In March 2020, the expected returns were high but not a lot of people invested. Now when the markets have zoomed, people expect that the run-up will continue. A lot of people have a misunderstanding of what to expect from the portfolio, also called expected return.
“The market’s not a very accommodating machine, it won’t provide high returns just because you need them” – Peter Bernstein
Rather than give a blanket perspective on what to expect from the portfolio, let’s look at the portfolio from three different perspectives.
1. Index-based investing
2. Large high growth and return companies
3. Small high growth and return companies
Index-based investing
An index is the basket of companies as defined by the index, say Nifty 50 is a basket of 50 companies, and the weight is based on the company's market capitalization.
One way to understand the expected return in an index is to look at earning yield.
Earning yield = Earning / Price
Here is the earning yield of NSE500. At the current time, earning yield of the index is around 4%. Recent low levels of earning yield were last seen in 1999/2000.
The average earning yield is around 5%, a 4% earning yield is not way off. However, a conscious investor may be wary of the current levels before allocating new capital.
“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful” – Warren Buffet
Large high growth and return companies
These companies have been in existence for a long time with a high return on investments and high growth numbers. For example, Asian Paints, Page Industries, Nestle, etc. Although these companies are part of the index, their return profile is different.
The expected return of these set of companies is the expected return on its earnings.
‘Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you’ll end up with one hell of a result.’ – Charlie Munger
A bad quarter, negative macro trend, SEBI investigation, etc., maybe some avenues to buy these companies cheap. Otherwise, these companies trade at a premium. However, if these businesses are held for a long time, the expected return should be similar to its earnings growth, which is usually above 15% p.a.
Small high growth and return companies
Many small companies are leaders in their category. Identifying a good company at a reasonable price is critical. The share price of these companies fluctuates a lot, and so does the earnings.
These companies often have a high return on investment, but their growth trajectory is yet to be defined. Therefore, the path needs to be studied well by the investor, and the position is scaled up gradually.
These opportunities would often be available irrespective of what is happening in the market. However, evaluating them and keeping a watch on these opportunities is the key. One critical aspect is that management should not engage in non-core activities, i.e., the focus should be only on the core business.
So, if you are an index investor, the return expectation should be muted. However, if you invest in large-sized quality companies, the expected returns may be enhanced depending on the expected earnings growth. A small quality company is a path to becoming extremely wealthy but staying course and controlling your behavioural biases is the key.
Disclaimers
Investment in securities market are subject to market risks. Read all the related documents carefully before investing.
The securities quoted are for illustration only and are not recommendatory.
Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.
Details of the advisor
Advisor: Ankur Kapur
SEBI RIA No.: INA100001406
BASL Member ID: BASL1337