Peer to Peer Returns

Source: Bloomberg – 23.02.2016

A picture is worth a thousand words, especially, when we have to understand a complex topic like investments and returns. The chart above clearly brings home the point that investments we think are safe and yet give us high returns, are in reality contrary when based on hard data. We all have invested in stock market, mutual funds, fixed deposits and gold, of course, the traditional mode of saving in India. However, have we looked at inherent risks and returns. Let us explore this a bit more.
A. Stock market
Typically all of us would have heard about Warren Buffet, Rakesh Jhunjhunwala and several others who have made fortune in equity market. We talk to our local brokers who will inundate us with multiple ‘cheap’ stocks. And then we get carried by the itch to make that ‘killing’ return, after all, we think that we are not that unlucky and may be this is the instance to get rich! Mind you, investing in stock market is unlike buying a lottery ticket where everyone has same probability of winning. Stock market is a place where people looking to make quick money lose the most, only well-read investors with deep pocket and ability to hold are real winners. Let us further understand investing in stock market, though we will restrict ourselves to brief qualitative overview. Following are some of the key study modules for a stock market investor.

• Industry: This is the starting point. Good company in a good industry is a ‘star’, even average ones are good for investment. So, based on macroeconomic situation and tail winds in the sector, one has to first select industries which are expected to grow fast and have large long term potential.

• Detailed understanding of a Company: Let me ask a question – Would you give money to a person without understanding his financial standing? Hope the answer is a big ‘No’. If so, then why invest in a company without properly understanding its financial standing? One has to analyze return on equity, return on capital employed, cash flows, debt levels, working capital, capital expenditure plans etc. to shortlist the companies. Next step is to understand the quality of management – execution capability and reputation, quality and independence of board of directors etc. As a smart investor, one has to look for sustainable competitive advantage that the selected company will have over its peers.

• Valuation: Again a question – Will you buy a piece of land without inquiring the price of adjacent plots? Similarly, for stocks. In fact stocks are even harder to evaluate as the sector itself might be overvalued, which will make comparison with peers a futile exercise. Nevertheless, comparison with peers is a quick way to understand if we are paying the right price. Backed by cashflow analysis, this is likely to give good indication of current valuation.

• Timing the Exit: This is the trickiest one and even experts falter more than often. However, research done by elite institutions clearly indicates that retail investors like us are even poorer in timing the stock market. We enter the market near its peak (riding on excitement) and sell near its bottom (out of fear)! Primary reason is information asymmetry when compared to big players who have higher resources to get regular pulse of the market.

It is not our intention to scare retail investors from investing in stock market but to give a glimpse of inherent risks which many of us are not aware of as we have short term memory by looking at people making fantastic returns for a while.

B. Mutual Funds
As per many studies conducted by various academics, on an average, mutual funds give lower returns than stock market index on a long term basis (and mutual funds are for long term investment, ironical I would say!). So, since the market is yielding negative / single digit returns (refer picture above), how would a poor fund manager give 20%+ returns? Impact on returns is compounded by the costs involved in managing the fund which includes mouth-watering salary of management team and profits taken home by them in good years in which they beat the market (of course no penalty for losing shirt in bad years!). One can argue that there are several funds giving superior returns. To answer simply, we would suggest analyzing all the funds managed by that fund manager over last 15 to 20 years including those which closed due to poor performance (also called survivorship bias). Answer always lies in details!

C. Gold
The picture above gives the recent ‘returns’ story from our longtime friend. However, it is important to understand that at times of global meltdown, gold and US Dollar are two safe investments. So, one should judiciously invest in gold.

D. Fixed Deposit
At last, having burnt fingers, people switch to fixed deposits and settle for low but safe 7% – 9% returns. But why to settle for low returns when other high return avenues of Peer to Peer Loans are available.

E. Peer to Peer Loans (P2P)
This is relatively new model of investment. It helps individuals like us to lend to real people to meet their real requirements and earn interest rates in 12% – 25% (30% in some cases) range. While it is still at a nascent stage in India, it is one of the leading means of investment in countries such as the US, the UK, Germany, China etc. However, since most of the P2P platforms list unsecured personal loans, these at times tend to discomfort some of investors. A key risk mitigant is that P2P loans are debt products backed by legally enforceable loan agreements and postdated cheques from borrowers. A defaulting borrower can easily be taken to court for recovery of dues. On the other hand, there are no similar provisions in case of loss suffered in mutual funds, stock market, gold, real estate etc. which are perceived to be safe! Another key point is to select credible platforms which diligently assess the risk of borrowers, list quality loans for investment, provide guidance to investors on appropriate interest rates and follow up with legal action in case of default or delayed payments on behalf of investors. On their part, investors should also be careful and invest small amount of money in multiple loans so that portfolio is diversified and there is less impact from singular events.

We strongly suggest the investors to properly evaluate the investment options and invest their precious and scarce capital judiciously. Though historical returns are no guarantee for future performance, yet provide invaluable information and should be considered in making investment decisions.