Is your money safe?

Popular asset classes like real estate, gold and even sectors like FMCG and pharma seem overpriced

A flight to safety can actually mean that hitherto-safe assets become overpriced. This has happened with asset classes like real estate and gold. In both cases, a perception of safety has led to massive investment and prices shooting up beyond "safe levels".

This also happens in the stock market. FMCG and pharma, for instance, are seen as safety plays. Both sectors perform steadily even during recessions. However, both sectors are valued much more highly than index averages.

Another category of stocks that seem to be receiving more attention are stable dividend plays. The classes overlap, since most FMCGs and pharma majors pay regular dividends. But dividend plays in other sectors also receive more investments during periods of uncertainty.

There is a tipping point of over-valuation where a safe asset becomes "unsafe". That is, it no longer promises steady returns, though it could see capital appreciation. Real estate, for instance, is a play on capital appreciation if the rental yield is below interest yield on property price.

Suppose the price of a given property is Rs 1 crore, and the going rental is Rs 5 lakh a year. An owner could sell, put the cash in a fixed deposit earning say, 7.5 per cent, rent his place back and live off the surplus. So, the expected gains from buying real estate in such situations is capital appreciation. (In India, this calculation has to be tweaked for a "black-white" split in property prices, since the black component of real estate prices earns zero or little interest.)

This brings us to a wider question of understanding safety. Safety is not just about preserving capital. There is also the question of beating inflation. If you parked your cash in a bank fixed deposit, you could, barring extreme circumstances, keep capital safe. However, the value would erode as inflation rose. An extreme premium on capital preservation leads to loss of buying power.

Going for a pure capital appreciation play is fine. Anybody who is buying growth stocks (which pay little or no dividend) is gambling on capital appreciation. But it is not "safe" in the sense that you will either beat inflation by some margin by buying growth or you will lose capital.

A dividend yield play is a different game. Buying a stock with a high dividend yield means you are hoping to beat inflation with a mix of steady returns and, hopefully, some capital appreciation. However, when a high-dividend stock is bid up beyond a certain point, the yield becomes insignificant. This is true for the Nifty or Sensex basket of blue-chips. The dividend yield in most of these is below two per cent. The only reason for buying a stock with that low a dividend yield has to be capital appreciation.

It's difficult to gauge Indian inflation because several different indices are used and the data is suspect. The best guess is that inflation has run at a compounded annual growth rate (CAGR) of somewhere between 6.5 and eight per cent for the average middle-class household in the past five years. Those numbers could change but if you're trying to beat inflation, you must target a return higher than that.

Fixed deposits will never yield enough to beat inflation in the long term, which means you need some equity exposure. Given the risky nature of equity, you should probably target a CAGR of above 10 per cent. If a stock gives a dividend yield of 1.5 per cent, you need a CAGR of 8.5 per cent from capital appreciation. Will a "safe" FMCG or pharma holding give that much? On the basis of historical returns, probably. Both FMCG and pharma have regularly beaten the broader indices, which in turn, offer a long-term CAGR of 13 per cent (plus dividend).

Be clear in your head, however, that investing in so-called safe stocks is rarely a "safe" proposition. You need the capital appreciation as well as the dividend yield and whenever capital appreciation is targeted, there is always a chance of capital loss as well.