Investing in capital market: Lessons from ex-post performance

Anyone thinking of investing in the capital market in Bangladesh is most likely to ask a couple of basic questions: what was the average annual return and risks of the capital market in the last 30 to 40 years, and what are the key parameters of investment to look for? First, if you ask about the average annual return of the capital market in Bangladesh, most likely, you will have answers that range from 10 to 16 per cent, but no one can tell you the exact answer and the annual risks. Perhaps most of the investment communities in Bangladesh have not even thought of this, at least in quantitative terms.

From 1987 to December 2000, the monthly annualised average return realised on Bangladesh's capital market is around 13.25 per cent, and annual risk measured in the standard deviation of return is about 32 per cent  (see the graph). How does this number compare to other markets? In the US, since 1926, the average annual return of the S&P 500, the main index to gauge the capital market's performance, is around 10 per cent , with a risk of around 18 per cent . In terms of absolute return, Bangladesh has done well, but our capital market is way too risky if you consider risk, as reflected in its higher standard deviation of return.

People might be interested to know how our capital market performed compared to fixed-income investments such as a bank deposit, which is very safe. A nice way to compare those two markets is to ask- what would be the ending value in December 2020 if you had invested 1 taka in a bank deposit in January 2001 that earns 8 per cent interest per year, and what would the ending value if you had invested in the capital market for the same period. The graph below shows the approximate result. As noted from the graph, the ending value from 1 taka investment in the capital market over the last 20 years is around 8 taka, whereas this is about 5 taka in the fixed income market. The capital market outperformed the fixed income market by approximately 60 per cent over the last 20 years. However, this superior performance tells only half of the story. The other part of the story is that this capital market also brought significant investment risk-- an annual standard deviation of more than 30 per cent.

Risk management of investment is one of the greatest considerations when deciding to make investment in the capital market especially in markets like ours. Risk might arise from business uncertainty, higher price volatility, and unreliable management team of the company that you are considering to invest in. So when you invest, consider the following safety measures to minimise the risk in capital market.

1. SAFETY OF BUSINESS: There are many sophisticated financial models and parameters to understand the business. The bottom line is that ultimately a firm makes money out of business by selling products or services. If a company has a reliable business model to sell its product safely at a good profit margin in the competitive market, it means it has probably secured its business. Look at the product or service the business is selling; can the business sell its product at good profit margin in future? How regulatory changes and industry dynamics might affect its product or services in future and does the company have good business model to respond to such changes? The performance of company with sound business model, better product/service offering should manifest in its key performance metrics such as high cash flow, improved profitability, lower leverage, growth in sales and profitability. For example, it has been empirically documented that companies with high profitability such as return on asset (ROA), return on equity (ROE) gives higher return. Similarly companies with higher growth in sales or earnings perform better. This is true in Bangladesh as well. For example, if all the stocks in Dhaka Stock Exchange (DSE) is sorted based on ROE at the beginning of the year and if companies with the highest ROE are held throughout the year and return is observed and the process is repeated from 2001 to 2019, then portfolio with the highest ROE (HROE) earns 5.24 per cent more return per year on an average than portfolio constructed based on lowest ROE (LROE) (see the table). Similarly portfolio constructed based on higher sales growth (HSG) and higher growth in net profit after tax (HGNPAT) outperforms the portfolio of stocks with lower sales growth (LSG) and lower growth in net profit after tax (LGNPAT) by 14.44 per cent  and 14.29 per cent  per year respectively. Other factors such as size, operating cash flow (OCF), free cash flow to firm (FCFF), and debt to equity ratio (LR) can be interpreted accordingly from the table.
2. SAFETY OF PRICE: No matter how safe the business is, if the price is already high above its approximate true value, it means it is no longer a good investment. We often mistake by readily considering good companies as good investment. A good company might not be a good investment any more if price has already risen above its intrinsic value. For safety of price, look at the P/E (price earnings ratio), dividend yield, and price to book value (P/BV) ratio. Empirically, it has been observed that on an average, companies with low P/E ratio, high dividend yield and low P/BV ratio perform better in future. This observation is true in Bangladesh as well. Portfolio created with low price to book value outperformed the portfolio with high price to book value by 3.91 per cent per year during the period from 2001 to 2019 in the capital market of Bangladesh. Similarly, high dividend yield stocks and low P/E stocks earned 4.44 per cent and 3.09 per cent  more return per year than stocks with low divided yield and high P/E ratio (See the table). 

Investment guru such as Warren Buffet and father of value investment, Benjamin Graham, also suggested buying stocks at a price which is at least 20-30 per cent below its intrinsic value. This discount of price compared to intrinsic value gives a margin of safety for the uncertain future.

3. SAFETY OF MANAGEMENT: No matter how safe is the business or the price, if management is not safe enough to trust with your money, it is always advisable to look elsewhere? Look at the profile and previous experience of the senior management, loan repayment and dividend payment records, previous history of senior management's ability to execute key corporate strategies, compliance with the corporate governance guideline, rule and regulations.

When you can ensure safety of the business, safety of price compared to intrinsic value, and safety of the management, and you are convinced about your investment due diligence, only then go for equity investment. If you are still uncertain, it is always advisable to put your hard-earned money in assets such as bank deposit with which you are comfortable with.

Md  Sajib Hossain, CFA, Fulbright Scholar at Syracuse University, USA and

Assistant Professor, Department of Finance, University of Dhaka.

[email protected]