying the management of the business taking into context the accompanying moats makes the business transparent, easy and simple to understand.
Sources of Economic Moats
The reasons behind a company commanding an economic moat may be diverse. An economic moat may be purely qualitative and may not be inferred by ratios, income statements or balance sheets. However, this underlying moat may be the reason behind historical profitability, efficiency and high margins. Some reasons behind the existence of an economic moat are (but not limited to):
Cost advantage: A company may command cost advantage over its peers by the virtue of direct supply chains, economies of scale or an expansive network. D-Mart commands these benefits by virtue of its efficient and huge inventory.
Intangible assets: A company with relevant patents, trademarks and goodwill commands higher profits. Colloquially a scooter in India is known by the name ‘Activa,’ which is reflective of the brand value commanded by Honda in this market.
High Switching Cost: A user may be worse off switching from the existing company due to the high costs involved in the procedure. The tech sector offers some of the clearest examples of the power of switching costs.
Company in Context: Asian Paints
Asian Paints is the largest paint business of India which has positioned itself far ahead from its closest competitor in terms of dealerships, ROCE, and margins. Banking on the tech and margin accumulation, Asian Paints has developed a strong moat which is not easy to dismantle.
Asian paints eliminated the distributors, and started supplying paints to the retailers directly from the factories. This led to the company absorbing more than 90% of the MRP. Its ROCE trend and profits are the testament to this fact. Secondly, Asian paints bought the first supercomputer far ahead from many universities and research institutes. Sitting on this massive pile of data and behavioural insights, Asian Paints efficiently manages its inventory with more than 70,000 dealers.
Therefore, investing and stock-picking is not just a numbers game. You must be intuitive in your analysis and study the business inside out in order to screen the effective moats and other qualitative aspects before jumping on to the income statements, balance sheets or ratios.