Markets on fire: How to make profit without getting burned

Two famous fund managers have started feeling somewhat uncomfortable about the stock market.

One is James Chanos, an American fund manager who is uncomfortable about the US stock market. The other is an Indian, Sankaran Naren of ICICI Prudential, who is uncomfortable about the domestic markets.

Chanos believes that the market has become highly speculative. In fact, he has not seen a more speculative market in his 45-year career except for 2021.

He feels the current US market is as speculative if not more than the market of 2021.

Now, Chanos is a highly successful investor in the US and therefore, when he speaks, it helps if we listen.

When it comes to investing, there is investment and then there is speculation.

Investment is an operation which, upon thorough analysis, promises the safety of the principal and an adequate return. Operations that do not meet these requirements are speculative in nature.

Now, what Chanos is saying is that what is happening in the US stock market is very little investment and too much speculation. In other words, people have become so careless that there is no safety of principal anymore.

Investors are taking huge risks and are risking their entire capital.

Now, to be honest, speculation has always been there in the stock market.

However, as a component of the total investment activity, its percentage has varied over the years. In some years, the speculative activity is on the lower side while it is higher in other years.

Right now, though, the speculative activity is the highest it has ever been in the US stock market as per Chanos.

Let me tell you that Chanos loves to track bad quality companies and also the ones that are trading at very high valuations. He tracks them not because he wants to invest in them. It is the opposite. He tracks them because he wants to profit from their share price collapse.

So, he likes a bubble to develop in overhyped companies with very bad fundamentals and then bets on their stock price collapse. And when the collapse starts, which it does more often than not, Chanos earns his money and walks away with a big, fat profit.

Put differently, he has a keen eye for speculation and therefore, when he is saying that speculation has gone up a lot in the US stock market, it will be foolish to ignore him.

Back home in India, it is Sankaran Naren of ICICI Prudential who is getting a little uncomfortable with the market.

On being asked how one should invest in this kind of market where there is so much liquidity and which does not seem to go away any time soon, here's what Naren replied.

Very tough task because see, over the years and thanks to too much experience I would call it, we are trained to be fundamentalists. We are not trained to think so much in terms of liquidity. We are trained to think in terms of fundamentals and valuations.

And we have seen this phase. In my investing career, I have seen one such phase, particularly in this 94-95 phase, where you had too much liquidity in the market, and we have again this phase.

So, what happens is, when you have too much liquidity and valuations are high and there does not seem to be any threat to the liquidity, there is no margin of safety.

Chanos has used the term 'highly speculative' for the US stock market while Naren has described the Indian market as a market where there is 'no margin of safety'.

If you think about it, the terms 'speculation' and 'margin of safety' have a deep relationship with each other.

When the margin of safety is low, the risk is on the higher side and when the margin of safety is high, the risk is on the lower side.

Let me help you understand with an example. Say a stock has an intrinsic value of ₹100 and the stock is available at ₹50. The margin of safety here is huge.

If a stock has an intrinsic value of ₹100, there is very little chance that it will fall below ₹50, its current share price.

On the other hand, even if it goes up to ₹75 over the next 1-2 years, you will still end up with good returns on the share price of ₹50.

Meanwhile, if the price of the share is not ₹50 but ₹90 right now, then the margin of safety is low. So, if the stock now falls to ₹75, you won't end up with a profit but a loss in the region of 20%.

So, the learning from this example is this:

When a stock with an intrinsic value of ₹100, trades at ₹50 or lower, the margin of safety is high and the speculative element is low. But if the same stock trades at ₹90, then the margin of safety is low, and the speculative element is high.

Therefore, a high margin of safety leads to low level of speculation and a low margin of safety leads to a high level of speculation.

Hence, both Chanos and S Naren are effectively saying the same thing about the US and the Indian stock market respectively.

They feel that the speculative element has gone up in both these markets and the margin of safety has gone down drastically.

Now, this brings us to the next important point.

If the margin of safety is low and if both the markets have become highly speculative in nature, how should one go about investing?

This is especially important when it is quite clear that the liquidity is going to remain strong and there is a good chance markets will keep going higher.

Let me repeat that. How to invest in market where valuations are high, speculation is high, and margin of safety is low, but liquidity is stronger than ever and where markets may continue to go higher?

Well, the solution is quite simple to be honest. You need to buy stock market insurance. Yes, that's right.

You see, you buy normal insurance policies to protect your family, your assets and yourself from financial risk/losses.

Likewise, you also need to buy a stock market insurance to protect yourself against a stock market crash.

And this insurance is nothing but the amount of money you want to set aside as cash or in the form of bonds or fixed deposits.

This proportion of bonds or fixed deposits will depend on how speculative you think the market has become.

If the market is highly speculative and there is no margin of safety, then you can be as much as 40-50% in bonds or fixed deposits or even higher.

If you feel that there is low risk to the market and the market will keep going up, then maybe you can be 75% in stocks and only 25% in bonds. However, keep the bond amount meaningful at all times.

You should not allow it to go below 25%, especially right now when the speculation in the market is on the higher side.

Having at least 25% in bonds or fixed deposits gives you enough money to invest after a market correction when the margin of safety will once again be on the higher side.

So, if you have lumpsum money to invest in stocks right now, keeping at least 25% aside in cash or fixed deposits, would be a good idea.

It is an insurance that will not only minimise your losses in a market crash but will also give you ammunition to buy stocks where the margin of safety has gone up to attractive levels.

In conclusion, the formula is quite simple. When the speculative activity is down and margin of safety is big across stocks, you can have little to no insurance.

However, if the speculative activity is up and margin of safety is very low or is non-existent, then do have substantial insurance in the form of cash or fixed deposits.

And yes, please don't make the mistake of assuming that you don't need any insurance because you are buying the best businesses.

Even the best businesses suffer significant share price declines during a market crash.

No businesses are spared. Megacaps, largecaps, midcaps, smallcaps, microcaps - all stocks fall in a market crash. Hence, insurance is a must, especially during current times when speculative activity is at its peak.

Happy investing.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.

This article is syndicated from Equitymaster.com