Last week a media person asked me a very good question. I thought it deserved a detailed explanation.

She said “The world has not seen such a turmoil ever. You can say keep investing in a SIP for 2-3-5 years, but where is the evidence that with so much of volatility, for equities to do well – is it not better to put money in debt instruments like PPF?”

Very fair question – and since I could not ask a woman her age, let me guess – she must be less than 25 years of age.

When equity markets are low one needs more confidence to be in the equity markets. To be in cash or debt markets seems to be the more sensible thing to do now. Why? Because everybody is doing it….right?

Well the market is a funny animal. It is also a slave of the earnings and another multiple called the ‘price earning ratio’. Without getting into too much of detail let us look at why does a person buy equities?

It is for 2 reasons:

– dividend income (not easy to predict, but at least an attempt can be made) and

– speculative income ( change in price earning ratio – far more difficult to predict).

Now let us take the example of a good company quoting at a price of Rs. 100. Let us assume that this company is T and has an EPS of Rs. 10 and has a price earning of 10 (Rs. 10 X 10 = Rs. 100).

Let us also assume that historically this share used to sell at a higher price earning – of say 15, but as the markets are down (i.e. the people do not want to pay a higher p-e for the market as a whole).

Now over the next 3 years – 2012, 2013 and 2014 the EPS of the company are 12, 18 and 20 respectively. What will happen to the price of the share?

Assuming that the companies future looks bright…etc. the likely scenario are as under:

Market remaining depressed ( i.e. p/e remaining at 10) the prices would be 100, 120, 180 and Rs. 200 over the next 3 years.

Market getting better (i.e. p/e remaining at 15) the prices would be 150, 180, 270 and Rs. 300 over the next 3 years.

Market clearly is a slave of these 2 numbers – there is no escaping at all.

Then why is everybody not buying? Just because of the following fears:

– what if it gets worse than what it is now?

– what if the price-earning ratio goes down?

– what if the earnings of the company go DOWN instead of going UP as you are saying?

– nobody is buying…why should I buy?

– FIIs are selling, why should I be buying?

– Every expert in the media is saying ‘do not catch a falling knife’ – is it not scary?

Frankly there are no easy answers – nor does any one person have an answer to all these questions. I am very comfortable answering these questions POSITIVELY for a large number of listed shares – just as I know that many companies will do badly! So answering for individual companies looks difficult, but as usual I am optimistic on a group.

A SIP in a good mutual fund (or an index if you wish!) over the next 3-5-7 years should see a return better than a debt fund. If you are more scared stick to a balanced fund (like say Hdfc Prudence – 65% in equities) and sit through the troubled times. Like Peter Lynch says one of the factors needed for making money in the markets is the ‘stomach to see churns’…

Answering her question of  ‘Is it the worst time in world affairs’…No my dear girl, no. This is the worst churn that YOU are seeing. Markets have seen famines, depressions, tsunamis, wars, riots, world wars, cold war, epidemics, bankruptcies, insolvencies, cheating, frauds, over optimism, over pessimism, …etc. etc. See a long term chart of say 150 years of the stock market existence – each of these events look like a blip.

The most important thing for an equity market to do well is DEMOCRACY – so next time there is an election – get off your butt and vote. No democracy no markets  – no wealth 🙁